A glimpse of the Forex Market

Introduction

The foreign exchange market, also known as "forex", is the largest financial market in the world. Make a guess of how large this market is? It has $4 trillion daily average trade volume which is more than twice the GDP of India. The forex market is an Over the Counter market with no physical location or exchange like BSE, NSE or NYSE. It runs electronically between banks over a 24-hour period. The reasons for trading in forex market can be one or all among speculation, hedging or arbitrage. Whether you are a large corporate giant planning to import machinery or a student planning to go abroad for studies or the finance minister, forex market has left no one untouched. The high volume, liquidity and leverage has attracted investors to use different ways of trading in forex market like spot, futures, options, and exchange-traded funds (or ETFs).

Some of the advantages of trading in forex market are:

1.      There is no fixed lot size as in derivatives and bond markets.

2.      The transaction costs are low.

3.      It is a 24-hour market unlike the stock markets.

4.      Since the transaction volumes are so high no one can corner the market.

5.      High leverage is available.

6.      High Liquidity

7.      Low Barriers to Entry

Some of the major market players:

1. Authorized Dealers like Bank of America or HDFC Bank.

2. Corporates like TCS, RIL.

3. Brokers like Mecklai and B&K Securities.

4. Central Banks of different countries like RBI, Federal Reserve.

Key Terminologies

Major and Minor Currencies

USD, EUR, JPY, GBP, CHF, CAD, NZD, and AUD are the most traded currencies and are the “major” currencies. All other currencies are referred to as “minor” currencies.

Base and Quote Currency

Currencies are always traded in pairs and their price is quoted in the form such as “USD/INR 55.75”.The first currency in any currency pair is called base currency and the second currency the quote currency. The quote like the above tells how much of quote currency (INR) is required to purchase 1 unit of base currency (USD).

Pip and Pipette

A pip is the smallest unit of price for any currency. It also equals the smallest change in the price of a currency. For a quote of EUR/USD 1.2958 the pip value is 0.0001 which means the next higher value that this pair can have is 1.2959 and the next lower value is 1.2957.

Pipette is one-tenth of a pip used by brokers to bring precision in quoting rates. For example, if EUR/USD moved from 1.29586 to 1.29588, it moved 2 pipettes.

Bid Price

The bid is the price at which the dealer is prepared to buy a specific currency pair. At this price, the trader can sell the base currency. It is shown on the left side of the quotation.

For example, in the quote EUR/USD 1.2986/92, the bid price is 1.2986. This means you sell one Euro for 1.2986 U.S. dollars to the dealer.

Ask Price

The ask is the price at which the dealer is prepared to sell a specific currency pair. At this price, you can buy the base currency. It is shown on the right side of the quotation.

For example, in the quote EUR/USD 1.2986/92, the ask price is 1.2992. This means you can buy one euro for 1.2992 U.S. dollars.

Spread

It is the difference between the bid and ask price. For the example given above it is .0006 USD. Spread is less if the market is highly liquid and less volatile. It can also be interpreted as the transaction cost of trading in currency. In a round turn trade which means a buy and sell and trade of the same size in the same currency pair, a dealer earns an amount equal to the spread.

 

Cross Currency

A cross currency is any pair in which neither currency is the U.S. dollar. Cross currency pairs frequently carry a higher transaction cost. A transaction in cross currency pair, if it is not directly available in market, is executed through two transactions. If you want to execute a transaction in EUR/INR it can be done by selling INR/USD buying EUR/USD.

Long/Short

If you want to buy (which actually means buy the base currency and sell the quote currency), you are going long in the base currency (Long = buy).

If you want to sell (which actually means sell the base currency and buy the quote currency), you are going short on the base currency (Short = sell).

Margin

Whenever you open a trading account with any broker you will have to submit a particular amount that will used as initial margin requirement when you initiate a trade. It is quoted in form of 100:1 for example, which means margin requirement is 1%. Now if you want to buy 1 lot = 1000 USD/INR 55.95 you will not require Rs 55950 but only Rs. 559.5 to execute the trade. The catch is that Rs 559.5 is the maximum loss you can make on the executed trade after which your position will be squared off.

Leverage

Leverage is the ratio of the value of a transaction to the required security deposit (margin). Leveraging varies with different brokers, ranging from 2:1 to 500:1. Higher the leverage, higher is the risk.

Where to trade?

For spot market currency trading, www.iforex.com and www.4xp.com/India can be used. For trading in currency derivatives, brokers like ICICIDirect and Sharekhan provide a very good platform.

How risky it is?

Forex Trading is a very risky form of investment given the high amount of leverage. The leverage ratio increases the risk by the same amount. It means if the leverage provided by a broker is 100:1 it means your rate of losing money has also increased 100 times. Also there are so many factors affecting the currency market that correctly speculating its direction is tough task.

Adarsh Chowdary

PGP12058