What Are the Functions of Foreign Currency Exchange Markets?

What Are the Functions of Foreign Currency Exchange Markets?
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The foreign exchange market, also known as the FOREX market, is a worldwide network that connects exchanges around the globe to enable round-the-clock trading from when the markets open Monday morning in Asia -- Sunday afternoon in the United States -- until the American markets close on Friday afternoon. The FOREX market provides essential functions that facilitate the growth of world commerce.

Foreign Exchange Markets

Currencies are bought and sold with prices determined by supply and demand with occasional government intervention. Currency transfers are accomplished by checks and bank drafts, bills of exchange, and mail and wire transfers. The players in the market are banks, brokers and businesses, with some individuals trading on their own accounts. The FOREX market supports world commerce by allowing the transfer of funds from one currency to another, providing credit to businesses in the import trade and offering a hedge against possible exchange-rate fluctuations.

Transfer Function

The most visible function fulfilled by the foreign exchange market is to facilitate the conversion of one currency to another. In doing so, the foreign exchange market is the mechanism that transfers purchasing power from one country to another. When an importer in the United States imports goods manufactured in Germany, for example, the exporter wishes to be paid in euros. The conversion of U.S. dollars to euros is done through the foreign exchange market. Likewise, if an American businessman plans a trip to India, he exchanges U.S. dollars for Indian rupees through the foreign exchange market.

Credit Function

By using the FOREX market, importers can obtain credit to finance their foreign purchases. Suppose an American company wishes to purchase an inventory of Chinese-manufactured tools. The American importer can pay for the purchase by using a bill of exchange in the FOREX market -- essentially an IOU with a three-month maturity. This instrument locks in the exchange rate and allows the importer 90 days to sell his products before the note is payable.

Hedging Function

While exchange rates fluctuate, they do not ordinarily exhibit dramatic shifts, barring international crises. Nevertheless, the chance that rates may change poses a risk to traders whose business lies in buying and selling merchandise, not speculating in currency-price movements. If a business is concerned that rates may change against him before the transaction is completed, he can make an offsetting transaction in the forward exchange market and then liquidate it when his initial transaction is completed. An exchange-rate profit in one will be balanced by a loss in the other, allowing him to complete the primary transaction with no fear of losing money because of an adverse currency movement.