Think of a businessman who is involved in exporting goods to foreign countries and import from international traders. In the domestic market, we can easily understand the trading system. You buy an item and pay the vendor in rupees. But what about international trading? A foreign trader will not accept rupee in exchange for goods and may demand payment in his native currency. Because of the complex nature of international trading, due to different currencies in different countries, the need to convert one currency to others at a market rate arises.
Foreign currencies are traded in a special market. The foreign exchange (or Forex or FX) market is the largest market, valuing over trillion dollars traded between forex traders. For example, one can swap rupees for the US dollar or any other currency in the foreign exchange market.
Foreign currencies are traded in various international locations, including the Indian market, and remain open for 24 hours. It is a vast network of banks, brokers, institutional investors, retail investors, and export-importers.
So, what is foreign exchange? In simple terms, converting one currency into another is called foreign exchange. For example, one Indian merchant has to convert rupees to dollars to pay a US vendor. The need arises because of the existence of different currencies in different countries. Post World War II, when international trading became a norm between countries, the global community agreed to elect the US dollar as the standard currency for all foreign exchange transactions. As a result, the domestic currency gets converted to a dollar before settling an international trader. Similarly, the seller also has to accept dollar payment and then convert it to his native currency. Nowadays, the rule has become less stringent, and direct conversions are also allowed for some currency pairs.
When we talk about foreign exchange, we talk about them in pairs, because foreign currencies are always traded in pairs. When one currency is bought, the other is sold. The first currency is called ‘base currency’ and the other one ‘quote currency’.
How The Rates In The Currency Market Are Determined?
In the Forex market, currencies are exchanged on an agreed-upon rate, called the exchange rates. These rates are updated regularly, determined based on several economic and political factors.
Currency trading happens in the domestic market, through stock exchanges, as well as in various international neutral markets like Singapore, Dubai, and London. The local market for foreign exchange is called the onshore market, and the foreign locations are called offshore markets. Offshore currency markets are a complex network of various stakeholders where traders indulge not only in currency trading but also in NDFs and rate arbitraging.
Currencies are quoted in pairs like UDS/INR, EUR/UDS, USD/JPY. And, there is a rate associated with each pair. Let’s say the quoted price for UDS/CAD is 1.2569. It means to buy one dollar you have to pay 1.2569 Canadian dollar.
Foreign currency market is volatile. Valuation of a currency depends on factors like economic and political conditions, interest rates, inflation, and more. When a country’s economy is booming, and the political situation is stable, its currency might appreciate in the international market. Similarly, economic volatility, internal and external political turmoil, or war can cause a currency price to fall. Sometimes, the government also participates in the foreign exchange market to influence rates.
When a domestic currency is appreciating, its value against the foreign currency goes up. Import becomes cheaper, and export becomes expensive. Let’s consider the above example. Say, the foreign exchange rate for CAD changes from 1.2569 to 1.2540. It means the Canadian dollar appreciates against the dollar, and USD becomes cheaper compared to CAD. Similarly, if the exchange rate increases to 1.2575, we will say the Canadian dollar has depreciated.
In the foreign exchange market, currency trading happens in three sizes, micro, mini, and standard lots. Micro is the smallest quantity, say 1000 units of any currency. Mini lot contains 10,000 units, and the standard lot is of 100,000 units. You can trade in any number of lots you want, like seven micro lots, three mini lots, or fifteen standard lots.
Trading In The Forex Market
The forex market is the largest in terms of size and volume, valuing over $6.6 trillion per day in 2019. The largest trading centres for forex trading are London, New York, Singapore, and Tokyo.
The foreign exchange market remains operative for five days a week, with Saturday and Sunday being holidays, 24 hours a day. It is a highly liquid market. Because of its nature, the foreign exchange market is different from the other markets.
Foreign exchange has different markets as following.
In the spot market, settlement happens within two days of acquiring the currency. The only difference is the Canadian dollar, which traders must settle on the next business day.
Spot market is highly volatile and dominated by technical traders who trade in the direction of the market trend in short duration. They try to capitalise on price fluctuations based on daily demand and supply factors. Long-term currency movements depend on more fundamental changes in the country’s economy, policy, interest rates and other political considerations.
The Forward Market
The opposite to spot market is the forward market, where currencies trading happens on a future date, rather than spot. The future price is decided by adding or subtracting forward points (interest rate differential between two currencies)with the spot rate. The rate is fixed on the transaction date, but the physical asset transfer happens on the maturity date.
Most forward contracts are for one year. But some banks also offer extended tenure contracts. These contracts can be for any volume of foreign currency, tailormade to meet the needs of the parties involved in the deal.
Futures contracts are also like forward contracts, where the deal is settled at a future date on a fixed upon rate. These contracts are traded in the commodity market and used by traders to invest in foreign currencies.
Forex trading: a real-life example
Forex trading is based on predictions. Let’s say the trader expects European Central Bank to readjust the price of Euro against dollar, and dollar will appreciate. So, he enters into a short for €100,000 for an exchange rate of 1.12. Now let’s say the market actually slows down and Euro depreciates to 1.10. so, in the trade, the trader earns a profit of $2000.
Shorting is a process of selling and repurchasing an asset when the price drops, often a common practice in the currency market. In the above example, shorting will allow trader to earn $ 112,000 from the transaction. When Euro depreciates, the trader will pay only $110,000 to repurchase the currency, thus striking a profit of $2000. But the trader would have incurred loss if the value of Euro appreciated.
The Key Highlights
- Foreign exchange is a thriving market played by many players – corporate, government, travellers, amateur traders, large investors, and speculators
- In terms of volume, it is the largest market, with trillions of dollars daily changing hands
- Currencies are traded in pairs, pricing one versus another – one is a base currency and the other, quote currency
- The foreign exchange market remains open round the clock, with one market closing and another opening simultaneously
- Currency values depend on supply and demand, as well as external factors like the country’s economy and politics
- Despite disperse market, exchange values don’t fluctuate significantly between exchanges to prevent widespread arbitraging
- Forwards and futures are the two ways to participate in the foreign exchange market. But there also exists a spot market where transactions happen at the current rate
- In India, you can trade in foreign currencies in BSE, NSE, and MCX-SX
- However, trading non INR pairs are illegal under FEMA
- Indian bourses offer forex trading instruments in USD/INR, GBP/INR, JPY/INR, and EUR/INR
- The forex market perhaps is the most accessible financial market. Adding foreign currency as an asset class assist in portfolio diversification
The forex market is highly volatile and liquid to summerise it all, where international currencies traded for profit. It is good to have a fair idea about the global currency market since it has a significant influence on the domestic market as well. Typically, currency traders deal on one or two pairs of currencies and follow the pairs through different markets for profit opportunities.
In India, forex trading is regulated, though not restricted. Indian residents can trade for currency pairs approved by RBI in the exchanges. Earlier, RBI imposed strict restrictions on trading non INR pairs, but it has since eased its policies. But it is still illegal to trade in currency pairs not approved by the apex bank.
You can easily diversify your portfolio by including forex trading instruments to it. To start, you would need to open a forex trading account with a broker.