Contents
I. Introduction 2
II. The structure of the foreign exchange market 3
1. What is the foreign exchange? 3
2. The participants of the foreign exchange markets 4
3. Instruments of the foreign exchange markets 5
III. Foreign exchange rates 6
1. Determining foreign exchange rates 6
2. Supply and Demand for foreign exchange 7
3. Factors affecting foreign exchange rates 11
IV. Conclusion 13
V. Recommendations 14
VI. Literature used 16
I. Introduction
Trade and payments across national borders require that one of the parties to the transaction contract to pay or receive funds in a foreign currency. At some stage, one party must convert domestic money into foreign money. Moreover, knowledgeable investors based in each country are aware of the opportunities of buying assets or selling debts denominated in foreign currencies when the anticipated returns are higher abroad or when the interest costs are lower. These investors also must use the foreign exchange market whenever they invest or borrow abroad.
I’d like to add that the foreign exchange market is the largest market in the world in terms of the volume of transactions. That the volume of foreign exchange trading is many times larger than the volume of international trade and investment reflects that a distinction should be made between transactions that involve only banks and those that involve banks, individuals, and firms involved in international trade and investment.
The phenomenal explosion of activity and interest in foreign exchange markets reflects in large measure a desire for self-preservation by businesses, governments, and individuals. As the international financial system has moved increasingly toward freely floating exchange rates, currency prices have become significantly more volatile. The risks of buying and selling dollars and other currencies have increased markedly in recent years. Moreover, fluctuations in the prices of foreign currencies affect domestic economic conditions, international investment, and the success or failure of government economic policies. Governments, businesses, and individuals involved in international affairs find it is more important today than ever before to understand how foreign currencies are traded and what affects their relative values.
In this work, we examine the structure, instruments, and price-determining forces of the world's currency markets.
II. The structure of the foreign exchange market
What is the foreign exchange?
The foreign exchange markets are among the largest markets in the world, with annual trading volume in excess of $160 trillion. The purpose of the foreign exchange markets is to bring buyers and sellers of currencies together. It is an over-the-counter market, with no central trading location and no set hours of trading. Prices and other terms of trade are determined by negotiation over the telephone or by wire, satellite, or telex. The foreign exchange market is informal in its operations: there are no special requirements for market participants, and trading conforms to an unwritten code of rules.
You know that almost every country has its own currency for domestic transactions. Trading among the residents of different countries requires an efficient exchange of national currencies. This is usually accomplished on a large scale through foreign exchange markets, located in financial centers such as London, New York, or Paris—in order of importance—where exchange rates for convertible currencies are determined. The instruments used to effect international monetary payments or transfers are called foreign exchange. Foreign exchange is the monetary means of making payments from one currency area to another. The funds available as foreign exchange include foreign coin and currency, deposits in foreign banks, and other short-term, liquid financial claims payable in foreign currencies. An international exchange rate is the price of one (foreign) currency measured in terms of another (domestic) currency. More accurately, it is the price of foreign exchange. Since exchange rates are the vehicle that translates prices measured in one currency into prices measured in another currency, changes in exchange rates affect the price and, therefore, the volume of imports and exports exchanged. In turn the domestic rate of inflation and the value of assets and liabilities of international borrowers and lenders is influenced. The exchange rate rises (falls) when the quantity demanded exceeds (is less than) the quantity supplied. Broadly speaking, the quantity of U.S. dollars supplied to foreign exchange markets is composed of the dollars spent on imports, plus the amount of funds spent or invested by U.S. residents outside the United States. The demand for U.S. dollars arises from the reverse of these transactions.
Many newspapers keep a daily record of the exchange rates in the highly organized foreign exchange market, where currencies of different nations are bought and sold. For instance, the Wall Street Journal shows the price of a currency in two ways: first the price of the other currency is given in U.S. dollars, and second the price of the U.S. dollar is quoted in units of the other currency. Pairs of prices represent reciprocals of each other. These rates refer to trading among banks, the primary marketplace for foreign currencies.