An exchange market is literally a place where money is traded and the exchange rate is determined for different currencies in the world. The main function of the foreign exchange market is to determine the prices at which goods and services of one country should be sold to another country. It is an open market that offers this and other information such as financing inventory in transit and hedging functions; round the clock to traders dealing in exports and imports of merchandise across countries (Hisrich, 2009).
Like any other market, the foreign exchange market has buyers and sellers, except that the role they play is not directly involved in the exchange of goods and services. Participants in the market have interests they want out the daily activities of the currency market. They range from individual traders to large corporations that can be classified as “speculators” or “hedgers” (Weithers, 2011). According to the author, participants in the FX market include investment banks which are large corporations; institutional investors such as those in mutual and pension funds, commercial banks, supranational and high net worth individuals. Central banks and governments are included in the class of institutional investors Bradstreet and Dun (2007) classify the participants into five categories as non-bank categories, banks that assist their clients to do foreign transactions, speculators that make a profit by buying exchange foreign currencies at lower rates and selling it at higher rates, arbitragers, although these are illegal and unlikely in developed markets where governments intervene through central banks (pg.9).
Transactions that are carried in the foreign exchange market are classified into four types of contracts, viz. spot contract, forward currency contracts, limit order, and time-option forward contracts. Bradstreet and Dun (2007) classify them into spot, forward, and swaps. These types arise due to the carrying time taken and the date when the transactions are carried out and settled. A spot contract is characterized by a short period of two business days after the day the spot transaction was concluded. A forward contract is done when an agreed maturity date and on the rate in the future when the deal would be settled, depending on the agreement between the buyer and seller. Swaps occur when buyers borrow currency to purchase domestic currency on the spot to hedge out risk or in case the currency is cheap. It can also be done by the domestic company selling currency to another foreign company on an agreement the company would also sell its domestic currency in the future (Quirk, 1988).
The rate at which a currency exchanges with another is the equilibrium of demand and supply of both currencies in the market. These forces are influenced by income levels, government regulations, relative inflation levels, and interest rates. High inflation in one country makes its products expensive and hence less demand for its currency and vice versa. High-interest rates on the other hand attract foreign currency through investors hence increasing demand (Madura, 2010).
Foreign exchange risk is related to variations in assets and liabilities, incomes due to unexpected changes in foreign exchange rates. Exposure varies from the amount of these risk factors such as political instabilities and agreements such as swaps that may not be binding. Risks such as high inflation, currency devaluation, varying interest rates, can be hedged out using futures and options.
The foreign exchange market is sensitive to a number of factors yet a useful component that determines rates at which currencies trade. Rate is sensitive to the relative economic performance of countries and given that they are varying forces, the market faces a number of risks that need to be managed. It is essential to understand these risks and foreign exchange determination, especially by international traders and investors.
List of references
Dun and Bradstreet, 2007. Foreign Exchange Market: New Delhi: Tata McGraw-Hill Education.
Hisrich, R. D., 2006. International entrepreneurship: starting, developing and managing a global venture, London: SAGE Publications.
Madura, J., 2010. International financial management. Abridged Edition. New York: Cengage Learning.
Quirk, P. J., 1988. Policies for developing forward foreign exchange markets. International Monetary Fund: Washington DC.
Weithers, T., 2011. Foreign Exchange: A practical guide to the FX Markets. New York: John Wiley and Sons.