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What is Foreign Exchange?

2016-12-02T10:14:58+00:00

The term 'Foreign Exchange' is included in the Economics edition of the Financial Dictionary. Get yours now on amazon in ebook or paperback format. Read more here...

Foreign exchange involves converting the currency of one nation into another nation’s currency. Foreign exchange rates can be set in several different ways determined by the country’s government. Free market economies allow their currency to float freely most of the time. The value of the money is determined by the markets according to supply and demand factors.

Other nations choose to peg the value of their money to a stronger and more stable currency like the U.S. dollar or the Euro. They might also choose to use a basket of currencies for such a peg. A third alternative is for a country’s government to fix the value of their money at a set rate. The majority of nations choose to allow their foreign exchange rates to float freely versus the ones of other nations. This causes them to fluctuate up and down constantly throughout the day.

Sometimes nations which allow the value of their money to float freely will choose to intervene in foreign exchange markets to devalue their exchange rate. They might feel that their money’s value has risen too fast and is hurting the competitiveness of their exports. As their exchange rate rises, the cost of their goods becomes more expensive to customers in foreign markets. In such a case, the country may announce that they are buying their own money at a lower rate or they may sell it off in Forex markets. Interventions like this tend to be less common except in volatile exchange environments.

Currency values are usually set by the forces of the market and are based on a number of national and international elements. These include trade and investment, flows of tourism, and geo political event risk. Trade and investment requires that the companies or nations purchase the host nation’s money for the transaction. Investors may also want to purchase investments in another country. They would need that nation’s money in order to make such investments.

When tourists come to visit a nation, they require the local money. They will exchange their own country’s money for that of the one which they are visiting. Every one of these transactions constantly requires foreign exchange. This explains why the forex markets are the largest financial marketplaces in the world by far.

Banks handle this foreign exchange between each other on an international level. This creates a forex market that operates 24 hours per day and six days a week. The major centers of foreign exchange are disbursed around the world. These trades and transactions mostly occur in eight major forex centers. These are London, New York City, Tokyo, Singapore, Switzerland (Zurich and Geneva), Hong Kong, Sydney, and Paris. Each of the transactions comes under the regulation of the Bank of International Settlements.

Floating exchange rates are set by the supply and demand of all of these trades. More demand for a currency against a stable supply will increase the value of it against another. The rates are also impacted by numerous economic reports and geopolitical events. Some of the better known and followed ones are unemployment rates, interest rate levels and decisions, manufacturing data, gross domestic product changes, and inflation reports.

For countries that choose to go the route of pegged exchange, their governments must artificially set and maintain their exchange rates. These rates do not change up and down throughout the day. Instead the government will reset its value on reevaluation dates. Emerging market countries often find this a useful means of managing their foreign exchange rates in order to ensure that they are stable. They will be required to maintain large reserves of their pegged currency so that they can manage the inevitable supply and demand changes that affect their own foreign exchange.

The term 'Foreign Exchange' is included in the Economics edition of the Financial Dictionary. You can get your copy on amazon in Kindle or Paperback version. See more details here.