What is Foreign Exchange Market

Forex Market Basics

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. 

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 then the value would be roughly around 79 as 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”.

1. Free floating currencies are those whose value depends solely on the demand and supply of the currency relative to other currencies. 
2. 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 5000 rubles per gram of gold.

Types of Forex Market

There are 5 types of currency markets in India – spot, forward, futures, options and swaps.

The spot market is the marketplace for currency trading at real-time exchange rates. 

On the other hand, forward markets deal in over-the-counter (OTC) forward contracts. Forward contracts are agreements between parties to exchange a particular quantity of currency pair at a specific rate and on a given date. They help in hedging currency risks 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:

1. They are highly illiquid (hard to find buyers or sellers randomly)
2. They usually do not require any collateral and thus have counterparty risk i.e. risk of parties not following through with an agreement

The futures markets are basically forward markets, 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 on INR and four currencies viz. US Dollars (USD), Euro (EUR), Japanese Yen (JPY) and Great Britain 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.

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 that of the NSE currency futures 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 245 as it is an international market. The market opens on Sunday 5pm EST and closes on Friday 5pm EST.  Therefore, there is a wider range of opportunities for trade. However, the risk also increases as an international incident in some far-away 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:

1. 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.
2. 24-Hour Trading: Forex trading takes place around the clock, allowing traders to access the market at any time. This is particularly beneficial for traders with other commitments during regular trading hours.
3. Diversification: The forex market offers traders a variety of currency pairs to trade, which allows them to diversify their trading strategies and reduce risk.
4. 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.
5. 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:

1. High Volatility: The forex market is highly volatile, which means that prices can fluctuate rapidly and unpredictably, leading to high levels of risk.
2. 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.
3. 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.
4. Complexities: Forex trading can be complex and requires significant knowledge and expertise to succeed. New traders may need help navigating the market.
5. 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

Following the collapse of the Bretton Woods system in 1971, foreign exchange operations gained momentum on a global scale as several countries shifted towards floating exchange rate regimes.

In India, the foreign exchange market began in 1978 when banks were authorized to engage in intra-day trading. However, it wasn’t until the 1990s that the Indian foreign exchange market underwent significant changes, coinciding with shifts in India’s currency regime. In March 1992, the previously pegged rupee exchange rate was partially floated, followed by a full float in March 1993, in response to the recommendations of the Committee on Balance of Payments chaired by Dr C. Rangarajan. 

The unification of the exchange rate was a critical step towards developing a market-determined exchange rate for the rupee and achieving current account convertibility, which was attained in August 1994.

The Expert Group on Foreign Exchange Markets in India (Chaired by O.P. Sodhani) submitted its report in June 1995, providing further momentum to the development of the Indian foreign exchange market by making several recommendations to deepen and broaden it. As a result, extensive reforms were implemented in the Indian foreign exchange market from January 1996 onwards.

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 85% of trades), 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 $6.6 trillion per day in April 2019. 

Conclusion

Now that you have learnt the basics of the foreign exchange market, check out how to start engaging in forex trading.