Introduction to currency markets

Have you ever tried to buy something off eBay? Or Macy’s? Or even Amazon.com? What’s common between all of these sites? Well, they sell products, of course. But there’s another common thread – they all show products listed in USD. Right? Say you’re browsing through Amazon.com and you spot a pair of cool headphones. The price tag reads $40. You think that’s a steal, but when you head to the checkout counter, you realize $40 is not that economical. After all, it’s not 40 units of currency as such. It’s 40 in USD, but when you, residing in India, decide to pay for it, you need to shell out approximately Rs. 3,000. 

Whoa! That escalated quickly, right?

So, why did $40 become Rs. 3,000? That’s because of the exchange rate between the Indian currency and the American currency. And this rate plays a key role when you trade in currency. It’s this rate that traders in the currency markets use to make profits. And it’s because of this that currency trading in India and the world always occurs in pairs – you pay in one currency for another. In other words, currencies are traded like goods here. But it wasn’t always like this. Way back in time, centuries ago, there were no currencies. Let’s take a peek into history before we revert back to the currency markets of today.

The history of the currency markets

The earliest known form of trade was the barter system. Let’s begin there.

Phase 1: The barter system

Initially, people traded goods for other goods. For instance, a farmer with bales of wheat would sell them for cattle. Or a weaver would sell sewn clothes in exchange for vegetables. But there were many problems with this system. Equating goods against one another, transportation, and divisibility were all cumbersome.

Phase 2: Goods for metal system

So, to make this easier, the barter system was replaced with a method where people exchanged goods for metal. Copper, iron, and even aluminium were sold in return for products. But the most popular metals, of course, were gold and silver. Their popularity eventually made them the standard metals for which products were sold. This eventually led to a tradition wherein people deposited gold or silver in safe spaces that provided a paper in return – with a value proportionate to the amount of gold or silver deposited. Sounds like the banks of today, right?

Phase 3: The gold standard system

As the years passed, trade flourished as intercontinental and international movements picked up. Now, there was a huge dilemma – the need for a currency that could be accepted globally, across all borders. By the latter half of the 19th century, it became a common practice to value the local currency against gold. This is what was known as the gold standard system. 

Phase 4: The Bretton Woods system

This system prevailed between the 1940s and the 1970s. It essentially required that all the currencies in the world would be valued against the USD. And the USD itself would be pegged against the yellow metal. This paved the way for easier exchange of international currency.

Phase 5: The market-driven approach

But when the Bretton Woods system also collapsed in the 1970s, the market, as always, took over. Today, like everything else, market forces determine the value of one currency against another. And looking back at what history tells us, this system appears to be the most stable of all the mechanisms we’ve had so far. It ensures that the currency markets function efficiently, round-the-clock.

Let’s learn more about the currency markets and how to trade currency.

What are currency markets?

Also known as the forex market, the currency markets are where traders trade in currencies. Unlike most other financial markets, which primarily include institutional and individual investors, the currency markets comprise multiple players. Here’s a quick preview of some common transactions that occur in the forex market.

• A traveller who’s planning to visit France from India gets his Indian rupees converted to Euros.
• An online shopper located in America wants to buy spices from India, so he converts his USD to INR to pay for his purchase.
• Central Banks across different countries often convert huge sums of local currencies to foreign currencies with regard to their reserves or their lending schemes. 
• Traders take advantage of currency pair movements and attempt to make profits. 

Characteristics of currency markets

Currency markets are marked by several distinct characteristics, many of which set them apart from the other financial markets we’ve seen so far. Let’s get to know the forex market better by learning about their defining characteristics. 

1. Unregulated, over-the-counter markets

As we’ve seen the share market and the derivatives markets are all exchange-regulated markets. But the forex market has no central marketplace like an exchange. This means that forex market trades and transactions are conducted electronically over-the-counter, through computer networks between traders and transacting parties located at various parts of the world

2. Maximum liquidity

The currency markets include players of different kinds - individuals, companies, banks and other financial institutions. So, naturally, the volume of trades that occur in this market is also significantly higher. Statistics show that the forex market records over $5 trillion dollars of currency being converted each day. How huge is that! And because of this kind of volume, there’s a great deal of liquidity in the forex market. In fact, it’s the most liquid financial market.

3. High level of volatility

So, with the volume of trades being so high, it naturally follows that every minute, there are billions of dollars being converted in the forex market. And what does that lead to? Yes, it results in a high level of volatility. Price trends can move in either direction, and they can move swiftly. This can be either a boon or a bane for traders who speculate on price movements. With the right trade, there’s the possibility of reaping huge profits. But the high degree of volatility also means that the markets can turn direction anytime. That’s why it’s necessary to limit your exposure to risk in the forex market. 

4. Trades that happen in pairs of currencies

As you’ve already read earlier,  currency trading in India and the world always occurs in pairs. In the USD-INR currency pair, for instance, the USD is the base currency (that you buy) and the INR is the quote currency (that you sell). So, when you’re buying the USD-INR pair, you’re actually buying the USD and selling the Indian rupee. Conversely, when you’re selling the USD-INR pair, you’re selling the USD and buying the Indian rupee.

5. An array of derivative products

The forex market offers traders and speculators a wide range of derivative products to choose from. To be more specific, you can trade in forwards, futures, options, and currency swaps in these markets. While futures and options are the most popular instruments, forwards and currency swaps can prove to be useful for traders who wish to hedge their positions and limit their losses.

6. Open 24 hours 

This is another definition element of the forex market. It’s open round-the-clock, 24 hours a day, for five and a half days a week. During this period, currencies are traded across the world in a number of the major financial centers in London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and Sydney. Notice how these cities are all located across different time zones. This is why the forex market appears to be always active. For instance, when the trading session in the U.S. comes to a close, the forex market opens for a new day in Tokyo and Hong Kong. 

Wrapping up

See how the forex market is quite different from the other financial markets we’ve seen so far? And just like their distinct features, they also use a set of jargon and terms that you’ll benefit from learning about before venturing into the detail of how to trade currency. That way, you can better understand how these markets work, and you can decipher related literature easily. In our next chapter, we’ve ventured to explain some such important terminology. 

A quick recap

• The earliest known form of trade was the barter system, where people traded goods for other goods.
• But there were many problems with this system. Equating goods against one another, transportation, and divisibility were all cumbersome.
• So, to make this easier, the barter system was replaced with a method where people exchanged goods for metal.
• Copper, iron, and even aluminium were sold in return for products. 
• By the latter half of the 19th century, it became a common practice to value the local currency against gold. This is what was known as the gold standard system. 
• The Bretton Woods system prevailed between the 1940s and the 1970s. It essentially required that all the currencies in the world would be valued against the USD. And the USD itself would be pegged against gold.
• But when the Bretton Woods system also collapsed in the 1970s, the market, as always, took over. Today, like everything else, market forces determine the value of one currency against another.
• Also known as the forex market, the currency markets are where currencies are traded. Unlike most other financial markets, which primarily include institutional and individual investors, the currency markets comprise multiple players.
• Currency markets are unregulated, over-the-counter markets.
• They’re the most liquid financial markets and they also see a high level of volatility.
• The markets are open round-the-clock and currencies are traded in pairs.
• The forex market offers traders and speculators a wide range of derivative products to choose from. To be more specific, you can trade in forwards, futures, options, and currency swaps in these markets.