A foreign exchange market is a platform in which different national currencies from different countries are traded or exchanged. The platform provides a means by which both individuals and firms can transfer the purchasing power from one country to another, gain or provide credit in order to facilitate international trade transactions as well as shield themselves to the risks associated with foreign exchange volatility (Eun & Resnick, 2008). In a relatively more general term, the foreign exchange market is a market necessitated by the existence of different national currencies in use by different economies for the sole purpose of necessitating purchase and sale transactions of these currencies.
Just like in transactions involving two or more commodities, foreign currency transactions require an agreement between two parties where one party commits to give or deliver to the other an amount of one currency at a specified rate of some other currency. Basically, foreign exchange markets operate in two levels: the retail or the client market and the wholesale or interbank market. Participants in foreign exchange markets include individuals such as dealers, individual importers and buyers, firms, such as banks and other multinationals, and even larger institutions such as central banks of various countries and global institutions (Eun & Resnick, 2008).
Whether the involved participants are individual persons, firms, or large institutions, and whether the participants chose to participate in the retail or wholesale market one particular attribute remains in that they are all involved in some form of transactions in the foreign exchange they hold. However, not all foreign exchange transactions are similar. Foreign exchange transactions are classified into three categories namely; forward, spot, and swap transactions depending on the manner of their execution. Of the three types of transactions, spot transactions are the most popular and most important commonly seen in the interbank market and forming nearly half of the transactions in the foreign exchange markets. Just like the name suggests, spot transactions require that the delivery of foreign exchange be made almost immediately after the agreement to transact is made (Eun & Resnick, 2008). For instance, an agreement can be made between two banks to transact foreign exchange and that delivery be made within a span of 24 hours after the agreement is reached. The date in which the agreement is settled in this case not a day after the lapse of 24 hours is the value date.
In contrast to span transactions, forward transactions do not require an immediate delivery but instead require the settlement of the agreement be made at a future value date. In such a case, the exchange rate is determined at the time the agreement was made rather than the future date when the agreement is settled. Forward transactions are meant to caution participants against exchange rate volatility. For example, a buyer importing goods from a foreign country may agree to pay the seller a particular amount of one currency depending on the prevailing exchange rates but at a later date regardless of the exchange rates then when the goods are shipped and delivered. Swap transactions involves simultaneous purchase and sale of foreign exchange for two different value dates.
In conclusion and from the above explanations, foreign exchange markets serve three core functions. The first core function of the foreign exchange markets is the transfer of purchasing power. This is a very vital function especially with regard to international transactions where usually the involved parties are from different countries using different national currencies and where either of the parties would prefer to transact in their respective countries. Through the platform offered by the market it is possible to know exactly how much of one currency is acceptable in exchange for another. The other key functions are namely provision of credit and insurance against foreign exchange risks through hedging.
References
Eun, C. S. and Resnick B. G. (2008). International Financial Management, 5th ed. New York: McGraw-Hill Irwin