Sharekhan Blog

Foreign Exchange Explained

  • Apr 18, 2024

However, with these opportunities come some complex challenges, especially when it comes to dealing with different currencies. How can you make sure that forex fluctuations won't impact your international endeavours? The answer lies in understanding the dynamics of currency exchanges and making smart conversions to cushion against those currency swings.

Keep reading to learn about some key forex facets that will help you navigate the global market while minimizing the risks and maximizing the benefits.

What is Foreign Exchange and Why Does It Matter?

Forex or Foreign exchange meaning is the conversion of one currency into another currency. It matters because it facilitates global business and trade. When a company in the U.S. buys goods from China, it needs to convert U.S. dollars into Chinese yuan to pay for the goods. When a tourist from Europe visits Japan, they need to convert euros into Japanese yen to pay for hotels, meals and shopping. The forex market is where these currency conversions take place.

Major Currencies Traded on the Forex Market

The U.S. dollar is the most widely traded currency, involved in more than 87% of all forex transactions. Other major currencies include:

1. Euro (EUR)

2. Japanese Yen (JPY) 

3. British Pound Sterling (GBP)

4. Australian Dollar (AUD)

5. Canadian Dollar (CAD) 

6. Swiss Franc (CHF)

These major currencies are the most liquid and widely traded. Unfamiliar currencies like the South African Rand or Thai Baht don't include the U.S. dollar and are less liquid but can also present trading opportunities.

What Factors Influence Currency Exchange Rates?

Currency exchange rates fluctuate based on factors like:

1. Economic Performance: The currencies of countries with stronger economic growth and stability tend to appreciate relative to countries with weaker outlooks.

2. Interest Rates: Higher interest rates in a country can attract foreign capital, driving demand for and value of its currency higher.

3. Inflation: High inflation typically devalues a currency by decreasing purchasing power. Low inflation generally supports a currency's value.

4. Political Factors: Political instability or uncertainty tends to undermine investor confidence and demand for a nation's currency. 

5. Trade Imbalances: If a country imports far more than it exports, it can negatively impact the value of its currency over time.

6. Sentiment and Speculation: Market psychology and speculative trading can also impact forex prices in the short run.

How Does the Forex Market Work?

1. The foreign exchange market is different from stock markets in some key ways:

2. There is no centralised exchange like the New York Stock Exchange in forex. Trades take place between parties directly via banks, brokers and electronic communication networks (ECNs) around the world.

3. The forex market is open 24 hours a day, five days a week, to facilitate trading across time zones. Market activity peaks when sessions overlap in Europe, Asia and North America.

4. Unlike stock markets, high leverage is common in forex. Leverage allows traders to control larger positions with less upfront capital but also increases risks. 200:1 leverage is not unusual.

5. Forex trades are done in flexible lot sizes: micro (1,000), mini (10,000), and standard (100,000) units of a currency.

Who Are the Major Participants in Forex Trading? 

Banks and financial institutions account for the majority of daily forex volume as they act as market makers for clients. However, many individuals and businesses also participate:

1. Central Banks & Governments

Central banks may intervene to manage exchange rates despite free market ideals due to government economic agendas.

2. Large Banks 

Bigger investment banks facilitate forex trading through proprietary desks, providing liquidity for client trades, exposure hedging, and speculation.

3. Hedge Funds & Institutions

Asset managers trade currencies for diversification, inflation hedging, and directional bets using global macro and CTA strategies. Pension funds are increasingly active in currency markets.

4.Multinational Corporations 

Global businesses trade currencies to hedge operations across different countries against adverse rate moves. Finance teams manage these FX risks carefully to contain costs.

5. Retail Forex Brokers

Market-makers provide access to risk capital through margin accounts using online trading platforms and mobile apps. Reputable brokers offer a diverse range of products and strong execution.

6.Individual Investors & Speculators

Individuals play a significant role in the interbank market, utilising it for both hedging and speculation purposes. This includes everyone from casual tourists in need of travel funds to professional investors.

Conclusion

Foreign exchange, commonly known as forex, involves the trading of trillions of dollars worth of currencies across the globe, all day and night. It serves as a pivotal link between countries and supports international business and investments. Staying up-to-date with forex trends can come in handy when you're planning a trip overseas or thinking about investing in foreign stocks.

Team Sharekhan
by Team Sharekhan

We care that your succeed

Leaving no stone unturned in creating a one-stop shop for the latest from the world of Trading and Investments in our effort to Make the Markets work for YOU!

Recent posts

Reasons Behind Investors Losing Money in Futures & Options

17 May 2024

Sharekhan’s Survey  unveils reasons behind investors losing money in Futures & Options Trading—an issue flagged by SEBI

Read More

India's Top Retail Broker & Analysts Awards

16 May 2024

A BIG thank you to our customers for Sharekhan being recognised as India’s No. 1 Retail Broker & our Research Analysts also winning top ranks.


Read More

What Is Large Cap Fund?

2 May 2024

Large-cap companies are well-established entities with a respectable vintage and reputation.

Read More

Intraday vs Delivery Trading: Which One is Right for you?

30 Apr 2024

Trading platforms in India offer retail investors easy access to equity markets; an oft-asked question is the suitability between utilising delivery-based investing versus higher velocity intraday trading.

Read More

Stock Market Timings in India

30 Apr 2024

India's stock markets play an important role in the growth of its economy and wealth creation for investors. But to actively participate in equity trading avenues, having a sound understanding of exact stock market timings and hours is key for tra

Read More