Foreign Exchange Market – AHSEC Class 12 Finance Chapter 8

Here is a comprehensive study note for the AHSEC Class 12 Finance textbook, focusing on Chapter 8: Foreign Exchange Market.

Chapter 8: Foreign Exchange Market

Summary Note

This chapter explains the concept of foreign exchange and the market where it is traded. It covers the meaning, features, participants, functions, and types of the foreign exchange market.

• Meaning of Foreign Exchange:
  • In simple terms, foreign exchange means the currency of a foreign country. For example, the US Dollar is foreign exchange for India, and the Indian Rupee is foreign exchange for the USA.
  • It also refers to the process of converting one country’s currency into another.
  • The Rate of Exchange is the price of one currency in terms of another (e.g., $1 = ₹82.43). This rate is determined by the forces of demand and supply.
• Meaning of Foreign Exchange Market (FOREX Market):
  • The foreign exchange market is the institutional arrangement for the purchase and sale of foreign currencies.
  • It is not a physical marketplace but an “Over-the-counter” (OTC) market where transactions are conducted electronically via telephones, telex, and computer networks.
  • It facilitates international trade and investment by enabling the conversion of different national currencies.
• Features of the Foreign Exchange Market:
  1. Global Market: Buyers and sellers are from different countries, connected through global communication networks.
  2. Operates 24 Hours: The market remains operational 24 hours a day (except on weekends) as trading moves from one time zone to another (e.g., from Tokyo to London to New York).
  3. OTC Market: It lacks a physical location and operates electronically.
  4. Largest Market: It is the largest financial market in the world in terms of the volume of transactions.
  5. High Liquidity: Due to the large volume of continuous trading, currencies can be bought and sold easily at any time.
  6. Market Transparency: Traders have full and free access to market data and information, allowing them to monitor currency price fluctuations easily.
• Participants of the Foreign Exchange Market:
  1. Commercial Banks: They are the major players, acting as dealers in foreign exchange for international transactions.
  2. Central Bank (RBI): The regulator and supervisor of the market. It intervenes by buying or selling foreign currency to stabilize the exchange rate.
  3. Brokers: They act as intermediaries between buyers and sellers (usually banks), helping to match deals without dealing directly themselves.
  4. Non-banking Financial Institutions & Acceptance Houses: They also participate in foreign exchange transactions.
  5. Corporations: Multinational corporations and firms engaged in exports and imports need to convert currencies for their business operations.
  6. Individuals: Tourists, students, and others who travel abroad or conduct business internationally participate on a smaller scale.
• Functions of the Foreign Exchange Market:
  1. Transfer Function: The basic function is to transfer purchasing power (currency) from one country to another. This is done through instruments like bank drafts, telegraphic transfers, and letters of credit.
  2. Credit Function: The market provides short-term credit to finance international trade. For example, an importer can get credit to finance imports.
  3. Hedging Function: It provides facilities for hedging, which means protecting against losses arising from fluctuations in the exchange rate. This is crucial for importers and exporters to manage risk.
• Types of Foreign Exchange Market:
  1. Retail Market: This is where ultimate customers (individuals, tourists, small businesses) buy and sell foreign currency from commercial banks or Authorised Money Changers (AMCs). The volume of transactions is small.
  2. Wholesale Market: This market serves to smoothen the large purchases or sales made by banks. It consists of:
     • Interbank Market: This is the core of the wholesale market where banks trade currencies with each other. No physical currency is transferred; only book-keeping entries are made.
     • Central Bank: The central bank also operates in the wholesale market when it intervenes to influence the exchange rate.

Complete Textual Question Answers

Here are the answers to all the questions given at the end of Chapter 8.

A. Very Short Answer Questions (1 Mark each)

1. Write the full form of OTC market.
   Ans: The full form of OTC market is Over-the-counter market.

B. Short Answer Questions (2 Marks each)

1. What is foreign exchange?
   Ans: Foreign exchange simply means the currency of a foreign country. It also refers to the system or process of converting the currency of one nation into that of another to settle international debts.
2. What is foreign exchange market?
   Ans: The foreign exchange market is the organizational framework or institutional arrangement for the purchase and sale of foreign currencies. It is an over-the-counter market where participants buy, sell, and exchange currencies.
3. Write two features of foreign exchange market.
   Ans: Two features of the foreign exchange market are:
   i. Global Market: It is a worldwide market where buyers and sellers are from different countries, connected electronically.
   ii. Operates 24 hours: The market is open 24 hours a day (except weekends) as trading moves across different global time zones.
4. State the transfer function performed by foreign exchange market?
   Ans: The transfer function of the foreign exchange market is its basic role of transferring purchasing power (currency) from one country to another. This is performed with the help of instruments like telegraphic transfers, bank drafts, and letters of credit.
5. State the credit function performed by foreign exchange market?
   Ans: The credit function of the foreign exchange market is to provide short-term credit to promote foreign trade. It provides pre-shipment and post-shipment credit to exporters and financing facilities to importers.
6. State the hedging function performed by foreign exchange market?
   Ans: The hedging function of the foreign exchange market is to provide protection against the risks of exchange rate fluctuations. It offers mechanisms (like forward contracts) that allow exporters and importers to lock in an exchange rate for a future transaction.
7. Briefly write about any two participants of foreign exchange market.
   Ans: Two major participants of the foreign exchange market are:
   i. Commercial Banks: They are the primary dealers in the market, buying and selling foreign currency on behalf of their customers (importers, exporters, tourists) and for their own accounts.
   ii. Central Bank (RBI): It acts as the regulator and supervisor of the market. It intervenes by buying or selling foreign currency to stabilize the exchange rate and manage the country’s foreign exchange reserves.
8. Briefly state the role of brokers in foreign exchange market.
   Ans: Brokers in the foreign exchange market act as intermediaries between the buyers and sellers of foreign currency (usually banks). They do not buy or sell currency themselves but bring the parties together to finalize a deal. By using brokers, banks can save time and effort in finding a counterparty for their transactions.

C. Long Answer Questions (Type-I) (5 Marks each)

1. State the features of foreign exchange market.
   Ans: The main features of the foreign exchange market are:
   • Global Market: It is a worldwide market with no geographical boundaries, connecting participants from all over the globe.
   • Operates 24 hours: It is a continuous market that operates 24 hours a day, five days a week, moving from one financial center to another.
   • OTC Market: It is an Over-the-counter market, meaning it has no physical location or central exchange. Trading is done electronically.
   • Largest Market: In terms of transaction volume, it is the largest financial market in the world.
   • High Liquidity: The large volume of transactions ensures that currencies can be bought and sold easily at any time without significantly affecting the price.
   • Market Transparency: Modern electronic systems provide traders with free and instant access to market data and price information.
2. Explain the functions of foreign exchange market.
   Ans: The foreign exchange market performs three main functions:
   • Transfer Function: This is the primary function of transferring funds or purchasing power from one country to another. When an importer in India needs to pay a seller in the USA, the market facilitates the conversion of Rupees into Dollars. This is done using credit instruments like bank drafts and telegraphic transfers.
   • Credit Function: The market provides a source of short-term credit to finance international trade. An importer may need credit to pay for goods before they are sold. The FOREX market provides mechanisms, such as letters of credit, that allow for such financing, thereby promoting global trade.
   • Hedging Function: This is a crucial risk-management function. Exchange rates are constantly fluctuating. The hedging function allows importers and exporters to protect themselves from potential losses due to adverse movements in exchange rates by locking in a future rate through instruments like forward contracts.
3. State about five participants of foreign exchange market.
   Ans: Five key participants in the foreign exchange market are:
   • Commercial Banks: They are the main players, acting as market makers by quoting buying and selling rates for currencies. They facilitate the foreign exchange needs of their customers.
   • Central Bank: The RBI in India acts as the custodian of foreign reserves and the regulator of the market. It intervenes to buy or sell currency to prevent excessive volatility and stabilize the exchange rate.
   • Brokers: They are intermediaries who match buyers and sellers (banks) without taking a position themselves. They earn a commission for their services.
   • Corporations: Multinational companies, exporters, and importers participate to convert currencies for their business needs, such as paying for imports, receiving payment for exports, or making international investments.
   • Individuals: Tourists, students studying abroad, and individuals making remittances participate in the retail segment of the market to meet their personal foreign currency needs.
4. Briefly state the types of foreign exchange market.
   Ans: The foreign exchange market is broadly divided into two main types based on the nature of its operation:
   • Retail Market: This is the market segment where ultimate customers, such as individuals, tourists, and small companies, buy and sell foreign currency. Transactions are conducted through commercial banks or Authorised Money Changers (AMCs). The transaction volume in this market is relatively small compared to the wholesale market.
   • Wholesale Market: This market is where large-volume transactions take place, primarily between banks and with the central bank. It serves to smoothen the excessive purchases or sales made by individual banks. The wholesale market itself consists of two components:
     • Interbank Market: This is the core of the market where banks trade currencies with each other.
     • Central Bank: The central bank also operates in the wholesale market when it intervenes to manage the exchange rate.

D. Long Answer Questions (Type-2) (8 Marks each)

1. What is foreign exchange market? State about the participants of foreign exchange market.
   Ans: (For this answer, combine the detailed definitions from B.2 and C.3. First, provide a comprehensive explanation of the foreign exchange market, defining it as an institutional arrangement for trading currencies, and highlighting its key features like being a 24-hour, global, OTC market. Then, discuss the various participants in detail, explaining the specific roles of Commercial Banks, the Central Bank, Brokers, Corporations, and Individuals in the market.)

Previous Year AHSEC Question Answers (2015-2025)

Short Questions (1-2 Marks)

• What is Foreign Exchange? (AHSEC 2015, 2019)
  Ans: Foreign exchange refers to the currency of a foreign country. It is also the mechanism by which one country’s currency is converted into another’s to settle international transactions.
• Mention two functions of the Foreign Exchange Market. (AHSEC 2017, 2022)
  Ans: Two functions of the foreign exchange market are: (i) Transfer Function: to transfer purchasing power from one country to another, and (ii) Hedging Function: to provide protection against risks from exchange rate fluctuations.
• What is Hedging? (AHSEC 2018)
  Ans: Hedging is a strategy used to protect against financial loss. In the foreign exchange market, it refers to the mechanism of protecting exporters and importers against losses arising from fluctuations in the exchange rate.
• Who are the major players in the foreign exchange market? (AHSEC 2020)
  Ans: The major players in the foreign exchange market are commercial banks.

Long Questions (5-8 Marks)

• Explain the functions of the Foreign Exchange Market. (AHSEC 2016, 2021)
  Ans: (This answer is the same as the textual Long Answer Question C.2. Please refer to that answer above).
• Discuss the features of the Foreign Exchange Market. (AHSEC 2018)
  Ans: (This answer is the same as the textual Long Answer Question C.1. Please refer to that answer above).

10 Most Important Questions

1. What determines the rate of exchange in a foreign exchange market?
   Ans: The rate of exchange is determined by the market forces of demand for and supply of a currency.
2. Why is the foreign exchange market called an “Over-the-Counter” (OTC) market?
   Ans: It is called an OTC market because it does not have a physical location or a central exchange; trading is conducted electronically through a network of banks, corporations, and individuals.
3. What is the difference between the retail and wholesale foreign exchange markets?
   Ans: The retail market is for small-volume transactions by individuals and small companies, while the wholesale market is for large-volume transactions, primarily between banks.
4. Explain the role of the Central Bank (RBI) as a participant in the FOREX market.
   Ans: The RBI participates in the FOREX market not to make a profit, but to regulate and stabilize the exchange rate by buying or selling foreign currency, thereby managing the country’s foreign exchange reserves.
5. What is the ‘Transfer Function’ of the foreign exchange market?
   Ans: The transfer function is the basic role of the market to transfer purchasing power from one country’s currency to another, which is essential for settling international trade and investment payments.
6. Why is the hedging function important for importers and exporters?
   Ans: The hedging function is important because it allows them to protect themselves from the risk of financial loss that could arise from adverse fluctuations in the exchange rate between the time a contract is signed and when payment is made.
7. Who are Authorised Money Changers (AMCs)?
   Ans: Authorised Money Changers are entities (like certain firms, hotels, or shops) that are granted a license by the RBI to deal in foreign currencies, notes, and traveler’s cheques in the retail market.
8. What is the Interbank Market?
   Ans: The Interbank Market is the core of the wholesale foreign exchange market where commercial banks trade currencies directly with each other to manage their foreign exchange positions.
9. Why is the foreign exchange market considered highly liquid?
   Ans: It is considered highly liquid because it is the largest financial market in the world with a massive volume of transactions occurring continuously, which ensures that currencies can be bought or sold easily at any time.
10. What is the difference between a broker and a dealer in the FOREX market?
    Ans: A dealer (like a commercial bank) buys and sells currency for their own account and acts as a market maker. A broker, on the other hand, acts only as an intermediary, matching buyers and sellers without taking a position themselves.