Basic Theory Behind
the Foreign Exchange Market
In the absence of a single world currency, the market for foreign exchange determines the value of one country's currency in relation to another on the basis of demand and supply. According to Jeffrey A. Frankel in "The Concise Encyclopedia of Economics," the foreign exchange market is where international currency is traded for a domestic currency.
Foreign Exchange Market Participants
The Forex market consists of privately owned banking institutions, exporters and importers, and currency traders and brokers who buy and sell international currencies for clients--individual and institutional. In "International Monetary and Financial Economics," Joseph P. Daniels and David Vanhoose wrote: "By providing an arrangement for valuing transactions and delivering payments, the foreign exchange system promotes the flow of goods, services, and assets from one nation to another."
Floating Exchange Rate Regimes
The primary role of the Forex market is to determine the exchange rates among international currencies. The relative value of each currency is a key indicator of a country's macroeconomic health. The exchange rate is a function of demand and supply for a particular currency in relation to another in the Forex markets, which are of two kinds. Spot exchange determines the exchange rate in real time. Forward exchange is where the currency is valued in the present but exchanged in the future. As with any commodity, there is an inverse relationship between demand and supply of foreign exchange in free-floating currency regimes such as the United States.
Fixed Exchange Rate Regimes
Some countries, for example China, follow a fixed-exchange rate regime. Here, exchange rates are not determined by market forces, but by the central bank. China's exchange rate is pegged against the U.S. dollar, and its central bank prevents the yuan from appreciating against the dollar because China is an export-driven economy and the United States is its largest international market.
Effective Exchange Rate
The weighted average value of a currency compared to a set of currencies determines the effective exchange rate index, by which the value of individual currencies are quantified.
Fundamental Analysis and Technical Analysis
Just as in the stock and bond markets, participants in the currency market use two tools to determine the value of a particular currency--fundamental analysis and technical analysis. In fundamental analysis, a country's macroeconomic numbers are the key determinants of its currency's worth. Unlike fundamental analysis, technical analysis does not take a country's macroeconomy into consideration. On the basis of past valuations, currency investors create mathematical models to project future trends.
