The ABCs of the Foreign Exchange Market
Eleftherios N. Botsas*

Exchange rates permit us to compare the international prices of goods and services. Comparison of prices for various goods and services expressed in terms of national currencies is facilitated by the exchange rate that translates them to a common unit of account. Since prices are quoted in terms of national (home) currencies, a buyer of goods not produced at home would have no way of knowing the equivalent prices in the absence of an exchange rate. An exchange rate is simply the price of one currency in terms of another, and the market in which foreign currencies are exchanged is called the foreign exchange market.

The Underlying Concept

There sometimes appears to be a mystery in the foreign exchange market. After all, when I buy scotch in Michigan I pay in US dollars, not pound sterling (£). It is the same currency that I use when I buy US produced goods and services. However, just as the US producer demands dollars to pay his bills, the British producer demands his national currency to pay bills. Therefore, whenever I demand British goods and services, I also demand British currency, and supply my national currency. Although I pay dollars, at some point in the importation process a currency exchange occurred. To a great extent, the price of a currency depends on the demand and supply of that currency. If Americans demand more imports (foreign exports) than foreigners demand American exports, the American supply of dollars exceeds the foreign demand for dollars, and the price of the dollar will fall. Changes in the exchange rate affect the relative prices of goods outside the home market. Therefore, they change the quantity demand for imported commodities. For example, at an exchange rate of $1.60 per British pound, a British automobile selling for £20,000 in the United Kingdom will sell for $32,000 plus the cost of transportation and taxes in the United States. If the exchange rate between the pound and the dollar changes to $1.40 per pound, then the price of the same automobile, still selling for £20,000 in Britain, will be $28,000 in the United States. When the dollar price of a foreign currency falls, we say that the dollar has appreciated and the other currency has depreciated. Appreciation and depreciation are simple, yet perplexing, concepts. If one currency appreciates vis- a-vis another, then the other currency depreciates. Appreciation of the dollar means the dollar price of the pound has fallen; it takes fewer dollars to buy a pound. Therefore, the pound price of the dollar has risen; it takes more pounds to buy a dollar. This makes US goods more expensive in Britain, and British goods cheaper in the United States, even when domestic prices have remained the same in the two countries. Thus, other things equal, appreciation of the dollar encourages US imports and discourages exports. That is why many commentators suggest that the United States can eliminate its trade deficit by letting the dollar fall. This will make US goods competitive in both the domestic and foreign markets. However, this will also make US assets cheaper for foreigners to acquire. Moreover, depreciation of a currency does not guarantee that a deficit in the trade account will turn into a surplus in the near term. Many commentators confuse their audiences by stating that the dollar has gained strength or has weakened. Because the world consists of more than two countries, the exchange rate between two countries, called the bilateral rate, tells little about the exchange rate versus other currencies. Thus, the dollar may be "strong" with respect to the pound, but "weak" relative to the Japanese yen. Exchange rates are quoted in two ways: the price of a foreign currency in terms of dollars (also called the American or direct terms), or the number of foreign-currency units per per unit of national currency (the British terms). Almost all financial papers report both ways. Since foreign exchange is just another commodity, the direct way is intuitively easier to understand. It is the number of home currency units necessary to buy a unit of the commodity. Fifty dollars per pair of shoes is more usual than 0.02 shoes per dollar. Market forces insure that the various exchange rates are brought into alignment. If there are any discrepancies between exchange rates of currencies in different markets, called the cross rates of traded currencies, arbitrage will eliminate the difference. The speed of today's communications ensures that currencies cannot stay out of line for long. Arbitragers keep a watchful eye on the possibility of cross-rate inequality. This is a sure source of profit with no risk by buying and selling instantaneously in two different locations.

The Main Markets

There are several markets for foreign exchange. The spot market is for immediate exchange of currencies, although immediate means two-day settlement, except in the case of North America where the settlement is one day after the commitment. Two participants agree on the price and the amount of currencies to be exchanged. This market, which accounts for 50 percent of the foreign exchange market, sets the tone for the daily activities of the market, but buyers and sellers may be exposed to foreign exchange risk. Since exchange rates vary from moment to moment, there is an exchange rate risk that may make an otherwise profitable transaction unprofitable. The forward market provides a hedge against exchange rate risk. There is no exchange of currencies until the agreed upon date, and at a currently agreed exchange rate, no matter what the future exchange rate happens to be. In other words, one party agrees to buy, and the other party to sell, a certain amount of a foreign currency days, months or years in the future at a currently agreed upon price. Banks tailor these contracts to their client's specifications. It must be noted, however, that not all currencies are transacted in the forward market. Most of the developing countries do not let their currencies be freely converted and traded. Foreign currency futures provide a second way of hedging against exchange rate fluctuations, but they come in fixed amounts and maturity dates. Moreover, futures require original margins with the broker and adjustments as the value of the contract varies with variations in the exchange rate. Currency futures are traded in organized exchanges like the Chicago International Money Market, while the market for spot and forward contracts is a worldwide network of financial institution and banks. Since, however, both futures and forward contracts lock buyers and sellers in an unbreakable commitment, the market has developed a third method of hedging: currency options. A participant can buy an option that gives him the right, but not the obligation, to buy or sell a foreign currency. The buyer of an option pays a fee that depends on (a) maturity (b) the relationship between the option price and the current spot rate and (c) the volatility of the currency. Both the price and the future date of the option are fixed in advance. If the option is not exercised, the buyer forgoes the fee paid. The buyer will exercise the option if the call price (also known as the strike price) is less than the market price of the option. Foreign exchange options were first introduced on the Philadelphia exchange in 1982. Futures and options are minor parts of the foreign exchange market. Together, they account for only 3 percent of the foreign exchange market, compared with a 47 percent share for the forward market (The Economists 12 December 1992). London is the premier financial center for foreign exchange, accounting for 27 percent of the global market; New York is second with a share of 18 percent and Tokyo third at 12 percent (Federal Reserve Bank of New York).

The Main Actors

International travelers know first hand the importance of exchange rates, because they exchange one national currency for another. Yet in spite of the significance of international travel, this constitutes a minor component of the volume of international currencies traded daily. Banks are the main participants in the market acting either for their clients or their own portfolio. Inter-bank transactions account for about 70 percent of the foreign exchange market. When the banks cannot rearrange their portfolios by themselves or they wish to remain anonymous, they employ the services of brokers who act as middlemen. Brokers receive commissions for bringing buyers and sellers together. They bear no risk. Multinational corporations constantly need various currencies for their operations and to hedge against foreign exchange risk. Political events affect the exchange rates, and exchange rates affect the profitability of subsidies and affiliates that operate in various national and international markets. Therefore, in order to avoid translation losses, multinationals sometimes engage in swaps, a spot sale of a currency with a forward repurchase of the same currency. Speculators and official agencies, mainly central banks, also play a role in the foreign exchange market. Speculators act under the conviction that the market is wrong, while central banks wish to alter the exchange rate of their currency, either up or down.

Exchange Rate Systems

The choice of an exchange rate system has been debated for a long time without consensus. Historically, there has been a spectrum of international financial systems between two extremes: a permanently fixed exchange rate and completely variable exchange rates. The former is associated with the classical gold standard. Its history is rather short, from the 1840s to 1914, but its mythification is long. The rules of the fixed exchange rate game were relatively simple. Each country defined the price of gold in terms of its domestic currency, stood ready to convert its currency to gold on demand, and varied the supply of money directly with the gain or loss of gold. Thus, the exchange rates between currencies remained fixed. There are several arguments in favor of the regime of fixed exchange rates. First, it introduces a needed discipline to macroeconomic policies. If for example, there is a deficit in the balance of payments, the deficit country will experience an outflow of gold or reserves and a fall in the supply of money, which in turn will reduce expenditures, prices and nominal wages until the balance of payments is restored. The opposite will happen in the surplus country. Equilibrium in the balance of payments is guaranteed, although equilibrium in the domestic economy can be achieved only through perfect price-wage flexibility and resource mobility. Although the surplus country will experience inflation, this will be offset by deflation in the deficit country. In an interdependent world, discipline in macroeconomic policies can prevent worldwide sustainable inflation. Yet the political realities of pursuing full employment at the expense of price stability have dominated macroeconomic policies. Therefore, advocates of fixed exchange rates argue, the system reduces the ability of the authorities to pursue policies that create and sustain inflation. The second argument in favor of fixed exchange rates is that the system promotes international coordination of monetary policies. In an interdependent world, monetary policies have spill-over effects that have to be coordinated. Since the exchange rate is removed as an instrument of national macroeconomic policy, the authorities are forced to coordinate their policies on the international level. For example, the European Union's economic and monetary union, proposed to be achieved by January 1, 1999, provides for permanently fixed exchange rates among member countries. Countries that follow an independent macroeconomic policy will experience a loss of resources. A regime of fixed rates reinforces the need for coordination of policies. In contrast to variable exchange rates, the fixed rate system reduces frequent shifting of resources between sectors that takes place because of constant change in exchange rates. Since exchange-rate variations alter the international price relationships, they alter imports and exports. Therefore, resources move in and out of sectors of the economy according to international demand. This, the advocates of fixed exchange-rate systems argue, is a wasteful mobility. A fourth, although not final, argument in favor of fixed exchange rates is that it is more conducive to trade and investment expansion because it eliminates exchange-rate risk. The statistical record on trade flows is not conclusive. Some investigators have found no negative effect of exchange-rate volatility and trade volume, while others have found the opposite. Since empirical studies depend on recorded data, the findings depend heavily on the period chosen and the assumptions made about what would have happened if the alternative system was present during the same period. Thus, we are far from knowing for certain what the system failed to achieve. With respect to long term capital mobility, the 1980's coincided with both exchange-rate volatility among the currencies of the industrial countries and high volume of capital mobility. But, it is possible that capital mobility would have been even higher under fixed exchange rates. The opposite system to fixed exchange rates is one of freely fluctuating exchange rates. An exchange rate between two currencies is simply the price of one currency in terms of the other. The price of a currency, like the price of any commodity or service, reflects relative scarcities. Since we know that fixing prices leads to resource misallocation, then why fix the price of one of the most important items in an economy? Variable exchange rate proponents argue that fixing the exchange rate interferes with optimal resource allocation in the world economy. A second argument favoring variable exchange rates is that a fixed exchange-rate system subordinates internal objectives of the monetary authorities to balance-of-payments equilibrium, while the variable system frees the hands of the policy makers to pursue internal equilibrium without having to worry about the balance of payments. Surpluses and deficits should self-destruct quickly through variations in the exchange rate, while under a fixed rate system, exchange rates play no role. Moreover, in a fixed exchange-rate system, business cycles originating in one country are transmitted to the rest of the world. A fixed exchange rate plays no active role to mitigate cyclical fluctuations, while exchange-rate variability plays an active role to insulate the economy from external shocks. A third argument is that fixed exchange rates require foreign exchange reserves that tie up resources that could be used more efficiently elsewhere in the economy. Since the exchange rate has to remain fixed, short run deficits can be financed through foreign-exchange reserves. But reserves are not unlimited. Sooner or later the authorities will have to change the par-value of their currency. An additional objection to fixed exchange rates is the doubtful viability of the system in the long run. Up to 1971, most currencies were pegged to the US dollar, and the dollar to gold. Yet currency after currency ran out of reserves and had to be devalued. Countries differ with respect to both inflation-unemployment preferences and economic structure. The fixed-exchange-rate system collapsed. Today the prevailing system is a hybrid of fixed and variable exchange rates. Although the exchange rates are market determined for the industrial countries, they are not free of governmental intervention.

Summary

Exchange rates are simply the price of one currency in terms of another. Just as money serves as a medium of exchange in an economy to facilitate the trade of goods, exchange rates serve as an intermediate exchange to facilitate international trade. Corporations and other institutions have developed various markets to facilitate exchange and to hedge against exchange risk. In addition, the choice of exchange rate systems has an important impact on the flow of global resources and the ability of countries to pursue individual macroeconomic policies.

*Professor of Economics, Oakland University, and editor of the International Economic Letter