Foreign Exchange Market and Foreign Exchange Rates
Foreign Exchange Market:
The foreign exchange market is a global decentralized market for the trading of currencies. This includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms of volume of trading, it is by far the largest market in the world. Foreign exchange markets are made up of banks, commercial companies, central banks, investment management firms and investors. The main participants in this market are the larger international bank surrounds the world function as anchors of trading between a wide range of multiple types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies.
As Kindle-Berger put:
“The foreign exchange market is a place where foreign moneys are bought and sold.”
Foreign exchange market is an institutional arrangement for buying and selling of foreign currencies. Exporters sell the foreign currencies. Importers buy them. The foreign exchange market is merely a part of the money market in the financial centers. It is a place where foreign moneys are bought and sold. The buyers and sellers of claim on foreign money and the intermediaries together constitute a foreign exchange market. It is not restricted to any given country or a geographical area. Thus, the foreign exchange market is the market for a national currency (foreign money) anywhere in the world, as the financial centers of the world are united in a single market.
There is a wide variety of dealers in the foreign exchange market. The most important among them are the banks. Banks dealing in foreign exchange have branches with substantial balances in different countries. Through their branches and correspondents, the services of such banks, usually called “Exchange Banks,” are available all over the world.
These banks discount and sell foreign bills of exchange, issue bank drafts, effect telegraphic transfers and other credit instruments, and discount and collect amounts on the basis of such documents. Other dealers in foreign exchange are bill brokers who help sellers and buyers in foreign bills to come together. They are intermediaries and unlike banks are not direct dealers.
Functions of Foreign Exchange Market
The basic function of the foreign exchange market is to facilitate the conversion of one currency into another, i.e., to accomplish transfers of purchasing power between two countries. This transfer of purchasing power is affected through a variety of credit instruments, such as telegraphic transfers, bank draft and foreign bills. To transfer finance, purchasing power from one nation to another. Such transfer is affected through foreign bills or remittances made through telegraphic transfer.
In performing the transfer function, the foreign exchange market carries out payments internationally by clearing debts in both directions simultaneously, analogous to domestic clearings.
Another function of the foreign exchange market is to provide credit, both national and international, to promote foreign trade. Obviously, when foreign bills of exchange are used in international payments, a credit for about 3 months, till their maturity, is required. To provide credit for international trade.
A third function of the foreign exchange market is to hedge foreign exchange risks. Hedging means the avoidance of a foreign exchange risk. In a free exchange market when exchange rate, i. e., the price of one currency in terms of another currency, change, there may be a gain or loss to the party concerned. Under this condition, a person or a firm undertakes a great exchange risk if there are huge amounts of net claims or net liabilities which are to be met in foreign money.
Exchange risk as such should be avoided or reduced. For this the exchange market provides facilities for hedging anticipated or actual claims or liabilities through forward contracts in exchange. A forward contract which is normally for three months is a contract to buy or sell foreign exchange against another currency at some fixed date in the future at a price agreed upon now. To make provision for hedging facilities, i.e., to facilitate buying and selling spot or forward foreign exchange.
The foreign exchange market consist of two tiers:
- 1- Tier 1
- 2- Tier 2
Tier 1: In tier 1 the inter-bank or wholesale market are involved.
Tier 2: In tier 2 the client or retail market are involved.
Five Broad Categories of Participants:
The 5 main participants that operate within these two tiers:-
- 1- Bank and Non-bank foreign exchange dealers
- 2- Individuals and firms.
- 3- Speculators and Arbitragers.
- 4- Central bank and treasuries.
- 5- Foreign exchange brokers.
Major Currencies of the World:
- 1- USD
- 2- EURO
- 3- YEN
- 4- POUND
Foreign Exchange Transaction:
- Any financial transaction that involves more than one currency is a foreign exchange transaction.
- Most important characteristics of a foreign exchange transaction is that it involves foreign exchange risk.
FOREIGN EXCHANGE RATE:
Foreign exchange rate is the price of one country’s currency expressed in another country’s currency. In other words, the rate at which one currency can be expressed for another.
Open Market Foreign Exchange Rate:
“TYPES OF FOREIGN EXCHANGE RATE”
- 1- Spot rate
- 2- Forward rate
The spot rate is also called spot price is based on the value of an asset at the moment of the quote. This value is based on how much buyers are willing to pay and how much sellers are willing to accept, which depends on factors such as current market value and exported future market value.
A spot transaction involves the payment and receipt of the foreign exchange within two business days after the day the transaction is agreed upon. The two days period gives adequate time for the parties to send instructions to debt and credit the appropriate bank accounts at home and abroad. This type of transaction is called a spot transaction and exchange rate at which the transaction takes place is called the spot rate.
A forward transaction involves an agreement today to buy or sell a specified amount of a foreign currency at a specified future date at a rate agreed upon today.
An arrangement in which two parties exchange specific amounts of different currencies initially and a series of interest payments on the initial cash flows are exchanged. Often one party will pay a fixed interest rate, which another will pay a floating exchange rate. At the maturity of the swap the principle amount are exchanged back. Unlike an interest rate swap the principle and interest are both exchange in full in currency swap.
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