Foreign Exchange Market: What is it?

To buy foreign goods or services, or to invest in other countries, companies and individuals may need to first buy the currency of the country with which they are doing business. Generally, exporters prefer to be paid in their country’s currency or in U.S. dollars, which are accepted all over the world.

When Canadians buy oil from Saudi Arabia they may pay in U.S. dollars and not in Canadian dollars or Saudi dinars, even though the United States is not involved in the transaction.

The foreign exchange market, or the "FX" market, is where the buying and selling of different currencies takes place. The price of one currency in terms of another is called an exchange rate.

The market itself is actually a worldwide network of traders, connected by telephone lines and computer screens—there is no central headquarters. There are three main centers of trading, which handle the majority of all FX transactions—United Kingdom, United States, and Japan.

Transactions in Singapore, Switzerland, Hong Kong, Germany, France and Australia account for most of the remaining transactions in the market. Trading goes on 24 hours a day: at 8 a.m. the exchange market is first opening in London, while the trading day is ending in Singapore and Hong Kong. At 1 p.m. in London, the New York market opens for business and later in the afternoon the traders in San Francisco can also conduct business. As the market closes in San Francisco, the Singapore and Hong Kong markets are starting their day.

The FX market is fast paced, volatile and enormous—it is the largest market in the world. In 2001 on average, an estimated $1,210 billion was traded each day—roughly equivalent to every person in the world trading $195 each day.

Foreign Exchange Market Participants

There are four types of market participants—banks, brokers, customers, and central banks.

• Banks and other financial institutions are the biggest participants. They earn profits by buying and selling currencies from and to each other. Roughly two-thirds of all FX transactions involve banks dealing directly with each other.
• Brokers act as intermediaries between banks. Dealers call them to find out where they can get the best price for currencies. Such arrangements are beneficial since they afford anonymity to the buyer/seller. Brokers earn profit by charging a commission on the transactions they arrange.
• Customers, mainly large companies, require foreign currency in the course of doing business or making investments. Some even have their own trading desks if their requirements are large. Other types of customers are individuals who buy foreign exchange to travel abroad or make purchases in foreign countries.
• Central banks, which act on behalf of their governments, sometimes participate in the FX market to influence the value of their currencies.

With more than $1.2 trillion changing hands every day, the activity of these participants affects the value of every dollar, pound, yen or euro.

The participants in the FX market trade for a variety of reasons:

• to earn short-term profits from fluctuations in exchange rates,
• to protect themselves from loss due to changes in exchange rates, and
• to acquire the foreign currency necessary to buy goods and services from other countries.

It would seem logical that if the dollar weakens, the trade balance will improve, as exports would rise. However, this does not always happen. U.S. trade balance usually worsens for a few months.

The J–curve explains why the trade position does not improve soon after the weakening of a currency. Most import/export orders are taken months in advance. Immediately after a currency’s value drops, the volume of imports remains about the same, but the prices in terms of the home currency rise. On the other hand, the value of the domestic exports remains the same, and the difference in values worsens the trade balance until the imports and exports adjust to the new exchange rates.

Exchange rates are an important consideration when making international investment decisions. The money invested overseas incurs an exchange rate risk.

When an investor decides to "cash out," or bring his money home, any gains could be magnified or wiped out depending on the change in the exchange rates in the interim. Thus, changes in exchange rates can have many repercussions on an economy:

• affects the prices of imported goods
• affects the overall level of price and wage inflation
• influences tourism patterns
• may influence consumers’ buying decisions and investors’ long-term commitments.

Determination of Foreign Exchange Rates

Exchange rates respond directly to all sorts of events, both tangible and psychological—

• business cycles;
• balance of payment statistics;
• political developments;
• new tax laws;
• stock market news;
• inflationary expectations;
• international investment patterns;
• and government and central bank policies among others.

At the heart of this complex market are the same forces of demand and supply that determine the prices of goods and services in any free market. If at any given rate, the demand for a currency is greater than its supply, its price will rise. If supply exceeds demand, the price will fall.

The supply of a nation’s currency is influenced by that nation’s monetary authority, (usually its central bank), consistent with the amount of spending taking place in the economy. Government and central banks closely monitor economic activity to keep money supply at a level appropriate to achieve their economic goals.

Monetary authorities must decide whether economic conditions call for a larger or smaller increase in the money supply.

Sources for currency demand on the FX market:

• The currency of a growing economy with relative price stability and a wide variety of competitive goods and services will be more in demand than that of a country in political turmoil, with high inflation and few marketable exports.
• Money will flow to wherever it can get the highest return with the least risk. If a nation’s financial instruments, such as stocks and bonds, offer relatively high rates of return at relatively low risk, foreigners will demand its currency to invest in them.
• FX traders speculate within the market about how different events will move the exchange rates. For example:

• News of political instability in other countries drives up demand for U.S. dollars as investors are looking for a "safe haven" for their money.
• A country’s interest rates rise and its currency appreciates as foreign investors seek higher returns than they can get in their own countries.
• Developing nations undertaking successful economic reforms may experience currency appreciation as foreign investors seek new opportunities.

Foreign Currency Trading

Traders in the foreign exchange market make thousands of trades daily, buying and selling currencies while exchanging market information. The $1.2 trillion that is traded everyday may be used for varied purposes:

• for the import and export needs of companies and individuals
• for direct foreign investment
• to profit from the short-term fluctuations in exchange rates
• to manage existing positions or
• to purchase foreign financial instruments

In the volatile FX market, traders constantly try to predict the behavior of other market participants. If they correctly anticipate their opponents’ strategies, they can act first and beat the competition.

Traders make money by purchasing currency and selling it later at a higher price, or, anticipating the market is heading down, selling at a high price and buying back at a lower price later.

To predict the movements of currencies, traders often try to determine whether the currencys price reflects its fundamental value in terms of current economic conditions. Examining inflation, interest rates, and the relative strength of the countrys economy helps them make a determination.

Currency Trading Between Banks

Banks are a major force in the FX market and employ a large number of traders. Trading between banks is done in two ways—through a broker or directly with each other.

Brokers: If a U.S. bank trades with another bank, a FX broker may be used as an intermediary. The broker arranges the transaction, matching the buyer and seller without ever taking a position and charges a commission to both the buyer and seller. About a third of transactions are arranged in this way.

Direct: Mostly banks deal with each other directly. A trader "makes a market" for another by quoting a two-way price i.e. he is willing to buy or sell the currency. The difference between the two price quotes (the spread) is usually no more than 10 pips, or hundredths, of a currency unit.

Most currencies are quoted in terms of how many units of that currency would equal $1. However, the British pound, New Zealand dollar, Australian dollar, Irish punt and the Euro are quoted in terms of how many U.S. dollars would equal one unit of those currencies.

The currencies of the world’s large, industrialized economies, or hard currencies, are always in demand and are actively traded. In terms of trading volumes, the FX market is dominated by four currencies: the U.S. dollar, the euro, the Japanese yen and the British pound. Together these account for over 80 percent of the market.

It is not always easy to find a market for all currencies. The demand for currencies of less developed countries, soft currencies, is a lot less than for the hard currencies. Weak demand internationally along with exchange controls may make these currencies difficult to convert.

Types of Transactions

There are different types of FX transactions:

        I.           Spot transactions: This type of transaction accounts for almost a third of all FX market transactions. Two parties agree on an exchange rate and trade currencies at that rate.

           Spot Transaction: How it works

Although spot transactions are popular, they leave the currency buyer exposed to some potentially dangerous financial risks. Exchange rate fluctuations can effectively raise or lower prices and can be a financial planning ordeal for companies and individuals.

One alternative for a company is to pay for the foreign good right away to avoid the exchange rate risk. But no one wants to part with money any sooner than necessary—if the company does pay the money in advance, it loses six months’ interest and risks losing out on a favorable change in exchange rates.

     II.           Forward transaction: One way to deal with the FX risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future and the transaction occurs on that date, regardless of what the market rates are then. The date can be a few days, months or years in the future.

• Futures: Foreign currency futures are forward transactions with standard contract sizes and maturity dates — for example, 500,000 British pounds for next November at an agreed rate. These contracts are traded on a separate exchange set up for that purpose.

• Swap: The most common type of forward transaction is the currency swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date.

In all of these transactions, market rates might change. However, the buyer and seller are locked into a contract at a fixed price that cannot be affected by any changes in the market rates. These tools allow the market participants to plan more safely, since they know in advance what their FX will cost. It also allows them to avoid an immediate outlay of cash.

   III.            Options: To address the lack of flexibility in forward transactions, the foreign currency option was developed. An option is similar to a forward transaction. It gives its owner the right to buy or sell a specified amount of foreign currency at a specified price at any time up to a specified expiration date.

For a price, a market participant can buy the right, but not the obligation, to buy or sell a currency at a fixed price on or before an agreed upon future date. The agreed upon price is called the strike price.

Depending on which—the option rate or the current market rate—is more favorable, the owner may exercise the option or let the option lapse, choosing instead to buy/sell currency in the market. This type of transaction allows the owner more flexibility than a swap or futures contract.

Floating and Fixed Exchange Rates

The FX market was not always quick to respond to changing events. For most of the 20^th century, the exchange rates were fixed, or kept constant, according to the amount of gold for which they could be exchanged. This was called the gold-exchange standard.

Under another system, the gold standard, U.S. households and businesses could exchange their dollars for gold. This practice was abandoned in 1933 during the Great Depression to allow freer expansion of money supply. However, foreign governments were still able to exchange their dollars for gold until 1971, when the United States terminated the gold-exchange standard entirely.

Role of Central Banks

Despite the size and importance of the foreign exchange market, it remains largely unregulated. There is no international organization that supervises it, nor any institution that sets rules. However, since the advent of the flexible exchange rate system in 1973, governments and central banks, such as the Federal Reserve System in the United States, occasionally intervene to maintain stability in the FX market.

There is no standard definition of instability or a disorderly market—circumstance must be evaluated on a case-by-case basis. Sharp rapid fluctuations of exchange rates and traders’ reluctance to be ready to either buy or sell currencies (maintaining a "two-way" market) may be signs of disorderly market.

To restore stability, the central banks often work together. However, a country taking a conservative view on intervention would act only in response to unusual circumstances that require immediate action, like political unrest or natural disasters. Most monetary authorities would be less likely to intervene to counteract the fundamental forces that drive FX markets, such as trade patterns, interest rate differentials and capital flows.

Intervention

The U.S. Treasury has the overall responsibility for managing the U.S. government’s foreign currency holdings. It works closely with the Federal Reserve to regulate the dollar’s position in the FX markets. If the Treasury feels that there is a need to weaken or strengthen the dollar, it instructs the Federal Reserve Bank of New York to intervene in the FX market as Treasury’s agent.

The Federal Reserve Bank of New York buys dollars and sells foreign currency to support the value of the dollar. The Fed also sells dollars and buys foreign currency to try and exert downward pressure on the price of the dollar.

The transactions in the intervention are small compared to the total volume of trading in the FX market and these actions do not shift the balance of supply and demand immediately. Instead, intervention is used as a device to signal a desired exchange rate movement and affect the behavior of investors in the FX market.

The frequency of intervention in the FX markets by the U.S. monetary authorities has reduced tremendously over the last decade. The Federal Reserve Bank of New York intervened only once since 1995.

Central banks in other countries have similar concerns about their currencies and sometimes intervene in the FX markets as well. Usually, intervention operations are undertaken in coordination with other central banks.

Most of the Federal Reserve Bank of New York’s activities in the foreign exchange market are for far less dramatic purposes than to influence exchange rates. The New York Fed often intervenes in the FX market as an agent for other central banks and international organizations to execute transactions related to flows of international capital.

Some countries have special arrangements with other countries to help them keep their currencies stable. Many less developed countries have their soft currencies pegged to hard currencies, so their value rises and falls simultaneously with the stronger currency. Some peg, or target, their currency to a basket of hard currencies, the average of a group of selected currencies.

Countries that are part of the European Union (EU) had pegged their currencies to the euro. There were formulas set for converting from the euro to the currency of each member nation. However, since January 2002, all currencies that were part of the Economic and Monetary System of the EU ceased to exist.

Intervention in the FX market is not the only way monetary authorities can affect the value of their countries’ currencies. Central banks can also affect foreign exchange rates indirectly by influencing interest rates.

Concerns about Eurocurrency

An important side effect of the increase of international economic activity over the past few decades has been the creation and growth of the Eurocurrency market. This is the name given to any bank deposits in any country held in a different country’s currency, like U.S. dollars in a British bank. A great deal of foreign exchange market activity involves the transfer of Eurocurrency deposits.

Eurocurrency, especially eurodollars (approximately two-thirds of Eurocurrency are U.S. dollars) are a source of concern to central banks and regulators because they are "stateless money"—subject to very little regulation. Rules governing currency and bank deposits— such as taxes, restrictions on capital movements and exchange controls—do not apply to the currency in the Eurocurrency markets.

Banks around the world use the Eurocurrency market to move and store funds more profitably than they could in many countries. This poses a problem for countries attempting to regulate capital flows.

International trade and foreign exchange cannot be viewed as two separate economic processes. The two are intimately connected on many levels. Increased trade and investment has brought the FX markets to their present level. Together, trade and foreign exchange affect peoples’ living standards and livelihoods all over the world.

Working across Borders

Many large companies are "multinational" in that they have branches and subsidiaries all over the world. By some estimates, intra-firm trade, or trade between branches of the same company in different countries, accounts for 40 percent of U.S. exports.

Many companies buy and sell goods overseas and others form partnerships with foreign companies so that cooperation replaces competition. This has a profound effect on how companies operate in the global marketplace. Businesses around the world work side-by-side to produce and market products, thereby reducing the economic risks of global production and marketing.

To remain competitive, individuals, companies, and governments all must adapt to the changing global marketplace.

Business practices vary from country to country and may require new approaches to making profits. In the United States, a signed contract is considered all but sacrosanct; in the Far East, southern Europe and the Middle East, the spirit of the agreement can sometimes matter more than the letter.

The "get down to business" approach that the U.S. and German businesses usually favor may be considered brusque or harsh in Japan or Korea. Even small details of business behavior—whether or not to look someone in the eye, tone of voice, exchange of gifts—vary significantly from country to country.

International Organizations and Trade Issues

As trade becomes more and more important to economic well being, international organizations have been formed to facilitate cooperation on trade issues.

The World Trade Organization (WTO), established on January 1, 1995, is the only global international organization dealing with the rules of trade between nations. It was created by the Uruguay Round of negotiations over a 14-year period and has 144 member countries (as of January 2002).

At the heart of the WTO are the various agreements, negotiated and signed by the bulk of the world’s trading nations and ratified in their parliaments. These agreements cover a range of topics:

• reductions in tariffs;
• fairer competition in agricultural trade;
• textiles trade;
• trade in services;
• protection and enforcement of intellectual property;
• issues related to anti-dumping, export subsidies, and safeguards; and
• other non-tariff barriers.

The goal of the WTO is to help producers of goods and services, exporters, and importers conduct their business. The agreements have three main objectives:

• to help trade flow as freely as possible,
• to achieve further liberalization gradually through negotiation, and
• to set up an impartial means of settling disputes.

Another organization, the International Monetary Fund (IMF), was founded at the United Nations Monetary and Financial Conference at Bretton Woods in 1944. The IMF is an international organization of 183 member countries, established to:

• promote international monetary cooperation, exchange stability, and orderly exchange arrangements;
• facilitate the expansion and balanced growth of international trade,;
• foster economic growth and high levels of employment; and
• provide temporary financial assistance to countries to help ease balance of payments adjustment.

The purpose of the IMF has remained unchanged but its operations — which involve surveillance, financial assistance, and technical assistance — have developed to meet the changing needs of its member countries in an evolving world economy.

A related organization, the World Bank, was founded in 1944 with the primary focus of helping the poorest people and the poorest countries. Its mission is to fight poverty for lasting results and to help people help themselves and their environment by providing resources, sharing knowledge, building capacity, and forging partnerships in the public and private sectors.

The Bank for International Settlements (BIS) in Basel, Switzerland, is an international organization that fosters cooperation among central banks and other agencies in pursuit of monetary and financial stability.

The BIS functions as:

• a forum for international monetary and financial cooperation;

• a bank for central banks, providing a broad range of financial services;

• a center for monetary and economic research, contributing to a better understanding of international financial markets and the interaction of national monetary and financial policies; and

• an agent or trustee, facilitating the implementation of various international financial agreements.

The Basel Committee on International Banking Supervision, a committee of the BIS that consists of representatives of some of the world’s largest countries, meets to establish uniform financial and performance guidelines for commercial banks around the world.

The Group of Seven, or G7, was created in 1975 with the objective of setting up a forum, at the highest decisional level and having formalities reduced to a minimum, in which to discuss important macroeconomic and monetary issues. The group was established with the intent of filling the gap created in the management of the monetary system following the breakdown of the Bretten Woods agreement in 1971.

The G-7 consists of the leaders of the United States, Germany, Japan, France, Great Britain, Canada, and Italy. The Birmingham Summit in 1998 marked Russia's official entry in the Group and the creation of the G8. Among other things the Group discusses

• economic issues
• trade relations
• foreign exchange markets

While economic issues still dominate the G8 meetings, discussions on environmental issues and arms control have been included in recent years.

A major change in the economic structures in recent years has been the creation of the European Union (EU). It is the result of a process of cooperation and integration that began in 1951 between six countries (Belgium, Germany, France, Italy, Luxembourg and the Netherlands).

After nearly fifty years, and four waves of accessions, the EU today has fifteen Member States.

One of the main objectives of the EU is to promote economic and social progress. Towards this end, Member States established the single market in 1993 and the single currency was launched in 1999. The completion of the EU’s internal "single market" boosted intra-EU trade, which represents two-thirds of the total EU Member States’ trade.

Suppliers of goods, services and investment from outside the EU have benefited from the single market program, just as much as people and companies within the EU. The EU has been busy consolidating its single market. Traders at home and overseas can market their goods in the EU based on one set of rules. The single market experience may include valuable elements for the multilateral system of the future.

Other nations have moved to build free-trade zones and common markets as well. Under the North American Free Trade Agreement (NAFTA), the United States, Canada and Mexico have agreed to eliminate barriers to trade and to facilitate the cross-border movement of goods and services. The agreement also aims to promote conditions of fair competition in the free trade area and to substantially increase investment opportunities.

Many smaller "trade blocs" are developing all over the world, in North Africa, South East Asia, different parts of Latin America, Eastern Europe and the Middle East. Over the last 50 years more than 100 regional economic agreements have been created.

A possible problem is that competing trade blocs will adopt protectionist policies and slow worldwide economic growth by restricting trade among groups of nations. However, rapid proliferation of trade blocs and free-trade zones has occurred because countries want the benefits of increased trade that accompany lower trade barriers.

The WTO has created a committee to study regional groups and to assess whether they are consistent with WTO rules. The committee is also examining how regional arrangements might affect the multilateral trading system, and what kind of relationship they might have.