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Foreign Exchange Market: Nature, Structure, Types of Transactions

The Foreign Exchange Market is a market where the buyers and sellers are involved in the sale and purchase of foreign currencies. In other words, a market where the currencies of different countries are bought and sold is called a foreign exchange market.

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The structure of the foreign exchange market constitutes central banks, commercial banks, brokers, exporters and importers, immigrants, investors, tourists. These are the main players of the foreign market, their position and place are shown in the figure below.

At the bottom of a pyramid are the actual buyers and sellers of the foreign currencies- exporters, importers, tourist, investors, and immigrants. They are actual users of the currencies and approach commercial banks to buy it.

The commercial banks are the second most important organ of the foreign exchange market. The banks dealing in foreign exchange play a role of “market makers”, in the sense that they quote on a daily basis the foreign exchange rates for buying and selling of the foreign currencies. Also, they function as clearing houses, thereby helping in wiping out the difference between the demand for and the supply of currencies. These banks buy the currencies from the brokers and sell it to the buyers.

The third layer of a pyramid constitutes the foreign exchange brokers. These brokers function as a link between the central bank and the commercial banks and also between the actual buyers and commercial banks. They are the major source of market information. These are the persons who do not themselves buy the foreign currency, but rather strike a deal between the buyer and the seller on a commission basis.

The central bank of any country is the apex body in the organization of the exchange market. They work as the lender of the last resort and the custodian of foreign exchange of the country. The central bank has the power to regulate and control the foreign exchange market so as to assure that it works in the orderly fashion. One of the major functions of the central bank is to prevent the aggressive fluctuations in the foreign exchange market, if necessary, by direct intervention. Intervention in the form of selling the currency when it is overvalued and buying it when it tends to be undervalued.

Functions of Foreign Exchange Market

Foreign Exchange Market is the market where the buyers and sellers are involved in the buying and selling of foreign currencies. Simply, the market in which the currencies of different countries are bought and sold is called as a foreign exchange market.

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The foreign exchange market is commonly known as FOREX, a worldwide network, that enables the exchanges around the globe. The following are the main functions of foreign exchange market, which are actually the outcome of its working:

  1. Transfer Function: The basic and the most visible function of foreign exchange market is the transfer of funds (foreign currency) from one country to another for the settlement of payments. It basically includes the conversion of one currency to another,wherein the role of FOREX is to transfer the purchasing power from one country to another.

For example, If the exporter of India import goods from the USA and the payment is to be made in dollars, then the conversion of the rupee to the dollar will be facilitated by FOREX. The transfer function is performed through a use of credit instruments, such as bank drafts, bills of foreign exchange, and telephone transfers.

  1. Credit Function: FOREX provides a short-term credit to the importers so as to facilitate the smooth flow of goods and services from country to country. An importer can use credit to finance the foreign purchases. Such as an Indian company wants to purchase the machinery from the USA, can pay for the purchase by issuing a bill of exchange in the foreign exchange market, essentially with a three-month maturity.
  2. Hedging Function: The third function of a foreign exchange market is to hedge foreign exchange risks. The parties to the foreign exchange are often afraid of the fluctuations in the exchange rates, i.e., the price of one currency in terms of another. The change in the exchange rate may result in a gain or loss to the party concerned.

Thus, due to this reason the FOREX provides the services for hedging the anticipated or actual claims/liabilities in exchange for the forward contracts. A forward contract is usually a three month contract to buy or sell the foreign exchange for another currency at a fixed date in the future at a price agreed upon today. Thus, no money is exchanged at the time of the contract.

There are several dealers in the foreign exchange markets, the most important amongst them are the banks. The banks have their branches in different countries through which the foreign exchange is facilitated, such service of a bank are called as Exchange Banks.

Types of Foreign Exchange Transactions

The Foreign Exchange Transactions refers to the sale and purchase of foreign currencies. Simply, the foreign exchange transaction is an agreement of exchange of currencies of one country for another at an agreed exchange rate on a definite date.

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  1. Spot Transaction: The spot transaction is when the buyer and seller of different currencies settle their payments within the two days of the deal. It is the fastest way to exchange the currencies. Here, the currencies are exchanged over a two-day period, which means no contractis signed between the countries. The exchange rate at which the currencies are exchanged is called the Spot Exchange Rate. This rate is often the prevailing exchange rate. The market in which the spot sale and purchase of currencies is facilitated is called as a Spot Market.
  2. Forward Transaction: A forward transaction is a future transaction where the buyer and seller enter into an agreement of sale and purchase of currency after 90 days of the dealat a fixed exchange rate on a definite date in the future. The rate at which the currency is exchanged is called a Forward Exchange Rate. The market in which the deals for the sale and purchase of currency at some future date is made is called a Forward Market.
  3. Future Transaction: The future transactions are also the forward transactionsand deals with the contracts in the same manner as that of normal forward transactions. But however, the transactions made in a future contract differs from the transaction made in the forward contract on the following grounds:
  • The forward contracts can be customizedon the client’s request, while the future contracts are standardized such as the features, date, and the size of the contracts is standardized.
  • The future contracts can only be traded on the organized exchanges,while the forward contracts can be traded anywhere depending on the client’s convenience.
  • No marginis required in case of the forward contracts, while the margins are required of all the participants and an initial margin is kept as collateral so as to establish the future position.
  1. Swap Transactions: The Swap Transactions involve a simultaneous borrowing and lending of two different currencies between two investors. Here one investor borrows the currency and lends another currency to the second investor. The obligation to repay the currencies is used as collateral, and the amount is repaid at a forward rate. The swap contracts allow the investors to utilize the funds in the currency held by him/her to pay off the obligations denominated in a different currency without suffering a foreign exchange risk.
  2. Option Transactions: The foreign exchange option gives an investor theright, but not the obligation to exchange the currency in one denomination to another at an agreed exchange rate on a pre-defined date. An option to buy the currency is called as a Call Option, while the option to sell the currency is called as a Put Option.

Thus, the Foreign exchange transaction involves the conversion of a currency of one country into the currency of another country for the settlement of payments.

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