Foreign Exchange Market

The foreign exchange market, also called the forex market, is a network of commercial banks, investment banks, brokerage houses, and other financial institutions that buy and sell currencies for profit. The currencies that are traded are called foreign exchange or, more simply, forex. The process of trading foreign exchange is called forex trading. In 2010 the daily turnover in the forex market was $4 trillion, a significant jump from daily trading of $1.2 trillion in 2001.[1] Most forex trading is short term and highly speculative. The foreign exchange market operates worldwide, but in 2010 more than half of all forex trading took place in just two countries—the United Kingdom (36.7 percent) and the United States (18 percent). Other major countries in the global forex market were Japan, Singapore, Switzerland, Hong Kong SAR, and Australia.[2]

The forex market represents the institutions and practices of banks, brokerage firms, securities dealers, and other participants in forex trading. Commercial banks assume a central role in forex trading through interbank or direct dealing transactions. Many large commercial banks operate globally and keep at least one forex trading station open at all times. Forex markets operate nonstop, 24 hours per day during a typical five-day business week. A global electronic transfer cooperative called SWIFT (Society for Worldwide Interbank Financial Telecommunication) processes and posts financial transactions.[3]

The modern foreign exchange market has changed significantly since its inception in 1946. Under the Bretton Woods System from 1946 to 1973, the main role of the foreign exchange market was currency conversion for purposes of trade. During this period the fixed exchange rate system pegged the value of national currencies to the U.S. dollar or to gold. The U.S. dollar was also fixed to gold, with $1US equal to 1/35th of an ounce

Table 11.4 Exchange Rates, July 11, 2013

Country

Currency

U.S. Equivalent

Currency per U.S. Dollar

Canada

dollar

$0.9648

1.0466

China

yuan

$0.1630

6.1352

Japan

yen

$0.0101

99.6600

United Kingdom

pound

$1.5182

0.6664

Euro Area[4]

euro

$1.3097

0.7706

Source: “Exchange Rates,” Wall Street Journal, July 12, 2013.

of gold. Most international trade was conducted with major currencies, often called hard currencies. Pegging currencies to the U.S. dollar and to gold stabilized the postwar global financial system.

During the 1970s a flexible exchange rate system replaced the fixed rate system. Under the flexible exchange rate system, the forces of supply and demand determine the value of national currencies. When the demand for a country's currency increases, the currency appreciates or gains strength compared to other currencies. When the demand for a currency decreases, however, the currency depreciates or weakens relative to other currencies. In the flexible exchange rate system, the primary mission of the forex market changed from the traditional currency conversion to the buying and selling of national currencies for profit. Over the past several decades governments, mainly through their central banks, have also intervened in the forex market to stabilize national currencies.

Exchange rates state the value of one currency compared to a second currency. Four pieces of information are included in published exchange rates: the country, the name of the currency, the U.S. equivalent, and the currency per U.S. dollar, as shown in Table 11.4.[5] The U.S. equivalent expresses the value of a foreign currency in terms of the U.S. dollar. For instance, on July 11, 2013, the Chinese yuan was worth about 16 cents compared to the U.S. dollar, while one United Kingdom's pound was worth $1.52 in U.S. currency. The currency per U.S. dollar states how many units of a foreign currency it would take to equal $1. Note that it would take about 100 Japanese yen to equal $1, but it would take just 77 euro cents to equal $1. Exchange rates are published daily in major newspapers such as the Wall Street Journal and the New York Times.

  • [1] Bank for International Settlements (BIS), “Table 1: Global Foreign Exchange Market Turnover by Instrument,” Triennial Central Bank Survey: Foreign Exchange and Derivatives Market Activity in 2010, November 2012 (Annex Tables).
  • [2] BIS, “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2010,”
  • [3] Society for Worldwide Interbank Financial Communication (SWIFT), “[Response to] ‘Principles for Financial Market Infrastructures,’ ” July 28, 2011, 1.
  • [4] Euro Area consists of the 17 European nations of the Eurozone.
  • [5] “Exchange Rates: New York Closing Snapshot,” Wall Street Journal, July 12, 2013
 
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