For those of you who frequently travel abroad, conduct business internationally, or are interested in the world of investment, the term foreign exchange (forex) is certainly familiar. However, do you know what foreign exchange is, including its functions, types, and the applicable exchange rate system? This article will explain foreign exchange to help you better understand its important role in the global economy.
Definition of Foreign Exchange (Forex)
Foreign exchange, or forex, is a foreign currency recognized and accepted as legal tender in international trade and economic transactions. Not all currencies can be used as foreign exchange; only currencies suitable for international transactions are generally considered hard currencies, namely currencies with strong and stable value because they originate from developed countries with significant economic influence, such as the United States dollar (USD), the euro (EUR), and the Japanese yen (JPY). Meanwhile, the rupiah is considered a soft currency.
Function of Foreign Exchange
Foreign exchange plays a significant role in supporting the smooth functioning of economies between countries. Here are some of its main functions:
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Means of exchange and international payment
Foreign exchange is used as the official means of payment in export-import transactions of goods and services between countries. For example, when Indonesia imports a vehicle from Japan, payment is made in yen.
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Exchange rate control tool
Governments and central banks utilize foreign exchange to maintain the stability of the domestic currency exchange rate to prevent excessive fluctuations.
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Facilitate international trade
With foreign exchange, buying and selling processes between countries can proceed more easily without being hampered by differences in each country's currency.
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Means of payment for foreign debt
Countries also use foreign exchange to settle debt obligations to other countries or international financial institutions.
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Investment instrument
Foreign exchange can be used as an investment instrument (forex trading) by profiting from the exchange rate differences resulting from foreign exchange buying and selling
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National foreign exchange reserves
Central banks also use foreign exchange as foreign exchange reserves to maintain economic stability and the national currency exchange rate.
Types of Foreign Currency
Foreign currency also has several types, here are several types of foreign currency:
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Based on Form
Based on form, foreign exchange can be divided into two main types:
- Physical foreign currency, which is foreign currency in the form of paper money, such as banknotes or coins. It is generally used for transactions requiring cash payments. Examples include the US Dollar (USD), Euro (EUR), Japanese Yen (JPY), and British Pound Sterling (GBP).
- Non-physical foreign currency, which is foreign currency in the form of demand deposits or securities, such as checks, money orders, and traveler's checks. Non-physical foreign currency is generally used for non-cash transactions such as bill payments or interbank transfers in international trade.
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Based on Nature
- Hard Currency, which is a stable currency and widely used in international trade. Examples include the US Dollar (USD), Euro (EUR), Japanese Yen (JPY), British Pound Sterling (GBP), and Swiss Franc (CHF).
- Soft Currency (Weak Foreign Currency) is a currency with an unstable exchange rate and little trust in the international market. It usually originates from countries with high inflation or weak economies. Examples include the Rupiah (IDR), the Argentine Peso (ARS), and the Vietnamese Dong (VND).
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Based on Limitations
- Free Foreign Currency is a currency that can be traded and exchanged freely in the international market without many government restrictions, for example, the US Dollar (USD), the Euro (EUR), and the Australian Dollar (AUD).
- Non-Free Foreign Currency is a currency whose use is restricted by the government and requires approval from monetary authorities, for example.
Types of Foreign Exchange Markets
Furthermore, based on market type, foreign exchange transactions are divided into several groups, including:
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Spot Market
A market that facilitates currency exchange transactions that are settled directly, usually at banks or money changers. Spot market transactions are generally conducted when planning a vacation abroad or when foreign tourists visit the country.
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Forward market
A market that handles foreign exchange purchase transactions through contracts with settlement at a future date as agreed. Forward transactions are typically conducted by individuals or banking/non-banking institutions that have a special contract with a bank, making these transactions interbank. Contract values in this market can reach millions of US dollars.
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Currency futures market
A market where futures contracts are traded for a specific volume of currency. Transactions in this market can be exchanged on a specific settlement date in the future, with the benefit of hedging and speculative purposes. There are two types of transactions in this market: foreign exchange (financial futures market) and commodities (commodity futures market).
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Currency options market
A market with contracts that give the right (but not the obligation) to buy or sell foreign exchange at a specific price and time. In this type of market, currency option contracts are divided into two types:
- Currency call, which is a contract that gives the right (but not the obligation) to buy a specific currency at an agreed-upon price on a specific date in the future.
- Currency put, which is a contract that gives the right (but not the obligation) to sell a specific currency at an agreed-upon price on a specific date in the future.
Foreign Exchange Rate System
The exchange rate is the exchange rate of one currency expressed in terms of another country's currency. There are three exchange rate systems commonly used by various countries:
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Fixed exchange rate system
The currency exchange rate is set and fully controlled by the government or central bank. This system provides exchange rate certainty but requires large foreign exchange reserves and risks the emergence of a black market. The government maintains control over the foreign exchange rate. For example, if there is excess supply resulting in a low foreign exchange rate, the government can purchase foreign exchanges to restore the exchange rate to the fixed rate. Conversely, if there is excess demand for foreign exchange resulting in the exchange rate rising above the benchmark rate, the government will sell foreign exchange to increase supply and lower the exchange rate.
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Floating exchange rate system
The exchange rate is determined entirely by market mechanisms, namely supply and demand, without government intervention. The advantages of this system are that the government does not need to provide foreign exchange reserves to control the market, there is no black market as occurs in a fixed exchange rate system, and the prevailing exchange rate is the equilibrium exchange rate.
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Managed Floating Exchange Rate System
This is a combination of the two previous systems. The exchange rate moves according to the market, but the government can still intervene if the exchange rate fluctuation is deemed too extreme, exceeding predetermined limits. For example, the lower and upper limits of an exchange rate are set at one percent. If the exchange rate moves beyond these limits, the government can intervene by buying foreign exchange or selling foreign exchange reserves.
Factors Influencing Foreign Exchange Rates
The value of a currency against another currency is greatly influenced by the following factors:
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Market Forces
Market forces, including trade activity, investment, tourism, and geopolitical risks. When foreign tourists visit a country or companies conduct cross-border business transactions, the need to exchange currency increases, thus affecting the demand for foreign exchange.
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Inflation Rate
Another important factor is inflation. High inflation rates tend to negatively impact a currency exchange rate, while low inflation does not always guarantee a favorable exchange rate. However, inflation typically has a significant negative effect on currency values and foreign exchange rates.
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Interest Rates
Higher interest rates generally attract more foreign investment, which can encourage a strengthening of a country's currency.
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