How foreign exchange markets operate

Overview

Foreign exchange market, demand curve for a currency slope downwards and supply curve of a currency slope upwards.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is a foreign exchange market?

   Model answer

   A foreign exchange market is the global network in which currencies are bought and sold against one another. It has no single physical location: banks, brokers, corporations, fund managers and central banks deal with each other electronically around the clock, with trading passing from one financial centre to another as the day moves round the world. The price established in it is the exchange rate, the amount of one currency that must be given to obtain a unit of another.

2. 2

   What determines the price of one currency against another in a floating market?

   Model answer

   The rate is set where demand for the currency equals its supply. Demand comes from foreigners buying the country's exports, from investors wanting its assets, and from speculators expecting it to appreciate; supply comes from residents buying imports, investing abroad, or selling the currency. Anything that shifts either side — relative interest rates, relative inflation, trade flows or expectations — moves the rate.

3. 3

   Who are the main participants in the foreign exchange market and why does each take part?

   Model answer

   Commercial banks and dealers make up the largest share of turnover, quoting prices to each other and to clients and managing their own positions. Firms take part because exporters receive foreign currency they need to convert and importers must buy foreign currency to pay suppliers. Investors and fund managers buy currency in order to purchase foreign shares, bonds and property. Tourists and migrants convert currency for travel and remittances. Speculators trade purely to profit from expected changes in the rate, and central banks intervene to influence the rate or manage reserves.

4. 4

   Explain how the exchange rate is determined in a freely floating market.

   Model answer

   The rate is set where the demand for the currency equals its supply. On a diagram with the exchange rate, say dollars per pound, on the vertical axis and the quantity of pounds traded on the horizontal axis, the demand curve for pounds slopes downward because a cheaper pound makes British goods and assets cheaper for foreigners, so more pounds are wanted. The supply curve of pounds slopes upward because a dearer pound buys more foreign currency, making foreign goods and assets cheaper for British residents, so more pounds are offered. Equilibrium is at the intersection, and any excess demand or supply moves the rate until the two are equal again.

5. 5

   Why does the demand curve for a currency slope downwards?

   Model answer

   A fall in the external value of the pound means that foreign buyers need fewer units of their own currency to obtain a pound, so British goods, services and assets become cheaper to them. They therefore buy more of these, and to do so they must buy more pounds. A lower price of the pound is thus associated with a larger quantity of pounds demanded, giving a downward-sloping curve. The reasoning is exactly the demand relationship applied to a currency, which is being treated as the good whose price is the exchange rate.

6. 6

   Why does the supply curve of a currency slope upwards?

   Model answer

   When the pound is worth more in foreign currency, each pound buys more foreign goods, services and assets, so British residents find imports and foreign investment cheaper and buy more of them. To do so they must sell pounds and buy foreign currency, so more pounds are supplied to the market. A higher price of the pound is therefore associated with a larger quantity of pounds supplied, giving an upward-sloping curve.

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