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:
Foreign exchange market plays a pivotal role in today’s economy because of the various important functions it performs. These functions are:
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:
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:
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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1. Foreign exchange as the term says is an exchange of foreign currency. Exchange of one country’s currency against another country’s is done in the foreign exchange or forex market.