Functions of the Foreign Exchange Market

The Foreign exchange market have 2 main functions:

  • Currency Conversion
  • Insurance against Foreign Exchange Risk

Currency Conversion

Every country has a currency in which goods and services are priced. There are many reasons why you may want to convert from one currency to another.

  • Tourists in a foreign country will need the foreign country’s currency if they want to buy goods and services there. In the borders of a country, one must use the national currency of that country
  • Businesses receiving income from foreign countries (for example for exports), will need to convert it into their home country’s currency before they can use it in their home country.
  • Businesses may also need to convert currency to pay businesses in foreign countries for their goods and services (For examples imports)
  • Foreign investments. If you have spare cash, you may want to invest it in a currency of another country where the interest rates are much higher. Just remember that the return will not only be determined by the interest rate, but also by the exchange rate.
  • Currency speculation involves short term movements of funds from one currency to another in the hope to profit from the transaction. For example, if you expect the Rand to lose value against the Dollar in the near future, you can buy Dollars and wait for the Rand to fall. When it does, you buy back Rands while it is undervalued. Currency speculation is very risky. There is no way to know for sure what exchange rates will be.

Insurance against Foreign Exchange Risk

The Foreign Exchange market provide insurance against adverse effects caused by unpredictable exchange rates (Foreign Exchange Risk). To explain how this works, we must distinguish between Spot Exchange rates, Forward Exchange rates and Currency Swaps.

Spot Exchange Rate

When two parties agree to exchange currency and execute the transaction immediately using the agreed exchange rate, we refer to it as a spot exchange.  The Spot exchange rate is the rate at which the foreign exchange dealer converts from one currency to the other.   Spot exchange rates are published daily in newspapers, but it  change continuously. 

The value of a currency is determined by supply and demand relative to other currencies.  For example if people want Dollars rather than Rands and Dollars are in short supply, they will pay more Rands for each Dollar.  Likewise, if the South African Reserve bank starts to print to much money, the value of the Rand will simply drop against most other currencies because of over-supply and you will just pay so much more to convert from Rand to another Currency.

Forward Exchange Rates

It is very difficult for companies to do business across borders using spot exchange rates. You can imagine the impact it can have on your business if you ordered something from a US company and your currency depreciates significantly against the Dollar between the time you placed the order and the time you pay for it. The dollar price will remain the same, but you will need to convert more Rands at a higher Rand/Dollar exchange rate. A transaction that was meant to be profitable, may now make a loss, because you paid more Rands for the products than what you can sell it for in South Africa.

A forward exchange is where two parties agree to exchange currency at a specific date in the future. Forward exchanges rates are different from spot exchange rates, because it reflects future expectations. So, in our example, the Forward exchange rate might have been higher than the spot exchange rate by the time the order was placed, but at least the rate would be fixed and you will not end up paying even more in the event where the Rand depreciate significantly more against the Dollar than expected.

Currency Swaps

Currency Swaps is a bit more sophisticated than Forward exchanges. A currency swap is the simultaneous purchase and sale of an amount of foreign exchange at two different value dates. For example you can do a spot against forward. This means I can convert my Rands into Dollars now using the spot exchange rate and buy my Rands back at some specific future date using the Forward exchange rate.

Conclusion

At this point I would like to point you to my Disclaimer. I am not a financial adviser. Speak to the experts. Peregrine Treasury Solutions provide holistic treasury solutions with expert advise. Give them a call.

References

Hill Charles W L, International Business Competing in the global marketplace.  Fifth Edition, Mc Graw Hill, 2005, Chapter 9



One Reply to “Functions of the Foreign Exchange Market”

  1. Hedging Function: The third function of a foreign exchange market is to hedge foreign exchange risks. The parties to the foreign exchange are often afraid of the fluctuations in the exchange rates, i.e., the price of one currency in terms of another. The change in the exchange rate may result in a gain or loss to the party concerned.

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