The world's largest market
Forex is the biggest financial market in the world — trading over $7 trillion per day, dwarfing stock markets. It operates 24 hours, five days a week, across global trading hubs (London is the largest, handling roughly 38% of daily volume). Unlike stock markets, there's no central exchange: forex trades happen directly between banks, institutions, and brokers in an over-the-counter network.
What drives exchange rates
Interest rates: the most important driver
The single most powerful driver of exchange rates is the interest rate differential between two countries. Higher interest rates attract foreign capital seeking better returns — investors buy the currency to invest in that country's bonds and deposits, driving the currency up. This is why the US dollar strengthened sharply in 2022 as the Fed raised rates aggressively: capital flowed in, boosting demand for dollars.
Purchasing power parity: the long-run anchor
Over very long periods, exchange rates tend to adjust toward purchasing power parity (PPP) — the rate at which the same basket of goods costs the same in both countries. The Economist's Big Mac Index is a famous (and surprisingly useful) informal PPP measure: if a Big Mac costs $5 in the US and 4 euros in France, the "correct" exchange rate implied by PPP is 1.25 dollars per euro. In the short run, PPP is nearly useless as a predictor; in the long run, it exerts genuine gravitational pull.
Fixed vs floating exchange rates
Most major currencies (dollar, euro, pound, yen) float freely — their rates are set by the market. Some smaller or developing economies peg their currency to a major one (typically the dollar), promising to maintain a fixed rate. Pegs simplify trade and reduce inflation uncertainty, but require substantial foreign exchange reserves to defend. When reserves run out, a peg can break dramatically — as happened with the Thai baht in 1997, triggering the Asian financial crisis.
"Exchange rates are determined by the combined force of millions of traders, investors, central banks, and corporations — each with different information and different needs."
What this means for you
Currency movements affect returns from foreign investments significantly. A UK investor in US stocks gained from both the stock market rise and sterling's weakness against the dollar in 2022 — or lost from both if positions were reversed. For most long-term investors, currency hedging adds complexity and cost for uncertain benefit. But understanding forex helps you interpret why global markets are moving and what central bank decisions really mean for your portfolio.