Reasons for buying and selling foreign currencies: trade in goods and services

International Trade and Globalisation – Foreign‑Exchange Rates (Cambridge 0455 / 9709)

1. Definition of a foreign‑exchange rate

A foreign‑exchange rate (or simply exchange rate) is the price of one currency expressed in terms of another currency.

Example: £1 = $1.30 means that one British pound can be exchanged for 1.30 US dollars.

2. Why is foreign currency needed for international trade?

In cross‑border transactions the seller normally wants to be paid in his own (or a mutually‑agreed) currency.

Consequently the buyer must obtain that foreign currency before the payment can be made, and the seller later converts the foreign currency back into his domestic money.

3. Reasons for buying foreign currency (obtaining foreign currency)

• Importing goods – a UK retailer buys smartphones from South Korea and must pay in South Korean won.
• Importing services – a British software firm outsources cloud hosting to a US provider and pays in US dollars.
• Outbound tourism – a British family travelling to Thailand needs Thai baht for hotels, meals and transport.
• Outward foreign investment – a UK pension fund purchases shares in an Australian mining company, requiring Australian dollars.
• Education abroad – a student pays tuition to a university in Canada, so she needs Canadian dollars.
• Repayment of foreign loans – a UK firm that borrowed Swiss francs must obtain francs to meet scheduled repayments.
• Speculative demand – investors buy a foreign currency expecting it to appreciate, hoping to sell it later at a higher price.

All of these outflows are recorded in the current account of the balance of payments.

When the total of such outflows exceeds inflows, the country runs a current‑account deficit; a surplus occurs when inflows are larger.

4. Reasons for selling foreign currency (converting foreign currency back to domestic)

• Exporting goods – a UK car maker sells vehicles to the United States and receives US dollars, which are then sold for pounds.
• Exporting services – a British consultancy provides advice to a client in India and receives Indian rupees.
• Inbound tourism – a hotel in Spain receives euros from British guests and converts them into pounds.
• Dividends, interest or rent from overseas assets – a UK investor receives dividend payments in Japanese yen.
• Inward foreign‑investment returns – a UK pension fund sells the Australian dollars received from its shareholding for pounds.
• Repayment of foreign loans (excess currency) – after a loan repayment, any remaining foreign currency is sold to bring the balance back into domestic money.
• Central‑bank purchases of foreign currency – when the Bank of England buys foreign currency, it is effectively “selling” domestic pounds and increasing its foreign‑exchange reserves.

These inflows are recorded as current‑account credits and, when the central bank purchases the foreign currency, they raise the country’s foreign‑exchange reserves.

5. Summary table – Buy vs. Sell

6. How the foreign‑exchange market works

The foreign‑exchange (Forex) market is a global, over‑the‑counter network where banks, dealers, corporations and individuals buy and sell currencies. The quoted rate tells a buyer how much of the foreign currency he will receive for each unit of his own currency.

Simple transaction flow (import):

1. A UK importer needs €10 000 to pay a German supplier.
2. The importer contacts his bank, which quotes the current spot rate (e.g., £1 = €1.15).
3. The bank converts the required amount of pounds into euros and transfers €10 000 to the supplier.
4. The German supplier’s bank converts the euros into pounds (or keeps them) according to the supplier’s preference.

Simple transaction flow (export):

1. A UK exporter receives $5 000 from a US buyer.
2. The exporter sells the dollars to his bank.
3. The bank credits the exporter’s account with pounds at the prevailing rate.

7. Determination of the foreign‑exchange rate

7.1 Floating (flexible) exchange‑rate system

In a floating system the rate is set by market forces of demand and supply for the foreign currency.

• Demand for a foreign currency rises when:

  • Imports increase – domestic buyers need more foreign money.
  • Foreign investors seek domestic assets (speculative demand).
  • Tourists travel abroad.

• Supply of a foreign currency rises when:

  • Exports increase – foreign buyers need the domestic currency to pay.
  • Domestic investors purchase foreign assets.
  • The central bank sells foreign reserves (or intervenes to keep the rate stable).

When demand exceeds supply the foreign currency appreciates (its price in domestic currency rises).

When supply exceeds demand the foreign currency depreciates (its price falls).

Diagram (illustrative) – a standard demand‑supply graph:

Price of foreign currency (domestic units)
|
|          S
|          /
|         /      D'
|        /      /
|-------/------/---------------- Quantity of foreign currency
|      /      /
|     /      /
|    /      /
|   /      /
|  /      /
| /      /
|//

• The vertical axis shows the price of the foreign currency (e.g., £ per €).

• The horizontal axis shows the quantity of the foreign currency.

• A right‑ward shift of D (demand) – caused by higher imports or speculation – leads to a higher equilibrium price → appreciation.

• A right‑ward shift of S (supply) – caused by higher exports or central‑bank sales of reserves – leads to a lower equilibrium price → depreciation.

7.2 Fixed (or pegged) exchange‑rate system

In a fixed system the government or central bank declares a target rate and maintains it by buying or selling foreign reserves.

• Mechanism: If the domestic currency is under pressure to depreciate, the central bank sells foreign reserves and buys domestic currency, supporting its value. If the currency is under pressure to appreciate, the bank buys foreign currency, increasing the supply of domestic currency.
• Pros:

  • Reduces exchange‑rate uncertainty – useful for trade and investment.
  • Can help anchor inflation expectations.

• Cons:

  • Requires large reserves; a sustained attack can deplete them.
  • Limits independent monetary policy – the central bank must prioritise the peg.
  • If the official rate diverges from market fundamentals, a “parallel” market may develop.

8. Numerical example (multi‑currency conversion)

Assume the following spot rates:

• £1 = $1.30
• \$1 = €0.85 (or equivalently, €1 = \$1/0.85 ≈ $1.176)

1. UK importer needs €10 000.

   1. Convert euros to dollars: €10 000 ÷ 0.85 = $11 764.71.
   2. Convert dollars to pounds: $11 764.71 ÷ 1.30 ≈ £9 050.55.

2. UK exporter receives $5 000.

   Convert to pounds: $5 000 ÷ 1.30 ≈ £3 846.15.

This illustrates how the prevailing exchange rates determine the amount of domestic money required (or received) for a foreign‑currency transaction.

9. Diagram – Flow of foreign currency in an import‑export transaction

10. Quick‑scan checklist for Cambridge 6.3

• Definition of foreign‑exchange rate – ✔
• Reasons for buying foreign currency – ✔ (includes balance‑of‑payments link and speculative demand)
• Reasons for selling foreign currency – ✔ (includes current‑account credit, reserves and central‑bank role)
• Floating‑rate determination – ✔ (demand‑supply drivers, diagram, appreciation/depreciation)
• Fixed‑rate system – ✔ (mechanism, advantages and disadvantages)