Wednesday, August 8, 2012

Essay on Currency Exchange

Essay on Currency Exchange

When nations buy and sell goods and services with one another, they need to know how much their money is worth in another nation. Exchange rates determine the value of one country’s currency in another country. If a country has a favorable exchange rate with the United States, U.S. dollars will be worth more in that country than if the exchange rate were unfavorable. Exchanges of different currencies take place in the foreign exchange market.

Exchange rates were fixed for the most of the 20th century. The rates were kept constant according to the gold-exchange standard. For each currency there was determined amount of gold which they could be exchanged. This system made foreign exchange markets very slow to respond to changing events.

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In 1944, representatives from forty-four western nations met at Bretton Woods, New Hampshire, to establish a fair way of determining worldwide exchange rates. Under the Bretton Woods system, exchange rates between foreign currencies were fixed against the value of the U.S. dollar. The U.S. dollar was fixed at $35 per ounce of gold and all other currencies were expressed in terms of dollars. The system worked well at first because the U.S. economy was much stronger than any other. However, after a few years, the economies of other nations grew and the relative value of the U.S. dollar went down throwing the Bretton Woods system out of the balance. Therefore, in 1971, the system was reformed into a floating exchange system, whereby the values of currencies relative to one another are free to change daily. In a floating exchange system, the value of a nation’s currency reflects the health of its economy.

Nevertheless, there were some advantages of the gold standard system. It served as a common measure of value. Rate changes were very rare which made long-term planning much easier and less risky. Inflation was under control.

There were also negative sides of this system. It began to weaken in the 60s. Amount of U.S. dollars began to grow in the foreign countries as well as their export to the Unites States, while U.S. no longer had enough gold to buy back all the dollars. The reserves of gold were constantly falling and United States had to terminate this system. Now currencies rise and fall in value according to the forces of demand and supply.

After the gold-exchange standard was no longer in use, the foreign exchange markets went from relatively unimportant financial institutions to the one of the most important activities of international economics.

The foreign exchange today is the largest financial market in the world. At foreign exchange markets currencies are traded between banks, multinational corporations, governments, currency speculators, and other financial institutions. In the global foreign exchange markets the daily trade is around 2 trillion dollars. Individuals can also participate in this market, but only indirectly through brokers or banks. The turnover of foreign exchange market consists of spot transactions, outright forwards, forex swaps, and other transactions.

Exchange-traded forex futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts. In last years their volume has grown rapidly and is about 7% of the whole foreign exchange market volume.

Some of the world major foreign exchange markets are in London, New York, Tokyo and Singapore. However, foreign exchange is mainly over-the-counter market, where brokers negotiate directly with one another, which does not require single unified foreign exchange market. There are no headquarters and the foreign exchange market simply a worldwide network of traders connected by phones and computers. Due to this fact, there is no single rate for each currency, but rather there is a number of different rates depending on who is trading. Normally the rates are very similar. There are four types of market participants—banks, brokers, customers, and central banks.

Among the main currency traders are Deutsche Bank, UBS AG, Citigroup, Barclays Capital, Royal Bank of Scotland, Goldman Sachs, HSBC, Bank of America, JPMorgan Chase, and Merrill Lynch.

Currency trading takes place continuously 24 hours excluding weekends. When stock exchange is opening in London it is already closing in Singapore, in several hours foreign exchange begins in New York, then San Francisco and so on.

Fluctuations of currency exchange rates are mainly caused by monetary flows and expectations of how these monetary flows will change. The changes can be caused by inflation, interest rates, GDP growth, trade deficit, and other factors. Main events and news are released publicly and many people receive access to the same information at the same time. The main factors affecting currency prices are supply and demand forces, which in return are influenced by economic factors, political conditions, and market psychology. Foreign exchange market, like no other, reflects everything that is going on in the world at any given time. Supply and demand factors constantly shift and prices of currencies shift accordingly.

There are several types of financial instruments commonly used.

Spot: It is a two-day delivery transaction and represents direct exchange between two currencies. It involves cash rather than a contract and does not consider interest. Spot, as an instrument, has the largest share by volume in the foreign exchange market.

Forward transaction: In this case, buyer and seller agree on an exchange rate for a specific date in the future, which can be in several days, months, or years. Futures: These are forward transactions that have standard contract size and date of exchange. They are usually traded on the specific exchanges. The length of the contract is around 3 months.

Swap: These are the most common types of forward transactions. They are not standardized and are not traded through an exchange.

Options: Option gives the right to the owner, but does not oblige him to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date.
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