Currency Market: Meaning, Types and How To Trade

Welcome to the new module about currency markets. Here, we will explore various aspects of foreign exchange, including exchange rates, inflation rates, currency appreciation, participant banks, and more. While in the beginning, it may seem too complex to comprehend, we will try to break it up into simpler concepts to facilitate a better understanding.

Have you also wondered how currencies change in value, why some things cost more in one country than another, and who decides all this anyway?

We will cover everything from understanding why a dollar today might not buy you the same thing tomorrow to figuring out the significant role of banks. In this introductory chapter, let us begin by understanding what currency markets are.

What Are Currency Markets?

The currency market, also known as the foreign exchange market (Forex or FX), is an important part of the global financial system. This market includes buying, selling, and exchanging currencies at current or pre-determined prices and is recognised as the largest financial market in the world. One can get a fair sense of its scale with the trading volumes that are trillions of dollars daily. The Forex market facilitates international trade and investments by enabling currency conversion. It is particularly useful for businesses and investors operating across borders as the ability to exchange currencies is essential for transactions in different countries.

One cannot begin understanding currency markets without a thorough understanding of exchange rates, which are a fundamental element of the currency markets. 

But what are they?

Let us understand them below.

Exchange Rates

Exchange rates refer to the price at which currencies can be exchanged. They determine how much of one currency can be obtained with another and fluctuate based on several factors, including economic indicators, market speculation, and geopolitical events. These rates are critical in the international economic environment as they influence the global flow of trade, investments, and financial services. The effect of any currency's exchange rate can be seen in everything, right from the price of goods and services in international trade to investment returns and the valuation of companies and assets. 

At the core of understanding exchange rates is distinguishing between direct and indirect quotes. A direct quote sets the domestic currency price for one unit of foreign currency. For instance, if you're in India, a direct quote might tell you how many Indian rupees you need to purchase one USD. So, if a direct quote for USD to INR is ₹83, it means 1 US dollar can be exchanged for ₹83. You're looking at the cost of a dollar in rupees.

On the flip side, an indirect quote does the opposite. It shows the foreign currency price of one unit of your domestic currency. If we flip our example, and you're in the US wanting to buy rupees, an indirect quote might tell you that 1 INR equals 0.012 USD (this is a simplified example for understanding purposes). This means for every rupee, you spend about 1.2 cents in dollars.

This way of looking at currencies helps everyone, from tourists to big businesses, understand how much their money is worth in a foreign country and make smarter choices about when to exchange their money. 

It's all about getting the best bang for your buck, or in this case, your rupee!

Currency Pairs 

The exchange we studied above is the USD/INR exchange. Here, USD/INR is a currency pair. Understanding currency pairs is fundamental to navigating the forex market, as these pairs represent the quotation and pricing structure of currencies traded. Below are the components of currency pairs. 

• Base currency: The base currency is the first currency listed in a currency pair. It serves as the reference element for the exchange rate of the pair and indicates how much of the quote currency is needed to purchase one unit of the base currency. For example, in the USD/INR currency pair, USD (U.S. Dollar) is the base currency. This means the exchange rate quoted for this pair tells you how many Indian Rupees you need to buy one U.S. Dollar.
• Quotation currency: Also known as the counter currency, the quotation currency is the second currency in the pair and complements the base currency. It shows how much of the counter currency is equivalent to one unit of the base currency. As in our previous example, if the USD/INR exchange rate is 83, it indicates that 83 Indian Rupees are required to buy 1 U.S. Dollar. Here, INR is the quotation currency.

How do Currency Pairs work?

Currency pairs allow market participants to quote and trade currencies. Based on their trading volume, liquidity, and market activity, they are categorised into major, minor, and exotic pairs.

Major pairs: These pairs involve the U.S. Dollar and the world's most powerful currencies like EUR (Euro), GBP (British Pound), and JPY (Japanese Yen). An example is EUR/USD, one of the most traded currency pairs in the world.

Minor pairs: These pairs do not include the U.S. Dollar but are still among the world's major currencies. An example is EUR/GBP, which shows how many British Pounds you can get for one Euro.

Exotic Pairs: These pairs combine a major currency with a currency from a smaller or emerging economy, like USD/SGD (Singapore Dollar) or USD/THB (Thai Baht). Exotic pairs are less liquid and can have higher spreads.

How To Trade Currency Options on Angel One?

1. Open the Watchlist and go to the Search tab.
2. Type the Currency pair that you want to trade, e.g. USD-INR. Choose the expiry date which you want to check.
3. Thereafter, you can open the option chain of the particular currency pair and expiry.
4. Choose the contract which you want to trade and click on ‘BUY’ or ‘SELL’.
5. Enter the quantity and order type, e.g. Carryforward, to enter a position. 

How Exchange Rates Are Determined?

You can find the prevailing exchange rates on various sources like websites, brokerage, airport exchange kiosks, etc. However, have you ever wondered how the rates are determined? The exchange rates in the global financial markets are determined based on several key factors, ranging from market dynamics to government intervention and economic indicators. Here's a breakdown of how these elements come together to influence currency values:

• Market Forces and Floating Exchange Rates

The concept of floating exchange rates is primarily driven by the forces of supply and demand within the forex market. In this system, the value of a currency is allowed to fluctuate according to the foreign exchange market's demand for it compared to other currencies. This means if there is a high demand for a particular currency, its value will rise; if the demand falls, so will its value. This mechanism reflects the market's response to changes in economic activity, geopolitical events, and market sentiment.

For instance, consider the Japanese yen (JPY) during a period of intense political stability and economic growth in Japan. As investors around the world observe Japan's robust economic performance and political harmony, their confidence in the Japanese economy grows. Consequently, demand for the yen increases as foreign investors seek to invest in Japanese stocks, real estate, or bonds, requiring them to convert their own currencies into yen to make these investments. This heightened demand for the yen drives up its value relative to other currencies.

On the flip side, if Japan were to experience a significant economic downturn or political unrest, the sentiment could shift quickly. Investors might start pulling their investments out of the country, converting large amounts of yen back into their own currencies. This increase in the supply of yen on the foreign exchange market, coupled with decreased demand, could lead to a depreciation of the yen's value.

• Government Intervention and Pegged Exchange Rates

Governments or central banks that tie their currency's value to another major currency or a basket of currencies determine fixed or pegged exchange rates. In such regimes, the central bank will buy and sell its own currency against the currency to which it is pegged to maintain the set rate. This approach is often employed to stabilise a currency's value, making it more predictable for international trade and investment. However, maintaining a fixed exchange rate requires significant reserves of the currency to which it is pegged and can limit a country's monetary policy options.

Consider the example of the Hong Kong dollar (HKD), which is pegged to the United States dollar (USD) within a tight range of 7.75 to 7.85 HKD to 1 USD. To maintain this fixed exchange rate, Hong Kong's monetary authority, if noticing the HKD value slipping beyond this range, steps in by buying or selling its own currency to keep the exchange rate within this fixed range. This pegging helps stabilise Hong Kong's currency for trade and investment by making its value predictable. However, it means Hong Kong must keep a large reserve of US dollars and cannot easily change its own monetary policies independently, as it needs to align with the US's policies to maintain the peg.

• Economic Indicators

Several economic indicators play a critical role in influencing exchange rates. Inflation rates, for example, can erode purchasing power and lead to a depreciation of the currency. Interest rates, set by a country's central bank, can attract foreign capital from investors seeking a higher return on their investments and affect the currency's value. Political stability and economic performance also weigh heavily on investor confidence, influencing the inflow and outflow of funds from a country. A stable political environment and robust economic growth can enhance a currency's attractiveness and lead to an increase in its price.

• Speculation

Speculation in the forex market can significantly impact exchange rates. Traders speculate on future economic events and policy changes, and their perceptions can lead to immediate reactions in the market. For example, if traders believe that a country's currency will strengthen due to positive economic developments, they may buy more of that currency, causing its value to rise even before the expected events occur. On the other hand, negative speculation can lead to selling pressure, which may depreciate the value of the currency.

Wrapping Up

Understanding exchange rates and currency pairs is essential for anyone participating in the currency markets, whether focusing on trading, investing, or hedging. The exchange rate environment is influenced by various factors, including market dynamics, government interventions, economic indicators, and speculation. You, as a market participant, can use these concepts to gain valuable insights into forex trading and the broader field of international finance and make informed decisions.

In the next chapter, we will explore factors influencing exchange rates in detail.