What is Foreign Exchange (Forex)?

Foreign exchange is a worldwide market in which one nation’s currency is converted into another nation’s currency. In further terms, exchanging of nations currency with foreign currencies. Foreign exchange happens at a specified rate which is termed the foreign exchange rate. The exchange rates are not constant continuously changing as they are derived by market forces of supply and demand. Widely used foreign currencies are the United States- dollar, Euro, Japanese Yen, British pound, and Australian dollar. US- dollar is the most denominated foreign currency. The Euro to US dollar is a widely used currency pair in the forex market as these two currencies represent the world’s enormous economy. Forex trade is simple as exchanging currencies at the bank. The main players of forex markets are the central banks, financial institutions, intermediaries, investments banks, and other banks. Central Bank is the supreme player who decides the currency value of their own nation on the forex market. Mostly foreign exchange-traded at FX market (forex market) when tourists’ visits a foreign country, import, and export happens between two countries.

What are the instruments of Foreign Exchange market?

Foreign exchange market users use different instruments to keep away from loss risks. These instruments are derivatives that are used to arbitrage or hedge the exchange rate risk arising from forex transactions. Five major forex instruments,

1. Spot contracts

Spot contracts are the contract of exchanging currencies, securities, and commodities at the price of the settlement date. If the arrangement is conducted at the transaction date exchange rate, which is known as spot rate contracts. It involves the immediate purchase and sale of currencies, securities, and commodities. It is suitable for short-term arrangements.

For example, the gold price on 01/04/20XX is $2,000. If the customer has a desire to purchase the gold @ $2,000 he can enter into spot contracts and take instant physical delivery of gold.

Characteristics of spot contracts

•  Immediate physical delivery.
• Only cash involved transactions.
• Takes less time to finish the arrangement.

2. Forward contracts

A forward contract is an agreement of buying or selling of particular asset on a mentioned future date at the specified rate. Here future dates may be longer-term (more than 12 months). Forward contracts are foreign exchange derivatives. It is utilized by players to restrict the risk of exchange rate uncertainty. Forward contracts take place over the counter, two parties sit across and negotiate the quantity, quality, cost, and date of the transaction. Forward contracts should be used to fix specific rates on the date of agreement to keep away from currency floating risks. If the price of the asset increased than the price of the forwarding contract, parties involved in the forward contract can purchase the currency or underlying asset at the forward contract price. If the loss occurred parties should amortize it over the period of time for their accounting purpose.

For example, a buyer X and a seller Y agree to do trade in 10 tons of gold on 31 December 2015 at $25,000 per ton. Here $25,000 per ton is the forward price of 31 December 2015 gold. Once the contract has been entered into, buyer X is obliged to pay $250,000 on 31 December 2015 and take delivery of 10 tons of gold. Same way seller Y is obliged to accept the $250,000  on 31 December 2015 and give 10 tons of gold in exchange.

3. Options

Options are exactly like a forward contract, parties can exercise options on favorable terms. It is also a type of forex derivative used to mitigate forex trading risks. It gives the purchaser the right, but not a responsibility to transfer any underlying asset, currencies, security, etc. at an agreed cost on a specified date. Parties involved in the options are called: option holders, option writers. Options have two key attributes.

Call option

It is a commitment that offers the purchaser the right, but not responding to buy a particular number quantity of assets from the seller of the option at a pre-determined price on the specified date.

Put option

It is a commitment that offers the purchaser the right, but not responding to sell a particular number quantity of assets from the seller of the option at a pre-agreed price on the specified date.

4. Futures

A futures contract is an arrangement between two agencies that make one agent purchase an asset, financial instruments, securities, currencies, and counterparty to sell an asset, financial instrument, securities, and currencies at a fixed future date. Futures requisite both the agencies in the arrangement have balance in their margin account. Future contracts are a derivative instrument that is used by investors to make huge profits on their investments. Because vast investments are always associated with high risk. CFD (Contract For Difference) permits players to invest in the future market without the physical movement of underlying assets.

For example, buyer A and seller B enter into future contracts of 1,000 kilograms of corn at $10 per kg. The second-day price of corn is $11. The price movement has led to a loss of $1,000 to seller B, while A has gained the corresponding amount.

5. Swaps

Foreign Exchange Swaps is the agreement between two agencies to exchange their revenue or cash flows from any assets or liabilities, which is occurred during particular intervals. Swaps are an exchange between two parties to trade currencies for a pre-determined period of time. Most interest rates are getting swapped between two agencies. The majority of swaps are categorized into the following groups:

• Interest rate swaps are derivative contracts which involves exchange of interest rates between two agencies. It is a forward contract which enable two parties to interchange their interest rate from fixed to floating or floating to fixed to pay their debts. It helps to reduce the movement in interest rates.
• Commodity swaps is derivative contract in which two parties agreed to exchange their cash flows related to the fundamental assets or commodity up to a defined period of time. Generally commodity swaps used to  protect against the cost variance of commodities in the market.
• Equity swaps is an arrangement in which total return on equity or dividends and equity capital is exchanged with floating or fixed rate of interest.
• Currency swap is a derivative, which allows two parties to agree to transfer same amount of money but in various currencies. Currency swap permits, organizations operated in foreign can avail loans at lower interest rates from their home country.

Advantages of Foreign Exchange Market

• Trading in forex markets are flexible, since there is no restriction on trading amount.
• Less costs, forex trading does not require much costs. It only requires account in foreign exchange market.
• Probability of making profits, many of the players in FX market uses this wisely and make profits by analyzing the price movement of trading assets, currencies and securities.
• Forex market provide traders variety of trading options as they can play with number of currency pairs.

Factors influencing Foreign Exchange Market

• Inflation, variations in market position affects currency rates.
• Political and economic environments.
• Country’s debt balances with foreign countries.
• Global trade affects country’s forex rate. In export nation get money and in import nation became liable to pay. If the nation’s export trade higher than its import, it means the currency value of country is increased.

Context and Applications

This topic is significant in the professional exams for both undergraduate courses & postgraduate courses and Competitive exams, especially for Bachelor of Commerce, Master of Commerce, Bachelor of Business Administration, Master of Business Administration, and CA-Inter and Final level.

Practice Problems

Question 1: What are the Forex Instruments?

a) Swaps

b) Future contracts

c) Forward contracts

d) All of the above

Answer: Option d is correct.

Explanation: Major foreign exchange instruments are spot contracts, futures contracts, forward contracts, options, and swaps.

Question 2: Which one is not a derivative forex instrument?

a) Future contracts

b) Forward contracts

c) Spot contracts

d) None of the above

Answer: Option c is correct.

Explanation: Spot contracts are not derivative instruments. Because there is no hedging against risks. The transaction occurred on the date of the contract.

Question 3: What is a widely used foreign currency in the forex market?

a) Euro/US dollar

b) British pound/US dollars

c) US dollar/Japanese yen

d) US dollar/ Indian Rupees

Answer: Option a is correct.

Explanation: The Euro to US dollar is a widely used currency pair in the forex market as these two currencies represent the world’s enormous economy.

Question 4: Which swaps involve the exchange of interest rates?

a) Equity swaps

b) Commodity swaps

c)  Interest rate swaps

d) Currency swaps

Answer: Option c is correct.

Explanation: Interest rate swaps are derivative contracts that involve the exchange of interest rates between two agencies.

Question 5: Which derivative instrument takes place Over the Counter?

a) Forward contract

b) Future contract

c) Options

d) Spot contract

Answer: Option a is correct.

Explanation: Forward contracts take place over the counter, two parties sit across and negotiate the quantity, quality, cost, and date of the transaction.