Intro to Forex Investments
Welcome to the chapter on Currency or Forex Investments.
The Foreign Exchange (Forex also called FX) market is a global marketplace where national currencies are exchanged against one another.
Unlike other investment options like stocks, MFs and commodities, there is no national or global central exchange for foreign exchange trading. Rather, the trading happens electronically over-the-counter (OTC) between forex traders from around the world.
The market is open 24 hours a day, five and a half days a week.
But before we go into details, here are our recommended brokers who can help you invest in currencies. We suggest you check each one and try at least 2 of them for a few months before you pick one platform for all your investments.
The reason the currency or forex market exists is that currencies have to be exchanged for foreign trade. Let us understand with an example.
Suppose an electronics manufacturer in India needs to buy machinery from Germany. Here the manufacturer will pay the machinery maker not in Rupees (INR) but Euros (EUR). Their rupees will be changed to euros and paid to the German company. Similarly, when the manufacturer sells the electronics products in Australia, they will be paid in Australian Dollars (AUD) and not rupees. The buyer will pay in Australian dollars and this will be converted into rupees to get the money into India.
Since global trade and money flow around the world are so huge, forex markets are the largest and most liquid markets in the world. The traders and speculators hedge against international currency and interest rate fluctuations, speculate on geopolitical events, or simply trade in forex to diversify their portfolios, among others.
All currencies trade against each other as exchange rate pairs. For example, INR/USD, INR/EUR, and so on. And depending on various factors such as the demand and supply of the currencies, interest rate fluctuations, economic performance of the two countries, future expectations, geopolitical events, and so on, the exchange rate moves up or down.
Types of Forex Markets
There are two types of Forex markets: Spot or Cash and Derivatives. The derivatives markets include futures, forwards, options and currency swaps.
Spot or Cash Market
The spot market is where currencies are bought and sold according to the current exchange rate. The price as explained earlier is determined by the demand and supply of the currencies, interest rate fluctuations, economic performance of the two countries, future expectations, geopolitical events, and so on.
The spot market is the largest market and forms the underlying asset needed for the derivatives markets to work.
Transactions occur between two parties after they agree on an exchange rate. The first party offers the agreed amount in the currency they have to the second party and in turn, receives a specified value of the currency they want at the agreed exchange rate. All transactions are in cash though settlements to get the final amount in the currency you have bought can take up to two days.
One thing you have to keep in mind is that forex trading is different from you buying another currency for foreign travel, or sending money abroad or receiving money from abroad.
When you buy currency for foreign travel, then you pay the dealer in cash and they hand over the equivalent amount in the currency you want. Here the transaction is instantaneous.
The same thing happens when you send money abroad or receive money from abroad in cash. When you send money abroad as cash, you pay the money transfer company a certain amount in rupees and the recipient gets the equivalent amount in their currency abroad after you send the receipt note. The same thing but in reverse happens when you receive money from abroad. In both cases the transactions are instantaneous.
The derivatives market is preferred more by companies that need to hedge their foreign exchange risks than by investors.
Unlike the Spot or Cash market, the derivatives market does not trade in actual currencies but instead in contracts that have to be settled at a specific date in the future on pre-decided exchange rates.
This market usually has four variants: futures, forwards, options and currency swaps.
Here standard size futures contracts are bought and sold with a future settlement date. These contracts are standardised and have specific details such as number of units to be traded, delivery and settlement dates and minimum price increments. All contracts are traded on the designated exchanges, which take care of the settlement and cleaning functions.
The settlements are done in cash on the expiry date but can also be bought and sold before they expire.
Currency futures started in India in 2008 on the National Stock Exchange (NSE). It was subsequently extended to other exchanges like the Bombay Stock Exchange (BSE), Multi Commodity Exchange of India (MCX) and United Stock Exchange. Not all currency pairs may be allowed to trade, however.
Currency futures in the NSE are allowed on four currency pairs, US Dollars (USD), Euro (EUR), Great Britain Pound (GBP) and Japanese Yen (JPY). You can also trade in cross currency futures such as EUR/USD, GBP/USD and USD/JPY.
In the forwards market, contracts are customised between two parties and bought and sold over the counter through currency traders. The two parties determine the terms of the agreement between themselves including number of units to be traded, delivery and settlement dates and other details.
Like the futures, forwards contracts are binding and settled for cash upon expiry.
Currency options give the investors the right, but not the obligation, to buy or sell a particular currency at a pre-specific exchange rate before the option expires. Investors can buy a call (buy) or put (sell) option but once bought they cannot be re-traded or sold.
Currency options were introduced in India in 2010 for the USD/INR pair of currencies. It was extended to include EUR/INR, GBP/INR and JPY/INR in 2018 as well as cross currency options contracts on EUR/USD, GBP/USD and USD/JPY.
These currency options allow multinational corporations, traders and investors to hedge currency risk or speculate on future currency fluctuations.
This makes these inherently complex derivatives more so. Factors such as interest rate differentials, market volatility, time until expiry, and current exchange rate are just a few of the many things an investor has to track to make a profit.
In Currency Swaps, two parties exchange the interest and the principal in one currency for the same in another currency. These are used to hedge long-term investments and to change the interest rate exposure of the two parties.
In most cases, the interest is the only component that is swapped. The principal is more of a notional amount that is used to calculate the interest for each period but is not exchanged. The reason the principal is not exchanged is that swapping the principal may create a larger burden as the exchange rate between the two currencies may have changed significantly from the exchange rate existing at the time of the currency swap.
Since interest rates can be floating or fixed, parties can exchange a fixed or floating rate in one currency for the fixed or floating rate in the other currency.
Currency swaps help bring stability to forex and capital markets and may be entered into between two countries for that purpose also.
The derivatives market is used more by multinational corporations to hedge against future exchange rate fluctuations that may reduce their sales numbers by a significant margin. But you will also see investors in these markets.
For multinational companies, forex futures are a smart way to reduce risk and safeguard their interests. For traders, it is another way to diversify their portfolios and reduce risk.
The risks from forex trading are nonetheless significant.
For example, it is complex. It is an unregulated market and any factor can have a significant influence on the exchange rate. Keeping track of even the factors mentioned earlier can be demanding. Understanding the demand and supply of currencies, interest rate fluctuations, economic performance of two countries, future expectations, geopolitical events, and so on, require more than a few hours of attention every day.
As such, newbie investors should stay away from the forex market.