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Foreign Exchange Markets and Exchange Rates

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.

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.

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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.

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:

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  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.

>> 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 Market

The market in which the foreign currencies are bought and sold is called a Foreign Exchange Market. Here the buyers and sellers are involved in the sale and purchase of currencies of different countries.

Types of Foreign Exchange Market

Broadly, the foreign exchange market is classified into two categories on the basis of the nature of transactions. These are:

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  1. Spot Market: A spot market is the immediate delivery market, representing that segment of the foreign exchange market wherein the transactions (sale and purchase) of currency are settled within two days of the deal. That is, when the seller and buyer close their deal for currency within two days of the deal, is called as Spot Transaction.

Thus, a spot market constitutes the spot sale and purchase of foreign exchange. The rate at which the transaction is settled is called a Spot Exchange Rate. It is the prevailing exchange rate in the market.

  1. Forward Market: The forward exchange market refers to the transactions – sale and purchase of foreign exchange at some specified date in the future, usually after 90 days of the deal. That is, when the buyer and seller enter into a contract for the sale and purchase of foreign currency after 90 days of the deal at a fixed exchange rate agreed upon now, is called a Forward Transaction.

Thus, the forward market constitutes the forward transactions in foreign exchange. The exchange rate at which the buyers or sellers settle the transactions in the forward market is called a Forward Exchange Rate.

Thus, the spot and forward markets are the important kinds of foreign exchange market that often helps in stabilizing the foreign exchange rate.

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