Foreign Exchange

Definition

Foreign exchange, or forex, refers to the global market where different national currencies are traded against one another. It is the largest and most liquid financial market in the world, enabling the exchange of one currency for another for purposes such as trade, tourism, or investment.

5 Must Know Facts For Your Next Test

1. The foreign exchange market is decentralized and operates 24 hours a day, with major centers in London, New York, Tokyo, and other financial hubs.
2. Currencies are typically traded in pairs, such as the U.S. dollar and the Euro (USD/EUR), with the exchange rate fluctuating based on supply and demand.
3. Factors that influence exchange rates include economic performance, inflation, interest rates, capital flows, and political stability.
4. The balance of trade, which measures the difference between a country's imports and exports, is a key determinant of its foreign exchange position.
5. Governments and central banks can intervene in the foreign exchange market to stabilize their currency or influence its value relative to other currencies.

Review Questions

• Explain how the foreign exchange market functions and its role in international trade and investment.
  • The foreign exchange market is the global marketplace where national currencies are traded against one another. It enables the exchange of one currency for another, facilitating international trade, tourism, and investment. Currencies are traded in pairs, with the exchange rate fluctuating based on supply and demand, which is influenced by factors such as economic performance, inflation, interest rates, and political stability. The foreign exchange market is decentralized and operates 24 hours a day, with major trading centers located in financial hubs around the world.
• Describe the relationship between a country's balance of trade and its foreign exchange position.
  • The balance of trade, which measures the difference between a country's imports and exports, is a key determinant of its foreign exchange position. A country with a trade surplus, where exports exceed imports, will typically see its currency appreciate in value relative to other currencies, as there is greater demand for its currency to pay for its exports. Conversely, a country with a trade deficit, where imports exceed exports, will often see its currency depreciate, as there is less demand for its currency to pay for its imports. Governments and central banks may intervene in the foreign exchange market to stabilize their currency or influence its value relative to other currencies, based on their trade and economic objectives.
• Analyze how changes in exchange rates can impact a country's economic performance and the well-being of its citizens.
  • Fluctuations in exchange rates can have significant implications for a country's economic performance and the well-being of its citizens. A currency appreciation can make a country's exports more expensive and less competitive in international markets, potentially leading to a decline in exports and economic growth. Conversely, a currency depreciation can make a country's exports more affordable and its imports more expensive, which can boost exports but also increase the cost of living for consumers. These exchange rate changes can affect employment, inflation, consumer purchasing power, and a country's overall standard of living. Governments and central banks often monitor and manage exchange rates to achieve desired economic outcomes, balancing the needs of exporters, importers, and domestic consumers.

Related terms

Exchange Rate:

The price of one currency in terms of another currency, or the rate at which one currency can be exchanged for another.

Currency Pair:

The quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market.

Balance of Payments:

A record of all monetary transactions between a country and the rest of the world, including payments for the country's exports and imports of goods, services, and capital, as well as financial transfers.