The Foreign Exchange market, commonly abbreviated as the Forex market, isthe largest and the most liquid financial market in the world, with daily volumes exceeding a whopping $5 trillion. The amount of transactions that take place in the Forex market is much larger than the amount of transactions that take place in the equity, bond, or the commodity markets. But what exactly is the Forex market?
In its simplest terms, Forex market is a market where currencies are exchanged for one another. It is amarket where various participants are involved in the buying and the selling of currencies either at the prevailing exchange rate or at a pre-determined rate. The objective behind the transactions made by the participants can vary widely. For instance, one person could be exchanging one currency for another because he or she wants to travel overseas, another person could be making payment in foreign currency because he or she has ordered a product or a service from overseas, yet someone else could be speculating or trying to capture an arbitrage opportunity, companies could be transacting in foreign currencies to move goods and services from one country to another, companies could be transacting in foreign currencies to hedge their underlying international exposure, and so on.
Various currencies are traded in the Forex market - US Dollars, Euro, Pound Sterling, Chinese Yuan, Indian Rupee, Australian Dollar, Canadian Dollar, Russian Ruble, Brazilian Real etc. just to name just a few. One thing to remember is that currencies are always traded in pairs. In other words, if a person is buying one currency, he or she is doing so by selling another currency. For instance, one could be buying euros by selling dollars, one could be buying yuan by selling rupees etc.A currency is never expressed in isolation, but rather in pairs. Later in the chapter, we will talk in depth about how currencies are expressed in terms of one another.
The Forex market is open virtually 24 hours a day, for 5 days a week. The week begins on Monday when markets across the Asia-Pacific region begin trading. By the time markets across Asia-Pacific approach their closing hours, markets across Europe begin trading. By the time markets across Europe are about to close for the day, markets across the Americas begin trading. And finally, by the time markets across the Americas are about to close on Monday, it is already Tuesday in Asia Pacific, where markets have just begun their day. This continues till Friday when the close of the Americas end the week. So, as we can see, the week begins when Forex markets across Asia Pacific open on Monday and ends when Forex markets across the Americas close on Friday. Broadly speaking, the Forex trading hours on each day can be divided into three sessions:
The Tokyo session, which is usually active between 5AM IST to 1PM IST
The London session, which is usually active between 12PM IST to 9PM IST, and
The New York session, which is usually active between 6:00PM IST to 2:00AM IST
Most of the volumes during the day take place when two markets from two different continents are open simultaneously for a brief period, i.e. when markets in Asia-Pacific and Europe overlap and then again when markets in Europe and the Americas overlap. This is also the time when a lot of economic data come out from the region that has just begun trading, adding to further volatility and a spurt in volume.Notice above that the Tokyo session and the London session are simultaneously open for a brief period, and so are the London session and the New York session. Because of a spurt in volume during times when two markets are simultaneously open, it is common to see the bid-ask spreads between major currency pairs declining during this period.
As per the United Nations statistics, there are 180 currencies in the world. However, only a few among these dominate the Forex market as far as volumes are concerned. In this section, we will talk about the most traded and the most important currencies in the world.
When one talks about the Dollar, he or she is, by default, referring to the US Dollar, the official currency of the United States. And so would we for the remainder of our currency course. The Dollar is by far the most traded, the most liquid, and the most watched after currency in the world. It is also the world’s reserve currency, because a lot of central banks around the world hold Dollars in the form of their foreign exchange reserves. Changes in the value of the Dollar can have a material impact on various asset classes such as global equities and most notably commodities, as most of the international commodities are priced in terms of the Dollar.
Most of the world’s currencies are primarily paired with the Dollar, such as EUR/USD, USD/JPY etc. A currency pair that is not paired with the Dollar is called a cross currency. For instance, EUR/GBP, GBP/JPY etc. We will talk about this in greater detail later.Most of the countries today allow their currencies to freely float against the Dollar. However, there are a few countries that have fixed (or pegged) their currencies to the Dollar. The most notable examples are the Hong Kong Dollar and a few Middle Eastern currencies such as the Bahrain Dollar. Technically, the Dollar is expressed using the code USD.
Because the Dollar is the world’s most important currency, the central bank that controls the supply of Dollars - the Federal Reserve - is without a doubt the most important financial institution in the world. The policy actions of the Federal Reserve can have a strong influence on the trajectory of the world markets, be it equities, commodities, debt, or currencies.
The Euro came into existence on 1stJanuary 1999 as a common currency of the Eurozone members. Today, the Euro is the official currency in 19 EU nations. Despite being just over two decades into the system, the Euro is the second most traded and liquid currency in the world. A few countries, especially those in Europe and Africa, have pegged their currencies against the Euro. Technically, the Euro is expressed using the code EUR.The pair EUR/USD is the most traded currency pair in the world.The central bank that is authorized to monitor and print the Euro is the European Central bank, commonly abbreviated as the ECB.
The Japanese Yen is the official currency of Japan. It is the third most traded and liquid currency in the world and is widely considered as a safe haven currency. It is quite common to see the Yen strengthening against most of its counterparts during times of global uncertainties. Technically, the Yen is expressed using the code JPY. The central bank that influences the supply of the Japanese currency is the Bank of Japan, commonly abbreviated as BoJ.
The Bank of Japan’s ultra-low interest rates and the Yen’s safe haven status have made the Japanese currency quite popular for conducting ‘carry trades’, wherein one borrows a currency that has a low interest rate and uses the proceeds to buy a currency that has a high interest rate, with the objective of profiting from the difference between the two interest rates. We will talk about carry trade in greater detail in a later chapter.
When one talks about the Pound, he or she is by default referring to the British Pound. The Pound is the official currency of the United Kingdom. It is the fourth most traded currency in the world. Technically, the Pound is expressed using the code GBP. The central bank that influences the supply of the Pound is the Bank of England, commonly abbreviated as BoE.
The Swiss Franc is the official currency of Switzerland. Just like the Yen, the Swiss Franc is also widely considered as a safe haven currency. It tends to rise during times of global uncertainties and weaken during times of global strength. Technically, the Franc is expressed using the code CHF. The central bank that influences the supply of the Swiss currency is the Swiss National Bank, commonly abbreviated as SNB.
The Canadian Dollar is the official currency of Canada. As Canada is a large exporter of various commodities, the Canadian Dollar is one of the most closely monitored commodity currency in the world. It is impacted not only by Forex-related news flows but also by commodities-related news flows, especially those relating to crude oil. Movements in the Canadian Dollar can occasionally provide clues on near-term movements in related commodities. Because Canadian Dollar is sensitive to trends in commodities, it tends to appreciate during times when commodity prices are going up, and vice versa. Technically, the Canadian Dollar is expressed using the code CAD. The central bank that influences the supply of the Canadian Dollar is the Bank of Canada, commonly abbreviated as BoC.
The Australian Dollar is the official currency of Australia. Just like Canada, Australia is a big producer and exporter of various commodities. Hence, the Australian Dollar is heavily impacted by news flows relating to commodities, especially those relating to metals and minerals. Movements in the Australian Dollar can occasionally provide clues on near-term movements in certain commodities, especially gold. Because Australian Dollar is sensitive to trends in commodities, it tends to appreciate during times when commodity prices are going up, and vice versa. Technically, the Australian Dollar is expressed using the code AUD. The central bank that influences the supply of the Australian Dollar is the Reserve Bank of Australia, commonly abbreviated as RBA.
The Chinese Yuan is the official currency of China. As China is the world’s second largest economy and has a strong impact on the global trade and markets, movements in the Yuan is closely monitored by market participants around the world. Large swings in Yuan can have a marked impact on global equities, commodities, currencies, and bonds. The Yuan was pegged to the Dollar until 2005. Since then, China has gradually opened its currency. Having said that, the Yuan is still not a free-floating currency, but is rather a managed float (we will talk more about these concepts later).Technically, the Yuan is expressed using the code CNY. The central bank that influences the supply of the Yuan is the People’s Bank of China, commonly abbreviated as PBoC.
The US Dollar index is not a currency, per se. Instead, as the name suggests, it is an index. It measures the performance of the Dollar relative to a basket of six currencies. These include the Euro, the Japanese Yen, the Pound Sterling, the Canadian Dollar, the Swedish Krona, and the Swiss Franc. If the index is rising, it means the Dollar is relatively outperforming the basket of currencies, and vice versa. The DXY was introduced in 1973, with a base value of 100. Technically, the Dollar index is expressed using the code DXY. The approximate weights of the six currencies in the Dollar index are mentioned in the table. The value and trends of the Dollar index are closely monitored by market participants around the world to get clues about how the Dollar is performing, in general.
We will cover in depth about this section from chapters 10 to 12. For now, we will just talk briefly about the currency pairs that are most traded in India.
Not surprisingly, the most traded currency against the Rupee is the Dollar. The Dollar is a very crucial currency for the Indian economy because most of the international products, services, commodities etc. are priced in terms of the US currency. As such, most of the international payments that take place in India are in Dollar terms. The currency is tradednot only in the Over-the-Counter (OTC) market, but also in the derivatives market, especially futures and options.
Besides the dollar, other currencies that are available for trading in India include the Euro, the Pound Sterling, and the Japanese Yen. These instruments are available for trading in the derivatives segment too.
The major exchanges that permit the trading of currency derivatives in India are the National Stock Exchange (NSE), the Bombay Stock Exchange (BSE), and the Multi-Commodity Exchange (MCX-SX).
One thing to always keep in mind is that the Forex market is relative. In other words, a currency never trades in isolation, but rather in pairs. One currency is expressed in terms of another currency to get the relative value of the pair. So, if somebody says that the Dollar has appreciated, it is always in relation to some other currency. But how exactly are currencies expressed? Well, the objective of this section is to familiarize the reader with the way currencies are expressed and calculated. Let’s start with a simple example.
EUR/USD = 1.2000
In the above expression, the term on the left (EUR) is called the base currency, while that on the right (USD) is called the quoted currency. A currency pair will always be expressed this way, with the base currency appearing on the left and the quoted currency appearing on the right. What the above expression tells us is how much of the quoted currency is needed to buy one unit of the base currency. So, the expression EUR/USD = 1.2000 tells us that to buy one unit of the Euro, 1.2000 units of the Dollar are needed. Similarly, the expression USD/INR = 70.05 tells us that to buy one unit of the Dollar, 70.05 units of the Rupee are needed.
If the value of EUR/USD increases from 1.2000 to 1.2035, it means the base currency has appreciated or strengthened against the quoted currency. As such, a person who is willing to buy the Euro now will have to shell out more Dollars (1.2035 USD instead of 1.2000 USD). On the other hand, if the value of EUR/USD decreases from 1.2000 to 1.1973, it means the base currency has depreciated or weakened against the quoted currency. As such, a person who is willing to buy the Euro now will have to shell out fewer Dollars (1.1973 USD instead of 1.2000 USD). As stated earlier, currencies are always relative. So, if EUR/USD has gone up from 1.2000 to 1.2035, one can say that either the Euro has appreciated (strengthened) or the Dollar has depreciated (weakened). Both mean one and the same.
A currency pair will always be displayed in the manner shown above. Each currency will be expressed using a three-letter code. Typically, the first two letters represent the country, while the third letter represents the currency. So, in case of USD, the first two letters stand for United States, while the third letter stands for the Dollar. Similarly, in case of INR, the first two letters stand for India, while the third letter stands for the Rupee.
There are various types of participants that are involved in the $5 trillion a day Forex market. Depending on their objectives, these participants can be classified as follows:
The interbank market, comprising of commercial banks/Forex dealers, is the largestentity in the foreign exchange market, transacting on behalf of their customers and for themselves. In fact, the interbank market forms a bulk of the Forex market. Some of the biggest banks transacting in the Forex market are Citibank, JP Morgan, UBS, Deutsche Bank, Bank of America Merrill Lynch, and Barclays. The volume of transactions done by these institutions is so enormous that the spread between the bid and ask pricesgets quite small during active trading hours. In fact, these are the entities that determine the bid-ask spread. Transactions that are done by these entities are decentralized, meaning they take place in an Over-the-Counter (OTC) market.
These are the entities that provide favourable Forex rates to their customers, which include interbank dealers and retail clientele. Because of their strong network with interbank dealers, they can facilitate an FX buyer to get as low a quote as possible, and an FX seller to get as high a quote as possible. To facilitate the trade, Forex brokers collect commission from both sides of the trade, i.e. from the buyer as well as from the seller.
Given that we live in the era of globalization, companies are increasingly seeking at avenues to expand their operations outside the country of their origin. These entities need huge amounts of foreign currency to expand their businesses overseas. The figures could vary from a few million dollars to billions of dollars. As such, corporations and MNCs form an important part of the Forex markets.
These are the entities that have an exposure in the Forex market and as such, hedge their exposure by taking an opposite position with the objective to eliminate/lower any unfavourable, adverse currency price swings. Hedgers can include importers and exporters as well as other entities such as businesses and corporations.
These entities engage in a foreign exchange transaction merely with the objective of making money. They could base their trading decisions on fundamental, technical, or any other factor as they deem fit. For instance, if an employment data from Australia comes out strong, a trader might consider buying AUD/USD in order to profit from a potential up move in the Australian dollar. Usually, speculators in the Forex market place short-term bets in the movements of currencies. Speculators vary in size - some could be very small, trading just a few dollars’ worth of currencies; while some could be very large, trading millions of dollars’ worth of currencies.
These entities trade the Forex market with the objective of profiting from a price discrepancy that might exist among different markets/channels. They are in the business to make risk-free profit by buying a currency pair that is under-priced in one market and then selling the same currency pair that is over-priced in another market. Until the arbitrage opportunity disappears, arbitrageurs will be there to take advantage of the price discrepancy.
Central banks and governments are important entities in the Forex market. Their objective in the Forex market is varied - transferring payments overseas, funding country-specific operations, managing the country’s Forex reserves, intervention in the forex market etc. One of the objectives of central banks and governments is to ensure that their nation’s currency is stable. Any run on the currency by speculators or other participants that causes adverse movement and wild swings in the currency is usually met with an intervention.
In this section, we will talk about the major types of Forex instruments that are available for trading in the Forex markets.
A spot transaction is a transaction wherein two parties agree today to exchangeone currency for another at the prevailing spot price.The settlement and the delivery of the transaction usually takes place on a T+2 basis (2 business days after the trade day) or in some cases on a T+1 basis (1 business day after the trade day), where ‘T’ stands for the trade day. This is one of the most common and one of the most transacted way of dealing in the Forex markets.Also, a spot transaction has the smallest timeframe as compared to any other Forex transaction. As per the Bank for International Settlements (BIS) estimates, spot transactions accounted for a third of the OTC Forex volumes in 2016.
A forward transaction is a transaction wherein two partiesagree today to exchange one currency for another at a pre-determined price, but for a future delivery. The delivery and exchange of cash flows takes place on the settlement date, which could be a few days, weeks, months, or even years from the trade date. As per the BIS estimates, outright forward transactions accounted for around 14% of the OTC Forex volumes in 2016.
While a forward is an OTC transaction, a futures transaction is traded on an exchange. Also, while forwards are customized contracts, futures are standardized contracts in terms of the size of each lot, the expiry date, the day-to-day margin settlement etc. Besides these features, futures and forwards are quite similar to each other. In fact, a futures contract is nothing but a standardized forward contract. These contracts are quite popular among speculators, who usually exit their trades before the settlement day.
A Forex option is a contract wherein the buyer of the option has the right to buy or sell a fixed quantity of a certain currency at a pre-determined price, called the strike price, on a pre-determined date. If the buyer exercises the right, the seller will be obliged to fulfil the contract. Else, the seller will get to keep the option premium, which is the price that the option buyer pays to the option seller for granting him or her the right to the option. A Forex option could be either traded on an exchange or in the OTC markets. As per the BIS estimates, option transactions accounted for around 5% of the OTC Forex volumes in 2016.
An FX swap is an agreement between two parties to exchange one currency for another for a pre-determined time. It is a type of foreign loan wherein one party agrees with the other to exchange principle and interest in one currency for principle and interest in another currency. Both the legs are transacted for an equivalent amount. Until maturity, both the parties continue paying each other periodic interest (fixed or floating, depending upon the terms of the swap) on the principle amount. On maturity, the principle is repaid at a pre-determined rate. There are various objectives because of which entities could enter an FX swap, such as reducing currency risk, raising foreign currencies at an attractive interest rate etc.As per the BIS estimates, swap transactions accounted for almost half of the OTC Forex volumes in 2016. The reason why swaps account for such a big share is because they usually involve dealing in both spot and forward instruments.
We will conclude this chapter by talking briefly about some of the key factors that impact the Forex market. The reason for talking briefly is because an entire chapter has been devoted to this section later.
Below mentioned are some of the major macro-economic factors that impact the Forex markets.
Interest rates between two currencies
The tone of central bank monetary policy - dovish or hawkish
Economic health of a nation
Trade and capital flows into and out of a nation
Movements in other markets - equities, bonds, and commodities
Besides, currencies are also impacted by technical factors, especially in the short to very short-term. We will discuss each of these factors in greater detail in Chapter 3.
Evolution of the Forex Market7 Lessons
This chapter talks in detail about how the Forex market has evolved over the course of last several centuries. We start with the earliest known system of exchange - the Barter system - and proceed all the way to today's digital era. The objective of this chapter is to introduce the reader with important milestones that have eventually shaped up the Forex market of today.
Factors that Drive the Forex Market14 Lessons
In this chapter, we shall study some of the major economic and fundamental factors that impact currencies. The objective is to enable the reader to understand the various facets that impact the Forex market of today.