Retail Investors who put all of their investments in one asset class are always confused about how other investors make such good profits in the financial market. As volatility is common, equity investors are forced to see their investments tank if the market turns bearish. However, it is those investors who dive into smart asset allocation and choose various other asset classes that make the highest profits.
For example, an investor may put 70% of the investment in equities and 30% of the investment in commodities. As both the asset classes have an inverse price relationship, a fall in equity prices would mean that the investor will make a profit through the commodities. Similarly, one of the most sought-after asset classes for professional investors is Foreign Currencies. But to trade in foreign currencies, you need to gain knowledge about the Foreign Exchange Market.
What is Foreign Exchange Market?
The foreign exchange market, also known as FX or forex, is a global marketplace that facilitates the trading of foreign currencies. The marketplace is responsible for determining the exchange rate for various currencies and is an over-the-counter marketplace. Participants in the foreign exchange market are buyers, sellers, exchangers, and speculators who trade in various currency pairs and make a profit based on the fluctuations in the exchange rates.
A foreign exchange market generally comprises banks, commercial companies, forex dealers, investment firms, central banks, retail investors, hedge funds, and forex dealers.
Understanding the Foreign Exchange Market
At its core, a foreign exchange market is a platform to buy and sell foreign currencies. However, it also allows for currency conversion for international trade investments and settlement. The market works on one principle that currencies are always traded in pairs. For example:
-
Indian Rupee vs United States Dollar (USD-INR) -
Indian Rupee vs Euro (EUR-INR) -
Indian Rupee vs Great Britain Pound (GBP-INR) -
Indian Rupee vs Japan’s Yen (JPY-INR)
Suppose you buy the first pair of USD-INR, you are referred to as going long, i.e. you are buying the numerator (the base currency), which is USD, and selling the denominator, which is the INR. It means that you are using INR to purchase USD. However, when you sell the pair, you are selling USD and buying INR again.
Types of Foreign Exchange Market
There are five types of foreign exchange markets. These are:
Spot Markets: Spot Market is known to deliver immediate returns as the market facilitates the quickest transaction of various currency pairs. This ensures immediate delivery to the buyer and payment to the seller. In this type of market, the traders are not exposed to market uncertainty, which lowers or increases the price of the agreement.
Futures Market: This allows two parties to make a legal agreement to buy and sell the currency pairs at a prespecified price and future date. These transactions are formal and ensure that both parties are protected by the pre-agreed conditions, which can not be changed.
Forwards Market: Forwards market in the foreign exchange market is identical to the Futures Market, but here, the parties negotiate the terms of the contract. Unlike futures markets, where the terms can not be changed, forward markets allow flexibility to customize the currency contract according to the parties’ needs.
Options Market: Options market allows investors the right but not the obligation to sell the currency contract at a future date. Currencies are also traded with the use of Options where the seller is provided with a premium by the buyer for the option of canceling the contract anytime.
Functions of Foreign Exchange Market
The foreign exchange market performs crucial functions to bring effectiveness and transparency for the buyers and sellers of foreign currencies. These are:
Transfer Function: One of the most basic functions of a foreign exchange market is to transfer foreign currencies or funds from one country to another. This is done to ensure smooth settlement of payments by converting one country’s currency to another.
Credit Function: The foreign exchange market also functions as a creditor to facilitate the smooth flow of goods and services across countries. Under the credit function, Forex provides short-term loans to importers to finance foreign purchases.
Hedging Function: The participants in the Foreign Exchange market are always worried about the fluctuations in the exchange rate. This market allows such participants to hedge the risks using financial instruments such as forward contracts or letters of credit.
Advantages of Foreign Exchange Market in India
Here are the advantages of the foreign exchange market:
-
Participants do not have to bind their orders with strict rules and standards as fewer rules exist in the foreign exchange market. -
There are no fees or commissions to be paid by the traders. -
You can trade anytime at the market as it is open 24/7. -
There is no cut-off time to participate in the market. Investors can trade anytime they prefer. -
You can get in and out quickly as the market has high liquidity.
The pros of the foreign exchange market in India take over the rare coins. You can either trade with cash or can use derivatives such as Futures, Options, and Forwards to buy and sell currency pairs at the foreign exchange market.
The Indian rupee is the 20th most actively traded currency globally, averaging approximately $53 billion a day. With such a high volume that keeps on increasing, currency trading can allow you to garner considerable profits while ensuring that you diversify your investments. For any further queries on currency trading and the advantages of the foreign exchange market in India, visit IIFL’s website or download the IIFL Markets app from the app store. You can also seek expert guidance from IIFL’s financial experts and make informed investment decisions.
Frequently Asked Questions
Q.1: What is the foreign exchange market, with an example?
Ans: A foreign exchange market is a global marketplace where buyers and sellers come to trade in foreign currencies. At the market, currencies of various countries are bought and sold in pairs, and the market facilitates the payment and the delivery. Examples of foreign exchange markets are Spot, Futures, Forwards, and Options Market.
Q.2: How does the foreign exchange market work?
Ans: Using the foreign exchange market, investors take positions on different currencies that are bought and sold in pairs. If the currency pairs are bought at a low price, the investors can sell them when the exchange rate for the pairs is high to make a profit. If the exchange rate falls, investors can incur a loss if they sell.
Q.3: What is the importance of the foreign exchange market?
Ans: The foreign exchange market manages risk, facilitates transactions, provides credit to importers, and ensures the right exchange rate for international currencies.
