You know that “foreign exchange” exists, and you have an inkling of what the newspapers are talking about when they mention it, but you really don’t understand the basics of what foreign exchange is and how it works. Here, therefore, is a short “primer” on the basics of foreign exchange.
The term “foreign exchange” basically refers to buying the currency of one country while selling the currency of another country. All nations have their own, different kinds of money (currency). This has existed throughout the ages, probably since the time of the Babylonians. As trading developed between nations, the need to convert one kind of money to another also developed. This is how a formal system of foreign exchange arose.
As trade between nations developed, Britain, as the nation with the largest and strongest navy, could spread its commercial interests far and wide. It therefore became the most active trading nation, with a vast empire of colonies. As a result, Britain’s currency, the pound sterling, became a benchmark to which other currencies were compared (and exchanged) for most of the seventeenth, eighteenth and nineteenth centuries. Today, most currencies are compared to the U.S. Dollar, currently the most active and commercially strong trading nation; many currencies are still “pegged” to the U.S. Dollar for their exchange rate.
How exactly are currencies traded?
A company that wants to import goods into the United States has to buy the foreign currency of the country the goods are coming from, in order to pay for them. The following is an example: an American shoe store may sell a lot of Brazilian shoes, since Brazil is a large exporter of leather goods (about $1.9 Billion per year). The owner of this store would have to buy Brazilian Reals (the currency of Brazil) to pay for a shipment of shoes. He has a number of choices. First, he could buy the Reals through his bank or a foreign exchange broker at fixed rate of exchange, and then order the shoes. Since he knows the exchange rate, he knows how much the shoes are worth in dollars, and how much his bill (in dollars) will be when he has to pay for the shipment of shoes. When he “takes delivery” of the Reals (that is, he tells his bank to pay the Brazilian exporter), his bank will debit him the U.S. Dollar equivalent at the rate agreed upon when he purchased the Reals.
This importer has the second option of waiting until the shoes arrive in the United States, and then buy the Reals to pay for them. He will not know how much he has to pay for this shipment of shoes until he pays for the Reals, rather when he entered into the contract to purchase the shoes. If the Real got stronger, in other words, became more expensive compared to the dollar, he would pay more for them in dollars than on the day of his contract. He could also pay less if the Real became weaker. But most businessmen want to protect themselves and the price of their products against higher costs and be able to manage their budgets.
Knowing the exchange rate of the real when he processed his order with the Brazilian exporter would allow him to include that rate into his selling costs. If he risks that the rate will come down (by not buying Reals ahead of time), and it goes up instead, he may end up with a loss in the price of his shoes. Most businessmen would rather leave this kind of “speculating” to foreign exchange traders.
Information is for educational purposes only and is not be interpreted as financial advice. This does not represent a recommendation to buy, sell, or hold any security. Consult your financial advisor.