FOREX : Foreign Exchange

Foreign exchange is the trading of different national currencies or units of account.

It is important because the exchange rate, the price of one currency in terms of another, is a major determinant of a nation’s economic health and hence the well-being of all the people residing in it.

At the wholesale level, the market for foreign exchange is conducted by a few score large international players in huge (> $1 trillion per day) over-the-counter spot and forward markets.

Those markets appear to be efficient in the sense that exchange rates follow a random walk and arbitrage opportunities, which appear infrequently, are quickly eliminated.

In the retail segment of the market, tourists, business travelers, and small-scale investors buy and sell foreign currencies, including physical media of exchange (paper notes and coins), where appropriate.

Compared to the wholesale ($1 million plus per transaction) players, retail purchasers of a foreign currency obtain fewer units of the foreign currency, and retail sellers of a foreign currency receive fewer units of their domestic currency.

The nominal level of exchange rates is essentially arbitrary. Some countries simply chose a smaller unit of account, a smaller amount of value. That’s why it often takes over ¥100 to buy 1 USD. But if the United States had chosen a smaller unit of account, like a cent, or if Japan had chosen a larger one (like ¥100 = ¥1), the yen and USD (and the euro, as it turns out) would be roughly at parity.

A strong currency is not necessarily a good thing because it promotes imports over exports (because it makes foreign goods look so cheap and domestic goods look so expensive to foreigners).

A weak currency, despite the loser-sound to it, means strong exports because domestic goods now look cheap both at home and abroad. Imports will decrease, too, because foreign goods will look more expensive to domestic consumers and businesses.

Purchasing power parity (PPP) is the application of the law of one price to entire economies.

It predicts that exchange rates will adjust to relative price level changes, to differential inflation rates between two countries. They indeed do, but only in the long run and not to precisely the same degree.

In the long run, exchange rates are determined by PPP (as described above) and relative differences in productivity, trade barriers, and import and export demand.

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