Foreign exchange is the simultaneous buying of one currency and selling of another. Currencies are traded through a broker or a dealer and are executed in currency pairs; for example, the Euro and the US dollar (EUR / USD) or the British pound and the Japanese yen (GBP / JPY).
The Foreign Exchange Market (FOREX) is the largest financial market in the world, with a daily volume of over $4 trillion. This is more than three times the total amount of the stocks and futures markets combined. Unlike other financial markets, the FOREX spot market has neither a physical location nor a central exchange.
It operates through an electronic network of banks, corporations, and individuals trading one currency for another. The lack of a physical exchange enables the FOREX market to operate on a 24 – hour basis, spanning from one time zone to another across the major financial centers. This fact – that there is no centralized exchange – is important to keep in mind as it permeates all aspects of the FOREX experience.
A spot market is any market that deals in the current price of a financial instrument. Futures markets, such as the Chicago Mercantile Exchange ( CME ), National Stock Exchange (NSE), MCX’ SX, BSE offer currency futures contracts whose delivery dates may span several months into the future. Settlement of FOREX spot transactions usually occurs within two business days.
There are two main groups that trade currencies. About 5 – 10 percent of daily volume is from companies and governments that buy or sell products and services in a foreign country and must subsequently convert profits made in foreign currencies into their own domestic currency in the course of doing business. This is primarily hedging activity. The other 90 – 95 percent consists of investors trading for profit, or speculation. Speculators range from large banks trading 10,000,000 million currency units or more and the home-based operator trading perhaps 10,000 units or less. Today, importers and exporters, international portfolio managers, multinational corporations, speculators, day traders, long-term holders, and hedge funds all use the FOREX market to pay for goods and services, to transact in financial assets, or to reduce the risk of currency movements by hedging their exposure in other markets. The speculator trades to make a profit by purchasing one currency and simultaneously selling another. The hedger trades to protect his or her margin on an international sale from adverse currency fluctuations. The hedger has an intrinsic interest in one side of the market or the other. The speculator does not.
Any resident Indian or company including banks and financial institutions can participate in the futures market. However, at present, Foreign Institutional Investors (FIIs) and Non-Resident Indians (NRIs) are not permitted to participate in currency futures market.
Currency prices are affected by a variety of economic and political conditions, but probably the most important are interest rates, international trade, inflation, and political stability. Sometimes governments actually participate in the foreign exchange market to influence the value of their currencies. They do this either by flooding the market with their domestic currency in an attempt to lower the price or, conversely, buying in order to raise the price. This is known as central bank intervention. Any of these factors, as well as large market orders, can cause high volatility in currency prices. However, the size and volume of the FOREX market make it impossible for any one entity to drive the market for any length of time.
This refers to imports and exports, and is probably the most important determinant of a currency’s value. When imports are greater than exports, you have a trade deficit. When exports are greater than imports, you have a surplus. A shift in the trade balance between two countries tends to weaken the currency of the country with greater deficit
Wealth is a country’s reserves, in the form of gold, cash, natural resources, and so on. Basically any factor that affects a country’s ability to repay loans, finance imports, and affect investments impacts the market’s perception of its currency and the currency’s value.
Internal budget deficit or surplus
A country running a current account deficit has, on balance, a weaker currency than one that runs a budget surplus. This is tricky, however, in that the direction of the surplus or deficit affects perceptions and currency valuations too
Funds move around the world electronically in response to changes in short-term interest rates. If three-month interest rates in Germany are running 1% less than three-month rates in the United States, then all other things being equal, “hot money” flows out of Euro into the Dollar.
Inflation in each country, and inflationary expectations, affect currency values. What good is a 10% short-term return in some country if inflation is running 15%?
Taxes, stability, whatever affects the international trade of a country, or the perception of “soundness” of the currency affect its valuation.