Currency markets are a source of fascination to market players and observers alike. The momentum and the volatility of the markets, the wide range of factors affecting exchange rates and their impact on the economy as a whole make this a particularly varied and interesting topic. There is good reason why currency market analysis is regarded as one of the key economic disciplines.
This publication looks at various aspects of the foreign currency markets. It starts with an overview of the main factors determining exchange rates and a brief history of the currency markets. However, the main focus is on how the currency markets work, with particular reference to new financial instruments. The aim is to provide a balanced insight into the theory and workings of the currency markets.
Anyone who has travelled abroad is aware that there is a certain element of risk involved in changing money. The price paid for a foreign currency – known as the exchange rate – can fluctuate. The following sections provide some basic definitions and outline the factors affecting long-term exchange rates. Terms such as exchange rates, volatility, balance of pay- ments and gross domestic product are introduced to illustrate the concept of purchasing power parity and the importance of capital flows in determining exchange rates. Currencies are referred to using the official ISO codes. For example, CHF stands for the Swiss franc and USD for the US dollar. Exchange rates show the purchasing power of a cur- rency in a different currency. They make the monetary value of goods, services, capital spending and investments comparable the world over. An exchange rate of e.g. USD/CHF 1.39 expresses the price of the US dollar in Swiss francs. The notation USD/CHF is the system used by traders, although mathematically it would be more correct to express the exchange rate the other way round, as it shows how many CHF have to be paid to obtain USD 1. At this exchange rate, CHF 1,000,000 would buy goods, services or securities worth USD 719,424. If the exchange rate were to drop from USD/CHF 1.39 to USD/CHF 1.37, the Swiss franc would appreciate. At the new exchange rate, we obtain more USD for the same amount of CHF, i.e. 1,000,000 would now buy USD 729,927. If one currency appreciates, the other automatically depreciates.