The Foreign Exchange Market
Foreign exchange, or forex, is central to the execution of global business transactions. Government officials, consumers, and private businesses may all be concerned with converting domestic currency to make overseas purchases, repatriating international sales, and also trading foreign exchange for a profit. Global commerce, however, does carry distinct risks of losses. Effective foreign exchange management minimizes these economic risks, while providing cash flow to meet everyday incidental expenses, overhead costs, and improve earnings.
Foreign Exchange Market
The foreign exchange market includes the network of individuals, banks, and organized financial exchanges that trade global currencies. Traders enter this market to deliver and accept currencies at fluctuating exchange rates. From here, individuals may either hold foreign currency in reserve to make payments, or repatriate overseas profits back home in the form of domestic banknotes. Proper foreign exchange management accounts for these transactions, while anticipating shifts in currency valuations that affect the bottom line.
Disciplined financial management requires that traders monitor current events that influence exchange rates for multiple industrialized countries. Private individuals and public officials generally prefer to transact business in nations that feature stable governments and strong economies.
Traders often clamor for strong currencies, order to establish international businesses and purchase investments likely to grow in value. Alternatively, investors may panic and liquidate overseas holdings amidst economic recession and political instability that mars the business climate of a particular country. For example, businesses would quickly sell assets and retreat from a nation that is undergoing military coup, where the incoming regime is hostile to foreign investors.
Trading Foreign Exchange
Beyond buying and selling goods, currencies may be traded for financial gain. Effective foreign exchange management analyzes the economic records of prospective countries, in order to uncover and buy undervalued currencies. The ultimate goal would be to hold these notes until exchange rates improve to mirror favorable developments, such as strong national employment reports and falling budget deficits. Successful currency trading increases profitability and buying power.
Foreign Exchange Risks
Adverse shifts in currency valuations may trigger severe financial losses. For example, exporters lose sales when domestic exchange rates strengthen. At that point, exported goods become more expensive to foreign buyers. Further, businesses that hold large foreign exchange reserves also lose purchasing power at home when the domestic currency values appreciate. Meanwhile, consumers face the risks of declining domestic exchange rates that increase the costs of imported goods and overseas purchases.
Foreign exchange management may use diversification and currency derivatives to manage risks and preserve profits. Currency derivatives are bought to establish predetermined exchange rates for set periods. These derivatives include futures, options and forwards. Currency futures and options trade on organized exchanges, such as the Chicago Mercantile Exchange. Forwards, however, are customized agreements between two parties to negotiate future exchange rates between themselves.
Smaller investors may elect to diversify with mutual funds according to geography, instead. For example, high commodity costs may force Japan into economic recession, while mutual funds investing in resource-rich Russia would then be generating lucrative investment returns.