What is Foreign Exchange? - A Complete Guide to Understanding the Forex Market

Foreign Exchange, or Forex, is a global trading marketplace where currencies are exchanged. A significant feature of Forex is the continuous fluctuation in currency prices relative to one another. These fluctuations reflect the exchange rate, which defines how much one currency is worth compared to another. These exchange rates are influenced by the laws of supply and demand. When demand for a currency increases, its value generally rises, while an increase in supply tends to decrease in value.

Exchange rates fluctuate continuously due to a variety of factors, including interest rates, political developments, and economic conditions. The fluctuation in the value of currency is the heartbeat of the Forex market.

According to Expert Market Research, “The global foreign exchange market size was valued at USD 812.14 billion in 2023. The market is further projected to grow at a CAGR of 6.8% between 2024 and 2032, reaching a value of USD 1476.12 billion by 2032.”

In this blog, we will explain foreign exchange, grasp the concepts of the currency market, and provide practical examples that will help you better understand this important topic.

Table of Contents:

1. What is Foreign Exchange?
2. Characteristics of the Foreign Exchange Market
3. Who are the Participants in a Foreign Exchange Market?
4. What are the Types of Foreign Exchange Markets? 
5. Types of Foreign Exchange Rate
6. Factors Affecting Currency Value

What is Foreign Exchange?

Foreign exchange (Forex or FX) refers to the process of converting one currency into another at a specific rate, called the foreign exchange rate. Nearly all currency conversion rates are subject to constant fluctuation due to supply and demand in the market.

Example: International trade requires foreign exchange. Trade between India and the United States (US) involves INR and USD. India must pay in dollars for any imports it makes from the US. The US must pay in rupees when importing goods or services from India. Foreign exchange plays an important role when one country invests in another. For its investments in India, the US is required to pay in rupees. These transactions raise the demand for foreign currency. 

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Understanding Forex Market

The foreign exchange market, also known as the forex market, is a decentralized global marketplace for buying and selling currencies. It is the biggest and most liquid financial market in the world, with trading volumes exceeding $7.5 trillion every day. The foreign exchange market (forex market) promotes global investment and trade by allowing companies to exchange one currency for another. 

The forex market operates five days a week, twenty-four hours a day, with trading taking place in major international financial hubs. Economic data, geopolitical developments, and central bank policies are some of the factors that influence the market. The market’s forces of supply and demand govern the exchange rate or the value of one currency with another. 

Characteristics of the Foreign Exchange Market

• It is a global network of the world’s banks with no centralized location of trading.
• It is the largest and most liquid financial market in the world, representing more than $7.5 trillion worth of transactions each day. 
• Primarily used for speculation, hedging, and arbitrage (approximately 95%), the rest is for need-based trading. 
• It is also a quote-driven market where the participants quote bids and ask prices. 
• The forex market opens on Sunday at 5 PM EST (10:00 PM GMT) and closes on Friday at 5 PM EST (10:00 PM GMT). It is a 24-hour market.
• Currencies are not physically traded; they are transferred from one bank account to another.
• Bilateral agreements are where trades are agreed upon between two counterparties (resulting in counterparty or settlement risk). 
• Low margin, high volume, and value market, with the freedom to trade anywhere at low costs.

Who are the Participants in a Foreign Exchange Market?

• Central Bank: The central bank plays a crucial role in the foreign exchange market by managing the interest rates and stabilizing the market by buying foreign currencies.
• Institutional Investors: The institutional investors trade a huge amount of money for investment in the foreign market, which can also affect the exchange rates.
• Commercial Banks: The commercial banks help customers and businesses exchange money for different currencies. They help them with various types of services to buy and sell foreign currencies.
• Brokers: Brokers act as mediators in the foreign exchange market. They buy and sell currencies on behalf of clients while charging a commission for the service
• Individuals: Individuals play a role in  the foreign exchange market by exchanging currencies for traveling and investing. 
• Companies: Companies exchange currencies for international trade, and they also manage the risks by using hedge funds.

What are the Types of Foreign Exchange Markets? 

1. Spot Forex Market 

The spot forex market allows traders to trade currencies for immediate delivery. This means that the exchange of foreign currencies happens at the current market price, which is fixed by supply and demand forces. The world’s most liquid and active market is the spot forex market, where trading occurs around the clock in all major financial hubs.

2. Forward Forex Market 

Contracts to buy or sell currencies at a fixed exchange rate at a future date are used in the forward forex market. This allows users to fix an exchange rate for the future, protecting them from changes in exchange rates. While it is not as actively traded as the spot market, the forward forex market is utilized for hedging.

3. Futures Forex Market 

A centralized exchange where standardized contracts are traded for the future delivery of a given currency at a predetermined price is the futures forex market. Futures contracts are traded on regulated exchanges and can be used for both speculative and hedging purposes. 

Types of Foreign Exchange Rate

There are three types of foreign exchange rates:

• Fixed Exchange Rate: BHD (Bahrain Dinar) and HKD (Hong Kong Dollar)
• Floating Rate: USD (United States Dollar) and INR (Indian Rupee)
• Reserve Currency Board: HKD (Hong Kong Dollar) and ARS (Argentina Peso)

1. Fixed Exchange Rate

A country’s exchange rate system under which the government or central bank ties the official exchange rate to another country’s currency or to the price of gold. Fixed rates provide greater certainty for exporters and importers, which also helps the government maintain low inflation, which in the long run will tend to keep interest rates down and stimulate increased trade and investment. Major industrialized nations have had floating exchange rate systems since the early 1970s, while developing economies continue to have fixed rate systems. A fixed exchange rate system’s goal is to keep the value of a nation’s currency within an extremely small range.

2. Floating Rate

A currency’s value is permitted to fluctuate in response to foreign exchange market mechanisms under a floating exchange rate system. A floating currency is one that is based on a fluctuating exchange rate. A floating currency is contrasted with a fixed currency whose value is tied to that of another currency, material goods, or a currency basket. Some economists believe that floating exchange rates are generally better than fixed exchange rates. A nation can mitigate the effects of shocks and foreign business cycles and avoid the possibility of a balance of payments crisis by utilizing floating exchange rates, which automatically adjust. However, they also engender unpredictability as a result of their dynamism. Monetary policies can be useful for other purposes, which is the main argument in favor of a floating exchange rate. Under fixed rates, monetary policy is committed to the single goal of maintaining the exchange rate at its announced level. Monetary policymakers can focus on other objectives, like stabilizing employment or prices, when there is a floating exchange rate system. Monetary policy has the power to affect a wide range of macroeconomic factors, including the exchange rate.

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3. Reserve Currency Board

According to the International Monetary Fund (IMF), a currency board agreement is a type of monetary system that combines limitations on the issuing authority with an explicit legislative commitment to exchange domestic currency for a specific foreign currency at a fixed exchange rate. The advantages of using a currency board include low inflation, economic credibility, and lower interest rates. There is practically no monetary independence as monetary policies will focus on maintaining the coverage of the reserve’s monetary supply to the detriment of other domestic considerations. The central bank will no longer act as a lender of last resort, and monetary policy will be strictly limited to that allowed by the banking rules of the currency board arrangement. For example, the Bulgarian Lev against the Euro or the Hong Kong dollar against the U.S. dollar.

Factors Affecting Currency Value 

Geopolitical risk, trade, investment, and tourism are the market forces that determine the value of any given currency. For example, each time a tourist travels to a new country, they have to use the local currency to pay for goods and services. Thus, a visitor has to convert their home currency into local currency. This type of currency exchange is one of the things that drives demand for a specific currency, like USD and YEN.

Elements of Foreign Exchange Trade

The elements of an FX (Foreign Exchange) trade describe different types of transactions involving buying and selling currencies. Here’s a breakdown of these elements:

What is a Forex Pair?

A forex pair (currency pair) is a set of two currencies that are exchanged for one another. Though there are countless possible pairings, some of the most widely used ones are the US dollar versus the Japanese yen (USD/JPY), the British pound versus the US dollar (GBP/USD), and the euro versus the US dollar (EUR/USD). 

What are the Base and Quote Currencies? 

In a currency pair, the base currency is always on the left and the quote is always on the right. The quote currency is the current quote price of the pair, which indicates how much of the quote currency will be needed to purchase one base. The base currency is always equal to one. Thus, you always sell one currency to buy another when you trade currencies.

ISO Currency Codes 

For the currencies traded on the foreign exchange market, quotation and pricing systems, or currency pairs, are based on ISO currency codes.

• The ISO currency codes are alphabetic codes consisting of three letters that stand for the different currencies that are used globally.
• In 1978, the ISO standard committees created standardized currency codes.
• In forex price quotes, the base and quote currencies are identified by ISO currency codes.
• In addition, ISO has assigned less-known numerical equivalents for the three-letter currency codes.

What is a pip in Forex?

In forex trading, the change in value between two currencies is defined by a measurement called a pip. The literal meaning of pip is ‘point in percentage’, and it is the smallest standardized move that a currency quote can change by. Traders use pip value to express the profit or loss on their position by calculating the difference between the ask and bid prices of a currency pair.

Formula to calculate pip value:

A pip in forex is generally a one-digit movement change in the fourth decimal place of a currency pair. So, if GBP/USD changes from $1.35351 to $1.35361, then it has changed a single pip. But if you’re trading JPY crosses, a pip is a change at the second decimal place. In forex trading, a price movement at the fifth decimal place is referred to as a pipette.

Example of pip in forex:

What is a Lot in Forex Trading?

A lot is a standardized unit of measurement in forex trading that is used to determine the size or volume of a specific trade. The quantity of money bought or sold in a trade is represented by a lot. Foreign exchange (forex) frequently offers various lot sizes that can be used to enter the market.

Which are the Currency Pairs Traded in India? 

Currency pairs in India are classified into two categories: cross-currency pairs and INR pairs. Let us quickly review these two classifications of currency pairs. 

Indian rupee (INR) pairs are currency pairs in which the quoted currency is almost always the Indian rupee. The following INR pairs have derivative contracts that can be traded in India. 

Conversely, cross-currency pairs have no connection to the Indian rupee. Rather, it is composed of two distinct foreign currencies. Here is a brief overview of the cross-currency derivative contracts that can be traded in India. 

What is Forex Quotation?

Ratio to convert one currency to the other that is the price of one currency (base) in terms of the other currency (quoted). It is also known as the Exchange Rate. Base currency is the first currency in the currency pair, whereas the quote currency will be the second in the currency pair.

• When a trader places an order to buy a currency pair, they do so at the ask price. 
• Conversely, when they place an order to sell, they do so at the bid price.
• The difference between the bid and ask prices is called the spread. 

For example:

Let’s consider the EUR/USD currency pair:

• Bid Price: $1.1000
• Ask Price: $1.1005

This means you can sell 1 euro for $1.1000 (bid price) or buy 1 euro for $1.1005 (ask price). The difference of 0.0005 represents the spread.

Example of Forex Quotation

How Inflation Affects Foreign Exchange Rates 

Inflation has a major effect on a country’s currency’s value as well as its foreign exchange rates with other currencies. Even though inflation is just one of many factors, it has the potential to have a significant negative impact on the value of a currency and the foreign exchange rate. While low inflation does not guarantee a promising exchange rate, high inflation is almost guaranteed to have a negative impact.

Interest rates and inflation are closely related since they both have an impact on exchange rates. Currency-issuing nations frequently find it challenging to manage the intricate relationship between interest rates and inflation. Low interest rates generally have a positive impact on currency value and encourage consumer spending and economic growth.

Inflation may occur if consumer spending rises and demand surpasses supply, though this is not always a bad thing. Higher interest rates attract foreign investment, which is likely to increase demand for a country’s currency, but low interest rates do not have the same effect.

How is the Currency Valued? 

The value of a nation’s currency is determined by supply and demand. As a result, it is constantly changing. We refer to this type of exchange rate as the floating exchange rate. This is the scenario in a free economy.

Likewise, market forces determine the value of a rupee. The rupee’s value is impacted by several factors, including inflation, interest rates, and imports and exports. Additionally, it would depend on both domestic and global political circumstances. Foreign exchange value is also influenced by tourism. This is the reason big businesses have plans for currency management. The purpose is to protect the company from foreign exchange rate fluctuations.

Foreign Exchange is Essential When Traveling Abroad

When traveling overseas, it is necessary to have the local currency. You will require US dollars if you are traveling to the US. You will require pounds if you are traveling to the UK. Rupees can be exchanged for the specified foreign currency. Travel agencies, banks, and foreign exchange dealers all provide this service. The available exchange rates are one aspect of this. You also pay a transaction fee to them. It is best to exchange your money at a bank or through an agent. If you are a valued customer, banks will provide you with competitive rates. The airport currency exchange is the most expensive, so it should be your last option.

Forex cards are another option for travelers. A Forex card can serve as a prepaid instrument. It accepts one or more currencies when loaded. Compared to carrying cash, this is a more convenient and safest option.

Foreign exchange plays a significant role in both international trade and summer travel.

Conclusion

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