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5. Functions of the Foreign Exchange Market

Functions of the Foreign Exchange Market

By Gilberto Fuentes
eHow Contributor

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The foreign exchange market facilitates trade between countries.
The foreign exchange market is the largest financial market in the world. With a network
of currency traders working from major financial centers around the world, the foreign
exchange market operates 24 hours a day. The New York Bank of the Federal Reserve
quantifies turnover of the foreign exchange market at $1.5 trillion every day. This amount
of money demonstrates the multiple functions the foreign exchange market plays in
financial transactions and investment around the world.

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1. Exchange Rate
o The foreign exchange market establishes the value of the world's currencies relative to
each other. For example, the value of U.S. dollars can be converted to an equal amount of
purchasing power in Mexican pesos. Establishing value parity among currencies is one of
 the key functions of the foreign exchange market because it facilitates transactions around
the world. However, economic events around the world still influence the foreign
exchange market, including central bank interventions, inflation, business cycles, and
political developments among other factors.

Global Commerce
o One of the key functions of the foreign exchange market is to provide governments and
businesses the capacity to make transactions in local currency. Since there is no one
global currency in existence, investors, businesses and governments convert currencies to
make transactions. For example, if a U.S. manufacturer makes direct foreign investments
in China, the manufacturer will likely need to make some transactions, like paying
employee salaries, in Chinese yuan.

On a global scale, international trade is an increasingly important part of national

economies around the world. The New York Bank of the Federal Reserve tabulates global
trade in 1950 at $58 billion. By 2000 global trade was valued at $6.3 trillion. As a result,
the foreign exchange market unites national economies into a single global marketplace.

Investment
o Like other financial marketplaces, the foreign exchange market provides the opportunity
for investors to make money. Generally, investors make money in the foreign exchange
market from the spread between the value of currencies. In financial markets, a spread is
the gap in value between two financial instruments. Spreads are important because if
timed right, currency speculators can make large amounts of money from trading
currency. For example, the New York Bank of the Federal Reserve calculates that
currency prices can change by as much as 20 times in one minute. By this standard, there
are continual opportunties to profit from currency spreads during the business day.

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