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The foreign exchange market (also referred to as the forex or currency market) is the marketplace for exchanging currencies between all stakeholders such as governments, central and commercial banks, firms, forex dealers, brokers and individuals. Such players can use the market for trading, hedging and speculating in currencies as well as obtaining credit.
Key Takeaways
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The foreign exchange market operates globally without a central hub, enabling continuous trading among banks, institutions, and retail traders
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Markets include spot, forward, futures, options, and swaps, each serving distinct trading and hedging purposes.
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Currencies are traded in pairs, with exchange rates determined by demand, supply, and government policies.
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Forex markets offer high liquidity, transparency, and low entry barriers, but also have drawbacks such as volatility, fraud, and complex trading mechanisms.
How Does a Foreign Exchange Market Work?
Forex was one of the early financial markets that was formed to bring structure to the global economy. The foreign exchange market in India, also known as Forex or the currency market, is among the largest financial markets in the world in terms of the value of currency units traded.
Managed by a global network of institutions based on four major trading hubs in various time zones like London, New York, Sydney and Tokyo, this market never sleeps. Since there is no central location, the forex market is operational throughout the day, except on weekends. Though forex is controlled by high operational banks and institutional firms, the market is open to all kinds of retail traders and investors.
Here, currencies are always traded in pairs so that the value of one currency in that pair is relative to the other. The main function of the foreign exchange market is to establish this price relationship for global markets. Currency pairs include EUR/USD, JPY/GBP, etc. A person would have to sell one currency, hoping that it would decrease relative to the currency they want to buy, or hoping it would rise, to make a profit.
How are Exchange Rates Determined?
Currencies are always traded in pairs, e.g., USD-EUR, USD-INR, etc. The relationship between the currencies is given by the formula:
Base currency / Quotation Currency = Value
For example, if the base currency is USD and the quotation currency is INR, the value would be roughly 79, since the rupee is trading at around INR 79 per USD.
Now, exchange rates are determined by various factors depending on whether the currencies in question have “free float” or “fixed float”. Free-floating currencies are those whose value depends solely on the demand and supply of the currency relative to other currencies.
Fixed floating currencies are those whose value is fixed by the government or the central bank, sometimes by pegging it to a standard. For example, the Russian Ruble was recently pegged to gold at 5,000 rubles per gram.
Types of the Forex Market
There are 5 types of currency markets in India – spot, forward, futures, options and swaps.
1. Spot Market
The spot market is the marketplace for currency trading at real-time exchange rates.
2. Forward Market
Forward markets deal in over-the-counter (OTC) contracts. Forward contracts are agreements between parties to exchange a particular quantity of a currency pair at a specific rate and on a given date. They help in hedging currency risk, i.e., the risk of changing values of currency assets due to fluctuations in currency exchange rates. However, forward markets do not have a central exchange for their operations. Therefore, they are highly illiquid (hard to find buyers or sellers randomly). They usually do not require any collateral and thus have counterparty risk, i.e., risk of parties not following through with an agreement
3. Futures Market
The futures market is basically the forward market, but with centralised exchanges like the NSE. Therefore, they have higher liquidity and lower counterparty risk than forward markets. Currency futures, or FX futures, or currency derivatives, are available on the NSE for INR and four currencies, viz. US Dollars (USD), Euro (EUR), Japanese Yen (JPY), and Great British Pound (GBP). Cross-Currency Futures & Options contracts on EUR-USD, USD-JPY and GBP-USD are also available for trading in the currency derivatives segment. Since all transactions are publicly available and settled in cash, it is easier to trade, speculate and perform arbitrage in the futures market.
4. Options Market
The options market allows traders the right to buy/sell currency at a specified price on a specified date through a central exchange such as the NSE. The currencies available are the same as those of the NSE currency futures market.
5. Swaps Market
Currency swaps are agreements between two parties to exchange a principal and interest amount in different currencies, only to be re-exchanged at a specific later date. At least one of the interest rates in the agreement is fixed.
Special Features of the Forex Market
The forex market has a higher degree of leverage than other markets (such as the stock market). Leverage is the loan given by a broker to a trader to allow the trader to invest in greater quantities than otherwise. However, higher leverage also means risk of higher losses.
There are no central clearing houses that oversee international currency trade. However, the central banks and governments usually regulate the forex trade.
The forex market has a large variety of currencies and is open 24/5 as it is an international market. The market opens on Sunday evenings and closes on Friday evenings. Therefore, there is a wider range of opportunities for trade. However, the risk also increases as an international incident in some faraway time zone might devalue your currency assets while you are sleeping.
There are fewer commissions and fees to be paid in currency trading.
Advantages and Disadvantages of the Foreign Exchange Market
Advantages of the Forex Market in India
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High liquidity: The foreign exchange market is one of the most liquid markets in the world, which means that traders can easily buy and sell currencies at any time, ensuring that there are always buyers and sellers available.
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24-Hour trading: While the global market is open 24/5, in India trading is restricted to specific, shorter hours on the local exchange. Trading hours for residents of India are restricted by Indian exchanges and regulators. The INR currency pairs are traded from 9:00 AM to 5:00 PM IST, while cross currency pairs trade until 7:30 PM IST.
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Diversification: The forex market offers traders a variety of currency pairs to trade, which allows them to diversify their trading strategies and reduce risk.
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Low entry barrier: The currency exchange market has a relatively low entry barrier, which means that traders can start with a small amount of capital and gradually increase their investment over time.
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Transparency: The foreign exchange market is highly transparent, and traders can easily access real-time market data and pricing information.
Disadvantages of the Forex Market in India
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High volatility: The forex market is highly volatile, which means that prices can fluctuate rapidly and unpredictably, leading to high levels of risk.
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Risk of fraud: Due to the global nature of the foreign exchange market, there is a risk of fraud and scams. Traders should be cautious when selecting brokers and trading platforms.
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Lack of regulation: The currency market in India is not as heavily regulated as some other markets, which can increase the risk of fraudulent activities.
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Complexities: Forex trading can be complex and requires significant knowledge and expertise to succeed. New traders may need help navigating the market.
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Exchange rate risk: Forex trading involves exchanging one currency for another, and fluctuations in exchange rates can lead to losses. Traders should be aware of the risks involved in trading currency pairs.
History of the Foreign Exchange Market
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Year/Period |
Event |
Significance |
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1971 |
Collapse of the Bretton Woods system. |
Global shift to floating exchange rate regimes, boosting worldwide foreign exchange operations. |
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1978 |
Indian banks authorized to engage in intra-day trading. |
Start of formal foreign exchange operations in India. |
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March 1992 |
Rupee exchange rate partially floated (previously pegged). |
Initial step in changing India's currency regime, based on Dr. C. Rangarajan's committee recommendations. |
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March 1993 |
Rupee exchange rate fully floated. |
Completion of the shift to a market-determined exchange rate regime in India. |
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August 1994 |
India achieved current account convertibility. |
Critical step in the liberalization and development of the Indian market. |
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June 1995 |
O.P. Sodhani Expert Group submitted its report. |
Provided recommendations to deepen and broaden the Indian foreign exchange market. |
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January 1996 onwards |
Extensive reforms implemented in the Indian market. |
Accelerated the development and growth of the Indian foreign exchange market. |
Currency Market in India
As per the RBI, OTC and spot markets are dominant in the Indian currency market, where around USD 33 billion was traded daily in 2019. Currency futures are traded on exchanges such as NSE, BSE, and MCX-SX.
Trends in the Forex Market
The USD is the most traded currency in the world (being a part of over 88% of trades as of 2022), which allows it to act as an unofficial reserve currency among other countries. The Euro and Yen come as distant second and third. As per a BIS report, trading in currency globally reached $7.5 trillion in 2022.
Participants in a Foreign Exchange Market
The Foreign Exchange Market has several participants, such as:
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Commercial banks: They facilitate currency exchange for businesses, individuals, and other financial institutions.
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Corporations: Companies involved in international trade and business require foreign exchange transactions for importing and exporting goods and services.
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Governments: Central banks and treasuries engage in forex markets to manage their foreign reserves and stabilise their country’s economy.
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Central banks: They take part in controlling monetary policy, interest rates, and regulating currency supply.
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Individual traders: Retail traders and speculators take part to profit from currency fluctuations.
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Hedgers: Entities like exporters and importers use the forex markets to hedge against currency fluctuations.
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Brokerage firms: They act as intermediaries, facilitating transactions for clients and providing access to the market.
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International organisations: Entities may participate in forex markets for policy implementation and financial assistance.
Factors Influencing the Foreign Exchange Market
Several factors influence the foreign exchange market, affecting currency exchange rates and market dynamics. These factors include
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Interest rates: Differences in interest rates between two countries can impact currency values. If the interest rate is higher in one country, it can attract foreign capital, increasing demand for its currency.
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Economic indicators: Economic data such as GDP growth, employment rates, and inflation can impact currency values. Strong economic performance often strengthens a nation's currency.
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Political stability: Political events, elections, and stability within a country can influence investor confidence and currency values.
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Market sentiment: Trader sentiment, influenced by news, events, and market psychology, can lead to sudden shifts in currency prices.
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Speculation: Traders often speculate on currency movements based on their analysis of future price trends.
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Central bank activities: Monetary policies, interventions, and interest rate decisions by central banks can significantly affect currency values.
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Global events: Events such as geopolitical tensions, natural disasters, and economic crises can trigger market volatility and currency fluctuations.
What is the Real Effective Exchange Rate (REER)?
The Real Effective Exchange Rate (REER) measures how valuable a country's currency is as compared to other countries. It considers how much things cost in different countries and provides a better sense of a country's currency value than the nominal exchange rate.
To calculate REER, the nominal exchange rate is used, adjusted for the inflation rates of the country and its business partners. If the REER is high, it means the country’s currency is overvalued; if it's low, the country's currency is undervalued.
Impact of Foreign Exchange Market on the Economy
The foreign exchange market plays an essential role in influencing an economy in several ways:
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Exchange rates: Forex markets determine the exchange rates between different currencies, affecting the cost of imported goods and the competitiveness of exports. Exchange rate fluctuations can impact a country's trade balance and overall economic health.
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Inflation: Exchange rate movements can influence a nation's inflation rate. A depreciating currency can lead to higher import costs, potentially fueling inflation. A central bank may need to adjust interest rates to counteract these effects.
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Currency reserves: Central banks hold foreign exchange reserves to manage their currency's value. These reserves can impact a country's monetary policy and overall financial stability.
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Tourism: Exchange rates influence the attractiveness of a country as a tourist destination. A weaker currency may attract more tourists, boosting the tourism industry.
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Economic confidence: A stable and strong currency can boost economic confidence, encouraging investment and economic growth. Conversely, a volatile or depreciating currency may erode confidence.
What Causes Exchange Rates Toto Fall?
The following are the reasons why exchange rates might fall:
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Low demand: If fewer people want a currency (to buy a country's goods, invest, etc.), it weakens. This can happen due to high inflation (reducing buying power) or a poor economic outlook.
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High interest rates elsewhere: Investors chase better returns, selling a currency for one with higher rates.
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Trade deficits: When a country imports more than it exports, it needs more foreign currency, weakening its own.
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Political instability: Investors flee risky situations, selling a currency tied to an unstable government.
Conclusion
Now that you have learnt the basics of the foreign exchange market, check out how to start engaging in forex trading.