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CHAPTER 1:FOREIGN EXCHANGE MARKET1.1

Introduction
The world has become so small. Businessmen and individual can legitimately move fromone
country to another. However with existence of comparative advantages and imperfectmarket,
investors, tourists and businessmen have induced trade internationally. Theforeign currencies are
vital to enable those dealing internationally to execute theirinternational transactions. The foreign
currency is made available through foreignexchange market.
1.2

The FOREX Market Definition

The foreign exchange market is an international market in which national currencies aretraded. It
is not an organized market trading place in the same sense as stock orcommodity exchanges are.
That is there is no single, physical site where buy and sellorders are executed. Rather it consist
an enormous, highly sophisticated, and efficientglobal communication system in which most
transactions are communicated verbally bytwo parties and executed by telephone or telex. In
summary we can say that, the FOREXMarket is an electronically linked network of participants
that facilitates trade by tradingin foreign exchange.The principle purpose of the FOREX market
it to finance international trade and otherforms of international operations that regularly needs
firms to MAKE and RECEIVEpayments in different foreign currencies. A
Foreign currency
refers to the currency of other countries. For instance for Tanzanian living in the United Republic
of Tanzania, aforeign currency is any currency other than a Tanzanian shilling.

The FOREX market is a worldwide market and thus is extremely large. The
London
FOREX market is the largest foreign exchange market followed by
New York
and then
Tokyo
. Other important foreign exchange centres are
Zurich
and
Frankfurt
. 90% of foreign currency deals are executed in US $; approximately 60% spot, 35% forward,
5%futures and options

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The FOREX market is highly competitive:
There are many buyers and sellers
The commodity is homogeneous
Via computer systems there is near perfect information on prices charged
Since the market is highly competitive, the prices of currencies are determined by
supplyand demand forces.
Virtually no differences exist between one FOREX market (e.g.London) and another (e.g.
Tokyo).
1.3Functions of Foreign Exchange Market1.3.1

Transfer of Purchasing Power

An international transaction involves parties from different countries with differentcurrencies.
Each party would like to trade in its own currency. Foreign currency marketpermit transfers of
purchasing power denominated in one currency to another. Forinstance, if a Japanese exporter
invoices in Japanese yen for Suzuki Escudo exported toTanzanian Importer, then Tanzanian
importer should buy Japanese yen with Tanzaniashilling or any other acceptable currency.
1.3.2

Facilitating International Trade and Investment

International trade and investment would not be possible without the ability to buy andsell
foreign currencies. Currencies must be bought and sold to enable those who needcertain
currencies to get them.
1.3.3Provision of Credit
The foreign exchange market provides a third source of credit. This is made throughspecialized
instruments such as bankers` acceptances and letters of credit. Thesedocuments enable to finance
international trade before delivery of goods.

3Minimization of Foreign Exchange Risk

International dealings are subjected to foreign exchange risk. This risk is associated
withunexpected change that may have positive or negative impact on the
internationaltransactions. A change in exchange rate is said to be positive if it leads to material
gainand it is said negative if it leads to material loss. Since it is difficult to predict thedirection of
expected change in exchange rate, then traders are uncertain of their futureposition. In this case
they would like to reduce the uncertainty through hedging i.e. theforex market provides such an
opportunity.
1.4 Participants in the Foreign Exchange Market
Participants in foreign exchange market refer to the actors who make foreign exchangemarket
active. They buy and sell foreign currencies for different purposes. The followingare participants
in the foreign exchange market:
1.4.1Large Commercial Banks
They are considered as the dominant players (main dealers) in the market. Thecommercial banks
hold inventories of FOREX which consist of deposit balances inother bank (denominated in
different currencies). These deposits are used to meetcustomer requests. The banks deal either
directly with other banks or more usuallythrough foreign exchange brokers.
1.4.2

Individuals
Individuals and firms use foreign exchange market for various purposes. Some may useforeign
exchange market for international portfolio investment, some may use foreignexchange for
purpose of hedging foreign exchange risk, and others use foreign exchangemarket to facilitate
commercial transactions e.g. exportation, importation, tourism etc.
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