Foreign Exchange Market

Foreign exchange market is any environment in which a national currency is exchanged for a foreign money or foreign currencies are exchanged with one another.

Foreign country currencies may be in cash form or may take the form of transfers, deposit certificates, payment orders, foreign exchange bills and other instruments denominated in those currencies. Foreign financial assets have very high liquidity and can be readily converted into cash at minimal cost. In banking especially, a distinction is made between these two type payment instruments.

In Türkiye, foreign currencies held directly in cash are referred to as “efektif” foreign exchange, while those held in highly liquid financial entity forms are called simply “döviz”. The main transactions in foreign exchange markets are not those involving cash foreign currencies but those conducted through “döviz”.

Functions of the Foreign Exchange Market

The primary function of the foreign exchange market is generally to facilitate international trade trade and capital flows. In carrying out these transactions, the foreign exchange market performs four fundamental functions:

1. Transfer of purchasing power: As is well known, in an economy without a universally accepted currency, trade in goods and services would be as difficult as barter. The same applies to a world without a foreign exchange market. In a world without a foreign exchange market or exchange rates, international transactions would face far greater difficulties if conducted through barter. The foreign currency required for both trade in goods and services and for short- or long-term foreign capital investments is obtained from the foreign exchange market. The foreign exchange market provides the necessary funds to individuals and firms that require other countries’ currencies for international transactions. Thus, all economic agents participating in the foreign exchange market transfer purchasing power to one another. This situation also encourages international division of labor and specialization.
2. Provision of credit facilities: In international trade, there may be a time lag between the exporter’s shipment of goods and the importer’s receipt of them. During this period, whether or not payment has been made creates a financing risk for trade. However, this risk is mitigated when the parties use letters of credit through their banks. In letter of credit-based trade, the exporter receives payment from the bank after presenting documents proving shipment of the goods. The importer, in turn, pays the required amount to obtain the necessary documents from his bank for delivery of the goods. Thus, the financing risk of trade is eliminated through the provision of short-term foreign exchange credit by banks, the key actors in the foreign exchange market.
3. Protection against exchange rate risk: Frequent and significant fluctuations in exchange rates negatively affect economic agents engaged in foreign exchange transactions. A rise or fall in the exchange rate before a foreign trade transaction is finalized can lead to losses for the trader. However, if financial techniques for hedging against exchange rate risk have been developed and are utilized by economic agents, then exchange rate risk and uncertainty are eliminated. Thus, the possibility of hedging against exchange rate risk is provided by the foreign exchange market.
4. Store of value: Another function of the foreign exchange market is to preserve savings by holding them in foreign currency, particularly in countries with high inflation where national currencies continuously lose value. The national currencies of high-inflation countries fail to fully serve as both a medium of exchange and a store of value. Therefore, residents of such countries prefer to hold their assets in foreign currency to mitigate potential financial risks.

Key Characteristics of the Foreign Exchange Market

1. Buyers and sellers in the foreign exchange market do not need to meet face to face.
2. The foreign exchange market is an over-the-counter market.
3. Foreign exchange markets are global markets.
4. Foreign exchange markets are markets that never close.
5. Foreign exchange markets are markets that closely resemble perfect competition.