Determination of Exchange Rates:
Theories of exchange rate determination are primarily set within a framework of market forces. Though, in practice, free working of market forces is restricted in varying degrees, the era of fully fixed rates and exchange control ended long ago and role of market forces is increasingly gaining in importance.
Remittance of Funds:
In an international transaction, at least one of the transacting parties makes (or receives) a payment in a foreign currency. Foreign exchange market provides a means for conversion of one currency into the other, and facilitates inter-country remittance of funds.
Credit Facilities:
As in the case of domestic trade and investment activities, international dealings also require credit financing. Financial institutions operating in the foreign exchange market provide this facility.
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Financial Intermediation:
Financial institutions, particularly banks and other dealers in foreign exchange, provide clearing services, and help buyers and sellers of foreign exchange in conducting their deals quickly, reliably and economically.
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In the absence of these intermediaries, individual dealers would have to search for each other and settle rates at which to strike deals.
Speculation, Hedging and Arbitrage:
Foreign exchange markets provide a channel of speculative activities. Depending upon the attendant circumstances, effects of these activities can be beneficial or harmful and contribute towards destabilisation or stabilisation of the open economies.
For example, a country with a weak currency and insufficient foreign exchange reserves runs the risk of a payments crisis fed by a flight of capital.
Foreign Exchange Reserves:
Open economies need foreign exchange reserves (that is, ownership of foreign currency balances) for:
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(i) Meeting normal discrepancies between inflows and outflows of foreign exchange; and
(ii) Tiding over contingencies like speculative movement of funds, etc.
In the last few decades, requirements of foreign exchange reserves have increased very rapidly; and several factors have contributed to this phenomenon, such as, paper standard currencies, market-determined exchange rates, and a rapid expansion in trade and capital flows, etc.
Parking:
Foreign exchange reserves need to be “parked” (that is, kept in the form of readily usable assets like bank deposits, and investments in foreign securities, etc.) so as to provide an optimum combination of safety and returns.
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Foreign exchange markets act as an efficient and cost-effective vehicle for achieving this objective.