Foreign exchange market refers to trading in foreign currencies. Just like any other tradable commodity in the market, foreign exchange includes multiple currencies, brokers, financial institutions and individual investors who hedge on the hike or fall in the value of a currency.
Foreign exchange markets serve an important function in society and the global economy. They allow for currency conversions, facilitating global trade (across borders), which can include investments, the exchange of goods and services, and financial transactions.
- How does Currency Exchange Affect Trade?
- How Trade Influences the Demand for Currency
- What is the Function of Currency Exchange?
- Why is Currency Exchange Important in Business?
- What is the Relation Between Foreign Exchange and Foreign Trade?
- What Happens When Exchange Rate Increases?
- What Affects the Currency Exchange Rate?
- What are the Advantages of Foreign Exchange Market?
How does Currency Exchange Affect Trade?
Currency exchange rates are quoted as relative values; the price of one currency is described in terms of another. For example, one U.S. dollar might be equal to 11 South African rand. In other words, an American business or person exchanging dollars for rand would buy 11 rand for every dollar sold, and a South African would buy $1 for every 11 rand sold.
How Trade Influences the Demand for Currency
These relative values are influenced by the demand for currency, which is in turn influenced by trade. If a country exports more than it imports, there is a high demand for its goods, and thus, for its currency. The economics of supply and demand dictates that when demand is high, prices rise and the currency appreciates in value.
In contrast, if a country imports more than it exports, there is relatively less demand for its currency, so prices should decline. In the case of currency, it depreciates or loses value.
For example, let’s say that candy bars are the only product on the market and South Africa imports more candy bars from the U.S. than it exports. As a result, it needs to buy more dollars relative to rand sold. South Africa’s demand for dollars outstrips America’s demand for rand.
This means that the value of the rand falls. In this situation, we’ll surmise that the rand might fall to 15 relative to the dollar. Now, for every $1 sold, an American gets 15 rand. To buy $1, a South African has to sell 15 rand.
The relative attractiveness of exports from that country also grows as a currency depreciates. For instance, assume an American candy bar costs $1. Before their currency depreciated, a South African could buy an American candy bar for 11 rand. Afterward, the same candy bar costs 15 rand, a huge price increase.
On the other hand, a South African candy bar costing 5 rand has become much cheaper by comparison: $1 now buys three South African candy bars instead of two.
South Africans might start buying fewer dollars because American candy bars have become quite expensive, and Americans might start buying more rand because South African candy bars are now cheaper. This, in turn, begins to affect the balance of trade. South Africa would then start exporting more and importing less, reducing the trade deficit.
What is the Function of Currency Exchange?
A currency exchange is a licensed business that allows customers to exchange one currency for another. Currency exchange of physical money (coins and paper bills) is usually done over the counter at a teller station, which can be found in various places such as airports, banks, hotels, and resorts. Currency exchanges make money by charging a nominal fee and through the bid-ask spread in a currency.
Also known as a “bureau de change” or “casa de cambio,” a currency exchange should not be confused with the foreign exchange (forex) market where traders and financial institutions transact in currencies.
Currency exchange businesses, both physical and online, allow you to exchange one country’s currency for another by executing buy and sell transactions. 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. The amount you would be able to purchase would be dependent on the international spot rate, which is basically a daily changing value set by a network of banks that trade currencies.
The currency exchange store will modify the rate by a certain percentage to ensure that it makes a profit on the transaction. For example, suppose the spot rate for exchanging U.S. dollars into Australian dollars is listed as 1.2500 for the day.
This means that for each U.S. dollar spent, you can buy 1.25 Australian dollars if traded at the spot rate. But the currency exchange store may modify this rate to 1.20, meaning you can buy 1.20 Australian dollars for 1 U.S. dollar. With this hypothetical rate change, their fee would effectively be 5 cents on the dollar.
Because the transaction is not conducted at the spot rate, and depends on the profit that the exchange wants to make, consumers may find that it is less expensive to incur ATM or credit card fees at the foreign destination, rather than use exchange services ahead of time. Travelers are advised to estimate how much money they will spend on a trip and compare the amounts saved through typical transactions.
Why is Currency Exchange Important in Business?
Exchange rates are the price of foreign currency that an amount of one currency can buy e.g. one-pound sterling. An increase in the value of the sterling means one pound can buy an increased amount of foreign currency, meaning you are getting more for the same amount of money.
Businesses that import and export goods need to pay close attention to these exchange rates as the value of goods is highly sensitive, chopping and changing with constant fluctuations. Businesses that trade domestically must also be aware of changes in exchange rates as they will have an indirect impact by virtue of the wider economy. So, how exactly do exchange rates affect a business? We will look at some examples below.
Selling overseas
If you run a business that sells products or services to a country abroad, then a change in the exchange rate will have a direct impact on your bottom line. The force of the impact will be dependent on how invoices are issued. If invoices are submitted in foreign currency, a risk remains where you will receive less money than expected if the exchange rate moves against you from the time the invoice as issued and date of payment.
Issuing invoices in your local currency should have a lesser impact, as the overseas buyer must change their local currency into yours to make payment. You’ll receive the full invoice amount regardless of where the exchange rate sits.
The potential risk here is that your prices may become uncompetitive as a result of variations to the exchange rate, leading to lost market share against foreign competitors who do not have to include transactional exchange rate changes.
Buying overseas
As with selling overseas, if your business contracts with a supplier from a foreign country, you become vulnerable to fluctuations in the exchange rate. For example, if you purchase goods from a supplier in China and payment of 300,000 Chinese Yuan for your next shipment is due in a month’s time with an exchange rate of 8.74, your invoice would sit at £34,330.83 if paid today.
However, in a month’s time when the payment is due if the exchange rate has moved to 8.8, your invoice would change to £34,090.90, meaning you’re paying £239.93 less for the same shipment of goods.
Of course, if the exchange rate was to go the other way, you would have to pay more for the same amount of goods. Some businesses put forward contracts that fix exchange rates for a set period in place to help reduce the risk to the business.
Indirect impact
Changes in the exchange rate can also indirectly impact your business, even when you do not buy or sell goods and services overseas. For example, if you transport products around the country using delivery trucks and the cost of fuel is raised due to changes in the exchange rate, you will end up paying more for your shipments to be delivered.
Exchange rate volatility can also have an effect on competition. Depreciation of your local currency makes the cost of importing goods more expensive, which could lead to a decreased volume of imports. Domestic companies should benefit from this as a result of increased sales, profits and jobs.
What is the Relation Between Foreign Exchange and Foreign Trade?
The main relationship between exchange rate and international trade is the manner in which fluctuations in exchange rates affect the value of imports and exports. When it comes to exchange rate and international trade, a weak currency may affect the type of goods as well as the quantity of goods that one country may be able to purchase. Such a disparity in exchange rate and international trade may also lead to a condition where there is a trade imbalance between two trading partners.
An analysis of the relationship between exchange rate and international trade can be done on the national or governmental level, or it may be seen from an individual perspective. On the national level, a country with a weaker currency is at a disadvantage when trading with a country with a much stronger currency.
This is due to the fact that the country with the weaker currency will not be able to attach the same value and satisfaction to the goods that it is able to purchase based on the exchange rate.
When a country is exporting a product, it may find out that a weaker currency will be to its advantage. Selling its goods on the international market will net more money in terms of local currency due to the fact that the local currency is weaker than the foreign one. This also works for individuals.
For instance, if a businessman’s currency sells for 100 to a dollar as opposed to a previous 50 to a dollar, this means that he can sell the goods for the usual dollar amount and make twice as much money in terms of the local currency based on the change in the exchange rate.
The problem would be that when the businessman tries to import products he would have to spend twice as much to buy the stronger foreign currency in order to facilitate the trade. This means that there is trade imbalance between the two countries in which the country with the stronger currency has the monetary advantage. The imbalance is due to a disproportionate variation in the exchange rates of the currencies of both countries.
In economic terms, any form of depreciation or appreciation that occurs in the exchange rate of a country directly affects the trade balance between that country and its trade balance. Thus, depending on whether the exchange rate depreciates or appreciates, the trade balance may change to the detriment or to the gain of the country in relation to trading with other countries.
Such factors also affect the competitiveness of a country in international trade. Some countries purposefully devalue their currency so as to improve the benefits of trading with countries that have stronger currencies. Devaluation increases the value of exports by making them cheaper while making imports expensive.
What Happens When Exchange Rate Increases?
Currencies are traded in the foreign exchange market. Like any other market, when something is exchanged there is a price. In the foreign exchange market, a currency is being bought and sold, and the price of that currency is given in some other currency. That price is expressed as an exchange rate.
For example, in the market for the Hamsterville snark, the exchange rate of the snark to the U.S. dollar (US$US$U, S, dollar sign) is US$5US$5U, S, dollar sign, 5 per snark. That means in order to buy a single snark, someone from the United States would need to pay for it with US$5US$5U, S, dollar sign, 5.
On the other hand, someone from Hamsterville who wants dollars would buy those dollars with snarks. So, the exchange rate of the dollar is the inverse of the exchange rate of the snark:
Exchange rate for snark=$5 per 1SN
Exchange rate for dollar=$5 per 1SN=1SN per $5
When an exchange rate changes, the value of one currency will go up while the value of the other currency will go down. When the value of a currency increases, it is said to have appreciated. On the other hand, when the value of a currency decreases, it is said to have depreciated.
For example, if it now takes USD$10USD$10U, S, D, dollar sign, 10 to buy a single Hamsterville snark instead of $5$5dollar sign, 5, the snark has appreciated and its value has increased. If prices in the United States haven’t changed, this is great news for Hamstervillians! Now the snark can buy more goods and services from the United States.
But, this is bad news for Americans who want to buy Hamsterville’s goods and services. Each U.S. dollar now buys only 0.1SN0.1SN0, point, 1, S, N instead of 0.2SN0.2SN0, point, 2, S, N as it did before. The dollar has depreciated against the snark and everything from Hamsterville just got a lot more expensive.
What Affects the Currency Exchange Rate?
As well as moving or traveling abroad, common reasons to exchange currencies include paying mortgages, funding a child’s education, or preparing for retirement overseas.
But currencies are exchanged on a much greater scale for other reasons, including trade – buying goods and services from another country – and investment.
The rising value of a country’s currency versus others may be an indicator of improving economic health. Or at least the prospect of it. If GBP is rising against the USD, for example, it’s in higher demand at that time.
Below are some of the key influences on exchange rate movements.
Interest rates and inflation
Inflation and interest rates are closely related, and both affect exchange rates.
Some inflation – rising prices of goods and services – is healthy for an economy, as it shows increasing demand versus supply. But too much inflation can be a problem, as goods and services become less affordable.
Central banks consider this balance when setting interest rates. For example, the Bank of England has an inflation target of 2%, as of 22 May 2020.
If inflation is below its target level, a central bank may look to cut interest rates. Lower interest rates make it cheaper to borrow, and less rewarding to save, which encourages people to spend. That increase in demand can push inflation higher.
But if inflation is rising too fast, a central bank may increase interest rates, aiming for the opposite effect. Higher rates can make it more expensive to borrow, and more rewarding to save, reducing demand and slowing inflation.
Higher interest rates can increase a currency’s value. They can attract more overseas investment, which means more money coming into a country and higher demand for the currency.
Trade
A country’s trading relationship with the rest of the world can also affect its currency. Countries that export more than they import – known as a trade surplus – will typically have stronger currencies than those with trade deficits.
If businesses outside the UK buy goods and services from the UK, for example, they’ll typically pay for them in pounds. The more a country exports, the higher the demand for its currency will be.
Market expectations
Market expectations – taking into account the above factors – play a big part in exchange rate fluctuations.
But an unexpected interest rate cut, or increase, could have a more pronounced effect on exchange rates.
The Bank of England holds regular Monetary Policy Committee meetings, where it decides whether to raise, cut, or leave rates unchanged. Similarly, in the US, the Federal Open Market Committee (FOMC) holds regular meetings to discuss monetary policy, including interest rates.
Other economic data, such as Gross Domestic Product (GDP) and unemployment rates, will also affect market expectations.
The stability of a country – economic and political – does too. The outcome of an election, could have a significant impact on a country’s currency, if the market expects it to result in faster or slower economic growth.
What are the Advantages of Foreign Exchange Market?
There are various advantages of the foreign exchange market. Let’s have a look at those:
Globalized marketplace:
There are no geographical or localized constraints in foreign exchange market. Investors are free to trade in currency pairs from across the globe. The constant buying and selling of different currencies from different locations makes foreign exchange a kind of global market. It is estimated that over 4 trillion dollars change hands in financial markets everyday
Flexibility:
Since there’s neither any regulatory authority nor any cap on the money that can be traded daily, foreign exchange market offers a lot of flexibility both to rookie investors as well as seasoned players in the market. Foreign exchange market also operates round the clock, so there’s simply no issue of time constraints or the need to schedule trading hours according to a different time zone.
By sitting in India, you can trade in foreign currencies you want and at the time of your convenience. The complete liberty to trade at any time and without any restrictions on the amount, makes foreign exchange market in India quite popular among those who have a day job and are in the currencies market as well.
Full transparency:
Markets are usually not immune from unscrupulous practices like insider trading and other malpractices that tilt the advantage towards a few to the detriment of a vast majority of individual investors. However, since the foreign exchange market literally spans over multiple continents, countries, geographies and time zones, the possibility of it being rigged or manipulated is very low.
With an extensive global scope, there’s no central bank or a national supervisory authority that can interfere much with its working or saddle it with regulations. This makes the foreign exchange market both highly transparent and efficient.
Wide range of trading options
With currencies of virtually every country up for trading, there are multiple trading options. Based on their priorities, traders can either enter into spot trading or future agreements. There’s a multiplicity of options available in future agreements to.
Be it a small investor or someone with massive cash flow, there’s an option for everyone in the foreign exchange market, according to the risk aversion level. The volume of everyday transactions in the foreign exchange market is higher than any other market, which leads to enough liquidity. Traders can both enter the market and leave it in a few minutes.
Low transaction costs:
Most types of trading, whether stocks or commodities include a certain commission or transaction fee, which varies based on several factors. Transaction cost in foreign exchange market is among the lowest, as it functions differently from other markets.
No commission:
There’s usually no commission charged in foreign exchange trade. In exceptional cases of big transactions, the commission is very low. No exchange fee or clearing fee is charged as well. Unlike stock brokerage firms, dealers in the foreign exchange market earn revenue via ‘the difference between the quoted buying price and the bid, which is mostly very low. This difference is known as ‘spread’.
Market Volatility:
High volatility is usually considered negative for markets, however, in foreign exchange market it can be a positive force as well. Fluctuations in foreign exchange market usually depend on external factors like political turbulence, economic growth, stability of the country, investors’ confidence, any new government policies or regulations, or natural disasters.
With the exception of natural disasters, all of the above events don’t strike randomly or unpredictably. They build up over a long time and the change is rarely sudden and dramatic. This gives informed investors the chance to decide whether to pull out or infuse more money in the markets. Major economy currency pairs and emerging market ones are associated with high volatility. Foreign exchange rates mostly hinge on economic indices and political stability.
Hi-tech marketplace
Since foreign exchange market operates 24X7 across 6 continents, 100+ countries and dozens of different time zones and the daily transaction volume is enormous, it requires seamless and uninterrupted connectivity for minimizing any lag.
It is completely decentralized and not under any single supervisory authority, also gives impetus to constantly improvise the trading platforms. Technological advances are swiftly embraced by the foreign exchange market. Nowadays, there are dozens of mobile apps with a truly easy and customer-friendly interfaces and connectivity.
Leverage:
Foreign exchange market has the highest leverage among all asset markets. It allows the investor to take risk and increase the profit margins exponentially. However, the downside is that since it’s risky, there may also be the possibility of a loss, so investors should use leverage at their discretion and after taking in consideration all odds. Due to the high leverage involved, even though pace of market movements is really slow, individual traders can make huge profits.
Demo Accounts:
As a practice simulation so that you can learn the tricks of the trade, a lot of foreign exchange market dealers offer demo accounts. Everything about these accounts is real except that it involves dealing in token play money, instead of real currency deals. For those looking for a dummy trial before they start with real trading, a demo account can get really helpful both to get the drill and boost your confidence.
