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”.
- 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 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:
- 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
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:
- 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.
- 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.
- Diversification: The forex market offers traders a variety of currency pairs to trade, which allows them to diversify their trading strategies and reduce risk.
- 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.
- 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:
- High Volatility: The forex market is highly volatile, which means that prices can fluctuate rapidly and unpredictably, leading to high levels of risk.
- 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.
- 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.
- Complexities: Forex trading can be complex and requires significant knowledge and expertise to succeed. New traders may need help navigating the market.
- 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.
Participants in a Foreign Exchange Market
The Foreign Exchange Market has several participants, such as:
- Commercial banks: They facilitate currency exchange for businesses, individuals, and other financial institutions.
- Corporations: Companies involved in international trade and business require forex transactions for importing and exporting goods and services.
- Governments: Central banks and treasuries engage in forex markets to manage their foreign reserves and stabilise their country’s economy.
- Central banks: They take part to control monetary policy, interest rates, and regulate currency supply.
- Individual traders: Retail traders and speculators take part to profit through currency fluctuations.
- Hedgers: Entities like exporters and importers use forex markets to hedge against currency fluctuations.
- Brokerage firms: They act as intermediaries, facilitating transactions for clients and providing access to the market.
- 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:
- 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.
- 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.
- Political stability: Political events, elections, and stability within a country can influence investor confidence and currency values.
- Market sentiment: Trader sentiment, influenced by news, events, and market psychology, can lead to sudden shifts in currency prices.
- Speculation: Traders often speculate on currency movements based on their analysis of future price trends.
- Central bank activities: Monetary policies, interventions, and interest rate decisions by central banks can significantly affect currency values.
- 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 gives a better idea of a country’s currency value compared to the nominal exchange rate.
To calculate REER, the nominal exchange rate is used, which is adjusted based on the inflation rate of a 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:
- 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.
- 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.
- 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.
- Tourism: Exchange rates influence the attractiveness of a country as a tourist destination. A weaker currency may attract more tourists, boosting the tourism industry.
- Economic confidence: A stable and strong currency can boost economic confidence, encouraging investment and economic growth. Conversely, volatile or depreciating currency may erode confidence.
Now that you have learnt the basics of the foreign exchange market, check out how to start engaging in forex trading.
What are the 3 types of foreign exchange market?
There are 3 types of foreign exchange market – spot, future and forward. Spot market is the live market where the assets are traded at the price applicable at that very point of time. Forwards are agreements to trade the currency assets at a particular rate on a particular day. Futures are forwards that can be publicly traded.
Which foreign exchange market is best?
The US dollar is the most widely traded currency in the world. However, there are other currencies which may be of interest to the trader such as Euros, Yens, Chinese Renminbi etc.
What are the main function of the forex market?
The main function of the forex market includes the smooth exchange of currencies as and when required by various parties. There should not be any glitches, excess transaction costs and lack of liquidity in an efficient forex market.
What are the advantages of foreign exchange?
Foreign exchange enables a fair exchange of value between international buyers and sellers that is beneficial to both parties. As investors, foreign exchange does give high returns at times, especially when there is volatility in the economy of multiple countries.