Currency Markets Are Large
On an average day in April 2004, an amount equivalent to $1.9 trillion was traded in the foreign-exchange market. These trades occurred between different agents (individuals, firms, banks, governments) and for different reasons, varying from tourist demand for currency to firms needing payment for goods in local currency. To put this number in perspective, on average in 2004, every 7 trading days a sum greater than the entire value of the U.S. annual GDP changed hands in the foreign-exchange market. Not surprisingly, turnover in the foreign-exchange market is larger than turnover in most other financial markets. For example, the dollar value of average daily trading on the New York Stock Exchange, the largest exchange in the world, was around $46 billion in 2004, roughly 2 percent of the turnover in all world foreign-exchange markets.
When currencies are traded in the foreign-exchange market, participants need to know the value of their currency relative to other currencies, just as participants in a traditional stock market need to know the value of the stocks they wish to buy or sell. In foreign-exchange markets, this price is known as the exchange rate, the number of units of one nation's currency that must be traded to acquire one unit of another nation's currency. For example, on October 11, 2006, a person wanting to acquire one British pound would have had to pay $1.86 in U.S. dollars. By November 30, 2006, a person wanting to make the same trade would have had to pay almost $1.97 for one British pound. In this case, the dollar is said to have depreciated. After the depreciation, more dollars are required to buy the same number of pounds. If the transactions are viewed from the perspective of the pound, the pound is said to have appreciated; fewer pounds are required to purchase each dollar.
In principle, an exchange rate exists between each possible pairing of the individual currencies in the world. Among the 52 nations (out of a world total of 193 nations) that reported formal exchange-market transactions in 2004, there are 820 possible bilateral exchange rates. If the 12 European nations that share the euro as their national currency had separate currencies, this number would be even higher.
In reality, a substantial portion of foreign-exchange trading occurs through an intermediate or a vehicle currency, that is, a currency that is widely used throughout the world. For example, the U.S. dollar serves as a global vehicle currency and the euro is becoming an important vehicle currency in Europe. A Turkish bank that wishes to exchange Turkish lira for Swedish krona may first exchange lira for euros and then exchange the euros for krona. Vehicle currencies reduce transaction costs in foreign-exchange markets because a bank wishing to provide foreign exchange for its customers need not keep stores of large numbers of currencies on hand. Instead, it need only maintain stores of its own domestic currency and one or two other vehicle currencies.
The U.S. dollar is the most important vehicle currency in the world. The dollar has served as an important vehicle currency in part because it has remained remarkably stable over time. This stability is in part a result of the United States long history of flexible exchange markets and its commitment to improving capital market and trade access to the United States. As of 2004, the U.S. dollar was used in almost 89 percent of world currency transactions; its average turnover was over $1.5 trillion per day, more than twice as much as the next most-used currency, the euro. Most of this trading occurs outside of the United States.
Just as a few vehicle currencies dominate the transactions, two trading locations dominate foreign-exchange market transactions. In 2004, over half of the world exchange-market transactions occurred either in London (31.3 percent) or New York (19.2 percent). The next-largest location in terms of trading share was Japan, with 8.3 percent of transactions. Foreign-exchange market transactions are also concentrated among a few large banks. In the United States, 75 percent of transactions were conducted by only 11 banks in 2004. In the United Kingdom, 16 banks captured 75 percent of foreignexchange market transactions.
Innovations in technology, such as computers and international communications networks, and breakthroughs in economic theory that have improved our understanding of the value of currencies, have made foreignexchange markets among the most sophisticated markets in the world. Investors can easily take advantage of small differences in exchange values across the different global markets, buying a currency for a lower amount in one location and selling it for a higher amount in another, making the global currency market one global exchange.
The sophistication of modern currency markets also helps multinational firms protect themselves, or hedge, against currency risk. Because costs and revenues of multinational firms are often denominated in different currencies, currency risk is a fundamental part of international trade, and changes in the exchange rate affect the cash flow of the firm. For example, a Mexican manufacturer may enter into a contract with a U.S. firm, agreeing to sell its product at a fixed dollar price for a set period of time, for example, 1 year. The Mexican manufacturer must pay its employees in Mexican pesos but will receive a fixed dollar stream of revenue. If the peso appreciates over the year (that is, if the peso becomes more valuable so that it takes fewer pesos to buy one U.S. dollar), the manufacturer's dollar-denominated revenue will fall in value relative to his peso-denominated costs. If the peso appreciates sufficiently, the manufacturer may not be able to cover his costs. To see this dilemma more clearly, suppose that when the Mexican firm enters into the contract with its U.S. counterpart, the exchange rate is 10 pesos per dollar. If the firm has costs of 1,000 pesos, and it receives $110, then the firm is able to cover its costs and has 100 pesos of profit after the transaction. However, if the peso appreciates over the year from 10 pesos per dollar to 8 pesos per dollar, after the firm receives payment of $110, it will only hold 880 pesos. The firm would not be able to cover the costs from the revenue it receives. If the firm has no way to hedge this risk, its owner may be unable or unwilling to enter into the contract and thus the opportunity for Mexico and the United States to realize gains from this trade may not be realized. Advances in economic theory that have helped companies learn how to price risk appropriately have enabled financial markets to develop contracts that allow firms to sell their currency risk.