The foreign exchange market is a global powerhouse, enabling international trade and investment. It's where currencies are bought, sold, and exchanged, with exchange rates determined by supply and demand. This market never sleeps, operating 24/5 across time zones.
International investments come in various forms. Foreign direct investment involves long-term commitments in physical assets abroad. Portfolio investments are shorter-term financial asset purchases. Hedging strategies help manage currency risks, protecting businesses from exchange rate fluctuations.
Foreign Exchange Market Fundamentals
Role of foreign exchange market
- Facilitates the buying, selling, and exchanging of currencies on a global scale
- Determines exchange rates between currencies based on the forces of supply and demand (U.S. Dollar, Euro, Japanese Yen)
- Enables international trade by allowing businesses to buy and sell goods and services across borders (exports, imports)
- Facilitates capital flows between countries, supporting international investment and financial transactions
- Represents the largest financial market globally, with trillions of dollars in daily trading volume
- Operates continuously, 24 hours a day, 5 days a week, across multiple time zones
Types of international investments
- Foreign direct investment (FDI) involves investing in physical assets or acquiring a significant stake in a foreign company (factories, real estate)
- Represents a long-term commitment to the host country
- Provides the investor with control over the investment and its operations
- Portfolio investment involves investing in financial assets, such as stocks, bonds, or mutual funds, in a foreign country
- Characterized by shorter-term horizons and higher liquidity compared to FDI
- Investor has no direct control over the underlying assets or company operations
- Hedging involves implementing strategies to minimize the risk of adverse price movements in foreign exchange markets
- Utilizes derivatives like forward contracts, futures, and options to manage currency risk (currency swaps)
- Helps businesses and investors protect against potential losses due to currency fluctuations
Exchange Rates and Currency Fluctuations
Currency fluctuations and exchange rates
- Currency appreciation occurs when the value of a currency increases relative to another currency
- Driven by higher demand for the currency or lower supply in the foreign exchange market
- Results in an exchange rate where more of the other currency is required to purchase one unit of the appreciating currency (1 USD = 0.85 EUR to 1 USD = 0.90 EUR)
- Currency depreciation occurs when the value of a currency decreases relative to another currency
- Caused by lower demand for the currency or higher supply in the foreign exchange market
- Results in an exchange rate where less of the other currency is required to purchase one unit of the depreciating currency (1 USD = 110 JPY to 1 USD = 100 JPY)
- Factors influencing currency appreciation and depreciation include:
- Interest rates: Higher interest rates attract foreign investment, increasing demand for the currency
- Inflation rates: Lower inflation relative to other countries can lead to currency appreciation
- Economic growth: Stronger economic performance can boost demand for a country's currency
- Political stability: Political instability can lead to currency depreciation as investors lose confidence
- Trade balances: A trade surplus can lead to currency appreciation, while a trade deficit can cause depreciation
- Purchasing power parity: The theory that exchange rates should adjust to equalize the purchasing power of different currencies
Economic impact of currency strength
- Stronger currency (appreciation) effects:
- Domestic consumers benefit from increased purchasing power for imported goods and services (cheaper electronics, travel)
- Domestic exporters may face challenges as their products become more expensive in international markets, potentially reducing competitiveness
- Foreign investors find investments in the country with the stronger currency more attractive due to higher returns
- Weaker currency (depreciation) effects:
- Domestic consumers experience decreased purchasing power for imported goods and services (more expensive fuel, imported food)
- Domestic exporters may gain a competitive advantage as their products become cheaper in international markets, potentially boosting exports
- Foreign investors may find investments in the country with the weaker currency less attractive due to lower returns
- Central banks and governments may intervene in foreign exchange markets to manage currency fluctuations and maintain stability
- Monetary policies, such as adjusting interest rates, can influence exchange rates (quantitative easing)
- Fiscal policies, such as government spending and taxation, can also impact currency strength (stimulus packages)
Market Characteristics
- Liquidity: The foreign exchange market is highly liquid, allowing for easy buying and selling of currencies
- Volatility: Exchange rates can experience significant fluctuations due to various economic and political factors
- Spot market: The market for immediate exchange of currencies at the current market rate
- Arbitrage: The practice of taking advantage of price differences in different markets to make a profit