What Are the International Currency Markets?
The international currency market is a market in which participants from around the world buy and sell different currencies. Participants include banks, corporations, central banks, investment management firms, hedge funds, retail forex brokers, and investors. The international currency market is important because it helps to facilitate global transactions, including loans, investments, corporate acquisitions, and global trade.
Forex Market Basics
- The international currency market is a market in which participants from around the world buy and sell different currencies.
- Participants include banks, corporations, central banks, investment management firms, hedge funds, retail forex brokers, and investors.
- The international currency market helps facilitate global transactions, including loans, investments, and global trade.
How the International Currency Markets Work
The international currency market is the largest financial market in the world, with an average daily trading volume of $5 trillion. In this market, transactions do not occur on a single exchange, but in a global computer network of large banks and brokers from around the world.
The currency market, or foreign exchange market ("forex"), was created to facilitate the exchange of currency that is necessary as the result of foreign trade. For example, if a Canadian company sells a product to a U.S. firm, it'll want to be paid in Canadian dollars. The U.S. firm would need to facilitate a foreign exchange conversion through its bank to pay the Canadian company. The U.S. firm's bank account would be debited in U.S dollars. The U.S. bank would transfer the funds to the Canadian company's bank. The funds would be converted to Canadian dollars at a preset exchange rate and credited to the Canadian company's account.
The global currency market helps to facilitate foreign trade because it allows companies to sell their goods globally and get paid in their local currency. Companies need to be paid in their local currency since their expenses, such as payroll, are in their local currency.
The forex market differs from the stock market in that it does not involve a clearinghouse. Transactions occur directly between parties without an intermediary to ensure that each party complies with its obligations. Currencies do not come with a single price but are priced in terms of other currencies.
The Major Currency Pairs
Below are the major currency pairs that are most widely exchanged for each other.
- EUR/USD: the euro of the Eurozone versus the U.S. dollar
- USD/JPY: the U.S. dollar versus the Japanese yen
- GBP/USD: the Great British pound versus the U.S. dollar
- USD/CHF: the U.S. dollar versus the Swiss franc of Switzerland
- USD/CAD: the U.S. dollar versus the Canadian dollar
- AUD/USD: the Australian dollar versus the U.S. dollar
The U.S. dollar is considered the world's reserve currency since the U.S. has a stable economy and financial system. Many products, commodities, and investments are transacted in U.S. dollars, which is why it's involved most of the major transactions and currency exchanges. Countries that don't have a stable market or currency exchange rate might opt to trade in dollars to attract investment and facilitate trade.
However, there are many other currency pairs that are traded globally. Although China has the yuan and the renminbi as their currencies, most of the transactions involving U.S. trade with China are facilitated in U.S. dollars.
Certain currencies have taken on a specific identity or role in the global markets. For example, Switzerland has long been considered a safe place to store money in times of political and economic upheaval. During troubling times, forex conversions from the other global currencies into Swiss francs tends to increase significantly.
Japan is also considered a safe-haven for investment flows since Japan is considered a stable economy. In times of economic recessions, many investors exchange their investments denominated in dollars, euros, and pounds for Japanese government bonds (JGBs), which are guaranteed by the government of Japan. As a result, the yen tends to appreciate against other major currencies during recessions. For example, U.S. investors might sell their dollar-denominated mutual funds or investments for yen-denominated Japanese government bonds, and in doing so, cause the yen to appreciate against the dollar due to the forex conversion.
International Currency Market Players
Although there are many participants involved in the global currency markets, below are some of the major players that are involved in the forex markets.
Sometimes corporations enter the forex market in order to hedge their international money transfers and foreign profits. A U.S. company with extensive operations in Mexico, for example, may enter into a forward contract, which merely locks in the exchange rate between the dollar and the Mexican peso. So, when it comes time to bring those Mexican profits home, the profits earned in pesos would not be subject to unexpected exchange rate fluctuations. Instead, the pesos would be converted to dollars at the preset forward exchange rate. Companies use forwards as part of an overall risk-management strategy to help prevent currency exchange rates from impacting earnings or profits.
Governments and Central Banks
Governments may seek to influence the value of their currencies–called devaluation–to help increase their exports or foreign sales. A country's central bank, which manages a country's money supply, may enter the market to sell the country's currency, helping to push the value down. When the exchange rate declines versus the other major currencies, the country benefits from having cheaper exports solely due to the exchange rate.
For example, if the U.S. and British pound exchange rate was $2, and an investor wanted to buy a home in Britain that costs 200,000 pounds, it would cost the investor $400,000 (2 * 200,000 pounds). If Britain lowered their exchange rate to $1.50, the U.S. investor could now buy the same property for $300,000 (1.50 * 200,000 pounds).
As a result, the devaluing of the British currency would likely attract enormous buying interest from foreign investors boosting demand for British goods, real estate, and bolstering the British economy. Sometimes countries that engage in currency exchange rate devaluations can be labeled a "currency manipulator."