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What is foreign exchange? Foreign exchange markets have existed since the days people first traded different currencies for livestock, food and other goods. In its simplest state, foreign exchange is the process of converting the currency of one country into that of another country.
Today, the foreign exchange market is an intricate network comprised of businesses and individuals around the globe. As business owners make their first foray into this complex sea of opportunity and risk, it helps to have a solid grasp of the factors that helped shape the foreign exchange market we have today.
The foreign exchange market — also called the “FX market” or “forex market” — is the largest market in the world and, unlike the stock market, there’s no centralized trading area. Once the forex market opens each week, it remains open 24 hours a day. The first market opens on Monday morning in Wellington, New Zealand, which is Sunday afternoon in the United States and Sunday evening in Europe. The market stays open until 5 p.m. Eastern time Friday in New York.
During the post-WWII era, many countries that set their exchange rates relative to the U.S. dollar adopted the Bretton Woods system.
At the same time, the United States fixed the price of gold at $35 an ounce. Since countries were prohibited from devaluing their currency to gain a foreign trade advantage, it left the exchange market relatively stable and constant.
By the early 1970s, the American trade deficit was growing and inflation was on the rise, contributing to the devaluation of the U.S. dollar. With these factors in mind, the United States abandoned the Bretton Woods Agreement in 1971 and put a fixed value on the dollar. This allowed the dollar to float — meaning exchange rates could fluctuate against other currencies based on supply and demand. Soon after, other countries agreed to float their exchange rates, too.
After the Bretton Woods system was abandoned, the foreign exchange market began to gain popularity, says Andrew Schrage, a former hedge fund analyst and co-owner of the Money Crashers Personal Finance Blog.
Today, many countries still keep a reserve of gold or foreign currencies, known as foreign exchange reserves, which countries buy and sell to stabilize their own currency when necessary.
By the end of the 1990s, modern technology allowed business owners to quickly buy and sell goods internationally over the Internet. As international business trade began to grow, so did business owners’ desire to protect against or “hedge” against currency fluctuation risks.
These days, small businesses can break their foreign exchange transactions into two major umbrella-like deals. There’s the “spot trade,” which means they can buy or sell for the current price.
However, many small business owners don’t want to buy or sell immediately. For example, take the case of a tailor in the United Kingdom who would like to sell his suits in the United States six months from now. Rather than risk unfavorable changes to the market, the business owner could use a forward contract, which locks in a currency exchange rate. This allows the business owner to execute the deal on a specific date or period of time.
It’s important to keep this basic foreign exchange principle in mind: “Never make a decision like you know where things are going,” says Martin Evans, professor of economics at Georgetown University in Washington, D.C. “Two things are usually true: You can’t predict where the current prices are going, and whatever it is now is almost sure to change.”
Example: 1USD = xx INR
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