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Forex: The Need for Foreign Exchange

Let us say that the businessman who operates in more than one country needs to understand not only the mechanism of the foreign exchange system, but also why changes in monetary values occur and how to cope with them.

Foreign exchange is the monetary mechanism by which transactions in two or more currencies are affected. The development of foreign exchange practices and procedures is similar to that of internal monetary systems.

In the beginning, trade took place on a barter basis. That had an obvious disadvantage: each of the parties in a transaction had to have something the other wanted. The basis of the alternative, a monetary exchange system, is a material that has an intrinsic value that is relatively stable and so is wanted by both parties in a transaction.

The most common examples of such a material--- the medium of exchange--- are gold and silver. When both buyer and seller accept a medium of exchange, it becomes possible to dispose of goods or services.

With the development of nations, each with its own monetary system, and international trade, a foreign exchange mechanism became necessary and was developed. By means of foreign exchange, goods produced in one country can be purchased in another country.

Regardless of its direction, such an international transaction must be denominated in a currency other than that of either the seller or buyer; that is, one party to the transaction must either buy or sell a foreign currency.

It does so through the international banking system, and the result is a foreign exchange transaction. The problem that then arises is convertibility, or the relative values of two different currencies.

Methods and procedures that have been developed by central banks and internal banking systems are the means of effecting actual foreign exchanges. Commercial transactions, in turn, are effected through the banking system. Both are international monetary system and the commercial banking constraints of each country must be thoroughly understood before the flow of financial transactions on a multinational scale to be optimized.

Despite the existence of an international monetary system, changes in the value of one currency in relation to another are common, and they make the management of international business more complex. Changes in monetary values are of two kinds: those that reflect supply and demand in the day-to-day market, and those that reflect an imbalance between the economies of countries.

This is where the Bretton Woods agreement was intended to limit fluctuations to the day-to-day market variety and give special consideration to the handling of imbalances between countries.

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