FOREX Market

A foreign exchange market is a place in which foreign exchange

transactions take place. In other words it is a market where foreign
money are bought and sold. It is a part of money market in the
financial center.

The basic and primary function of a foreign exchange market is to

transfer purchasing power between countries. The transfer function
is performed through T.T, M.T, Draft, Bill of exchange, Letters of
credit, etc. the bill of exchange is the most important and effective
method of transferring purchasing power between two parties
located in different countries.

Another important function of foreign exchange market is to provide

credit to the importer debtor. The exporters draw the bill of
exchange on importers on their bankers. On acceptance of the bills
by the importer or their bankers, the exporter will get the money
realized on the maturity of the bills. In case the exporters are anxious
to receive the payment earlier, the bills can be discounted from their
bankers, or foreign exchange banks or discount houses.

The foreign exchange market performs the hedging function

covering the risks on foreign exchange transactions. There are
frequent fluctuations in exchange rates. If the rate is favourable, the
exporter will gain and vice verse. In order to avoid the risk involved,
the foreign exchange market provides hedges or actual claims
through forward contracts in exchange against such fluctuations. The
agencies of foreign currencies guarantee payment of foreign
exchange at a fixed rate. The exchange agencies bear the risks of
fluctuation of exchange rates.

Functions of the Forex Market

The Gold Standard

A gold standard is a system in which countries agree to buy and sell
gold at a defined number of currency units (Ball et al., 2006). This, in
effect, created the exchange rate between nations currency by taking
the difference between the currency determinations and creating a
product that would be valued the same if the currencies were
identical (Ball et al., 2006). There are positive and negative aspects of
using a gold standard.

The exchange rates in FOREX are set then by the market and not by
governments (Ball et al., 2006), thus referred to as the floating
currency exchange rate. Other approaches to determining the
exchange rate like the purchasing power parity (PPP) theory which
states that exchange rates in the long run will adjust to equalize the
purchasing power of differing currencies (Ball et al., 2006).
Therefore, products in competitive markets will sell for identical
prices when valued in the same currency (Cross, 1998). The PPP
relies on a portion of another approach in determining exchange
rates, balance of payments (BOP). BOP approach relies on assessing
foreign exchange flows and evaluating balance of payments on
current and capital accounts (Cross, 1998). Even with these
determinations, the biggest player in defining the exchange rates rely
on supply and demand of American goods and currency.

Points of Bretton Woods System

The main points of the postwar system evolving from the
Bretton Woods agreement that are important for our
purposes can be summarized as follows:

1. A new institution, The International Monetary Fund

(IMF), would be established in Washington, D.C. Its
purpose would be to lend foreign exchange to any
member whose supply of foreign exchange had become
scarce. This lending would not be automatic, but would be
conditional on the member's pursuit of economic policies
consistent with the other points of the agreement, a
determination that would be made by the IMF.
2. The U.S. dollar (and, de facto, the British pound) would
be designated as reserve currencies, and other nations
would maintain their foreign exchange reserves principally
in the form of dollars or pounds.

3. Each Fund member would establish a par value for its

currency, and maintain the exchange rate for its currency
within 1 percent of par value. In practice, since the
principal reserve currency would be the U.S. dollar, this
meant that other countries would peg their currencies to
the U.S. dollar, and--once convertibility was restored--
would buy and sell U.S. dollars to keep market exchange
rates within the 1 percent band around par value. The
United States, meanwhile, separately agreed to buy gold
from or sell gold to foreign official monetary authorities at
$35 per ounce in settlement of international financial
transactions. The U.S. dollar was thus pegged to gold, and
any other currency pegged to the dollar was indirectly
pegged to gold at a price determined by its par value.

4. A Fund member could change its par value only with

Fund approval and only if the country's balance of
payments was in "fundamental disequilibrium." The
meaning of fundamental disequilibrium was left
unspecified, but everyone understood that par value
changes were not to be used as a matter of course to
adjust economic imbalances.

5. After a postwar transition period, currencies were to

become convertible. That meant, to anyone who was not
a lawyer, currencies could be freely bought and sold for
other foreign currencies. Restrictions were to be removed,
and hopefully eliminated. So, in order to keep market
exchange rates within 1 percent of par value, central
banks and exchange authorities would have to build up a
stock of dollar reserves with which to intervene in the
foreign exchange market.
6. The Fund would get gold and currencies to lend through
"subscription." That is, countries would have to make a
payment (subscription) of gold and currency to the IMF in
order to become a member. Subscription quotas were
assigned according to a member's size and resources.
Payment of the quota normally was 25 percent in gold and
75 percent in the member's own currency. Those with
bigger quotas had to pay more but also got more voting
rights regarding Fund decisions.