Com International Finance and Foreign Exchange Market

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Foreign Exchange Market
Trade across national boundaries is complicated by the fact that nations generally use
different currencies to buy and sell goods in their respective markets. The British use
pounds, the Japanese yen, the Mexicans pesos and so on. Therefore, when a good or
service is purchased from a seller in another country, it is generally necessary for
someone to convert one currency to another. This adds to the complexity of international
exchange. This complication could be avoided if the trading partners were to uses a
common currency. This is precisely what 12 European nations have decided to do.
These countries have adopted a common currency—the euro—that is now uses to
conduct trade throughout entire region.

Most exchanges across national boundaries, however, still involve currency conversion.
If you travel in Europe, Asia, or South America, you will have to convert your dollars to
another currency in order to purchase items. This chapter will focus on the foreign
exchange market.

The foreign exchange market trades currencies. It lets banks and other institutions
easily buy and sell currencies. The purpose of the foreign exchange market is to help
international trade and investment. A foreign exchange market helps businesses convert
one currency to another. For example, it permits a U.S. business to import European
goods and pay Euros, even though the business's income is in U.S. dollars.

Presently, the foreign exchange market is one of the largest and most liquid financial
markets in the world. Traders include large banks, central banks, currency speculators,

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corporations, governments, and other financial institutions. The average daily volume in
the global foreign exchange and related markets is continuously growing. Daily turnover
was reported to be over US$3.2 trillion in April 2007 by the Bank for International
Settlements. Since then, the market has continued to grow. According to Euro-money's
annual FX Poll, volumes grew a further 41% between 2007 and 2008.
The exchange rate (also known as the foreign-exchange rate or FX rate) is one of the
most important prices because it enables consumers in one country to translate the prices
of foreign goods into units of their own currency. Specifically, the dollar price of a
foreign good is determined by multiplying the foreign product price by the exchange rate
(the dollar price per unit of the foreign currency). For example, if it takes $1.50 to obtain
1 pound, then the British shoes priced at 30 pounds would cost $45 (30 times the $1.50
price of the pound).
An appreciation in the value of a nation’s currency means that fewer units of the
currency are now required to purchase one unit of a foreign currency. For example, in
2000, only 92.3 cents were required to purchase a European euro, down from 106.5 in
1999. As the result of this appreciation in the value of the dollar relative to the euro,
goods purchased from countries in euro zone became less expensive to Americans. An
appreciation increases the purchasing power of domestic currency for foreign goods.
When a depreciation occurs, it will take more units of the domestic currency to purchase
a unit of foreign currency. A depreciation reduces the purchasing power of the domestic
currency for foreign goods.

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The exchange rate regime is the way a country manages its currency in respect to
foreign currencies and the foreign exchange market. It is closely related to monetary
policy and the two are generally dependent on many of the same factors.

The basic types are a floating exchange rate, where the market dictates the movements of
the exchange rate, a pegged float, where the central bank keeps the rate from deviating
too far from a target band or value, and the fixed exchange rate, which ties the currency to
another currency, mostly more widespread currencies such as the U.S. dollar or the euro.

Floating rates are the most common exchange rate regime today. For example, the dollar,
euro, yen, and British pound all float. However, since central banks frequently intervene
to avoid excessive appreciation or depreciation, these regimes are often called managed
float or a dirty float.

Just as countries calculate their gross domestic product (GDP) so that they have a general
idea of their domestic level of production, most countries also calculate their balance of
international payments in order to keep track of transactions across national boundaries.
The balance of payments (or BOP) summarizes all international economic transactions
between a country and all other countries for a specific time period, usually a year. It
reflects all payments and liabilities to foreigners (debits) and all payments and obligations
received from foreigners (credits). Balance of payments is one of the major indicators of
a country's status in international trade, with net capital outflow. The balance of

payments comprises the current account, the capital account, and the official reserve
account.

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The current account is the sum of the balance of trade (exports minus imports of goods
and services), net factor income (such as interest and dividends) and net transfer
payments (such as foreign aid).

The capital account records all transactions between a domestic and foreign resident that
involves a change of ownership of an asset. It is the net result of public and private
international investment flowing in and out of a country. This includes foreign direct
investment, portfolio investment (such as changes in holdings of stocks and bonds) and
other investments (such as changes in holdings in loans, bank accounts, and currencies).

The current exchange rate regime is not a pure flexible rate system. Governments
sometimes seek to modify the foreign exchange values of their currency by engaging in
official reserve transactions. A substantial appreciation of a currency will make it more
difficult for a nation’s export industries to compete in world markets. In an effort to
improve the competitiveness of export industries, governments will sometimes respond to
an appreciation by purchasing foreign currency reserves (and selling the domestic
currency) in the foreign exchange market. Conversely, if a nation’s currency is
depreciating rapidly, the government may seek to halt the depreciation by using some of

its foreign currency reserves to purchase the domestic currency in the foreign exchange
market.

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