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:
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 an over-the-counter global market where the buying and selling of global currencies occur, determining their exchange rates.
What is a summary of foreign exchange risk? ›
Foreign exchange risk is the chance that a company will lose money on international trade because of currency fluctuations. Also known as currency risk, FX risk and exchange rate risk, it describes the possibility that an investment's value may decrease due to changes in the relative value of the involved currencies.
What is foreign exchange markets in your own words? ›
The foreign exchange market or forex market is the market where currencies are traded. The forex market is the world's largest financial market where trillions are traded daily. It is the most liquid among all the markets in the financial world.
What is the significance of the foreign exchange market? ›
The forex market plays a critical role in facilitating international trade and investment, as well as providing opportunities for individuals and institutions to profit from fluctuations in currency values. The forex market operates 24 hours a day, 5 days a week, with trading volumes exceeding $6 trillion per day.
What is the primary purpose of the foreign exchange market? ›
Definition of a foreign exchange market
At its core, a foreign exchange market is a global decentralised or over-the-counter (OTC) marketplace where participants trade currencies. In simpler terms, it's the place where one country's currency is exchanged for another's.
What is foreign exchange explained simply? ›
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 tend to be the world's largest and most liquid asset markets.
What are the problems with foreign exchange? ›
The three types of foreign exchange risk include transaction risk, economic risk, and translation risk. Foreign exchange risk is a major risk to consider for exporters/importers and businesses that trade in international markets.
What is the foreign exchange management Act summary? ›
The Foreign Exchange Management Act, 1999 (FEMA), is an Act of the Parliament of India "to consolidate and amend the law relating to foreign exchange with the objective of facilitating external trade and payments and for promoting the orderly development and maintenance of foreign exchange market in India".
How does foreign exchange affect international business? ›
For entrepreneurs, changes in exchange rates affect their businesses in two main ways: by changing the cost of supplies that are purchased from a different country, and by changing the attractiveness of their products to overseas customers.
What is the foreign market in simple terms? ›
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. Companies looking to enter a new market need to carefully research the potential opportunity and create a market entry strategy.
Forex trading offers several advantages over other markets, such as flexibility with types of contracts and 24 hours a day trading for five days a week. It also allows investors to leverage their trades by 20 to 30 times, which can magnify gains. On the downside, this leverage can also lead to major losses fast.
What is the meaning of foreign exchange in simple words? ›
Foreign exchange refers to exchanging the currency of one country for another at prevailing exchange rates. Let us take a close look at the meaning of foreign exchange. Different countries have different currencies. Foreign exchange converts the currency of one country into another.
What does the foreign exchange market affect? ›
What Are Foreign Currency Effects? Foreign currency effects are gains or losses on foreign investments due to changes in the relative value of assets denominated in a foreign currency. A rising domestic currency means foreign investments will have lower returns when converted back to the local currency.
What is the primary characteristic of the foreign exchange market? ›
The foreign exchange market is a global platform where different countries' currencies are exchanged. It's also known as forex or currency market. Its key features include high transaction volume, global reach, 24/7 operation, and diverse instruments and participants.
What is the currency market summary? ›
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.
What is the explanation of market exchange? ›
Definition of Market Exchange
(noun) An economic system in which goods and services are produced, distributed, and exchanged by the forces of price, supply, and demand.
What is the foreign exchange market quizlet? ›
Foreign-exchange market (FEM) the market where one country's money is traded for that of another country. Exchange rate. the price of one country's money in terms of another.
