FINANCIAL MARKETS AND ENVIRONMENT
Paper Code: BBA-II-N-506
BBA (IIFSB) _ 5th Semester
UNIT – 3 (Part 3 of 4)
Foreign Exchange Market
A Foreign exchange market is a market in which currencies are bought and sold.
It is to be distinguished from a financial market where currencies are borrowed and lent.
Foreign exchange market is described as an OTC (Over the counter) market as there is no physical place
where the participants meet to execute their deals. It is more an informal arrangement among the banks
and brokers operating in a financing center purchasing and selling currencies, connected to each other by
telecommunications like telex, telephone and a satellite communication network, SWIFT.
The foreign exchange market (forex market) is not limited by any geographical boundaries. It does not
have any regular market timings, operates 24 hours 7 days week 365 days a year, characterized by ever-
growing trading volume, exhibits great heterogeneity among market participants with big institutional
investor buying and selling millions of dollars at one go to individuals buying or selling less than 100
dollar.
Forex market participants can be categorized into five broad categories. These five categories are
Forex Market participants:
Commercial Banks and financial institutions
Merchants / Exchange Brokers
Other customers
Speculators and hedgers
Central bank
The foreign exchange market is the largest market in the world with average daily turnover of US$ 3.2
trillion. It spans all over the world and operates 24 hours a day.
Types of forex market participants:
The forex market is an OTC (Over the Counter) market without any centralized clearinghouse.
It consists of two tiers.
• The interbank or wholesale market,
• Client or retail market.
Wholesale Forex Market:
Major forex trading in the wholesale forex markets is undertaken by banks – popularly known as
interbank market. In this market, banks and non-bank financial institutions transact with each other.
They undertake trading on behalf of customers, but majority of trading is undertaken for their own
account by proprietary desks.
Besides banks and non-bank financial institutions, multinational corporations, hedge funds, pension and
provident funds, insurance companies, mutual funds etc. participate in the wholesale market.
Big multinational companies earn their revenue and incur expenses in many different currencies. For
example, Switzerland based Nestle operates in 86 countries across the globe. To hedge their foreign
exchange risk these multinational companies directly participate in the wholesale market.
Hedge funds are also major player in this market. Hedge funds collect huge sums from high net worth
individuals and undertake speculative trades in equity, debt, forex and derivatives market.
Mutual funds with international equity portfolio are also major players in this market.
Retail Market:
In the retail market, individuals (tourists, foreign students, patients traveling to other countries for
medical treatment) small companies, small exporters and importers operate. Money transfer
companies/remittance companies (for example like Western Union) are also major players in the retail
market.
Retail traders buy/sell currency for their genuine business/personal requirements. For example, an
exporter enters into forward contract to convert foreign currency to domestic currency.
A tourist buys foreign currency in the spot market before undertaking the journey.
An UK patient visiting India to undertake an operation.
Majority of retail trading happens in the spot market. As retailers’ requirements are normally not
repetitive in nature, they buy or sell the currency as when the requirement arises.
Note:
Major part of the forex turnover in an economy comes from banks – banks acting as forex dealers
(provide two way quotes) as well as acting as brokers.
Functions of foreign Exchange Market
The foreign exchange market is a market in which foreign exchange transactions take place.
1.) Transfer of Purchasing Power:
The Primary function of a foreign exchange market is the transfer of purchasing power from one
country to another and from one currency to another. The international clearing function
performed by foreign exchange markets plays a very important role in facilitating international
trade and capital movement.
This function is performed through credit instruments like bills of foreign exchange, bank drafts
and telephonic transfers.
2.) Provision of credit:
The credit function performed by foreign exchange markets also plays a very important role in
the growth of foreign trade. International trade depends to a great extent on credit facilities.
Exporters may get pre shipment and post shipment credit. Credit facilities are available also for
importers.
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.
The Euro dollar market has emerged as a major international credit market.
3.) Provision of Heding Facilities:
The other important of the foreign exchange market is to provide hedging facilities. Heding
refers to covering of foreign trade risks, and it provides a mechanism to exporters and importers
to guard themselves against losses arising from fluctuations in exchange rates.
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.
Kinds of Foreign Exchange Markets:
Foreign exchange markets are classified on the basis of whether the foreign exchange transactions
are spot or forward accordingly, there are two kinds of foreign exchange markets:
(i) Spot Market, (ii) Forward Market.
(i) Spot Market:
Spot market refers to the market in which the receipts and payments are made immediately. Generally, a
time of two business days is permitted to settle the transaction. Spot market is of daily nature and deals
only in spot transactions of foreign exchange (not in future transactions). The rate of exchange, which
prevails in the spot market, is termed as spot exchange rate or current rate of exchange.
Note: The term ‘spot transaction’ is a bit misleading. In fact, spot transaction should mean a transaction,
which is carried out ‘on the spot’ (i.e., immediately). However, a two day margin is allowed as it takes
two days for payments made through cheques to be cleared.
(ii) Forward Market:
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. The exchange rate quoted in forward transactions is
known as the forward exchange rate. Generally, most of the international transactions are signed on one
date and completed on a later date. Forward exchange rate becomes useful for both the parties involved
in the transaction.
Forward Contract is made for two reasons:
(a) To minimize the risk of loss due to adverse changes in the exchange rate (through hedging);
(b) To make profit (through speculation).
