In this lesson summary review and remind yourself of the key terms and graphs related to the market for foreign exchange (FOREX).
Lesson summary
The foreign exchange market is like any other market insofar as something is being bought and sold. However, the foreign exchange market is unique in two ways:
A currency is being bought and sold, rather than a good or service
The currency being bought and sold is being bought with a different currency.
Key Terms
Key term
Definition
exchange rate
the price of one currency in terms of another currency; for example, if the exchange rate for the Euro (€) is 132 Yen (), that means that each Euro that is purchased will cost 132 yen.
foreign exchange market
a market in which one currency is exchanged for another currency; for example, in the market for Euros, the Euro is being bought and sold, and is being paid for using another currency, such as the yen.
demand for currency
a description of the willingness to buy a currency based on its exchange rate; for example, as the exchange rate for Euros increases, the quantity demanded of Euros decreases.
appreciate
when the value of a currency increases relative to another currency; a currency appreciates when you need more of another currency to buy a single unit of a currency.
depreciate
when the value of a currency decreases relative to another currency; a currency depreciates when you need less of another currency to buy a single unit of a currency.
floating exchange rates
when the exchange rate of currencies are determined in free markets by the interaction of supply and demand
When the exchange rate of a currency increases, other countries will want less of that currency. When a currency appreciates (in other words, the exchange rate increases), then the price of goods in the country whose currency has appreciated are now relatively more expensive than those in other countries. Since those goods are more expensive, less is imported from those countries, and therefore less of that currency is needed.
For example, suppose the price of a cell phone in the U.S. is , and the current exchange rate in Japan is 90 ¥ per dollar. That means that it takes: to buy the same cell phone in Japan. If two cell phones are imported into Japan, then a total of 800 US dollars will be needed to buy these phones.
However, if the dollar appreciates so that it now takes to buy a dollar, the same cell phone now costs . Because cell phones are more expensive, only one is imported into Japan from the United States, so the quantity of US dollars that Japan wants will fall from to .
The equilibrium exchange rate is the interaction of the supply of a currency and the demand for a currency
As in any market, the foreign exchange market will be in equilibrium when the quantity supplied of a currency is equal to the quantity demanded of a currency. If the market has a surplus or a shortage, the exchange rate will adjust until an equilibrium is achieved.
For example, suppose Westeros is a trading partner of Hamsterville, and the currency of Westeros is the Westeros Gold Dragon (). Currently, the exchange rate is per Hamsterville snark (). At this exchange rate, Hamsterville wants to sell , but Westeros only wants to buy . Therefore, there is a surplus of .
Like any surplus, this will place downward pressure on the price. If the exchange rate is flexible, then the exchange rate will decrease until the quantity supplied is equal to the quantity demanded.
Suppose the United States and Japan are trading partners. Japan’s currency is the Yen () and United States’ currency is the U.S. dollar (). We can represent the market for the U.S. Dollar in the foreign exchange market, as shown here:
[I’m still not feeling it. Can you give me a memorable example?]
Common misperceptions
We are used to thinking about buying things with a currency, so many new learners are confused about what the price should be in the market for a currency. Buthe price of an orange is never given in oranges; it’s given in some other currency. Just like an orange, a dollar can’t be bought with itself, but instead it needs to be bought with some other currency.
A common misperception is to confuse 1) the things that cause shifts in the supply or demand of a currency with 2) changes in quantity supplied or quantity demanded. To keep this straight, ask yourself “why is this change happening?” If a change is happening in response to a change in the exchange rate, then you are moving along a curve. If a change is happening in response to something else, the entire curve shifts.
It might seem like a time saver to take short-cuts on labeling graphs, but this is never a good idea. Take your time labeling the foreign exchange market carefully using the elements of a market:
Demand - the demand for the currency that is being exchanged
Supply - the supply of the currency that is being exchanged
Quantity - the quantity of the currency that is being exchanged
Price - some other currency that is being used to buy the currency that is being exchanged
Questions for review
China and Ghana are major trading partners. The currency of China is the and the currency of Ghana is the . In a correctly labeled graph of the foreign exchange market for the cedi, show the impact of an increase in imports from Ghana to China. Then, explain what is going on in your graph.
[I tried my best. Can I check my work?]
List 3 things that would cause the exchange rate of the U.S. dollar, in terms of Yen, to increase.
The foreign exchange market is an over-the-counter global market where the buying and selling of global currencies occur, determining their exchange rates.
Foreign exchange risk is the chance that a company will lose money on international trade because of currency fluctuations. Also known as currency risk, FX risk and exchange rate risk, it describes the possibility that an investment's value may decrease due to changes in the relative value of the involved currencies.
Foreign-exchange market (FEM) the market where one country's money is traded for that of another country. Exchange rate. the price of one country's money in terms of another.
Key Takeaways. The foreign exchange (forex or FX) market is a global marketplace for exchanging national currencies. Because of the worldwide reach of trade, commerce, and finance, forex markets tend to be the world's largest and most liquid asset markets. Currencies trade against each other as exchange rate pairs.
The purpose of foreign exchange is to compare one currency with another for showing their relative values. Foreign exchange rate can also be said to be the rate at which one currency is exchanged with another or it can be said as the price of one currency that is stated in terms of another currency.
Answer and Explanation: The foreign exchange market is a market where one country's currency is traded for that of another (answer b.) The foreign exchange market entails a market in which the currency of a given country is traded with the currency of another country.
The foreign exchange market serves two main functions. These are: convert the currency of one country into the currency of another and provide some insurance against foreign exchange risk.
Changes in currency exchange rates affect international trade by increasing or decreasing exports and imports. A strong domestic currency will cause exports to decrease and imports to increase. As exchange rates decrease, exports rise and imports go down.
The relative values of the two currencies could change between the time the deal is concluded and the time payment is received. If you are not properly protected, a devaluation or depreciation of the foreign currency could cause you to lose money.
The two main purposes of a securities exchange are to provide a place for people to buy and sell securities and to determine fair market prices for those securities based on supply and demand.
facilitate the exchange of goods and services between buyers and sellers. The exchange of goods and services without the use of money is called "over-the-counter exchange." A market is always a specific location or store.
The primary purpose of a medium of exchange is to assist a sale or purchase. The process of exchange is carried through a medium of exchange as participating parties acknowledge the worth of the medium.
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