What is the Currency Market?
The currency market is a one-stop marketplace where participants operating in various jurisdictions worldwide can buy and sell different currencies. It is also known as the foreign exchange market. This market plays a pivotal role in conducting international trade and the financial sector. Overall, the global currency market operates on two levels:
- The Interbank Market: This is the section of the currency market that has some of the largest banks in the world as prominent players. In this interbank market, these banks exchange currencies with each other and conduct large-scale trades among themselves. This is an exclusive subsection of the foreign exchange market.
- Over-the-counter Market: This is the section of the currency market where companies and individuals can trade in currencies. With the means of a broker and an online trading platform, anyone can participate in currency trading.
Functions of the Currency Market
- Transfer Function: The most fundamental and evident purpose of the currency market is to move money, or foreign currencies, from one nation to another so that payments can be settled. A currency can be exchanged for another on the market.
- Credit Function: The currency market offers a way for people who buy things from other countries to get a temporary loan. This helps make it easier for goods and services to move between different countries. When someone buys things from abroad, they can use their own borrowed money to pay for them.
- Hedging Function: The third function of a foreign exchange market is to hedge the currency risk. It implies protection against risk related to fluctuations in the foreign exchange rate. Under this function, buyers and sellers agree to sell and buy goods on a future date at some commonly agreed exchange rate.
Types of Currency Market
There are 5 major currency markets listed below:
- Spot Markets: This market provides rapid execution of transactions and gives immediate payment to the buyers and the sellers as per the current exchange rate. Nearly one-third of all currency exchanges and trades, which typically take one or two days to settle, occur in the spot market.
- Forward Markets: There are two parties in the forward market, which could be two businesses, two people, or nodal government entities. This kind of market involves an agreement to execute a trade at a predetermined price and quantity at a later time.
- Future Markets: A futures market is a centralised marketplace where participants can buy and sell standardised contracts (futures contracts) for the future delivery of a specific quantity of a commodity, financial instrument, or other asset at a predetermined price.
- Option Markets: In this market, “options” are bought and sold. An option is a contract that permits (but does not mandate) an investor to purchase or sell an underlying asset, such as a share, exchange-traded fund, or index, at a predetermined price over a predetermined duration.
- Swaps Markets: A swap is a kind of derivative arrangement in which the liabilities or cash flows from two distinct financial instruments are traded between two parties. These cash flows are predicated on a principal amount in the majority of swaps.
What is Currency Trading?
Currency trading is the process of buying one currency while simultaneously selling another. It involves exchanging one currency for another with the objective of generating profits from the changes in exchange rates between them.
Currencies are always traded in pairs in the currency market. A currency pair consists of two currencies, such as the Indian Rupees (INR) and the US Dollar (USD), and is represented as INR/USD. The first currency in the pair (INR) is called the base currency, and the second currency (USD) is the quote currency.
For example, today, the US dollar stands at 79.37 Indian rupees – if you expect the dollar to appreciate against the rupee, you buy more dollars. Conversely, if you expect the dollar to depreciate against the rupee, you will buy rupees. You must always choose a pair of currencies like INR/USD, for example.
Basics of Trading in the Currency Market
Trading in the currency market always works in pairs, and this applies to both buying and selling of the currencies. The value of these trades is determined by the exchange rate, which is the value of a currency with respect to another.
The appropriate symbols denote the exact nature of a currency trade. For instance, INR stands for the Indian Rupee, while USD stands for the American Dollar. If you were to trade Indian Rupees against American Dollars, the trade would be denoted as such – INR/USD. Similarly, every currency in the world is denoted by three unique letters, and the direction of the trade is denoted with a ‘/’ sign.
How Does Currency Trading Work?
Currency trading works like any other transaction where you are buying one asset using a currency. In the case of currency, the market price tells a trader how much of one currency is required to purchase another. Every currency has its own code –allowing traders to quickly identify it as part of a pair.
- Currency Pairs: In the currency market, currencies are traded in pairs, such as INR/USD (Indian Rupees/US Dollar), GBP/JPY (British Pound/Japanese Yen), or USD/JPY (US Dollar/Japanese Yen). The first currency in the pair is the base currency, and the second is the quote currency.
- Market Participants: Currency trading involves various participants, such as banks, financial institutions, governments, corporations, and individual retail traders. These participants trade currencies with different objectives, which mainly include hedging against currency risk, conducting international business, or speculating on price movements.
- Trading Platforms: The currency market can be accessed through online trading platforms provided by brokers, which provide tools, charts, and real-time quotes to facilitate trading. Popular trading platforms include MetaTrader 4 (MT4) and MetaTrader 5 (MT5).
Benefits of Currency Trading (Forex Trading)
- Seize forex volatility: Some currencies have unusually volatile price changes because of the large number of currency trades that occur every day, which amounts to billions of dollars every minute. You can generate large profits by making a prediction on price movements in either direction.
- Available for 24 Hours: The currency market is open 5 days a week, 24 hours a day. These extended trading hours are made feasible because currency transactions are conducted over the counter (OTC) rather than through a central exchange.
- High Liquidity: The currency market is the most liquid in the world because there is a large number of buyers and sellers seeking to make a trade at any given time. Its high liquidity means that transactions can be completed quickly and easily.
How to Start Trading in Currencies?
You can trade currency derivatives from your Angel One app by the following steps:
Step 1: You can search the desired currency future in the search bar on the Home page and Watchlist.
Step 2: Now click on the Buy tab and enter the other required details like the number of lots, price and the order type (limit or market). After this, you can place your order.
What are the hard currencies in the world?
Hard currencies refer to currencies that can be freely traded around the world and that are backed by strong domestic economies. For example, currencies like the US Dollar, the Euro, the Pound, and the Japanese Yen are examples of hard currencies as they are widely accepted and traded.
Does every country issue its own currency?
Yes, every country issues its own currency, which is normally issued by the central bank of the country e.g. RBI in the case of India, Federal Reserve in the case of the US, and Bank of England in the case of the UK, etc.
The only exception is the Euro region, which uses a common currency called the Euro. For example, big nations like Germany, France, Italy, Spain, and the Netherlands have all given up their own currencies and are now using the common currency Euro.
What are currency pairs, and how are they traded?
In a currency pair, there are 2 distinct pieces, viz., the base currency and the quotation currency.
The base currency is always expressed as 1 unit. These currency pairs form the basis for currency trading in India. However, forex market trading hours on the currency futures exchange are limited, while globally, the currency market is a 24-hour market.
In the rupee/dollar trade, the USD is normally the base currency, and the INR is the quotation currency. So when we write USD 1 / INR. = ₹79, then the USD is the base currency, the INR is the quotation currency, and Rs.79 is the value. The base currency is always expressed in 1 unit.
Does the US Dollar have to be the base currency in currency trading?
Not necessarily. Any currency can be the base currency. For example, in Euro / Dollar trades, it is normally the Euro that is the base currency, and the US dollar is the quotation currency. Similarly, when we write INR 1 / Yen = 1.95, the INR becomes the base currency, and the Japanese Yen becomes the quotation currency with a value of 1.95 Yen.
How to do forex trading in India (for companies)?
- Currency futures can be used by companies that have currency risk
- Say you are an importer who has an amount of $5 million payable in dollars after 3 months
- You can hedge this risk by buying a USD/INR pair
- You have a payable of $5 million in March 2018
- Your risk is that if the dollar appreciates from 67 to 70, then you end up paying higher in rupee terms. So, you can hedge your risk by buying equivalent USD/INR futures.
- If the dollar appreciates to ₹70, then the loss on your import payable will be compensated by your profit on the currency futures position.
How can I manage my risk in currency trading?
There are numerous approaches you can take to control your exchange risk. This includes adopting a trading style that aligns with your attitude towards risk, placing stops and limits on your position, and setting price alerts.