Foreign Exchange Market Meaning, Characteristics, Functions

Table of Content:-

  1. Meaning of Foreign Exchange Market
  2. What is Foreign Exchange Market?
  3. Characteristics of Foreign Exchange Markets
  4. Functions of Foreign Exchange Market

Meaning of Foreign Exchange Market

The foreign exchange market is also known as the currency market, FOREX or FX. It includes the trading of various currencies. Foreign exchange market transactions typically involve one party purchasing a quantity of one currency in exchange for paying a quantity of another currency. The Foreign exchange market is the world’s largest and most liquid financial market. It involves trading between large banks, central banks, currency speculators, governments, corporations, and other financial institutions.

In today’s world, no economy is self-sufficient, so there is a need to exchange goods and services among different countries. In modern global society, the method of exchanging goods and services has evolved significantly from the primitive age. Every sovereign country in the world has a legal tender currency in its territory, which does not act as money outside its boundaries.

Whenever a country engages in the purchase or sale of goods and services from another country, the residents of those two countries have to exchange currencies. If all countries adopt a unified currency, the necessity for foreign exchange would cease to exist. 

What is Foreign Exchange Market?

According to Kindleberger, “Foreign exchange market is a place where foreign money is bought and sold”. The foreign exchange market is a financial institutional arrangement for buying and selling foreign currencies. Exporters sell foreign currencies, and importers purchase them.

The foreign exchange market is an integral element of the overall money market within financial centres. It is a dynamic hub where foreign money is bought and sold. The buyers, sellers, and intermediaries together constitute a foreign exchange market, which serves as a platform for trading claims on foreign currency. This market is not limited to any specific country or geographical region. Thus, the foreign exchange market refers to the global market where national currencies (foreign money) are traded. This market is created by the integration of financial centres worldwide, resulting in a unified platform for currency exchange.

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Characteristics of Foreign Exchange Market

Characteristics of Foreign Exchange MarketSome of the important characteristics of a foreign exchange market are as follows:

1) Geographical Dispersal

One of the unique aspects of the money market is its lack of limitation to a single location. The market spreads widely across the major financial centres worldwide, including New York, London, Paris, Zurich, Tokyo, Amsterdam, Hong Kong, Frankfurt, Toronto, Milan, and other cities.

2) Electronic Market

The foreign exchange market does not possess a physical location. It is a market whereby trading of various currencies occurs through the electronically interconnected network of banks, foreign exchange brokers and dealers. Its primary function is to bring together buyers and sellers of foreign exchange.

3) Intermediary

The foreign exchange market provides a convenient way of converting the currencies earned into currencies wanted by their respective countries. To facilitate this process, the market acts as an intermediary between people or commodities involved in the buying and selling of foreign exchange.

4) Volume

A special feature of the forex market is that out of the total trading transactions in the foreign exchange market, around 95 per cent takes the form of cross-border purchase and sale of assets, known as international capital flows. Only around 5 per cent relates to export and import activities.

5) Provision of Credit

A foreign exchange market provides credit through specialised instruments such as bankers’ acceptances and letters of credit. The credit provided is immensely beneficial to traders and businessmen in the international market.

6) Minimising Risks

The forex market helps the importer and exporter in foreign trade to minimise their risks of trade. The provision of hedging facilities achieves this. This enables traders to transact business in the international market to earn a normal business profit without exposure to an expected change in anticipated profit. The reason for this phenomenon is the sudden fluctuation in exchange rates.

7) Transfer of Purchasing Power

The forex market facilitates the transfer of purchasing power denominated in one currency to another, where one currency trades for another currency. For example, an Indian exporter sells computer software to a U.S. firm for dollars and a U.S. firm sells supercomputers to an Indian company for rupees. In these transactions, firms of respective countries would like to have their payments settled in their currencies, i.e., Indian firms in rupees and U.S. firms in U.S. dollars. The currency market plays a crucial role in facilitating a settlement between countries using their respective currency units.

Functions of Foreign Exchange Market

The following are some of the important functions of the forex market:

1) Credit Function

The forex market provides credit, both nationally and internationally, to promote the international trading environment. International payments made using foreign bills of exchange require a credit period of approximately three months until the payment matures.

2) Hedging Function

A third function of the foreign exchange market is to mitigate foreign exchange risks through hedging. In a free exchange market, when the exchange rate, i.e., the price of one currency in terms of another money, changes, there may be a gain or loss to the party concerned.

Under this condition, a person or a firm undertakes a great exchange risk when confronted with substantial amounts of net claims or net liabilities that must be settled in foreign currency. Exchange risk as such should be avoided or minimized.

3) Transfer Function

The basic function of any forex market is to facilitate the conversion of one currency into another, i.e., to accomplish transfers of purchasing power between two countries. A range of credit instruments, including bank drafts, telegraphic transfers and foreign bills, affects this transfer of purchasing power.

For this, the exchange market provides facilities for hedging anticipated or actual claims or liabilities through the use of forward contracts. A forward contract which is normally for three months is an agreement to purchase or sell foreign exchange against another currency at some fixed date in the future at a price agreed upon now.

No money transactions occur at the time of the contract. However, the contract makes it possible to ignore any likely changes in the exchange rate. The existence of a forward market facilitates the opportunity to mitigate risks associated with an exchange position.

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