What is the Foreign Exchange Market?

The Foreign Exchange Market is the financial market in which currencies are bought and sold that is a transaction is entered into where a given amount of currency is exchanged for another amount of currency. The need for the Foreign Exchange Market (commonly referred to as the Forex Market) developed to facilitate International trade where currencies were required to be settled from the country of both the importer and the exporter. It therefore plays an extremely important role in facilitating cross-border trade, financial transactions and investment. More recently, it allows borrowers to have access to the International capital markets in order to meet their financing needs in the currency which is most conducive to their requirements.

Characteristics of the Foreign Exchange Market

The Forex Market does not exist physically. It is a framework in which participants are connected by computers, telephones and telex (SWIFT) and operates in most financial centres globally. Because the Forex Market is so highly integrated globally, it can operate 24 hours a day - when one major market is closed, another major market is open to facilitate trade occurring 24 hours a day moving from one major market to another. Most exchanges of currency are made through bank deposits that is transferred electronically from one account to another.

Why do we make use of the Foreign Exchange Market?

Trading in a domestic market is substantially different from doing business in an offshore market. In the complex world of international trade, merchants face a number of risks that need to be managed in order to ensure the success of their cross-border transactions. In order to protect themselves, these corporations apply hedging techniques using various foreign exchange instruments and products in order to negate the impacts of exchange rate fluctuations. Successful companies employ effective risk management techniques when making business decisions, and evaluate commercial risk in an explicit and logical manner in order to offset financial loss occasioned by the volatility in exchange rates (currency risk).

Exchange rates

An exchange rate refers to the ratio at which the unit of currency of one country may be, or is, exchanged for the unit of currency of another country. It is the price of one country's currency expressed in terms of another country's currency. Each currency has a code by which it is identified. Each code consists of three letters - the first two letters identify the country and the 3rd letter is the first letter of the name of the currency. For example South Africa = ZA, rand = R thus the currency = ZAR.

An exchange rate is a two-way interpretation that is the price of currency A (for example USD) in terms of currency B (for example rand / ZAR). For example, an exchange rate of USD1 = ZAR7.70 can be interpreted that it will cost you ZAR7.70 to buy 1 USD, or alternatively, for 1 USD you will receive ZAR7.70.

Thus, a foreign exchange transaction involves two currencies. Quotes using a country's home currency as the unit currency are known as direct price quotation and are used in most other countries. Direct quotation: Home currency/Foreign Currency for example ZAR/USD, Indirect Quotation: Foreign Currency/Home Currency for example USD/ZAR.

Note if a unit currency is strengthening / appreciating (that is if the currency is becoming more valuable) then the exchange rate number decreases. Conversely, if the price currency is strengthening, the exchange rate number decreases and the unit currency is depreciating.