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My understanding of forex exchange is that when there are two currencies cur1 and cur2, they are balanced in the world with a certain rate. People who buy cur1 at a high rate and sell in a lower rate effectively end up paying for the profit which someone has made by selling cur1 when the rate was high and buying when the rate was lower.

In a hypothetical world where no one sells their reserve of cur2 but people having cur1 reserves keep on buying cur2, how will the system be balanced? Who will gain or loose to compensate for the imbalance created? Please correct me if you think the question is incorrect or missing something.

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    $\begingroup$ In this hypothetical world, how is someone buying cur2 if no one is selling it? $\endgroup$ – dismalscience Mar 6 at 23:41
  • $\begingroup$ I believe this was the missing link. You cannot buy a currency unless someone else sells it. But what does the whole transaction look in the big picture as a buyer is not aware from whom he/she is buying? Is it the banks who sell the currency? If you can explain the whole transaction, I will accept the answer. Thanks $\endgroup$ – smaug Mar 7 at 14:23
  • $\begingroup$ When particular currency become a commodity that allow massive future-trading/shorting, it works exactly like a commodity. $\endgroup$ – mootmoot Mar 7 at 14:49
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The foreign exchange market is a huge over-the-counter market, primarily intermediated by large dealer banks with subsidiaries around the world (sometimes referred to as “money center” banks).

A buyer or seller of a currency is almost certainly at or trading with one of these banks. The dealer banks make money via a “spread,” where every buyer or seller of a currency effectively pays the dealer they’re trading with. For example, if 1 cur1 = 1 cur2, a buyer of cur2 might have to pay 1.01 cur1 for it, and a seller of cur2 might receive 0.99 cur1 for it, with the dealer taking .01 on both sides.

The forex market is large and highly competitive, and balance between the prices of any two currencies is just determined by supply and demand— as people trade cur1 for cur2, the supply of cur1 at dealer banks will rise, and the supply of cur2 will fall, so the price of cur2 will rise relative to cur1. From a practical standpoint, as more people trade cur1 for cur2, a dealer bank will have to replenish its reserves of cur2, which it will often do by borrowing it.

In my opinion, the simplest way to think about all this is to remember that the primary source of demand for any currency is people who want the stuff denominated in that currency (be it consumer goods, financial or real assets, etc.). When more people want that stuff, relative to the stuff in other currency areas, the price of that stuff (i.e., the value of the currency) rises. For example, Canada is a huge oil exporter, and if you want Canadian oil, you first have to get Canadian dollars. As a result, when demand for oil rises, the value of the Canadian dollar rises.

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  • $\begingroup$ that was a beautifui answer. $\endgroup$ – mark leeds Mar 7 at 19:08
  • $\begingroup$ Nice explanation @dismalscience. When you say that the dealer bank has to replenish its reserve of a currency, from whom is it borrowing? The central bank of that country/currency issuing organization? $\endgroup$ – smaug Mar 11 at 20:49
  • $\begingroup$ Outside of pretty extreme crisis periods, it’s not usually borrowed from the central bank of the issuing country (the notable exception would be the uncapped dollar swap lines the Fed had with foreign central banks during the crisis). The borrowing is most typically a combination of borrowing in the relevant overseas market itself (e.g., the “Eurodollar” market), and intra-firm transfers (e.g., an overseas affiliate borrows dollars from the US affiliate, which itself borrows dollars from a domestic money fund). $\endgroup$ – dismalscience Mar 12 at 2:22

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