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THE SPOT MARKET FOR FOREIGN EXCHANGE AND FUNCTIONS OF FOREIGN EXCHANGE MARKET

Updated on March 8, 2011

Exchange of currencies applies whenever people or firms in different countries buy goods and services from and sell to each other. It is in the foreign exchange market that national currencies are bought and sold against one another. The foreign exchange market for any currency is made up of all the locations where the currency is sold and bought for other currencies. The primary purpose of the foreign exchange is to assist international trade and investment, by allowing businesses to convert one currency to another currency. For example, it permits a US business to import British goods and pay pound sterling even though the business's income is in US dollars. The different locations of monetary centers, such as London, Frankfurt, Singapore, Tokyo and New York are connected by computer and telephone networks and video screens, which are in constant contact with one another, thus forming a single international foreign exchange market. This is also called the spot market for foreign exchange. It is a market for immediate delivery of foreign exchange normally between two to three days interbank transaction. It involves approximately US$ 1.4 to 1.7 trillion in daily global transaction. The Wall Street Journal currency trading table provides spot and forward rates. Forward rates are for forward contracts, or the future delivery of a currency.

Market quotation of currency is of two kinds. We have the direct or price quotation and the indirect or volume quotation. Direct quotation of exchange rate is the foreign currency per unit of the domestic currency and the indirect quotation is foreign currency price of the local currency. If for example the local currency is the Canadian dollar (C$), then for Direct Exchange rate: 1 US$ = 0.6770 C$ (assumed). Indirect Exchange rate is 1C$ = US$ 1.4771.

IMPORTANT FUNCTIONS PERFORMED BY THE FOREIGN EXCHANGE MARKET

1. The foreign exchange market provides the platform for one currency to be exchanged for another. In other words purchasing power is transferred from one currency to another and from one country to another. For example the US dollar may be converted into Australian dollar or the Euro. The exchange rate which may be flexible or fixed, determines the extent of conversion. A flexible exchange rate regime allows the exchange rate to be determined solely by the forces of demand and supply. Fixed exchange rate is determined by the monetary authority or the central bank of a country. It is fixed.

2. The foreign exchange market also provides facilities for hedging against foreign exchange risk. Due to instability of exchange rates in the foreign exchange market, multinational corporations are prone to suffering losses, should there be wide fluctuations away from the expected. To curtail losses such companies usually make use of forward rates for transactions, based on agreement between the parties involved. Forward rates are exchange rates agreed on by two parties to exchange currency and transact business on a date in the future specified by the two parties. This enables businesses reduce the risk, such instability in exchange rates may have on a company’s profit.

3. Investors may take some reasonable level of risk in predicting the future movement of foreign exchange rate by betting on it. By buying currency and selling it at prices higher than the cost of purchasing the currency, the investor makes profit. The platform for this trade is offered by the foreign currency exchange market.

4. The foreign exchange market facilitates international transaction of goods and services and the buying and selling of bonds.

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