Foreign Exchange Market

What is a Foreign Exchange Market?

Also known as FOREX market. An over the line counter or a decentralized market that deals in the exchange of the currencies of different countries is called a foreign exchange market. A market dedicated to the buying and selling of currencies. It actually is a system not a physical market. For example you have decided to spend your vacations in London, you estimated the total expenses at 300 Euros, but Britain is not a part of Euro zone, so you will have to buy some Pounds. You rush to the bank to exchange 300 Euros for Pounds. At the time 1 Euro is 0.88 Pound, so you will get 263.11 Pounds without the brokerage fee. This bi sale exchange took place on the foreign exchange market. It is comprised entirely of the supply and demand for international currency and each currency around the world has its own market. Through voluntary exchange the supply and demand for an international currency sets an equilibrium exchange rate in the market. This rate is the price at which one currency can be bought with another. Changes in either supply or demand of foreign currency will change the exchange rate in the foreign market which impacts the value or international pursue power of the currency, the price of imports and exports and ultimately affects a nation’s trade balance.

Type of Markets

Spot Market or Cash Market

Spot market or cash market is a public financial market in which the commodities or financial instruments are traded for immediate delivery, receives and payments are made immediately. The rate of exchange is current, also called spot transactions, spot current rate or current exchange rate Settlement happens in T=2 days , that is delivery of cash and commodities must be done within 2 days of the trade. Spot market can operate wherever the infrastructure exists to conduct the transactions.

The spot foreign exchange market imposes a 2 day delivery period, this is due to the time it would take to move cash from one bank to another. Most speculative retail forex trading is done as spot transactions on an online trading platform. The most commonly traded currencies in the spot market are EUR/USD, USD/JPY and GBP/USD.

Forward Market

Forward market is a market in which the transactions takes place in future date. Forward market is also an over the counter market that deals with price of a financial instrument or asset for future delivery. It is also applicable to markets of securities, commodities as well as interest rates. The rate is of the transaction is based on interest rate discrepancies. The most commonly traded currencies in the forward market are same as the spot market i.e., EUR/USD, USD/JPY and GBP/USD.

Functions

Transfer Function

The transfer of purchasing power. Transfer of purchasing power is explained as for example America invested in India i.e. it bought INR, it will mean that investment in India has increased. So the purchasing power of US is added into that of India. This is the main function of the foreign exchange market, transferring the purchasing power of a country to another one. Such a transfer is affected through remittances or foreign bills made through telegraphic transfer.

Hedge Function

Hedge means investments made to avoid losses. A function of the forex market is to hedge foreign exchange risks. In a free exchange where exchange rates , that is, the price of one currency in terms of another currency takes place there can be a risk of facing a loss. In order to avoid these risks the forex market provides facilities for hedging the anticipated or actual claims even liabilities through forward contracts in exchange. 

Credit Function

This can be called as the basic function of the forex market which is to provide credit to promote foreign trade, the credit is both national and international.