Foreign Exchange Markets

The foreign exchange market also known as forex, FX, or the currencies market) is an over-the-counter (OTC) global
marketplace that determines the exchange rate for currencies around the world.

Participants in these markets can buy, sell, exchange, and speculate on the relative exchange rates of various currency
pairs.

Currency Pair

A currency pair is the quotation of two different currencies, with the value of one currency being quoted against the
other. The first listed currency of a currency pair is called the base currency, and the second currency is called
the quote currency.

It indicates how much of the quote currency is needed to purchase one unit of the base currency.

Currencies are identified by an ISO currency code, or the three-letter alphabetic code they are associated with on the
international market. So, for the U.S. dollar, the ISO code would be USD.

•When an order is placed for a currency pair, the first listed currency or base currency is bought while the second listed
currency in a currency pair or quote currency is sold.

•The EUR/USD currency pair is considered the most liquid currency pair in the world. The USD/JPY is the second most
popular currency pair in the world.1
Trading currency pairs is conducted in the foreign exchange market, also known as the forex market.

It is the largest and most liquid market in the financial world.

This market allows for the buying, selling, exchanging, and speculation of currencies. It also enables the conversion of
currencies for international trade and investment.

The forex market is open 24 hours a day, five days a week (including most holidays), and sees a huge amount of trading
volume.

All forex trades involve the simultaneous purchase of one currency and the sale of another, but the currency pair itself
can be thought of as a single unit—an instrument that is bought or sold.

When you buy a currency pair from a forex broker, you buy the base currency and sell the quote currency.

Conversely, when you sell the currency pair, you sell the base currency and receive the quote currency.

Currency pairs are quoted based on their bid (buy) and ask prices (sell).

The bid price is the price that the forex broker will buy the base currency from you in exchange for the quote or counter
currency.

The ask—also called the offer—is the price that the broker will sell you the base currency in exchange for the quote or
counter currency.
When trading currencies, you're selling one currency to buy another.

Conversely, when trading commodities or stocks, you're using cash to buy a unit of that commodity or a number
of shares of a particular stock.

Economic data relating to currency pairs, such as interest rates and economic growth or gross domestic product (GDP),
affect the prices of a trading pair.

Gross domestic product (GDP) is the total monetary or market value of all the finished goods and services produced within
a country’s borders in a specific time period. As a broad measure of overall domestic production, it functions as a
comprehensive scorecard of a given country’s economic health.

A widely traded currency pair is the euro against the U.S. dollar or shown as EUR/USD.

In fact, it is the most liquid currency pair in the world because it is the most heavily traded.

The quotation EUR/USD = 1.2500 means that one euro is exchanged for 1.2500 U.S. dollars.

In this case, EUR is the base currency and USD is the quote currency (counter currency).

This means that 1 euro can be exchanged for 1.25 U.S. dollars. Another way of looking at this is that it will cost you
$125 to buy 100 euros.
Major Currency Pairs

There are as many currency pairs as there are currencies in the world.

The total number of currency pairs that exist changes as currencies come and go. All currency pairs are categorized
according to the volume that is traded on a daily basis for a pair.

The currencies that trade the most volume against the U.S. dollar are referred to as the major currencies, which include:

•EUR/USD or the Euro vs. the U.S. dollar

•USD/JPY or dollar vs. the Japenese yen
•GBP/USD or the British pound vs. the dollar
•USD/CHF or the Swiss franc vs. the dollar
•AUD/USD or the Australian dollar vs. the U.S. dollar
•USD/CAD or the Canadian dollar vs. the U.S. dollar

The final two currency pairs are known as commodity currencies because both Canada and Australia are rich in
commodities and both countries are affected by their prices.

The major currency pairs tend to have the most liquid markets and trade 24 hours a day Monday through Thursday.

The currency markets open on Sunday night and close on Friday at 5 p.m. U.S. Eastern time
Minors and Exotic Pairs

Currency pairs that are not associated with the U.S. dollar are referred to as minor currencies or crosses.

These pairs have slightly wider spreads and are not as liquid as the majors, but they are sufficiently liquid markets
nonetheless.

The crosses that trade the most volume are among the currency pairs in which the individual currencies are also majors.
Some examples of crosses include the EUR/GBP, GBP/JPY, and EUR/CHF.

A cross currency refers to a currency pair or transaction that does not involve the U.S. dollar.

A cross currency transaction, for example, doesn't use the U.S. dollar as a contract settlement currency. A cross currency
pair is one that consists of a pair of currencies traded in forex that does not include the U.S. dollar.

Common cross currency pairs involve the euro and the Japanese yen.

Exotic currency pairs include currencies of emerging markets. These pairs are not as liquid, and the spreads are much
wider. An example of an exotic currency pair is the USD/SGD (U.S. dollar/Singapore dollar).

An emerging market economy is the economy of a developing nation that is becoming more engaged with global
markets as it grows. Countries classified as emerging market economies are those with some, but not all, of the
characteristics of a developed market.
The foreign exchange market—also called forex, FX, or currency market—was one of the original financial markets formed
to bring structure to the burgeoning global economy.

This asset class makes up the largest financial market in the world in terms of the value of currency units being traded.

Aside from providing a venue for the buying, selling, exchanging, and speculation of currencies, the forex market also
enables currency conversion for international trade settlements and investments.

Currencies are always traded in pairs, so the "value" of one of the currencies in that pair is relative to the value of the
other.

This determines how much of country A's currency country B can buy, and vice versa.

Establishing this relationship (price) for the global markets is the main function of the foreign exchange market.

This also greatly enhances liquidity in all other financial markets, which is key to overall stability.

The value of a country's currency depends on whether it is a "free float" or "fixed float."

Free-floating currencies are those whose relative value is determined by free-market forces, such as supply-demand
relationships.

A fixed float is where a country's governing body sets its currency's relative value to other currencies, often by pegging it
to some standard. Free-floating currencies include the U.S. dollar, Japanese yen, and British pound, while examples of
One of the most unique features of the forex market is that it's made up of a global network of financial centers that
transact 24 hours a day, closing only on the weekends.

As one major forex hub closes, another hub in a different part of the world remains open for business.

This increases the liquidity available in currency markets, which adds to its appeal as the largest asset class available to
investors.

The most liquid trading pairs are, in descending order of liquidity:

1.EUR/USD
2.USD/JPY
3.GBP/USD
Forex Leverage

The leverage available in FX markets is one of the highest that traders and investors can find anywhere. Leverage is a loan
given to an investor by their broker. With this loan, investors can increase their trade size, which could translate to greater
profitability. A word of caution, though: losses are also amplified.

For example, investors who have a $1,000 forex market account can trade $100,000 worth of currency with a margin of 1%.
This is referred to as having a 100:1 leverage. Their profit or loss will be based on the $100,000 notional amount.

Types of Foreign Exchange Markets

There are three main forex markets: the spot forex market, the forward forex market, and the futures forex market.
Spot Forex Market: The spot market is the immediate exchange of currencies at the current exchange. On the spot. This
makes up a large portion of the total forex market and involves buyers and sellers from across the entire spectrum of the
financial sector, as well as those individuals exchanging currencies.

Forward Forex Market: The forward market involves an agreement between the buyer and seller to exchange currencies at
an agreed-upon price at a set date in the future. No exchange of actual currencies takes place, just the value. The forward
market is often used for hedging.

Futures Forex Market: The futures market is similar to the forward market, in that there is an agreed price at an agreed date.
The primary difference is that the futures market is regulated and happens on an exchange. This removes the risk found in
other markets. Futures are also used for hedging.
 A spot trade, also known as a spot transaction, refers to the purchase or sale of a foreign currency, financial
instrument, or commodity for instant delivery on a specified spot date.
Most spot contracts include the physical delivery of the currency, commodity, or instrument; the difference in the price
of a future or forward contract versus a spot contract takes into account the time value of the payment, based on
interest rates and the time to maturity.
In a foreign exchange spot trade, the exchange rate on which the transaction is based is referred to as the spot exchange
rate.

•Most spot market transactions have a T+2 settlement date.

•Spot market transactions can take place on an exchange or over-the-counter.

The current price of a financial instrument is called the spot price.

It is the price at which an instrument can be sold or bought immediately.
Buyers and sellers create the spot price by posting their buy and sell orders.

Foreign exchange spot contracts are the most popular and the
spot foreign exchange market, traded electronically, is the
largest in the world.
•A forward contract is a customizable derivative contract between two parties to buy or sell an asset at a specified price
on a future date.

•Forward contracts can be tailored to a specific commodity, amount, and delivery date.

•Forward contracts do not trade on a centralized exchange and are considered over-the-counter (OTC) instruments.

•For example, forward contracts can help producers and users of agricultural products hedge against a change in the
price of an underlying asset or commodity.

•Financial institutions that initiate forward contracts are exposed to a greater degree of settlement and default risk
compared to contracts that are marked-to-market regularly.

A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price
at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a
futures exchange.

The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures
contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset
at the expiration date.
Structure of Foreign Exchange Market

The market is open for 24 hours a day and 5 days in a week excluding holidays.

It is one of the key financial market that facilitates the international payments system.

Forex market has 2 tiers: – Interbank market and over the counter market.

Interbank market is one where large banks exchange currencies with each other whereas over the counter market is one
where individuals and companies trade.

This global market is highly risky in nature as it is not regulated by any central body.

Spot market, Future market, Forward market, Option market and Swap market are major types of foreign exchange
market.
Structure of Foreign Exchange Market

The structure of foreign exchange market is composed of different participants who are the main players and occupies
different positions.

These participants are commercial banks, central banks, immigrants, importers, exporters, tourists and investors. Role played
by these participants in forex market is discussed in detail below: –

Commercial Bank

Commercial banks are important organs of foreign exchange market which are termed as “market makers”.

These banks trade in foreign currencies for themselves and also for their clients.

Commercial banks quote the foreign exchange rate on a daily basis for purchasing and selling of foreign currencies.

They act as a clearing house by facilitating the carrying off of differences in between the demand and supply of these
currencies. Currencies are purchased from broker by commercial banks for selling them to buyers.
Central Bank

Central bank is the apex body in foreign exchange market which has power to regulate operations related to trading of
foreign currency.

It directly intervenes in the functioning of forex market to avoids aggressive fluctuations.

For controlling fluctuations, currency is sell off when it is overvalued and purchased in case it is undervalued

Central bank ensure that an exchange rate is at optimum that fulfills the needs of national economy.

Foreign Exchange Brokers

Broker in foreign exchange market work as an intermediary in between the commercial bank and central bank and also in
between the commercial banks and buyers.

These persons carry a large source of information about market. Brokers only facilitate the currency trade but do not get
themselves involved in market transactions.

They work on a commission basis where do the task of striking the deal in-between the seller and buyer.
The U.S. dollar is the central currency against which other currencies are traded. In its most recent triennial survey of the
global foreign exchange market in 2010, the Bank for International Settlements (BIS) found that the U.S. dollar was on one
side of about 85 percent of all reported forex market transactions.

The U.S. economy is the largest national economy in the world.

The U.S. dollar is the primary international reserve currency.
The U.S. dollar is the medium of exchange for many cross-border transactions. For example, oil is priced in U.S. dollars. So
even if you’re a Japanese oil importer buying crude from Saudi Arabia, you’re going to pay in U.S. dollars.
The United States has the largest and most liquid government debt markets in the world.
The United States is a global military superpower, with a stable political system.

The U.S. dollar remains the primary reserve currency, but recent years have increasingly seen calls for an alternative to a
single global reserve currency.

The euro is frequently cited as a potential replacement for the greenback, and some are calling for a basket of currencies to
serve as the global reserve standard.

The U.S. dollar’s role as the primary reserve currency is likely to diminish in coming years, but it will be a very long-term
process, likely spanning decades.

As long as the United States has the largest government bond market, which is what international reserve managers
ultimately seek to invest in, the U.S. dollar should remain the primary reserve currency.
Mechanics of currency Trading

In Long

In FX, it refers to having bought a currency pair, meaning you’ve bought the base currency and sold the counter currency.
When you’re long, you’re looking for prices to move higher, so you can sell at a higher price than where you bought.
When you want to close a long position, you have to sell what you bought. If you’re buying at multiple price levels,
you’re adding to longs and getting longer.

In Short

In forex markets, it means you’ve sold a currency pair, meaning you’ve sold the base currency and bought the counter
currency. So you’re still making an exchange, just in the opposite order and according to currency-pair quoting terms.
When you’ve sold a currency pair, it’s called going short or getting short, and it means you’re looking for the pair’s price
to move lower so you can buy it back at a profit. If you sell at various price levels,
you’re adding to shorts and getting shorter.

Squaring up

If you have no position in the market, it’s called being square or flat. If you have an open position and you want to close
it, it’s called squaring up. If you’re short, you need to buy to square up. If you’re long, you need to sell to go flat. The
only time you have no market exposure or financial risk is when you’re square.
 Major currency pairs used
Mechanics of currency Trading

It is traded in lots called Micro, Mini and Standard lots.

Micro lot is 1000 worth of given currency

Mini lot is 10000 worth of given currency

Standard lot is 100000 worth of given currency

Trades takes place in set of blocks of currency

Trading volume in the forex is generally very large

Largest trading centers are London New York Singapore Hongkong and
Tokyo
Settlement dates

The standard settlement timeframe for foreign exchange spot transactions is T+2; i.e., two business days
from the trade date.

Notable exceptions are USD/CAD, USD/TRY, USD/PHP, USD/RUB, and offshore USD/KZT and offshore
USD/PKR currency pairs, which settle at T+1

. USD/COP settles T+0. [3] Majority of SME FX payments are made through Spot FX, partially because
businesses aren't aware of alternatives.[4]
Exchange rate quotations

In trading, exchange rate quotes can be provided in two different ways.

They include direct and indirect quotations.

A direct quote is a more common way when 1 unit of foreign currency is expressed in 1 unit of the domestic currency.

Oppositely, indirect quotes show 1 unit of domestic currency expressed in a foreign currency.

In financial terms, the exchange rate is the price at which one currency will be exchanged against another currency.

Since the US dollar (USD) is the most dominant currency, usually, the exchange rates are expressed against the US dollar.
However, the exchange rates can also be quoted against other countries’ currencies, which is called as cross currency.

Now, a lower exchange rate in a direct quote implies that the domestic currency is appreciating in value. Whereas, a lower
exchange rate in an indirect quote indicates that the domestic currency is depreciating in value as it is worth a smaller
amount of foreign currency.
The exchange rate has two components—the base currency and the counter currency.

In a direct quotation, the foreign currency is the base currency and the domestic currency is the counter currency.

In an indirect quotation, it’s the other way around. The domestic currency is the base and the foreign currency is the
counter.

For example, USD to INR is a direct quote and INR to USD is an indirect quote.

Most exchange rates list the USD as the base currency.

Exceptions, in this case, include the Euro and the Commonwealth currencies such as Great Britain Pound (GBP), Australian
Dollar (AUD), and the New Zealand Dollar (NZD).
Exchange rate determination and forecasting
 Forecasting of exchange rate

1. Fundamental Analysis
This forecast method includes all the factors mentioned above, such as monetary policy, domestic and foreign government
policy, and global economic and political conditions. Knowing the factors that may affect a currency and constantly following
economic releases and news, a trader has the potential to forecast its value.

2.Technical Analysis
This approach doesn’t consider the influence of external forces. Rather, it uses patterns discovered from historical price data and
statistics to forecast future movement. Indicators, trendlines, and candlestick and chart patterns are essential instruments of
technical analysis
3. Relative Economic Strength
a country’s inflation or unemployment rate can give traders an idea of what its monetary policy will be like. So, traders can
observe these economic factors. By doing this, they get an idea of what’s going to happen to the domestic economy and exchange
rates.
4. Econometric Model
This FX rate forecast method is personal, as it differs between traders. Here, Forex traders select whatever metrics they believe
influence the currency market the most. Comparing economic conditions in two countries, traders could forecast an exchange
rate.
For example, considering the EUR/USD pair, a trader could compare interest rates in the EU and the US, GDPs, and the
unemployment rate. By determining differences, they may predict the direction of a pair’s rate.
 5. Purchasing Power Parity (PPP)

While the relative economic strength approach gives a direction for currency movement, purchasing power parity says what
the rate is supposed to be.

This method asserts that the price of goods and services should be equal, regardless of the country. If there are any
differences in price, a trader can calculate the suitable exchange rate that will make goods or services cost the same.
For example, a table in France costs €50, while that same table is priced at $80 in the USA.

Considering the difference in price, a trader can determine the EUR/USD pair’s value.

Knowing the required exchange rate, traders might determine whether a currency is overvalued or undervalued. With this,
they can make a guess at future currency values.

Purchasing Power Parity PPP is a theory which suggests that exchange rates are in equilibrium when they have the same
purchasing power in different countries.

Purchasing power parity will involve looking at a basket of goods to determine effective living costs. The purchasing power
parity is determined by dividing a basket of goods in one country, by the cost of basket of goods in another.
A simple example of purchasing power parity

Suppose a Big Mac costs £2 in the UK and $4 in the US. The correct exchange rate according to purchasing
power parity would by £1 equals $2. This would leave a customer indifferent to buying the good in the UK
and buying it in the US.

Purchasing power and differences in prices

If UK citizens want to buy more
•Suppose the Pound/Dollar exchange rate is £1 to $2. US goods, they will supply
•If an Apple Mac costs £1,000 in the UK and $1000 in Pounds to buy dollars. This will
the US. put downward pressure on the
•If a UK citizen was able to travel to US, he would only value of the Pound helping to
need £500 to convert into a $1,000. This suggests that move exchange rate closer to
it is much cheaper to buy the Mac in America. In this the purchasing power parity
case, the current exchange rate is not reflecting the equilibrium.
true living costs.
•Therefore, UK citizens will want to import the good
from America, this will involve selling pounds and
buying dollars causing the Pound to depreciate.
6. Interest Rate Parity (IRP)
The interest rate parity is quite similar to purchasing power parity. But PPP focuses on the prices of goods, while IRP
focuses on currency and interest rates.
The general concept of this model is that the differential between interest rates should equal the differential between spot
and forward exchange rates.
So, if an investor exchanges a domestic currency for a foreign one and invests it in a foreign economy or uses a domestic
currency to invest in the home country and converts the proceeds from the investment into a foreign currency, their earnings
will be the same in both cases.
The Interest Rate Parity method implies the following formula:

Where:
•F0 = Future exchange rate
•S0 = Current (spot) exchange rate
•ia = Interest rate of the country of the quote currency
•ib = Interest rate of the country of the base currency
The theory says that a trader should calculate the current
currency pair rate and the interest rates of both countries to
determine the future exchange rate of a currency pair.
7. Balance Payment Theory
This foreign exchange model determines future currency values by considering a country’s rate of imports and exports.
The theory behind this method is that the domestic currency appreciates when it exports more than it imports and
depreciates when the opposite occurs.