There are two foreign exchange markets: (a) the retail market and (b) the interbank market.
1. Retail Market:
In the retail foreign exchange market, the individual and firms who require foreign currency can buy it and those who have acquired foreign currency can sell it. The commercial banks dealing in foreign exchange serve their customers by purchasing foreign exchange from some and selling foreign exchange to other.
Thus, each bank acts as a clearing house where purchases of exchange can be offset by sales of foreign exchange.
2. Interbank Market:
Interbank foreign exchange market serves to smoothen the excessive purchases or sales made by individual banks. At times, the quantity of foreign exchange supplied exceeds the quantity demanded, or vice versa.
When such an imbalance occurs, the exchange rate changes. If the foreign exchange is in excess supply, the exchange rate falls; if the foreign exchange is in excess demand, the exchange rate rises, the movement in the exchange rate helps to correct the situation by encouraging or discouraging additional buyers and sellers into or from the market.