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Fixed Exchange Rate

The chief features of the Bretton Woods system were an obligation for each country to adopt a monetary policy that maintained the exchange rate of its currency within a fixed value—plus or minus one percent—in terms of gold and the ability of the IMF to bridge temporary imbalances of payments. In the face of increasing financial strain, the system collapsed in 1971, after the United States unilaterally terminated convertibility of the dollars to gold. This action caused considerable financial stress in the world economy and created the unique situation whereby the United States dollar became the "reserve currency" for the states which had signed the agreement.

King Crushes Sterling

The news that the Bank of England's MPC are keeping the option of reducing the rate of interest banks receive on deposits in a effort to avoid a liquidity trap sent sterling spiraling yesterday. Governor King said that it would be a “useful supplement” to stimulate the ailing UK economy as it has proved to be in Sweden, where this has been in effect for 3 weeks or so. The aim is to raise lending and stop banks hoarding cash.

GBP fell to a 4 month low against the euro with similar dips seen against the dollar, Swiss franc and Japanese Yen as the market quickly lost belief in the pound’s recent rally.

The announcement overshadowed the news that inflation in the UK has fallen to the lowest level since January 2007 although the 1.6% figure was higher than the 1.4% market estimate. This follows are exact thoughts that inflation here in the UK will remain more sticky for a considerable time.

Production of Gold

Gold extraction is most economical in large, easily mined deposits. Ore grades as little as 0.5 g/1000 kg (0.5 parts per million, ppm) can be economical. Typical ore grades in open-pit mines are 1–5 g/1000 kg (1–5 ppm); ore grades in underground or hard rock mines are usually at least 3 g/1000 kg (3 ppm). Because ore grades of 30 g/1000 kg (30 ppm) are usually needed before gold is visible to the naked eye, in most gold mines the gold is invisible.

Since the 1880s, South Africa has been the source for a large proportion of the world’s gold supply, with about 50% of all gold ever produced having come from South Africa. Production in 1970 accounted for 79% of the world supply, producing about 1,000 tonnes. However by 2007 production was just 272 tonnes. This sharp decline was due to the increasing difficulty of extraction, changing economic factors affecting the industry, and tightened safety auditing. In 2007 China (with 276 tonnes) overtook South Africa as the world's largest gold producer, the first time since 1905 that South Africa has not been the largest.

Price of Historically gold coinage

Like other precious metals, gold is measured by troy weight and by grams. When it is alloyed with other metals the term carat or karat is used to indicate the amount of gold present, with 24 carats being pure gold and lower ratings proportionally less. The purity of a gold bar can also be expressed as a decimal figure ranging from 0 to 1, known as the millesimal fineness, such as 0.995 being very pure.

The price of gold is determined on the open market, but a procedure known as the Gold Fixing in London, originating in September 1919, provides a daily benchmark figure to the industry. The afternoon fixing appeared in 1968 to fix a price when US markets are open.

Historically gold coinage was widely used as currency; When paper money was introduced, it typically was a receipt redeemable for gold coin or bullion. In an economic system known as the gold standard, a certain weight of gold was given the name of a unit of currency. For a long period, the United States government set the value of the US dollar so that one troy ounce was equal to $20.67 ($664.56/kg), but in 1934 the dollar was devalued to $35.00 per troy ounce ($1125.27/kg). By 1961 it was becoming hard to maintain this price, and a pool of US and European banks agreed to manipulate the market to prevent further currency devaluation against increased gold demand.

Price records of Gold

Since 1968 the price of gold on the open market has ranged widely, from a high of $850/oz ($27,300/kg) on January 21, 1980, to a low of $252.90/oz ($8,131/kg) on June 21, 1999 (London Gold Fixing).[36] The 1980 high was not overtaken until January 3, 2008 when a new maximum of $865.35 per troy ounce was set (a.m. London Gold Fixing).[37] The current record price was set on March 17, 2008 at $1023.50/oz ($32,900/kg)(am. London Gold Fixing).[37]

Long term price trends

Since April 2001 the gold price has more than tripled in value against the US dollar,[38] prompting speculation that this long secular bear market (or the Great Commodities Depression) has ended and a bull market has returned.[39] In March 2008, the gold price increased above $1000,[40] which in real terms is still well below the $850/oz. peak on January 21, 1980. Indexed for inflation, the 1980 high would equate to a price of around $2400 in 2007 US dollars.

In the last century, major economic crises (such as the Great Depression, World War II, the first and second oil crisis) lowered the Dow/Gold ratio (which is inherently inflation adjusted) substantially, in most cases to a value well below 4.[41] During these difficult times, investors tried to preserve their assets by investing in precious metals, most notably gold and silver.

Gold History During the 19th century

During the 19th century, gold rushes occurred whenever large gold deposits were discovered. The first documented discovery of gold in the United States was at the Reed Gold Mine near Georgeville, North Carolina in 1803. The first major gold strike in the United States occurred in a small north Georgia town called Dahlonega. Further gold rushes occurred in California, Colorado, the Black Hills, Otago, Australia, Witwatersrand, and the Klondike.

Because of its historically high value, much of the gold mined throughout history is still in circulation in one form or another.

History Of Gold In Other Countries

There is an age-old tradition of biting gold in order to test its authenticity. Although this is certainly not a professional way of examining gold, the bite test should score the gold because gold is a soft metal, as indicated by its score on the Mohs' scale of mineral hardness. The purer the gold the easier it should be to mark it. Painted lead can cheat this test because lead is softer than gold (and may invite a small risk of lead poisoning if sufficient lead is absorbed by the biting).

Gold in antiquity was relatively easy to obtain geologically; however, 75% of all gold ever produced has been extracted since 1910.[24] It has been estimated that all the gold in the world that has ever been refined would form a single cube 20 m (66 ft) on a side (equivalent to 8000 m³).

One main goal of the alchemists was to produce gold from other substances, such as lead — presumably by the interaction with a mythical substance called the philosopher's stone. Although they never succeeded in this attempt, the alchemists promoted an interest in what can be done with substances, and this laid a foundation for today's chemistry. Their symbol for gold was the circle with a point at its center (☉), which was also the astrological symbol and the ancient Chinese character for the Sun. For modern creation of artificial gold by neutron capture, see gold synthesis.

Gold Price

Although the price of some platinum group metals can be much higher, gold has long been considered the most desirable of precious metals, and its value has been used as the standard for many currencies (known as the gold standard) in history. Gold has been used as a symbol for purity, value, royalty, and particularly roles that combine these properties. Gold as a sign of wealth and prestige was made fun of by Thomas More in his treatise Utopia. On that imaginary island, gold is so abundant that it is used to make chains for slaves, tableware and lavatory-seats. When ambassadors from other countries arrive, dressed in ostentatious gold jewels and badges, the Utopians mistake them for menial servants, paying homage instead to the most modestly-dressed of their party

History Of Gold In Empire in Africa

The Mali Empire in Africa was famed throughout the old world for its large amounts of gold. Mansa Musa, ruler of the empire (1312–1337) became famous throughout the old world for his great hajj to Mecca in 1324. When he passed through Cairo in July 1324, he was reportedly accompanied by a camel train that included thousands of people and nearly a hundred camels. He gave away so much gold that it depressed the price in Egypt for over a decade. A contemporary Arab historian remarked:“ Gold was at a high price in Egypt until they came in that year. The mithqal did not go below 25 dirham and was generally above, but from that time its value fell and it cheapened in price and has remained cheap till now. The mithqal does not exceed 22 dirham or less. This has been the state of affairs for about twelve years until this day by reason of the large amount of gold which they brought into Egypt and spent there.

The European exploration of the Americas was fueled in no small part by reports of the gold ornaments displayed in great profusion by Native American peoples, especially in Central America, Peru, Ecuador and Colombia.

History Of Gold In Roman

The Romans developed new methods for extracting gold on a large scale using hydraulic mining methods, especially in Spain from 25 BC onwards and in Romania from 150 AD onwards. One of their largest mines was at Las Medulas in León (Spain), where seven long aqueducts enabled them to sluice most of a large alluvial deposit. The mines at Roşia Montana in Transylvania were also very large, and until very recently, still mined by opencast methods. They also exploited smaller deposits in Britain, such as placer and hard-rock deposits at Dolaucothi. The various methods they used are well described by Pliny the Elder in his encyclopedia Naturalis Historia written towards the end of the first century AD.

History Gold Coin

The legend of the golden fleece may refer to the use of fleeces to trap gold dust from placer deposits in the ancient world. Gold is mentioned frequently in the Old Testament, starting with Genesis 2:11 (at Havilah) and is included with the gifts of the magi in the first chapters of Matthew New Testament. The Book of Revelation 21:21 describes the city of New Jerusalem as having streets "made of pure gold, clear as crystal". The south-east corner of the Black Sea was famed for its gold. Exploitation is said to date from the time of Midas, and this gold was important in the establishment of what is probably the world's earliest coinage in Lydia around 610 BC. From 6th or 5th century BC, Chu (state) circulated Ying Yuan, one kind of square gold coin.

History Of Gold

Gold has been known and highly valued since prehistoric times. It may have been the first metal used by humans and was valued for ornamentation and rituals. Egyptian hieroglyphs from as early as 2600 BC describe gold, which king Tushratta of the Mitanni claimed was "more plentiful than dirt" in Egypt. Egypt and especially Nubia had the resources to make them major gold-producing areas for much of history. The earliest known map is known as the Turin Papyrus Map and shows the plan of a gold mine in Nubia together with indications of the local geology. The primitive working methods are described by Strabo and included fire-setting. Large mines also occurred across the Red Sea in what is now Saudi Arabia.

Characteristics

Gold is the most malleable and ductile of all metals; a single gram can be beaten into a sheet of 1 square meter, or an ounce into 300 square feet. Gold leaf can be beaten thin enough to become translucent. The transmitted light appears greenish blue, because gold strongly reflects yellow and red.

Gold readily creates alloys with many other metals. These alloys can be produced to modify the hardness and other metallurgical properties, to control melting point or to create exotic colors (see below). Gold is a good conductor of heat and electricity and reflects infra red radiation strongly. Chemically, it is unaffected by air, moisture and most corrosive reagents, and is therefore well-suited for use in coins and jewelry and as a protective coating on other, more reactive, metals. However, it is not chemically inert. Free halogens will react with gold, and aqua regia dissolves it via formation of chlorine gas which attacks gold to form the chloraurate ion. Gold also dissolves in alkaline solutions of potassium cyanide and in mercury, forming a gold-mercury amalgam.

Common oxidation states of gold include +1 (gold (I) or aurous compounds) and +3 (gold (III) or auric compounds). Gold ions in solution are readily reduced and precipitated out as gold metal by adding any other metal as the reducing agent. The added metal is oxidized and dissolves allowing the gold to be displaced from solution and be recovered as a solid precipitate.

High quality pure metallic gold is tasteless; in keeping with its resistance to corrosion (it is metal ions which confer taste to metals).

In addition, gold is very dense, a cubic meter weighing 19300 kg. By comparison, the density of lead is 11340 kg/m³, and that of the densest element; osmium is 22610 kg/m³.

Foreign exchange reserves

Foreign exchange reserves (also called Forex reserves) in a strict sense are only the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, SDRs and IMF reserve positions. This broader figure is more readily available, but it is more accurately termed official international reserves or international reserves. These are assets of the central bank held in different reserve currencies, mostly the US dollar, and to a lesser extent the euro, the UK pound, and the Japanese yen, and used to back its liabilities, e.g. the local currency issued, and the various bank reserves deposited with the central bank, by the government or financial institutions.

Gold-Exchange Standard

Under this system, the value of all currencies was fixed in terms of how much gold for which they could be exchanged.

For example, if one ounce of gold was worth 12 British pounds or 35 U.S. dollars, the exchange rate between dollars and pounds would remain constant at just under three to one.

There were many advantages of the gold-exchange system:

It served as a common measure of value

It helped keep inflation in check by keeping money supply in the gold-exchange standard economies fairly stable

Long-term planning was easier as rate changes were infrequent

This system was put in place in 1944, when the leaders of allied nations met at Bretton Woods, New Hampshire, to set up a stable economic structure out of the chaos of World War II. The U.S. dollar was fixed at $35 per ounce of gold and all other currencies were expressed in terms of dollars.

The Bretton Woods system began to weaken in the 1960s, when foreigners accumulated large amounts of U.S. dollars from post World War II aid and sales of their exports in the United States. There were concerns as to whether the U.S. had enough gold to redeem all the dollars.

With reserves of gold falling steadily, the situation could not be sustained and the U.S. decided to abandon this system. In 1971, President Nixon announced that U.S. dollars would no longer be convertible into gold. By 1973, this action led to the system of floating exchange rates that exist today. Currently, currencies rise and fall in value according to the forces of demand and supply.

After the abandonment of the gold-exchange standard, the foreign exchange market went from a relatively unimportant financial specialty to the forefront of international economics.

Under another system, the gold standard, U.S. households and businesses could exchange their dollars for gold. This practice was abandoned in 1933 during the Great Depression to allow freer expansion of money supply. However, foreign governments were still able to exchange their dollars for gold until 1971, when the United States terminated the gold-exchange standard entirely.

Types of Transactions

There are different types of FX transactions:

Spot transactions: This type of transaction accounts for almost a third of all FX market transactions. Two parties agree on an exchange rate and trade currencies at that rate.

Spot Transaction: How it works

A trader calls another trader and asks for a price of a currency, say British pounds.

This expresses only a potential interest in a deal, without the caller saying whether he wants to buy or sell.

The second trader provides the first trader with prices for both buying and selling (two-way price).

When the traders agree to do business, one will send pounds and the other will send dollars.

By convention the payment is actually made two days later, but next day settlements are used as well.

Although spot transactions are popular, they leave the currency buyer exposed to some potentially dangerous financial risks. Exchange rate fluctuations can effectively raise or lower prices and can be a financial planning ordeal for companies and individuals.

Exchange Risks in Spot Transactions

Suppose a U.S. company orders machine tools from a company in Japan.

Tools will be ready in six months and will cost 120 million yen.

At the time of the order, the yen is trading at 120 to a dollar.

U.S. company budgets $1 million in Japanese yen to be paid when it receives the tools (120,000,00 yen ¸ 120 yen per dollar = $1,000,000)

There is no guarantee that the rate will remain the same six months later.

Suppose the rate drops to 100 yen per dollar:

Cost in U.S. dollars would increase (120,000,000 ¸ 100 = $1,200,000) by $200,000.

Conversely, if the rate goes up to 140 yen to a dollar:

Cost in U.S. dollars would decrease (120,000,000 ¸ 140 = $857,142.86) by over $142,000

One alternative for a company is to pay for the foreign good right away to avoid the exchange rate risk. But no one wants to part with money any sooner than necessary—if the company does pay the money in advance, it loses six months’ interest and risks losing out on a favorable change in exchange rates.

Floating and Fixed Exchange Rates

The FX market was not always quick to respond to changing events. For most of the 20th century, the exchange rates were fixed, or kept constant, according to the amount of gold for which they could be exchanged. This was called the gold-exchange standard.

Foreign Currency Trading

Traders in the foreign exchange market make thousands of trades daily, buying and selling currencies while exchanging market information. The $1.2 trillion that is traded everyday may be used for varied purposes:

For the import and export needs of companies and individuals

For direct foreign investment

To profit from the short-term fluctuations in exchange rates

To manage existing positions or

To purchase foreign financial instruments

In the volatile FX market, traders constantly try to predict the behavior of other market participants. If they correctly anticipate their opponents’ strategies, they can act first and beat the competition.

Traders make money by purchasing currency and selling it later at a higher price, or, anticipating the market is heading down, selling at a high price and buying back at a lower price later.Trader purchases a lot of currency è long on the currency (e.g. long dollar, long yen)

Trader sells a lot of a currency è short on the currency (e.g. short sterling)

To predict the movements of currencies, traders often try to determine whether the currency’s price reflects its fundamental value in terms of current economic conditions. Examining inflation, interest rates, and the relative strength of the country’s economy helps them make a determination.Currency under priced è price will go up

Currency overpriced è price will go down

Currency Trading Between Banks

Banks are a major force in the FX market and employ a large number of traders. Trading between banks is done in two ways—through a broker or directly with each other.

Brokers: If a U.S. bank trades with another bank, a FX broker may be used as an intermediary. The broker arranges the transaction, matching the buyer and seller without ever taking a position and charges a commission to both the buyer and seller. About a third of transactions are arranged in this way.

Direct: Mostly banks deal with each other directly. A trader "makes a market" for another by quoting a two-way price i.e. he is willing to buy or sell the currency. The difference between the two price quotes (the spread) is usually no more than 10 pips, or hundredths, of a currency unit.

Most currencies are quoted in terms of how many units of that currency would equal $1. However, the British pound, New Zealand dollar, Australian dollar, Irish punt and the Euro are quoted in terms of how many U.S. dollars would equal one unit of those currencies.

The currencies of the world’s large, industrialized economies, or hard currencies, are always in demand and are actively traded. In terms of trading volumes, the FX market is dominated by four currencies: the U.S. dollar, the euro, the Japanese yen and the British pound. Together these account for over 80 percent of the market.

It is not always easy to find a market for all currencies. The demand for currencies of less developed countries, soft currencies, is a lot less than for the hard currencies. Weak demand internationally along with exchange controls may make these currencies difficult to convert.

Determination of Foreign Exchange Rates

Exchange rates respond directly to all sorts of events, both tangible and psychological—

Business cycles;

Balance of payment statistics;

Political developments;

New tax laws;

Stock market news;

Inflationary expectations;

International investment patterns;

And government and central bank policies among others.

At the heart of this complex market are the same forces of demand and supply that determine the prices of goods and services in any free market. If at any given rate, the demand for a currency is greater than its supply, its price will rise. If supply exceeds demand, the price will fall.

The supply of a nation’s currency is influenced by that nation’s monetary authority, (usually its central bank), consistent with the amount of spending taking place in the economy. Government and central banks closely monitor economic activity to keep money supply at a level appropriate to achieve their economic goals.

Too much money è inflation è value of money declines è prices rise

Too little money è sluggish economic growth è rising unemployment

Monetary authorities must decide whether economic conditions call for a larger or smaller increase in the money supply.

Sources for currency demand on the FX market:

The currency of a growing economy with relative price stability and a wide variety of competitive goods and services will be more in demand than that of a country in political turmoil, with high inflation and few marketable exports.

Money will flow to wherever it can get the highest return with the least risk. If a nation’s financial instruments, such as stocks and bonds, offer relatively high rates of return at relatively low risk, foreigners will demand its currency to invest in them.

FX traders speculate within the market about how different events will move the exchange rates. For example:

News of political instability in other countries drives up demand for U.S. dollars as investors are looking for a "safe haven" for their money.

A country’s interest rates rise and its currency appreciates as foreign investors seek higher returns than they can get in their own countries.

Developing nations undertaking successful economic reforms may experience currency appreciation as foreign investors seek new opportunities.

Foreign Exchange Rates

Most common contact with foreign exchange occurs when we travel or buy things in other countries.Suppose a U.S. tourist travelling in London wants to buy a sweater. Price tag is 100 pounds.

Current exchange rate Price of sweater in dollars

$1.45 to £1

$1.30 to £1

$1.60 to £1

Pound falls

Pound rises 100 x 1.45 = $145.00

100 x 1.30 = $130.00

100 x 1.60 = $160.00

Thus, small changes in exchange rates may not seem significant. But when billions of dollars are traded, even a hundredth of a percentage point change in exchange rates becomes important.

Stronger US

dollar implies U.S. can buy foreign goods more cheaply

è

Cost of purchasing foreign goods falls

Foreigners find U.S. goods more expensive and demand falls

Weaker U.S.

dollar implies Foreigners buy more U.S. goods

Helps firms that rely on exports

Foreign goods become more expensive Demand for imports falls

It would seem logical that if the dollar weakens, the trade balance will improve, as exports would rise. However, this does not always happen. U.S. trade balance usually worsens for a few months.

The J–curve explains why the trade position does not improve soon after the weakening of a currency. Most import/export orders are taken months in advance. Immediately after a currency’s value drops, the volume of imports remains about the same, but the prices in terms of the home currency rise. On the other hand, the value of the domestic exports remains the same, and the difference in values worsens the trade balance until the imports and exports adjust to the new exchange rates.

Exchange rates are an important consideration when making international investment decisions. The money invested overseas incurs an exchange rate risk.

When an investor decides to "cash out," or bring his money home, any gains could be magnified or wiped out depending on the change in the exchange rates in the interim. Thus, changes in exchange rates can have many repercussions on an economy:

Affects the prices of imported goods

Affects the overall level of price and wage inflation

Influences tourism patterns

May influence consumers’ buying decisions and investors’ long-term commitments.

Foreign Exchange Market Participants

There are four types of market participants—banks, brokers, customers, and central banks.

Banks and other financial institutions are the biggest participants. They earn profits by buying and selling currencies from and to each other. Roughly two-thirds of all FX transactions involve banks dealing directly with each other.

Brokers act as intermediaries between banks. Dealers call them to find out where they can get the best price for currencies. Such arrangements are beneficial since they afford anonymity to the buyer/seller. Brokers earn profit by charging a commission on the transactions they arrange.

Customers, mainly large companies, require foreign currency in the course of doing business or making investments. Some even have their own trading desks if their requirements are large. Other types of customers are individuals who buy foreign exchange to travel abroad or make purchases in foreign countries.

Central banks, which act on behalf of their governments, sometimes participate in the FX market to influence the value of their currencies.

With more than $1.2 trillion changing hands every day, the activity of these participants affects the value of every dollar, pound, yen or euro.

The participants in the FX market trade for a variety of reasons:

To earn short-term profits from fluctuations in exchange rates,

To protect themselves from loss due to changes in exchange rates, and

To acquire the foreign currency necessary to buy goods and services from other countries

Foreign Exchange Market: What Is It?

To buy foreign goods or services, or to invest in other countries, companies and individuals may need to first buy the currency of the country with which they are doing business. Generally, exporters prefer to be paid in their country’s currency or in U.S. dollars, which are accepted all over the world.

When Canadians buy oil from Saudi Arabia they may pay in U.S. dollars and not in Canadian dollars or Saudi riyals, even though the United States is not involved in the transaction.

The foreign exchange market, or the "FX" market, is where the buying and selling of different currencies takes place. The price of one currency in terms of another is called an exchange rate.

The market itself is actually a worldwide network of traders, connected by telephone lines and computer screens—there is no central headquarters. There are three main centers of trading, which handle the majority of all FX transactions—United Kingdom, United States, and Japan.

Transactions in Singapore, Switzerland, Hong Kong, Germany, France and Australia account for most of the remaining transactions in the market. Trading goes on 24 hours a day: at 8 a.m. the exchange market is first opening in London, while the trading day is ending in Singapore and Hong Kong. At 1 p.m. in London, the New York market opens for business and later in the afternoon the traders in San Francisco can also conduct business. As the market closes in San Francisco, the Singapore and Hong Kong markets are starting their day.

The FX market is fast paced, volatile and enormous—it is the largest market in the world. In 2001 on average, an estimated $1,210 billion was traded each day—roughly equivalent to every person in the world trading $195 each day.

More statistics on the foreign exchange market:

Bank for International Settlements: International Financial Statistics.

Economic factors

These include: (a)economic policy, disseminated by government agencies and central banks, (b)economic conditions, generally revealed through economic reports, and other economic indicators.

Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).

Economic conditions include:

Government budget deficits or surpluses

The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency.

Balance of trade levels and trends

The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency.

Inflation levels and trends

Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising [. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.

Economic growth and health

Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be.

Productivity of an economy

Increasing productivity in an economy should positively influence the value of its currency. Its effects are more prominent if the increase is in the traded sector

Foreign exchange

The foreign exchange market (currency, forex, or FX) trades currencies. It lets banks and other institutions easily buy and sell currencies. [1]

The purpose of the foreign exchange market is to help international trade and investment. A foreign exchange market helps businesses convert one currency to another. For example, it permits a U.S. business to import European goods and pay Euros, even though the business's income is in U.S. dollars.

In a typical foreign exchange transaction a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market started forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.

The foreign exchange market is unique because of

its trading volumes,

the extreme liquidity of the market,

its geographical dispersion,

its long trading hours: 24 hours a day except on weekends (from 22:00 UTC on Sunday until 22:00 UTC Friday),

the variety of factors that affect exchange rates.

the low margins of profit compared with other markets of fixed income (but profits can be high due to very large trading volumes)

the use of leverage

Top 10 currency traders [5]

% of overall volume, May 2009Rank Name Market Share

1 Deutsche Bank 20.96%

2 UBS AG 14.58%

3 Barclays Capital 10.45%

4 Royal Bank of Scotland 8.19%

5 Citi 7.32%

6 JPMorgan 5.43%

7 HSBC 4.09%

8 Goldman Sachs 3.35%

9 Credit Suisse 3.05%

10 BNP Paribas 2.26%

Determinants of FX Rates

See also: exchange rates

The following theories explain the fluctuations in FX rates in a floating exchange rate regime (In a fixed exchange rate regime, FX rates are decided by its government):

(a) International parity conditions viz; purchasing power parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world.

(b) Balance of payments model (see exchange rate). This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous appreciation of dollar during 1980s and most part of 1990s in face of soaring US current account deficit.

(c) Asset market model (see exchange rate) views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by people’s willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that “the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.”

None of the models developed so far succeed to explain FX rates levels and volatility in the longer time frames. For shorter time frames (less than a few days) algorithm can be devised to predict prices. Large and small institutions and professional individual traders have made consistent profits from it. It is understood from above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces of demand and supply. The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange.

Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology.