What is the Currency Market?
Currency Market (Also known as Foreign Exchange Market) is a one-stop marketplace where different currencies can be bought and sold by different participants operating in different jurisdictions around the globe. This market plays a very pivotal role in the conduct of international tradeInternational TradeThe trading or exchange of products and/or services across international borders is referred to as international trade. It frequently includes other risk factors such as exchange rate, government policies, economy, laws of the other nation, judicial system, and financial markets that impact trade between the two. and financial sector and serves companies and individuals by enabling them to purchase and sell goods and services denominated in foreign currencies as well as the smooth flow of capital. The currency markets operate round the clock and have major participants in the form of Large International Banks, Corporations, Government Entities, Retail participants, etc.
Market participants enter currency markets with a different purpose and together they make the market more liquid and efficient in the process. Due to the operation on around the clock basis currency market provides a greater opportunity to the international banking system to handle the current account and capital accountCapital AccountThe capital account refers to the general ledger that records the transactions related to owners funds, i.e. their contributions earnings earned by the business till date after reduction of any distributions such as dividends. It is reported in the balance sheet under the equity side as “shareholders’ equity.” transactions and as such these markets are the driving force behind vibrant global economies.
It is important to note here that currency market is not a single market exchange but a network of global markets which do not work simultaneously and work as per different time zones starting with Japanese Markets followed by Hongkong, Singapore, India, Middle East (Bahrain), Europe, United Kingdom, USA, Canada and ending with Australia.
Examples of Foreign Exchange Market
Let’s understand the role of foreign exchange market play with the help of a few examples:
Nomura, the Japanese Investment BankInvestment BankInvestment banking is a specialized banking stream that facilitates the business entities, government and other organizations in generating capital through debts and equity, reorganization, mergers and acquisition, etc. has recently concluded a deal and expects to 20 million Euros after 3 months. After three months the price of Yen/Euro can move in any direction and as such has Yen/Euro exchange risk as a result. To overcome this risk, Nomura enters the currency market and enter into a forward currency contract to sell 20 million euros at the end of three months at a predetermined price in terms of Yen. By entering into such a contract which is facilitated by the currency market, Nomura can eliminate its foreign exchange riskForeign Exchange RiskForeign exchange risk is an unfavourable change in the settlement value of a transaction entered in a currency other than the base currency (domestic currency), also referred to as currency risk or exchange rate risk. associated with the transaction.
The above is an example of how currency markets help in hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market. the risk arising on account of exchange rate fluctuation.
Xylo is a Trading firm and believes that the economic crisis in India will impact its fiscal deficitFiscal DeficitFiscal deficit refers to the situation where the total budget expenditure exceeds the total budget receipts, excluding the government borrowings in a given fiscal year. It determines the amount the government needs to borrow for meeting its excess expenditure. and this will have widespread impact on the local currency against the Dollar and expect the rupee to depreciate heavily against the dollar and builds into speculative positions by taking buy-side position in USD/INR expecting depreciation of local currency, INR against the USD and making gain for the firm.
The above is an example of how currency markets are used to speculation arising on account of exchange rate fluctuation and is often entered into by Investors, Companies and Financial Institutions such as Banks and Investment funds.
Advantages of the Currency Market
Some of the advantages are as follows:
- They bring in the liquidity of money and enables huge volumes of trade to happen which provides ample source of employment and profits for various business.
- They are so huge that no single entity can impact and there is a seamless flow of information that makes the currency markets highly efficient.
- It is necessary to make foreign investments as it allows the currency to be converted into local currency for investment in the business of the country in question.
- It enables the different currency to be priced in relation to other currencies and a usually stronger currency is characterized by strengthening the economy.
- Currency Market enables multinational corporations that engage in cross border transactions to hedge the risk of their future receipts and payments denominated in foreign currencies.
Disadvantages of the Currency Market
Some of the disadvantages are as follows:
- They are controlled by the respective governments of the local currency and central banks of local countries engage in forex transactions to affect exchange rates in accordance with government policy resulting in violent exchange rate movements. For instance, Central bank of any country, can decrease the supply of its local currency and increase its price in terms of other currencies by selling foreign reserves such as a large amount of gold and foreign currencies
- They increase various risk, out of which the most prominent is counterparty risk as the currency market is an international market and failure of one counterparty can impact a whole lot of other counterparties.
- Due to the sheer size of currency markets, they are largely unregulated despite any number of measures being taken by the local government of each country.
- They are high leverage trades and big Institution, Hedge fundsHedge FundsA hedge fund is an aggressively invested portfolio made through pooling of various investors and institutional investor’s fund. It supports various assets providing high returns in exchange for higher risk through multiple risk management and hedging techniques. bet heavily in these markets which make them prone to failure and closure in case their bets went wrong.
Important Points to Note about Currency Market
- It comprises two sides: Buy-SideBuy-SideThe term "buy-side" refers to entities that advise their clients like individual investors and institutional buyers on investments and securities purchases. Private equity firms, mutual fund companies, life insurance companies, unit trusts, hedge fund companies, and pension fund entities are examples of buy-side firms. which consists of buyers of foreign currencies and forward FX contracts and sell-side which consists of primary dealers in currencies and originators of forwarding foreign exchange contracts such as large corporations.
- Due to the different time zones and geographical distribution of forex centers dealing in various currencies in different centers of the world, it is more difficult to perceive, predict and forecast about the exchange and interest rates that move currencies in the currency market.
- Currency Markets deals with different currencies and these currencies are hugely impacted by the fundamental factors such as the balance of payments formulaBalance Of Payments FormulaThe formula for Balance of Payment is a summation of the current account, the capital account, and the financial account balances. The term balance of payments refers to the recording of all payments and obligations pertaining to imports from foreign countries vis-à-vis all payments and obligations pertaining to exports to foreign countries. It is the accounting of all the financial inflows and outflows of a nation., expected economic growth rate, fiscal policy by the governmentFiscal Policy By The GovernmentFiscal policy is a government policy that is used to control a country's finances and revenue, and it includes various taxes on goods, services, and individuals, i.e., revenue collection. It has an impact on spending levels, so it is referred to as monetary policy's sister policy. of the country, the autonomy of the central bank in implementation of monetary policy and interest rate environment in general which makes once currency depreciateCurrency DepreciateCurrency depreciation is the fall in a country’s currency exchange value compared to other currencies in a floating rate system based on trade imports and exports. For example, an increase in demand for foreign products results in more imports, resulting in foreign currency investing, resulting in domestic currency depreciation. or appreciate against other currencies.
It is an important market and plays an indispensable role in the exchange of currency from one country to another. The successful integration of the world and free flow of trade is possible due to the flourishing currency market which enables buyers of goods and services and sellers of such goods and services to convert their foreign exchange receipts/payments into local currency. Currency Markets involves Traders, Speculators, Arbitrageurs, Investors, Banks/FI and corporations, etc and together they make the currency markets highly efficient and liquid.
This has been a guide to what is currency market and it’s a definition. Here we discuss examples of foreign exchange markets along with advantages and disadvantages. You can learn more about financing from the following articles –