What is the currency market?
The currency market, also known as the foreign exchange market, consists of currencies worldwide. This market determines the rate of all currencies based on the buying and selling of forex. It is an over-the-counter market. It is the largest and most liquid market based on trade volume.
The currency market has several layers in it. Financial institutions, insurance companies, and brokerage houses that are market participants carry out a large trade volume amongst themselves. Such institutions are known as dealers. This market also lends funds to the banks and is more popularly known as the interbank market.
Characteristics of the currency market
- There is an absence of a central location.
- It is the most liquid market due to the nature of the assets being traded.
- There is no sovereign or governmental regulation for the currencies being traded.
- The rates of currencies are determined by the activity of this market.
- The trading margins in this market are low in comparison to the other markets.
The major currencies traded in the currency market are the U.S. dollar, Euro, British Pound, Canadian dollar, Australian dollar, and Japanese Yen. Apart from these, currencies of almost all the nations are traded in this market. The U.S. dollar makes up almost two-thirds of the total volume traded. Currencies are always traded in pairs. So, the value of a currency is expressed in terms of some other currency. For example, if one wants to know the value of the Japanese Yen and Euro in terms of U.S. dollars, it will be expressed as JPY/USD and EURO/USD, respectively. Since USD is the most traded currency, Dixie or DX expresses the value of the U.S. Dollar concerning several other currencies. Euro, too, are traded in high volumes.
In recent times, cryptocurrencies like Bitcoin, Litecoin, etc., have gained a lot of prominences. Cryptocurrency is blockchain-coded data that is used as a medium of exchange. It is not the same as fiat money. Bitcoin is the most valuable and most talked about cryptocurrency globally.
Bitcoin vs forex trading
The growth of bitcoin trading has created a multi-million dollar trading market. Bitcoin trading is similar to forex trading in specific ways and has several differences. Firstly, trading in bitcoin or any other cryptocurrency is governed by the demand and supply of that currency, just like in forex trading. The difference to be noted here is that bitcoin is not subjected to supply deficits like forex. Secondly, the most crucial factor to be considered is liquidity. Bitcoin has very little liquidity, whereas forex trade creates significant liquidity. Finally, Bitcoin trading is more volatile in comparison to forex trading.
The currency market comprises almost all the international banks and financial institutions. There is no central location for the currency exchange. Instead, it is an electronic marketplace having nodes in brokerage firms and banks. Financial centers have been established globally to ease forex trading. The most prominent financial centers are London, Sydney, New York, and Tokyo. These financial centers operate on weekdays for twenty-four hours. The two most important financial centers are London and Wall Street in the USA. The market participants have been described below.
- Central Banks: The central banks of all countries are an important part of FX trading. These banks have forex reserves with them which they use to trade in the currency market. This helps the banks in controlling the flow of funds in the economy and also helps in controlling inflation and stabilizing the value of national currency vis-à-vis foreign currency.
- Companies: Large multinational firms or firms engaged in the import and export of goods and services form a part of the currency market. These companies need foreign exchange to pay for the goods and services received from abroad or exported to foreign locations.
- Investment firms: Investment firms that deal in foreign exchange on behalf of their clients also form a part of the currency exchange market. Apart from this, investment funds like pension funds are also market participants in the currency market.
- Retail FX traders: Retail traders form a large chunk of the forex market. Retail traders include hedgers, arbitrageurs, and speculators. The retail traders also include the dealers who act as principals or agents on behalf of the retail traders.
- Non-bank forex companies: The companies that offer physical delivery of currency to the bank accounts of individual investors are called non-bank forex companies. These companies charge a fee called markup, in return for the services provided by them.
- Remittance companies: There are companies that are engaged in the business of remitting forex to individuals. Pixabay, Western Union, TransferWise are examples of such companies. These companies facilitate the remittance and exchange of forex for the account holders.
Functions of the currency market
The currency market performs several functions. Some of the functions are mentioned below:
- The most important function performed by the currency market is the setting of the price of currencies with respect to one another.
- The currency market also helps with minimizing the risks associated with the currency exchange rate. Exchange rate refers to the rate of one currency expressed in terms of the other. The exchange rate is used to measure the amount of currency needed for exports. The exchange rate also shows the investor confidence in a currency. The price of currencies keeps changing every minute. This entails a risk of currency exchange rate for investors and traders. There are high chances of exports becoming cheap in case of devaluation of currency and vice versa. In such cases, the working of the FX market ensures stability in exchange rates to some extent. Derivative contracts like futures contracts, forward contracts, and options, help in hedging foreign exchange rate risk.
- The currency market plays an important role in the exchange of funds between countries. As such, it helps the countries in maintaining the balance of payments and helps in easing cross-border trade.
- The currency market plays an important role in international trade by providing credit or liquidity for trade.
Working of the currency market
The currency market does not have a regulator like other financial markets. Traders who wish to trade currencies can open an account with any brokerage firm. A trader benefits if the value of the currency held by him increases. Trading currencies is highly profitable because of the low trading costs and high leverage available to traders. Due to the time difference in the operation of financial centers worldwide, arbitrage opportunities arise. Speculators make money by speculating or predicting currency price movements.
Types of derivatives for hedging foreign currency risk
Several derivatives contracts are available in the foreign exchange markets for hedging exchange risks. The most common derivatives contracts are futures, forwards, options, and swaps. Derivative contracts have an underlying stock on which the value of the contract is based. The four types of derivatives contracts mentioned above successfully help lock the contract value at a fixed rate. It ensures that any adverse changes in the price of currencies do not affect the contract value adversely. The different types of derivatives contracts are mentioned below in detail:
- Futures contract: The parties to a futures contract are obligated to purchase and sell each other the underlying asset at a predetermined rate and date. This ensures that the contract value does not change, irrespective of the fluctuation in the currency value. Futures contracts are exchange-traded, thus minimizing the risk of default.
- Forward contract: The parties to a forward contract have the obligation to exchange an asset at a later date and at a price that has been agreed upon beforehand. A forward contract is a customizable and over-the-counter product.
- Options contract: The parties in an options contract have the right but are not obligated to buy or sell the underlying asset. If they choose to exercise their right, they have to settle the contract on the maturity date at the predetermined rate. Trading in the spot market is particularly helpful in mitigating exchange risk.
- Swap contract: The swap contract helps the investor to hedge the risk by exchanging or swapping a high-interest payable asset with a low-interest payable asset.
Context and Applications
This topic is significant in the professional exams for both undergraduate courses & postgraduate courses and competitive exams, especially for:
- Masters of Business Administration (Finance)
- Bachelor of Business Administration (Finance)
- Chartered Financial Analyst
- Certified Public Accountant
Question 1: Identify the market that deals in currency trading.
(a) Derivatives market
(b) Money market
(c) Foreign exchange market
(d) Financial center
Answer: Correct option: (c)
Explanation: The derivatives market deals in derivative contracts like futures, forward, options, and swaps. The money market deals in short-term financial instruments like treasury bonds. A foreign exchange market deals in currencies.
Question 2: Identify the category of traders who take advantage of the fluctuations in the price of a currency traded in different time zones.
(c) Retail traders
Answer: Correct option: (a)
Explanation: Arbitrageurs take advantage of arbitrage opportunities, i.e., a disparity in the price of financial assets due to differences in time zones or other factors.
Question 3: Identify the type of derivative contract traded on an exchange.
(a) Interest rate swaps
Explanation: Interest rate swaps, forward contracts, and swaps are customized contracts traded over the counter. A futures contract is a standardized, exchange-traded contract.
Question 4: Identify the derivative contract that is standardized.
(a) Zero-coupon swaps
Explanation: A futures contract is not customizable. Rather, it is a standardized contract. All the other derivative contracts mentioned above are customizable.
Question 5: Identify the derivative contract that gives the holder the right but not the obligation to execute the contract.
Explanation: Futures, forward, and swap contracts obligate the holder to execute the contract, but an option does not carry any such obligation.
Students often mistake forward contracts for future contracts and vice versa. Further, confusion arises while studying options contracts. A thorough understanding of the derivatives market and derivative market products is imperative to understand the currency market in depth.
While studying this topic, it is important to read the following topics to get a better knowledge:
- Financial markets
- Derivatives market
- Money market
- Commodities market
Want more help with your finance homework?
*Response times may vary by subject and question complexity. Median response time is 34 minutes for paid subscribers and may be longer for promotional offers.
Currency Market Homework Questions from Fellow Students
Browse our recently answered Currency Market homework questions.