Forex
Overview
The foreign exchange (forex or FX) market is the place at which currencies are bought and sold against one another and is by far the largest financial market in terms of the total value of the transactions, since trillions of dollars are traded every day as businesses, investors, governments and central banks convert one currency into another; however, not all currencies have the same value in this market, a small number of important currencies, namely the US dollar, the euro, the British pound and the Japanese yen, hold a leading position in global trading and with regard to liquidity, the currencies of developing economies, known as emerging market (EM) currencies, are traded on narrower and more volatile markets and are subject to a completely different set of rules. To understand the forex market, you need to understand both ends of the spectrum.
Major currencies
Liquidity centres on the main currencies for one reason: the more a currency is already in use, the cheaper and safer it becomes to use again.
When looking at the US dollar, the dollar's position of supremacy is the result of three factors: its role as a reserve currency (central banks all over the world hold dollars, especially US Treasury bonds, as their main safety cushion in times of crisis, according to data from the IMF, about 57% of the world's identifiable central bank foreign exchange reserves are in dollars), the petrodollar system (oil and most of the major commodities are priced and settled mostly in dollars, which creates a constant demand for the dollar regardless of the state of the US economy), and its leading role in trade invoicing (a significant portion of global trade is invoiced in dollars even when neither of the two parties concerned is from the United States).
The pound still plays a bigger-than-expected role because of the size of the UK economy, mainly due to the depth of London's foreign exchange and derivatives markets.
Currencies such as GBP/USD or EUR/USD are influenced by three main factors:
Differences in interest rates (since capital usually seeks higher returns, if the Fed maintains higher interest rates than the Bank of England, assets denominated in dollars become relatively more attractive), trade balances (a nation that regularly imports more than it exports has to sell its currency in order to purchase foreign goods, thus creating a built-in barrier), and safe-haven flows (during times of global stress, investors transfer their funds into dollars, yen and Swiss francs regardless of the state of those respective economies).
A clear example was the situation on 6 August 2025, when the Bank of England's Monetary Policy Committee reduced the Bank Rate to 4 per cent by means of an unprecedented tied vote which led to a second round of voting, the pound reached a session high of $1.34 because traders interpreted the split decision as an indication that further rate cuts would not happen quickly, thus demonstrating how a currency can increase in value even when its own central bank is cutting rates, provided that the market believes other central banks are reducing their rates more rapidly.
Emerging market currencies
European currencies, for instance, the Brazilian real, the Indian rupee, the South African rand and the Turkish lira, differ greatly in terms of risk.
There are instances which show this: in June 2025 the Turkish lira hit 46 to the US dollar as a result of a prolonged and deliberately controlled depreciation, the Turkish central bank having been attempting to reduce inflation in the economy without allowing the currency to collapse completely, inflation having stayed above 60-70% over the past few years.
In April 2025, the Argentine peso dropped by more than 11% against the dollar in one day, this representing its biggest one-day fall since the country's crisis in 2002, after the government led by President Javier Milei had abolished most of its capital controls as part of a new programme with the IMF, thereby placing the peso on a managed floating band.
The examples show the main risks which distinguish emerging market currencies from others: capital tends to pull back (in emerging markets money can leave very quickly when confidence falls, since a large portion of the funds had been provided as portfolio investment rather than as long-term direct investment), inflation is unpredictable, there is political risk (for example, in January 2025 a well-known Turkish opposition politician was arrested, and as a result the USD/TRY rate went up almost immediately, showing that a single such event can have a greater effect on an emerging market currency than months' worth of economic data), liquidity is low (this is because the order books are thin, so prices can rise sharply even with only small volumes), and there is "dollar debt" risk (since so many governments and companies in emerging markets have borrowed in dollars, a decrease in the value of the local currency raises the cost of servicing that debt when measured in local currency and therefore triggers a feedback effect which can make the currency's decline more severe).
In order to cope with this kind of volatility, the central banks in emerging markets still have the means at their disposal which would be entirely impossible in the UK or in the eurozone: direct intervention in the foreign exchange market, the imposition of formal capital controls, and managed floating bands which allow the currency to move only within a certain range.
The carry trade
A common method involves both sides of the foreign exchange market: the carry trade, which is when an investor borrows in a currency that has very low interest rates and then uses that money to purchase assets in a currency that provides a significantly higher return, thereby earning a profit from the difference between the two rates as long as the exchange rates do not move against them.
For many years, the Japanese yen was the currency most commonly used for borrowing, with the Bank of Japan maintaining interest rates near zero while investors worldwide took out loans at low yen rates to reinvest in higher-yielding assets such as emerging-market bonds and US equities.
The strategy works very well until it doesn't: between 2021 and mid-2024, the yen dropped from about 103 to 161 per dollar as the Federal Reserve raised its rates well above those in Japan, leading to an estimated $4 trillion in short-yen carry positions.
When the Bank of Japan unexpectedly announced an increase in interest rates on 31 July 2024, those positions were quickly reversed within a few days, the yen surged sharply, Japan's Nikkei 225 fell by around 20% in less than a week (representing its steepest decline since 1987), and volatility spread to US and
European equities as leveraged positions were simultaneously closed out worldwide. It remains a classic example of how a carry trade built up over years can collapse in a few days when the financing currency changes.
Risks
Although the main currencies make up the least volatile part of the foreign exchange market, they still carry risk, as central bank measures can undermine the current consensus and political events can cause the sterling or the euro to move sharply within a single trading session.
Currencies from emerging markets involve considerably greater risk in all respects: sudden capital flight, inflation shocks, political instability, thin liquidity and the need to service debt denominated in dollars can all lead to rapid and large movements, and as the example of the 2024 yen shows, even funding risks linked to a "safe" major currency can suddenly surface when policy changes occur.