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Foreign Exchange Markets-Its functions*

International investment is the purchase of of real and financial assets in a country other than that of the investor. Whereas, investment is an inter-temporal transaction; a payment made in a period, expecting a return in future.

In order to undertake international investment, foreign exchange markets are of greater importance. The foreign exchange market as stated by Hill and Hult (2017), is a market serving two main purposes.

  1. Currency conversion

Both tourists and international traders make use of the foreign exchange market. Tourists, being the minor participant, make use of this market, when spending in the country of visit. International traders use the market to convert currencies, to send back the return to their home country.

Also, they make use of the market to purchase products from other countries. For example, Dell buys many of its components for computers, from Malaysia.

Also, international traders are interested in investing their spare income in other countries. The foreign exchange market will become important in this case too. In this case, currency speculation becomes another use of these foreign exchange markets. This means the short term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates.

However, speculation is in general a risky business. This is basically a gamble. Yet, the most common kind of speculation in recent years is known as the carry trade.

Carry trade involves borrowing in a currency where the interest rates are low and then using the funds to invest in another currency which gives higher interest rates.

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2. Insuring against foreign exchange risk

The foreign exchange market assists businesses to hedge. Hedging is the insurance of a firm against foreign exchange risk.

There are two main types of foreign exchange rates.

  1. Spot Exchange Rates
    • This is when two parties agree to exchange the currency and make the deal immediately.
    • Therefore, these keep on changing constantly
  2. Forward exchange rates
    • This is when two parties agree to exchange currency and make the deal in a future date. For most major currencies, forward exchange rates are quoted for 30 days, 60 days, etc.
    • This is when hedging occurs.
    • That is, when a firm enters into a forward exchange contract, it is taking out insurance against the possibility that future exchange rate movements will make a transaction unprofitable by the time that transaction has been executed.

According to the most recent data, forward exchanges account for two-thirds and spots for one third. However, the forward exchanges mostly take the form of currency swaps.

Currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different dates with different currency values.

Resource credits to Econtutor@Zeecollege

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