What It Means
In the field of economics, the term foreign exchange is defined as a foreign currency, or money. In more common usage, however, foreign exchange refers to the exchange of the currency of one nation for the currency of another. People who travel in foreign countries must exchange their own currency for the local currency wherever they travel in order to pay for hotels, meals, and other purchases. Most international trade requires foreign exchange, too; without it businesses could not buy or sell goods or services beyond the borders of their own country. If a large department store chain in the United States wants to buy thousands of televisions made in Japan, the store must pay for the televisions in Japanese currency (yen) rather than in dollars. The U.S. company would contact its bank, which would arrange to purchase yen for the transaction on the foreign exchange market (or FX market) at a certain price, known as an exchange rate. An exchange rate is the expression of one currency in terms of another. When 1 dollar can be traded for 100 Japanese yen, for example, the exchange rate is 100 to 1.
The FX market is the largest financial market in the world, with more than one trillion dollars worth of currency trading hands each day. The market is comprised of a worldwide network of brokers (agents who arrange purchases and sales) and banks concentrated in New York, London, Tokyo, and Singapore that buy and sell currency.
Currency exchange rates constantly change depending on a number of factors, including supply (the quantity of a currency available for sale) and demand (the quantity desired by buyers), as well as a country’s economic strength, national debt (how much money the country owes to other countries), rate of inflation (the general rise in prices that can cause currency to lose value), and political stability. Thus the countries with the most consistently valuable currencies (the United States, the United Kingdom, the European Union, and Japan) are those with the strongest economies and little political upheaval.
When Did It Begin
Throughout history most trade between countries was conducted with goods rather than with money. For reasons of convenience and portability, gold and silver coins evolved as small, valuable, and easily traded commodities. The coins were made from rare metals whose value was widely accepted. A gold coin minted in one country was worth its weight in gold in any other country.
The eighteenth and nineteenth centuries saw the rise of paper money. So that people would be willing to ascribe value to a mere piece of paper, issuing banks guaranteed that the printed currency could be exchanged at any time for an equal amount of gold (or in some cases, silver) held in reserve at that bank. Most major world currencies came to be backed by gold and silver; the gold and silver had a universal value, and the exchange rate was consistent.
The global importance of foreign exchange markets emerged in 1971, when the United States (and subsequently most other countries) stopped backing currency with gold. With no universal standard for the world’s major currencies, each one’s value could now float (or fluctuate) in relation to the others depending on a variety of market forces.
More Detailed Information
The electronically connected network of banks and traders on the foreign exchange market has no central headquarters; its operations are spread across the globe and it functions 24 hours a day. As traders in Tokyo finish their day, their counterparts in London are just getting going; when the London traders go to lunch, the New York traders are beginning; and so on.
The FX market is comprised of four groups: banks, brokers, customers, and central banks. The banks are by far the largest participants. They buy currencies from and sell currencies to each other on behalf of customers or as a form of investment. A bank may make an investment when, for example, through detailed research, it comes to believe that the euro is going to go up in value relative to the dollar. If the bank were to purchase $100 million worth of euros at an exchange rate of 1.3 euros to 1 dollar, the bank would end up with 130 million euros. If the exchange rate between euros and dollars does change in favor of the euro, and 1 euro now equals 1 dollar, the bank may exchange the euros it bought for dollars. It will now have $130 million, including a hefty profit of $30 million. Approximately two-thirds of all FX transactions consist of banks dealing directly with each other, investing or trying to earn profits by trading currencies.
Brokers act as intermediaries between banks. They work with a variety of banks and know which of them are offering the best price on which currencies at any given time. A person or corporation who wishes to speculate in currency (that is, to invest in the hope of making a profit) contacts a broker to find out the best bank to use for the transaction. When investors deal with large sums of money, even a small fluctuation in an exchange rate can generate large profits (or losses). As an intermediary the broker also offers anonymity for the buyer or seller. Brokers earn money by charging a fee for their services.
Customers in the foreign exchange market can range from corporations looking to make large international purchases to people traveling to Mexico and in need of pesos for the trip. Some of the largest international corporations employ their own currency traders on staff for the sole purpose of tracking and trading in currency.
Central banks (such as the Federal Reserve, an independent agency of the U.S. government) act on behalf of their respective governments. Their primary role is to ensure the stability of the national currency. A central bank occasionally exerts its influence in the FX market by either increasing or reducing its country’s money supply. This will lower or raise the value of the national currency. Central banks use this tactic to stabilize rapid changes in the value of the nation’s currency that can result from both internal factors, such as inflation, or external factors, such as FX market fluctuations.
Variations in supply and demand can also cause changes in the value of a particular currency. When demand for a currency goes up (that is, when more buyers want to purchase it), so does the price of that currency in the market. This is known as appreciation of the currency. Conversely, when there is lower demand for a certain currency, the price of that currency often goes down; this is called depreciation of the currency. Because of the enormous amounts of currency being traded each day, even a fraction of a percent increase or decrease in value can have a significant impact on how much (or how little) a currency is traded.
When the value of the dollar goes up, or appreciates, each dollar will buy a greater amount of foreign currency. This means that the overall price of imported goods, such as televisions and cars, goes down. On the other hand, when the value of the dollar goes down, those same imports become more expensive. The value of any country’s currency has a direct impact on the balance of its international trade (the difference in value, over a period of time, between its imports and exports): the number of exports and imports rises or falls depending on the strength or weakness of the currency. Currency values can also affect tourism: for example, if a country’s currency becomes too strong, travelers from other countries will not be able to afford to visit that country.
Since the early part of the twenty-first century, China has had one of the largest and most rapidly expanding economies in the world. The growth has been driven in large part by the vast amount of goods China exports. One of the ways China has kept the demand high for its exported goods around the world is by artificially sustaining its currency at a low, fixed value in the FX market. By undervaluing its currency, China ensures that its exported goods are be affordable. High demand means that China continues to export more and more goods and therefore can build more and more factories and hire more and more workers. Under normal market conditions, as China’s economy grew and became more stable, the value of its currency would rise in the marketplace; instead, China’s central bank has made sure to keep the exchange rate for the Chinese yuan fixed within a narrow range. Many U.S. manufacturers, unable to compete with China’s relatively low wages and lower production costs, have gone out of business. The United States has worked hard to convince China to float its currency in the market. This would inevitably lead to an appreciation, or rise in value, of the Chinese currency.