____________________________________________________________________________________________________ Subject BUSINESS ECONOMICS Paper No and Title 9, Financial Markets and Institutions Module No and Title 35, Trading Procedures in Forex Markets Module Tag BSE_P9_M35 BUSINESS PAPER NO.: 9, FINANCIAL MARKETS AND INSTITUTIONS ECONOMICS MODULE NO.: 35, TRADING PROCEDURES IN FOREX MARKETS ____________________________________________________________________________________________________ TABLE OF CONTENTS 1. Learning Outcome 2. Introduction 3. Foreign Exchange Market 3.1 Forex Trading 3.2 Currency Pairs 3.3 Two Trade Opportunities 3.4 Currencies Traded in Forex Market 4. Pips, Lots and Leverage 4.1 What is a Pip? 4.2 What is a Lot? 4.3 What is Leverage? 4.4 How do Pips, Lots and Leverage work together? 5. Steps in Forex Trading 6. Arbitrage in Forex Market 6.1 Meaning of Arbitrage 6.2 Arbitrage Strategies in Forex Market 6.2.1 Case 1 6.2.2 Case 2: Arbitrage in Forex Futures Market 7. Government Intervention in Forex Market 7.1 Reasons for Government Intervention 7.2 Types of Government Intervention 7.2.1 Direct Intervention 7.2.2 Indirect Intervention 8. Foreign Exchange Reserves 9. Summary BUSINESS PAPER NO.: 9, FINANCIAL MARKETS AND INSTITUTIONS ECONOMICS MODULE NO.: 35, TRADING PROCEDURES IN FOREX MARKETS ____________________________________________________________________________________________________ 1. Learning Outcomes After studying this module, you shall be able to - Gain an insight about the foreign exchange market and how trading is carried out in this market. Understand the process of forex trading. Analyze the meaning of arbitrage and the various arbitrage strategies used in the forex market. Explain how governments use direct and indirect intervention to influence exchange rates. 2. Introduction When we travel abroad, we have to exchange our domestic currency for that of the country we are visiting. For this purpose, we make use of exchange rates. An exchange rate is the rate at which one country’s currency can be converted into another. Exchanging currencies isn’t just for travelers. The price difference is something you can trade. In the global economy, thousands of business transactions take place every day that require organizations to exchange the value of one currency for that of another. When a United States automobile manufacturer buys steel from Japan, he needs to convert dollars to yen to make the payment. In every exchange, prices need to be adjusted because one currency is typically weaker (has less value) while the other is stronger (has more value). A decline in a currency’s value is referred to as depreciation. Similarly, an increase in a currency’s value is referred to as appreciation. For example- Yesterday, the exchange rate was $1= ₹60 Suppose, today’s exchange rate is $1= ₹62 This means that the rupee has fallen in value (depreciated) and the US dollar has risen in value (appreciated) because now you have to pay more rupees to purchase same amount of dollars. Throughout the course of the day, the value of one currency compared to another can change in response to political news, economic conditions and interest rate changes. These frequent changes in the value of currencies drive forex trading and a trader’s profit potential in the currency markets. BUSINESS PAPER NO.: 9, FINANCIAL MARKETS AND INSTITUTIONS ECONOMICS MODULE NO.: 35, TRADING PROCEDURES IN FOREX MARKETS ____________________________________________________________________________________________________ Let us understand two important trends in the market- 1. Bull market- A bull market is a market in which prices are rising or are expected to rise. It is characterized by optimism and investor confidence. Bull markets offer investors opportunities to earn profits by buying financial instruments at a lower price and closing their position by selling at a higher price. 2. Bear market- A bear market is a market in which prices are falling or are expected to fall. It is characterized by pessimism and continuous selling which further pushes down the prices. Bear markets offer traders opportunities to sell at a higher price and close positions by buying at a lower price. In a bear market, traders sell to exit the market and minimize losses. Although, many financial products have restrictions on selling to capitalize on bear market opportunities, forex does not have these restrictions. 3. Foreign Exchange Market The foreign exchange market is very big. Unlike the stock and bond markets, forex market is open 24 hours a day and 5.5 days a week. It is the most traded markets in the world. In the forex market, one currency is always strengthening against another (bullish), and therefore, one currency is always weakening against another (bearish). Because of this, you have equal opportunity to buy or sell to enter the market. So, if the US Dollar (USD) is strengthening against the Indian Rupee (INR), it implies that the Indian Rupee (INR) is weakening against the USD. 3.1 Forex Trading In foreign exchange or currency trading, traders hope to generate a profit by speculating on the value of one currency compared to another. This is why currencies are always traded in pairs— the value of one unit of currency doesn’t change unless it’s compared to another currency. 3.2 Currency Pairs A currency pair tells us how much of the quote currency is needed to purchase one unit of the base currency. For example- CURRENCY PAIR A SAMPLE QUOTE FOR THIS PAIR EUR/USD 1.33820 The first currency listed is called the base So in this case, 1 Euro is worth approximately currency. The second currency is called the 1.33 USD. quote or terms currency. BUSINESS PAPER NO.: 9, FINANCIAL MARKETS AND INSTITUTIONS ECONOMICS MODULE NO.: 35, TRADING PROCEDURES IN FOREX MARKETS ____________________________________________________________________________________________________ 3.3 Two Trade Opportunities SCENARIO 1: BUY TRADE If a trader believes that the euro is bullish against the US Dollar, i.e. the euro is strengthening against the USD, then he/she may enter a trade to buy euros, expecting to gain from the stronger value of euro compared to the US Dollar. SCENARIO 2: SELL TRADE Conversely, if a trader believes that the euro is bearish against the US Dollar, i.e. the euro is weakening against the USD, then he/she may enter a trade to sell euros in the hope that the currency’s value will become weaker compared to the US dollar. 3.4 Currencies Traded in the Forex Market Traders can trade almost any currency depending on the currency pairs offered by the dealers. Although some retail dealers trade exotic currencies like the Thai baht or the Czech koruna, the majority trade the eight most liquid currencies in the world that are: 1. U.S. dollar (USD) 2. Canadian dollar (CAD) 3. Euro (EUR) 4. British pound (GBP) 5. Swiss franc (CHF) 6. New Zealand dollar (NZD) 7. Australian dollar (AUD) 8. Japanese yen (JPY) 4. Pips, Lots and Leverage 4.1 What is a Pip? Pip stands for "percentage in point" and is the smallest measure of change in a currency pair in the forex market. In the FX market, currency pairs display their prices with four decimal points. The change in that fourth decimal point is called 1 pip. Among the major currencies, the only exception is the Japanese yen which displays two decimal places. A pip is a standardized unit and is the smallest amount by which a currency quote can change, which is usually $0.0001 for U.S.-dollar related currency pairs, which is more commonly referred to as 1/100th of 1%, or one basis point. This standardized size helps to protect investors from huge losses. For example, if a pip was 10 basis points, a one-pip change would cause more extreme volatility in currency values. BUSINESS PAPER NO.: 9, FINANCIAL MARKETS AND INSTITUTIONS ECONOMICS MODULE NO.: 35, TRADING PROCEDURES IN FOREX MARKETS ____________________________________________________________________________________________________ Since a pip is a very small measurement unit, you may wonder how forex trading can be worthwhile by speculating on such a small fraction of a currency. The answer is that since forex is traded in large volumes, called lots, the pip value also gets multiplied. The higher volume you trade the more each pip will be valued. This will be clear after studying the following illustration: Suppose the USD/EUR direct quote is 0.9246.This quote means that for US$1, you can buy about 0.9246 euros. If there was a one-pip increase in this quote (to 0.9247), the value of the U.S. dollar would rise relative to the euro, as US$1 would allow you to buy slightly more euros. The effect that a one-pip change has on the dollar amount, or pip value, depends on the amount of euros purchased. If an investor buys 10,000 euros with U.S. dollars, the price paid will be US$10,815.49 ([1/0.9246] x 10,000). If the exchange rate for this pair experiences a one-pip increase, the price paid would be $10,814.32 ([1/0.9247] x 10,000). In that case, the pip value on a lot of 10,000 euros will be US$1.17 ($10,815.49-$10,814.32). When the same investor purchases 1,00,000 euros at the same initial price, the pip value will be US$11.7. As this example demonstrates, the pip value increases depending on the amount of the underlying currency purchased (in this case, euros). 4.2 What is a Lot? In forex, a lot is a standard unit of measurement. At most forex dealers, one standard lot usually equals 100,000 worth of currency. 4.3 What is Leverage? One of the benefits of foreign exchange market is the ability to trade on leverage.