A foreign exchange (FX)
transaction is a transaction which allows funds to flow between banks deposits
denominated in
different currencies.
Foreign exchange is the conversion of one country's currency into that of
another. In a free economy, a country's currency is valued according to factors
of supply and demand. In other words, a currency's value can be pegged to
another country's currency, such as the U.S. dollar, or even to a basket of
currencies. A country's currency value also may be fixed by the country's
government. However, most countries float their currencies freely against those
of other countries, which keep them in constant fluctuation.
The value of any particular currency is determined by market forces based on
trade, investment, tourism, and geo-political risk. Every time a tourist visits
a country, for example, he or she must pay for goods and services using the
currency of the host country. Therefore, a tourist must exchange the currency of
his or her home country for the local currency. Currency exchange of this kind
is one of the demand factors for a particular currency. Another important factor
of demand occurs when a foreign company seeks to do business with a company in a
specific country. Usually, the foreign company will have to pay the local
company in their local currency. At other times, it may be desirable for an
investor from one country to invest in another, and that investment would have
to be made in the local currency as well. All of these requirements produce a
need for foreign exchange and are the reasons why foreign exchange markets are
so large.
Foreign exchange is handled globally between banks and all transactions fall
under the auspice of the Bank of International Settlements.
History of the Foreign Exchange Trading Market
Traditionally, retail investors' only means of gaining access to the foreign
exchange market was through banks that transacted in large amounts of currencies
for commercial and investment purposes. Trading volume has increased rapidly
over time, especially after exchange rates were allowed to float freely in 1971.
From 1944 until 1971, most of the world's major currencies were pegged to the US
dollar under an arrangement called the Bretton Woods Agreement. Participating
countries agreed to try and maintain the value of their currency with a narrow
margin against the US dollar and a corresponding rate of gold, as needed. These
countries were prohibited from devaluing their currencies to gain a foreign
trade advantage. Consequently, the foreign exchange market was relatively
static.
Importance of Foreign Exchange
1-Foreign exchange reserves show the financial strength and the stage of
development of the economy.
2 -The acceptance of currency at a predetermined rate makes the international
trade easy.
3- The foreign exchange ratio shows direct relationship between the prices of
the commodities in the national and international market.
4-The foreign exchange balances of a country directly affect the rates of
exchange. A hard currency nation has stability in foreign exchange rate.
5-The rising foreign exchange balances of a nation increases its credit
worthless in the international capital market.
The global market is an important thing for the world’s economy. It keeps on
changing the world’s economy. The volume of the global market keeps on changing
too. There were transactions as big as 1900 billion dollars in 2004. It includes
600 billion cash transactions and about 1300 billion in the future operations.
The volume of transactions was about 53% between the banks itself and about 33%
between banks, fund managers and non-bank financial organizations. There is
about 14% between banks and non-financial organizations including all the major
banks, and retailers or dealers. There are some teams based in Australia and
Asia has succeeded the foreign exchange in other continents such as America and
Europe. This means that all of people can do foreign exchange anywhere in this
world.
People can do the forex anywhere in this world. However, the main market of
Forex is in London. In their last three-yearly review showed, the BIS or Bank
for International Settlements announced that more people are choosing to invest
in foreign exchange than any other businesses. Although still a small minority
of transactions and volume devoted to private investors has increased too. Many
people have chosen to invest their money in the foreign exchange, because of the
technology today. There are many services on the internet where people can
access the information about forex in which they can track their business all
over the time.
The $1.5 trillion-per-day foreign exchange (FX) market surpasses stocks and
bonds as the largest market in the world. Foreign exchange markets are critical
for setting exchange rates between countries.
Liquidity
In terms of international trade, liquidity is the ease in which foreign currency
is converted into domestic currency. FX markets, such as the New York Mercantile
Exchange, match buyers and sellers to bring about speedy, orderly transactions.
Rates
Buyers and sellers set prices using the auction method in the FX market. Sellers
try to earn the highest "ask" price possible, and buyers try to purchase
currency at the lowest "bid." Buyers and sellers meet at the "spot" price, the
current value and exchange rate for a particular currency against others.
Reserves
International governments enter the FX market to build and manage foreign
exchange reserves. They build the reserves to make official payments and
influence domestic currency values.
International Trade
Businesses rely on FX markets to buy currency that is spent to obtain overseas
goods. Corporations will also look to FX markets to convert international
earnings back into the domestic currency.
Hedging
Traders use foreign exchange derivatives, which "derive" their valuations and
costs from the spot market. Options and futures contracts effectively lock in
exchange rates for a set period, to hedge against the risks of currency
fluctuations.
Foreign exchange controls
Foreign exchange controls are various forms of controls imposed by a government
on the purchase/sale of foreign currencies by residents or on the purchase/sale
of local currency by nonresidents.
Common foreign exchange controls include:
• Banning the use of foreign currency within the country
• Banning locals from possessing foreign currency
• Restricting currency exchange to government-approved exchangers
• Fixed exchange rates
• Restrictions on the amount of currency that may be imported or exported
Countries with foreign exchange controls are also known as "Article 14
countries," after the provision in the International Monetary Fund agreement
allowing exchange controls for transitional economies. Such controls used to be
common in most countries, particularly poorer ones, until the 1990s when free
trade and globalization started a trend towards economic liberalization. Today,
countries which still impose exchange controls are the exception rather than the
rule.