Unraveling the Foreign Exchange Market:

The Foreign Exchange market is among the most significant markets globally today. The New York Stock Exchange, Nasdaq, and Tokyo Stock Exchange are the three largest security markets globally, with a combined daily trading volume of around 300 billion US dollars. In contrast, the foreign exchange market boasts a daily trading volume of approximately USD $6.6 trillion. According to the Bank for International Settlements, which serves as the central bank for central banks, this daily amount exceeds the annual GDP of all but two of the largest nations on earth, namely China and the USA. In this exploration, we aim to understand why the foreign exchange market is so vast and influential, who participates in these transactions, and the reasons behind the UK pound's high value compared to other currencies.

Globalization has transformed the way businesses operate in today's world, with an increasing reliance on global supply chains to optimize the production and delivery of goods and services. In the past, countries primarily focused on local production, but now it is common practice to seek the best manufacturing locations worldwide. For instance, products can be manufactured cheaply in China, built to high standards in Germany, or sourced for quality from Japan. This shift towards global trade is driven by the concept of comparative advantage, where countries specialize in producing goods that they are most efficient at, leading to mutually beneficial trade agreements.

Comparative Advantage illustrates how different countries excel in specific industries due to factors like labor costs, infrastructure, and regulations. For example, while Germany could easily produce iPhones, its high labor costs and strict regulations would result in expensive products. Conversely, China's strength lies in mass-producing goods like phones due to its abundant low-skilled labor and flexible regulations. By focusing on their respective strengths, countries can trade goods efficiently, ensuring a wide range of affordable products for consumers. This economic principle has fueled the growth of the foreign exchange market, reflecting the expansion of global trade and currency exchange.

Bretton Woods

The Bretton Woods conference in July 1944 at the Mount Washington Hotel established a gold standard for currencies, with 44 countries participating. The conference, attended only by the Allies of World War II, created the International Monetary Fund and the World Bank, and set guidelines for a fixed exchange rate system. Under this system, countries pegged their currency to the US dollar at a fixed rate of USD $35 per ounce, disregarding supply and demand. While initially successful, the system faced challenges due to the forces of supply and demand.For those familiar with economics, it is understood that trying to resist the impact of supply and demand is akin to battling against the current of a river - ultimately, the persistent forces will prevail. The first major issue arose in 1967 with a run on gold and an attack on the British Pound, leading to a 14.3% devaluation despite efforts to maintain the fixed rate. President Nixon later took the US off the gold standard in 1971, leading to the collapse of the system by 1973. Currencies were then allowed to float freely in the market, traded like other commodities. This shift allowed currencies to find their market value, shaping the influential market we see today. Participants in this trade include multinationals, governments, and speculators.

It's probable that the majority of individuals have limited exposure to the foreign exchange market, aside from trading currencies for travel or online shopping on websites that do not automatically convert currencies. These retail transactions represent a small fraction of the overall foreign exchange market. The primary players are companies, investment firms, and governments, all of which have significant influence. Businesses are the most straightforward to comprehend - when expanding into a new country, they must transfer and convert money into the local currency to cover expenses like labor and supplies. However, a challenge arises in scenarios like when an American fast-food chain invests in Australia. Initially transferring $50 million US dollars would have resulted in about $55 million Australian dollars due to the exchange rate. If the business flourishes and is later sold for $75 million, representing a 50% return in US dollars, the fluctuation in the Australian dollar's value could diminish the true return to 0%. This exemplifies the impact of foreign exchange risk, a crucial consideration for international business ventures. While most businesses are willing to take risks within their industry, they prefer to avoid risks stemming from currency fluctuations. This is where investors, willing to shoulder such risks, come into play. 

Investors are attracted to the foreign exchange market due to its potential for high returns, facilitated by financial instruments known as derivatives. In essence, investors engage in a form of wager with the company: if the value of a foreign currency increases relative to their home currency, the investor receives payment; conversely, if the foreign currency depreciates, the investor pays the company. This setup ensures a stable profit for the company regardless of fluctuations in the Australian dollar, as illustrated in the previous example. In the event of a currency depreciation, the investor would compensate the company approximately $25 million USD. Conversely, if the Australian dollar appreciates, the company would pay the investor $25 million USD, resulting in a consistent profit of $75 million dollars for the company. This arrangement allows the company to avoid the uncertainties of the foreign exchange market, while the investor takes on risk in pursuit of potential profits, which is inherent in the nature of investing. Speculative investors seek risk for profit potential, while regular international businesses aim to mitigate foreign exchange risk, even if it means foregoing speculative gains. This symbiotic relationship between the two entities is highly beneficial. Governments, such as the Chinese government, play a significant role in foreign exchange markets by manipulating their currency value. For instance, the Chinese government intentionally devalues its currency by purchasing large amounts of foreign currency, driving up its price and lowering the price of the Chinese currency. This strategy builds substantial foreign currency reserves for the Chinese government, sparking concerns among conspiracy theorists.

Despite the speculation, trading, and volatility, the British Pound has consistently remained the most valuable currency in the world. While it has faced challenges due to the Brexit turmoil, it still holds the title of the world's most expensive currency unit. Interestingly, there is currently no clear explanation for this status. In the past, when currencies were linked to precious metals, the exchange rate was 1 US dollar for 1.5 grams of gold, while 1 pound sterling was equivalent to 1 pound of sterling silver, which was then and remains now more valuable than 1.5 grams of gold. Although the gold and silver standards have been abandoned, a portion of the pound's value today can be attributed to its historical connection to these metals.

In essence, delving too deeply into it shouldn't be necessary. An easier way to grasp the concept is by considering the example of Seaboard Corporation and Amazon's stock prices. Presently, a share of Seaboard Corporation is priced at approximately USD $4200, while a share in Amazon costs around USD $1813. However, these figures don't hold much significance unless you take into account the number of shares each company has. In reality, Amazon is significantly larger than Seaboard Corporation, despite the similar share prices. This confusion arises from people being more accustomed to buying items with tangible value, such as a Toyota Corolla or a McLaren 720. While the price difference between these cars reflects their respective value and prestige, the same logic doesn't apply to derivatives. Derivatives lack intrinsic value and are essentially just representations on paper or digital records. Their true worth is determined by what others are willing to trade for them, rather than any fixed value assigned to them.