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The Foreign Exchange Market

The foreign exchange market allows for the purchase and sale of currencies to facilitate international purchases of products, services, and securities. The foreign exchange market is not based in one location; it is composed of large banks around the world that serve as intermediaries between those firms or investors who wish to purchase a specific currency and those that wish to sell it.

spot market

A market that facilitates foreign exchange transactions that involve the immediate exchange of currencies.

spot exchange rate (spot rate)

The prevailing rate at which one currency can be immediately exchanged for another currency.

Spot Market for Foreign Exchange

A key component of the foreign exchange market is the spot market. The spot market facilitates foreign exchange transactions that involve the immediate exchange of currencies. The prevailing exchange rate at which one currency can be immediately exchanged for another currency is referred to as the spot exchange rate (or spot rate). For example, the Canadian dollar's value has ranged between $0.60 and $0.80 in recent years. When U.S. firms purchase foreign supplies or acquire a firm in another country, and when U.S. investors invest in foreign securities, they commonly use the spot market to obtain the currency needed for the transaction.

During the so-called Bretton Woods era from 1944 to 1971, exchange rates were virtually fixed. They could change by only 1 percent from an initially established rate. Central banks of countries intervened by exchanging their currency on reserve for other currencies in the foreign exchange market to maintain stable exchange rates. By 1971 the boundaries of exchange rates were expanded to be 2.25 percent from the specified value, but this still restricted exchange rates from changing substantially over time.

In 1973 the boundaries were eliminated. This came as a result of pressure on some currencies to adjust their values because of large differences between the demand for a specific currency and the supply of that currency for sale. As the flow of trade and investing between the United States and a given country changes, so does the U.S. demand for that foreign currency and the supply of that foreign currency for sale (exchanged for dollars).

Because the demand and supply conditions for a given currency change continuously, so do the spot rates of most currencies. Thus most firms and investors that will need or receive foreign currencies in the future are exposed to exchange rate fluctuations.

 
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