In international trade foreign exchange occupies an indispensable role to play. The national currency is not acceptable in making the settlement of international debts. The international payments are made in the currency of creditor country. So, the problem of foreign exchange starts as soon as we make a transaction with a foreign country. The creditor does not accept the currency of debtor country whereas the debtor would like to make the payment in his national currency.
The problem is solved by the central banks of the two countries and other constituents of foreign exchange market converting one currency into other currency.Thus, the settlement of foreign debt in foreign currency (of the respective country) in exchange of the national currency may be referred to as foreign exchange.
Dr. S.E. Thomas defines foreign exchange as “foreign exchange is that branch of the science of economics in which we seek to determine the principles on which the people of the world settle their debts one-to the other.” Thus, the term foreign exchange has been used in the above definition as a science which relates to the determining of rate of exchange’ and other related problems in the settlement of debts. As an art, the term, foreign exchange, refers to the institutions instruments and the mechanism involved in the settlement of international debts.
Hartley Withers defines the Foreign Exchange “as a mechanism by which international indebtedness is settled between one country and another.”
Thus, foreign exchange, represents a controlled system with the help of which trading countries settle their international indebtedness and includes all institutions, credit instruments mechanism etc. In other words, foreign exchange signifies the following two things-
(i) The rate of exchange at which the different monetary units are exchanged.
(ii) The process or mechanism through which payments are liquidated by different countries.