Foreign Exchange Market : Meaning, Functions and Types

Every nation has a unique currency that it uses for commerce and business, in India, it’s Indian Rupee, but what about the global market? The lack of flexibility of the currencies makes them a barrier to international trade. The Foreign Exchange Market was formed to solve this problem. This is a specific kind of market where the currency exchange rates are fixed. In the absence of a foreign exchange market, the global economy would suffer greatly. The Foreign Exchange Market is the market in which the national currencies are traded for one another. 

The Foreign Exchange Market refers to the market for national currencies of different countries in the world. It is the center of trade for the different currencies. In simple words, it is a market in which buying and selling of foreign currencies take place. In this market buyers and sellers constitute people who wish to buy or sell foreign exchange. The buyers can be individuals, firms, commercial banks (like the State Bank of India), the central bank( Reserve Bank of India), commercial companies, and investment brokers.

Sometimes there is a confusion that the foreign exchange market is a physical place where we can go and trade the currencies of different countries. But, the foreign exchange market is not confined to a place, it is a system. Moreover, there are a large number of foreign currencies like the Dollar, Pound, Yen, and many others, which can be traded, converted, and exchanged in this market and not restricted to one or few foreign currencies. The exchange rate for all currencies is decided on the foreign exchange market, which is a global market. Currency Market or Forex are other names for the foreign exchange market. The players in this market can exchange, buy, sell, and speculate on the currencies.

The foreign exchange market or forex is an immense and decentralized system where countries’ money is traded. Think of it like a huge market that’s open 24/5 (closed on weekends) for buying and selling currencies just as if they were any other goods. Unlike a shop where things have set prices, in the forex world we use what’s called “floating exchange rates”—this means one country’s currency’s value goes up or down constantly in comparison with another as people want to buy more or less of it based on how much there is. Companies do business with each other across borders; investors try to make profits by buying low now only sell high later on when rates may have changed again etc. All this continuous trade sets the rate at which we convert money before going abroad or sending it overseas for trade purposes.

Foreign Exchange refers to the currencies of countries other than the domestic currency of a given country. In simple terms, it is the aggregation of the Foreign currencies held by the country’s government, and Securities and bonds issued by foreign companies and governments. The rate at which one currency is exchanged for another is called the Foreign Exchange Rate or Foreign Rate of Exchange. It is the price paid in domestic currency for buying a unit in foreign currency. For example, If 60 rupees are to be paid to get one dollar then the exchange rate, in that case, is $ 1: ₹ 60.

1. Transfer Function

It is the primary function of the foreign exchange market. It facilitates the transfer of purchasing power in terms of foreign exchange between the countries that are involved in the transactions. Purchasing power (or buying power) is the number of products and services that one unit of currency can purchase. The function is performed through credit instruments like bills of exchange, bank drafts, and telephonic transfers. Therefore, it involves sending money or foreign currencies from one nation to another to settle their accounts.

2. Credit Function

Just like domestic trade, foreign trade also depends on credit. The Credit Function of the Foreign Exchange Market implies the provision of credit in terms of foreign exchange for the export and import of goods and services. For this, bills of exchange are generally used for making payments internationally. The duration of Bills of Exchange is usually three months. The main purpose of credit is to help the importer in taking possession of goods, sell them and obtain the money to pay the bills.

3. Hedging Function

It implies to protection against risk related to fluctuations in the foreign exchange rate. Under this system, buyers and sellers agree to sell and buy goods on a future date at some commonly agreed rate of exchange. The basic purpose behind Hedging Function is to avoid losses that might be caused because of variations in the exchange rate in the future. 

4. Global Liquidity

The foreign exchange market serves as a global exchange for foreign currencies, enabling the seamless flow of international capital, a lifeblood of global economic activity. This liquidity empowers various players: Businesses engaged in international trade can access the necessary foreign currency to import or export goods and services. Governments can borrow funds denominated in foreign currencies from international investors, facilitating infrastructure projects or addressing other needs. Investors benefit from the ability to diversify their portfolios by investing in foreign currency-denominated assets, potentially enhancing returns and mitigating risks tied to a single currency. This global liquidity fosters international trade, investment, and ultimately, drives overall economic growth.

A Foreign Exchange Market can be classified as a Spot Market and Forward Market based on the period of transactions undertaken.

1.  Spot Market(Current Market):

Spot market refers to the market in which receipts and payments are made immediately. In this market sales and purchase of foreign currency are affected by the prevailing rate of exchange on the spot. Simply put, it refers to a market in which current transactions in foreign exchange take place. The delivery of foreign exchange takes place in a single moment. The rate at which current transactions take place is called Spot Rate. For example, if a person receives a gift of $50 from a relative abroad, and if the current exchange rate is $1 = ₹60, then the account is credited with ₹3000.

The principles characteristics of a Spot Market are:

• In the spot market, transactions take place on a daily basis.
• The rate of exchange that is determined in the spot market is known as the Spot Exchange Rate or Current Rate of exchange. The spot rate of exchange is the rate that prevails at the time of making transactions.

2.  Forward Market:

Forward Market refers to the market in which the sale and purchase of foreign currency are settled on a specific future date at a rate agreed upon today. The rate at which forward transactions take place is called the Forward Exchange Rate. In this market, payment will be made on the specified date in the future. In simple words, these transactions are signed today but they will materialize on some future date.

The principles characteristics of a Forward Market are:

i) In the forward market, only future transactions take place. It does not consider spot transactions in foreign exchange.

ii) The rate of exchange that is determined in the forward market is known as the Forward Exchange Rate. In the forward rate of exchange future delivery of foreign exchange takes place.

A forward contract is entered into for two reasons:

• To minimize the risk of loss due to adverse changes in the exchange rate.
• To make speculative gains.

The choice between spot and forward markets depends on your particular requirements. Spot markets are meant for immediate transactions and take advantage of current market conditions. It’s perfect for situations where you need to buy or sell instantly and you’re okay with the present price. On the other hand, the forward market helps businesses manage risks by fixing prices for future purchases or sales. This is especially useful for companies that need cost certainty on raw materials they will use in the future. Although forward contracts might be a little less liquid, they offer predictability and can aid in financial planning.

Why is Foreign Exchange Important?

Foreign exchange is important because it allows countries to trade goods and services with each other. Without a way to exchange currencies, it would be impossible to determine the value of imports and exports, hindering international business. The foreign exchange market facilitates these conversions, acting as the backbone of international trade.

When Does Foreign Exchange Market Open?

Unlike stock markets, the foreign exchange market is open 24/7 most weekdays due to overlapping sessions in different time zones. Major trading hours occur in London, New York, Tokyo and Sydney. However, activity and liquidity vary throughout the day.

How Often do Foreign Exchange Rates Change?

Foreign exchange rates fluctuate constantly, like a giant marketplace. They can change by the minute or even second based on supply and demand for each currency. This is because the forex market operates 24/7, constantly responding to global economic news and events.

Is Foreign Exchange Trading Profitable?

Foreign exchange trading can be profitable, but it’s also risky. Success requires knowledge, experience and a strong risk management strategy. Many traders lose money because of market volatility and the use of leverage.