Definition of Foreign Exchange Markets

Foreign Exchange Markets

The foreign Exchange Market is the market in which currencies are bought and sold against each other. It is the largest market in the world. In this market where financial paper with a relatively short maturity is traded. However, the financial paper traded in the foreign exchange market is not all denominated in the same currency. In the foreign exchange market, paper denominated in a given currency is always traded against paper denominated in another currency. One justification for the existence of this market is that nations have decided to keep their sovereign right to have and control their own currencies. Unlike the money market and capital markets, the foreign exchange market deals not in credit but in means of payment. This brings one to a fundamental point. While foreign exchange deals frequently take place between residents of different countries, the money being traded never actually leaves the country of the currency.

Thus, when a US company exports to a foreign country of India, for example, foreign exchange is required. The people manufacturing and performing services in the United States must be paid in local currency, US dollars. The people consuming the goods and services in India have only their local currency, Rupees with which to pay. There are now two possibilities for settling the account between the United States and India. The US exporter bills the Indian importer either in US dollars or in Rupees.

(a) If the US exporter bills in dollars, the Indian importer must sell Rupees to purchase dollars in the foreign exchange market.

(b) If the US exporter bills in Rupees, the exporter must sell rupees to purchase dollars.

As one can see, whatever the currency for invoicing is, somebody has to go into the foreign exchange market to sell rupees and purchase dollars. In contrast to a spot transaction, a forward foreign exchange contract calls for delivery at a fixed future date of a specified amount of one currency for specified amount of another currency. By borrowing money in one currency, buying a second currency spot, placing the funds in a deposit in the foreign currency and simultaneously selling the foreign currency forward, an arbitrageur can profit if the domestic interest rate does not equal the foreign interest rate, adjusted for the forward premium or discount. Dealing business across national boundaries means dealing with more than one currency and therefore involves exchange risk. Exchange risk is the additional systematic risk to a firm’s flows arising from exchange rate changes.