foreign exchange market mechanism

FOREIGN EXCHANGE MARKET MECHANISM

By, JAYAKRISHNAN K.R

FOREIGN EXCHANGE

• Foreign exchange is the system or

process of converting one national

currency in to another, and of transferring

money from one country to another.

FUNCTIONS OF FOREIGN EXCHANGE MARKET

The foreign exchange market is a market in which national currencies are bought and sold against one another.

It performs three important functions :-1. Transfer of Purchasing power2. Provision of Credit3. Provision of Hedging facilities

• Transfer of Purchasing power

It is the primary function of a foreign exchange market =

“Transfer of purchasing power from one country to another and from one currency to another”.

• Provision of Credit

The credit function performed by forex

market is plays an important role in the

growth of foreign trade, for international

trade depends to a greater extent on credit

facilities.

• Provision of Hedging facilities

Hedging refers to covering of foreign

trade risks, and provide a mechanism to

exporters and importers to guard

themselves against losses arising from

fluctuations in exchange rates.

PARTICIPANTS IN FOREX MARKET

COMMERCIAL BANKS

BROKERS & CUSTOMERS

CENTRAL BANKS

NON –BANK FOREX COMPANIES

• COMMERCIAL BANKS : The inter bank market market caters

for both the majority of commercial turnover and large amounts of speculative trading every day.

• BROKERS : Individuals constitute a growing

segment of this market, both in size and importance, they participate indirectly through Brokers.

They charge a commission in addition to the price obtained in the market.

• CENTRAL BANKS :

National central banks are play an important role in the forex market.

They try to control the money supply , inflation and interest rates and often have official or unofficial target rates for their currencies.

They can use their often substantial foreign exchange reserves to stabilize the market.

• NON-BANK FOREX COMPANIES :

Non-bank forex companies offer currency exchange and international payments to private individuals and companies.

They are also known as forex brokers, but are distinct in that they do not offer speculative trading but currency exchange with payments , ie, there is usually a physical delivery of currency to a bank account.

TYPES OF TRANSACTIONS IN FOREX MARKET

SPOT & FORWARD EXCHANGES

FUTURES

OPTIONS

SWAP OPERATIONS

ARBITRAGE

SPOT & FORWARD EXCHANGES : SPOT - The transactions are completed on the spot or immediately. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involve the cash rather than a contract. FORWARD – Market forward contracts are delivered at a specified future date. In this, money does not actually change hands until some agreed up on future trade. A buyer and seller agree on an exchange rate for any date in the future , and transactions occurs on that date, regardless of what the market rates are then.

• FUTURES : Foreign currency futures are

exchange traded forward transactions with standard contract size and maturity dates.

Futures are standardized and are usually traded on an exchange created for this purpose.

Futures transactions are usually inclusive of any interest amounts.

• OPTIONS : ( FX Option) FX Option is a derivative

where the owner has the right but not the obligation to exchange money denominated in one currency in to another currency at a pre-agreed exchange rate on a specified date.

Fx option market is the deepest , largest and most liquid market for option of any kind in the world.

• SWAP : The most common type of

forward transaction is the Fx Swap.

In an fx swap , two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date.

These are not standardized contracts and are not traded through an exchange.

• ARBITRAGE : Arbitrage is the simultaneous

buying and selling of foreign currencies with the intention of making profits from the differences between the exchange rate prevailing at the same time in different markets.