DEFINITION of 'Foreign Exchange Market'

DEFINITION of 'Foreign Exchange Market'
The market in which participants are able to buy, sell, exchange and speculate on currencies. Foreign exchange markets are made up of banks, commercial companies, central banks, investment management firms, hedge funds, and retail forex brokers and investors. The forex market is considered to be the largest financial market in the world.


The foreign exchange market assists international trade and investments by enabling currency conversion. For example, it permits a business in the United States to import goods from the European Union member states, especially Eurozone members, and pay Euros, even though its income is in United States dollars. It also supports direct speculation and evaluation relative to the value of currencies, and the carry trade, speculation based on the interest rate differential between two currencies.[3]
In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying for some quantity of another currency. The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.
The foreign exchange market is unique because of the following characteristics:
its huge trading volume representing the largest asset class in the world leading to high liquidity;
its geographical dispersion;
its continuous operation: 24 hours a day except weekends, i.e., trading from 22:00 GMT on Sunday (Sydney) until 22:00 GMT Friday (New York);
the variety of factors that affect exchange rates;
the low margins of relative profit compared with other markets of fixed income; and
the use of leverage to enhance profit and loss margins and with respect to account size.Advantages
The forex market is extremely liquid, hence its rapidly growing popularity. Currencies may be converted when bought or sold without causing too much movement in the price and keeping losses to a minimum.

As there is no central bank, trading can take place anywhere in the world and operates on a 24-hour basis apart from weekends.

An investor needs only small amounts of capital compared with other investments. Forex trading is outstanding in this regard.

It is an unregulated market, meaning that there is no trade commission overseeing transactions and there are no restrictions on trade.

In common with futures, forex is traded using a “good faith deposit” rather than a loan. The interest rate spread is an attractive advantage.

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Disadvantages
The major risk is that one counterparty fails to deliver the currency involved in a very large transaction. In theory at least, such a failure could bring ruin to the forex market as a whole.

Investors need a lot of capital to make good profits because the profit margins on small-scale trades are very low.Functions of the Foreign Exchange Market:

The foreign exchange market performs the following important functions:

(i) to effect transfer of purchasing power between countries- transfer function;

(ii) to provide credit for foreign trade - credit function; and

(iii) to furnish facilities for hedging foreign exchange risks - hedging function.Like any other market, foreign exchange market is a system, not a place. The transactions in this market are not confined to only one or few foreign currencies. In fact, there are a large number of foreign currencies which are traded, converted and exchanged in the foreign exchange market.

Functions of Foreign Exchange Market:

Foreign exchange market performs the following three functions:

1. Transfer Function:

It transfers purchasing power between the countries involved in the transaction. This function is performed through credit instruments like bills of foreign exchange, bank drafts and telephonic transfers.

2. Credit Function:

It provides credit for foreign trade. Bills of exchange, with maturity period of three months, are generally used for international payments. Credit is required for this period in order to enable the importer to take possession of goods, sell them and obtain money to pay off the bill.

3. Hedging Function:

When exporters and importers enter into an agreement to sell and buy goods on some future date at the current prices and exchange rate, it is called hedging. The purpose of hedging is to avoid losses that might be caused due to exchange rate variations in the future.

Kinds of Foreign Exchange Markets:

Foreign exchange