THE FOREIGN EXCHANGE MARKET

 THE FOREIGN EXCHANGE MARKET

• The wide-reaching collection of markets and institutions that handle the exchange of foreign currencies is known as the foreign exchange market. In this market, the participants use one currency to purchase another currency. 
• The foreign exchange market operates worldwide and is by far the largest market in the world in terms of cash value traded. Being an over-the-counter market, it is not a physical place; rather, it is an electronically linked network of big banks, dealers and foreign exchange brokers who bring buyers and sellers together. 
• With no central trading location and no set hours of trading, the foreign exchange market involves enormous volume of foreign exchange trading worldwide. The participants such as firms, households, and investors who demand and supply currencies represent themselves through their banks and key foreign exchange dealers who respond to market signals transmitted instantly across the world.
•  The foreign exchange markets operate on very narrow spreads between buying and selling prices. But since the volumes traded are very large, the traders in foreign exchange markets stand to make huge profits or losses.
• The major participants in the exchange market are central banks, commercial banks, governments, foreign exchange Dealers, multinational corporations that engage in international trade and investments, nonbank financial institutions such as asset- management firms, insurance companies, brokers, arbitrageurs and speculators.
•  The central banks participate in the foreign exchange markets, not to make profit, but essentially to contain the volatility of exchange rate to avoid sudden and large appreciation or depreciation of domestic currency and to maintain stability in exchange rate in keeping with the requirements of national economy. If the domestic currency fluctuates excessively, it causes panic and uncertainty in the business world. Commercial banks participate in the foreign exchange market either on their own account or for their clients. 
• When they trade on their own account, banks may operate either as speculators or arbitrageurs/or both. The bulk of currency transactions occur in the interbank market in which the banks trade with each other. Foreign exchange brokers participate in the market as intermediaries between different dealers or banks. Arbitrageurs profit by discovering price differences between pairs of currencies with different dealers or banks.
•  Speculators, who are bulls or bears, are deliberate risk-takers who participate in the market to make gains which result from unanticipated changes in exchange rates. Other participants in the exchange market are individuals who form only a very insignificant fraction in terms of volume and value of transactions.
• Regardless of physical location, and given that the markets are highly integrated, at any given moment, all markets tend to have the same exchange rate for a given currency. This phenomenon occurs because of arbitrage. Arbitrage refers to the practice of making risk-less profits by intelligently exploiting price differences of an asset at different dealing locations. 
• There is potential for arbitrage in the forex market if exchange rates are not consistent between currencies. When price differences occur in different markets, participants purchase foreign exchange in a low-priced market for resale in a high-priced market and makes profit in this process. Due to the operation of price mechanism, the price is driven up in the low- priced market and pushed down in the high-priced market. 
• This activity will continue until the prices in the two markets are equalized, or until they differ only by the amount of transaction costs involved in the operation. Since forex markets are efficient, any profit spread on a given currency is quickly arbitraged away. 

In the foreign exchange market, there are two types of transactions:
(i) current transactions which are carried out in the spot market and the exchange involves immediate delivery, and

(ii) contracts to buy or sell currencies for future delivery which are carried out in forward and/or futures markets

Exchange rates prevailing for spot trading (for which settlement by and large takes two days) are called spot exchange rates. The exchange rates quoted in foreign exchange transactions that specify a future date are called forward exchange rates. The currency forward contracts are quoted just like spot rate; however, the actual delivery of currencies takes place at the specified time in future. When a party agrees to sell euro for dollars on a future date at a forward rate agreed upon, he has ‘sold euros forward’ and ‘bought dollars forward’. A forward premium is said to occur when the forward exchange rate is more than a spot trade rates. On the contrary, if the forward trade is quoted at a lower rate than the spot trade, then there is a forward discount. Currency futures, though conceptually similar to currency forward and perform the same function, they are distinct in their nature and details concerning settlement and delivery.

While a foreign exchange transaction can involve any two currencies, most transactions involve exchanges of foreign currencies for the U.S. dollars even when it is not the national currency of either the importer or the exporter. On account of its critical role in the forex markets, the dollar is often called a ‘vehicle currency’.