The foreign exchange market is a market for converting the currency of one country into that of another country. Without the foreign exchange market, international trade and international investment would be impossible on the scale that we see today; companies would have to resort to barter. The foreign exchange market is the lubricant that enables companies based in countries that use different currencies to trade with each other.
International trade and investment have their risks. Some of these risks exist because future exchange rates cannot be perfectly predicted. The rate at which one currency is converted into another typically changes over time. One function of the foreign exchange market is to provide some insurance against the risks that arise from changes in exchange rates, commonly referred to as foreign exchange risk. Although the foreign exchange market offers some insurance against foreign exchange risk, it cannot provide complete insurance. Currency fluctuations can make seemingly profitable trade and investment deals unprofitable, and vice versa.
In addition to altering the value of trade deals and foreign investments, currency movements can also open or close export opportunities and alter the attractiveness of imports. In 1984, for example, the US dollar was trading at an all-time high against most other currencies. At that time one dollar could buy one British pound or 250 Japanese yen, compared to 0.55 of a British pound and about 85 yen in early 1995. In the 1984 US presidential campaign, then President Ronald Reagan boasted about how good the strong dollar was for the United States. Many US companies did not see it that way. Companies such as Caterpillar that earned their living by exporting to other countries were being priced out of foreign markets by the strong dollar. In 1980 when the dollar-to-pound exchange rate was $1 = £0.63, a $100,000 Caterpillar earthmover cost a British buyer £63,000. In 1984, with the exchange rate at $1 = £0.99, it cost close to £99,000 - a 60 percent increase in four years! At that exchange rate Caterpillar's products were overpriced in comparison to those of its foreign competitors, such as Japan's Komatsu. At the same time, the strong dollar reduced the price of the earthmovers Komatsu imported into the United States, which allowed the Japanese company to take US market share away from Caterpillar.
Thus, while the existence of foreign exchange markets is necessary for large-scale international trade and investment, the movement of exchange rates introduces many risks into international trade and investment. Some of these risks can be insured against by using instruments offered by the foreign exchange market, such as the forward exchange contracts; others cannot be.