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Forex: Functions of the Foreign Exchange Market

The bridge over which one travels to get from one national currency to another is the foreign exchange market. Unlike traveling on an ordinary bridge, one must exchange with somebody else who is coming across the other way.

For anybody wanting to sell dollars to get British sterling, there must be somebody else wanting to cross over from the pound sterling into the dollar at the same exchange rate, or the price of one currency in units of the other. The foreign exchange market performs an international clearing function by bringing together the parties wanting to exchange currencies and giving them the chance to clear their balances in individual currencies by agreeing on a market rate of exchange.

The clearing process that transfers purchasing power through the foreign exchange market is the international analogue of the domestic bank clearing that takes place informally between banks of the same community, in city clearinghouses, within a Federal Reserve district, and in the Interdistrict Setlement Fund.

Today's foreign exchange markets follow the sun around the globe with the help of communications satellites. West German marks, for example, can be traded between Europe and New York when the sun is over the Atlanctic, between San Francisco and East Asia as the sun crosses the Pacific, and between East Asia and Europe as the sun returns to Europe.

What the traders exchange are typically bank deposits denominated in different currencies. A New York bank selling U.S. dollars for British pounds is in effect buying the right to issue checks on a British bank, paying with a check on a New York bank, perhaps the bank itself.

Verbal deals are quickly consummated by cable. The whole process of buying and selling different currencies proceeds at a hectic pace, with exchange rates changing at least every hour of business.

The foreign exchange market provides clearing services to many kinds of businesses and individuals. Ordinary tourists usually meet this marketplace in some airport, such as Juarez Airport in Mexico City, or Heathrow in London, at the exchange counter with the signboard announcing the current rates. Less familiar to most is the larger flow of billions each year in transactions involving international trade in goods.

At the center of the market process determining the value of any nation's currency is the set of currency transactions established by that nation's exports and imports of goods and services. Let us say, as in most of the examples that follow, that the foreign country, here buying the aircraft, is the United Kingdom. If the British government or a private British firm pays by writing a check in pounds sterling, the U.S. firm receiving the sterling check must either be content to hold onto sterling bank balances, or try to sell the sterling for dollars.

A nation's exports of goods and services cause foreign currencies to be sold in order to buy that nation's currency. If the United States sells a million dollars' worth of aircraft to a foreign buyer, it is unlikely, though not necessary that somebody will end up trying to sell foreign currencies to get a million dollars.