The FOREX or the Foreign Exchange Market is a global decentralized market for the trading of currencies. This particular market determines the foreign exchange rates for every currency.  While the major participants of the FOREX market are mostly large banks, it does operate through financial institutions that trickle down to several levels. Also, unlike most stock markets, the FOREX market is open 24/7, five and a half days a week. Thus, the market can be extremely active at any point of the day, and prices keep changing continuously.

A short history of the FOREX market:

Unlike most stock markets, the modern FOREX market is fairly new. It came into existence only when the Bretton Woods System collapsed in 1971. This change allowed currencies to be pegged against one another. Since then the investment banks and other entities have been trading on the FOREX market representing their clients.

How significant is the FOREX market?

Let us start off with a fairly simple example. Suppose you want to buy an iPhone from the United States, you can either travel all the way, or have someone get it for you, or get it couriered. 

Either way, your final payment has to be made in US Dollars. You will have to exchange your Indian Rupees to get equivalent dollars at whatever the rate is. If the Dollar increases so does the price of the phone, and vice-versa. This basic exchange rate thus holds a lot of significance, and indirectly affects the price of a large number of goods and services. This exchange rate has now become an indicator of various economic factors for a country.

Alright, but what changes the FOREX rates? To understand this better, we need to categorize the change into 3 categories: short-term, medium-term, and long-term.

Determining exchange rates in the short-term: 

Taking the short term period to be a few days or a few weeks, quite a few factors play a role in these exchange rates. Since the FOREX market is based on pure speculation and does not have the same amount of historical data as stock markets do, there is little room for analysis in the short term. In the short term, rates are generally based on market sentiment and crowd behavior.

Another factor called currency correlation also comes into play. It basically implies that if a certain currency is poised to change in the short term, other few currencies may follow suit later. For example, the working of EUR/USD in pairs is a good example of this. However, most short-term bets are usually speculation, rumors, and basic supply and demand. If the supply is greater than demand the currency will fall and vice-versa.

Determining exchange rates in the medium-term:

A medium-term is generally a period of a few weeks to six months. A lot of geo-political factors come into play for this period. The fundamental factors play an increasingly important role here. The monetary policy is an important factor that drives the exchange rates. The financials of a country and the monetary policy of the central bank are a deciding factor.

The interest rate differentials are probably the most important factors when deciding rates in the medium-term. The interest rates are also a better indicator of rise and fall compared to currency trends and thus influence the FOREX rate too.

Determining exchange rates in the long-term:

Quite a few factors now come into play. The political scenario to foreign policy to even worldwide trends can influence the rate. For example, oil prices can change currency rates worldwide for years. FOREX rates are influenced by a multitude of global and local factors.

Understanding and accurately predicting changes in this rate is important and multiple factors need to be considered. The FOREX market can be very lucrative for people with limited funds. However, a good fundamental based trading approach is required for people searching for long term gains.