Meaning of Foreign Exchange

By | May 2, 2021

The term foreign exchange is quite broad, but differentiates depending on the application. Foreign currencies initially refer to all currencies that are used outside of one’s own currency area. However, a distinction must be made between foreign exchange, the accounting size, and types, the specific presence of a currency in coins and bills. If there is a transfer from Germany to the USA and the invoice amount is converted from euros to US dollars, it is based on the exchange rate. If a vacationer changes euro bills for US dollars at the bank counter, the conversion takes place on the basis of the exchange rate. According to abbreviationfinder, FOREX stands for Foreign Exchange.

  • In contrast to sorts, foreign currencies also denote means of payment in foreign currency, for example checks or bills of exchange.
  • On the one hand, exchange rates arise from supply and demand on the currency exchanges.
  • A common variant in forex trading is currency forwards.

Foreign exchange as a payment obligation

In contrast to sorts, foreign exchange also denotes means of payment in foreign currency, for example checks or bills of exchange. This means that there is a payment obligation in a foreign currency. For banks, the keeping of deposits in foreign currency is the motto. The official definition is “sight deposits in foreign currency on the current accounts of foreign and domestic banks”. Foreign currencies ensure that receivables can be settled in a foreign currency at short notice.

Forex trading

With a daily turnover of around 5.3 trillion US dollars, foreign exchange trading is the largest marketplace in the world. Even stock trading does not come close to these numbers. On the other hand, the high volumes can certainly be understood. Profits in forex trading occur to the fourth decimal place. In order to be able to achieve significant profits, correspondingly high positions have to be moved. In the interbank business, such positions are actually traded in concrete terms. The name for this is spot trading. For some years now, private investors have had the opportunity to participate in trading via so-called forex brokers (“Forex” is an abbreviation for “Foreign Exchange”). The basis, however, are so-called leverage transactions, in which the currency itself is not acquired, but an abstract right to a foreign exchange position. Only a small fraction of the traded volume is used for this, which in turn results from the leverage set by the broker.

Sample calculation

An investor wants to trade a position of 100,000 euros against US dollars. The leverage for this deal is 1: 100. The actual amount to be brought in is 1,000 euros (100,000 / 100) and is deposited as a security deposit. In fact, the broker grants a loan.

Free convertibility requirement for foreign exchange transactions

It was and still is not absolutely common for all currencies that the value in comparison to another currency can be freely determined through supply and demand. The value of the Chinese yuan, for example, is linked to the development of a currency basket. This basket takes into account US dollars, Australian dollars, yen, euros and Swiss francs. It has not yet been possible to export the yuan. A bond denominated in yuan was placed for the first time in May 2014 in Frankfurt.

Cuba also pursues a restrictive foreign exchange policy and differentiates between a purely domestic currency for the citizens of the state and a counterpart that visitors receive when they exchange their currency.

The course determination

On the one hand, exchange rates arise from supply and demand on the currency exchanges. On the other hand, the official exchange rates are set every day. These are determined by the European Central Bank. Every trading day around 1 p.m., a total of 17 banks report to the Bundesbank the mean values ​​of the foreign exchange traded on that day. This will be followed by a telephone conference between the European Central Bank and the individual central banks to determine the exact exchange rates in relation to the euro. These will be published around 2 p.m.

Forward foreign exchange transactions

A common variant in foreign exchange trading is currency forwards. Here the banks agree directly with each other that a certain position will be accepted at a later point in time at the price specified when the contract was concluded. The background to this is the protection against fluctuations in the very volatile foreign exchange market. If the currency exchange takes place within 48 hours of the conclusion of the contract, we are talking about a foreign exchange spot transaction as a counterpart to the longer-running forward transaction.

foreign exchange