Forex – An introduction

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Foreign Exchange called forex or FX is the trading of one currency for another. For example, one can swap the US dollar for the Euro or Rupees. Foreign exchange transactions can take place on the foreign exchange market, also known as the forex market. Did you know, the forex market is the largest, and the most liquid market in the world, with trillions of dollars changing hands every day? There is no centralized location as the forex market is an electronic network of banks, brokers, institutions, and individual traders (mostly trading through brokers or banks).

The market determines the value, which we call as trading currencies, and they are listed in pairs, such as USD/INR, EUR/INR, or USD/JPY. These represent the U.S. dollar (USD) versus Indian Rupee (INR), the Euro (EUR) versus the INR, and the USD versus the Japanese yen (JPY). There will also be a price associated with each pair. In the forex market, currencies trade in lots, called as micro, mini, and standard lots. A micro lot is 1,000 worth of a given currency, a mini lot is 10,000, and a standard lot is 100,000. While trading in the electronic forex market, trades take place in set blocks of currency, but you can trade as many blocks as you like. For example, you can trade seven micro lots (7,000), three mini lots (30,000), or 75 standard lots (7,500,000).

The foreign exchange market is unique because of its size. Trading volume in the forex market is generally too large. As an example, trading in foreign exchange markets averaged $6.6 trillion per day in April 2019, stated the Bank for International Settlements, which is owned by 63 central banks across the globe and is used to work in monetary and financial responsibility. The largest trading centers are located in London, New York, Bombay, Singapore, Hong Kong, and Tokyo.

How does trading occur? The market is open 24 hours a day, five days a week across major financial centers around the world i.e., you can buy or sell currencies at any time during the day. The foreign exchange market isn’t exactly a one-stop shop. There are a whole variety of different paths that an investor can go through in order to execute forex trades. You can go through different dealers or through different financial centers which use a host of electronic networks.

From a historical standpoint, foreign exchange was once a perception for only governments, large companies, and hedge funds. But in today’s technology-driven world, trading currencies is only  a mouse click away, accessibility is no longer an issue, that means anyone can do it. Many investment companies offer the chance for individuals to open accounts and trade currencies however and whenever they choose. When you’re trading in the forex market, you’re buying or selling the currency of a country and there’s no physical exchange of money from one hand to another. That’s contrary to what happens at a foreign exchange kiosk in a bank, think of a tourist visiting New York City or Washington DC from India. They may be converting their INR to actual U.S. dollars so that  can spend their money while they’re traveling.

But in the world of electronic markets, traders usually take a position in a specific currency, with the hope that there will be some upward movement and strength in the currency that they’re buying (or weakness if they’re selling) so they can make a profit.

There are some fundamental differences between foreign exchange and other markets. First and foremost, there are fewer rules, which means investors do not have strict standards or regulations as those in the stock, futures, or options markets, that means there are no clearing houses and no central bodies that oversee the forex market. Secondly, since trades don’t take place on a traditional exchange, you won’t find the same fees or commissions that you would on another market. There’s no cutoff as to when you can and cannot trade. Since, the market is open 24 hours a day, you can trade any time of day. Finally, because it’s such a liquid market, you can get in and out whenever you want and you can buy as much currency as you can afford.

The U.S. dollar is the most actively traded currency in the world. The most common pairs are the USD versus the Euro, Japanese yen, British pound, and Australian dollar. Trading pairs that do not include the dollar are referred to as crosses. The most common crosses are the euro versus the pound and yen. forward trade is any trade that settles further in the future than spot.

A trader thinks that the European Central Bank (ECB) will be easing its monetary policy in the coming months as the Eurozone’s economy slowed down due to the Pandemic. As a result, the trader bets that the euro will fall against the US dollar and sells short €100,000 at an exchange rate of 1.15. Over the next several weeks the ECB stated that it may indeed ease its monetary policy which caused the exchange rate for the euro to fall to 1.10 versus the dollar. Hence it created a profit for the trader of $5,000.

By shorting €100,000, the trader took in $115,000 for the short sale. When the euro fell, and the trader covered their short, it cost the trader only $110,000 to repurchase the currency. The difference between the money received on the short-sale and the buy to cover it is the profit. Had the euro strengthened versus the dollar, it would have resulted in a loss.

The latest triennial survey conducted by the Bank for International Settlements (BIS), trading in foreign exchange markets averaged $6.6 trillion per day in 2019 and by contrast, the total notional value of U.S. equity markets on October 7, 2021, which was approximately $501 billion.

When you’re making trades in the forex market, you’re basically buying the currency of a country and simultaneously selling the currency of another country. But there’s no physical exchange of money from one hand to another. Traders are usually taking a position in a specific currency, with the hope that there will be some strength in the currency, relative to the other currency, that they’re buying or selling, so they can make a profit. In today’s world of electronic markets, trading currencies is as easy as clicking of a mouse.

Anupama

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