International Trade

The Market of Foreign Exchange

Currency markets include spot trades, which happen immediately, and forward and swap trades, which are set for future dates.
The foreign exchange market is not a physical place, nor does it close. Because trade is continuous across time zones around the world, foreign exchange takes place all day, every day. The participants in foreign exchange fall into two broad categories. The first is banks. The world's largest banks (Mitsubishi UFJ Financial Group, JPMorgan Chase & Co., and Bank of China) take part in intensive currency exchange on the interbank market, the foreign exchange market among major banks. The second market, which consists of companies and individuals, is the over the counter (OTC) market. This is the trade people participate in when they exchange currency to travel abroad. The OTC market deals with transactions that vary from quite small to very large. The interbank market, on the other hand, deals with trades that start in the millions of dollars.

Three types of trade are conducted. The first, called a spot trade, is an immediate exchange in currency conducted at the exchange rate at the time of the trade. A spot trade could occur between Morgan Stanley in the United States and the Mitsubishi UFJ Financial Group in Japan. Mitsubishi UFJ Financial Group could offer to trade Japanese yen for U.S. dollars with Morgan Stanley, and they may be motivated to do this if they see the U.S. dollar as gaining value. This trade is immediate and will complete in one or two business days.

The second type is a forward trade. In a forward trade, two entities make an agreement to exchange currencies in the future at a set rate. A forward trade could, for example, be done by a hedge fund manager in New York, who could agree with a bank in China to buy an asset in the future for a fixed price. The hedge fund manager wants the value of the Chinese yuan to increase, thereby increasing the hedge fund manager's profit. The third type is a swap trade, in which currency is bought as a spot trade, then sold as a forward trade. In swap and forward trades, dealers limit their risk by setting future prices.

While many currencies are traded and used in international trade, a few currencies dominate. The most important is the U.S. dollar, followed by the euro. The dollar is used and accepted around the world because the comparatively strong U.S. economy underwrites the dollar. Furthermore, the Bretton Woods Agreement in 1944 led to the developed nations of the world agreeing to peg, or attach, their currencies to the U.S. dollar. Bretton Woods formed the basis for post-WWII international trade because the stability of the dollar, backed by the massive gold reserves held by the United States, guaranteed a solid basis for trade. Gold reserves are stores of gold held by a country to back currency in a gold standard. A gold standard is a system in which money is backed by gold held in reserve. Although the United States abandoned the gold standard in the 1970s, the dollar remains the bedrock of international trade. A great majority of world foreign exchange trading involves the purchase and sale of U.S. dollars, and a good proportion of global debt is also held in dollars. In many countries, especially in areas of Latin America and eastern Europe, dollars are preferred to less valuable or more volatile local currencies, stimulating international demand for trade in dollars.