The Foreign Exchange Market
The foreign exchange market is where currencies trade and where the exchange rate, the price of one currency in terms of another, is set. Deals settle on the spot market for delivery in about two business days (T+2) or the forward market for a later agreed date. A currency appreciates when it buys more foreign currency and depreciates when it buys less.
Why it matters
Every cross-border purchase, investment, or loan needs one currency swapped for another, and the exchange rate is just the price that clears that enormous market. Most of the volume is not trade in goods but trading in financial assets.
Worked examples
The exchange rate moves from 23,000 to 24,000 dong per US dollar. Did the dong appreciate or depreciate?
The dong depreciated. It now takes more dong to buy one dollar, so each dong buys less foreign currency. Equivalently, the dollar appreciated against the dong.
Common mistakes
- ✗A "strong" currency is always good for a country. A strong currency makes imports cheaper but exports dearer, so it helps some groups and hurts others.
- ✗The exchange rate mainly reflects trade in goods. Most foreign-exchange volume is trading in financial assets, which is why exchange rates move so much day to day.
Revision bullets
- •The exchange rate is the price of one currency in another
- •Spot (about T+2) vs forward (future) settlement
- •Appreciate means it buys more foreign currency, depreciate means less
Quick check
If it takes more domestic currency than before to buy one unit of foreign currency, the domestic currency has
Connected topics
Sources
- Mishkin (2018), Ch. 18Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.The foreign exchange market, exchange rates, and the spot versus forward distinction.