Forex for beginners

What is forex?
Forex or foreign exchange is changing one currency for another at the prevailing exchange rate.
A simple foreign exchange transaction normally takes place when we travel to another country where the national currency is different from the home currency.
Ex- If you’re living in Germany, your income would generally be in EURO’s. Suppose you travel to France where the national currency of the country is also the EURO, the necessity of foreign exchange does not arise. But if you travel to Japan, you would need to exchange your EUROS to YEN to pay for your travel, leisure, food and shelter, which is a straightforward foreign exchange transaction.
The foreign exchange markets or forex markets are the largest financial markets in the world with the daily turnover exceeding USD 4 trillion

Where are they traded?
Forex trading takes place over a massive network of global telephone lines and electronic communication networks (ECN), 24 hours a day, 5days a week.
In put it differently, they are de- centralized markets with no centralized trading floor as all forex trading is bilateral in nature. All trades are carried out ‘over the counter’ through broker- dealer networks.

Who are the market participants?
Central banks, commercial and investment banks, non- banking forex companies, fund managers, corporations, hedge funds, money transfer/ remittance companies, traders, arbitragers, and individual investors.

What are the other forex instruments traded ‘over the counter’?
Besides spot forex, the other forex instruments traded ‘over the counter’ are

Forex forwards-
Are bilateral contracts to buy or sell a predetermined amount of foreign currency, at a predetermined exchange rate before a predetermined time in future.

Forex swaps-
Are combinations of spot and forward transactions. It comprises of the purchase and sale of two currencies at two different dates; one of them being the spot date and the other a forward date.

How are they different from exchange traded currencies?
The foremost differences between OTC traded currencies and exchange traded currencies are mentioned below

OTC markets-

• Bilateral trading agreements, no intermediary
• Trading de-centralized
• Largely un-regulated
• Customized contracts/ lot sizes
• Low transaction costs
• High counterparty risk
• Most trades result in exchange of physical currencies
• Customized contract expiry, can be decided bilaterally
• Large turnover
• Good number of forex pairs available for trading

Exchange traded-

• Exchange acts as the counter- party to every trade
• Centralized trading
• Highly regulated
• Standardized  contracts/ lot sizes
• High transaction costs
• Low counterparty risk
• Trades are mostly cash settled
• Contract expiry decided in advance by the exchange
• Comparatively lower turnover
• Only a few selected currency pairs available for trading

Which are the most commonly traded forex pairs?
EUR/USD
USD/JPY
GBP/USD

What are direct and indirect currencies?
A forex pair quoted in fixed units of the home currency and variable units of a foreign currency is called a direct currency and the converse is an indirect currency
Example-
GBP/ USD - Direct currencies
AUD/USD
USD/CAD - Indirect currencies
USD/CHF

What are cross currencies?
A currency pair that does not include the US dollar is called a cross currency.
Example-
EUR/JPY
GBP/CAD

Who regulates forex markets?
Individual countries have their own independent regulatory agencies overseeing off- exchange forex operations. Some of them are

• Commodity futures trading commission (CFTC)
• National futures Association (NFA)
• Financial services authority (FSA)
• Swiss Reg
• Australian securities and investments commission (ASIC)

Common terminologies
Bid-
Buying price of a forex pair
Ask-
Selling price of a forex pair
Pip-
Abbreviation for ‘price interest point’ and are the smallest price increase/ decrease in a currency pair
Fractional pip-
Are also called decimalized pricing and are quoted in tenths of a pip resulting in lower spreads.
Example-
EUR/USD- 1.3350/ 1.3355- Normal spread
EUR/USD- 1.33496/ 1.33548- The highlighted numbers are called fractional pips
Spread-
Is the difference between the bid and ask price