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Students Zone - Chapter Introductions
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Chapter 1 - The Foreign Exchange Market
When studying open economies that trade with one another, there is a major difference in the transactions between domestic and foreign residents as compared to those between residents of the same country; namely, that differing national currencies are usually involved. A US importer will generally have to pay a Japanese exporter in yen, a German exporter in euros and a British exporter in pounds. For this reason, the US importer will have to buy these currencies with dollars in what is known as the
foreign exchange market. The foreign exchange market is not a single physical place, rather it is defined as a market where the various national currencies are bought and sold. Exactly what factors determine how much domestic currency has to be given in exchange to obtain a unit of foreign currency, the behaviour of exchange rates and the impact of exchange rate changes on the economy is one of the major fields of study in international economics and is the subject matter of later chapters of this book.
In this chapter, we look at some preliminary issues; we examine the various participants in the foreign exchange market and the basic forces that operate in the market.
We then examine the basic determinants of exchange rate behaviour. The chapter proceeds to examine various exchange rate definitions and their economic significance. We then look at the basic operational differences between fixed and floating exchange rate regimes. The chapter finishes by examining the relationship between the spot and forward exchange rate.
One of the most fascinating things about the foreign exchange market is the huge sums of money that are exchanged on a daily basis, Table 1.1 shows the result of surveys carried out by the Bank for International Settlements (BIS). The main centre for foreign exchange trading is London, with some $753 billion worth of foreign exchange traded on a daily basis, quite a lot when one considers that the annual gross domestic product of the United Kingdom is slightly over twice that amount. Other important foreign exchange centres are New York with $461 billion, Tokyo with $199 billion, Singapore $125 billion, Paris $64 billion and Frankfurt $118 billion. The net volume of foreign exchange dealing globally was in April 2004 estimated to be in excess of $2.4 trillion per day.
