All About Foreign Exchange

The Foreign Exchange market performs an international clearing function by bringing two parties wishing to trade currencies at agreeable exchange rates.

The Foreign Exchange market takes place between dealers and brokers in financial centers around the world. During the hours of business common to different time zones, they rapidly exchange shorthand messages expressing their bids for different currencies.

To make a profit on Foreign Exchange maneuvers, a trader or broker has to make quick decisions correctly. Foreign exchange traders lead an exciting and hectic life, and the pressure often shortens many careers.

The fastest possible communications are used. Before the trans-Atlantic cable was laid in 1865 by Cyrus West Field (after many failed attempts), somebody wanting to exchange dollars for pounds often had to wait the time required for a roundtrip voyage to clear up the transaction. Modern telephone links have reduced the transaction costs on foreign exchange to near zero for large transactions. Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases.

Some investment management firms also have more speculative specialist currency overlay operations, which manage clients’ currency exposures with the aim of generating profits as well as limiting risk. While the number of this type of specialist firms is quite small, many have a large value of assets under management) and, hence, can generate large trades. National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Nevertheless, the effectiveness of central bank “stabilizing speculation” is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading.

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