Module 16. Foreign Exchange Markets
1. Foreign Exchange Market
The foreign exchange (FX) market is a decentralized, 24-hour global market for trading currencies and is the world’s largest financial market, with daily turnover rising from about $6.6 trillion in 2019 to nearly $9.6 trillion by 2025. It enables currency conversion for international trade and investment, determines exchange rates that influence trade competitiveness, capital flows, inflation, and financial stability, and is closely monitored by central banks, which may intervene to limit excessive volatility.
In India, foreign exchange moved from strict controls under the FERA regime to a market-determined system after early-1990s reforms, achieving current account convertibility in 1994; today, the rupee operates under a managed float, with RBI intervention as needed. Overall, the FX market provides high liquidity, transparent pricing, supports cross-border transactions, transfers purchasing power across countries, and allows hedging of exchange rate risk.
Forex Trading Market Segments
The forex market is divided into segments based on the timing and terms of currency delivery, allowing participants to meet payment, trading, and risk-management needs.
Spot Market
The spot market involves immediate exchange of currencies, typically settled within two business days, at the prevailing spot rate determined by real-time supply and demand. It is highly liquid and mainly used for prompt international payments, such as importers paying overseas suppliers.
Forward Market
The forward market is an over-the-counter market where participants agree today on an exchange rate for a future date. Forward contracts lock in rates, helping firms hedge against exchange rate risk and eliminate uncertainty from future currency movements.
Swap Market
An FX swap consists of a spot transaction combined with a simultaneous forward transaction, allowing currencies to be exchanged now and reversed later at a predetermined rate. Swaps are widely used for short-term liquidity management and hedging, while longer-term currency swaps help manage long-term financing and investment exposures.
Futures and Options
Currency futures are standardized contracts traded on exchanges, while currency options provide the right, but not the obligation, to exchange currency at a specified rate before a future date. These instruments increase market depth, flexibility, and overall forex trading volumes.
Key Participants in Forex Markets
The forex market includes a wide range of participants with different objectives, such as trade facilitation, investment, risk management, and speculation.
Commercial Banks and Dealers
Banks are the most active participants, trading currencies in the interbank market for clients and for their own accounts. They provide foreign exchange services to importers, exporters, travellers, and investors, and act as market makers by quoting buy and sell rates. In India, Authorized Dealer (AD) banks licensed by the RBI—especially Category-I AD banks—handle the bulk of forex transactions under RBI regulations.
Central Bank (RBI)
The Reserve Bank of India plays a key role in maintaining orderly market conditions and managing foreign exchange reserves. It monitors exchange rate movements and intervenes by buying or selling foreign currency to curb excessive volatility, without targeting a fixed exchange rate. The RBI may intervene through spot, forward, or swap markets, regulate the market via guidelines and monetary policy, and maintain reserves to strengthen confidence and enable effective intervention.
Business Corporates
Companies involved in international trade or foreign investments are major participants. Exporters sell foreign currency earnings, importers buy foreign currency for payments, and corporates use instruments like forwards and options to hedge exchange rate risk. Large firms often manage FX exposure through treasury departments or banks, while foreign institutional investors and Indian firms investing abroad also transact in forex for cross-border capital movements.
Retail Customers and Others
Retail participants include travellers, NRIs, small traders, and individual investors who access the forex market through banks, money changers, or authorized fintech platforms. In India, Full-Fledged Money Changers (FFMCs) serve retail needs under RBI oversight. Hedge funds, investment managers, brokers, and speculators also participate, adding liquidity and depth to the market, though capital controls limit speculative activity in the Indian rupee, leading to offshore NDF trading.
Role of RBI in the Forex Market
The Reserve Bank of India (RBI) performs a dual role in the foreign exchange market—as regulator and as an active participant—to ensure stability and orderly functioning.
Regulatory Oversight
Under the Foreign Exchange Management Act (FEMA), all forex transactions in India must be conducted through RBI-authorized entities such as ...
