Global Investing

CHAPTER 6Currency Risk

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Currency Market Overview

Currencies as we know them today are termed fiat currencies since their value is based on government decree. Most currencies are therefore controlled by the actions of a single government. Currency trading is what enables global trade and facilitates financial transactions of all kinds. In fact, the currency market is considered the largest and most liquid financial market in the world. Daily trading volumes are estimated to be the equivalent of US$6.6 trillion, far surpassing the combined dollar value of all stock and bond trades each day. Figure 6.1 shows the most widely traded currencies in the world as of 2019, including spot and derivative transactions. The term spot transaction refers to trades that are for immediate (typically next day) settlement, while derivative transactions are for settlement at some future date. Keep in mind that each transaction involves a pair of currencies and therefore Figure 6.1 shows double the actual total daily trading volume.

Exchange Rate Dynamics

Like most other assets, the exchange rate between two countries is determined by supply and demand. Demand is generated by trade and investment flows between a single country and all other countries that interact with it. For example, a US company building a manufacturing plant in Japan would need to convert US dollars to Japanese yen in order to pay the local construction firm. It may also need to purchase euros to buy equipment ...