Purpose of the Foreign Exchange Market

Foreign exchange transactions are central to global commerce. The foreign exchange market is the network of private citizens, corporations and government officials who trade overseas currencies among each other. Beyond coordinating payments, foreign exchange rates and markets function as leading economic indicators. Investors and institutions analyze these foreign exchange market trends to create wealth and manage risks.

Consumers acquire foreign exchange so they can purchase overseas goods. Alternatively, businesses might receive foreign exchange and enter the market to convert that money back into domestic currency.

The foreign exchange market also serves the purpose of attracting investors. Investors diversify and increase their asset holdings with currency reserves.

Foreign exchange rates describe the amount of another currency that one unit of a certain currency can buy. Because of their association with specific nations, foreign exchange rates gauge economic and political sentiment. Low exchange rates translate into weak demand for a currency, as foreign investors liquidate that country’s stocks, bonds and real estate. At that point, foreigners might fear recession, or politics that are hostile to foreign investment. For example, high tax rates on foreign profits can cause foreigners to withdraw from a particular country.

Conversely, high exchange rates define strong economies and effective political regimes. Investors are then encouraged to trade for that currency and to purchase its home nation’s assets. The increased demand for the currency supports elevated exchange rates.

Government officials can manage their home economies through foreign exchange transactions. Low exchange rates for the domestic currency improve the export economy, because these goods become more affordable to foreign buyers. However, domestic consumers prefer higher exchange rates, which grants them more purchasing power for imported goods.

Government leaders use foreign exchange reserves to influence currency exchange rates. Nations can buy large amounts of foreign exchange reserves to devalue the home currency. China owned $900 billion worth of U.S. treasuries as of April 2010, the U.S. Treasury reported. These holdings lower exchange rates for the Chinese yuan and support China’s export economy.

Foreign exchange markets do introduce distinct risks of financial losses and contagion. Institutions that hold a particular currency lose purchasing power when its exchange rates deteriorate. However, as a home currency strengthens, multinational corporations suffer sales declines because their wares become more expensive overseas.

"Contagion" refers to the process of financial distress in one region growing into a global crisis. For example, Mexico might default on its sovereign debt, which causes the peso to collapse. From there, foreign businesspeople with exposure to Mexico might be forced to sell off all assets to raise cash. The selling compounds, and it causes markets to crash globally.

Foreign exchange markets offer currency derivatives to hedge against risks. Currency derivatives, such as futures, forwards and options establish predetermined exchange rates over set periods of time. Futures and options trade on major exchanges, such as the Chicago Mercantile Exchange. Forwards are private agreements between two parties to negotiate exchange rates at later points in time.