FOREX BASICS

What Is Forex?

Forex is the acronym for Foreign Exchange. The foreign exchange market is the "place" where currencies are traded. Currencies are important to most people around the world, whether they realize it or not, because currencies need to be exchanged in order to conduct foreign trade and business. If you are living in India and want to buy cheese from France, either you or the company that you buy the cheese from has to pay the French for the cheese in euros (EUR). This means that the Indian importer would have to exchange the equivalent value of India Rupees (INR) into euros. The same goes for traveling. A French tourist in Egypt can't pay in euros to see the pyramids because it's not the locally accepted currency. As such, the tourist has to exchange the euros for the local currency, in this case the Egyptian pound, at the current exchange rate.

The need to exchange currencies is the primary reason why the forex market is the largest, most liquid financial market in the world. It dwarfs other markets in size, even the stock market, with an average daily turnover of US$ 4.0 Trillion.

One unique aspect of this international market is that there is no central marketplace for foreign exchange. Rather, currency trading is conducted either through brokers or electronically over-the-counter (OTC), which means that all transactions occur via computer networks between traders around the world, rather than on one centralized exchange. The market is open 24 hours a day, five and a half days a week, and currencies are traded worldwide in the major financial centres of London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and Sydney - across almost every time zone. This means that when the trading day in the U.S. ends, the forex market begins anew in Sydney followed by Tokyo and Hong Kong. As such, the forex market can be extremely active any time of the day, with price quotes changing constantly.

Forex is used by anyone exchanging currency for any reason –

·       Travel

·       International Trade - Import/Export

·       Central Authorities

·       Investments/ Borrowings in Foreign Currency

How Forex Rate Movements can affect an ECONOMY?

Movement in Foreign Exchange market can have a big influence on the planning and determination of monetary policy of any economy. Sometimes this policy can be formulated on the basis of assumptions made by economic planners on currency trends internationally. Broad areas where Forex can have an impact on the economy are –

Monetary Policy- The pattern of international currency flow in and out of an economy may have an influence on domestic money supply, and hence on monetary policy. This in turn also affects the interest rates.

Consumer Prices– In any economy a proportion of all consumer goods are imported. Therefore currency fluctuations and the price of the importer's currency vis a vis the exporter's currency will influence the cost of the goods when being sold at home

Inflation- Inflation is the process of steadily rising prices, resulting in the diminishing purchasing power of a given sum of money. Therefore the price of imports, of which exchange rates are a factor, can directly affect inflation levels in an economy

Exports- The performance of the home currency against foreign currencies on the international markets will have a direct influence on the competitiveness of exports, e.g. if a currency is undervalued, the exports of that country will appear relatively cheap to holders of foreign currency and this should have the effect of increasing the volume of exports.

Employment- Inflation & export competitiveness have a direct bearing on the level of employment in an economy; particularly in industries that are export oriented. Also, due to possible cheaper import substitutes (because of currency fluctuations) employment in an industry whose markets are home based may also suffer.

Factors influencing Exchange Rates

The actual exchange rate, at any given time, is primarily determined by the supply and demand conditions for the relevant currencies. We will now look at the factors which influence supply and demand levels for a currency and thus influence the Exchange Rate

Balance of Payment- A currency will tend to fluctuate according to its country's performance with its trading partners. With a Balance of payments SURPLUS currency tends to strengthen while with a DEFICIT currency tends to weaken. In the latter situation more goods and services are being imported than exported. There is a net outflow of currency to pay for these imports. Foreign currency has to be bought in exchange for the local currency to transact payment. Therefore there will be more sellers than buyers and the exchange rate will tend to drop. This process makes imports more expensive, but it also makes exports cheaper and more competitive.

Interest Rates- As the prevailing interest rate of one currency against another rises or falls, the currency with the LOWER interest rate will tend to be SOLD and the currency with the HIGHER interest rate will tend to be BOUGHT to avail of the higher returns. Because of the demand for the currency with the higher interest rates, the price of this currency vis-a-vis the other will be higher.

Government Policies- If the Central Bank decides that intervention in the market will be effective and if the results of that intervention are in line with Government policy then exchange rates will be influenced by Central Bank participation. Hence, many a times, Central Banks are witnessed buying or selling amounts of local currency to stabilise it at levels perceived to be realistic. How market participants view Government Policy in terms of deflation or reflation, FDI, ODI, FIIs, etc. and their view of future trends of that policy will also affect exchange rates.

Political Development- The stability of a currency very often moves in line with the stability of the political situation. Generally the more stable the political life of the country the more stable will be its currency. Exchange rates are also influenced by global political situation. Increasing world tension can cause dramatic flights in and out of various currencies leading to instability in the Forex market

Market Sentiment- The Foreign Exchange Market does not always follow a logical pattern. Intangible factors such as market sentiment, gut feelings, individual perceptions and analysis of various international, political and economic events all have a role in influencing rates.

Speculation- Speculative activities by large market operators can also be a determining factor in exchange rates. In fact the volumes on the Foreign Exchange Market directly relating to international trade are relatively small. A large proportion of these transactions are speculative in nature and this can cause runs on various currencies, thus influencing the rates.

Understanding the Currency Pairs

In the world of Forex, currencies are called currency pairs.A currency pair is simply one currency expressed in terms of other like – USD/INR, USD/JPY, USD/CHF, GBP/USD, EUR/USD etc. The currency to the left of the slash is the base currency, while the currency on the right is called the variable or counter currency. When a currency is quoted, it is done in relation to another currency, so that the value of one is reflected through the value of another. Currency Pairs are quoted on a  Bid - Ask Basis.

                    BID                                                                                         ASK

                            means                                                                                      means

                 A BID for one currency in terms  of  another                              An OFFER for one currency in terms of another

                                                    i.e                                                                                           i.e

                      The party quoting will BUY one currency and                              The party quoting will SELL one currency and

                                  will  pay for it  with another                                                           will accept for it in another

For Example - 

USD / INR
55.20 / 55.30

BID      /      ASK

                                                                            This is a BID for dollar and the party

                                                                        quoting will pay INR 55.20 for each dollar

                                                                                                                &

                                                                       This is an OFFER to sell dollar and the party

                                                               quoting will accept INR 55.30 as payment for each dollar

Spreads and Pips

The difference between the bid price and the ask price is called a spread. If we were to look at the following quote: EUR/USD = 1.2500/03, the spread would be 0.0003 or 3 pips, also known as points. Although these movements may seem insignificant, even the smallest point change can result in thousands of dollars being made or lost due to leverage. Again, this is one of the reasons that speculators are so attracted to the forex market; even the tiniest price movement can result in huge profit.

The pip is the smallest amount a price can move in any currency quote. In the case of the U.S. dollar, euro, British pound or Swiss franc, one pip would be 0.0001. With the Japanese yen, one pip would be 0.01, because this currency is quoted to two decimal places. So, in a forex quote of USD/CHF, the pip would be 0.0001 Swiss francs.

Direct Currency Quote vs. Indirect Currency Quote

There are two ways to quote a currency pair, either directly or indirectly. A direct currency quote is simply a currency pair in which the domestic currency is the base currency; while an indirect quote, is a currency pair where the domestic currency is the quoted currency. In the forex spot market, most currencies are traded against the U.S. dollar, and the U.S. dollar is frequently the base currency in the currency pair. In these cases, it is called a direct quote like USD/INR, USD/JPY, USD/CHF, USD/CAD. However, not all currencies have the U.S. dollar as the base. The Queen's currencies - those currencies that historically have had a tie with Britain, such as the British pound, Australian Dollar and New Zealand dollar - are all quoted as the base currency against the U.S. dollar. The euro is quoted the same way as well. In these cases, the U.S. dollar is the counter currency, and the exchange rate is referred to as an indirect quote like EUR/USD, GBP/USD, AUD/USD, NZD/USD.

Cross Currency

When a currency quote is given without the U.S. dollar as one of its components, this is called a cross currency like EUR/INR, JPY/INR, GBP/INR etc. The most common cross currency pairs are the EUR/GBP, EUR/CHF and EUR/JPY. These currency pairs expand the trading possibilities in the forex market, but it is important to note that they do not have as much of a following (for example, not as actively traded) as pairs that include the U.S. dollar, which also are called the majors.

TRANSACTIONS IN THE FOREX MARKET

There are actually three ways that institutions, corporations and individuals trade forex:

       Spot market

       Forwards market

       Futures market

The forex trading in the spot market always has been the largest market because it is the "underlying" real asset that the forwards and futures markets are based on. With the advent of electronic trading, the spot market has witnessed a huge surge in activity and now surpasses the futures market as the preferred trading market for individual investors and speculators. When people refer to the forex market, they usually are referring to the spot market. The forwards and futures markets tend to be more popular with companies that need to hedge their foreign exchange risks out to a specific date in the future.

What is the spot market?

More specifically, the spot market is where currencies are bought and sold according to the current price. That price, determined by supply and demand, is a reflection of many things, including current interest rates, economic performance, sentiment towards ongoing political situations (both locally and internationally), as well as the perception of the future performance of one currency against another. When a deal is finalized, this is known as a "spot deal". It is a bilateral transaction by which one party delivers an agreed-upon currency amount to the counter party and receives a specified amount of another currency at the agreed-upon exchange rate value. After a position is closed, the settlement is in cash. Although the spot market is commonly known as one that deals with transactions in the present (rather than the future), these trades actually take two days for settlement.

What is the Forward Market?

Unlike the spot market, the forwards do not trade actual currencies. Instead they deal in contracts that represent claims to a certain currency type, a specific price per unit and a future date for settlement. The main difference between SPOT and FORWARD dealing is that Spot Dealing is more concerned with tactical short term decisions. Forward Dealing involves taking a longer term view on the interest rate movements of the currencies involved. The Forward Market operates mostly in the time span between overnight and one year. Forward rates are determined by the interest rates prevailing in the deposit markets of the two currencies involved. Forward prices are usually quoted in POINTS. Forward prices are calculated by adding or subtracting the points, to or from the spot prices. The addition or subtraction is determined by the order of the points quoted. If the points are quoted LOW Figure – High Figure then they are added to the Spot rates to arrive at forward rates and if the points are quoted HIGH figure – LOW figure then we subtract points from the spot rates.

Types of Forward Transactions –

1.       Forward Outright

2.       Forward Swaps

Difference between Forward Outright and Forward Swaps

A foreign exchange outright forward is a contract to exchange two currencies at a future date at an agreed upon exchange rate. Whereas, a Swap Transaction is the simultaneous buying and selling of the same amount of a given currency, against the sale and purchase of another, at an agreed upon rate for two different fixed dates in future.

What is the Future Market?

Unlike, the forward market where contracts are bought and sold OTC between two parties and they determine the terms of the agreement between themselves, futures contracts are bought and sold based upon a standard size and settlement date on public commodities markets / exchanges. Futures contracts have specific details, including the number of units being traded, delivery and settlement dates, and minimum price increments that cannot be customized. The exchange acts as a counterpart to the trader, providing clearance and settlement.

Both types of contracts are binding and are typically settled for cash for the exchange in question upon expiry, although contracts can also be bought and sold before they expire. The forwards and futures markets can offer protection against risk when trading currencies. Usually, big international corporations use these markets in order to hedge against future exchange rate fluctuations, but speculators take part in these markets as well.