Foreign exchange, or Forex, is the conversion of currency of one country to another. In a free economy, the country’s Currency is valued according to the laws of supply and demand. In other words, the value of the currency can be pegged to another currency such as the dollar, or even to a basket of currencies. The country’s currency value can also be set by the government. However, in most countries floating their currencies against other countries, which keeps them in constant fluctuation.
The value of any particular currency is determined by market forces based on trade, investment, tourism, and geo-political risks. Every time a tourist visits a country, for example, they have to pay for goods and services in the currency of the host country. Therefore, a tourist must exchange the currency of their country for the local currency. The exchange of this currency is one of the factors of demand for a particular currency. Another important factor of demand occurs when a foreign company seeks to do business with each other in a particular country. As a rule, foreign companies will be forced to pay in the local currency of the company. In other cases it may be desirable for an investor from one country to invest in another, and that investment should be in local currency as well. All of these requirements to show a need for foreign currency and contribute to the enormous Size of currency markets.
Foreign currency exchange is carried out globally between banks and all transactions fall under the auspices of the Bank for international settlements (BIS).
For further reading on this topic, see our Forex Tutorial.