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Overview of the forex or foreign exchange market

In simple terms, Forex, Foreign Exchange or FX is the act of trading in the foreign exchange market or in foreign currencies by individuals, corporates and financial institutions including commercial and central banks. The global foreign exchange market is by far the biggest market in the world, and its modern avatar has a history that dates back to the creation of the gold standard monetary system introduced in 1875. After World War II, it was replaced by the Bretton Woods system where the US Dollar replaced the gold standard. The Bretton Woods system was in turn replaced by the Jamaica Agreement of 1976, which introduced floating foreign exchange rates.

Forex trading is a global marketplace that never sleeps, and that doesn’t have a central physical structure where trading in conducted. It is a constantly dynamic market with investors, speculators, traders and brokers and governments engaging in understanding the intricacies of the demand, supply and price movements of foreign currency. It is the largest trading market in the world and is larger than the stock market. It is estimated that the average traded value per day worldwide is approximately $2,000 billion.

The foreign exchange market is open 24 hours a day for around five and a half days of the week. The trading week starts on Monday morning Sydney time (which is still Sunday evening New York time) and ends on Friday evening New York time (which is Saturday morning Sydney time). Because of the time difference across the globe, forex trading carries on continuously during the week across countries and across time zones.

Most currencies are traded against the US Dollar. Other popularly traded currencies are the Euro, British Pound, Japanese Yen, Swiss Franc and Australian Dollar.

Participants in the forex market

The major participants contributing to the exchange of currencies and augmenting the forex market are governments and central banks, banks and financial institutions, corporates, investors, importers and exporters, and speculators.

Forex trading might seem a complex and daunting subject but it impacts ordinary individuals as well. For instance, if you are planning to visit Switzerland as a tourist, you cannot use rupees while on holiday there. You will need to buy Swiss Francs on the forex market with your Indian rupees in order to make any purchases on your holiday.

On a larger scale, the forex market is necessary for import and export - when a foreign company seeks business opportunities with a specific country. The foreign company will have to pay in the currency of the host country. For example, if an Indian company wants to import toys from the US, it will need to pay the American company in dollars. Similarly, if an American company wishes to import cheese from France, it will need to pay the French company in French francs. All this international business activity produces a need for foreign exchange and is one of the reasons why foreign exchange markets are so large. The foreign currency market enables the smooth conduct of import/export transactions around the world.

On an even larger scale, governments trade in currency as a way of managing their monetary policies. For example, if a government wants to devalue their currency, perhaps to make exports cheaper for instance, they will release large sums of the local currency in the market so that supply exceeds demand and the value of the currency goes down. If on the other hand, they want to drive up the value of the currency, they will buy the currency thereby creating a scarcity of supply and increasing its value.

Because of the size of the foreign exchange market, it is very difficult for any single entity whether individual, institution or government, however large, to manipulate the market for any length of time.

How does the foreign exchange market/forex trading work?

Currency in forex is always traded in pairs and is pitted against another in any transaction taking place in the forex market. The first currency quoted in a currency pair on forex is called the base currency. This is generally the domestic currency. The second currency is called the quote currency and is typically the foreign currency which the investor is trading in.

For example, if an investor is trading in Euro-Dollar, Euro would be the base currency and the dollar would be the quote currency. The rate reflects how much of the quote currency (USD) is needed to trade one unit of the base currency (Euro). The forex rates are based on a range of economic and political factors and can change on a continuous basis.

Forex trading is, in a way, similar to stock trading. Stock traders will buy a stock if they think it will strengthen in the future and sell a stock if they think it is losing its value or will lose its value in the future. Similarly, forex traders will buy a currency pair if they expect its exchange rate will strengthen in the future and sell a currency pair if they expect its exchange rate will lose its face value in the future.

Having said that, it is important to make a distinction between the stock market and the foreign exchange market. There are several fundamental differences between the two and knowledge of one does not necessarily mean it can be translated to the other. Like all other market-based activities, the highly volatile forex market requires specialized knowledge and constant monitoring of price movements among other elements of success.

What is a foreign exchange rate or forex rates?

The rate at which one currency is exchanged for the other is known as the exchange rate. It is also known as the foreign exchange rate, forex rate, or FX rate. It is the price of one currency in relation to another currency in the forex market. There are two kinds of forex rates in the foreign exchange market. They are the Bid and Ask.

Bid is the rate at which the market will buy the quote currency for in relation to the base currency.

Ask is the rate at which the market will sell one unit of the base currency in relation to the quote currency.

Different kinds of forex trading

There are three ways in which participants engage in forex trading. They are the spot market, forward market and futures market.

1. Spot Market

A spot exchange rate is the rate at which a currency is bought and sold for immediate delivery. It is the largest of the three ways of forex trading and has seen a big upsurge in popularity with the introduction of electronic trading. It represents the price that a buyer is expected to pay for a foreign currency in another currency at the current price. The market operation is of a daily nature, and is known as the spot market. The final deal is known as a spot deal. Though spot deals are based on current prices and transactions, spot foreign exchange contracts are settled on the second day after the deal is made, which is the globally accepted settlement cycle, and the settlement is in cash. The demand-supply movement of currencies helps in spot rate analysis.

2. Forward Market

Forward exchange rate is the exchange rate at which a trader exchanges one currency for another at a future delivery date. The trader enters into a contract based on a particular currency, a specific price and future date of settlement.

Commercial banks, multinational corporations, and other financial institutions enter into forward contracts for hedging reasons, i.e., to minimize the risk of loss due to possible adverse fluctuations in the foreign exchange market, and to make profits though speculation.

There are several factors that influence the forward exchange rate of a particular currency including the following indicators:

  • Domestic interest rate
  • Inflation rate
  • International trade
  • Investor’s vested interest in the foreign currency
  • Political and economic situation of the country

3. Futures Market

In the futures market, the currencies are bought and sold for a standard size and settlement date, with a difference being that is it is conducted in a public commodities market, like the Chicago Mercantile Exchange, for example. The forward and futures market offer a measure of protection against risk when trading in the highly volatile currency market. Typically, large multinational corporates engage in the futures market to hedge against future volatility in foreign exchange rates.

In India, any resident Indian or company (including banks and other financial institutions) can participate in the futures market.

Features of forex trading

Forex traders use a variety of technical tools and extensive analysis to study foreign currency movements, similar to the way other assets are studied.

Forex traders will delve into copious data to determine indicators that they can use in their trading strategies.

Forex trades have minimal commissions and related fees and the margins are very low when compared to the stock market. However, the foreign exchange market is a very liquid market in contrast to the stock market.

Forex trading can be a volatile and high-risk field and those new to the domain of foreign currency trading need to be aware of the elements required to be successful in the market.