How does currency trading work in India?
Currency markets, or the foreign exchange markets, also known as the forex market, is the largest financial market in the world, bigger than even the stock market. There exist certain factors which happen to be unique to the forex market and in this article, we will understand how currency trading works in India.
Currency trading takes place in the currency or forex market, which is a marketplace where national currencies are bought and sold. In India, currency trading is carried out through the use of currency derivatives like futures and options on recognised exchanges. The currency market does not have a central location and connects traders across the world electronically. Currency trading occurs around the world continuously 24 hours a day and 5 days a week.
Let’s now go through some basic terminology around currency trading.
Currency trading terminology
Currencies are always traded in pairs, for example the USD/INR pair and there exist 3 types of currency pairs, namely major pairs, minor pairs, and exotic pairs. Major currency pairs mostly involve the US dollar in the pair like USD/CAD which stands for the US dollar and the Canadian dollar. Minor currency pairs involve other major currencies against each other instead of the US dollar, like INR/JPY which stands for Indian Rupee and Japanese Yen, or GBP/INR which stands for the Pound Sterling and the Indian Rupee. Exotic currency pairs involve 1 major currency and one minor currency, like the US dollar and the Norwegian Krone.
A pip, or a point in price is defined as the smallest movement or change in the valuations of the currency pair. Let’s understand this through an example. Assume that the USD/INR rate is 78.7502 on a Tuesday and it becomes 78.7501 on the next day, Wednesday. In this case the pip would be 0.0001.
Base currency and Quote currency
Currency pairs are denoted by writing both the currencies and separating them by a backward slash, for example USD/INR. In a currency pair, the currency on the left is the base currency and the one on the right is the quote currency. In our example, the US dollar would be the base currency and the Indian Rupee would be the quote currency. In a currency pair, the value of the base currency is always 1, so a USD/INR currency pair signifies that one can buy 1 US dollar against 78.75 Indian Rupees, if the exchange rate is 78.75.
Bid and Ask price
Let’s now understand the bid and ask price. Bid price is the price for buying the base currency and the ask price is the price for selling the base currency. As an example, if USD/INR is quoted as 78.7233/78.7236, it means that one needs 78.7236 Indian Rupees to buy 1 US dollar and receive 78.7233 Indian Rupees on selling 1 US dollar.
Let’s now understand the term spread. Spread is just the difference between the bid price and the ask price. So, in the example which we took above, the spread would be 78.7236 – 78.7233, which is 0.0003.
Similar to stock derivatives, currency derivatives are also traded in lots. A lot size is the minimum quantity of units that have to bought or sold under a contract.
Leverage essentially allows a trader to trade more than what they have in cash as they only need to pay a margin instead paying full amount. As an example, if one has 10,000 Rupees in their trading account and the margin required is 5%, then they can trade currencies up to 2 lakh rupees. But one should remember that leverage magnifies gains and losses as well, so one should be careful with it.
Currency trading features
Let’s now go through a few features of currency trading in India. All currency trading contracts are speculative in nature, which means that one does not get the physical delivery of currency. Moreover, currency trading is only allowed in 7 pairs, namely: USD/INR, EUR/INR, JPY/INR, GBP/INR, EUR/USD, GBP/USD, and USD/JPY. Forex trading is facilitated on 3 exchanges in India, namely the NSE, BSE, and the Metropolitan Stock Exchange of India Ltd and is regulated jointly by both SEBI and RBI. The lot size for USD/INR, EUR/INR and GBP/INR is 100 units and the lot size for JPY/INR is 1,00,000 units.
Let’s now talk about a few advantages and disadvantages of currency trading. One major advantage of trading in the forex markets is that almost all information on interest rates and price movements is readily available in the market and there is little possibility of any long-term price manipulation by forex market participants like central banks. When it comes to the disadvantages, one should remember that currencies are susceptible to volatility as currencies fluctuate every second with such fluctuations becoming drastic during times of geopolitical turmoil.
Participants of the currency market
Commercial and Investment banks are one of the major players in the currency markets and the greatest volume of currency is traded in the interbank market. The interbank market is where banks of all sizes electronically trade currency with each other. Banks either facilitate forex transactions for the clients they serve, and the bid-ask spread represents their profits or conduct speculative trades through their own trading desks to profit on currency fluctuations.
Central banks also happen to be one of the most important currency market participants. The interest rate policies set up by central banks and open market operations have a significant impact on currency rates. Central banks are the ones who are responsible for managing the price of their native currencies on forex and any actions taken by them is done with the objective to stabilize or increase the competitiveness of the respective nation’s economy. They may also engage in currency interventions with the goal of making their respective currencies appreciate or depreciate.
Investment managers and hedge funds also are major participants in this market, and they trade currency for their clients like pension funds. They may either purchase or sell currency to trade in foreign securities or make speculative trades as part of their investment strategies.
Then there are companies which are involved in imports and exports who also participate in currency markets as they have to conduct foreign transactions to pay or receive foreign currencies for goods and services. Companies also tend to make forex trades with the objective of hedging the risk which is associated with foreign currency translations and also add some safety to offshore investments.
- Firstly, we defined what is meant by currency trading and the foreign exchange market, which happens to be the largest market in the world.
- Secondly, we understood some basic terminologies around the currency market like what are currency pairs, what is the bid ask spread, what one means by base currency and quote currency, etc.
- And then finally, we discussed about the major players in the currency market and what they wish to accomplish by trading in the forex market.
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