Foreign Exchange Market Difference From a Domestic Market
There are several key differences between the foreign exchange market and domestic market; first of all, in the domestic market, there is only one entity that has the right to issue one accepted currency – the government of a given sovereign nation. In the foreign exchange market, however, currencies are as numerous as the governments, and each of the latter has the power to implement its economic policies. As one would assume, these policies, ranging from taxes and customs tariffs to economic sanctions, influence the movement of goods, labor force, and capital across the borders. This fact leads to additional complications in converting purchasing power between the currencies, which is the essence of the foreign exchange market. As a result, the number of factors that impact the foreign exchange market is much higher than in the domestic market – that is, if a purely domestic market is even possible under the conditions of globalization. Thus, the foreign exchange market provides an expanded opportunity set, especially due to market imperfections, at the cost of increased political risks due to the much greater number of entities involved.
Spot market offers the opportunity to convert purchasing power between the currencies almost immediately, using the current spot rate quotations. In most cases, the traders on the spot market operate using US dollars that provide a universal measurement against all other currencies. For the reasons of simplicity, it includes currency against currency trades, when one non-dollar currency is traded for another. The defining feature of the spot market is that assets are swapped effective immediately, even though the official transfer will usually take up to 2 business days. Suppose a German importer wants to make an immediate $10,000 purchase from a US exporter and is content with the current exchange rate of 1.1437 from a direct US perspective. In this case, the German importer’s bank A debits its client’s deposit account for $10,000/1.1437=€8772. It then instructs its corresponding bank B in North America to debit Bank A’s account for $10,000 and credit the same sum to the German importer’s account. Finally, bank A credits its books €8772, corresponding to the €8772 debit of the German importer’s account, effective immediately.
The forward market is similar to the spot market in its purpose, which is transferring purchasing power between different currencies – but differs in detail. The defining feature of the forward market is that the sides agree on the exchange rate today, but the transfer of funds happens at a designated point in the future rather than immediately. Forward rate quotations may be at a premium, at a discount, or, in some cases, identical to the spot rate quotation. Say an American client wants to contract for a purchase of 10,000 Australian dollars six months in the future. This client then contacts his bank to inquire about a forward rate quotation in six months, which is 0.7083 indirect American terms. If the client is content with a transaction on these terms, the forward contract is made immediately, but the actual transfer of funds on these terms will only occur on the maturity date. Forward contracts are especially valuable for those obliged to pay a certain sum in foreign currency at a certain date and want to obviate the risks of exchange rates changing dramatically over this time.