Page 91 - Introduction to Business

CHAPTER 2 The Environment of Business 65

the world and most of them trade with each other, and many have their own cur-
rencies as well. Most of these countries would like to use their own currencies to
transact international trade. The question is, with so many currencies in circula-
tion, where does the exchange of currencies take place and how are currency values
determined?

Foreign Exchange Markets. The exchange of currencies takes place in for- foreign exchange markets Financial
eign exchange markets, that is, financial centers where a network of international centers where a network of international
banks and currency traders (people who
banks (exporters and importers work with these banks), central banks (that want to
buy, sell, or speculate on currencies)
buy or sell currencies to manage exchange rates), and currency traders (who buy, sell, transact business
or speculate on currencies) transact business. There is no central bank or financial
institution that controls this network. Almost $1.9 trillion worth of currencies are
traded each day at the various foreign exchange markets globally. The three largest
foreign exchange markets are in London, New York, and Tokyo, followed by Hong
Kong and Singapore. Each of these centers caters to the foreign exchange needs of
certain regions of the world. For historical reasons, and largely serving Europe, the
Middle East, and Africa, London is the largest foreign exchange market and handles
some 32 percent of the world’s daily transactions. Second is New York, which handles
some 19 percent of the global transactions and caters to the needs of the Western
Hemisphere. Tokyo ranks third with some 9 percent of world transactions and serves
Asia along with other strong competitors like Hong Kong and Singapore. Then there
are smaller foreign exchange markets in almost all countries (generally located at
their key commercial centers). The foreign exchange market is a 24-hour market, and
the various financial institutions in these centers are connected by means of sophis-
ticated telecommunications systems that enable instant, real-time exchange rate
quotations. The function of the foreign exchange market is to facilitate international
trade in goods and services and investment (FDI, portfolio investment, as well as
short-term capital flows); this in turn helps determine exchange rates.

The Exchange Rate. What is the exchange rate, and how are exchange rates
currently determined? An exchange rate is nothing but the price of one currency exchange rate The price of one
compared with that of another currency. As you already know, in a free market sys- currency compared with that of another
currency
tem price is determined by the interaction of demand and supply. Similarly, in a free-
market-oriented foreign exchange market, currency values are determined by the
demand for and supply of currencies—called the floating exchange rate system. floating exchange rate system The
The value of the world’s major currencies, namely, the U.S. dollar, the euro, and the system in which currency values are
determined by the demand for and
yen, is market determined. The U.S. dollar plays a major role in foreign exchange
supply of currencies in a foreign
markets all over the world. A contributing factor to the dollar’s dominant role is that exchange market
a number of important commodities (crude oil, steel, etc.) and goods are priced in
U.S. dollars; this in turn creates a massive demand for dollars in the world’s foreign
exchange markets. The value of some currencies (e.g., the Indonesian rupiah, Thai
baht, Russian ruble, Indian rupee, and Singapore dollar) is determined partly by
demand and supply in the foreign exchange market and partly by active government
managed floating exchange rate
intervention (central bank purchases and sales of their own currencies by countries system A floating exchange rate system
to manage their currency values) in the foreign exchange market—called the man- in which the values of some currencies
are partly determined by active
aged floating exchange rate system. Furthermore, since some countries conduct
government intervention (central bank
the bulk of their international transactions with a few major trade partners, they link purchases and sales of their own
their currencies (e.g., the Hong Kong dollar, Chinese yuan, Malaysian ringgit, and currencies)
Saudi Arabian riyal) to those of their major trade partners. The reason for doing this fixed exchange rate system The system
is simple. These countries do not want their trade flows to be disrupted by changing in which a country pegs (fixes) its
currency value (formally or de facto) at
exchange rates, especially since the major trade partner is well identified. Such a sys- a fixed rate to a major currency or a
tem is called the fixed exchange rate system, one in which the country pegs (fixes) basket of currencies

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