What are the Important Functions of Foreign Exchange Market?

The foreign exchange market performs the following important functions:

1. 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. The transfer function is performed through the credit instruments like, foreign bills of exchange, bank draft and telephonic transfers.

2. Credit Function:

Another function of foreign exchange market is to provide credit, both national and international, to promote foreign trade. 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.

3. Hedging Function:

In a situation of exchange risks, the foreign exchange market performs the hedging function. 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 free exchange market, when the value of foreign currency varies, there may be a gain or loss to the traders concerned. To avoid or reduce this exchange risk, the exchange market provides facilities for hedging anticipated actual claims or liabilities through forward contracts in exchange.

Forward contract is a contract of buying or selling foreign currency at some fixed date in future at a price agreed upon now. Thus, without transferring any currency, the forward contract makes it possible to ignore the likely change in the exchange rate and avoid the possible losses from such change.