As for Foreign Exchange Market (FXM), over the years it has undergone major structural changes. The changes that are taking place are attributed to institutional developments, as well as technological advances. Those changes had a significant impact on various dimensions of the market, such as the way trading is done, competition, the size of the market, and the efficiency of the market. It is therefore necessary to provide an update of the environment in which the currency prices are determined.
The most important change in the FXM in recent years is the evolution of an independent cross market in which non-dollar rates are determined based on free supply and demand forces. The evolution of an independent cross market offered more products and more opportunities to traders and therefore increased the volume of trading volume of the market as well. The term Foreign Exchange market simply means the exchange of one national currency for another. FX rates are the equalizing prices that link different national currencies.
When prices are determined by free market forces, they are subject to change, depending on the performance of the economy and on the economic policies of the government in a particular country. Changes in these prices can, and do significantly affect the value of cash flows in trading transactions, as well as the implicit values of foreign claims, investments, and obligations. Over the past two decades, an important development has been the growth of multinational enterprises, companies that do business in other countries.
As a result, there has been an increase in the volume of import-export, and other related transactions. In addition, over the past decade, a dramatic increase in international financial investment was observed especially in Euromarkets. Consequently there was an increasing need for FX, that is, exchanging one currency for another to settle transactions and claims that arose from the above developments. Another factor that contributed to a dramatic increase for FX over the years is increased in demand for speculative activity.
Although the purpose of the FXM is to facilitate trade and financial investment, market participants use the market more for speculation than anything else. Finally, the FX liberalization policies of industrialized countries’ central banks has also led to an increase of FX trading. Over the past 10 years Germany, Great Britain, and Japan had undergone a series of loosened FX restrictions and regulations, thus liberating trade even more.
Although it is impossible to determine and isolate the effect of any of the above developments on the volume of FX turnover, we can definitely conclude that due to the reasons set forth above, there has been a dramatic increase in the demand and supply for FX.. The FXM, is by far the largest financial market in the world. The market is estimated to be in the range of $640 billion a day, as reported by the Bank of England, in its 1989 FX review, to $700 billion a day. Unlike other financial markets, the FXM has no physical location where trading takes place.
It is an over-the-counter market and is based on telecommunications systems. The unique characteristic of the FXM is that it is a global market, and that trading is continuous 24 hours a day. Market participants are located around the world, and they trade using the most advanced telecommunications systems technology can offer. A transaction can take place, at any time of the day or night, between two parties that are located. A nation’s balance of payments has an important effect on the exchange rate of its currency.
Bills of exchange, drafts, checks, and telegraphic orders are the principal means of payment in international transactions. The rate of exchange is the price in local currency of one unit of foreign currency and is determined by the relative supply and demand of the currencies in the foreign exchange market. Buying or selling foreign currency in order to profit from sudden changes in the rate of exchange is known as arbitrage. The chief demand for foreign exchange within a country comes from importers of foreign goods, purchasers of foreign securities, government agencies purchasing goods and services abroad, and travelers.