In the modern global financial world, Forex is not only the largest financial market but also a crucial hub for international economic and financial activities. From facilitating international transactions to creating profit opportunities, Forex plays an undeniable role in shaping and supporting the global economy. In this article, we will explore the factors that contribute to the importance of Forex and how it impacts the financial world we know today.
1. FOREX SERVES INTERNATIONAL TRANSACTIONS
Forex plays a key role in facilitating international trade and investment. Through currency conversion, businesses can buy and sell goods in various markets without worrying about currency risk. For example, a U.S. company can easily buy raw materials from a Japanese company and pay in yen, thanks to the Forex market.
Currency Valuation
Forex is the largest and most widespread market in the world, with over 5 trillion U.S. dollars traded every day. The value of each currency reflects the economic strength of a country. If a country’s economy is strong, its currency will appreciate against other currencies.
A classic example is a U.S. company wanting to purchase goods from suppliers in Europe. This company needs to exchange U.S. dollars (USD) for euros (EUR) to complete the transaction. The exchange rate between these two currencies will be determined on the Forex market.
Boosting International Trade and Investment
Forex helps mitigate risks associated with exchange rate volatility, allowing businesses to plan their operations and investments effectively. This facilitates international trade and investment, enhancing connectivity between global economies. Investment funds and international companies often use Forex to convert currencies when they wish to invest in different countries.
For example, a USD-based investment fund wanting to invest in stocks of a Japanese company would need to exchange USD for Japanese yen (JPY) on the Forex market.
Inflation and Interest Rate Adjustment
Through activities on the Forex market, central banks can adjust the amount of cash in the system, influencing interest rates and helping control inflation.
For example, if a central bank buys its currency, its value goes up, reducing inflation. A classic example is the Fed (U.S. Federal Reserve) buying or selling USD on the Forex market to change the amount of cash in the banking system, which affects interest rates.
Global Economic and Financial Information
The Forex market reflects the speculations and predictions of millions of investors worldwide. Any change in economic indicators, such as GDP, inflation, interest rates, or even political instability, can lead to significant fluctuations in the value of currencies. Suppose there is news about political instability in a country, this can create uncertainty in the market, leading to a decrease in the value of that country’s currency on the Forex market.
Support for Commercial Banks and Investment Funds
Banks and investment funds often use Forex to hedge against foreign exchange risk. For example, they can use futures contracts or options to insure against unwanted fluctuations in the value of currencies they hold. Banks and investment funds often use financial instruments such as futures and foreign exchange options on the Forex market to protect against unwanted exchange rate fluctuations.
Creating Investment Opportunities for Individuals
With the development of technology and market accessibility, more individual investors can participate in the Forex market. They can use Forex for investment, risk protection, or profit from fluctuations in the value of currencies.
An individual investor might predict that the euro will appreciate against the U.S. dollar and buy euros on the Forex market. If the prediction is correct, they can later sell the euros at a higher price and make a profit.
2. ASSISTING IN FINANCIAL RISK MANAGEMENT
Forex plays a crucial role in helping manage financial risks, especially those related to currency fluctuations. Here are some ways Forex assists in financial risk management:
Hedging Currency Risk
Businesses and investors often use Forex to “hedge” or insure against currency risk. This helps them protect against unforeseen fluctuations in currency values.
Example: A U.S. company signs a contract to purchase goods from a German company for 1 million euros. However, if the exchange rate between the U.S. dollar and the euro changes, the value of the contract will also change when converted to U.S. dollars. To hedge this risk, the U.S. company can buy a Forex futures contract for 1 million euros. If the exchange rate changes, the profit or loss from the futures contract will offset the change in the contract’s value.
Diversification
Forex provides an opportunity to diversify investment portfolios. Investing in different currencies can help reduce risk due to the volatility of a specific currency.
Example: An investor can hold a portfolio comprising different currencies like U.S. dollars, euros, Japanese yen, and Canadian dollars. If the value of one currency falls, the loss can be offset by profits from other currencies.
Risk Valuation
Forex allows businesses and investors to evaluate currency risk and use this information to manage financial risks. This is often done through financial derivatives like options and futures.
Example: An investor buys a Forex option that allows them to purchase a specific amount of currency at a fixed price in the future. This helps them assess currency risk and protect against unwanted price fluctuations. However, it should be noted that while Forex can help manage financial risks, it also carries its own risks. Traders and investors should always be cautious and fully understand the associated risks before participating in the Forex market.
3. INVESTMENT AND ASSET VALUATION
Forex plays an important role in the global economy, providing a platform for foreign exchange trading and assisting in asset valuation based on currency values. In this section, here are the main categories you should pay attention to:
Foreign Direct Investment (FDI)
Forex plays a crucial role in valuing and executing FDI transactions. For international investors, being aware of the exchange rate and potential fluctuations is essential when investing in a specific country. For example, a U.S. company wanting to set up a factory in Vietnam needs to convert U.S. dollars to Vietnamese Dong for local expenses. The exchange rate between the two currencies will directly impact the investment cost and future profits of the project.
Portfolio Investment
Forex is also related to portfolio investment, where investors buy and sell currencies, stocks, bonds, and other assets across different markets, often for profit-making or hedging purposes.
For example, an investor in the UK wanting to buy shares of a U.S. company will need to convert British Pounds to U.S. Dollars to make the transaction. Any fluctuation in the exchange rate can affect the investor’s profit or loss.
Forex Risk Management
In investment and asset valuation, managing forex risk plays a vital role. Forex provides investors with tools to protect themselves from unforeseen fluctuations in currency values.
An export company in Australia, such as a food producer, signs a contract to sell goods to a company in the U.S. The contract stipulates that payment will be made in U.S. Dollars (USD). However, the Australian company needs Australian Dollars (AUD) for local expenses and investments. They are concerned that fluctuations in the USD/AUD exchange rate could negatively impact their revenue when converting U.S. Dollars to Australian Dollars.
To hedge against this risk, the Australian company decided to use futures or options contracts on the Forex market. They choose to buy a futures or options contract that allows them to sell a fixed amount of U.S. Dollars in exchange for Australian Dollars at a predetermined exchange rate at a specific future date.
Assuming the futures or options contract is set at an exchange rate of 0.75 AUD/USD, the Australian company can be certain that they will receive 0.75 Australian Dollars for every U.S. Dollar they sell, regardless of market fluctuations. This helps them accurately forecast their revenue in Australian Dollars from this deal, aiding in effective financial planning and investment.
Using such futures or options contracts helps the company avoid the risk associated with exchange rate fluctuations, ensuring they can maintain profitability and financial stability despite changes in the international currency market.
Valuation and Categorization of Assets across Different Markets
Forex aids in asset valuation by providing a basis for comparing the value of assets across different markets. This helps investors decide whether to buy, sell, or hold assets.
For example, suppose you are an investor in the U.S. and you want to purchase shares of a company in Japan. These shares are listed in Japanese Yen, so you will need to convert your U.S. Dollars to Japanese Yen to buy the shares. The exchange rate between U.S. Dollars and Japanese Yen will directly affect the price you pay for the shares. If the exchange rate changes (for example, the U.S. Dollar strengthens against the Japanese Yen), the price of the shares will change in U.S. Dollar terms, even though the price in Japanese Yen remains the same.
Therefore, fluctuations in the exchange rate can impact the value of your assets and the profit from buying and selling assets. Additionally, comparing the value of assets across different markets also requires the use of exchange rates. For instance, suppose a house in the U.S. is priced at 300,000 U.S. Dollars and a comparable house in the UK is priced at 200,000 British Pounds.
To compare the value of these two houses, we need to convert the value of one house into the currency unit of the other house. This can only be done through the exchange rate.
4. ENSURING CURRENCY STABILITY
Forex, or the foreign exchange market, plays a central role in the global economy and helps ensure currency stability. Below are some detailed topics on the importance of Forex in ensuring currency stability:
Creating Liquidity
Forex is the largest and widest financial market in the world, with a daily trading volume reaching several trillion dollars. This high liquidity allows investors, banks, and other financial institutions to buy or sell currencies quickly without significantly affecting the exchange rate, ensuring currency stability.
According to the 2019 report by the World Central Bank (BIS), the Forex market has an average daily trading volume of 6.6 trillion U.S. dollars. This immense liquidity keeps the Forex market always ready for any transaction, regardless of the trade size.
Supporting International Trade
Forex plays a significant role in international trade by assisting companies and banks in converting currencies. This allows companies to purchase goods and services from abroad in the local currency, and then pay in their own currency. Stimulating international trade can improve economic stability.
For example, a U.S. company wants to purchase goods from a German company for 1 million euros. The U.S. company will need to convert their U.S. dollars to euros through the Forex market to make this transaction. Assuming the exchange rate is 1 U.S. dollar for 0.85 euros, the U.S. company would need about 1.18 million U.S. dollars to buy 1 million euros.
Providing Investment Opportunities and Earning Profits
Forex provides investors with opportunities to profit from the fluctuations of currency pairs. This can create economic benefits by attracting investment capital and helping to spread risk.
An investor buys 1,000,000 Japanese yen when the exchange rate is 1 U.S. dollar for 110 yen. If the exchange rate later changes to 1 U.S. dollar for 100 yen, the investor can sell their 1,000,000 yen for 10,000 U.S. dollars, earning a profit of 1,000 U.S. dollars.
Adjusting Exchange Rates
Central banks often participate in the Forex market to try to stabilize or adjust the value of their currency. By buying or selling currency, they can influence the exchange rate, helping to prevent excessive currency volatility. During the 2008 financial crisis, the U.S. Federal Reserve (Fed) pumped hundreds of billions of dollars into the financial system through expanded repurchase operations (QE). A portion of this money was used to buy foreign assets, aiming to reduce the value of the U.S. dollar to stimulate exports.
Protecting Against Forex Risk
Forex provides businesses and investors with tools to protect against forex risk. For example, futures contracts and options can help a company lock in the current exchange rate to avoid future price fluctuation risks.
A U.S. company plans to pay a 1 million euro invoice to a German supplier in 3 months. To protect against exchange rate fluctuation risks, the company can buy a Forex futures contract assuming an exchange rate of 1 U.S. dollar for 0.85 euros. When it comes time to pay, even if the actual rate is 1 U.S. dollar for 0.80 euros, the company can still purchase euros at the rate of 0.85, saving about 59,000 U.S. dollars. Thus, Forex plays a significant role in stabilizing currencies and stimulating global economic growth.
Forex not only helps ensure currency stability and supports international trade, but also creates opportunities for traders to profit. Below are some detailed topics on the importance of Forex in creating profit opportunities:
Currency Price Fluctuations
The Forex market is where the value of different currencies continuously changes relative to each other. Traders can take advantage of these fluctuations to buy currencies at low prices and sell them at high prices, profiting from the differences.
Example: A trader buys 1,000 euros when the exchange rate is 1.1 U.S. dollars for 1 euro (totaling 1,100 U.S. dollars). Over time, the rate increases to 1.3 U.S. dollars per euro. The trader then sells their 1,000 euros for a total value of 1,300 U.S. dollars, making a profit of 200 U.S. dollars.
Leveraged Trading
Forex allows for leveraged trading, which means traders only need to put down a small portion of the total trade value. This creates opportunities to earn significant profits from a small investment, though it also increases the risk of losing money.
Example: If a Forex trading platform offers a 1:100 leverage, it means that with 1,000 U.S. dollars, a trader can buy or sell currencies worth up to 100,000 U.S. dollars. If the trader buys 100,000 U.S. dollars and the exchange rate increases by 1%, the trader will earn 1,000 U.S. dollars, doubling their initial investment.
24/7 Market Operation
The Forex market operates 24 hours a day throughout the week, from the opening of the market in Sydney at the start of the week to the closing in New York at the end of the week. This allows traders to participate in the market at any time they wish, creating unlimited profit opportunities.
Example: A trader in London can trade currencies in the middle of the night if there is an important event in Australia or Japan that affects the value of the currency there!
Profit Opportunities from Both Rising and Falling Trends
In the Forex market, traders can profit from both rising trends (by buying and then selling at a higher price) and falling trends (by selling and then buying back at a lower price).
Example: A trader predicts that the value of the U.S. dollar will decrease against the euro. They decide to sell 1,000 U.S. dollars when the exchange rate is 1 U.S. dollar for 0.85 euros. After a while, the exchange rate drops to 1 U.S. dollar for 0.80 euros. The trader then buys back 1,000 U.S. dollars at a lower price, spending only 800 euros, thereby making a profit of 50 euros.
Note: While Forex can create many profit opportunities, it also carries many risks. Leveraged trading can lead to losses exceeding the initial investment, and currency prices can change rapidly and unpredictably. Therefore, those participating in the Forex market should have solid knowledge and understanding of how the market works.
5. PROVIDING INSIGHT INTO THE GLOBAL ECONOMIC SITUATION
The Forex market is the largest and most complex financial market in the world, with over 6 trillion U.S. dollars traded every day. This indicates that the Forex market not only plays a crucial role in financial risk management but also serves as a valuable source of information about the global economic situation. Below are some ways Forex provides insights into the global economy:
Reflecting Economic Conditions
Fluctuations in the prices of currency pairs can reflect the economic condition of a country or region. If an economy is growing strongly, its currency usually appreciates against other currencies.
Example: If the U.S. economy is experiencing strong growth, the value of the U.S. dollar (USD) typically rises against other currencies, like the euro (EUR) or the Japanese yen (JPY). This can be observed in the Forex market with currency pairs like USD/EUR and USD/JPY.
Predicting Monetary Policy
The Forex market often reacts to predictions about monetary policy. Market participants try to anticipate the actions of central banks and accordingly, the value of currencies change.
Example: If the market anticipates that the European Central Bank (ECB) will raise interest rates, the value of the euro may increase against other currencies even before the ECB announces its decision.
Responding to Economic and Political Events
The Forex market often reacts strongly to significant economic and political events. This can provide information about the global economic situation and market perceptions of these events.
Example: During the 2020 U.S. presidential election, the Forex market reacted sharply to the election results. As it became evident that Joe Biden would be the next president, the U.S. dollar appreciated against other currencies as the market predicted that his policies would be favorable for U.S. economic growth.
Indicating Economic Health
Fluctuations in currency pair prices can indicate the economic health of a country or region. If an economy is growing strong, its currency typically rises in value compared to others.
Example: If the U.S. economy is growing strong, the value of the U.S. dollar (USD) usually increases compared to other currencies, such as the euro (EUR) or the Japanese yen (JPY). This can be observed in the Forex market through currency pairs like USD/EUR and USD/JPY.
Predicting Monetary Policy
The Forex market often anticipates monetary policy changes. Market participants try to predict central bank actions, and currency values change accordingly.
Example: If the market predicts that the European Central Bank (ECB) will raise interest rates, the value of the euro might rise against other currencies even before the ECB makes its decision.
Response to Economic and Political Events
The Forex market often reacts strongly to important economic and political events. This can provide insights into the global economic situation and the market’s perception of these events.
Example: During the 2020 U.S. presidential election, the Forex market reacted strongly to the election results. When the results indicated that Joe Biden would become the next president, the U.S. dollar appreciated against other currencies as the market anticipated that his policies would facilitate U.S. economic growth.
Information on International Capital Flows
The Forex market provides information on how capital flows globally. International investors often move their capital to countries with higher interest rates, and this typically increases the value of that country’s currency.
Example: If interest rates in Australia are higher than in the U.S., investors may move their capital from the U.S. to Australia to take advantage of the higher rates. This can increase the value of the Australian dollar against the U.S. dollar, and this will be reflected in the AUD/USD currency pair on the Forex market.
Impact of Global Events
The Forex market also reflects the market’s assessment of major world events, from political crises to natural disasters.
Example: When the COVID-19 pandemic broke out in 2020, many currencies became unstable due to concerns about its negative impact on the global economy. The U.S. dollar, considered a safe-haven currency, appreciated against many other currencies.
