Functions of Foreign Exchange Market

Definition: 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:

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.

2. 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.
3. 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.
Foreign Exchange Market
Definition: The foreign exchange market or the ‘forex market’, is a system which establishes an
international network allowing the buyers and sellers to carry out trade or exchange of currencies of
different countries. A forex market can be stated as one of the most liquid financial markets which
facilitate ‘over-the-counter’ exchange of currencies.

In New York, advanced telecommunication technology called Society for Worldwide Interbank
Financial Telecommunications (SWIFT) is used by the banks for carrying out foreign exchange
transactions at the electronic clearinghouses like Clearing House Interbank Payment System (CHIPS).

Content: Foreign Exchange Market

1. Participants
2. Characteristics
3. Transactions
4. Functions
5. Advantages
6. Disadvantages
7. Note

Participants in the Foreign Exchange Market

The participants here refers to the people involved in the exchange or trade of foreign currency. These
can be the buyers, sellers or the intermediaries.

The participants in a forex market include the following five parties:

1. Central Bank: The central bank regulates the exchange rates of the currency of their
respective country to ensure fluctuations within the desired limit and keep control over the
money supply in the market.
2. Commercial Banks: The commercial banks are the medium of forex transactions,
facilitating international trade and exchange to its customers along with other forex functions
like making foreign investments.
3. Traditional Users: The traditional users involve foreign tourists, companies carrying
out business operations across the globe, patients taking treatment in other country’s hospitals
and students studying abroad.
4. Traders and Speculators: The traders and speculators are the opportunity seekers and
look forward to making a profit through trading on short-term market trends.
 5. Brokers: They are considered to be financial experts who act as an intermediary between the
dealers and the investors by providing the best quotations.

Characteristics of the Foreign Exchange Market

To understand what a forex market is, we must first go through its essential features.

Discussed below are the various characteristics of the foreign exchange market which differentiates it

from other financial markets:

 Market Transparency: It is effortless to monitor the fluctuations in the value of currencies

of different countries in a forex market easily through account tracking and real-time portfolio,
without the involvement of brokers.
 Dollar is Extensively Traded Currency: The USD, which is paired with almost every
country’s currency and listed on the forex, is the most widely traded currency in the world.
 Most Dynamic Market: The value of the currencies in the forex market keeps on changing
every second and function twenty-four hours a day. This makes it one of the most active markets
in the world.
 International Network of Dealers: The foreign exchange market establishes a medium
among the dealers and also with the customers. There are dealer’s institutions located globally to
carry out the exchange and trading activities.
 “Over-The-Counter” Market: In different countries, the forex market is the highly
unregulated market initiating over the counter trade by the banks through telex and telephone.
 High Liquidity: The currency is considered to be the most widely traded financial
instrument across the globe, making the forex market highly liquid.
 Twenty-Four Hour Market: The foreign exchange market is operational for twenty-four
hours of the day, initiating the active trade and exchange of currencies at any time.
Transactions in Foreign Exchange Market
A forex market performs three significant operations which are explained in detail below:

Spot Market Transactions

The forex transactions which are executed immediately, or usually within two days, is known as the
spot transaction. Such a forex market is termed as a spot market, and the rate of exchange is called a
spot rate.

Futures Market Transactions

The market in which the exchange of currencies involve a future delivery and payment and the rate of
exchange for the same is pre-determined is called a futures forex market.  Such exchange rate is
known as a future rate. It protects the buyer from the risk of a rise in the value of the currency.

Forward Market Transactions

A forward forex market is however very similar to the futures market, but here, the terms of the
contract are negotiable and can be amended by any of the parties involved.

 Options: In an options contract, the holder is not bound to but have the right to buy or sell
the specified asset quantity at the pre-determined price on the specific future.
 Futures: In a future contract, the quantity of an asset, date of execution and price of the
contract is fixed and standardized.
 Swap: Usually, commercial banks adopt swap contracts if they perform forward exchange
business operations. Here, they sell off a particular currency in the spot market to buy that same
currency in the forward market.
 Arbitrage: The rigorous buying and selling of different currencies in the forex market to
fetch gains out of such transactions are called arbitrage.
Functions of Foreign Exchange Market
A foreign exchange market is the largest global financial market which performs some crucial
functions. The three of the primary functions of a forex market are as follows:

1. Hedging Function: The globally trading business entities can hedge the risk of currency
fluctuations by adopting means like a letter of credit or forward contract. Here, the goods are to
be delivered on a pre-determined future date and at a mutually agreed price.
2. Transfer Function: The forex market majorly functions to exchange the currency of one
country into that of other, to facilitate international trade activities.
3. Credit Function: Providing the credit facility at the time of making overseas payments
through foreign bill of exchange to its maturity or execution, is another significant function of the
forex market.

Advantages of Foreign Exchange Market

As we know that ‘trade makes everyone better-off’ and so goes for the exchange or trade of currencies.

Let us now discuss the various benefits of the foreign exchange market:

High Leverage: A forex investor can avail the facility of leverage or loan of up to 20 or 30 times of
his/her capacity, for trading in the forex market.

International Trade: Every country has its currency and therefore, to facilitate trade activities
between two countries, the forex market is essential.
Trading Option: For the speculators or traders, foreign exchange market is just like other financial
markets where they can make money on short term fluctuations in the currencies.

Flexibility: We know that the forex market is a twenty-four-seven market, and there is no minimum
or maximum limit of the exchange amount. It provides the flexibility of investment or exchange to the
traders.

Hedging Risk: The forex market provides for hedging the risk of loss on currency fluctuations while
carrying global business operations and trading in foreign currency.

Low Transaction Costs: Since brokers are not very much entertained in the forex market, the
transaction cost (called as ‘spread’) charged by the dealers is reasonably low if compared to other
financial markets.

Inflation Control: To maintain the economic stability in the country and control situations like
inflation, the central bank maintains a forex reserve which consists of currencies of different countries
around the world.

It adopts other means too, like decreasing bank lending rates and selling out domestic currency for
foreign currency.

Disadvantages of Foreign Exchange Market

A forex market is not always favourable and involves various kinds of risks. These can be seen as its
drawbacks and are elaborated below:

 Leverage Risks: Leverage refers to loan in other terms. Forex market initiates the leverage
of up to 20 to 30 times the investment capacity of the traders or speculators, which may even
lead the loss of the entire amount of the investor.
 Counterparty Risks: The forex is highly unregulated with no central authority for currency
exchange or trading risk mitigation. Thus, it may encounter the risk of non-fulfilment of the
obligations by any of the parties involved in such a contract.
 Operational Risks: Since forex is a twenty-four hours market, it is difficult to manage its
operations by humans. As a result, the traders and MNCs rely on the algorithms, and trading
desks spread, respectively, to safeguard their investment in their absence.
Note

The countries which actively participate in the forex trading includes US, UK,  Australia, Germany,
Switzerland, France, Italy, Japan, Indonesia, Cyprus, Malta, Bulgaria, Romania and many Central and
Eastern Europe countries.

In countries like China, South Africa, Nigeria, Russia, Egypt and Ukraine, forex trading is allowed but
under the restrictions of the central government.

However, in India, Bosnia Herzegovina, Israel, Belgium, Malaysia, North Korea, France and Pakistan,
forex trading is strictly prohibited.