FOREIGN EXCHANGE MARKET
Economics
INTRODUCTION
The foreign exchange market, commonly known as the Forex or FX market, is the global marketplace where currencies of different countries are bought, sold, and exchanged. It is the mechanism through which international trade, investment, tourism, remittances, and financial transactions are settled.
The foreign exchange market is not located at a single place. Instead, it operates through a network of banks, financial institutions, dealers, and electronic trading platforms spread across the world. Because of this structure, the forex market functions continuously for 24 hours a day, five days a week.
PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET
The foreign exchange market consists of a wide range of participants, each playing a specific role.
Commercial Banks:
Commercial banks are the most important participants. They buy and sell foreign currencies for their customers and also trade on their own account. Inter-bank trading forms the backbone of the forex market.
Central Banks:
Central banks participate to manage exchange rates, control inflation, and maintain financial stability. They intervene in the forex market by buying or selling foreign currencies and by setting monetary policy.
Foreign Exchange Dealers and Brokers:
Forex dealers and brokers act as intermediaries between buyers and sellers of foreign currencies. Retail forex brokers facilitate currency trading for individual investors.
Investment Institutions:
These include hedge funds, mutual funds, pension funds, and insurance companies. They participate mainly for portfolio diversification, speculation, and hedging purposes.
Commercial Companies:
Companies engaged in international trade demand foreign exchange to pay for imports and receive foreign exchange from exports.
Retail Participants:
Individual investors and traders participate through online forex trading platforms, mainly for speculative purposes.
DEMAND FOR FOREIGN EXCHANGE
Demand for foreign exchange arises when residents of a country require foreign currency. Major sources of demand include:
Imports of goods and services from other countries.
Payment for foreign education, tourism, medical treatment, and transport services.
Remittances and gifts sent abroad.
Purchase of foreign financial assets such as shares, bonds, and real estate.
Capital outflows in search of higher returns abroad.
SUPPLY OF FOREIGN EXCHANGE
Supply of foreign exchange refers to the availability of foreign currency in the domestic economy. Major sources include:
Exports of goods and services to foreign countries.
Foreign tourists spending in the domestic economy.
Remittances received from abroad.
Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI).
Foreign loans and aid.
Sale of domestic financial assets to foreign investors.
FOREIGN EXCHANGE RATE
The foreign exchange rate is the price of one currency expressed in terms of another currency. For example, the value of the Indian rupee in terms of the US dollar represents an exchange rate.
Exchange rates enable comparison of international prices and costs and play a crucial role in international trade and capital flows.
TYPES OF FOREIGN EXCHANGE MARKETS
Spot Market:
The spot market deals with immediate exchange of currencies, usually settled within two working days.
Forward Market:
In the forward market, currencies are exchanged at a future date at a rate agreed upon today. It helps in hedging exchange rate risk.
Swap Market:
A swap involves simultaneous purchase and sale of a currency for different maturities.
Futures Market:
Currency futures are standardized contracts traded on exchanges to buy or sell currencies at a future date.
Options Market:
Currency options give the holder the right, but not the obligation, to buy or sell a currency at a predetermined rate.
FEATURES OF FOREIGN EXCHANGE MARKET
It is the largest and most liquid financial market in the world.
It operates round the clock due to different time zones.
It is an over-the-counter (OTC) market, not centralized in one location.
Transactions are executed electronically using telecommunication networks.
London, New York, and Tokyo are the major trading centers.
Daily turnover runs into trillions of dollars, as reported by the Bank for International Settlements (BIS).
EVOLUTION OF FOREIGN EXCHANGE DEMAND
Initially, foreign exchange demand arose mainly from international trade transactions. Over time, financial flows such as capital movements, speculation, arbitrage, and hedging have become more dominant than trade flows.
Interest rate differentials between countries attract short-term capital flows, significantly influencing exchange rates.
EXCHANGE RATES AND GOVERNMENT POLICY
Foreign exchange markets often act as a continuous assessment of government economic policies. If investors lose confidence in a country’s economic management, they may withdraw capital, leading to currency depreciation.
This creates a policy dilemma for governments, often described as the “Impossible Trinity” or “Trilemma”.
THE IMPOSSIBLE TRINITY
A country can achieve only two of the following three objectives at the same time:
Monetary policy autonomy.
Exchange rate stability.
Free movement of capital.
Historically, different monetary systems have emphasized different combinations of these objectives.
BRETTON WOODS SYSTEM
The Bretton Woods system emphasized fixed exchange rates and domestic monetary autonomy while restricting capital mobility. Its collapse led to floating exchange rates and increased volatility in currency markets.
POST-BRETTON WOODS ERA
After the collapse of Bretton Woods, most countries adopted floating exchange rate systems. Exchange rates are now largely determined by market forces.
Governments attempt to manage volatility through:
Occasional intervention.
International coordination.
Regional monetary arrangements.
Capital controls in some cases.
GLOBAL RESPONSES TO EXCHANGE RATE VOLATILITY
United States:
Preferred ad hoc coordination such as the Plaza Accord (1985) and Louvre Accord (1987).
Europe:
Moved towards monetary integration to eliminate exchange rate risk, leading to the Euro.
Developing Countries:
Many opted for managed exchange rates, currency pegs, or dollarization.
GLOBAL GOVERNANCE OF FOREIGN EXCHANGE MARKETS
The international monetary system is governed by a mix of public and private institutions.
Banks are the dominant players and are regulated by national authorities.
Basel Committee on Banking Supervision under the BIS provides international banking standards.
Credit rating agencies influence capital flows and currency movements.
Risk management has become largely internalized within major global banks.
FOREIGN EXCHANGE CRISES
The currency crises of the 1990s in Mexico, Brazil, East Asia, and Argentina highlighted the vulnerabilities of the international monetary system.
These crises renewed discussions on reforming the global financial architecture, though progress has remained limited.
CONCLUSION
The foreign exchange market is central to the functioning of the global economy. While it provides liquidity, efficiency, and opportunities for trade and investment, it also exposes economies to volatility and speculative pressures. Managing exchange rate stability while maintaining growth and policy autonomy remains a key challenge for governments, especially in an era of globalization and high capital mobility.
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Subject: Economics
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