Definition of foreign exchange market
Foreign exchange is the system or process of converting one national currency into another, and of transferring money from one country to another. The term foreign exchange is also used to refer to foreign currencies. That is,
foreign exchange is the foreign currency and includes all deposits, credits and balance payable in any foreign currency and any drafts, traveler’s deposits, letters of credits and bill of exchange, expressed or drawn in domestic
currency, but payable in any foreign currency.
Functions of foreign exchange market
The foreign exchange market is a market in which foreign exchange transactions take place. In other words, it is a market in which national currencies are bought and sold against one another.
A foreign exchange market performs three important functions:-
i. Transferring of purchasing power – The primary function of a foreign exchange market is the transfer of purchasing power from one country to another and from one currency to another. The international clearing function performed by foreign exchange markets plays a very important role in facilitating international trade and capital market.
ii. Provision of credit – International trade depends to a great extent on credit facilities. Exporters may get pre-shipment and post-shipment credit. Credit facilities are available also for exporters. The Euro-dollar Market has emerged as a major international credit market.
iii. Provision of hedging facilities – Foreign exchange market provide hedging facilities. Hedging refers to covering of export risks, and it provides a mechanism to exporters and importers to protect themselves against losses
from fluctuation in exchange rates.
Determinants of demand and supply of foreign currency
The demand for foreign currency is fixed by the supply and demand curve (just like any other commodity in an open market). The demand for foreign currency arises from the traders who have to make up payments for imported
goods i.e. demand for a currency in the foreign exchange market is a derived demand. The supply arises from those who have exported goods and services abroad. This depends largely on how much foreigners are willing to buy goods
and services from a particular country.
Foreign exchange is demanded
i. to buy things denominated in it (goods, services, or assets)
ii. to hold interest-bearing accounts in that currency
iii. greater quantity demanded at lower price/exchange rate
Non-price Determinants of Demand.
i. increased (decreased) demand for foreign goods and services
increased (decreased) domestic income
lower (higher) relative price levels for goods and services denominated in currency
ii. Increased (decreased) relative return on assets denominated in foreign currency
Supply of foreign exchange: wanting to sell a currency greater quantity supplied at higher price/exchange rate
People wanting to sell more (less) of a currency at any given exchange rate is an increase (decrease) in supply
i. change in foreign income
ii. change in relative price levels
iii. change in relative rate of return on domestic assets
7.3. Exchange rate
Exchange rate: – this is simply the price of one currency in terms of another.
There are two methods of expressing exchange rate:-
Foreign exchange units per unit of the domestic currency. For example, taking the Kenya shilling as the domestic currency, we can have approximately Kshs. 85.6 required to purchase one US dollar (Kshs.
Foreign units per unit of domestic currency. Again taking Kenya Shillings as a domestic currency, we can have approximately $0.01162/Kshs.1 required to obtain one pound.