The foreign exchange market is merely a part of the money market in the financial centers is a place where foreign moneys are bought and sold. The buyers and sellers of claims on fore' 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 amongst 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 for 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.
Acceptance houses are another class of dealers in foreign exchange. They help foreign remittances by accepting bills on behalf of customers. The central bank and treasury of a country are also dealers in foreign exchange. Both may intervene in the market occasionally. Today, however, those authorities manage exchange rates and implement exchange controls in various ways. In India, however, where there is a strict exchange control system, there is no foreign exchange market as such.
Functions of the Foreign Exchange Market:
The foreign exchange market performs the following important functions:
(i) to effect transfer of purchasing power between countries- transfer function;
(ii) to provide credit for foreign trade - credit function; and
(iii) to furnish facilities for hedging foreign exchange risks - hedging function.
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 effected through a variety of credit instruments, such as telegraphic transfers, bank drafts and foreign bills.
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.
A third function of the foreign exchange market is to hedge foreign exchange risks. In a free exchange market when exchange rates, 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. No money passes at the time of the contract. But the contract makes it possible to ignore any likely changes in exchange rate.
The existence of a forward market thus makes it possible to hedge an exchange position.