The volume of international transactions has grown enormously over the past 60 years. Exports of goods and services by the United States now total more than 10% of gross domestic product. For both Canada and Great Britain, this figure exceeds 25%. Imports are about the same size. Similarly, annual capital flows involving hundreds of billions of dollars occur between the United States and other nations. International trade and investment of this magnitude would not be possible without the ability to buy and sell foreign currencies. Currencies must be bought and sold because the U.S. dollar is not the acceptable means of payment in most other countries. Investors, tourists, exporters, and importers must exchange dollars for foreign currencies, and vice versa.
The trading of currencies takes place in foreign exchange markets whose primary function is to facilitate international trade and investment. Knowledge of the operation and mechanics of these markets, therefore, is important for any fundamental understanding of international financial management. This chapter provides this information. It discusses the organization of the most important foreign exchange market—the interbank market—including the spot market, the market in which currencies are traded for immediate delivery, and the forward market, in which currencies are traded for future delivery. Chapter 8 examines the currency futures and options markets.