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Foreign Exchange Market: Functions and Types

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  • Last Updated : 22 Nov, 2022
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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.

What is Foreign Exchange Market?

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 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. 

It 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.

Functions of Foreign Exchange Market

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. 

Types of Foreign Exchange Market

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:

i) In the spot market, transactions take place on a daily basis.

ii) 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.

Spot Market v/s Forward Market

Basis

Spot Market

Forward Market

Handles

It handles current transactions. It handles transactions meant for future delivery.

Rate of Transaction

The rate at which current transactions take place is called Spot Rate. The rate at which forward transactions take place is called the Forward Exchange Rate.

Hedging

It does not allow Hedging. It allows Hedging.
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