What is Foreign Exchange and Foreign Exchange Market?

What is Foreign Exchange and Foreign Exchange Market?

21 Jun 2018 04:05 PM

What is foreign exchange?

Foreign exchange refers to the exchange of one currency for some other currency. In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying with some quantity of another currency. The foreign exchange market indicates a market in which the various participants are able to buy, sell, exchange and speculate on currencies depending upon their rates. They various components and participants that make up foreign exchange market include banks, commercial companies, hedge funds, investors, central banks, retail foreign exchange brokers and investment management firms. The market mainly determines the foreign exchange rate. The foreign exchange market assists international trade and investments by enabling currency conversion There are various features and characteristics that make foreign exchange market unique and attractive.

Some of them are:

  • Liquidity – this market is characterized by high liquidity since the dealing takes place in highly liquid assets and on frequent basis.
  • Operates 24 hours, 5 days a week - Since foreign exchange deals with the currencies of different nations. Thus, in case of Forex market as one major foreign exchange market closes in one part, another market in a different part of the world opens for business.
  • Leverage- leverage is a form of loan given by a broker to his investor. With this loan investors are able to enhance profits.
  • Trading Volume – trading volume in this form of market is huge because of the large number of people who participate in it.

Foreign exchange market plays a pivotal role in today’s economy because of the various important functions it performs. These functions are:

  • Transfer function – which aids the transfer o funds and purchasing power from one country to another
  • Credit function – the market helps to provide credit for smooth international trade activities
  • Hedging function – hedging facilities are provided for investors (customers)

There are various financial instruments that aid the smooth functioning of the foreign exchange market. Financial instruments in basic terms refer to a type of financial medium that are used for borrowing purposes in financial markets.

Some of the common financial instruments are:

  • Cash: a cash transaction refers to the fastest mode of settling transaction, here the payment is made right away.
  • Tom: Tom indicates the transactions that will be completed by the next day i.e. tomorrow. Thus, if a transaction is entered into today it will be settled by tomorrow.
  • Spot: a spot transaction in most days refers to a 2-day delivery transaction. These 2 days refer to business days. It represents a direct exchange between 2 currencies in a shortest time frame.
  • Forward: in case of a forward contract money changes hands on a specified future date. The transaction occurs on a future date pre-determined mutually by the buyer and seller. The transaction takes place on that specific date regardless of the market rates at that point of time. The duration may vary from days to years.
  • Non-deliverable forward (NDF): NDF contracts are derivatives with no real deliver- ability. NDFs are offered by forex banks, prime brokers and ECNs for currencies with restrictions (currency that cannot be traded on open market with other major currencies).
  • Futures: futures are standardized forward contracts and are usually traded on an exchange created for this purpose. They are similar to forward contracts In terms of obligations with an average contract length of 3 months.
  • Option: it is a derivative where the owner of the option has the right but not the obligation to exchange currency at a pre-agreed exchange rate on a specified date.

The basic function of a foreign exchange market is to determine the foreign exchange rate. What do we mean by the term exchange rate? Exchange rate refers to the rate at which one currency is exchanged for another currency. The exchange rate can be spot or forward. Spot rate is the current exchange rate whereas forward rate is the rate quoted for a forward contract. Exchange rate is a relative concept. Broadly there are 2 types of exchange rates- fixed exchange rates and flexible exchange rates. The exchange rates which are determined by the foreign exchange market and fluctuate on a moment to moment basis are flexible rates. Fixed exchange rates do not fluctuate according to the foreign exchange market, they remain constant. Exchange rate isn’t determined on the basis of a single factor, it is determined and influenced by a variety of factors and all are related to the trading relationship between two countries, some of them being: balance of payments, interest rate level, inflation rate of a nation, the fiscal and monetary policy of a country, venture capital, terms of trade, the extent of government intervention in the market and the economic strength of a country.

Foreign Exchange Risk and Its Management

Every business and every market deal with some costs and risks, foreign exchange market is no exception. Foreign exchange market contains certain types of risks. Foreign exchange risk is a financial risk that exists when a financial transaction is denominated in a currency other than that of the base currency of the company. Since we deal in currencies and assets which are highly liquid and volatile. The various types of risk exposures are:

  • Transaction Risk: Exchange rate is a relative figure based upon the currencies the rate is concerned with. Transaction risk is related the time gap between entering into a transaction and settling of a transaction. Since exchange rates keep fluctuating, firms face risk of changes in exchange rate between foreign and domestic currency. As firms negotiate with set prices and delivery dates, transaction risk indicates the risk associated with fluctuation in exchange rate between the time an enterprise initiates a transaction and settles it.
  • Economic risk: Economic risk also known as forecast risk is the risk associated with the firm’s market share position with regard to its competitors, future cash flows, etc. it refers to the degree to which the firm’s market value is influenced by unexpected exchange rate fluctuations. Economic risk can affect the present value of future cash flows
  • Translation risk: It refers to the impact upon the financial reporting of the firm due to exchange rate movements. This problem is faced by multinational organizations since they deal in various nations having different currencies.
  • Contingent risk: A contingent risk arises from the potential chance of a firm to suddenly face a transnational or economic foreign exchange risk. Contingency indicates the fact that the event may or may not occur.

When dealing in foreign exchange market, one cannot turn a blind eye towards the risk they may face. Having an idea about the measure of risk that might be faced helps in better prevention and management of that risk. Financial risk is most commonly measured in terms of variance or standard deviation. In the foreign exchange market, a financial risk management technique called value at risk (VaR) is used which examines the tail end of a distribution of returns for changes in exchange rates to highlight the outcomes with the worst returns. Each andevery firm adopts certain techniques to manage the risk that will be faced. A one stop solution to manage risk is Transaction Forex Risk Advisory which basically is an advisory service provided by MyForexEye providing proper guidance with respect to what action should be taken and when it should be taken. The service is provided by a group of highly experienced professionals having in depth knowledge of the market.

Firms may use a number of other Foreign Exchange hedging strategies to minimize exchange rate risk. The various techniques and strategies that can be used to mitigate risk can be internal as well as external. Internal techniques to manage or reduce risk must always be considered before going on with external techniques.

Internal techniques include: invoice in home currency, leading and lagging and matching the revenues and expenses. The external techniques will include: forward contracts, money market hedges, future contracts, options, Forex swaps and currency swaps.

Thus, although foreign exchange market faces a number of risks all or them can be managed either by adopting different strategies or by taking the TFRA service of MyForexEye.

Read more about foreign exchange risk and exposure

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