In simplest terms, forex is the market for exchanging foreign currencies. One currency is bought and another is sold while the profit is determined by the exchange rate which itself gets determined by the forces of demand and supply. This global marketplace operates 24 hours daily from Monday to Friday with all the trades conducted over the counter. There is no physical exchange and the market operations are overseen by a global network of financial institutions and banks. Mostly the forex market activities occur between fund managers, people working for banks, and multinational corporations. These institutional traders either hedge against or speculate about exchange rate fluctuations rather than taking physical possession of the currencies.
Types of Forex Pairs
While trading foreign exchange, you will see that every currency is indicated by a three-letter code of which two-letter pertains to the region and the last one is the currency itself. For example, JPY stands for Japanese Yen, and, USD stands for US Dollar. Currency pairs are segregated into the following three categories:
- Major Currency Pair – EUR/USD, GBP/USD, USD/JPY, NZD/USD, USD/CAD, USD/CHF, AUD/USD – these seven pairs comprise a lion’s share of trade happening in the forex market. These pairs offer the highest level of liquidity and low volatility courtesy of a large number of traders involved.
- Minor Currency Pair – Just as the name suggests, these currency pairs are traded less in comparison to their major peers. They have wider spreads and are less liquid than the major currency pairs.
- Exotic Currency Pair – They comprise a currency belonging to an emerging market country. Trading them comes with added challenges as the currencies are generally illiquid, have fewer market-makers, and have wider spreads. The Mexican Peso (MXN), Hong Kong Dollar (HKD), and South African Rand (ZAR) are some currencies that comprise exotic currency pairs.
Base & Quote Currency in Forex Pricing
Every currency pair is represented as the current exchange rate between two currencies. You can take the example of EUR/USD. The information is interpreted as follows:
- Euro is the base currency and the US dollar is the quote currency.
- The exchange rate is determined by how much of the quote currency is required for purchasing 1 unit of the base currency. The quote currency depends on the current market whereas the base currency is denoted as a single unit. EUR/USD exchange rate at the time of writing this article was 1.13. This denotes that €1 will buy $1.13.
- A rise in the exchange rate means that the relative value of the base currency has increased compared to the quote currency and now €1 will buy more US dollars. Similarly, a fall in the exchange rate signifies that the value of the base currency has decreased.
Types of Forex Market
- Spot Market – Exchange rates are determined by swapping currencies on a real-time basis in a spot market. Physical exchange of currencies might either take place on the spot or after a short while.
- Forward Market – Forex traders enter into a contract and lock in an exchange rate to buy or sell a specified amount of currency on a future date and a predetermined price.
- Futures Market – A standardized contract is entered upon by traders to either buy or sell a specified amount of currency at a fixed rate and future date. This contract is exchange-traded unlike the private transactions of the forward market.
Both forward and futures markets are used primarily by forex traders who wish to hedge or speculate against currency price alterations. Their exchange rates are based on the occurrences of the spot market wherein most of the forex trades take place.
Determinants of Forex Rate
Just like all other markets, currency prices are determined by the forces of demand and supply. However, certain macro factors come into play which has been listed down below:
- Central banks control the supply of money as the measures they announce can significantly affect a currency’s price. Often the central banks inject more money into the economy causing a drop in the currency’s price. An economy’s base interest rate is also controlled by the central bank. Purchasing assets in a currency having a high-interest rate can offer higher returns. As a result, investors swarm countries whose interest rates have been raised recently and this drives up its currency while boosting the economy. Borrowing money becomes harder when the interest rates are high and this can weaken the currencies slowly as investment becomes harder.
- Both investors and commercial banks want to invest in strong economies. News can have a big role to play by encouraging investment and adding to the demand for a particular currency. If its supply doesn’t increase parallelly then this hike in demand can push up its price. Similarly, negative news can bring down a currency’s price.
- Currency prices are also reactive to market sentiment. If traders are hopeful about changes in a certain currency, then they will trade accordingly and others will follow suit causing an overall rise or fall in demand.
Understanding Risk Management to Make the Most of Forex Trading
Risk management serves as an important part of currency trading as it helps determine when to exit the trade and when to take more risk. We will explain this concept with the help of a small example. Suppose you have two opaque boxes, the first one with three 1000-dollar blue balls and one 0-dollar red ball. The other box has just one 700-dollar green ball.
In the first scenario, you need to pick a ball from either of the boxes and this will be the amount you will be paid. Picking from the first box can pay you 1000 dollars on picking any of the blue balls but nothing if you land the red one. The second box on the other hand can guarantee a sure shot of 700 dollars. In the second scenario, you are again asked to pick a ball from any of the two boxes and the ball you choose will be the amount you lose.
In both the above-mentioned scenarios, there is no correct or wrong choice. However, certain choices are made by successful traders which help them stand out from the queue. They would opt for the first box in the first scenario and the second box in the second scenario. This is simple math and can offer a higher return in the long run.
In the first box, there are three 1000 dollars balls that offer a 75% chance of making 1000 dollars. The second box guarantees a 100% chance of making 700 dollars. While getting paid, successful traders would choose the first box as they would have a higher probability of earning 50 dollars more in the long run (1000*75% = 750$) compared to the guaranteed return of 700 dollars with the second box.
The exact opposite holds in the second scenario as traders will try and minimize their long-run loss. Choosing the second box means a guaranteed loss of 700 dollars which might be $750 in the first box.
Forex being the largest market in the world, its dealings impact everything from the price of your cocktail while vacationing in Bali to the price of imported clothing from France. Easy internet and smartphone accessibility have enhanced the popularity of forex trading amongst laymen.