Concept of Foreign Exchange

Foreign Exchange refers to all currencies other than the domestic currency of a given country.

For example, India’s domestic currency is Indian rupee and all other currencies like: US Dollar, Pound, Kuwaiti Dinar etc. are foreign exchange.

The foreign exchange market (also known as forex, FX, or the currency market) is an over-the-counter (OTC) global marketplace that determines the exchange rate for currencies around the world. Participants are able to buy, sell, exchange, and speculate on currencies.

Foreign exchange markets are made up of banks, forex dealers, commercial companies, central banks, investment management firms, hedge funds, retail forex dealers, and investors.

The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms of trading volume, it is by far the largest market in the world, followed by the credit market.

The main participants in this market are the larger international banks. Financial centers around the world function as anchors of trading between a wide range of multiple types of buyers and sellers around the clock, with the exception of weekends. Since currencies are always traded in pairs, the foreign exchange market does not set a currency’s absolute value but rather determines its relative value by setting the market price of one currency if paid for with another. Ex: US$1 is worth X CAD, or CHF, or JPY, etc.

The foreign exchange market works through financial institutions and operates on several levels. Behind the scenes, banks turn to a smaller number of financial firms known as “dealers”, who are involved in large quantities of foreign exchange trading. Most foreign exchange dealers are banks, so this behind-the-scenes market is sometimes called the “interbank market” (although a few insurance companies and other kinds of financial firms are involved). Trades between foreign exchange dealers can be very large, involving hundreds of millions of dollars. Because of the sovereignty issue when involving two currencies, Forex has little (if any) supervisory entity regulating its actions.

The foreign exchange market assists international trade and investments by enabling currency conversion. For example, it permits a business in the United States to import goods from European Union member states, especially Eurozone members, and pay Euros, even though its income is in United States dollars. It also supports direct speculation and evaluation relative to the value of currencies and the carry trade speculation, based on the differential interest rate between two currencies.

In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying with some quantity of another currency.

The modern foreign exchange market began forming during the 1970s. This followed three decades of government restrictions on foreign exchange transactions under the Bretton Woods system of monetary management, which set out the rules for commercial and financial relations among the world’s major industrial states after World War II. Countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed per the Bretton Woods system.

The foreign exchange market is unique because of the following characteristics:

• Its huge trading volume, representing the largest asset class in the world leading to high liquidity;
• Its geographical dispersion;
• Its continuous operation: 24 hours a day except for weekends, i.e., trading from 22:00 gmt on sunday (sydney) until 22:00 gmt friday (new york);
• the variety of factors that affect exchange rates;
• the low margins of relative profit compared with other markets of fixed income; and
• The use of leverage to enhance profit and loss margins and with respect to account size.

Supply of Foreign Exchange

1. Exports of Goods and Services: Supply of foreign exchange comes through exports of goods and services.
2. Foreign Investment: The amount, which foreigners invest in the home country, increases the supply of foreign exchange.
3. Remittance (Unilateral transfers) from abroad: Supply of foreign exchange increase in the form of gifts and other remittances from abroad.
4. Speculation: Supply of foreign exchange comes from those who want to speculate on the value of foreign exchange.
5. Foreign tourism in our country.

Scope

Transfer Function

This function is to transfer finance and purchasing power from one country to another country. Through foreign bills or remittances which were made through telegraphic transfer, such type of transfer gets affected.

Hedging Function

This function is for hedging facilities such as; facilitate buying and selling spot or forward foreign exchange. Hedging refers to the “foreign exchange risk avoidance” as in foreign exchange market there might be gain or loss to the party because of change in the price of one currency in terms of another currency. In case of huge amount of net claims or net liabilities in foreign exchange then a person or a firm as the case may undertake a high exchange risk.

Such exchange risk should be reduced. In exchange, through forwarding contracts, foreign exchange market provides such facilities for anticipated hedging. A forward contract is a type of contract related to buying or selling foreign exchange against another currency in future at the fixed date on the agreed price. This type of contract makes it possible to avoid changes in exchange rate. This forward market helps in hedging exchange position.

Credit Function

This function is to issue credit for the purpose of international trade.

Foreign Exchange Markets helps in determining the value of foreign savings. It is a marketplace where the foreign money is bought and sold and we can also say it is a type of institutional arrangement where the foreign currencies are bought and sold. Under this, importers buy the foreign currency which is sold by the exporters.

In financial centers, this type of market merely forms a part of money market where the foreign money is bought and sold. Foreign exchange market is not restricted to any geographical area. It is a market for foreign currencies.

In foreign exchange markets, there are a wide variety of dealers such as banks. Banks which deal in foreign exchange have their branches in different countries. These are also called as “Exchange Banks” from where the services are available in all over the world.

Significance

• It acts as a central focus whereby prices are set for different currencies.
• With the help of foreign exchange market investors can hedge or minimize the risk of loss due to adverse exchange rate changes.
• Foreign exchange market transfers purchasing power across different countries, which results in enhancing the feasibility of international trade and overseas investment.
• Foreign exchange market allows traders to identify risk free opportunities and arbitrage these away.
• It facilitates investment function of banks and corporate traders who are willing to expose their firms to currency risks.