How Forex Market Works?

Nations, organizations, and individuals require foreign currencies for various purposes like global trade and commerce, GDP comparisons, maintenance of forex reserves, travel, portfolio diversification, currency risk management, etc. The virtual marketplace for procuring and exchanging one currency for another is known as the forex market. Forex markets function like decentralized OTC (Over-the-Counter) markets with minimal governmental controls and no physical exchange floor.

As of 2021, the global forex market is valuated at $2.41 quadrillion. Forex trades worth $6.6 trillion are executed on a daily basis. The instruments with the highest daily turnovers are forwards, forex swaps, currency swaps, and options. 79% of the total international trades take place in five major hubs – UK, USA, Japan, Singapore, and Hong Kong. The major FX pairs traded are USD/GBP, USD/JPY, USD/EUR, USD/AUD, USD/CAD, USD/CNY, and USD/CHF.

Impact of currency appreciations and depreciations on forex rates

Currencies are always traded in pairs. Exchange rates are therefore relative values. A currency appreciates when its value rises in terms of another currency. Conversely, a currency depreciates when its value falls with respect to another currency. One will be the stronger or appreciating currency in an FX pair while the other will be the weaker or depreciating currency.

 

For example, if the price of USD/JPY pair is 110.69, it means that 1 USD equals 110.69 Yen. USD is the base currency and JPY is the quoted currency. In other words, the base currency is expressed in terms of the quoted currency. If USD appreciates, the import costs of US goods will rise for other countries. Moreover, the value of their exports in terms of USD will fall.

forex market

Different types of forex market investments

1. Foreign Direct Investment (FDI): FDI involves a firm holding minimum of 10% stake in a business or company based out of another country. In other words, when a foreign firm sets up a new venture or becomes a controlling owner in a business based in your country, it means that FDI has flown into your country. Conversely, when a multinational firm closes its operations in your country, it means there have been FDI outflows from your country. Acquisition of foreign assets is also construed as FDI. In FY 2020-21, FDI inflows into India totaled a record high value of $81.72 billion.

2. Foreign Exchange Earnings (FEE):The other type of foreign currency inflows occurs when foreign tourists visiting your country convert their currencies into your country’s legal tender. These are known as Foreign Exchange Earnings (FEE). In 2018 and 2019, the FEE of India stood at $28.59 billion and $29.96 billion respectively. However, between January to June 2020, the FEE dropped significantly to $6.15 billion due to the COVID-19 pandemic.

3. Retail investments: Individual investors across the world invest in foreign stocks, bonds, mutual funds, etc to diversify their investment portfolio overseas. Overseas diversification also minimizes the overall portfolio risk.

For example, if you have $10,000 worth of investment in say, Apple stocks and Tata power stocks each. Then, if for some reason, the US stock market has crashed and the Indian stock market is doing well, your losses from holding Apple stocks will be mitigated by the gains from Tata Power stocks. The converse is true if the Indian economy is going through a rough patch while the US economy is doing well.

4. Currency hedging:Currency hedging is a mechanism by which investors take opposite positions in different markets to offset losses. You can take opposite positions in two spot markets or in the spot and derivative markets.

For example, you are bullish about GBP currency vis-a-vis USD. Currently, the GBP/USD exchange rate is 1.39. Thus, at the current conversion rate, 10,000 GBP equals USD 13,913.65. Suppose, a month later, the GBP/USD FX rate falls to 1.35 and you convert the USD back to GBP. Now, you get 10,306.40 GBP. You made a gain of GBP 306.40.

Spread betting in the forex market

Spread betting is an advanced trading strategy wherein you bet on the currency price or FX rate movements without actually trading the currency pair. There are three aspects to it – expected FX rate direction (bullish/bearish), bet size, and speculated spread. The spread is the difference between the bid and ask price of an FX pair. The lower the spread, the more lucrative it is due to reduced transaction costs.

You can resort to leveraged trading strategy while engaging in spread betting. Under a leveraged trading mechanism, you have to pay a small margin amount to your broker. The margin amount will be a certain percentage of the total transaction value. Such a trading strategy will allow you to take large positions in the forex market with less money in your pocket.

Spread betting can also be undertaken using other trading strategies like forex scalping, forex hedging, news trading, and trend trading. Forex scalping involves holding long and short positions in FX pairs for a few seconds or minutes. This could be a profitable strategy when the exchange rates are very volatile. Trend trading strategy is quite commonly used for spread betting. It involves going long when the price is moving up and going short when the price is moving down. As the name suggests, news trading involves taking a position based on the current forex market updates.

Final words

The strength of a currency is determined by demand and supply forces in the forex market. The US dollar is the defacto currency for global trade and commerce. Most nations maintain the US dollar as a reserve currency. Hence, the demand for the US dollar is usually high in the forex market. Moreover, the value of a currency in the forex market is usually determined by pegging it to the US dollar. Other powerful currencies are AUD, GBP, EUR, CAD, JPY, CHF, etc.

The forex market not only allows investors, businesses, and countries to convert currencies but also to manage currency risks by locking in an exchange rate. Most retail investors can also get the benefit of overseas risk diversification through forex market investments.

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