Foreign Exchange

Markets

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When trade takes place between the residents of two countries, the two countries being a sovereign
(not controlled by any other country) state have their own set of regulations and currency. Due to the
different currency the problem arises in the conduct of international trade and settlement of the
transactions.

While the exporter would like to get the payment in the currency of his country, the importer can pay
only in the currency of the importers country. This creates a need for the conversion of the currency of
importer‘s into that of the exporter‘s country. Foreign exchange is the mechanism by which the currency
of one country is converted into the currency of another country. The conversion is done by the banks
who deal in foreign exchange.
➢ A market for the purchase and sale of foreign currencies is called a ‘foreign exchange market’.

➢ The purpose of such a market is to facilitate international trade and investments.

➢ The need for a foreign exchange market arises because of the presence of the different international
currencies such as US-dollar, UK-pound sterling, Europe-Euro, Japanese-Yen etc. and the need for
trading in such currencies.
 Foreign exchange
market
• Is an essential part of the global financial system and plays an
important role in the economy.
• Is the market where the buyers and sellers are involved in the buying and selling of foreign
currencies.

• It is crucial in sustaining efficiency and arbitrage conditions in most other international

financial markets, including the bond, stock and derivatives markets.

• The pricing mechanisms of the FX market affect financial conditions, resource utilization
and inflation, and so a proper understanding of these mechanisms is at the heart of central
bank mandates and operations in many countries around the world.
 What are the main functions of Foreign Exchange Market ?

Transfer Function

• The basic function of the foreign exchange market is to transfer purchasing

power between countries, i.e., to facilitate the conversion of one currency into
another.

• 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.

• The international clearing function performed by foreign exchange markets

plays a very important role in facilitating international trade and capital
movement.

• The transfer function is performed through a use of credit instruments, such as

bank drafts, bills of foreign exchange, and telephone transfers
 What are the main functions of Foreign Exchange Market ?

Credit Function

• Foreign Exchange Markets provide a short-term credit to the importers so as to

facilitate the smooth flow of goods and services from country to country.

• Exporters may get pre shipment and post shipment credit. Credit facilities are
available also for importers.

• An importer can use credit to finance the foreign purchases. Bills of exchange
used in the international payments normally have a maturity period of three
months.

• Thus, credit is required for that period to enable the importer to take possession
of goods, sell them and obtain money to pay off the bill.
 What are the main functions of Foreign Exchange Market ?

Hedging Function

• A foreign exchange hedge (also called a FOREX hedge) is a method used

by companies to eliminate or "hedge" their foreign exchange risk resulting
from transactions in foreign currencies.

• In other words Hedging is the act of equating one’s assets and liabilities in
foreign currency to avoid the risk resulting from future changes in the value
of foreign currency.

• In a situation of exchange risks, the foreign exchange market performs the

hedging function.

• 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.
 What are the main functions of Foreign Exchange Market ?

Hedging Function

• Thus, due to this reason the foreign Exchange Market 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.

 What are the main functions of Foreign Exchange Market ?

Hedging Function

• It involves using financial instruments to increase protection against

unexpected fluctuations, thus making cash flows more stable and
predictable.

• As a result, companies can estimate income, taxes and revenues more

reliably.

• Hedging is not a way of making more money. It is rather a series of

methods for minimizing risks. Hedging reduces not only your potential
loses, but it also reduces potential sudden earnings.
 What are the main functions of Foreign Exchange Market ?

Hedging Function

• For investors, hedging is like buying insurance on their assets or

portfolios. Foreign exchange hedging is common among investors and
companies involved in international operations.
• It allows them to manage their exposure to currency exchange
movements and minimize the impact of adverse fluctuations.
• Some companies might choose to hedge 100% of the portfolio, while
others might not hedge at all.
• Most of them are likely to hedge a percentage, so they partially protect
themselves but also accept some risks and leave the door open to
additional earnings. It depends on their particular tolerance to risk.
What are the different types of transactions undertaken in a foreign Exchange market ?

Spot Market or Exchange

Forward Market or Transaction

Future Transaction
What are the different types of transactions undertaken in a foreign Exchange market ?

Option Transaction

Swap Transaction

Arbitrage
 ❖ The term spot exchange refers to the class of
foreign exchange transaction which requires
Spot Market the immediate delivery or exchange of
currencies on the spot.
or Exchange ❖ In practice the settlement takes place within
two days in most markets. The rate of
exchange effective for the spot transaction is
known as the spot rate and the market for
such transactions is known as the spot
market.
 ❖ The forward transactions is an agreement between two
parties, requiring the delivery at some specified future
date, usually 90 after days of a specified amount of
Forward Market foreign currency by one of the parties, against payment
in domestic currency be the other party, at the price
or Transaction agreed upon in the contract.

❖ The rate of exchange applicable to the forward contract

is called the forward exchange rate and the market for
forward transactions is known as the forward market.

❖ Forward exchange facilities, obviously, are of

immense help to exporters and importers as they can
cover the risks arising out of exchange rate fluctuations.
 ❖ The future transactions are also like the forward
transactions and deals with the contracts in the
same manner as that of normal forward transactions.

Future Transaction ❖ But however, the transactions made in a future

contract differ from the transaction made in the
forward contract.

❖ While a forward contract is tailor made for the client

by his international bank, a future contract has
standardized features the contract size and maturity
dates are standardized.

❖ Futures can be traded only on an organized

exchange and they are traded competitively.
 ❖ The foreign exchange option gives an investor the
right, but not the obligation to exchange the currency
in one denomination to another at an agreed
exchange rate on a pre-defined date.
Option Transactions
❖ An option to buy the currency is called as a Call
Option, while the option to sell the currency is called
as a Put Option.

❖ Buying or selling the underlying asset via the option

is known as exercising the option. The stated price
paid (or received) is known as the exercise or
striking price.

❖ The buyer of an option is known as the long and the

seller of an option is known as the writer of the
option, or the short.

❖ The price for the option is known as premium.

 ❖ The Swap Transactions involve a simultaneous
borrowing and lending of two different currencies
between two investors.
Swap Transactions ❖ Here one investor borrows the currency and lends
another currency to the second investor.

❖ The obligation to repay the currencies is used as

collateral, and the amount is repaid at a forward rate.

❖ The swap contracts allow the investors to utilize the

funds in the currency held by him/her to pay off the
obligations denominated in a different currency
without suffering a foreign exchange risk.
Arbitrage

❖ Arbitrage is the simultaneous buying and selling of

foreign currencies with intention of making profits
from the difference between the exchange rate
prevailing at the same time in different markets.
Characteristics / Features of Foreign Exchange Market :

01 Electronic Market

02 Geographical spreading

03 Transfer of Purchasing Power

04 Intermediary

05 Volume
Characteristics / Features of Foreign Exchange Market :

06 Provision of Credit

07 Minimizing Risk

08 24 Hours Market

09 Currencies Traded
Characteristics / Features of Foreign Exchange Market :

01 Electronic Market

• Foreign Exchange market is described as OTC (Over the Counter)

market as there is no physical place where the participants meet to
execute the deals.

• It means, foreign exchange market does not have a physical place. It is a

market whereby trading in foreign currencies takes place through the
electronically linked network of banks, foreign exchange brokers and
dealers whose function is to bring together buyers and sellers of foreign
exchange.
Characteristics / Features of Foreign Exchange Market :

02 Geographical Spreading

• A feature of the foreign exchange market is that it is not to be found in

one place.

• The market is vastly dispersed throughout the leading financial center of

the world such as London, New York, Amsterdam, Tokyo, Hong Kong
Toronto and other cities.
Characteristics / Features of Foreign Exchange Market :

03 Transfer of Purchasing Power

• Foreign exchange market aims at permitting the transfer of purchasing

power denominated in one currency to another whereby one currency is
traded for another currency.

• For example – an India exporter sells software to a U.S. firm for dollars
and a U.S. firms sells super computers to an Indian Company for rupees.
In these transactions, firms of respective countries would like to have
their payment settled in their currencies i.e. Indian firm in rupees and
U.S. firm in U.S. dollars.

• It is the foreign exchange market, which facilitates such a settlement

between countries in their respective currency units.
Characteristics / Features of Foreign Exchange Market :

04 Intermediary

• Foreign exchange markets provide a convenient way of converting the

currencies earned into currencies wanted of their respective countries.

• For this purpose, the market acts as an intermediary between buyers

and sellers of foreign exchange.
Characteristics / Features of Foreign Exchange Market :

05 Volume

• A special feature of the foreign exchange market is that out of the trading
transactions that take place in the foreign exchange market, around 95%
takes the firm of cross-border purchase and sale of assets, that is,
international capital flows. Only around 5% relates to the export and
import activities.
Characteristics / Features of Foreign Exchange Market :

06 Provision of Credit

• A foreign exchange market provides credit through specialized

instruments such as bankers’ acceptance and letters of credit.

• The credit thus provided is of much help to the traders and businessmen
in the international market.
Characteristics / Features of Foreign Exchange Market :

07 Minimizing Risks

• The foreign exchange market helps the importer and exporter in the
foreign trade to minimize their risks of trade. This is being done through
the provision of ‘Hedging’ facilities.

• This enables traders to transact business in the international market with

a view to earning a normal business profit without exposure to an
expected change in anticipated profit.

• This is because exchange rates suddenly change.

Characteristics / Features of Foreign Exchange Market :

08 24 Hours Market

• The markets are situated throughout the different time zones of the
globe in such a way that when one market is closing the other is
beginning its operations.

• Thus at any point of time one market or the other is open.

• Therefore, it is stated that foreign exchange market is functioning

throughout 24 hours of the day.
Characteristics / Features of Foreign Exchange Market :

09 Currencies Traded

• In most markets, US dollar is the vehicle currency, this currency is used

to denominate international transactions.