Functions of the Foreign Exchange Market

The foreign exchange market facilitates the international trade of goods and services. Companies and individuals from different countries need to conduct business transactions in foreign currencies.

Transactions in the financial markets account for a large percentage of the daily turnover in the foreign exchange markets. Investors make inter-currency conversions to move funds into or out of foreign assets. Therefore, market participants experience the risk of exchange rates moving against them in the transaction process. For example, a Canadian investor buying stocks of Apple (AAPL), denominated in US dollars, bears the risk that the stock might drop and that the US dollar might drop in value compared to the Canadian dollar while the investor holds the stock. Such a risk is known as foreign exchange risk.

The foreign exchange market provides products that ensure the flexibility needed to meet a complex set of financial goals. One of these is the spot transaction. Spot transaction refers to the exchange of currencies for immediate delivery. Other products include FX swaps, FX options, and outright forward contracts. Some market participants try to predict future foreign exchange movements through foreign exchange instruments. The motivation behind such predictions is the possibility of benefitting even as others simply try to hedge their risks.

Participants in the Foreign Exchange Market

Foreign exchange market participants consist of two broad categories: The buy-side and the sell-side. The sell-side consists of large FX trading banks such as Citigroup. On the other hand, the buy-side consists of clients who use these banks to undertake transactions. The buy-side includes:

Corporate Accounts

Corporations perform transactions during cross-border purchases or sales of goods and services through FX markets. As a result, this facilitates cross-border investments.

Real Money Accounts

These are investments controlled by mutual funds, insurance companies, or pension funds, among other institutional investors. These accounts are restricted in their use of financial derivatives.

Government

Most sectors of the government have to perform foreign transactions. For example, the security sector might purchase military equipment from abroad.

Central Banks

Central banks might intervene in the foreign exchange market to either influence the level or trend of the domestic exchange rate. This is most often the case for net exporting countries that want to keep their currency at relatively low levels to keep their prices competitive in the global markets.

Question

Which of the following is most likely a function of foreign exchange markets?

1. To hedge risk.
2. To create money.
3. To set interest rates.

Solution

The correct answer is A.

FX markets facilitate international trade between different countries globally. They are also used to hedge foreign exchange rate risk.

B and C are incorrect.  They are duties of central banks which, in turn, influence the foreign exchange market. However, they are not functions of foreign exchange markets.