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Chapter III Foreign Exchange Market

By, Carol Peters PrabhuII B ComMahesh College of Management

A foreign exchange market refers to buying foreign currencies with domestic currencies and selling foreign currencies for domestic currencies.

Thus it is a market in which the claims to foreign moneys are bought and sold for domestic currency.

Exporters sell foreign currencies for domestic currencies and importers buy foreign currencies with domestic currencies.

According to Ellsworth, "A Foreign Exchange Market comprises of all those institutions and individuals who buy and sell foreign exchange which may be defined as foreign money or any liquid claim on foreign money". Foreign Exchange transactions result in inflow & outflow of foreign exchange.

What Exactly Is Forex?With a daily trade volume of up to 4 trillion USD, forex is the largest financial market in the world. In comparison, the daily trade volume of the New York Stock Exchange is only USD 25 billion. There is an evident disparity in the trade volumes between forex and stock markets. Its actual trade volume is more than 3 times the total trade volume of the stock and futures market!What is traded in the Forex Market?

The answer is simple, money. Forex trading is the buying of one currency and the selling of another simultaneously

Trading of foreign currency is done in pairs, e.g. Euro against US Dollars (EUR/USD) or British Pounds against Japanese Yen (GBP/JPY). Buying and selling foreign currencies is like investing in a countrys stock. When you buy Japanese Yen, for example, you are actually acquiring a stake in Japanese economy.

FUNCTIONS OF FOREIGN EXCHANGE MARKETForeign exchange is also referred to as forex market

Participants are importers, exporters, tourists and investors, traders and speculators, commercial banks, brokers and central banks

Foreign bill of exchange, telegraphic transfer, bank draft, letter of credit etc. are the important foreign exchange instruments used in foreign exchange market to carry out its functions.

The foreign exchange market performs the following important functions:

(i) to effect transfer of purchasing power between countries- transfer function;

(ii) to provide credit for foreign trade - credit function;

(iii) to furnish facilities for hedging foreign exchange risks - hedging function.

1.Transfer FunctionThe basic function of the foreign exchange market is to facilitate the conversion of one currency into another, i.e., to accomplish transfers of purchasing power between two countries. This transfer of purchasing power is effected through a variety of credit instruments, such as telegraphic transfers, bank drafts and foreign bills.In performing the transfer function, the foreign exchange market carries out payments internationally by clearing debts in both directions simultaneously, analogous to domestic clearings.

2. Credit FunctionThe foreign exchange market also provides credit to both national and international, to promote foreign trade.

It is necessary as sometimes, the international payments get delayed for 60 days or 90 days. Obviously, when foreign bills of exchange are used in international payments, a credit for about 3 months, till their maturity, is required. For e.g. Mr. A can get his bill discounted with a foreign exchange bank in New York and this bank will transfer the bill to its correspondent in India for collection of money from Mr. B after the stipulated time.

3. Hedging FunctionA third function of foreign exchange market is to hedge foreign exchange risks. By hedging, we mean covering of a foreign exchange risk arising out of the changes in exchange rates. Under this function the foreign exchange market tries to protect the interest of the persons dealing in the market from any unforeseen changes in exchange rate. The exchange rates under free market can go up and down; this can either bring gains or losses to concerned parties. Hedging guards the interest of both exporters as well as importers, against any changes in exchange rate.

Hedging can be done either by means of a spot exchange market or a forward exchange market involving a forward contract.

A forward contract which is normally for three months is a contract to buy or sell foreign exchange against another currency at some fixed date in the future at a price agreed upon now. No money passes at the time of the contract. But the contract makes it possible to ignore any likely changes in exchange rate.

The existence of a forward market thus makes it possible to hedge an exchange position.

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