THE FOREIGN EXCHANGE MARKET
Like most other prices, foreign exchange rates vary from week to week and month to month according to the forces of supply and demand. The foreign exchange market is the market in which currencies of different countries are traded and foreign exchange rates are determined. Foreign currencies are traded at the retail level in many banks and firms specializing in that business. Organized markets in New York, Tokyo, London, and Zurich trade hundreds of billions of dollars worth of currencies each day We can use our familiar supply and marinade curves to illustrate how markets determine the price of foreign currencies. Figure 29-3 shows the supply and demand for U.S. dollars that arise in dealings with japan.” The supply of U.S. dollars comes from people in the United States who need yen to purchase Japanese goods, services, or financial assets. The demand for dollars comes from people in Japan who buy U.S. goods, services, or investment and
who, accordingly, need dollars to pay for these items. The price of foreign exchange-the foreign exchange rate-settles at that price where supply and demand are in balance.
What lies behind the demand for dollars (represented in Figure 29-3 by the DD demand curve for dollar foreign exchange)? Foreigners demand U.S. dollars-when they buy American goods, services, and assets. For example, suppose a Japanese student buys
an American economics textbook or takes a trip to the United States. She will require U.S. dollars to pay for these items. Or when Japan Airlines buys a Boeing 767 for its fleet, this transaction inclines the demand for U.S. dollars. If Japanese funds 111- vest in U.S. Internet stocks, this ,would require a purchase of dollars. Foreigners demand U.S. to j)(I), [or their purchases of American goods, services, find assets.
Market forces move the foreign exchange rate up or down to balance the supply and demand. The price will settle at the- equilibrium foreign exchange rate, which is the rate at which the dollars willingly bought just equal the dollars willingly sold.
We have discussed the foreign exchange market in terms of the supply and demand for dollars. But in this market, there are two currencies involved, so we could just as easily analyze the supply and demand for Japanese yen. To see this, you .,should sketch a supply-and-demand diagram with •. yen foreign exchange on the horizontal axis and the yen rate ($ per ¥) on the vertical axis. If the equilibrium looking from the point of view of the dollar, then $O.OI/¥ is the reciprocal exchange rate. As an exercise, go through the analysis in this section for the reciprocal market. You will see that in this simple bilateral world, for every dollar statement there is an exact yen counterpart: supply of dollars is demand for yen; demand for dollars is supply of yen.
There is just one further extension necessary·to get to actul foreign exchange markets. In reality, there are many different currencies. We therefore need to find the supplies and demands for each and every currency. And in a world of many nations, it is the many-sided exchange and trade, with demands and supplies coming from all parts of the globe, that determines the entire array of foreign exchange rates.
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Foreign Exchange Market (FOREX) Assignment Help
The foreign exchange market (forex, FX, or currency market) is a worldwide decentralized over-the-counter financial market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies.
The primary purpose of the foreign exchange is to assist international trade and investment, by allowing businesses to convert one currency to another currency. For example, it permits a US business to import British goods and pay Pound Sterling, even though the business's income is in US dollars. It also supports speculation, and facilitates the carry trade, in which investors borrow low-yielding currencies and lend (invest in) high-yielding currencies, and which (it has been claimed) may lead to loss of competitiveness in some countries
In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market began forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.
The foreign exchange market is unique because of
- its huge trading volume, leading to high liquidity
- its geographical dispersion;
- its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday;
- the variety of factors that affect exchange rates;
- the low margins of relative profit compared with other markets of fixed income; and
- the use of leverage to enhance profit margins with respect to account size
Market Size and liquidity
The foreign exchange market is the largest and most liquid financial market in the world. Traders include large banks, central banks, institutional investors, currency speculators, corporations, governments, other financial institutions, and retail investors. The average daily turnover in the global foreign exchange and related markets is continuously growing. According to the 2010 Triennial Central Bank Survey, coordinated by the Bank for International Settlements, average daily turnover was US$3.98 trillion in April 2010 (vs $1.7 trillion in 1998). Of this $3.98 trillion, $1.5 trillion was spot foreign exchange transactions and $2.5 trillion was traded in outright forwards, FX swaps and other currency derivatives. Trading in London accounted for 36.7% of the total, making London by far the most important global center for foreign exchange trading. In second and third places, respectively, trading in New York City accounted for 17.9%, and Tokyo accounted for 6.2%.
Turnover of exchange-traded foreign exchange futures and options have grown rapidly in recent years, reaching $166 billion in April 2010 (double the turnover recorded in April 2007). Exchange-traded currency derivatives represent 4% of OTC foreign exchange turnover. FX futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts.
Most developed countries permit the trading of FX derivative products (like currency futures and options on currency futures) on their exchanges. All these developed countries already have fully convertible capital accounts. A number of emerging countries do not permit FX derivative products on their exchanges in view of controls on the capital accounts. The use of foreign exchange derivatives is growing in many emerging economies. Countries such as Korea, South Africa, and India have established currency futures exchanges, despite having some controls on the capital account
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