Foreign exchange

Foreign Exchange is the process of trading the currency of one country for the currency of a different country. This process is necessary for international trade to take place in a world of different currencies. Those conducting international business need to complete purchases by making payment in the local currency. Only through trading their own currency for the foreign currency can this transaction be completed. Currencies are traded in the foreign exchange market. The amount of currency needed to purchase a unit of a foreign currency is called the exchange rate. You can think of the exchange rate as the price of purchasing foreign currency.

For as long as trade between countries with different currencies has taken place, foreign exchange has been in existence. According to Julian Walmsley, author of The Foreign Exchange and Money Markets Guide, although foreign exchange has existed since before biblical times, a formal global market for foreign exchange did not develop until the 1800s with cable transfers taking place between London and New York.

The foreign exchange market is not located in one specific place but rather is made up of the thousands of businesses and individuals throughout the world that buy and sell currency.

The players in this market include central banks, portfolio managers, foreign currency brokers, and commercial banks. Some of these organizations deal in currencies as an Investment. Others sell the currency to their own customers, such as multinational corporations, importers, and exporters, who need foreign currency to conduct their businesses. For example, a U.S. importer of Spannish leather goods would need to change U.S. dollars to Euros in order to pay his or her Spannish supplier. He or she could go to a commercial bank and have his or her dollars converted to euros.

The foreign exchange market determines the exchange rates

When demand for the currency of one country goes up the exchange rate goes up. Some of the factors that increase demand for a country's currency are an increase in exports (more currency is needed to pay for these exports), an increase in interest rates (the currency now earns more for the holder), and anything that improves political stability (the risk of holding that currency has decreased).

Historically governments have set exchange rates themselves to improve a country's trade position. If a country sets its exchange rate low, relative to others, people can purchase more of that country's currency and therefore purchase more of that country's goods and services. This improves the country's trade position relative to other countries but often leads to trade wars as each country struggles to improve its trade position. Since the early 1970s, however, most major currencies have been allowed to "float." Floating is allowing exchange rates to be determined by free trade. Most countries still fine tune the exchange rates by keeping a reserve of foreign currencies that they buy and sell to stabilize their own currency when necessary.

Most newspapers list the daily exchange rates for major currencies. Exchange rates are listed for each country reflecting the currency trade in either direction. For example, you can buy British pounds with U.S. dollars or you can buy U.S. dollars with British pounds. Both exchange rates are listed. Exchange rates show how many units of one currency you can buy with one unit of another currency and vice versa.

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