2. Foreign Exchange Market
ïForeign exchange market is the market in which foreign
currencies are bought and sold.
ïThe buyers and sellers include individuals, firms, foreign
exchange brokers, commercial banks and the central bank.
ïLike any other market, foreign exchange market is a system, not
a place.
ïThe transactions in this market are not confined to only one or
few foreign currencies.
ïIn fact, there are a large number of foreign currencies which are
traded, converted and exchanged in the foreign exchange market.
3. 1. Transfer Function
It transfers purchasing power between the countries involved in
the transaction.
This function is performed through credit instruments like bills of
foreign exchange, bank drafts and telephonic transfers.
Functions
4. 2. Credit Function
It provides credit for foreign trade. Bills of exchange, with maturity
period of three months, are generally used for international
payments.
Credit is required for this period in order to enable the importer to
take possession of goods, sell them and obtain money to pay
off the bill
Functions
5. 3. Hedging Function
When exporters and importers enter into an agreement to sell and
buy goods on some future date at the current prices and
exchange rate, it is called hedging.
The purpose of hedging is to avoid losses that might be caused
due to exchange rate variations in the future.
Functions
6. Kinds
ïSpot market refers to the market in which the receipts and payments are made
immediately.
ïGenerally, a time of two business days is permitted to settle the transaction.
ïSpot market is of daily nature and deals only in spot transactions of foreign
exchange (not in future transactions).
ïThe rate of exchange, which prevails in the spot market, is termed as spot
exchange rate or current rate of exchange.
ïThe term âspot transactionâ is a bit misleading. In fact, spot transaction should
mean a transaction, which is carried out âon the spotâ (i.e., immediately).
ïHowever, a two-day margin is allowed as it takes two days for payments made
through cheques to be cleared.
(i) Spot Market
7. Kinds
ï Forward market refers to the market in which sale and purchase of foreign
currency is settled on a specified future date at a rate agreed upon today.
ïThe exchange rate quoted in forward transactions is known as the forward
exchange rate.
ï Generally, most of the international transactions are signed on one date and
completed on a later date.
ï Forward exchange rate becomes useful for both the parties involved in the
transaction.
ïForward Contract is made for two reasons
ï(a) To minimize the risk of loss due to adverse changes in the exchange rate
(through hedging);
ï(b) To make profit (through speculation).
(ii) Forward Market
8. Types of transactions
ïIt is a method of covering risk arising from a change in the
exchange rate.
ïIt actually means settling the exchange rate by agreement 90 days
in advance for forward transactions with a view to avoid the loss due
to the exchange rate fluctuations
1. Hedging
9. Types of transactions
ïIt is an act of simultaneous purchase and sale of different
currencies in two or more exchange markets.
ïThe objective is to make profits by taking advantages of
exchange rate differentials in different markets.
2. Arbitrage
10. Types of transactions
ïIt is a deliberate assumption of risk to make profits from
fluctuations in the exchange rates.
ïThe speculative sale and purchase of foreign currency is
based on the speculatorâs expectations about the future
exchange rates.
3. Speculation
11. Types of transactions
ïIt is a kind of foreign exchange transaction in which there is a
spot sale of currency and a forward purchase of the same
currency in a single sale-purchase transaction.
ïThese transactions are usually made by the banks
4. Currency swap