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Between the two markets there are contrasting differences which makes each market unique in its nature. It caters to different types of investors and their different requirements for different returns. The foreign exchange market is a worldwide decentralized over-the-counter financial market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends.

The north and south poles of the financial markets

We will now compare the two extreme poles of the magnet which have comparative features and describe the type of trading classified in their markets. Each market caters to different types of investors for a wide range of purposes. If either of these markets is for you than the following comparison will help you differentiate each market through its various attributes characterizing the markets.

Foreign exchange reserves (also referred to as Forex reserves) in a strict sense are only the foreign currency deposits and bonds that are held by central banks and monetary authorities. However, commonly foreign exchange and gold, SDRs and IMF reserve positions are included in the term in popular usage.

This broader figure is more readily available, but more accurately it is referred to as official international reserves or international reserves. These are assets of the central bank that the central bank holds in different reserve currencies, mostly in the US dollar, and to a lesser extent in the euro, the UK pound, and the Japanese yen, and it is used to back its liabilities, e.g. the local currency issued, and the various bank reserves that are deposited with the central bank, by the government or financial institutions.

History

Official international reserves, that were the means of official international payments, formerly consisted only of gold, and occasionally silver. But under the Bretton Woods system, the US dollar functioned as a reserve currency, so the US dollar also became part of a nation’s official international reserve assets. From 1944-1968, through the Federal Reserve System the US dollar was convertible into gold, but after 1968 only central banks were able to convert dollars into gold from official gold reserves, and after 1973 no individual or institution has the permission to convert US dollars into gold from official gold reserves.

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A quotation of exchange system is given by stating the number of units of "term currency" (that is also known as "price currency" or "quote currency") that can be bought in terms of 1 "unit currency" (which is also referred to as "base currency"). For example, in a quotation that elaborates the EURUSD exchange rate is 1.4320 (1.4320 USD per EUR), then in this quotation USD is the term currency and EUR is the base currency.

Among two currency which is the base currency and which is the term currency, it is determined by a market convention. In most parts of the world, this is the order: EUR – GBP – AUD – NZD – USD – others. Thus if you are doing a conversion from EUR into AUD, the base currency is EUR, and the term currency is AUD and you will know it from the exchange rate that how many Australian dollars you would pay or receive for 1 euro.

EUR and GBP are reversed in some areas of Europe and in the non-professional market in the UK,  so that GBP is quoted as the base currency to the euro. When both currencies are not listed (i.e. both are "other"), then in order to determine which is the base currency, market convention use that currency as the base currency which gives an exchange rate greater than 1.000. Doing this rounding issues and exchange rates being quoted to more than 4 decimal places are avoided. To this rule there are few exceptions e.g. the Japanese often quote their currency as the base to other currencies.

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A change is shown by a market based exchange rate whenever there is a change in values of either of the two component currencies. Whenever the demand for a currency is greater than the available supply a currency will tend to become more valuable. Opposite will be the case whenever demand is less than available supply means a currency will become less valuable in this case, but this does not mean that people no longer want money, what it means is just that they prefer to hold their wealth in some other form, may be possible in another currency.

The currency’s demand is increased due to either an increased transaction demand for money, or an increased speculative demand for money. There is a great correlation between the transaction demand for money  and the country’s level of business activity, gross domestic product (GDP), and employment levels.

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In this article I will explain you the balance Balance of payments model and Asset market model.

Balance of Payments Model 

This model holds that a foreign exchange rate must be at its equilibrium level.It is the rate by which a stable current account balance is produced. A nation that is facing a trade deficit will experience reduction in its foreign exchange reserves and due to this the value of its currency will  ultimately lowers (depreciates). The nation’s goods (exports) become more affordable in the global market place due to the cheaper currency while it makes imports more expensive. After that an intermediate period is reached then the imports are forced down and exports rise, thus it stabilizes the trade balance and push the currency towards equilibrium.

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In finance, the exchange rates is also known as the foreign-exchange rate, forex rate or FX rate. Between two currencies it is specified by the exchange rates that how much one currency is worth in terms of the other. The value of a foreign nation’s currency in terms of the home nation’s currency is given by exchange rates. For instance an exchange rate of 95 Japanese yen (JPY, ¥) to the United States dollar (USD, $) means that the value of JPY 95 is the same as USD 1. One of the largest markets in the world is the foreign exchange market. According to an estimates, every day about 3.2 trillion USD worth of currency are exchanged.

the current exchange rate is referred to as the spot exchange rate. The forward exchange rate refers to such type of exchange rate that is quoted and traded today but its delivery and payment is agreed on a specific future date.

Free or pegged Exchange Rates

If a currency is free-floating, then its exchange rate is permitted to vary against that of other currencies and this exchange rate is determined by the market forces of supply and demand. For such currencies exchange rates are likely to change almost constantly as quoted on financial markets, mainly by banks, around the world.

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Each private central bank has got the monopoly control over the supply and production of the country’s own currency, in most of the cases. There are exchange rates in order to facilitate trade between these currency zones, which are those prices at which the currencies (and the goods and services of individual currency zones) can be exchanged against each other. On the basis of their exchange rate regime currencies can be classified as either floating currencies or fixed currencies.

Control of a currency is exercised either by a central bank or by a Ministry of Finance in such cases where a country does have control of its own currency. In either case, the monetary authority is the name given to that particular institution that has control of monetary policy. The government provides varying degrees of autonomy to the monetary authorities. In the United States, the Federal Reserve System is operated without direct oversight by the legislative or executive branches. Here it is important to note that the government creates a monetary authority and the government also provides support to it, so its independence can be reduced or revoked by the legislative or executive authority by which it is created. However, in practical terms, the revocation of authority is not likely. The monetary authority is largely independent from the government, in almost all Western countries.

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In foreign exchange markets, the first currency in a currency pair is the base currency. Whereas the second currency is referred to as the quote currency which is also called as counter currency, terms currency. Exchange rates are quoted in per unit of the base currency. The thing that should be noted is that FX market convention is the reverse of mathematical convention.

Currently for base currency, the euro has first precedence; as a result of this all currency pairs involving it should have the euro as the first currency. For instance, the exchange rate will be identified as EUR/USD between the US dollar and the euro; the number shows the amount of US dollars that can be traded for one euro.

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Trade of currencies is done by the foreign exchange market, which is also known as currency, forex, or FX. It provides an ease to banks and other institutions for buying and selling currencies.

Basic Purpose of Foreign Exchange Market

The basic purpose of the foreign exchange market is to facilitate international trade and investment. A foreign exchange market provides help to businesses for converting one currency to another. For instance, a U.S. business is permitted by it to import European goods and pay Euros, even though the income of  business is in U.S. dollars.

In a typical foreign exchange transaction what happens is that a quantity of one currency is purchased by a party by paying a quantity of another currency. The modern foreign exchange market has been started initiating during the 1970s, at that time countries gradually switched to floating foreign exchange from the previous exchange regime, which does not change and remained fixed as per the Bretton Woods system.

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