Define foreign exchange market. State its functions.

Meaning of foreign exchange market. The market in which national currencies of various countries are converted, exchanged or traded for one another is called foreign exchange market. Alternatively, it is the market where national currencies are traded for one another. It is not any physical place but is a network of communication system which connects the whole complex of institutions. It includes banks, specialised foreign exchange dealers, brokers and official government agencies through which the currency of one country can be exchanged (converted) for that of another. Again foreign exchange market is of two types — Spot market and forward market. 
Functions: Foreign exchange market performs three main functions, namely, (i) transfer function, (ii) credit function, and (iii) hedging function. Transfer function refers to transferring purchasing power between countries; credit function refers to providing credit channels for foreign trade and hedging function pertains to protecting against foreign exchange risks. Hedging is an activity which is designed to minimize risk of loss. When people want to operate in the foreign exchange market, it implies that they intend to buy or sell foreign exchange depending on their demand for or supply of foreign exchange. For instance, when we (Indian residents) buy foreign goods, say Japanese goods, it shows supply of rupees to foreign exchange market to be exchanged for Yen because seller of Japanese goods will expect payment in Yen only. Similarly, Indian exporters of their goods will expect to be paid in rupees for which foreigners will have to sell their currency in the exchange market to buy rupees in return. It shows demand for rupees in foreign exchange market. Transactions in foreign exchange market are reflected in the balance of payment account.