Functions of the Foreign Exchange Market

The foreign exchange market performs mainly three functions

Transferring the purchasing power

Provision of credit for foreign trade and

Furnishing facilities for hedging for foreign exchange risks

Transferring the purchasing power

The most important function is the transfer of purchasing power from one country to another and from one national currency to another. The purchasing power is transferred through the use of credit instruments. The main credit instrument is used for the transferring the purchasing power is the telegraphic transfer (TT) of the cabled order by one bank (in country A) to its correspondent abroad (in country B) to pay B funds out of its deposit account to its designated account or order.

The telegraphic transfer is simply a sort of cheque, which is wired or radioed rather than sent by post. Purchasing power may also be transferred through bank drafts. There is also the commercial bill of exchange or acceptance, through which even today a considerable amounts of payments in international trade is made. A bill of exchange is an order, written by the exporters of goods directing the importer to pay the exporter or the party bank, discount house, or other financial institutions with whom the exporter has discounted the bill.

Provision of Credit for Foreign Trade

The foreign exchange market also provides credit for foreign trade. Like all the traders, international trade also requires credit. It takes time to move the goods from seller to purchaser and during this period, the transaction must be financed. When the exporter does not need credit for the manufacture of export goods, credit is necessary for the transit of goods. When the special credit facilities of the foreign exchange market are used, the foreign exchange department of a bank or the bill market is used; the foreign exchange department of the bank or the bill market of one country or the other extends the credit facilities to finance the foreign trade.

Furnishing Facilities for Hedging Foreign Exchange Risks

The foreign exchange market by providing facilities of buying and selling at spot or forward exchange, enables the exporters and importers to hedge their exchange risks arising from change in the foreign exchange rate. The forward market in exchange also enables those banks, which are unlikely to run any considerable exchange position to cover their commitments.