Term Paper on the Overview of Foreign Exchange Market

The foreign exchange market is one of the most important financial markets. The $3.98 Trillion (April 2010)-per-day foreign exchange (FX) market surpasses stocks and bonds as the largest market in the world. Foreign exchange markets are critical for setting exchange rates between countries. It affects the relative price of goods between countries and so can affect trade. It means that it affects the price of imports and so affects a country’s price level (inflation rate). It also affects the international investment and financing decision. In this project, we will try to find why exchange rate would give many risks to a company and how a company can hedge itself.

Foreign exchange is a commodity that consists of currencies issued by countries other than one’s own. Like the prices of other commodities, the price of foreign exchange i.e. exchange rate between domestic currency foreign currency is set by demand and supply in the market place. As for example, the demand for Japanese yen is derived from foreigners demand for Japanese yen.

In simplest language, foreign exchange is the system of exchanging the money of one currency for that of another country.

Foreign exchange market is a market for converting the currency of one country into that of another country. The foreign exchange market has two major: Over the counter market (O.T.C) and the exchange-traded market. The OTC market is composed of banks, both commercial banks and other financial institutions, and it is where the most of the foreign exchange activity takes place. The exchange-traded market is composed of securities exchanges, (such as Chicago Mercentile Exchages, Philadelphia Stock Exchange) where certain types foreign exchange instruments such as exchange-traded futures, and options are traded.

The primary purpose of the foreign exchange is to assist international trade and investment, by allowing businesses to convert one currency to another currency. For example, it permits a US business to import British goods and pay Pound Sterling, even though the business's income is in US dollars. It also supports speculation, and facilitates the carry trade, in which investors borrow low-yielding currencies and lend (invest in) high-yielding currencies, and which (it has been claimed) may lead to loss of competitiveness in some countries.
In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market began forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.