What are the Functions of the Foreign Exchange Market?
Posted by Ripon Abu Hasnat on Wednesday, September 3, 2014 | 0 comments
The foreign exchange market performs
the following important functions:
Transfer Function:
The basic function of the foreign
exchange market is to facilitate the conversion of one currency into another,
i.e., to accomplish transfers of purchasing power between two countries. This
transfer of purchasing power is affected through a variety of credit
instruments, such as telegraphic transfers, bank drafts and foreign bills.
In performing the transfer function,
the foreign exchange market carries out payments internationally by clearing
debts in both directions simultaneously, analogous to domestic clearings.
Credit Function:
Another function of the foreign
exchange market is to provide credit, both national and international, to
promote foreign trade. Obviously, when foreign bills of exchange are used in
international payments, a credit for about 3 months, till their maturity, is
required.
Hedging Function:
A third function of the foreign
exchange market is to hedge foreign exchange risks. In a free exchange market
when exchange rates, i.e., the price of one currency in terms of another
currency, change, there may be a gain or loss to the party concerned. Under
this condition, a person or a firm undertakes a great exchange risk if there
are huge amounts of net claims or net liabilities which are to be met in
foreign money.
Exchange risk as such should be avoided
or reduced. For this the exchange market provides facilities for hedging
anticipated or actual claims or liabilities through forward contracts in
exchange. A forward contract which is normally for three months is a contract
to buy or sell foreign exchange against another currency at some fixed date in
the future at a price agreed upon now. No money passes at the time of the
contract. But the contract makes it possible to ignore any likely changes in
exchange rate.
The existence of a forward market thus
makes it possible to hedge an exchange position.
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