Foreign Exchange Market: Its Meaning, Features, Participants & More

Key Highlights

• The Foreign Exchange Market (Forex) is a global marketplace for trading currencies.
  

• Forex operates 24/7 across major financial centres worldwide, with electronic trading.
  

• The market's value is determined by supply and demand, influenced by economic data and geopolitical events. Functions of Forex include currency conversion, credit provision, and hedging against exchange rate risks.
  

• The market offers high liquidity and openness and operates continuously.
  

Meaning of Foreign Exchange Market

The global over-the-counter (OTC) foreign exchange market is where the exchange rates for different currencies are decided. Commonly known as the currency market or forex, this market comprises a wide range of participants – banks, forex dealers, commercial businesses, central banks, investment management companies, hedge funds, retail forex dealers, and investors.

How Does the Foreign Exchange Market Work?

The conversion of one currency to another is made possible by the foreign exchange market. In order to promote international trade and investment and to speculate on changes in currency prices, market participants buy and sell currencies. The forces of supply and demand in the market influence the exchange rate, which is the value of one currency in relation to another.

Numerous variables, such as economic statistics, geopolitical developments, and central bank policies, have an impact on currency prices. The forex market is open 24 hours a day, 5 days a week, in all major financial centres across the world. Transactions can be made over the counter or through electronic trading platforms.

History of the Indian Foreign Exchange Market

The Indian foreign exchange market has come a long way from its strictly regulated beginnings. Until 1978, currency transactions were governed by the Foreign Exchange Regulation Act (FERA), and the Reserve Bank of India (RBI) controlled the rupee’s exchange rate, which was pegged to a basket of key trading partner currencies. A turning point came in 1978 when banks were allowed to trade foreign exchange during the day, marking the start of a more structured market.

The 1990s brought about major reforms in line with India’s broader economic liberalisation. In 1991, the rupee was devalued and by 1993, a market-determined exchange rate was introduced under the Liberalised Exchange Rate Management System (LERMS). With this, India achieved current account convertibility by 1994. Based on the recommendations of the O.P. Sodhani Committee in 1995, more reforms were implemented to increase transparency, introduce new instruments and allow broader participation.

Since then, the market has greatly matured, with increasing trading volumes, better risk management tools and wider integration with global financial systems. Though Mumbai remains the core of forex activity, cities like Delhi, Chennai and Kolkata have also emerged as active centres. The RBI continues to play a supervisory role, ensuring orderly functioning and stability even during global shocks.

Different Types of Foreign Exchange Markets

The three primary categories of foreign exchange markets are:

1. Spot Forex Market Where currencies are traded for rapid delivery is the on-the-spot forex market. This indicates that currency conversion happens at the current market rate, which is governed by forces of supply and demand. The spot FX market, which trades continuously across the world's major financial hubs, is the most liquid and actively traded there is.

2. Forward Forex Market Contracts used to buy or sell currencies at a future date at a fixed exchange rate are traded on the forward foreign exchange market. This offers security against currency swings by enabling participants to lock in a future exchange rate. Although it is not as active as the spot market in terms of trading, the forward foreign exchange market is utilised for hedging.

3. Futures Forex Market The futures FX market is a centralised marketplace where standard contracts for the future delivery of a specific currency at a set price are transacted. Futures contracts are exchanged on regulated exchanges and utilised for speculative and hedging reasons. Less liquid than the spot market, the FX futures market necessitates margin posting from players.

Functions of the Foreign Exchange Market

The functions of the foreign exchange market are as follows:

Transfer Function: Moving money or foreign currencies from one nation to another in order to settle accounts is the fundamental and most obvious function of the foreign exchange market. In essence, the market transforms one currency into another.

Credit Function: In order to support the efficient movement of products and services from diverse countries, forex offers short-term loans to importers. The importer may fund international imports with his credit.

Hedging Function: A foreign currency market's third function is to hedge against foreign exchange risks. The price of one currency relative to another currency, or the variations in exchange rates, are frequently feared by the parties involved in foreign exchange.

Features of the Foreign Exchange Market

It is necessary to identify the unique qualities that this type of exchange market possesses. The following are some characteristics of the foreign exchange market:

High Liquidity: The world's most liquefiable financial market is the foreign currency market. This entails the global trade of different currencies. In this market, traders are allowed to buy or sell currencies whenever they see fit.

Marketplace Openness: In this market, there is a lot of certainty. The foreign exchange market's traders have complete access to all market data and information. This enables real-time portfolio management and allows for better decision making.

Changing Market: The market structure of the foreign currency market is dynamic. Currency exchange rates fluctuate in various marketplaces every second and hour.

Open 24 hours a day: The foreign currency markets are open 24 hours a day. This gives the traders the flexibility to trade whenever they choose.

Who are the Participants in a Foreign Exchange Market?

The foreign currency market has a diverse spectrum of participants, including:

Commercial banks: Banks are the most active participants in the foreign exchange market, trading for their accounts as well as those of their clients.

Central banks: Central banks engage in market activity to control their nation's monetary policy and maintain stable exchange rates.

Hedge funds and investment firms: These businesses engage in forex trading to make profits for their clients.

Corporations: Multinational firms manage their currency risk on the forex market, especially while engaging in international trade.

Retail traders: Individual traders who want to make money from changes in currency prices can participate in the forex market through online brokers.

Governments: Governments participate in the forex market to control the value of their national currencies and ensure the stability of their economies.

What Factors Influence the Foreign Exchange Market?

Interest rates: Central banks adjust interest rates to control inflation and economic growth. Higher interest rates often attract foreign capital, thus increasing demand for the local currency.

Inflation rates: A country with consistently low inflation generally sees a rising currency value because its purchasing power increases relative to other currencies.

Economic indicators: Data like GDP growth, unemployment rates, industrial production and retail sales impact investor sentiment and currency strength.

Political stability and performance: Stable governments and sound economic policies attract foreign investment, thus strengthening the local currency. Political uncertainty, in contrast, can weaken it.

Balance of trade: A trade surplus increases demand for a country’s currency, while a trade deficit can reduce it.

Foreign investment flows: Higher levels of foreign direct investment (FDI) or foreign portfolio investment (FPI) in a country tend to boost its currency.

Speculation and market sentiment: Traders’ expectations and market psychology also influence short-term currency movements. If a currency is expected to rise, demand for it may increase in advance.

Central bank interventions: Central banks can buy or sell their own currencies in the market to influence exchange rates, mainly to control volatility or support economic goals.

Geopolitical events: Wars, sanctions and diplomatic tensions can cause sudden shifts in exchange rates due to risk aversion and capital flight.

Advantages & Disadvantages of Foreign Exchange Markets

The foreign currency market includes a number of benefits and drawbacks. Having a thorough understanding of these might assist traders in making decisions about their involvement in the market.

Conclusion

The foreign exchange market is a global over-the-counter platform where international currencies are actively bought and sold, and exchange rates are determined. It plays a crucial role in enabling international trade, investment and financial connectivity. A wide range of participants like banks, forex dealers, commercial enterprises, central banks, investment firms, hedge funds, and retail investors, engage in trading currency pairs. As one of the largest and most liquid financial markets in the world, the forex market continues to evolve with changing global dynamics, offering both opportunities and challenges to participants.