The Foreign Exchange Market

Overview An exchange-rate system is the set of rules established by a nation to govern the value of its currency relative to other foreign currencies. The exchange-rate system evolves from the nation's monetary order, which is the set of laws and rules that establishes the monetary framework in which transactions are conducted. When one currency is traded for another, a foreign exchange market is established. The foreign exchange market or FX market is the largest market in the world. The amount of cash traded exceeds the world's stock markets. Participants in the FX market include large commercial banks, central banks, governments, multinational corporations and other financial markets and institutions. Small retail traders also play a very minor part in the foreign exchange market. The characteristics of the FX market that make it so unique are: the volume of trading, liquidity of the market, geographical dispersion, the 24 hours trading day (except on the weekends), the number and variety of market traders, and the factors that affect the exchange rate. This market has a number of marketplaces where currencies are traded at different rates. To avoid exploitation by arbitragers, difference in rates are usually kept at a minimum. Banks all over the world are involved in foreign exchange trading, but the main trading centers are located in Tokyo, London and New York, allowing the market to remain open 24 hours a day; when Asian trading is ending, European trading is starting, and U.S. trading ends the daily session. Traders do not have to wait for the market to open. Monetary flows and economic changes such as GDP growth, interest rates, inflation, and budget and trade deficits or surpluses, cause fluctuations in the exchange rate. Because news affecting foreign exchange is well publicized, insider information is almost nonexistent in the FX market. The world relies on the foreign exchange market. When buying foreign goods and services or investing in other countries, individuals and companies need to purchase the currency of the country where they are transacting business. Currencies are traded everyday in the FX market to be used for direct foreign investments, import and export needs of companies and individuals, purchases of foreign instruments, and managing existing positions. In addition, the FX market is often used as a means to obtain profits from short-term fluctuations of exchange rates. The U.S. dollar, the euro and the Japanese yen dominate the foreign exchange market. These hard currencies, representing the world's largest industrialized economies, are always in demand and make up 80% of the FX market trades. There are three popular forms of foreign exchange transactions: 1.) spot transactions, 2.) forward transactions and 3.) options. With spot transactions, there is an agreement between two parties regarding a rate of exchange, and the currencies are traded at that rate. In a forward transaction, money does not change hands until a future date. The buyer and seller agree on an exchange rate and the future date when the transaction will occur, regardless of what the market exchange rate is on that date. The future exchange can be a matter of days, months or years. An option is more flexible than a forward transaction. It allows the option owner the right to buy or sell a specific amount of foreign currency at a certain price before the chosen expiration date. Depending on the market, the option owner may exercise his option or allow the option to lapse and buy at the less expensive current market rate. For years, foreign exchange rates were relatively stable or fixed, and were dependent upon the goldexchange standard. The FX market in the past was slow to respond to changing events. Under the gold standard, the currencies were valued by their exchange worth in gold. This system was established in 1944 at the Bretton Woods, New Hampshire Conference. In planning for the end of World War II, the

conference sought to establish stability in the world economic structure. The U.S. dollar was chosen as the base of the system. The values of all currencies were expressed in relation to the worth of the dollar. The dollar was valued at $35.00 per ounce of gold. Problems arose in the 1960's regarding the supply of gold owned by the U.S. government. There were concerns about whether the United States owned enough gold to redeem the dollars accumulated in other countries. In 1971, U.S. dollars were no longer exchanged for gold; and in 1973, the floating exchange rate system that governs the FX market today was put into place. Now, all currencies are valued by the market forces of supply and demand. Since the abandonment of the gold standard, the FX market has become an important part of international economics. With the advent of floating exchange rates, the foreign exchange market has become unregulated. No institution sets rules for trading, and it is not under the supervision of any international organization. When necessary, governments and central banks often work together to restore stability to the FX market. Foreign exchange and international trade are closely connected. Together, they affect the economic situation of people throughout the world.