Foreign exchange, known as Forex or FX, trading involves exchanging one currency for another; for example, trading U.S. dollars for the euro or Japanese yen for the euro. Businesses, financial institutions, governments, investors and individuals use the foreign exchange markets to hedge or speculate. The money markets are used for trading short-term financial assets that mature in one year or less, such as federal funds, U.S. Treasury bills and short-term commercial bonds.
Foreign Exchange Markets
The FX market operates over the counter through a global network of banks, corporations and individuals. There is no physical FX market comparable to the New York Stock Exchange for stocks; nonetheless, the FX market is huge. According to a July 2010 "Bloomberg Businessweek" report, global foreign exchange trading was more than $4.1 trillion in April 2010. FX markets were originally developed to facilitate cross border trade conducted in different currencies by governments, companies and individuals.
Foreign Exchange Rates
Foreign exchange rates are determined by several factors. Investment decisions drive rates in the short term. Money flows into markets and countries with the highest return expectations. For example, if the United States' economy is strong, money will flow into U.S. assets, and a higher demand for U.S. dollar denominated assets will increase the value of the U.S. dollar versus other currencies. Other factors affecting FX rates include speculators driving a currency up or down based on expectations of central bank actions; a country's trade deficit: if exports are less than imports, it usually means a lower FX rate; deterioration in domestic economic and political conditions that can lead to a loss of investor confidence and loss in currency strength; direct intervention by central banks to buy or sell currencies in order to influence rates.
Money Markets
Money markets provide an important mechanism for transferring short-term funds from lenders to borrowers. Corporations, governments and financial institutions can invest their surplus cash to each other to fulfill temporary funding requirements. Money market securities are regarded as safe and liquid investments, meaning they can be quickly converted into cash and there is little to no risk of losing the principal. Individual investors can invest in money market securities, such as Treasury bills and commercial paper, directly or indirectly through money market mutual funds.
Money Market Rates
The U.S. Federal Reserve sets monetary policy by setting target ranges for its key overnight lending rate, known as the federal funds rate. This affects short-term interest rates, including U.S. Treasury bill rates, which then influence other rates such as money market rates, mortgage rates and credit card rates. Supply and demand conditions may also temporarily affect money market rates. For example, if investors feel that the economy is headed toward a recession, they may move funds from riskier investments such as stocks into safer money market financial instruments, thus driving their prices higher and rates lower; the reverse is true when investors feel more confident and move in the other direction and toward riskier assets.
