The foreign exchange market is a global decentralized market for trading currencies. It involves the exchange of one currency for another at an agreed exchange rate. Factors like inflation, interest rates, current account deficits, public debt, terms of trade, and political stability can influence exchange rates. The value of a currency is determined by the forces of supply and demand in the forex market.

1. Forex, FX or currency market

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Foreign exchange markets, where money in one currency is exchanged
for another
Exchange rate, the price for which one currency is exchanged for
another
Foreign exchange reserves, holdings of other countries' currencies
Foreign exchange controls, controls imposed by a government on the
purchase/sale of foreign currencies
Retail foreign exchange platform, speculative trading of foreign
exchange by individuals using electronic trading platforms
Foreign exchange risk, arises from the change in price of one currency
against another
International trade, the exchange of goods and services across national
boundaries
Foreign exchange company, a broker that offers currency exchange and
international payments
Bureau de change, a business whose customers exchange one currency
for another
Currency pair, the quotation of the relative value of a currency unit
against the unit of another currency in the foreign exchange market

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It is a global decentralized market for the
trading of currencies.

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Foreign exchange market needs dealers to
facilitate foreign exchange transactions.
Bulk of foreign exchange transaction are
dealt by Commercial banks & financial
institutions.
RBI has also allowed private authorized
dealers to deal with foreign exchange
transactions i.e. buying & selling foreign
currency.

6. In foreign exchange market two types of
exchange rate operations take place.
They are,
 Spot exchange rate.
 Forward exchange rate.
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When foreign exchange is bought and sold
for immediate delivery, it is called spot
exchange.
It refers to a day or two in which two
currencies are involved.
The basic principle of spot exchange rate is
that it can be analyzed like any other price
with the help of demand and supply forces.

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Here foreign exchange is bought or sold for
future delivery i.e., for the period of 30, 60 or
90 days:
There are transactions for 180 and 360 days
also.
Thus, forward market deals in contract for
future delivery.
The price for such transactions is fixed at the
time of contract, it is called a forward rate.

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Transfer Function
Credit Function
Hedging Function

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In a free exchange market when exchange
rates, i.e., the price of one currency in terms
of another currency, change, there may be a
gain or loss to the party concerned.
Under this condition, a person or a firm
undertakes a great exchange risk if there are
huge amounts of net claims or net liabilities
which are to be met in foreign money.

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Exchange risk as such should be avoided or reduced.
For this the exchange market provides facilities for
hedging anticipated or actual claims or liabilities
through forward contracts in exchange.
A forward contract which is normally for three months
is a contract to buy or sell foreign exchange against
another currency at some fixed date in the future at a
price agreed upon now.
No money passes at the time of the contract. But the
contract makes it possible to ignore any likely changes
in exchange rate.

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To provide credit, both national and
international, to promote foreign trade.
Obviously, when foreign bills of exchange are
used in international payments, a credit for
about 3 months, till their maturity, is
required.

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To facilitate the conversion of one currency
into another, i.e., to accomplish transfers of
purchasing power between two countries.
Through a variety of credit instruments, such
as telegraphic transfers, bank drafts and
foreign bills.

14. Before we look at these forces,
 we should sketch out how exchange rate
movements affect a nation's trading
relationships with other nations.
 A higher currency makes a country's exports
more expensive and imports cheaper in foreign
markets; a lower currency makes a country's
exports cheaper and its imports more expensive
in foreign markets.
 A higher exchange rate can be expected to
lower the country's balance of trade, while a
lower exchange rate would increase it.

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Inflation
Interest Rates
Current-Account Deficits
Public Debt
Terms of Trade
Political Stability and Economic
Performance

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As a general rule, a country with a consistently lower
inflation rate exhibits a rising currency value, as its
purchasing power increases relative to other
currencies.
During the last half of the twentieth century, the
countries with low inflation included Japan, Germany
and Switzerland, while the U.S. and Canada achieved
low inflation only later.
Those countries with higher inflation typically see
depreciation in their currency in relation to the
currencies of their trading partners.
This is also usually accompanied by higher interest
rates.

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By manipulating interest rates, central banks
exert influence over both inflation and
exchange rates, and changing interest rates
impact inflation and currency values.
Higher interest rates offer lenders in an
economy a higher return relative to other
countries. Therefore, higher interest rates
attract foreign capital and cause the
exchange rate to rise.

18. The current account is the balance of trade between a country and
its trading partners, reflecting all payments between countries for
goods, services, interest and dividends.
 A deficit in the current account shows the country is spending
more on foreign trade than it is earning, and that it is borrowing
capital from foreign sources to make up the deficit.
 In other words, the country requires more foreign currency than it
receives through sales of exports, and it supplies more of its own
currency than foreigners demand for its products.
 The excess demand for foreign currency lowers the country's
exchange rate until domestic goods and services are cheap
enough for foreigners, and foreign assets are too expensive to
generate sales for domestic interests.
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Countries will engage in large-scale deficit
financing to pay for public sector projects and
governmental funding.
While such activity stimulates the domestic
economy, nations with large public deficits and
debts are less attractive to foreign investors.
The reason? A large debt encourages inflation,
and if inflation is high, the debt will be serviced
and ultimately paid off with cheaper real dollars
in the future.

20. A ratio comparing export prices to import prices, the
terms of trade is related to current accounts and the
balance of payments.
 If the price of a country's exports rises by a greater rate
than that of its imports, its terms of trade have favorably
improved.
 Increasing terms of trade shows greater demand for the
country's exports. This, in turn, results in rising revenues
from exports, which provides increased demand for the
country's currency (and an increase in the currency's
value).
 If the price of exports rises by a smaller rate than that of
its imports, the currency's value will decrease in relation to
its trading partners.
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Foreign investors inevitably seek out stable countries
with strong economic performance in which to invest
their capital.
A country with such positive attributes will draw
investment funds away from other countries
perceived to have more political and economic risk.
Political turmoil, for example, can cause a loss of
confidence in a currency and a movement of capital to
the currencies of more stable countries.

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If the forward rate is above the present spot
rate, the foreign exchange rate is said to be at
a premium.
If the forward rate is below the present spot
rate, the foreign exchange rate is said to be at
a discount.
Thus foreign exchange rate may be at
forward premium or at forward discount.

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http://www.investopedia.com/articles/basics/
04/050704.asp
http://en.wikipedia.org/wiki/Foreign_exchang
e_market