Table of Contents
Meaning of Foreign Exchange
Foreign exchange, also termed as Forex refers to the conversion of one country’s currency into another country’s currency. A single country’s currency is valued against another’s currency or against a basket of currencies.
The global foreign exchange market involves daily volumes ranging in trillions of dollars thereby making it the largest financial market in the world. Foreign exchange transactions are executed over the counter and there is no specific centralised market for the same.
On knowing the meaning of foreign exchange, let us now know about the foreign exchange market.
Meaning of Foreign Exchange Market
The foreign exchange market is a floor provided for buying, selling, exchanging and speculation of currencies. Foreign exchange market also undertakes currency conversion for investments and international trade. The Foreign exchange markets also termed as, Forex markets, consists of investment management firms, central banks, commercial companies, retail forex brokers, and investors.
On understanding about the foreign exchange market, we will gain an insight on the foreign exchange transactions that take place in these markets.
Meaning of Foreign Exchange Transactions
Foreign exchange transaction refers to purchase and sale of foreign currencies. The transactions are done with an exchange of a specific country’s currency for another at an agreed exchange rate on a specific date.
Let us move on and know about the types of foreign exchange transactions.
Types of Foreign Exchange Transactions
Foreign exchange transactions include all conversions of currencies which may be done by a traveler on an airport kiosk or billion-dollar payments made by financial institutions and governments. The growth in globalisation has led to a massive increase in a number of foreign exchange transactions in the recent years.
The following are the types of foreign exchange transactions:
This method of transaction is the fastest way to exchange currencies. Spot transaction refers to the exchange or settlement of the currencies by the buyer and seller within two days of the deal without a signed contract. The Spot Exchange Rate is the prevailing exchange rate in the market.
Forward transactions are future transactions when the buyer and seller enter into an agreement of purchase and sale of currency after 90 days. The agreement is framed on the basis of a fixed exchange rate for a definite date in the future. The rate at which the deal is fixed is termed as Forward Exchange Rate.
Future transactions also deals with contracts in the same manner as forward transactions. However, in case of future transactions, standardized contracts in terms of features, date, and size should be followed. Whereas, regular forward transactions have flexibility and can be customised. In future transactions, an initial margin is fixed and kept as collateral in order to establish a future position.
A simultaneous lending and borrowing of two different currencies between two investors are referred to as swap transaction. One investor borrows a currency and repays in the form of a second currency to the second investor. Swap transactions are done to pay off obligations without suffering a foreign exchange risk.
The exchange of currency from one denomination to another at an agreed rate on a specific date is an option for an investor. Every investor owns the right to convert the currency but is not obligated to do so.
In a nutshell, foreign exchange is the conversion of one currency of a country into the currency of another country in order to settle payments.1–3