The Foreign Exchange Market – A Quick Guide

Cross boarder exchanges are becoming more and more seamless due to new technology and fintech businesses. Today we thought we would deep dive into foreign exchange, the basics, the market and the key players.

So what is Foreign Exchange?

Foreign exchange market is the market in which foreign currencies are bought and sold. The buyers and sellers include individuals, firms, foreign exchange brokers, commercial banks and the central bank.

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.

Nature of Foreign Exchange Market

The foreign exchange market is the place where money denominated in one currency is bought and sold with money denominated in another currency. It provides the physical and institutional structure through which the currency of one country is exchanged for that of another country, the rate of exchange between currencies is determined, and foreign exchange transactions are physically completed.

The primary purpose of this market is to permit transfer of purchasing power denominated in one currency to another. For example, a Japanese exporter sells automobiles to a U.S. dealer for dollars, and a U.S. manufacturer sells instruments to a Japanese Company for yen. The U.S. Company will like to receive payment in dollar, while the Japanese exporter will want yen.

The Foreign Exchange Players

Participants in Foreign exchange market can be categorised into five major groups; commercial banks, Foreign exchange brokers, Central bank, MNCs and Individuals and Small businesses.

1. Commercial Banks

The major participants in the foreign exchange market are the large Commercial banks who provide the core of market. As many as 100 to 200 banks across the globe actively “make the market” in the foreign exchange. These banks serve their retail clients, the bank customers, in conducting foreign commerce or making international investment in financial assets that require foreign exchange.

These banks operate in the foreign exchange market at two levels. At the retail level, they deal with their customers-corporations, exporters and so forth. At the wholesale level, banks maintain an inert bank market in foreign exchange either directly or through specialised foreign exchange brokers.

The bulk of activity in the foreign exchange market is conducted in an inter-bank wholesale market-a network of large international banks and brokers. Whenever a bank buys a currency in the foreign currency market, it is simultaneously selling another currency.

2. Foreign Exchange Brokers

Foreign exchange brokers act as agents who facilitate trading between dealers. Unlike the banks, brokers serve merely as matchmakers and do not put their own money at risk.

They actively and constantly monitor exchange rates offered by the major international banks through computerised systems and are able to find quickly an opposite party for a client without revealing the identity of either party until a transaction has been agreed upon. This is why inter-bank traders use a broker primarily to disseminate as quickly as possible a currency quote to many other dealers.

3. Central banks

Another important player in the foreign market is Central bank of the various countries. Central banks frequently intervene in the market to maintain the exchange rates of their currencies within a desired range and to smooth fluctuations within that range. The level of the bank’s intervention will depend upon the exchange rate regime flowed by the given country’s Central bank.

4. MNCs

MNCs are the major non-bank participants in the market as they exchange cash flows associated with their multinational operations. MNCs often contract to either pay or receive fixed amounts in foreign currencies at future dates, so they are exposed to foreign currency risk.

5. Individuals and Small Businesses

Individuals and small businesses also use foreign exchange market to facilitate execution of commercial or investment transactions. The foreign needs of these players are usually small and account for only a fraction of all foreign exchange transactions. Even then they are very important participants in the market.

 

Originally published at Your Article Library, Foreign Exchange Market: Meaning, Functions and Kinds & Foreign Exchange Market: Nature, Participants and Segments.

 

More brain food: