Foreign Exchange Market

Foreign Exchange Market

The foreign exchange market is an institutional arrangement for the sale and purchase of foreign currencies, importers buy and exporters sell foreign currencies. A foreign exchange market is a market in which foreign money or currency is bought and sold.

International transactions involve payments or receipts in currencies other than the home currency of trading countries.

This results in the necessity of buying and selling foreign exchange. The market in which different currencies are bought and sold for one another is called the foreign exchange market.

In other words, the foreign exchange market is a market in which foreign exchange transactions take place. This market is a vehicle that makes possible the exchange of national currencies. The basic purpose of the foreign exchange market is to facilitate international trade and investment.

In countries like India, which have adopted a strict exchange control system there is no foreign exchange market as such.

All the exporters must surrender the foreign currency to the central bank in exchange for the home currency at a fixed rate.

Types Of Foreign exchange Market :

There are two foreign exchange markets :

1. Retail Market :

In this foreign exchange market, the individuals and firms that require foreign currency can buy it and those who have acquired foreign currency can sell it.

The commercial bank dealing in foreign exchange serve their customers by purchasing foreign exchange from some and selling foreign exchange to others.

2. Inter-bank Market :

This bank serves to smoother the excessive purchases or sales made by the individual banks.

At times, the quality of foreign exchange supplied exceeds the quantity demanded or vice versa.

At this point when such an imbalanced happened the exchange rate changes. If the foreign exchange is in excess demand, the exchange rate rises, if the foreign exchange is in excess supply, the exchange rate falls.

Dealers in Foreign Exchange Market :

Important dealers in the foreign exchange market are the following :

1. Banks: The bank dealing in foreign exchange have branches in different countries and keep up considerable foreign currency balances in these branches.

These branches discount and sell a foreign bill of exchange, issue Bank draft, make the telegraphic transfer, etc.

2. Brokers: Banks use the services of foreign exchange brokers. Brokers act as intermediaries between the buyers and sellers of foreign exchange among banks.

The brokers receive a commission from the purchasing or selling bank if he succeeds in carrying out the transaction.

3. Acceptance Houses: Acceptance houses accept bills on behalf of their customers and thus help in remittance of funds.

4. Central Banks: Central banks are the most official participants in the foreign exchange market.

They may intervene in the exchange market occasionally. They enter the market both as buyers and sellers to prevent excessive fluctuations in the exchange rates.

Functions of Foreign Exchange market :

The main important functions of Foreign exchange market :

1. Facilitates transfer :

The basic function of the foreign exchange market is to transfer purchasing power between countries I.e to provide a platform whereby the currency of one country is converted into the currency of another country at the prevailing exchange rate.

The transfer function is performed through the credit instruments like the foreign bill of exchange, bank draft and telephonic transfers.

2. Facilitates Credit :

Foreign bills of exchange used in international payments normally have a maturity period of three to six months.

This period of credit is required to enable the importer to take possession of goods, sell them and realize money to make payments to the exporter. The foreign exchange market performs the function of providing credit to promote foreign trade.

The credit function is performed through acceptance houses that accept bills on behalf of their customers.

3. Facilitates hedging :

In a situation of exchange risks, the foreign exchange market performs the hedging function.Hedging is an act of equating one’s assets and liabilities in a foreign currency to avoid the risk resulting from future changes in the value of the foreign currency.

In a free exchange market, when the value of foreign currency varies, there may be a gain or loss to the traders concerned.

To avoid or reduce this exchange risk, the exchange market provides facilities for hedging anticipated or actual claims or liabilities through forwarding contracts in exchange.

A forward contract is a contract of buying or selling foreign currency at some fixed date in the future at a price agreed upon now.

4. Facilitates trade and investment :

International trade and investment would not have been possible without the arrangements or mechanism for buying and selling foreign currency.The foreign exchange market is required to undertake import and export transactions.

Foreign exchange is made by converting the currency of one country into another at the prevailing exchange rate.

Features of Foreign Exchange Market :

  1. This market has no geographical location. It is an electronically linked network.
  2. The trading in this market is done usually 24 hours a day by telephones, display monitors, telex, fax machines and other means of communication.
  3. The exchange dealers are bound by an informal code of moral conduct.
  4. Most transactions are based on oral communication to start with, the written documents follow later on.

Understanding of Foreign Exchange Market :

The principal participants in the foreign exchange market are Banks, Foreign exchange dealers, brokers, firms and central banks.

For instance, in India, the Reserve Bank of India authorizes banks and other financial institutions to transact foreign exchange business. They are called authorized dealers.

There are also authorized money changers who are issued licenses to transact foreign exchange business of issuing and encashing traveller’s cheques and foreign currencies.

Banks dealing in foreign exchange are the market makers in the market. This means that they quote buying and selling rates of a currency in relation to another currency and are prepared to buy and sell it at those rates.

The brokers in this market act as a middle man between two banks. They inform the banks about rates at which firm buyers and sellers are prepared to buy and sell the specific currency.

The broker strikes the deal and collects his commission. But brokers do not buy or sell currencies for themselves.

Thus, the foreign exchange rates are set in these inter-bank and bank broker dealings. Firms need foreign exchange for making payments of imports and interest on foreign loans, conversion of export receipts, hedging of receivable and payable, etc.

They do not deal with a foreign exchange like banks. The central bank intervenes in this market from time to time to influence the exchange rates when the country is not on a fully flexible exchange rate system.

For instance, in India when the price of the dollar rises above a certain level, the Reserve Bank intervenes by releasing a large supply of dollars so as to bring its price at that level.

Even in countries with full flexible systems, the central banks do intervene to smooth out fluctuations in the exchange rate when the situation demands. This is called a dirty floating system.

Frequently questions & Answers

1. Where is the largest foreign exchange market?

Ans: the United States of America is the largest foreign exchange market.

2. Where is the foreign exchange market located?

Ans: There is no such location in the foreign exchange market. It often changes from time to time.

3. What is mean by FEMA?

Ans: The full form of FEMA is Foreign Exchange Market Act.

4. Is forex trading legal in the USA?

Ans: Yes forex trading is legal in the USA.

5. What is the main aim of the foreign exchange market?

Ans: The main aim of the foreign exchange market is to facilitate international trade and investment.

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