Major Functions Of The Foreign Exchange Market
In simple words, the foreign exchange market is a financial exchange zone for fiat currencies. Forex traders buy and sell international currencies in this market and these currencies are always traded in pairs. Visit multibankfx.com
In order to trade in the forex market, you will have to find a dealer or a forex broker. There are many options to choose from, however, it is worth mentioning that most forex brokers are banks. Generally, banks tend to have branches at international locations and thus they have a large corpus of funds in various currencies. These corresponding branches often labelled as Exchange Banks enable access to the forex market. To do this, these banks facilitate numerous processes such as issuing bank drafts, conducting telegraphic transfers among other credit instruments, and of course, discounting, selling and collecting forex bills.
While banks are direct dealers, there are also bill brokers who act as intermediaries. They help in connecting the right buyers with their respective sellers who wish to carry out a trade.
The forex market has to carry out certain operations in order to allow the exchange of currencies globally. These are also the main functions of the forex market:
- Function of Transfer
Without the forex market, it would be very difficult to trade internationally. This is because a key and perhaps the most important aspect of the forex market is that it facilitates the movement of foreign currency from one nation to another. To settle payments through forex, a trader/business can exchange a currency for another.
Let’s understand this better with an example. Say an English exporting company wants to import products from the United States and the payment for it should be made in dollars. Then via online forex trading, Euros or pound sterling would have to be converted to dollars. Further to enable the transfer of funds, credit instruments like bank drafts, foreign exchange bills, and telephone transfers come into the picture.
Capital flows, receipts, and payments for imports and exports are factors that contribute to establishing the exchange rate. As per the gold standard prior to 1972, currencies had to be pegged against the U.S dollar. This implied that the exchange rate could not be decided by the forces of supply and demand in the foreign exchange market. It is only when governments of the leading global economies allow their currencies to fluctuate without any sanctions, the need for a foreign exchange market arises. Hence, the transfer function is a key aspect of the foreign exchange market.
Floating currency
When a currency has the liberty to respond to supply and demand, it is known as a free-floating currency.
Managed float
In situations when central banks step into the market to buy and sell forex to ensure the national currency stays well within a particular band, then it is said that the currency is managed.
Pegged currency
If the local currency’s exchange rate remains fixed by decree, we can say that it has been pegged.
- Function of Credit
In order to ease the import process of goods, products, and even services, short-term forex loans are offered to importers. For example, a Dubai-based company that wishes to buy equipment in Japan may use a bill of exchange for the purchase. The bill of exchange, issued by the forex market, would have a maturity period of three months or more.
- Function of Hedging
Hedging forex-related risks is another key feature of the foreign exchange market. Price fluctuations, changes in the exchange rate, or an unprecedented fall in currency prices often concern traders as the stakes are high and one may profit greatly or lose severely.
To safeguard against unexpected scenarios, most online forex trading brokers roll out hedging offers for existing claims and liabilities in exchange for forwarding contracts. What are forward contracts? These are deals of usually 12 weeks that allow the sale or purchase of one currency for another at a pre-decided rate at a particular date in the future. Note that in this process, there’s no exchange of money.
Banks are the most important forex brokers as they have international branches that can facilitate foreign exchange. Since you’re now at the end of this article, we hope that you’ve learned about the functions of forex markets and are thus ready to trade.
Major Players
- Central Banks
Central banks have a very central role in the foreign exchange market. They help the government in implementing its economic policies. The reserve bank is yet another key player when it comes to safeguarding the value of a local currency, particularly in countries that have a managed exchange rate or a pegged exchange rate. The central bank intervenes in this scenario by purchasing and selling foreign currency in the forex market. One must remember that such an intervention on the part of central banks is often seen negatively as it may worsen the position of a depreciating currency. Central banks keep a watch on the transfer function of the forex market.
- Authorised Banks
Authorised dealer banks are among the most important players in the forex market. They are the market makers as they are the ones who can name the price of the buying and selling rates in the forex spot and forward markets. Banks are the ones that facilitate the transfer, speculation, risk management, and short-term credit functions in this market.
- Exporters and Importers
Companies that purchase and sell supplies from various nations have to pay suppliers and workers in the local currency of the country where their operations are based. Such firms also get payments from customers spread all over the world, who pay in their own currency. In such cases, the company’s foreign currency earnings must be converted into its national currency. Exporters and importers rely heavily on the transfer function of the foreign exchange market.
- Investors
Individuals and companies put their money on various financial assets like shares, bonds, and property in multiple countries. They have to get their home currency converted into foreign currency so they can pay for their investments as they invest in another country. Another thing is that the returns from the foreign direct investment also have to be converted into the local currency.
- Speculators
Speculators could be anyone right from banks, professionals, and individuals. A Speculator would purchase and sell foreign currency with the expectation to make a profit. Foreign currency is similar to a commodity that can be traded. Many times, speculators are the ones to blame currencies’ volatile nature as a weak currency can be leveraged by selling it off, which would lead to its depreciation. Another thing that speculators might do is buy a strong currency which causes its demand to increase further and hence it becomes overvalued.