by The foreign exchange market is the place where money denominated in one currency is bought and sold with money denominated in another currency. It provides the physical and institutional structure through which the currency of one country is exchanged for that of another country, the rate of exchange between currencies is determined, and foreign exchange transactions are physically completed.
The primary purpose of this market is to permit transfer of purchasing power denominated in one currency to another. For example, a Japanese exporter sells automobiles to a U.S. dealer for dollars, and a U.S. manufacturer sells instruments to a Japanese Company for yen. The U.S. Company will like to receive payment in dollar, while the Japanese exporter will want yen.
It would be inconvenient for individual buyers and sellers of foreign exchange to seek out one another. So a foreign exchange market has developed to act as an intermediary. It is the largest financial market in the world with prices moving and currencies trading somewhere every hour of every business day.
Major world trading starts each morning in Sydney and Tokyo; moves West to Hong Kong and Singapore; passes on to Bahrain; shifts to the main European markets of Frankfurt, Zurich and London; Jumps the Atlantic to New York; goes west to Chicago, and ends in San Francisco and Los Angeles.
It is the largest financial market in the world having daily turnover of over 1600 billions dollar in 2001. Bulk of the trading is accounted for by a small number of currencies the U.S. dollar, Deutschemark (DM), Yen, Pound Sterling, Swiss Franc, and Canadian dollar.
Foreign exchange market is of two types, viz.; retail market and wholesale market, also termed as the inter-bank market. In retail market, travellers and tourists exchange one currency for another. The total turnover in this market is very small.
Wholesale market comprises of large commercial banks, foreign exchange brokers in the inter-bank market, commercial customers, primarily MNCs and Central banks which intervene in the market from time to time to smooth exchange rate fluctuations or to maintain target exchange rates.
Over 90% of the total volume of the transactions is represented by inter-bank transactions and the remaining 10% by transactions between banks and their non-bank customers. It is worth noting that central bank intervention involving buying or selling in the market is often indistinguishable from the foreign exchange dealings of commercial banks or of other participants.
The foreign exchange is similar to the over-the counter market in securities. It has no centralized physical market place (except for a few places in Europe and the futures market of the International Monetary Market of the Chicago Mercantile Exchange) and no fixed opening and closing time.
The trading in foreign exchange is done over the telephone, telexes, computer terminals and other electronic means of communication. The currencies and the extent of participation of each currency in this market depend on local regulations that vary from country to country.
It is interesting to note that bulk of the turnover in the international exchange market is represented by speculative transactions.
Foreign exchange market in India is relatively very small. The major players in that market are the RBI, banks and business enterprises. Indian foreign exchange market is controlled and regulated by the RBI. The RBI plays crucial role in settling the day-to-day rates.
Participants in Foreign Exchange Market
Participants in Foreign exchange market can be categorized into five major groups, viz.; commercial banks, Foreign exchange brokers, Central bank, MNCs and Individuals and Small businesses.
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Commercial Banks
The major participants in the foreign exchange market are the large Commercial banks who provide the core of market. As many as 100 to 200 banks across the globe actively “make the market” in the foreign exchange. These banks serve their retail clients, the bank customers, in conducting foreign commerce or making international investment in financial assets that require foreign exchange.
These banks operate in the foreign exchange market at two levels. At the retail level, they deal with their customers-corporations, exporters and so forth. At the wholesale level, banks maintain an inert bank market in foreign exchange either directly or through specialized foreign exchange brokers.
The bulk of activity in the foreign exchange market is conducted in an inter-bank wholesale market-a network of large international banks and brokers. Whenever a bank buys a currency in the foreign currency market, it is simultaneously selling another currency.
A bank that has committed itself to buy a certain particular currency is said to have long position in that currency. A short-term position occurs when the bank is committed to selling amounts of that currency exceeding its commitments to purchase it.
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Foreign Exchange Brokers
Foreign exchange brokers also operate in the international currency market. They act as agents who facilitate trading between dealers. Unlike the banks, brokers serve merely as matchmakers and do not put their own money at risk.
They actively and constantly monitor exchange rates offered by the major international banks through computerized systems such as Reuters and are able to find quickly an opposite party for a client without revealing the identity of either party until a transaction has been agreed upon. This is why inter-bank traders use a broker primarily to disseminate as quickly as possible a currency quote to many other dealers.
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Central banks
Another important player in the foreign market is Central bank of the various countries. Central banks frequently intervene in the market to maintain the exchange rates of their currencies within a desired range and to smooth fluctuations within that range. The level of the bank’s intervention will depend upon the exchange rate regime flowed by the given country’s Central bank.
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MNCs
MNCs are the major non-bank participants in the forward market as they exchange cash flows associated with their multinational operations. MNCs often contract to either pay or receive fixed amounts in foreign currencies at future dates, so they are exposed to foreign currency risk. This is why they often hedge these future cash flows through the inter-bank forward exchange market.
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Individuals and Small Businesses
Individuals and small businesses also use foreign exchange market to facilitate execution of commercial or investment transactions. The foreign needs of these players are usually small and account for only a fraction of all foreign exchange transactions. Even then they are very important participants in the market. Some of these participants use the market to hedge foreign exchange risk.
Segments of Foreign Exchange Market
There are two segments of foreign exchange market, viz., Spot Market and Forward Market.
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Spot Market
In spot market currencies are exchanged immediately on the spot. This market is used when a firm wants to change one currency for another on the spot. The procedure is very simple. A banker can either handle the transaction for the firm or may have it handled by another bank.
Within minutes the firm knows exactly how many units of one currency are to be received or paid for a certain number of units of another currency.
For instance, a US firm wants to buy 4000 books from a British Publisher. The Publisher wants four thousand British Pounds for the books so that the American firm needs to change some of its dollars into pounds to pay for the books. If the British Pound is being exchanged, say, for US $ 1.70, then £ 4,000 equals $ 6800.
The US firm simply pays $ 6800 to its bank and the bank exchanges the dollars for 4000 £ to pay the British Publisher.
In the Spot market risks are always involved in any particular currency. Regardless of what currency a firm holds or expects to hold, the exchange rate may change and the firm may end up with a currency that declines in values if it is unlucky or not careful.
There are also risks that what the firm owes or will owe may be stated in a currency that becomes more valuable and, as such possibly harder to obtain and use to pay the obligation.
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Forward Market
Forward market has come into existence to avoid uncertainties. In Forward market, a forward contract about which currencies are to be traded, when the exchange is to occur, how much of each currency is involved, and which side of the contract each party is entered into between the firms.
With this contract, a firm eliminates one uncertainty, the exchange rate risk of not knowing what it will receive or pay in future. However, it may be noted that any possible gains in exchange rate changes are also estimated and the contract may cost more than it turns out to be worth.
For example, suppose that the ninety-day forward price of the British pound is 2.000 (US$ 2.00 per £) or quoted £ 0.5000 per US $, and that the current spot price is US $ 1.650. If a firm enters into a forward contract at the forward exchange rate, it indicates a preference for this forward rate to the unknown rate that will be quoted ninety days from now in the spot market.
However, if the spot price of the pound increases by 100 per cent during the next 90 days, the pound would be US $ 3.3000 and the £ 5,00,000 could be converted into US $ 1,650,000 The forward market, therefore, can remove the uncertainty of not knowing how much the firm will receive or pay. But it creates one uncertainty-whether the firm might have been better off by waiting.
Functions of Foreign Exchange Market
Foreign exchange market plays a very significant role in business development of a country because of the fact that it performs several useful functions, as set out below:
- Foreign exchange market transfers purchasing power across different countries, which results in enhancing the feasibility of international trade and overseas investment.
- It acts as a central focus whereby prices are set for different currencies.
- With the help of foreign exchange market investors can hedge or minimize the risk of loss due to adverse exchange rate changes.
- Foreign exchange market allows traders to identify risk free opportunities and arbitrage these away.
- It facilitates investment function of banks and corporate traders who are willing to expose their firms to currency risks.
