How does foreign exchange work?

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Foreign exchange, commonly known as Forex or currency exchange, refers to the conversion of one country’s conversion to another according to the respective country’s currency value. An example of foreign exchange is the conversion of dollars into Euros when USA residents purchase European goods.

Foreign exchange is important in international trade. If two countries want to exchange goods, they go through the foreign exchange market in order to convert their respective currencies. This is known as the real economy trade which makes up only 2% of the forex market, the rest 98% is speculation.

Foreign exchange market

The foreign exchange market is an online network where traders deal with currencies, globally. It sets currency rates for floating currencies. It is based on two-tier, one is the Interbank Market and the other is over-the-counter market or OTC market. Interbank refers to monetary trade between banks and OTC refers to monetary trade between businesses.

This Industry is highly fluctuating at all times. A unique feature Forex is that it’s the biggest market in the world, valuing at 1.5 trillion USD per day! It’s 28 times bigger than the equity market. It also works on several levels and is operated through financial institutions (like banks).

Currencies

The entire foreign exchange market is based around currencies and what they value against other currencies. The types of currencies that exist are floating and fixed.

‘Fixed’ refers to currencies that are determined by a particular country’s government. However, the more common of the two is floating currencies. These currencies ‘float’ on the global foreign exchange market.

Determinants of floating currency exchange rate

What really determines a currency’s value? Honestly, it is not just one thing but a combination of many factors that change currency exchange rates. Some of these factors are inflation, import levels and export levels, tourism, stability of government, foreign geographical and political factors, and tourism.

Some models that determine how the currency exchange rates change includes:

  • Asset Market Model: This model emphasizes financial assets and basically implies that a currency will have a higher value and a higher rate if the capital that flows into the financial markets of the country increases. This is proved to be true in the case of developed countries like the USA, England, and Japan.
  • Balance of Payment Model: Balance of Payment tells if a country has saved up to pay for its foreign imports. BOP deficit means that a country’s currency will lose value.
  • International Parity Conditions: This model is based on theoretical conditions, for example, the free flow of goods (no quotas etc.). And so, it seldom ever applies to real life situations.

Importance of foreign exchange

While it may seem inconvenient to have whole market dedicated to currencies, forex is the backbone of foreign transactions and international trade. Through this system, countries do not have to make do with their own resources, they can supply goods that are in demand through trade. And trade is not possible without foreign exchange.

Forex also helps countries’ financial growth. For example, if a country supplies most of the weapons in the world, this demand will cause the country’s currency value to increase, making it prosper financially and also making it able to import more goods.

Investors also use the foreign exchange market. They trade currencies to buy and sell security as well as international assets.