The Foreign Exchange Market (also known as the Forex or FX market) is a global, decentralised marketplace where currencies are traded. It is the largest and most liquid financial market in the world. Its primary function is to facilitate international trade and investment by enabling currency conversion.
Simple Analogy: Think of the Forex market as a massive, worldwide money changer that allows an Indian company to convert Rupees into US Dollars to buy machinery from the USA, or a foreign tourist to convert Euros into Rupees to travel in India.
Key Functions of the Forex Market
1. Transfer of Purchasing Power
This is the most basic function. The Forex market helps in converting one currency into another, thereby transferring purchasing power between countries. For example, it allows an Indian importer to pay a German exporter in Euros.
2. Provision of Credit
The market provides short-term credit to finance international trade. For instance, an Indian importer can get a 90-day credit to pay a US exporter. This allows the importer time to ship and sell the goods before making the payment.
3. Hedging against Foreign Exchange Risk
Currencies’ values fluctuate constantly. This creates a risk for businesses involved in international trade. The Forex market offers tools (like forward contracts and options) that allow businesses to “hedge” or protect themselves against losses from adverse movements in exchange rates.
How Exchange Rates are Determined
The exchange rate is simply the price of one currency in terms of another (e.g., $1 = ₹90). In a free market, this rate is determined by the forces of supply and demand.
- High Demand for a Currency: If many people want to buy US Dollars (e.g., to invest in the US or pay for imports), the demand for the dollar will increase, and its value will rise against the Rupee.
- High Supply of a Currency: If many foreign investors are selling US Dollars to invest in India, the supply of dollars in the market will increase, and its value will fall against the Rupee.
The Forex Market in India
The Regulator: The Reserve Bank of India (RBI) is the custodian of India’s foreign exchange reserves and the primary regulator of the forex market. The RBI often intervenes in the market by buying or selling US Dollars to prevent excessive volatility and maintain the stability of the Indian Rupee. The rules governing the market are laid out in the Foreign Exchange Management Act (FEMA).
Participants: Major players include commercial banks, corporations engaged in international trade, foreign exchange brokers, and individual traders.