Foreign Exchange Markets in Global

Foreign Exchange Markets

In global finance, the foreign exchange market is a way to exchange currencies in a decentralized manner using international currencies. Individual financial centers around the world function as traders between a number of different buyers and sellers, usually 24 hours during the Monday-Friday work week. The foreign exchange market actually determines the relative value of divergent currencies. This is particularly important within the paradigm of globalization, the idea that countries have more open economic policies with each other that will counterbalance any political or cultural differences they might have. Foreign exchange markets enhance international investment and trading by enabling currency conversion, allowing commerce to occur within that country's monetary system, but globally. The market also helps buttress the speculation in foreign currencies, the interest rate difference and value of the currency between two countries (Levinson, 2006).

Governments use both direct and indirect intervention in foreign exchange markets, largely because the huge trading volume represents one of the world's largest asset classes with huge geographical areas of dispersion. Additionally, the low margin of relative profit compared with other markets of fixed income allow for greater stability over time, particularly with the use of leverage that enhances profit and loss margins for specific traders and/or countries. Direct intervention is usually seen as foreign exchange transactions that are conducted by the official monetary authority of that country and aimed at influencing the exchange rate. Indirect currency intervention are ways to influence this without doing the actual exchange; capital controls, taxes, restrictions, exchange controls, etc. (Graham, 2000).

Nonsteralized intervention is considered to be quite effective as a way to influence the exchange rate by causing changes in the stock of the host monetary base. This then, causes broader changes in the interest rate, market expectations, supply of money, and thus ultimately the exchange rate. For instance, the purchase of foreign-currency bonds usually causes the increase of the home-country's money supply and then decreases the exchange rate (Sarno and Taylor, 2001).

Sterilized intervention tends to be more ambiguous. This form should have little or no effect on domestic interest rates, since the level of that country's money supply has remained constant. However, using a portfolio balanced channel, agents of the government balance their portfolios among domestic money and bonds as well as foreign currency and bonds. When economic conditions change, the portfolio is adjusted to a new equilibrium which in turn, influences the exchange rate. Agents can also view futures on exchange rates by looking at how certain countries are intervening in monetary policy. This method requires the reading of signals, because the change of expectations rate will also affect the current market rate (Muss, 1981).