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The Foreign Exchange Market

Last updated date: 16th Apr 2024
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Exchange Rate of Currencies in Foreign Exchange Market

Every country has their respective currencies which they use in their trade and businesses, but what about in the foreign market? With the lack of versatility of the currencies, they become a hurdle in world trade. To solve this problem, the Foreign Exchange Market was introduced. This is a type of marketplace that will fix the exchange rate for the currencies. 

Without the foreign exchange market, the world economy would suffer terribly. Thus, it becomes important for us to consider this topic as a prior study. In this context, we will define the foreign exchange market, discuss the types, features, and participants in the same market.

Define Foreign Exchange Market

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The foreign exchange market is over a counter (OTC) global marketplace that determines the exchange rate for currencies around the world. This foreign exchange market is also known as Forex, FX, or even the currency market. The participants engaged in this market are able to buy, sell, exchange, and speculate on the currencies.

These foreign exchange markets are consisting of banks, forex dealers, commercial companies, central banks, investment management firms, hedge funds, retail forex dealers, and investors. In our prevailing section, we will widen our discussion on the ‘Foreign Exchange Market’.

Types of Foreign Exchange Market

The Foreign Exchange Market has its own varieties. We will know about the types of these markets in the section below:

The Major Foreign Exchange Markets −

  • Spot Markets

  • Forward Markets

  • Future Markets

  • Option Markets

  • Swaps Markets

Let us discuss these markets briefly:

  • Spot Market

In this market, the quickest transaction of currency occurs. This foreign exchange market provides immediate payment to the buyers and the sellers as per the current exchange rate. The spot market accounts for almost one-third of all the currency exchange, and trades which usually take one or two days to settle the transactions. 

  • Forward Market

In the forward market, there are two parties which can be either two companies, two individuals, or government nodal agencies. In this type of market, there is an agreement to do a trade at some future date, at a defined price and quantity.

  • Future Markets

The future markets come with solutions to a number of problems that are being encountered in the forward markets. Future markets work on similar lines and basic philosophy as the forward markets. 

  • Option Market

An option is a contract that allows (but is not as such required) an investor to buy or sell an instrument that is underlying like a security, ETF, or even index at a determined price over a definite period of time. Buying and selling ‘options’ are done in this type of market. 

  • Swap Market

A swap is a type of derivative contract through which two parties exchange the cash flows or the liabilities from two different financial instruments. Most swaps involve these cash flows based on a principal amount.


Functions of Foreign Exchange Market

The various functions of the Foreign Exchange Market are as follows: 

  • Transfer Function: The basic and the most obvious function of the foreign exchange market is to transfer the funds or the foreign currencies from one country to another for settling their payments. The market basically converts one’s currency to another.

  • Credit Function: The FOREX provides short-term credit to the importers in order to facilitate the smooth flow of goods and services from various countries. The importer can use his own credit to finance foreign purchases.

  • Hedging Function: The third function of a foreign exchange market is to hedge the foreign exchange risks. The parties in the foreign exchange are often afraid of the fluctuations in the exchange rates, which means the price of one currency in terms of another currency. This might result in a gain or loss to the party concerned.


Features of Foreign Exchange Market 

This kind of exchange market does have characteristics of its own, which are required to be identified. The features of the Foreign Exchange Market are as follows:

  1. High Liquidity

The foreign exchange market is the most easily liquefiable financial market in the whole world. This involves the trading of various currencies worldwide. The traders in this market are free to buy or sell the currencies anytime as per their own choice.

  1. Market Transparency

There is much clarity in this market. The traders in the foreign exchange market have full access to all market data and information. This will help to monitor different countries’ currency price fluctuations through the real-time portfolio. 

  1. Dynamic Market

The foreign exchange market is a dynamic market structure. In these markets, the currency values change every second and hour.

  1. Operates 24 Hours

The Foreign exchange markets function 24 hours a day. This provides the traders the possibility to trade at any time. 

Who are the Participants in a Foreign Exchange Market?

  • The participants in a foreign exchange market are as follows:

  • Central Bank: The central bank takes care of the exchange rate of the currency of their respective country to ensure that the fluctuations happen within the desired limit and this participant keeps control over the money supply in the market.

  • Commercial Banks: Commercial banks are the channel of forex transactions, which facilitates international trade and exchange to its customers. Commercial banks also provide foreign investments. 

  • Traditional Users: The traditional users consist of foreign tourists, the companies who carry out business operations across the globe.

  • Traders and Speculators: The traders and the speculators are the opportunity seekers who look forward to making a profit through trading on short-term market trends.

  • Brokers: Brokers are considered to be the financial experts who act as a sure intermediary between the dealers and the investors by providing the best quotations.

Advantages of Foreign Exchange Market

The whole world economy is relying upon this foreign exchange market for obvious advantageous reasons. Let us check what are the advantages gained in the foreign exchange market-

  • There are very few restrictive rules, this allows the investors to invest in this market freely.

  • There are no central bodies or clearinghouses that head the Foreign Exchange Market. Hence, the intervention of the third party is less.

  • Many investors are not required to pay any commissions while entering the Foreign Exchange Market.

  • As the market is open 24 hours, the investors can trade here without any time-bound.

  • The market allows easy entry and exit to the investors if they feel unstable. 

Did You know?

  1. The Foreign Exchange Market is the biggest and the most liquid financial market in the whole world.

  2. The foreign exchange market trades 24/5. It starts its operation on Sunday at 5 pm EST and closes its operation on Friday at 5 pm EST.

  3. This market represents a $3.98 trillion value of transactions in a single day!

  4. You can even have access to Foreign Exchange Market provided you have an internet connection.

  5. USD (United States), EUR (EuroZone), JPY (Japan), GBP (Great Britain) – some of the major currencies of the world. 

FAQs on The Foreign Exchange Market

1. What is the Difference between the Forwarding Market and the Futures Market?

The forward contract and the futures contract are what comprise the forward and futures market. A forward contract is a private and customizable agreement that is being settled at the end of the agreement and is traded over-the-counter (OTC). Whereas, a future contract has standardized terms and is being traded on an exchange, where the prices are settled on a day-to-day basis till the end of the contract.

In the Forward markets, these are used to contract for the physical delivery of a commodity. While futures markets are the 'paper' markets that are used for hedging price risks or for speculation activities rather than for negotiating the actual delivery of goods.

2. What is Meant By an Underlying Security?

The underlying security is a term that is used in investing which denotes the negotiable financial instrument that is a financial derivative, such as an option on a stock – is based. The Underlying securities include stocks, bonds, and market indexes.

An underlying security is a stock or a bond on which the derivative instruments are based. This is the primary component of how the derivative gets its own value. 

3. What is an Option?

An option is a type of contract, which furnishes the buyer the options or the right but not the obligation to buy or sell the underlying at a future fixed date (or time) and at a fixed price.