In this lesson summary review and remind yourself of the key terms and graphs related to the market for foreign exchange (FOREX).
Lesson summary
The foreign exchange market is like any other market insofar as something is being bought and sold. However, the foreign exchange market is unique in two ways:
- A currency is being bought and sold, rather than a good or service
- The currency being bought and sold is being bought with a different currency.
Key Terms
| Key term | Definition |
|---|
| exchange rate | the price of one currency in terms of another currency; for example, if the exchange rate for the Euro (€) is 132 Yen (), that means that each Euro that is purchased will cost 132 yen. |
| foreign exchange market | a market in which one currency is exchanged for another currency; for example, in the market for Euros, the Euro is being bought and sold, and is being paid for using another currency, such as the yen. |
| demand for currency | a description of the willingness to buy a currency based on its exchange rate; for example, as the exchange rate for Euros increases, the quantity demanded of Euros decreases. |
| appreciate | when the value of a currency increases relative to another currency; a currency appreciates when you need more of another currency to buy a single unit of a currency. |
| depreciate | when the value of a currency decreases relative to another currency; a currency depreciates when you need less of another currency to buy a single unit of a currency. |
| floating exchange rates | when the exchange rate of currencies are determined in free markets by the interaction of supply and demand |
Key takeaways
Why the demand for a currency is downward sloping
When the exchange rate of a currency increases, other countries will want less of that currency. When a currency appreciates (in other words, the exchange rate increases), then the price of goods in the country whose currency has appreciated are now relatively more expensive than those in other countries. Since those goods are more expensive, less is imported from those countries, and therefore less of that currency is needed.
For example, suppose the price of a cell phone in the U.S. is , and the current exchange rate in Japan is 90 ¥ per dollar. That means that it takes: to buy the same cell phone in Japan. If two cell phones are imported into Japan, then a total of 800 US dollars will be needed to buy these phones.
However, if the dollar appreciates so that it now takes to buy a dollar, the same cell phone now costs . Because cell phones are more expensive, only one is imported into Japan from the United States, so the quantity of US dollars that Japan wants will fall from to .
The equilibrium exchange rate is the interaction of the supply of a currency and the demand for a currency
As in any market, the foreign exchange market will be in equilibrium when the quantity supplied of a currency is equal to the quantity demanded of a currency. If the market has a surplus or a shortage, the exchange rate will adjust until an equilibrium is achieved.
For example, suppose Westeros is a trading partner of Hamsterville, and the currency of Westeros is the Westeros Gold Dragon (). Currently, the exchange rate is per Hamsterville snark (). At this exchange rate, Hamsterville wants to sell , but Westeros only wants to buy . Therefore, there is a surplus of .
Like any surplus, this will place downward pressure on the price. If the exchange rate is flexible, then the exchange rate will decrease until the quantity supplied is equal to the quantity demanded.
Key Graphical Models
Suppose the United States and Japan are trading partners. Japan’s currency is the Yen () and United States’ currency is the U.S. dollar (). We can represent the market for the U.S. Dollar in the foreign exchange market, as shown here:
You bet! The nation of Nickelstan uses nickels as their currency. The nation of Cookiestan uses the Cookiestan Cookie () as their currency. Of course, the CC is not an actual cookie, but a round piece of paper with the impression of a cookie.
Nickelstan is a popular vacation destination for the citizens of Cookiestan, and people traveling to Nickelstan need the local currency, the Nickel, to buy things. They go to the foreign exchange market for the Nickel to buy Nickels.
Well, how are they going to pay for these Nickels? Not with Nickels! The are going to trade in their own currency. So the demand for the Nickelstan Nickel is based on countries like Cookiestan wanting to buy Nickels.
The higher the exchange rate (that is, the more it takes to buy a Nickel), the less currency will be demanded. For example, suppose a lime smoothie costs Nickels in Nickelstan, and the current exchange rate is per nickel. To the citizens of Cookiestan, a lime smoothie costs once you account for the exchange rate. If suddenly the exchange rate is per nickel, that lime smoothie’s price shot up to . Suddenly those smoothies don’t seem as appealing, so as people buy less of them, they need fewer Nickels to do so.
Ok, so where does the supply of these Nickels come from? Well, Nickelstanians are also fond of travel and need other countries currencies to buy things abroad. So, Nickelstan will supply their own currency in hopes of trading them in for other currencies.
The interaction of the supply of Nickels and the demand for Nickels will yield an equilibrium exchange rate. The graph illustrates the foreign exchange market for Nickels in equilibrium. Note that cookies are the label for the price of Nickels, because that is how the Nickels are being paid for. Also, note that a nickel is on the quantity label because that is what is being bought.
Common misperceptions
We are used to thinking about buying things with a currency, so many new learners are confused about what the price should be in the market for a currency. Buthe price of an orange is never given in oranges; it’s given in some other currency. Just like an orange, a dollar can’t be bought with itself, but instead it needs to be bought with some other currency.
A common misperception is to confuse 1) the things that cause shifts in the supply or demand of a currency with 2) changes in quantity supplied or quantity demanded. To keep this straight, ask yourself “why is this change happening?” If a change is happening in response to a change in the exchange rate, then you are moving along a curve. If a change is happening in response to something else, the entire curve shifts.
It might seem like a time saver to take short-cuts on labeling graphs, but this is never a good idea. Take your time labeling the foreign exchange market carefully using the elements of a market:
Demand - the demand for the currency that is being exchanged
- Supply - the supply of the currency that is being exchanged
- Quantity - the quantity of the currency that is being exchanged
- Price - some other currency that is being used to buy the currency that is being exchanged
FAQs
The foreign exchange market is like any other market insofar as something is being bought and sold. However, the foreign exchange market is unique in two ways: A currency is being bought and sold, rather than a good or service. The currency being bought and sold is being bought with a different currency.
What is the foreign exchange market summary? ›
The foreign exchange market is an over-the-counter global market where the buying and selling of global currencies occur, determining their exchange rates.
What is forex summary? ›
Forex is foreign exchange, which refers to the global trading of currencies and currency derivatives. It is the largest financial market in the world, involving the buying and selling of currencies in pairs, taking advantage of changing rates.
What is the point of the foreign exchange market? ›
The main functions of the market are to (1) facilitate currency conversion, (2) provide instruments to manage foreign exchange risk (such as forward exchange), and (3) allow investors to speculate in the market for profit.
What is an example of a currency exchange? ›
For example, if you have U.S. dollars and you want to exchange them for Australian dollars, you would bring your U.S. dollars (or bank card) to the currency exchange store and buy Australian dollars with them.
What is foreign exchange explained simply? ›
Key Takeaways. The foreign exchange (forex or FX) market is a global marketplace for exchanging national currencies. Because of the worldwide reach of trade, commerce, and finance, forex markets combine to be the world's largest and most liquid asset markets. Currencies trade against each other as exchange rate pairs.
What is the primary purpose of the foreign exchange market? ›
The foreign exchange market is an over-the-counter (OTC) marketplace that determines the exchange rate for global currencies. The forex market is where banks, funds, and individuals can buy or sell currencies for hedging and speculation.
Why is foreign exchange important to the economy? ›
Foreign exchange is the trading of different national currencies or units of account. It is important because the exchange rate, the price of one currency in terms of another, helps to determine a nation's economic health and hence the well-being of all the people residing in it.
How do you explain forex to someone? ›
Forex trading, also known as foreign exchange or FX trading, is the conversion of one currency into another. FX is one of the most actively traded markets in the world, with individuals, companies and banks carrying out around $6.6 trillion worth of forex transactions every single day.
What is an example of a foreign exchange market? ›
a market in which one currency is exchanged for another currency; for example, in the market for Euros, the Euro is being bought and sold, and is being paid for using another currency, such as the yen.
International businesses have four main uses of the foreign exchange markets.
- Currency Conversion. Companies, investors, and governments want to be able to convert one currency into another. ...
- Currency Hedging. ...
- Currency Arbitrage. ...
- Currency Speculation.
In conclusion, the foreign exchange market is a dynamic and essential component of the global financial system. It serves as a platform for the exchange of currencies between countries, facilitating international trade and investment.
Who benefits from foreign exchange market? ›
The Bottom Line. There is a reason why forex is the largest market in the world: It empowers everyone from central banks to retail investors to potentially see profits from currency fluctuations related to the global economy.
What is the highest currency in the world? ›
The highest-valued currency in the world is the Kuwaiti Dinar (KWD). Since it was first introduced in 1960, the Kuwaiti dinar has consistently ranked as the world's most valuable currency. Kuwait's economic stability, driven by its oil reserves and tax-free system, contributes to the high demand for its currency.
How do banks make money from foreign exchange? ›
Banks make a profit by charging a higher ask rate when selling a currency to customers and buying at a slightly lower bid rate when purchasing from customers.
What is the difference between money exchange and foreign exchange? ›
In the currency market, a foreign exchange transaction invariably deals with two kinds of money. Whereas in the money market, typically a loan business, only involves one kind of money. Another difference between the currency market and the money market lies in the function of the respective markets.
What is the foreign market in simple terms? ›
Foreign market
Foreign markets are any markets outside of a company's own country. Selling in foreign markets involves dealing with different languages, cultures, laws, rules, regulations and requirements.
What are the three main components of the foreign exchange market? ›
Before you even think about opening a Forex account, be sure that you are familiar with the foreign exchange market's three distinctive elements: geographical, functional, and participant.
What are the four major functions of the foreign exchange market? ›
Functions of Foreign Exchange Market
- Transfer Function. It is the primary function of the foreign exchange market. ...
- Credit Function. Just like domestic trade, foreign trade also depends on credit. ...
- Hedging Function. It implies to protection against risk related to fluctuations in the foreign exchange rate. ...
- Global Liquidity.
For example, suppose the price of a cell phone in the U.S. is , and the current exchange rate in Japan is 90 ¥ per dollar. That means that it takes: 90 × $ 400 = 36,000 ¥ to buy the same cell phone in Japan.
