Foreign Exchange Market

Where do you exchange your US dollar for Mexican Pesos when you go on holiday to Mexico? How do the currency exchange work, and where are they facilitated? Is there a market just for currencies? This article will help you learn everything you need to know about the foreign exchange market.

Foreign exchange market definition economics

International trade and openness of economies, particularly during the last century, have created a considerable trading volume of goods and services between different countries.

There are many people in the United States buying products from Japan and other parts of the world. When considering the trade between the U.S. and Japan, think that they have different domestic currencies. The currency you use to pay for goods and services in the U.S. is the U.S. dollar - $. Whereas, in Japan, you pay for goods in ¥ - Japanese yen. So how does the transaction occur when a U.S. citizen buys products in Japan? In which currency do they pay?

Well, there are two ways this can happen. A U.S. citizen either buys some Japanese Yen and then pays for Japanese goods, or it pays in U.S. dollars, and then the Japanese supplier converts the dollars into Japanese Yen. This conversion we are talking about forms a market, where one currency is exchanged for another. That market is known as the foreign exchange market.

The foreign exchange market operates just like any type of other markets we’ve seen. However, instead of exchanging goods, you have currencies from different countries, and instead of prices, you have the exchange rate.

The foreign exchange market is significant for countries as it allows them to conduct international trade with other countries. Moreover, it has a huge impact on economies as it determines the value of their currency, and if their currency devalues by a significant percentage, it causes turmoil in the markets. This is especially true for developing countries.

The foreign exchange market structure and graph

The foreign exchange market graph consists of the demand and supply for a given currency. There are many individuals as well as institutions involved on the demand and supply side. Additionally, the demand for foreign currency includes businesses that pay their suppliers from abroad, as well as hedge funds that trade for profits.

The demand in the foreign exchange market results from the demand for the currency to buy the country’s goods, services, and financial assets. There is an inverse relationship between the exchange rate and the quantity demanded of the currency. For example, if you were to consider the demand for the U.S. dollar, whenever the U.S. dollar would depreciate, meaning the U.S. dollar becomes cheaper, you have more quantity demanded of the U.S. dollar.

The supply in the foreign exchange market results from making payments to other countries, which causes individuals to sell their U.S. dollars to exchange it for foreign currency. There is a positive relationship between the exchange rate and quantity supplied. The higher the exchange rate, the higher the quantity supplied of the currency.

Foreign exchange market equilibrium occurs when there is such a level of exchange rate so that the quantity demanded and supplied of a currency are equalized.

Fig. 1 - Foreign Exchange Market Graph

Figure 1. shows the foreign exchange market graph for US dollar and Japanese Yen. You have the supply for U.S. dollars on the supply side, and on the demand side, you have the demand for the U.S. dollar.

The point where equilibrium occurs, is the point where the exchange rate forms, and it is expressed in terms of the other foreign currency for which the U.S. dollar is being exchanged, in our example - Japanese Yen. In this case, the equilibrium exchange rate forms at 128 Japanese Yen, meaning that 128 Yen is needed to buy 1 U.S. dollar. In other words, the 128 Yen represents the price of a U.S. dollar.

The equilibrium exchange rate changes only when there is a shift in either demand or supply for U.S. dollar. When the foreign exchange market is not at an equilibrium point, then we can say that a disequilibrium occurs. Disequilibrium in the foreign exchange market is associated with a shortage or surplus for a said currency. Market forces would then act to restore the balance and bring the market back to equilibrium.

Factors influencing foreign exchange market

Factors influencing the foreign exchange market are factors that are intrinsically linked to either the demand or the supply in the foreign exchange market. These include interest rates, economic stability, future expectations, rate of return.

To better understand how these factors influence the foreign exchange market, you need to understand shifts in the demand and supply in the foreign exchange market.

Demand shifts in foreign exchange market

Fig. 2 - A shift in demand in the foreign exchange market

Figure 2. shows a rightward shift in the demand for the U.S. dollar. The new equilibrium exchange rate (located at E₂) occurs at a higher level of Japanese yen per dollar. This means that more Japanese Yen are needed to buy 1 U.S. dollar. In other words, dollars can get you more Japanese yen now. This means that the exchange rate has been appreciated.

Supply shifts in foreign exchange market

Fig. 3 - A shift in supply in the foreign exchange market

Figure 3. represents a shift to the right of the supply curve in the foreign exchange market. This results in a lower equilibrium exchange rate (located at E₂), meaning fewer Japanese Yen are needed to buy one U.S. dollar. This causes a depreciation of the exchange rate.

Remember that in a freely floating exchange system appreciation occurs when the currency gains value, whereas depreciation occurs when the currency loses value.

Fig. 4 - Currency appreciation and depreciation in a freely floating exchange rate system

Figure 4 shows the appreciation and depreciation of the currency in a freely floating exchange rate system. In a freely floating exchange rate system, the demand and supply of the currency cause a change in the value of the currency. Appreciation of currency occurs when the demand for a currency increases (shifts to the right) or when the supply of currency decreases (shifts to the left). Depreciation occurs when the demand for the currency decreases (shift to the left), or when the supply of the currency increases (shifts to the right).

Factors that can influence either the demand or the supply in the foreign exchange market

Factors that can influence either the demand or the supply in the foreign exchange market are:

Foreign Exchange Market: Interest rate

Interest rates significantly influence the foreign exchange market. Consider the case when the Fed increases the interest rate in the U.S. economy. This will encourage people in the U.S. to save more, therefore causing a decrease in the supply of the U.S. dollar on the Forex market (as they no longer want to exchange their U.S. dollar for foreign currency). When the interest rate is higher, it becomes more valuable to hold the US dollar as you get a higher return on your savings. If the interest rate went up from 5% to 10% on your savings, you would earn double on your savings. It also becomes more valuable for foreigners to make investments in the United States as the rate of return on their investment increases. This results in the appreciation of the U.S dollar.

Foreign Exchange Market: Economic stability

The economic stability of a country influences the foreign exchange market. When a country has a solid economic structure that allows for investment and growth, it will have a more valuable currency than other countries as the demand for that currency grows. However, in countries that are prone to economic instability and high inflation rates, their currency will devalue. That is because under economic instability, there will be higher inflation, and the currency will lose value every day. You could easily be paying twice the price the next month due to inflation. People living in such countries tend to keep their money in U.S. dollars or other relatively stable currencies to preserve their purchasing power. Additionally, economic instability creates a less favorable environment for foreign investors, as they are uncertain whether they can make a profit. This then reduces the demand for the currency and devalues it even further.

Foreign Exchange Market: Future expectations

Future expectations about a given currency play an influencing role in the foreign exchange market. If there are positive future expectations about the U.S. dollar, it will cause an increase in demand for the U.S. dollar. This will, in turn, appreciate the U.S. dollar.

Foreign Exchange Market: Rate of return

The rate of return from assets in a specific country plays an essential role in the foreign exchange market. Consider what happens in the case that the stock market in the U.S. started generating higher returns than other stock markets around the world? It will cause a shift in the demand for the U.S dollar, resulting in an appreciation of the currency.

Difference between money market and foreign exchange market

The money market is where short-term loans are transferred between borrowers and lenders. On the other hand, the foreign exchange market is the market where countries' currencies are exchanged.

The main difference between the money and foreign exchange markets is the "goods" and "price units."

In the money market, you have short-term debt investments as goods, whereas in the foreign exchange market, you have a quantity of currency serving as a good.

Additionally, the "price" in the money market is expressed in terms of the interest rate, whereas the "price" in the foreign exchange market is expressed in the foreign exchange rate.

Short-term assets like certificates of deposit, treasury bills, and repurchase agreements are traded in the money market. In contrast, currencies of different countries are traded in the foreign exchange market, such as the Australian dollar, British Pound, Euro, etc.

Functions of foreign exchange market

The foreign exchange market is important to international trade and economies around the world. The main functions of a foreign exchange market include: enabling currency exchanges, providing investment opportunities, reducing foreign exchange risk.

Foreign Exchange Market: Currency exchanges

This is perhaps the most important function of the foreign exchange market. It allows individuals of a country to exchange their currency for another country's currency. This is instrumental in conducting international trade. Businesses buy foreign currency to pay their foreign suppliers; individuals purchase foreign currency to pay for the goods and services they consume abroad.

Foreign Exchange Market: Investment opportunities and profit

Investment opportunities and profit provided by the foreign exchange market is an important function that allows investors to grow their portfolios around the world. This involves betting against another currency and making a profit in return. The best part of it is that the gains you make from investing and trading are not taxed!

Foreign Exchange Market: Reduce foreign exchange risk

Reducing foreign exchange risk is another essential function of the foreign exchange market. Some countries are prone to economic, political, and social instability, translating into risk in terms of their currency value. To prevent investors from incurring losses, the foreign exchange market provides a forward exchange — current exchange rate agreement for a future period.

Meaning of hedging in the foreign exchange market

The meaning of hedging in the foreign exchange market refers to individuals or institutions aiming to reduce their risk exposure to foreign exchange volatility. This is a common strategy amongst investors and traders in the foreign exchange market. Usually, hedging is a short-term strategy. Traders and investors use this strategy when they expect that there will be news that will negatively affect a specific currency. One of the main instruments investor hedge in the foreign exchange market is by trading forwards and futures.

Forwards and futures are derivatives that involve an agreement on the set price of a currency at a certain date in the future. In other words, investors would agree to buy to pay a certain amount of U.S. dollars in exchange for the foreign currency on a future date, regardless of what happens to the exchange rate. So, if investors expect the U.S. dollar to appreciate in the future, they will buy forwards and futures that sell U.S. dollars at a cheaper rate. The difference between the rate they agreed and the rate that occurs in the market provides the profit for investors.