Foreign exchange markets, Microeconomics


A foreign exchange market (sometimes informally called the forex market, or denoted FEM) is a market in which different currencies are bought and sold. Foreign exchange markets arise because various countries have different monetary systems and require different currencies to buy goods, services and financial assets. So people demand different currencies since they have demand for goods, services and financial assets of other countries. Naturally, there is a supply element to this as well. To carry out these transactions between individuals and firms of different countries, there arises a demand and supply of various currencies. So related but independent markets arise, big organised markets, where currencies themselves are all the time being traded for each other. The markets for foreign exchange facilitate foreign trade. The forex market is not a market say, where Germans give dollars to import jeans from America. Or the American exporter of jeans says, "fine, you can pay me in Marks and I will get the marks changed to dollars in my country." The forexmarket is a cash inter-bank or inter-dealer market. To understand how foreign exchange markets work, we need to understand the concept of exchange rates.

The exchange rate represents the number of units of one currency that exchanges for a unit of another. There are two ways to express an exchange rate between two currencies (e.g. the $ and rupee). One can either write $/Rs. or Rs./$ . These are reciprocals of each other. Thus if E is the $/Rs. exchange rate and V is the Rs./$ exchange rate then E = 1/V. It is important to note that the value of a currency is always given in terms of another currency. Thus the value of a US dollar in terms of Indian rupees is the Rs/$ exchange rate. The value of the Japanese yen in terms of dollar is the $/¥ exchange rate.

We always express the value of all items in terms of something else. Thus, the value of a litre of milk is given in rupees, not in milk units. The value of car is also given in rupee terms, not in terms of cars. Similarly, the value of a rupee is given in terms of something else, usually another currency. Hence the rupee/dollar exchange rate gives us the value of the dollar in terms of rupees.

Exchange rate quotes by participants in the forex market may be direct or indirect. A direct quote is the number of units of a local currency exchangeable for one unit of a foreign currency. An indirect quote is the number of units of a foreign currency exchangeable for one unit of a local currency. Thus indirect quote is the reciprocal of a direct quote. We know that a currency appreciates with respect to another when its value rises in terms of the other. The Rupee appreciates with respect to the yen if the ¥/Re exchange rate rises. On the other hand, a currency depreciates with respect to another when its value falls in terms of the other. The Rupee
depreciates with respect to the yen if the ¥/Re exchange rate falls. Note that if the ¥/ Re rate rises, then its reciprocal, the Re/¥ rate falls. Since the Re/¥ rate represents the value of the yen in terms of rupees, this means that when the rupee appreciates with respect to the yen, the yen must depreciate with respect to the rupee. The rateof appreciation (or depreciation) is the percentage change in the value of a currencyover some period of time. Thus, an appreciation means a decline in the directquotation.

Posted Date: 11/9/2012 5:56:29 AM | Location : United States

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