Foreign Exchange Market (FOREX): Definition, Explanation & Examples
Foreign exchange market or FOREX
The foreign exchange market, also known as FOREX or Currency Market, is a decentralized world market where currencies are traded.
The foreign exchange market, from the economic point of view, is an internal market where the supply and demand for foreign currency interact and where the exchange rate between the different foreign currencies and the national currency is determined.
It’s the market where the currency of one country is exchanged for that of another, this market is made up of thousands of people, institutions, importers, exporters, banks, and specialists in currency trading called money changers.
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Fundamental terms of foreign exchange
The foreign exchange market has three fundamental terms:
Exchange rate
Exchange rate is the price that must be paid to acquire a foreign currency, the units of domestic currencies that are needed to acquire a unit of foreign currency. For example, on April 2022, 4.44 bolivars are needed to acquire one dollar according to the Central Bank of Venezuela.
Depreciation
Depreciation is the loss of value of one currency with respect to another, for example, the exchange rate goes from 4.44 bolivars per dollar to 5 bolivars per dollar.
Appreciation
Appreciation is the increase in value of the currency, it’s the opposite of depreciation. For example, the exchange rate goes from 5 bolivars per dollar to 4 bolivars per dollar.
The demand for foreign exchange
The demand for foreign currency is the amount of foreign currency desired, it’s a derived demand because it results from wanting to acquire other good or service from abroad, or assets such as bank accounts, stocks, businesses, etc.
Demand and Supply Shifts in Foreign Exchange Markets
A change in any one factor that influences the amount of foreign currency that people want, affects the demand for it and shifts the corresponding curve, the demand can increase or decrease because of exchange rate, imports and the expected benefit of it.
As the price of a foreign currency increases, the quantity of that currency demanded will decrease, this is the law of demand.
Exchange rate
The exchange rate influences the quantity demanded of foreign currency because the law of demand also applies. In this case, that is, the higher the exchange rate, the less quantity of a currency will be demanded, this manifests itself in two ways:
- The import effects. The more is imported, the more foreign currency will be demanded, in turn, the higher the exchange rate, other things being equal, the more expensive it will be to import goods and services from abroad. For that reason the demand will decrease, on the contrary, if the exchange rate is lower, the demand for foreign exchange increases.
- Expected benefit effect. The greater the expected benefit of holding a currency, the greater the quantity demanded. This depends on the exchange rate, because the lower the price, other things being equal, the expected benefit will be greater.
For example, when people in certain countries buy dollars in the hope that the price will go up and keeping it for a profit in the future.
Read more: Law of demand
Domestic and foreign interest rate
People and legal entities buy financial assets to obtain a profit, the higher the interest rate of assets abroad compared to the interest rate of domestic assets, the greater the demand for assets abroad. What matters here is the difference between the foreign and domestic interest rates.
The expected future exchange rate
Other things being equal, the higher the expected exchange rate in the future, the greater the demand for foreign exchange, because this implies future profit.
See also