Foreign Exchange Market

WHAT IS FOREIGN EXCHANGE

Foreign exchange is the mechanism by which

the currency of one country gets converted
into the currency of another country.

The conversion of currency is done by the

banks who deal in foreign exchange. These
banks maintain stocks of one currencies in the
form of balances with banks
 Cntd ….
It also refers to the stock of foreign currencies
a nd other foreign assets. The foreign
exchange management ACT 1999 defines
“Foreign exchange means foreign currency
and
includes…

(a)Deposits credits an d balances payable in any

foreign currency.

(b)Draft traveler’s cheques, letter or credit or bills

of exchange expressed or drawn in Indian
currency but payable in any foreign currency.

(c)Drafts travelers cheques, letter of credit or bills

of exchange drawn by banks, institution or
persons outside India, but payable in Indian
currency
Nature of foreign exchange
Volatile, affected by hedger, arbitrager, speculator.
Affected by d e m a n d a n d supply.
Affected by rate of interest.
Affected by balance of payment surplus a nd deficit.
Affected inflation rate.
Spot a n d forward rates are different.
Affected by the economic stability of the country.
Affected by the fiscal policy of the government.
Affected by the political condition of the country.
It c a n b e quoted directly or indirectly
Operation of foreign exchange market:
Foreign exchange market operates either as:-
Spot Market: (Current Market)
Spot market for foreign exchange is that market which
handles only spot transaction or current transactions.

Principle characteristics:-
Spot Market is of daily nature. It does not trade in future
deliveries.
 Spot rate of exchange is that rate which happens to
prevail at the
time when transactions are incurred.
Forward Market:
Forward Market for foreign exchange is that market which
handles such transaction of foreign exchange as are meant for
future delivery.

Principles Characteristics:-
 It only caters to forward transaction.

 It determines forward exchange rate at which forward

transaction
are to be honored.
 Exchange Rate
► Fixed Exchange Rate System
Fixed rates provide greater certainty for
exporters an d importers.
► Flexible Exchange Rate System

Flexible exchange rate or floating exchange

rates change freely a n d are determined
by trading in the forex market.
 History of Foreign exchange
Foreign exchange history c a n b e viewed as a
series of solutions that allowed countries to
issue their own currency a nd to conduct their
own monetary policy while also allowing
international trade to b e co ndu ct ed by
providing a means of exchanging one
currency for another according to the
exchange rate between them, which was
either agreed-upon or set by the market.
 Exchange rate fluctuations
A reliable forecast or future spot rate is
called study of empirical patterns of
exchange rate fluctuation. It provides
essential information for an exchange rate
exposure.
The Foreign Exchange Market for Beginners
►The foreign exchange market or forex market as it is
often called is the market in which currencies are
traded.
►Currency Trading is the world’s largest market

consisting of almost trillion in daily volumes a n d

as investors learn more a n d b e c o m e more
interested, market continues to rapidly grow.
►All trades that take place in the foreign exchange

market involve the buying of one currency a n d the

selling of another currency simultaneously. This is
because the value of one currency is determined by
its comparison to another currency.
► The first currency of a currency pair is called the

“base currency,” while the second currency is

called the counter currency.
 Contd….
►Foreign exchange Capital Markets (FXCM) is
an online currency trading firm that offers a
free d e m o account to traders who are new
a nd interested in the foreign exchange
market.
►Registering for a d e m o account allows a

new trader to download the online trading

platform that is used by the company’s clients
trading live accounts a nd make trades as if
they were doing it with real money.
Characteristics of foreign exchange
☻ Its huge trading volume representing the
largest asset class in the world leading to high
liquidity.
☻ Its geographical dispersion;

☻ Its continuous operation: 24 hours a day

except weekends, i.e., trading from
20:15 GMT on Sunday until 22:00 GMT
Friday.
☻The use of leverage to enhance profit
an d
loss margins a nd with respect to account
size.
 Retail Exchange Market
People
may need to exchange currencies in
a number of situations.for Eg…
Fluctuations in exchange rates
A market based exchange rate will change
whenever the values of either of the two
component currencies change.
The higher a country's interest rates, the

greater will b e the d e m a n d for that currency.

 Market Participants
Central banks participate in the foreign exchange
market to align currencies to their economic
needs.
Commercial companies
. Commercial companies often trade fairly small
amounts compared to those of banks or
speculators, a nd their trades often have little short
term impact on market rate.
Central bank
National central banks play an important role in
the foreign exchange markets. They try to control
the money supply, inflation, and/or
interest rates a nd often have official or
unofficial target rates for their currencies.
Measures Initiated to Develop the Foreign
Exchange Market in India
Institutional Framework
Foreign Exchange Regulation Act
(FERA), 1973 was replaced by the
market
friendly Foreign Exchange Management
Act
(FEMA), 1999.
Money a nd Securities Markets set up by the
Reserve Bank in 1999 was expanded in 2004
to include foreign exchange markets
FOREIGN EXCHANGE MARKET STRUCTURE
Market Segments
Foreign exchange market activity takes place
onshore with
Many countries prohibiting onshore entities
from undertaking the operations in offshore
markets for their currencies. It is the central
bank, or professional dealers association,
which normally issues the c o d e of conduct
(Canales-Kriljenko, 2004).In auction
markets, an auctioneer or auction
mechanism allocates foreign exchange
by matching supply and d e m a n d orders.
CURRENCY TRADING RULES

► PLAN YOUR TRADE AND TRADE YOUR

PLAN.
► THE TREND IS YOUR FRIEND.

►FOCUS ON CAPITAL PRESERVATION.

►KNOW WHEN TO CUT LOSS.

►TAKE PROFIT WHEN THE TRADE IS GOOD

►BE EMOTIONLESS.

►NOT TRADE BASED ON A TIP FROM A

FRIEND OR BROKER.
Mistakes of Foreign exchange Traders
► Trading Out of Boredom or Anger
► Having Unrealistic Expectations.

► Taking Highly Correlated Trades.

► Failing to Use a Stop.

► Taking Unnecessary Risks.

►Being Too Patient With Losers and Not Patient

Enough With Winners.

► Being a “Possum Trader”.
  Trading Out of Boredom or Anger. 
 The trader’s high never goes away.   Regardless of whether you have been
trading for a month, a year or a decade, there is always an initial adrenaline rush
when you put on the trade.
   However, being bored and seeking excitement is one of the worst reasons to
trade.  When the markets are quiet and you are looking to put on a position,
there is a very good chance that after scanning through a few charts over a few
different time frames that you will convince yourself that the trade is right.
 Unfortunately what you are actually doing is forcing a trade, which can
eventually lead to losses.  Professional traders wait for a currency pair to setup
according to their plan and do not create a plan based upon the desire to trade.
 Being angry is even worse than being bored.  Have you ever heard the saying
that revenge is never sweet? The most dangerous time for any trader occurs
right after a major loss.
 The instinct for revenge trading (the desire to get it all back at once) can be far
more damaging than the initial loss, leading many traders to make impulsive,
irrational decisions that often lead to complete destruction of the account. 
 It is much better to chip away at the losses by assuming less and less risk until
the losses are recovered. This strategy stands in sharp contrast to what many
novice traders do, which is to create even more risk by trying to revenge trade
after a big loss.
  Having Unrealistic Expectations.
  I can never forget the one time that I encountered an overly eager
trader at a Forex Expo who asked me if my trading returns were better
than the winners of forex trading contests. 
 I responded by saying, “Considering that the winners make between
500 to 3,000 percent return in one month, which would equate to an
yearly return of 6,000 to 360,000 percent, there is a very good chance
that he is taking a lot of risk, trading irrationally using a strategy that he
would never use if he was trading a significant amount of real money. 
 Usually these contests are either for demo trading accounts, mini and
micros where the average account size is between $500 and $2,500. 
Even the best fund hedge managers in the world are not able to make
1,000 percent return, let alone 360,000 percent return on a consistent
basis.
   Having unrealistic expectations encourages greater risk taking which
is one of the primary reasons why many new traders blow up their
accounts.  Seasoned forex traders are happy if they can beat the
performance of the S&P 500 and elated if they can consistently
generate double digit returns every year.
   The key to being a successful forex trader is to approach it like any
other asset class and to expect reasonable and not sky high returns.
 Taking Highly Correlated Trades. 
 What many new traders cease to realize is that currencies will often
move in the same direction.
 For example on any given day, if the Australian dollar is up against the
U.S. dollar, there is a very good chance that the New Zealand dollar
appreciated as well. 
 Many new forex traders will look at their charts and see that the
AUD/USD and NZD/USD are breaking out at the same time and will
naively go long both currencies. However, by doing so, the trader is
basically doubling up on the same position.
   This redundant exposure could be intentional but for most new
traders it probably isn’t which can be a big mistake because if one
comes crashing down, there is a good chance the other will follow. 
 The reason why currencies will move in the same direction is
because of the U.S. dollar.  On most days, the U.S. dollar will be
either up against all of the major currencies or down. 
 The magnitude of the moves will be different which may be a reason
why a trader has decided to spread his risk between the AUD/USD
and NZD/USD, but if that is not the intention, then rather than being
diversified, the exposure is highly concentrated, which creates a
hidden risk in the positions.
  Failing to Use a Stop. 
 Another question that is asked often at Trade Shows is the
importance of using a stop. I am always shocked to find out that
many forex traders do not believe in using stops.
   Their argument is that if they do not use a stop, the currency will
eventually get back to their initial entry.  This is true until it isn’t. 
When the trend in currencies is strong, it can move aggressively in
one direction with little retracement. 
 Eventually it MAY get back to prior levels, but that could takes
days, weeks, months, and sometimes even years.  Unfortunately
markets can stay irrational far longer than most people can stay
solvent, which means there may not be enough equity in the
account to last until the currency pair finally gets back to its prior
level. 
 It goes without saying that all traders should use a use a stop. 
Trading at its core is ultimately an exercise in controlling the chaotic
and often unpredictable markets. 
 If you do not use a stop you are at the mercy of the market and
lose all control of your trade.  At that time, the best thing to think
about is whether the trade would still be attractive if you were not
already in the position.
 Taking Unnecessary Risks. 
 New Yorkers are notoriously guilty of jaywalking. 
   In fact, they would probably never jaywalk at that time
and in that madness because it is an unnecessary risk. 
 When it comes to trading, holding a position over the
weekend when the finance ministers and central bankers
are holding a summit is an example of taking an
unnecessary risk. 
 The outcome of these meetings is oftentimes
unpredictable and can trigger a gap open on Sunday
evening.
 Staying on top of upcoming news releases and events
can help new traders avoid exposing the position to
unnecessary risks.
 Being Too Patient With Losers and Not Patient
Enough With Winners. 
 Inexperienced traders are usually too patient with their
losers and not patient enough with their winners. 
 Cut your losses quickly and let your winners ride is a
common piece of advice that traders will receive.
   However is it even more relevant to forex trading
because of how strong trends can be.  Many traders fall
victim to the mistake of nursing their losers until they
become so large that it wipes out their account.
   Some will even keep their losing trade open and trade
around the losses hoping to recover at least some of it
back.  Yet these are most likely the same traders who will
abandon their trades as soon as it turns a small profit. 
 Unfortunately this is not the most efficient way to trade
currencies.  It is generally smarter to bag a small profit
early and leave open a part of the position in case the
move begins a big one.
Possum Trader

 If you have ever had a losing trade and decided to shut off
your computer or walk away with the hope that it will turn
around if you stopped watching it, then you have fallen victim
to what my good friend Rob Booker calls Possum Trading.
Leave the position open, close your eyes, cross your fingers
and hope that the trade will work itself out.  Unfortunately this
almost never happens and more often than not, the losses
become even greater.  Trading is a game of survival and
closing your eyes hoping that the fire will put itself out is not
the right decision.  If it is a small fire, it is smarter put it out
before it even comes close to burning down your house and if
it is a large one, it is better to abandon your home and call in
the firefighters. In trading, if the reason for the trade is no
longer valid, then get out before the losses grow.  Don’t keep
the trade on and turn into a possum.