Forex Market

The foreign exchange (Forex) market stands as the world's largest and most liquid financial market, exhibiting a daily turnover exceeding $6$ trillion. It is instrumental in global trade and economic engagement by facilitating the exchange of currencies across nations and supporting international business activities.

Functions of the Foreign Exchange Market

Key Functions

• Currency Conversion: Serves the conversion of currencies essential for international trade.

  • Example: UK businesses convert GBP into USD for importing goods from the US.

• Exchange Rate Determination: Governed by supply and demand dynamics.

  • Economic principles such as Purchasing Power Parity (PPP) and Interest Rate Parity (IRP) are fundamental.

• Currency Hedging: Offers protection against exchange rate volatility.

  • Instruments include futures, options, and forward contracts.

• Speculation and Arbitrage:

  • Speculation entails predicting future exchange rate movements for profit.
  • Arbitrage involves capitalising on price discrepancies in the market.

  

• Purchasing Power Transfer: Ensures the seamless transfer of financial assets across borders.

Establishment of Exchange Rates

Exchange rates, defining how currencies are swapped, are essential in global transactions, impacting trade prices and inflation.

Demand and Supply in Currency Markets

• Demand: Indicates the currency's attractiveness.
• Supply: The quantity of currency available.

Factors Influencing Exchange Rates

• Interest Rates: Elevated rates lure foreign investments, enhancing currency value.
• Inflation Rates: High inflation diminishes a currency's purchasing power.
• Political Stability and Economic Performance: More stable economies often attract investment.

Participants in the Forex Market

Major Participants

• Central Banks: Ensure currency value stability and manage foreign reserves.
• Commercial Banks: Act as market makers and provide market liquidity.
• Financial Institutions: Engage in speculation and risk management.
• Corporations: Utilise hedging to achieve financial predictability.
• Retail Forex Traders: Contribute to market liquidity through online trading.

Detailed Analysis of Participants

Exchange Rate Regimes

• Floating Exchange Rate System: Dictated by market forces.
• Fixed Exchange Rate System: Pegged to another currency.
• Pegged Exchange Rate System: Maintained within specified limits.

Impact on Economic Health

Balance of Payments

• Current Account: Encompasses trade in goods and services, with currency valuation influencing the trade balance.

• Capital Account: Captures transactions implying changes in asset ownership.

• Financial Account: Reflects the impact of currency on international investment flows.

Depreciation and Appreciation

• Depreciation: Can enhance export competitiveness.
• Appreciation: Could result in trade deficits.

Grasping these currency dynamics is essential for forecasting economic trends and formulating effective fiscal policies.