Foreign Exchange Basics: How Currency Markets Work

Key Takeaways

• Global FX turnover averaged $7.5 trillion per day in April 2022 (BIS Triennial Survey); the US dollar was on one side of about 88% of all trades.
• FX swaps, combining a spot trade with an offsetting forward, made up 51% of 2022 volume; spot was only 28%.
• Forward exchange rates are not forecasts; they are arbitrage conditions set by interest-rate differentials via covered interest parity.
• The carry trade earns the interest differential between a high-yield and low-yield currency but can lose it all quickly when the high-yield currency sells off sharply.

What It Is

An FX price is a ratio between two currencies. A quote like EUR/USD = 1.08 means one euro buys 1.08 US dollars. The first currency in the pair is the base currency and the second is the quote currency. The number tells you how many units of the quote currency one unit of the base currency is worth.

The market trades almost continuously from Sunday evening to Friday evening ET across Tokyo, London, and New York. According to the BIS 2022 Triennial Survey, global FX turnover averaged $7.5 trillion per day in April 2022, up from $6.6 trillion three years earlier. The US dollar was on one side of about 88 percent of all trades.

The Intuition

Every cross-border transaction settles in some currency. An Italian company paying a US supplier needs dollars. A Japanese pension fund buying European stocks needs euros. A tourist in Thailand needs baht. FX is the plumbing that converts one unit of account into another, and the price reflects supply and demand across trade, investment, and speculation.

Because the dollar sits on one side of most trades, dollar strength or weakness ripples through every other pair and into commodity prices, emerging-market debt, and global equity flows. Reading an FX chart is partly reading a proxy for global risk appetite.

How It Works

FX trades in three main instruments. Spot is immediate delivery, usually two business days later. Forwards lock in a rate today for settlement on a future date. FX swaps combine a spot trade with a forward in the opposite direction, and are the single largest instrument by turnover. In 2022, FX swaps made up about 51 percent of volume, spot 28 percent, and outright forwards 15 percent.

Quote direction matters. If EUR/USD moves from 1.08 to 1.10, the euro strengthened and the dollar weakened. If USD/JPY moves from 150 to 155, the dollar strengthened against the yen. The base currency is the one that is either getting stronger or weaker relative to the other.

Forward prices are driven by interest-rate differentials, via covered interest parity. If US rates are 5 percent and euro rates are 3 percent, the one-year EUR/USD forward trades at a premium to spot that offsets the 2 percent yield gap. The forward curve is not a forecast, it is an arbitrage condition.

The carry trade is the strategy that most directly uses that rate gap. A trader borrows in a low-yield currency (historically JPY or CHF, more recently EUR) and invests in a high-yield currency (MXN, BRL, AUD, ZAR). The position earns the interest differential as long as exchange rates stay stable, but can lose it all quickly when the high-yield currency sells off.

Worked Example

Assume EUR/USD is quoted at 1.0800 bid and 1.0802 offered. A corporate treasurer needs to convert 10 million euros to dollars for an invoice. She sells euros at the bid and receives 10,000,000 x 1.0800 = $10,800,000. The 2-pip spread cost her about $2,000, which is the dealer's fee.

One month later, EUR/USD has moved to 1.1000. If she had waited, the same 10 million euros would have bought $11,000,000. That $200,000 difference is pure FX exposure. Corporates routinely hedge this risk by locking in forward rates at the time the invoice is issued, paying a small premium in exchange for certainty.

Common Mistakes

1. Confusing quote direction. EUR/USD going up means the euro is stronger and the dollar is weaker. USD/JPY going up means the dollar is stronger and the yen is weaker. The base currency is the one that moves with the quote. Getting this backwards flips the entire directional view.

2. Treating central-bank interventions as permanent. When the Bank of Japan or the Swiss National Bank steps in to weaken or strengthen its currency, the move can be dramatic but often fades as market forces reassert themselves. Intervention buys time, it rarely reverses a structural trend.

3. Ignoring carry costs. Holding a short in a high-yield currency or long in a low-yield one means paying the rate differential every day. On a 1-year horizon, a 5 percent rate gap is a real hurdle. Many chart-driven traders forget that spot moves have to outrun carry to be profitable.

4. Underestimating liquidity differences. Majors like EUR/USD have razor-thin spreads around the clock. Emerging-market pairs can gap violently when local markets close or when capital controls tighten. A position that looks cheap to enter can be very expensive to exit.

Frequently Asked Questions

How are FX exchange rates quoted? An FX price is a ratio between two currencies. EUR/USD = 1.08 means one euro buys 1.08 U.S. dollars. The first currency is the base; the second is the quote. If EUR/USD moves from 1.08 to 1.10, the euro strengthened and the dollar weakened. USD/JPY moving from 150 to 155 means the dollar strengthened. Getting the direction backwards flips the entire view.

Why are FX forward rates not forecasts? Forward prices are set by the covered interest parity arbitrage: if U.S. rates are 5% and euro rates are 3%, the one-year EUR/USD forward trades at a premium to spot that exactly offsets the 2% yield differential. Any deviation would create a riskless profit, so the market arbitrages it away. The forward rate tells you about rate differentials, not where the market expects the spot rate to go.

What is the carry trade in FX? The carry trade borrows in a low-yield currency (historically JPY or CHF) and invests in a high-yield currency (MXN, BRL, AUD, ZAR), earning the interest differential. The position works as long as exchange rates stay stable, but can unwind violently when the high-yield currency sells off sharply. Carry unwinds during global risk-off events are among the fastest moves in any financial market.

How large is the FX market? According to the BIS 2022 Triennial Survey, global FX turnover averaged $7.5 trillion per day in April 2022, up from $6.6 trillion three years earlier. FX swaps were the largest instrument at 51% of volume; spot accounted for only 28%. The U.S. dollar was on one side of about 88% of all trades.

What is the bid-ask spread in FX and why does it matter? The bid is the price a dealer pays to buy the base currency; the offer (ask) is the price they charge to sell it. A 2-pip spread on EUR/USD at 1.0800/1.0802 costs a corporate treasurer converting 10 million euros roughly $2,000. Spreads in major pairs are very tight; in emerging-market pairs they can be much wider and can blow out dramatically during stress, making positions expensive to exit.

Sources

1. Bank for International Settlements. "Triennial Central Bank Survey of foreign exchange and OTC derivatives markets in 2022." https://www.bis.org/statistics/rpfx22.htm
2. Bank for International Settlements. "Press release: Triennial Survey shows global foreign exchange trading averaged $7.5 trillion a day in April 2022." https://www.bis.org/press/p221027.htm
3. Federal Reserve Bank of San Francisco. "Interest Rates, Carry Trades, and Exchange Rate Movements." https://www.frbsf.org/research-and-insights/publications/economic-letter/2006/11/interest-rates-carry-trades-and-exchange-rate-movements/
4. International Monetary Fund. "Balance of Payments and International Investment Position Manual." https://www.imf.org/external/pubs/ft/bop/2007/bopman6.htm

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.