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:
[I’m still not feeling it. Can you give me a memorable example?]
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 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 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 forex summary? ›
The foreign exchange market, commonly referred to as the Forex or FX, is the global marketplace for the trading of one nation's currency for another. The forex market is the largest, most liquid market in the world, with trillions of dollars changing hands every day.
What is foreign exchange explained simply? ›
The aim of forex trading is simple. Just like any other form of speculation, you want to buy a currency at one price and sell it at higher price (or sell a currency at one price and buy it at a lower price) in order to make a profit. We all trade forex if we go on holiday abroad.
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 main uses of the foreign exchange markets? ›
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? ›
Businesses use the forex market to facilitate international trade. For example, they may need to convert payments for goods and services bought overseas or to exchange payments from international customers into their preferred currency. And investors use the forex market to speculate on changes in currency prices.
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 an example of a foreign exchange? ›
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.
Why is the foreign exchange market important? ›
The benefits of the Foreign Exchange Market in India are vital to the country's economic framework. Its role in facilitating international trade, managing risks, attracting investments, and fostering economic stability showcases its significance in India's financial landscape and global integration.
How do you explain forex to a beginner? ›
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. Currencies trade against each other as exchange rate pairs.
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 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 is foreign market exchange in economics? ›
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 foreign exchange market short term? ›
The market basically converts one's currency to another. Credit Function: The FOREX provides short-term credit to the importers in order to facilitate the smooth flow of goods and services from various countries.
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.
