Foreign Exchange Market Meaning Participants Types Graph

Foreign Exchange Market Meaning

It comprises many markets, and they trade between individual currencies to provide international liquidity. Large commercial banks in financial centers deal in foreign-currency-denominated deposits with one another in the foreign exchange market. The value of the base currency is determined by comparing it to the other currency through its purchase and sales.

Key Takeaways

The foreign exchange market or Forex market is the platform where different currencies are traded. It is an over-the-counter (OTC) market with no central marketplace to facilitate trading, transaction ease, and standardization during exchange of currencies.Different countries’ currencies are traded in pairs in exchange for each other. As a result, the value of one of the currencies will differ from the other. Different types of Forex markets, such as the spot market, swap market, forward market, options market, futures market, and participants, make up the foreign exchange market structure.

Foreign Exchange Market Explained

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The Foreign Exchange Market is the world’s largest and most liquid currency exchange market. It is open to any entity or country regarding the total cash value transacted. Since there is no central currency, it is an OTC exchange market. Foreign exchange, or foreign currency exchange, is an important aspect for any company and people functioning in an international context. It facilitates the exchange of foreign currency into domestic currency and vice versa.

Countries must convert foreign currency into domestic currency for utilization in the home country. A nation should deal with all foreign entities on a one-to-one basis, meaning that all imports from a foreign country needs payment in its currency, and all exports needs payment in the other currency. However, it is not practically possible because it requires keeping track of many currency rates and the accompanying payment issues. As a result, most countries select a common currency for trading among themselves.

How Foreign Exchange Market works?

One compares a country’s currency with its common currency for international transactions. Trades would take place in this currency, which is the economically dominant currency. As a result, a country must trade in U.S. dollars or other major currencies such as the Euro, Pound, or Japanese yen. A balance of payment account helps to keep track of a country’s external trade. This account is credited with foreign currency receipts while debited with foreign currency payments. Other factors being constant, a country with a deficit balance of payments will have a weak national currencyNational CurrencyA national currency (NC) is any form of money used by the people of a nation as a medium of exchange to engage in economic transactions.read more, and vice versa. Therefore, the demand for foreign currency increases when the country’s balance of payment account is in deficit. As a result, their value relative to the home currency rises.

One trades the currencies of different countries in pairs in exchange for each other. As a result, one of the currencies will have a different value than the other. This decides how much currency a country can purchase from another country and vice versa based on supply and demand. The currency market’sCurrency Market’sFor those wishing to invest in currencies, the currency market is a one-stop solution. In the currency market different currencies are bought and sold by participants operating in various jurisdictions across the world. It is important in international trade and is also known as Forex or Foreign Exchange.read more primary job is to establish this price relationship worldwide. This improves liquidity in all other financial marketsFinancial MarketsThe term “financial market” refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more, critical for overall stability.

Types of Forex Market

The foreign exchange market features different modes of trading, and they are embodied as follows:

#1 – Spot Market

Transactions demand quick payments at the prevailing exchange rates. It requires immediate currency delivery or exchange on the spot- often within 48 hours. Spot transactions are those in which currency exchange occurs two days following the contract date. The spot rateSpot RateSpot Rate’ is the cash rate at which an immediate transaction and/or settlement takes place between the buyer and seller parties. This rate can be considered for any and all types of products prevalent in the market ranging from consumer products to real estate to capital markets. It gives the immediate value of the product being transacted.read more is the effective exchange rate for a spot transaction, and the spot market is the market for such transactions. When an increase or decrease in the commodity’s price occurs between the actual agreements and traded time, traders face uncertainty. Spot market traders are less prone to such uncertainties in the market.

#2 – Forward Market

The forward marketForward MarketForward Market refers to a market that deals in over the counter derivative instruments and thereby agree to take delivery on a set price and time in the future. In addition, the contract can be customized with regard to the rate, quantity, and also with regard to the date.read more involves transactions in which exchange takes place at a specified date in the future for a specific price. In other words, the forward currency market entails making a contract today to purchase or sell foreign currency in the future. Forward ratesForward RatesThe forward rate refers to the expected yield or interest rate on a future bond or Forex investment or even loans/debts.read more are similar to spot rates, except the delivery takes place much later. However, there may be differences between the spot and forward rates. The difference is the forwarding margin or swap points. In addition, traders can customize the period of delivery at their will. This exchange helps exporters and importers avoid the challenges of rate fluctuations by using relevant forward exchange contracts.

#3 – Future Market

A futures contract is another version of a forward contract traded publicly on a futures exchange. It includes the price and the time in the future to buy or sell an asset, just like a forward contract. Unlike a forward contract, a futures contract has a fixed contract size and maturity date. Futures can only be exchanged on an organized exchange and they undergo competitive trading. A forward contract does not require margins, unlike all players in the futures market. Furthermore, traders must pay an initial marginInitial MarginInitial margin refers to the equity to be contributed by the investor trading on margin to the margin account, and it is expressed as a percentage of the total purchase price. read more into a collateral account to create a future position.

#4 – Swap Market

Swaps allow the exchange of two streams of cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more in two different currencies. Swaps, or double transactions, are operations in which a purchase or sale of the same currency for forwarding delivery follows a simultaneous sale or purchase of spot currency. The spot currency is swapped against the forward currency. Commercial banksCommercial BanksA commercial bank refers to a financial institution that provides various financial solutions to the individual customers or small business clients. It facilitates bank deposits, locker service, loans, checking accounts, and different financial products like savings accounts, bank overdrafts, and certificates of deposits.read more that engage in forwarding exchange activity may use a swap operation to alter their fund position.

#5 – Options Market

Options are derivative instruments that allow a foreign exchange market operator to buy or sell a foreign currency at a predetermined rate (strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more) on or before a specific date (maturity date). A call optionCall OptionA call option is a financial contract that permits but does not obligate a buyer to purchase an underlying asset at a predetermined (strike) price within a specific period (expiration).read more allows traders to buy the underlying asset, whereas a put option allows them to sell it. Exercising the option means purchasing or selling the underlying asset through the option. In the options market, exercising the option is not an obligation for traders.

Foreign Exchange Market Graph

To demonstrate the working of a foreign exchange market, let us take an example of two currencies: U.S. dollars and the Chinese Yuan. When the market traders exchange dollars for the Chinese Yuan, the demand for Yuan goes up, and the supply of dollars also goes up. The supply of dollars increases as there has to be an equal number of value-denominated dollars to buy Yuan from the market. The demand and supply factors work simultaneously. When people give more and more dollars to buy Yuan, the value of dollars depreciates. The Yuan’s value appreciates as there is an existing demand for that currency. When a country’s currency appreciatesCurrency AppreciatesCurrency appreciation is a rise in the value of a national currency over the importance of international currencies due to an increase in the demand for domestic currency in a global market, a rise in inflation and interest rates, and flexibility of fiscal policy or government borrowing.read more, its imports become cheaper. When the currency depreciatesCurrency DepreciatesCurrency depreciation is the fall in a country’s currency exchange value compared to other currencies in a floating rate system based on trade imports and exports. For example, an increase in demand for foreign products results in more imports, resulting in foreign currency investing, resulting in domestic currency depreciation.read more, imports become expensive. The country now has to pay domestic currency value equal to the other currency to pay for their goods.

The graph shows that the point where the price of Yuan and the supply of dollars meet is the point of equilibrium (of price and quantity). It is otherwise known as the foreign exchange rate.

Participants in Forex Market

The foreign exchange market structure constitutes various participants, and a few of them are:

#1 – International Companies

International business enhances the flow of cash across markets. For example, suppose a U.S.-based company sells tools in the United Kingdom. The trade will involve the conversion of pounds into dollars for repatriation. This makes them participants in the foreign exchange market.

#2 – Traders

Individuals who trade their own money for profit are called traders. Retail traders account for a sizable and rapidly expanding sector of the market. These retail dealers serve customers seeking to buy or sell foreign currency for educational, travel, or tourism purposes.

#3 – Central Banks

From the foreign exchange market history days, these institutions have been participants in the forex market. They control the money supply in their country, interest rates, and inflation to stabilize their economy (examples: the U.S. Central Bank – U.S. Federal Reserve (Fed) and European Central Bank (ECB)). Interventions from them reduce the fluctuation of the domestic currency and ensure the exchange rate is following the requirements of their economy. For example, if the euro shows signs of depreciation, the central bank may decide to sell a certain amount of its foreign currency holdings. The increased supply of foreign currency will reduce the demand and help pause the declining trend of the euro.