Meaning of Foreign Exchange Market: H.E. Evitt has defined foreign exchange market
as follows:

Foreign exchange market is the section of economic science which deals with the means and methods by which rights to wealth in one country’s currency are converted into rights to wealth in terms of another country’s currency”.

He further observes that,

it involves the investigation of the method by which the currency of one country is exchanged for that of another, the causes which render such exchange necessary, the forms which such exchange may take, and the ratios or equivalent values at which such exchanges are effected”.

There are different interpretations of the term foreign exchange, of which the following two are most important and common:

1. Foreign exchange is the system or process of converting one national currency into another, and of transferring money from one country to another.

2. Secondly, the term foreign exchange is used to refer to foreign currencies. For example, the Foreign Exchange Regulation Act, 1973 (FERA) defines foreign exchange as “foreign currency and includes all deposits, (‘I edits and balance
payable in any foreign currency and any draft, traveler’s cheques, letters of credits and bills of exchange, expressed or drawn in Indian currency, but payable in any foreign currency.

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FUNCTIONS OF FOREIGN EXCHANGE MARKET

The foreign exchange market is a market in which foreign exchange transactions take place. In other words, it is a market in which national currencies are bought and sold against one another. A foreign exchange market performs three important functions:

1. Transfer of Purchasing Power: The primary function of a foreign exchange market is the transfer of purchasing power from one country to another and from one currency to another. The international clearing function performed by foreign
exchange markets plays a very important role in facilitating international trade and
capital movements.

2. Provision of Credit: The credit function performed by foreign exchange markets also plays a very important role in the growth of foreign trade, for international trade
depends to a great extent on credit facilities. Exporters may get pre-shipment and post-shipment credit. Credit facilities are available also for importers. The Euro-dollar
market has emerged as a major international credit market.

3. Provision of Hedging Facilities: The other important function of the foreign exchange market is to provide hedging facilities. Hedging refers to covering of export risks, and it provides a mechanism to exporters and importers to guard themselves
against losses arising from fluctuations in exchange rates.

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Methods of Affecting International Payments: There are five important methods to effect international payments.

1. Telegraphic Transfer: By this method, a sum can be transferred from a bank in one country to a bank in another part of the world by cable or telex. It is, thus, the quickest method of transmitting funds from one centre to another.

2. Mail Transfer: Just as it is possible to transfer funds from a bank account in one centre to an account in another centre within the country by mail, international transfers of funds can be accomplished by Mail Transfer. These are usually made by air mail.

3. Cheques and Bank Drafts: International payments may be made by means of cheques and bank drafts. The latter is widely used. A bank draft is a cheque drawn on a bank instead of a customer’s personal account. It is an acceptable means of payment
when the person tendering is not known, since its value is dependent on the standing of a bank which is widely known, and not on the credit-worthiness of a 11 or
individual known only to a limited number of people.

4. Foreign Bill of Exchange: A bill of exchange is an unconditional order in writing, addressed by one person to another, requiring the person to whom it is addressed to pay a certain sum on demand or on a specified future date. There are two important differences between inland and’ foreign bills. The date on which
an inland bill is due for payment is calculated from the date on which it was drawn, but the period of a foreign bill runs from the date on which the bill was accepted. The reason for this is that the interval between a foreign bill being drawn and its acceptance may be
considerable, since it may depend on the time taken for the bill to pass from the drawer’s country to that of the acceptor. The second important difference between the two types of
bill is that the foreign, bill is generally drawn in sets of three, although only one of them bears a stamp, and of course, one of them is paid.

5. Documentary (or reimbursement) Credit : Under this method, a bill of exchange is
necessarily employed, but the distinctive feature of the documentary credit is the opening by the importer of a credit in favor of the exporter, at a bank in the exporter’s country.