1. What are the importance of foreign exchange market? Answer: Importance of Foreign Exchange Markets 2013: The foreign exchange market is a crucial international market and is the world’s most respected financial institution. On a dail y basis, the Forex exchange trades with approximately app roximately two trillion U.S Dollars. I will analyze some vital functions of the foreign exchange market in this article.
Forex trade has facilitated international trade among countries. When your business is dealing with investors from another country, you need to acquire their currency to trade. Transfer of purchasing is facilitated through foreign exchange among countries. You are able to acquire capital that will enhance you purchasing power when dealing with another country, Importance of Foreign Exchange Markets. Forex markets have a credit provision and this goes a long way in enhancing the growth of foreign trade. Most investors dealing with international trade depend on the credit facilities that are advanced to them by Forex markets. The advanced credit is used to purchase imports from other countries. It is easier to get credit from Forex markets because they have enormous capital reserves that are in liquid form. Governments as a way of protecting their currencies trade in the foreign exchange to accumulate a ccumulate reserves. Money reserves affect the value of currencies, and at the same time they can be b e used to payments. Governments through their central banks must ensure they have sufficient reserves to to be able to stabilize their currencies in the event of changes in the economy. Foreign exchange markets also provide the market with hedging facilities. Hedging here means that you can protect your business against risk. It provides business owners with mechanisms that guard them against incurring losses in the eve nt that values of the currencies they the y trade in fluctuate. As the economy changes chan ges the value of currencies is affected. Therefore, as a business person you need to have hedging facilities to prevent suffering losses, Importance of Foreign Exchange Markets.
The foreign exchange market provides liquidity for currencies. Liquidity is the ease with which you can convert a foreign currency into a domestic currency. The ease with which currencies are changed translates to ease with which business transactions are carried out. If you are a business and have foreign exchange reserves, it becomes easy to change the currency to your domestic carry and transact effectively. Another importance of foreign exchange is the provision of job opportunities. With the increased use of the internet, online Forex exchange has become a prominent feature in the foreign exchange market. Many people earn a living by trading currencies online on a daily basis. There are enormous returns to the investment made in starting up a foreign exchange market.
2. What kind of currencies are used in foreign exchange business? Answers: MAJOR CURRENCIES
The top five major currencies in foreign exchan ge trading are the US dollar, Euro, Japanese yen, Swiss franc, and British sterling. They should not be con fused with similar abbreviations such as that for the G5 or even the G7 – the Group of seven nations, which comprise USA, France, Great Britain, Germany, Japan, Canada, and Italy. Each of the top five major currencies exhibits complete currency convertibility in large amounts, with an active long-dated forward market, sometimes over five years forward.
MINOR CURRENCIES
These are the currencies where there is complete convertibility but where there may be difficulties executing the full amount in a large transaction, for ex ample in excess of USD 50 million equivalent. Alternatively, the forward market may only go out for perhaps 12 months or a year, or it may be relatively expensive.
EMERGING MARKET CURRENCIES
Over the last few years the term ‘Exotic currency’ has been dropped and those currencies are now included within the term ‘emerging market’, which can cover many things. Generally these
are the currencies of the newly deregulated Eastern bloc countries, such as Poland, the Czech Republic, Slovakia and Hungary, Russia, Romania, the Baltic states of Lithuania, Latvia and Estonia, together with all of the South American currencies and all of the African currencies. If you then include the old exotic currencies which were typically Far Eastern (Thai baht, Singapore dollar, etc.) you have a currency block which covers a major part of the globe.
CROSS CURRENCIES
The definition of a cross currency is where a foreign exchange market price is made in two currencies, not involving the US dollar. Historically, the US dollar has been used as the medium of exchange, between currencies, but about twenty years ago the FX market started to expand the use of direct ‘cross’ dealing. Consider a company based in the UK, selling goods to Switzerland and receiving payment in Swiss francs. Before ‘crosses’ evolved to their current level, it would have been necessary for the company to sell the Swiss francs for dollars and then sell the dollars for sterling. This would have involved them not only paying away the ‘bid _ – _ offer spread’ but also the possibility of running a potential dollar exposure if the two deals were not transacted simultaneously, not to mention further complications with forwards and options, etc. The major traded crosses are: _ EUR_JPY _ EUR_GBP _ EUR_CHF Notice that the EUR is an integral part of cross-trading, although other crosses exist such as: _ GBP_CHF _ GBP_JPY As the growth of cross markets continued, more a nd more banks were faced with customers requiring both cross currency rates and cross derivatives. By the early 1990s the market had grown enormously, leading to a common trading practice where some cross rates are used to quote other less well traded crosses.
HARD CURRENCIES
Hard currency, safe-haven currency or strong currency refers to a globally traded currency that is expected to serve as a reliable and stable store of value. Factors contributing to a
currency's hard status might include the long-term stability of its purchasing power, the associated country's political and fiscal condition and outlook, and the policy posture of the issuing central bank.
SOFT CURRENCIES
A currency with a value that fluctuates as a result of the country's political or economic uncertainty. As a result of the of this currenc y's instability, foreign exchange dealers tend to avoid it.
Also known as a "weak currency". Currencies from most developing countries are considered to be soft currencies. Often, governments from these developing countries will set unrealistically high exch ange rates, pegging their currencies to a currency such as the U.S. dollar.
BASE CURRENCY
The first currency quoted in a currency pair on forex. It is also typically con sidered the domestic currency or accounting currency. For accounting purposes, a firm may use the base currency to represent all profits and losses. For example, if you were looking at the CAD/USD currency pair, the Canadian dollar would be the base currency and the U.S. dollar would be the quote currency. The price represents how much of the quote currency is needed for you to get one unit of the base currency.
3. What are the functions of foreign exchange markets? Answers: Functions of the Foreign Exchange Market:
The foreign exchange market performs the following important functions: (i) To effect transfer of purchasing power between coun tries- transfer function;
(ii) To provide credit for foreign trade - credit function; a nd (iii) To furnish facilities for hedging foreign exchange risks - hedging fun ction. Transfer Function :
The basic function of the foreign exchange market is to facilitate the conversion of one currency into another, i.e., to accomplish transfers of purchasing power between two countries. This transfer of purchasing power is effected through a variety of credit instruments, such as telegraphic transfers, bank drafts and foreign bills. In performing the transfer function, the foreign exchange market c arries out payments internationally by clearing debts in both directions simultaneously, analogous to domestic clearings. Credit Function :
Another function of the foreign exchange market is to provide credit, both national and international, to promote foreign trade. Obviously, when foreign bills of exchan ge are used in international payments, a credit for about 3 mo nths, till their maturity, is required. Hedging Function:
A third function of the foreign exchange market is to hedge foreign exchange risks. In a free exchange market when exchange rates, i.e., the price of one currency in terms of another currency, change, there may be a gain or loss to the party concerned. Under this condition, a person or a firm undertakes a great exchange risk if there are huge amounts of net claims or net liabilities which are to be met in foreign mone y. Exchange risk as such should be avoided or reduced. For this the exchange market provides facilities for hedging anticipated or actual claims or liabilities through forward contracts in exchange. A forward contract which is normally for three months is a contract to buy or sell foreign exchange against another currency at some fixed date in the future at a price agreed upon now. No money passes at the time of the contract. But the contract makes it possible to ignore any likely changes in exchange rate.
4. What is the composition of a foreign exchange market? Answers:
