Many of us have the misconception that the forex market involves complex financial transactions and are best left to experts. However, it is actually quite simple if you get down to the basics. When you buy a product or service in the US, you use dollars to make your purchases. Similarly, when you purchase another currency, you ‘pay’ with, say dollars. How many dollars you pay for any currency depends on the ‘demand’ for that currency, and this usually fluctuates within a range in the current scenario. The rate for any currency expressed in terms of another currency is called the exchange rate.
Why Do People Need to Buy Other Currencies At All?
Today, international trading in goods and services has become an important part of almost all economies. Goods and services produced in one country are satisfying consumers in another. However, payment for these necessarily involves trading in currencies.
For example, say you buy a piece of Egyptian cotton cloth. Sitting in the US, you probably get it cheaper than some varieties produced in the US as the product has been manufactured using cheap labor and raw materials in the country of origin.
The money you are willing to pay (in dollars) is useless to the producer because he cannot use it in his country or anywhere else, except in the US. As the simplest solution, you pay him in Egyptian Pound (EGP) if you knew the exchange rate (how many USD per EGP). This is why, on a larger scale, countries, banks and other entities trade in currencies – to facilitate trade.
Prior to the World War I, international practice was to follow the gold standard, which means the unit of each currency was defined as a standard weight of gold. The Bretton Woods Conference, following World War II, had 44 nations signing an agreement to have ‘par values’ of currencies with the approval of the IMF, and maintain it within a range of 1%. Today, most countries have adopted a floating exchange rate system, which means the exchange rate of a currency is decided by the demand and supply for it in the market.
The forex market or the foreign exchange market is where the trading of currency takes place. Different participants in the market include banks and financial institutions, currency speculators, corporations, governments and other institutions.
The ‘buying’ and ‘selling’ rates in the forex market are different. This means that if you are ‘buying’ say, a pound sterling, you have to pay more dollars at a given point of time than you would receive if you were selling it. The difference is the commission.
Again, the buying and selling rates vary over different periods. If you buy when the price is low and sell the same currency when it appreciates, you make a profit. Just like equity, but in reality, easier to handle. Let us see why the forex market actually easier to handle than equity or shares trading:
• It is genuinely open round the clock; you don’t have to wait for the opening and closing bells in the respective exchanges in the different countries.
• Most of the transactions are in the 6-7 major and stronger currencies or which are more in demand such as the US Dollar, Pound Sterling or Japanese Yen, to name a few. You need not keep track of thousands of corporate players and the different factors affecting them to spot opportunities.
• You can ‘go short’ in the w, wthat is, sell before you have bought if you expect prices of a currency to fall. Short selling is restricted by law in equity trading.
Given the advantages of trading in foreign exchange, many private individuals are participating in the forex market to make quick and easy profit. However, you would be well advised to do a bit of research and simulated activity before you get actually involved in forex trading.