Currency markets are the most liquid and deep financial markets in the world. The highest amount of trading both by volume and value takes place in the currency markets. Unlike equity markets, a unique feature of the currency markets is that it is a 24 hour market. This is because business hours in various financial centres around the world overlap which makes it possible to trade currencies at virtually any time. For example, between the four largest financial exchange centres, i.e., Tokyo, Singapore, London and New York, one of the four, if not more, is open for business at any given time and any currency (pair) can be traded in either market.
Currency trading is becoming extremely popular in India. Big financial institution and small traders alike, trade currencies on various exchange platforms. The depth of these markets is such that the exchange rates of major currencies are virtually the same in all markets at any given time and there hardly exists an opportunity to arbitrage (i.e. buy in one market and sell in another with a view to earn a price difference).
I do not want to dwell too much into how currency markets work – for two reasons. First, unless you want to actively start trading currencies, it will be of no help. Second, the subject is so vast that a write-up on it could turn into many pages; I am not ready to start that project as yet. Nevertheless, given how economies are coming close to each other, I think it is important to know currency trading basics.
Why have exchange rates for currencies?
If exchange rates remain stable, business can be conducted across borders without worrying about the value of local currencies. However, this is not the case. Currencies around the world constantly appreciate or depreciate against foreign currencies based on many factors such as local countries imports, exports (i.e. balance of payments) and other factors which cause accumulation and/or outflow of foreign currency. For this reason, currency rates serve as a major economic indicator highlighting the health of a nations economy.
Take the Example of an Indian Company (“IndCo“) which makes an order to buy 1,000 Kg of American almond for US$ 550. The consignment is to arrive in a period of 1 month. On the date of placing the order USD/INR exchange rate was @ 52.50 (Cost = Rs. 28,875/-). Let’s assume that over the period of one month (before the company makes the payment for the order), the US$ appreciates to 53.50 against the INR. This will increase the cost by Rs. 550 (to Rs. 29,425/-). To avoid this situation, the IndCo can hedge its position against an appreciation of the US$.
In currency markets, hedging typically works as an insurance where you pay a small premium and in return you get the right to buy the foreign currency at a given price on a future date. In our example above the IndCo could hedge its position by buying a right to purchase the US$, at today’s rate of USD/INR @ 52.50 in a month from now by paying a small premium. For exporters, who expect to receive US$ denominated payments in future and are worried that the dollar will depreciate over that time, thus making them earn less, the strategy would be the reverse, i.e., they will pay a premium to sell the dollar at today’s price on a future date.
Apart from hedgers who have an interest in the underlying business/transaction and undertake currency trading to avoid foreign exchange volatility risks, currency market participants also include arbitrageurs and speculators, who do not really have any economic or business exposure but trade currencies with a view to earn money based on price differential or price swings between different currencies.
Reading Currency Quotes
Each currency has a unique 3 letter symbol known as currency ISO code given by the International Organization for Standardization. The ISO code for Indian national currency is ‘INR’ (Indian Rupees).
Currency pairs are in the form of a six letter symbol, represented by two 3-letter symbols. First 3 letters in the pair represent the Base Currency and the next three represent theQuote Currency (also called terms currency).
The currency pair quotes indicate – How much of quote currency will 1 unit of base currency translate into, or in other words, it shows the amount of quote currency needed to purchase one unit of base currency.
For Example, the quote of US$ versus the Indian Rupees will be stated as:
This notation indicates that 1 US Dollar is equal to Rs. 55.30. In other words you have to pay Rs. 55.30 to buy 1 US Dollar.
Majors, Minors and cross-currency calculations
The currency pairs which generate high trading volumes are called the ‘Majors’. Six currency pairs are generally considered major currency pairs. These are:
Euro vs. US Dollar (EUR/USD)
US Dollar vs. Japanese Yen (USD/JPY)
British pound vs. US Dollar (GBP/USD)
Australian Dollar vs. US Dollar (AUD/USD)
US Dollar vs. Canadian Dollar (USD/CAD)
US Dollar vs. Swiss Franc (USD/CHF)
EUR/USD accounts for almost 28 % of the daily trading volume in the currency markets followed by USD/JPY which accounts for almost 14%.
All other currency pairs are called ‘Minors’, for example USD/INR (US Dollar vs. Indian Rupee) or a ‘Cross Currency Pair’ such as INR/MXN (Indian Rupee vs. Mexican Peso).
Cross currency pairs
Cross currency rate calculation is necessary when the base currency and the quote currency rate are not quoted by FOREX dealers or banks. For example, if an Indian company imports tobacco from Mexico and has to make a payment in Mexican Peso (MXN), the Indian Company will have to undertake two separate transactions:
Transaction 1 – Sell the base currency (i.e. INR) for US$
Transaction 2 – Sell US$ for the quote currency (i.e. MXN)
This is because FOREX dealers or banks may not provide a direct quote for INR/MXN. As you can see, the US$ here acts as the vehicle currency for the transaction.
In practice, cross currency pairs are always calculated by using a vehicle currency. The US Dollar is currently the main vehicle currency.
So a quote which reads GBP/INR 91 is in reality calculated by first selling the GBP for US Dollar and then selling the US Dollar for INR. This is the ideal way of calculating the exchange rates because the GBP/USD market and the USD/INR markets are more widely traded (in comparison to the GBP/INR market) and have much better information availability which makes it easier for FOREX dealers and banks to focus their research on the US Dollar. Additionally, this approach helps them in limiting the number of currencies they hold.
 This is done by using currency future contracts. In our example above the USD/INR spot exchange rate was @ 52.50. If this spot exchange rate remains unchanged after one month, the IndCo will have to pay Rs. 28,875/- to buy US$ 550 to pay for the almonds. However, as we see in the example, if the exchange rate changes to USD/INR 53.50, then the IndCo will have to pay more. Naturally, IndCo would want to keep itself protected from any adverse currency movements.
To do so, IndCo will enter into a futures contract to buy US$ 550 at Rs. 52.50 and lock-in the future cash outflow in terms of INR. By doing this, no matter what the prevailing spot market price be (after one month), IndCo’s liability is locked in at INR Rs. 28,875/- and the company is protected against adverse foreign exchange rate movement.
Note: In reality, this will work as a two transactions, first, where IndCo will pay the seller (of almonds) @ 53.50 and second, where it will buy US$ @ 52.50 and sell it in the open market at the spot price of 53.50. In the first transaction IndCo will suffer a loss of Rs. 1,000 on account of adverse exchange rate movement and in the second it will profit by Rs. 1,000.
About the Author
Rajat Sharma is a well known stock market analyst and commentator. He has covered Indian markets for over a decade and is regarded for consistently identifying early stage investment opportunities. Attorney by qualification, Rajat has done extensive work for improving corporate governance and disclosure standards.Follow @SanaSecurities