Foreign Exchange Market: Meaning, Functions and Kinds!

Meaning:
Foreign exchange market is the market in which foreign currencies are bought and
sold. The buyers and sellers include individuals, firms, foreign exchange brokers,
commercial banks and the central bank.
Like any other market, foreign exchange market is a system, not a place. The
transactions in this market are not confined to only one or few foreign currencies. In
fact, there are a large number of foreign currencies which are traded, converted and
exchanged in the foreign exchange market.
Functions of Foreign Exchange Market:
Foreign exchange market performs the following three functions:
1. Transfer Function:
It transfers purchasing power between the countries involved in the transaction. This
function is performed through credit instruments like bills of foreign exchange, bank
drafts and telephonic transfers.

2. Credit Function:
It provides credit for foreign trade. Bills of exchange, with maturity period of three
months, are generally used for international payments. Credit is required for this
period in order to enable the importer to take possession of goods, sell them and obtain
money to pay off the bill.
3. Hedging Function:
When exporters and importers enter into an agreement to sell and buy goods on some
future date at the current prices and exchange rate, it is called hedging. The purpose
of hedging is to avoid losses that might be caused due to exchange rate variations in
the future.
Kinds of Foreign Exchange Markets:

Foreign exchange markets are classified on the basis of whether the

foreign exchange transactions are spot or forward accordingly, there are
two kinds of foreign exchange markets:
(i) Spot Market,
(ii) Forward Market.
(i) Spot Market:
Spot market refers to the market in which the receipts and payments are made
immediately. Generally, a time of two business days is permitted to settle the
transaction. Spot market is of daily nature and deals only in spot transactions of
foreign exchange (not in future transactions). The rate of exchange, which prevails in
the spot market, is termed as spot exchange rate or current rate of exchange.
The term ‘spot transaction’ is a bit misleading. In fact, spot transaction should mean a
transaction, which is carried out ‘on the spot’ (i.e., immediately). However, a two day
margin is allowed as it takes two days for payments made through cheques to be
cleared.
(ii) Forward Market:
Forward market refers to the market in which sale and purchase of foreign currency is
settled on a specified future date at a rate agreed upon today. The exchange rate quoted
in forward transactions is known as the forward exchange rate. Generally, most of the
international transactions are signed on one date and completed on a later date.
Forward exchange rate becomes useful for both the parties involved in the transaction.
Forward Contract is made for two reasons:
(a) To minimize the risk of loss due to adverse changes in the exchange rate (through
hedging);
(b) To make profit (through speculation).

Foreign exchange market (forex, or FX, market), institution for the

exchange of one country’s currency with that of another country. Foreign
exchange markets are actually made up of many different markets, because
the trade between individual currencies—say, the euro and the U.S. dollar—
each constitutes a market. The foreign exchange markets are the original
and oldest financial markets and remain the basis upon which the rest of the
financial structure exists and is traded: foreign exchange markets provide
international liquidity, preferably with relative stability.
A foreign exchange market is a 24-hour over-the-counter (OTC) and dealers’
market, meaning that transactions are completed between two participants
via telecommunications technology. The currency markets are also further
divided into spot markets—which are for two-day settlements—and the
forward, swap, interbank futures, and options markets. London, New York,
and Tokyo dominate foreign exchange trading. The currency markets are the
largest and most liquid of all the financial markets; the triennial figures from
the Bank for International Settlements (BIS) put daily global turnover in the
foreign exchange markets in trillions of dollars. It is sobering to consider that
in the early 21st century an annual world trade’s foreign exchange is traded
in just less than every five days on the currency markets, although the
widespread use of hedging and exchanges into and out of vehicle
currencies—as a more liquid medium of exchange—means that such
measures of financial activity can be exaggerated.
The original demand for foreign exchange arose from merchants’
requirements for foreign currency to settle trades. However, now, as well as
trade and investment requirements, foreign exchange is also bought and
sold for risk management (hedging), arbitrage, and speculative gain.
Therefore, financial, rather than trade, flows act as the key determinant of
exchange rates; for example, interest rate differentials act as a magnet for
yield-driven capital. Thus, the currency markets are often held to be a
permanent and ongoing referendum on government policy decisions and the
health of the economy; if the markets disapprove, they will vote with their feet
and exit a currency. However, debates about the actual versus potential
mobility of capital remain contested, as do those about whether exchange
rate movements can best be characterized as rational, “overshooting,” or
speculatively irrational.
The increasingly asymmetric relationship between the currency markets and
national governments represents a classic autonomy problem. The
“trilemma” of economic policy options available to governments are laid out
by the Mundell-Fleming model. The model shows that governments have to
choose two of the following three policy aims: (1)
domestic monetary autonomy (the ability to control the money supply and
set interest rates and thus control growth); (2) exchange rate stability (the
ability to reduce uncertainty through a fixed, pegged, or managed regime);
and (3) capital mobility (allowing investment to move in and out of the
country).

Historically, different international monetary systems have emphasized

different policy mixes. For instance, the Bretton Woods system emphasized
the first two at the expense of free capital movement. The collapse of the
system destroyed the stability and predictability of the currency markets. The
resultant large fluctuations meant a rise in exchange rate risk (as well as in
profit opportunities). Governments now face numerous challenges that are
often captured under the term globalization or capital mobility: the move to
floating exchange rates, the political liberalization of capital controls, and
technological and financial innovation.
In the contemporary international monetary system, floating exchange rates
are the norm. However, different governments pursue a variety
of alternative policy mixes or attempt to minimize exchange rate fluctuations
through different strategies. For example, the United States displayed a
preference for ad hoc international coordination, such as the Plaza
Agreement in 1985 and the Louvre Accord in 1987, to intervene and manage
the price of the dollar. Europe responded by forging ahead with a
regional monetary union based on the desire to eliminate exchange rate risk,
whereas many developing governments with smaller economies chose the
route of “dollarization”—that is, either fixing to or choosing to have the dollar
as their currency.
The international governance regime is a complex and multilayered
bricolage of institutions, with private institutions playing an important role;
witness the large role for private institutions, such as credit rating agencies,
in guiding the markets. Also, banks remain the major players in the market
and are supervised by the national monetary authorities. These national
monetary authorities follow the international guidelines promulgated by
the Basel Committee on Banking Supervision, which is part of the BIS.
Capital adequacy requirements are to protect principals against credit risk,
market risk, and settlement risk. Crucially, the risk management, certainly
within the leading international banks, has become to a large extent a matter
for internal setting and monitoring.
The series of contagious currency crises in the 1990s—in Mexico, Brazil,
East Asia, and Argentina—again focused policy makers’ minds on the
problems of the international monetary system. Moves, albeit limited, were
made toward a new international financial architecture. Most importantly,
these crises led to the establishment of the Financial Stability Forum (since
2009 the Financial Stability Board), which investigated the problems of
offshore, capital flows, and hedge funds; and the G20, which attempted to
broaden the international regime’s membership and thus deepen its
legitimacy. In addition, there were calls for a currency transaction tax, named
after Nobel Laureate James Tobin’s proposal, from many civil
society nongovernmental organizations as well as some governments. The
success of international monetary reform is a crucial issue for governments
and their autonomy, firms and the stability of their investments, and citizens
who ultimately are those who absorb these effects as they are transmitted
into everyday life.