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Forex is short for foreign exchange, but the actual asset class we are referring to is currencies. Foreign exchange is the act of changing one country's currency into another country's currency for a variety of reasons, usually for tourism or commerce. Due to the fact that business is global, there is a need to transact with other countries in their own particular currency.
After the accord at Bretton Woods in 1971, when currencies were allowed to float freely against one another, the values of individual currencies have varied, which has given rise to the need for foreign exchange services. This service has been taken up by commercial and investment banks on behalf of their clients, but it has simultaneously provided a speculative environment for trading one currency against another using the internet. (If you want to start trading forex, check out Forex Basics: Setting Up an Account.)
Commercial enterprises doing business in foreign countries are at risk due to fluctuation in the currency value when they have to buy goods or services from or sell goods or services to another country. Hence, the foreign exchange markets provide a way to hedge the risk by fixing a rate at which the transaction will be concluded at some time in the future. To accomplish this, a trader can buy or sell currencies in the forward or swap markets, at which time the bank will lock in a rate so that the trader knows exactly what the exchange rate will be and thus mitigate his or her company's risk. To some extent, the futures market can also offer a means to hedge currency risk, depending on the size of the trade and the actual currency involved. The futures market is conducted in a centralized exchange and is less liquid than the forward markets, which are decentralized and exist within the interbank system throughout the world. (For a new way to hedge your currency, read Hedge Against Exchange Rate Risk With Currency ETFs.)
Forex as a Speculation
Since there is constant fluctuation between the currency values of the various countries due to varying supply and demand factors, such as interest rates, trade flows, tourism, economic strength, geopolitical risk and so on, an opportunity exists to bet against these changing values by buying or selling one currency against another in the hopes that the currency you buy will gain in strength or that the currency you sell will weaken against its counterpart. (For addition reading, see Top 7 Questions About Currency Trading Answered.)
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