The foreign exchange market, also known as the forex market or the FX market, refers to trading one currency for another. It is by far the largest market in the world.
Historically, currencies were backed by gold. This prevented the value of money from being debased and inflation. However, the Bretton Woods Agreement replaced this gold standard after the Second World War, which aimed to prevent speculation in currency markets by fixing all currencies against the US dollar and making the dollar convertible to gold at a fixed rate of US$35 per ounce. Under this system, countries were prohibited from devaluing their currencies by more than 10%, which they might have been tempted to improve their trade position, i.e., exports.
The growth of international trade, and increasing pressure for the movement of capital, eventually destabilized this agreement, which was finally abandoned in the 1970s. Currencies were allowed to float freely against one another, leading to the development of new financial instruments and speculation in the currency markets.
Trading in currencies became 24-hour, as it could occur in the various time zones of Asia, Europe, and America. Being placed between the Asian and American time zones, London was well set to take advantage of this and has grown to become the world’s largest forex market. Other large centers include the US, Japan, and Singapore.
What is Currency Trading?
Currency trading, often referred to as foreign exchange or Forex, is the purchasing and selling of currencies in the foreign exchange marketplace to make profits. It is referred to as ‘speculative Forex trading.’ Forex trading is the largest market in the world, with more than $6 trillion traded daily. The main factor that differentiates currency trading from other types of trading is its liquidity.
Currencies are Traded in Pairs
Trading of foreign currencies is always done in pairs. In a currency pair, currencies are mentioned in abbreviated form, e.g., USDINR, GBPUSD, etc. The left side currency is known as the base currency, and the right side currency is called quote currency.
In forex trading, (currency trading) base currency is traded for quote currency, i.e., bought or sold.
Example: USDINR is 78. It means 1 USD is equal to INR 78. This is also an exchange rate of 1 USD in INR. If an exchange rate goes up, it means the value of the base currency is rising relative to the quote currency and is referred to as strengthening, and the currency is said to be weakening when the opposite is the case.
When currency pairs are quoted, a market maker or foreign exchange trader will quote a bid, and an ask price.
The most commonly quoted currency pairs in the global market and exchanges are:
- US Dollar and the Japanese Yen: USDJPY.
- Euro and US Dollar: EURUSD.
- US Dollar and Swiss Franc: USDCHF.
- British Pound and US Dollar: GBPUSD.
At Indian exchanges, commonly quoted currency pairs are:
- USDINR
- GBPINR
- EURINR
- JPYINR
Primarily, the forex market is an over-the-counter (OTC) market, where brokers and dealers negotiate directly. The main participants are large international banks that continually provide the market with bids (buy) and ask (sell) prices. Central banks are also major participants in foreign exchange markets, which they use to control the money supply, inflation, and interest rates.
Forex trading is also done at regulated exchanges, i.e., LSE, NYSE, NSE, BSE, etc. Exchanges provide an opportunity for individuals to trade in currency trading.
Example of Forex Transactions
Spot Market
Let’s assume that Vivek is planning for an overseas trip after three months. He buys USD 10,000 @ Rs 78. If at the time of his travel, USD increases to INR 80, then the value of USD 10,000 would increase by INR 20,000 {(Rs 80-78)*USD 10,000}. An early purchase of USD has saved Rs 20,000 for Vivek. t should be noted that the USD value may fall instead of appreciation.
Exchange Transaction
Instead of purchasing USD 10,000, Vivek may take a long position in USDINR, i.e., buy USD Futures by paying the margin amount. The margin amount is a fraction of the total transaction value, say 4-5% of Futures contracts. If the USD appreciates in the future at the time of travel, then any extra amount incurred to buy USD in the spot market would be offset by a gain in the Futures Contract. An advantage of a Futures contract is that it requires only a fraction to take a position in a derivatives contract.
Types of Transactions in Foreign Exchange
There are several types of transactions undertaken in the foreign exchange market, particularly:
Spot Transactions
The spot rate is the rate quoted by a bank for exchanging one currency for another with immediate effect. However, it’s worth noting that, in many cases, spot trades are settled two business days after the transaction date.
Forward Contacts
In this type of transaction, money does not change hands until some agreed future date. Buyer and seller agree on an exchange rate for any date in the future for a fixed sum of money, and the transaction occurs on that date, regardless of the prevailing market rates. Forward contracts could be of a few days, months, or years. Forward contracts are usually made between corporates and banks or financial institutions.
Futures
Foreign currency futures are standardized versions of the Forward Contracts. Futures are traded in standard sizes and maturity dates on the exchanges. The duration of Futures contracts could be weekly or monthly. At many exchanges, futures contracts are available for the next twelve months. However, liquidity would be more in near months contracts.
Swaps
A common type of forwarding contract is the currency swap. In a currency swap, two parties exchange currencies for an agreed period and agree to reverse the transaction later. These exchange-traded contracts are negotiated individually between the parties to a swap. Swaps are a type of OTC derivative.
What Causes Currencies to Fluctuate?
Many factors can contribute to changes in the value of a currency. Some of these factors include terms of trade, differences in interest rates in two countries, inflation rates, public debt, etc. So, let’s take a-It’s each one of these factors.
Balance of Trade
Balance of trade affects the value of a country’s currency. For example, when the value of a country’s exports is higher than its imports, there is a trade surplus, and it has a positive effect on the currency’s value, i.e., it appreciates the currency against other major currencies of the world—an improvement in trade.
Inflation Rates
Countries with lower inflation rates than other countries experience increased currency values. This increase means that the currency’s purchasing power will also be increased. For example, a country that previously spent $1 million for 10,000 units of a foreign product may now be able to purchase >10,000 units with the same $1 million. Conversely, high inflation means there will likely be a depreciation in the currency’s value.
Public Debt
When a country’s debt remains high, foreign investors lose confidence in its economy and make fewer or no investments. Historically, significant and consistent public debt encourages inflation and can devalue the currency.
Conclusion: Forex Market for Hedging and Speculation
Currency trading, often referred to as foreign exchange or Forex, is the purchasing and selling of currencies in the foreign exchange marketplace to make profits and hedge through derivative contracts like Forwards, Futures, etc.
Unexpected news events can cause volatility in the forex markets. During volatile mart conditions, aggressive use of leverage could result in substantial losses. Limiting the risk you are exposed to on each trade is good practice. For example, you can use only a percentage of your overall trading account balance on each transaction, say 1 or 2 %.
It is essential to bear in mind, however, that applying stop-loss may not guarantee that your position will be closed out at the price you set. When markets are volatile, i.e., with high movement in currency values, usually by 50 p or a rupee against USD, stop loss orders might not get executed. As a result, the price may move from one level to another. This is known as slippage.
Trading in the forex market requires skills like understanding the economy, the impact of global factors, movement of currency values, etc. As a result, Forex may be better for newer traders with smaller capital.
