How the Foreign Exchange (FOREX) Market Works?

[YAGAY andSUN]

The Foreign Exchange Market (Forex Market or FX Market) is the largest and most liquid financial market in the world, where currencies are traded globally. This market plays a crucial role in facilitating international trade and investments by enabling the exchange of one currency for another. It operates in a decentralized manner, meaning that there is no centralized exchange like the stock market, but instead, the market is composed of various participants trading currencies directly or via brokers.

1. How the Foreign Exchange Market Works

Currency Pairs

Currencies are always traded in pairs (e.g., USD/INR, EUR/USD). The first currency in the pair is known as the base currency, and the second currency is the quote currency. The exchange rate between the two currencies indicates how much of the quote currency is needed to buy one unit of the base currency.

For example:

• EUR/USD = 1.10 means that 1 euro (EUR) is worth 1.10 US dollars (USD).
• USD/INR = 82.50 means that 1 US dollar is worth 82.50 Indian rupees.

Participants in the Forex Market

Several key participants contribute to the functioning of the foreign exchange market, both in India and globally:

1. Banks and Financial Institutions:
   • Central Banks: Central banks, like the Reserve Bank of India (RBI) or the U.S. Federal Reserve, play a pivotal role by controlling monetary policy and intervening in the forex markets to stabilize their domestic currencies.
   • Commercial Banks: Banks, such as HSBC or State Bank of India, facilitate currency trading for corporate clients, institutions, and retail traders. They act as market makers, offering liquidity to the market.
2. Forex Brokers:
   • Forex brokers act as intermediaries between retail traders and the global forex market. They provide platforms and leverage to traders to execute their currency trades.
3. Corporations:
   • Corporations engaged in international business need the forex market for foreign exchange risk management and for converting currencies for payments, imports, and exports. For example, an Indian company importing goods from the United States may need to purchase USD to pay the supplier.
4. Retail Traders:
   • Retail traders (individual investors) participate in forex trading via online platforms. They often trade using high leverage to take advantage of currency price fluctuations. However, retail traders make up a small portion of the market volume compared to banks and institutional investors.
5. Hedge Funds and Investment Managers:
   • These institutional investors trade large volumes of currency for speculative purposes, arbitrage, and hedging.

6. Governments and Sovereign Wealth Funds:
   • Countries' governments hold reserves of foreign currencies to meet trade obligations and stabilize their economies. They may intervene in the forex market to either devalue or support their currency.

2. Global Foreign Exchange Market Structure

Decentralized and Global

The forex market is decentralized, meaning it does not have a central exchange. Trading occurs directly between parties through:

• Over-the-Counter (OTC) transactions
• Electronic platforms and brokerage firms
• Interbank networks, where transactions between banks are executed

The market operates 24 hours a day, five days a week, with major trading centres around the world:

1. Sydney (opens the market at 5:00 PM EST on Sunday)
2. Tokyo
3. London
4. New York (closes the market at 5:00 PM EST on Friday)

These centres allow forex trading to occur globally without interruption, with currency prices constantly fluctuating.

Spot, Forward, and Futures Markets

• Spot Market: The spot market is where currencies are bought and sold for immediate delivery, typically settled within two business days.
• Forward Market: The forward market allows participants to enter into agreements to buy or sell currencies at a future date, based on an agreed-upon exchange rate. This is primarily used by companies to hedge against future currency fluctuations.
• Futures Market: Currency futures are standardized contracts that obligate the buyer to purchase or the seller to sell a currency at a predetermined date in the future, traded on exchanges like the Chicago Mercantile Exchange (CME).

3. Forex Trading in India

In India, forex trading operates under a regulatory framework set by the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI), which governs trading in currency derivatives on exchanges like NSE, BSE, and MCX-SX.

Currency Derivatives

Indian traders and investors can participate in the forex market through currency derivatives. These instruments include futures and options contracts on currency pairs such as USD/INR, EUR/INR, and GBP/INR. These contracts allow participants to hedge against currency fluctuations or speculate on currency price movements.

Currency Exchange Markets

India has two primary venues for trading currencies:

1. Over-the-counter (OTC) Market: Major banks and authorized dealers in India offer currency trading services. Forex transactions occur at market-driven rates.
2. Exchange-Traded Markets: In India, the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) allow currency futures and options trading. The Indian government and RBI regulate these exchanges to ensure market integrity.

Regulation

• FEMA (Foreign Exchange Management Act, 1999) governs foreign exchange transactions in India and regulates the buying and selling of foreign currency.
• SEBI (Securities and Exchange Board of India) regulates currency futures and options trading and ensures that market participants follow guidelines related to trading practices.

Limitations on Speculative Trading

Indian retail traders face limitations on speculative currency trading. Unlike in other countries, where individuals can trade freely in the forex market, Indian residents are restricted from trading foreign currencies for speculation. However, they can trade currency derivatives on recognized exchanges.

4. Global Forex Trading Trends

Globally, the forex market is highly liquid and active due to the following key factors:

1. Market Size: The global forex market is estimated to have a daily trading volume exceeding $6.6 trillion as of 2022 (as per the Bank for International Settlements), with a significant portion of the market driven by institutional investors, hedge funds, central banks, and multinational corporations.
2. Impact of Central Banks: Central banks around the world, including the Federal Reserve (US), European Central Bank (ECB), Bank of Japan (BOJ), and Reserve Bank of India (RBI), influence currency movements through monetary policy. For example, when the US Federal Reserve raises interest rates, the USD typically strengthens against other currencies.
3. Geopolitical Events: Political events, such as elections, wars, or trade negotiations, can significantly impact currency movements. For example, the Brexit vote caused significant volatility in the GBP.
4. Economic Indicators: Key indicators like GDP growth, unemployment rates, inflation, and interest rates influence forex prices. Economic data reports are closely watched by forex traders to gauge the future direction of a currency.
5. Technological Advancements: With the rise of digital platforms, algorithmic trading and artificial intelligence (AI) have become integral in forex trading. These technologies allow for faster execution of trades and the ability to capitalize on short-term price fluctuations.

5. Risks and Volatility in the Forex Market

The forex market is inherently volatile, and traders face several risks:

• Exchange Rate Risk: The possibility that the exchange rate may fluctuate unfavorably between the time a trade is made and when it is settled.
• Leverage Risk: Using leverage can magnify profits but also amplify losses, making it a high-risk strategy for traders.
• Political and Economic Risks: Geopolitical events, such as wars or elections, can drastically affect currency values, causing high volatility.

Conclusion

The foreign exchange market is a complex, global network where currencies are bought and sold. It plays an essential role in facilitating international trade and investment. In India, the forex market is regulated by the RBI and SEBI, and currency trading is primarily done through currency derivatives on recognized exchanges. The market operates 24/5, driven by factors such as interest rates, economic data, geopolitical events, and central bank policies.

Understanding how the forex market works in both the Indian context and globally requires an awareness of the different participants, trading instruments, regulatory frameworks, and the risks involved. For individuals and institutions, forex trading offers opportunities but also comes with significant risks due to the volatility and complexity of currency markets.