WHAT “FOREIGN EXCHANGE” MEANS
“Foreign exchange” refers to money denominated in the currency of another nation or group of nations. Any person who exchanges money denominated in his own nation’s currency for money denominated in another nation’s currency acquires foreign exchange.
That holds true whether the amount of the transaction is equal to a few dollars or to billions of dollars; whether the person involved is a tourist cashing a traveler’s check in a restaurant abroad or an investor exchanging hundreds of millions of dollars for the acquisition of a foreign company; and whether the form of money being acquired is foreign currency notes, foreign currency denominated bank deposits, or other shortterm claims denominated in foreign currency.
A foreign exchange transaction is still a shift of funds, or short-term financial claims, from one country and currency to another. Thus, within the United States, any money denominated in any currency other than the U.S. dollar is, broadly speaking, “foreign exchange.”
Foreign exchange can be cash, funds available on credit cards and debit cards, traveler’s checks, bank deposits, or other short-term claims. It is still “foreign exchange” if it is a short-term negotiable financial claim denominated in a currency other than the U.S. dollar.
But, in the foreign exchange market described in this article—the international network of major foreign exchange dealers engaged in high-volume trading around the world—foreign exchange transactions almost always take the form of an exchange of bank deposits of different national currency denominations. If one bank agrees to sell dollars for Deutsche marks to another bank, there will be an exchange between the two parties of a dollar bank deposit for a DEM bank deposit. In this article, “foreign exchange” means a bank balance denominated in a foreign (non-U.S. dollar) currency.
ROLE OF THE EXCHANGE RATE
The exchange rate is a price—the number of units of one nation’s currency that must be surrendered in order to acquire one unit of another nation’s currency. There are scores of “exchange rates” for the U.S. dollar. In the spot market, there is an exchange rate for every other national currency traded in that market, as well as for various composite currencies or constructed monetary units such as the International Monetary Fund’s “SDR,” the European Monetary Union’s “ECU,” and beginning in 1999, the “euro.” There are also various “trade-weighted” or “effective” rates designed to show a currency’s movements against an average of various other currencies.
Quite apart from the spot rates, there are additional exchange rates for other delivery dates, in the forward markets. Accordingly, although we talk about the dollar exchange rate in the market, and it is useful to do so, there is no single, or unique dollar exchange rate in the market, just as there is no unique dollar interest rate in the market.
A market price is determined by the interaction of buyers and sellers in that market, and a market exchange rate between two currencies is determined by the interaction of the official and private participants in the foreign exchange rate market. For a currency with an exchange rate that is fixed, or set by the monetary authorities, the central bank or another official body is a key participant in the market, standing ready to buy or sell the currency as necessary to maintain the authorized pegged rate or range.But in the United States, where the authorities do not intervene in the foreign exchange market on a continuous basis to influence the exchange rate, market participation is made up of individuals, nonfinancial firms, banks, official bodies, and other private institutions from all over the world that are buying and selling dollars at that particular time.
The participants in the foreign exchange market are thus a heterogeneous group. Some of the buyers and sellers may be involved in the “goods” market, conducting international transactions for the purchase or sale of merchandise. Some may be engaged in “direct investment” in plant and equipment, or in “portfolio investment,” dealing across borders in stocks and bonds and other financial assets, while others may be in the “money market,” trading short-term debt instruments internationally. The various investors, hedgers, and speculators may be focused on any time period, from a few minutes to several years. But, whether official or private, and whether their motive be investing, hedging, speculating, arbitraging, paying for imports, or seeking to influence the rate, they are all part of the aggregate demand for and supply of the currencies involved, and they all play a role in determining the market exchange rate at that instant.
Given the diverse views, interests, and time frames of the participants, predicting the future course of exchange rates is a particularly complex and uncertain business. At the same time, since the exchange rate influences such a vast array of participants and business decisions, it is a pervasive and singularly important price in an open economy, influencing consumer prices, investment decisions, interest rates, economic growth, the location of industry, and much else. The role of the foreign exchange market in the determination of that price is critically important.
Read More : Why We Need Foreign Exchange
