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currency exchange and the forex market

Currency Exchange & the Forex Market

Not too many people ask themselves what the difference between currency exchange and the forex market is, even less can answer it. The topic is not as complicated as you might think. Once you have a clear understanding of the market, its workings, and the terminologies, it will be clearer to you. 

To get to this point of understanding we will answer some questions like:

  1. What is currency? And why is it different from money as we know it?
  2. What is an exchange or a currency exchange?
  3. Are the Forex market and currency exchange the same?
  4. How do we interact with them and why is it important?

Once we break these questions down, you will have a basic understanding of Forex, currency, and money. After that, we will give you a few examples to finish off.

What is currency? And why is it different from money as we know it?

In simple terms, currency is a form of money. Currency falls under the category of fiat money. This means that select intra-national and international institutions are in charge of monitoring currency. Value comes from the collective perception of usefulness for currency, or any other form of money. A value that is influenced by each government’s monetary policies as well as political and social events. 

  1. Money is something intangible. A concept of value that manifests itself in different ways. Currency is a manifestation of money.
  2. Currency is ONE medium through which money becomes live
  3. Money is a medium of exchange accepted by the general public. In a barter economy, any desired goods are a form of money. As we can see now with the cryptocurrency revolution, digital forms of money are becoming more and more relevant. 

In other words, currencies are different manifestations of money as accepted by the public. Crypto is a kind of currency, the dollar is another type of currency. Both are forms of money.

Now that we know what’s the difference between money and currency. We can know how we interact with it and where.

What is an exchange or a currency exchange?

Buying or selling things in return for another is a trade. The place where it happens is referred to as an exchange. Therefore, markets are exchanges.

A physical or digital marketplace where securities, commodities, derivative contracts, and other financial instruments are traded is a financial exchange.

In conclusion currency exchange is a place where currency trades or transactions take place.

Differences between currency exchange and forex exchange

Many years back I went to an overseas holiday destination. In my first trip abroad I had very little knowledge of what it would be like for me in a different country.

Few things were clear to me. I needed a visa to travel abroad, my luggage and most importantly I needed the local currency which I had to carry with me when I reached my destination.

This is when I had my first encounter with currency exchange. To change my currency I had to go to a currency exchanger which is a licensed entity to carry out this conversion.

Also, I needed to know the location of the exchanger. The easiest way to find one is to go to an airport where you have physical currency exchange points. This exchange takes place at the currency exchange counter.

Few points one must remember:

  • Currency exchange can take place at physical locations such as banks, airports, at licensed exchangers in your location, as well as unlicensed exchanges such as when you purchase a burger at McDonald’s in some countries.
  • These exchanges will charge you exchange fees and commissions over the exchange rate or in the case of McDonald’s simply a very poor exchange rate.
  • The exchange rate is the rate at which one currency can be changed with another currency. E.g. the interbank exchange rate of 74 Indian Rupees to 1 United States Dollar. Means Rs.74 will fetch me $1.

This is at the nominal rate, but if we deal with an exchanger this same transaction will have fees or commissions. This means there will have some difference in the buying and selling rate which is known as the real rate.

So coming back to my experience I had to get my currency exchanged with another country’s currency if I had to travel there. But that was not the only issue; the trip was planned for 3 months in the future.

This means I had to worry about the future price of both the currency as any appreciation or depreciation in this would mean I might get more on conversion or less on conversion at that time. So how could I mitigate the loss if any at the future price?

And that is how I got introduced to the world of Forex and FX trading.

A Currency market or Forex (FX) exchange is a worldwide electronic marketplace for trading international currencies and currency derivatives. Currency derivatives can be future or forward contracts. These are traded in the centralized exchange whereas the other forex market is decentralized and is traded in the over the counter( OTC) market.

We will get into details of this market later. So to protect against price changes during the currency conversion I had to understand the basics of the market and how to trade in it. This turned out later to be my career choice.

The price of Rupees then was 50Rs per 1$ which means if the price of US dollars were to increase I would have to spend more Indian rupees to get the same amount of USD. For eg: I needed $10,000 during my travels which then would have cost me Rs500,000.

Assuming that the USD price would appreciate after 3 months to say 52R this means there would be an additional increase of 2R on the exchange price at that time. This would cost me 520000-500000=Rs20000($400) more on the future date.

As I learned about trading and different markets I realized that there are different ways to mitigate this future loss. Some of them are as follows

  1. Forward currency contracts.
  2. Currency options
  3. Contracts for difference (CFDs)

We will discuss the easiest way that is used for trading

Trading in CFDs

A CFD is a derivative which means it gets its value from its underlying asset. Which in this case will be from the exchange price or from banks? The trader is not required to own the currency as the agreement is for the exchange of value related to the difference in the price of the asset.

Related: How to Trade CFDs

When you buy or sell CFD’s the market price can move in any direction which could make you a profit if it moves in your direction or a loss if it goes against your direction. Since CFDs are leveraged products, they don’t require a large portion of funds to enter a trade.

All I had to do then was to open a trading account with a Forex broker and opena buy trade in USD/INR with a small  amount so that I could cover the difference that might arise and do the settlement later.

There are other ways in which you can mitigate your risk as mentioned above, trading in currency futures or options. But we will discuss these sometime later. As of now let us understand what forex trading is.

Forex is a 24 hr market open 5 days a week. Unlike stock exchanges where you have limited trading hours. We use the term FX to mean foreign exchange. There is no physical settlement in the FX market as it is done over the currency exchange counter.

The Forex market is the largest and the most liquid market in the world having daily trading volumes over $7 trillion. The major participants in this market are banks, financial institutions, hedge funds, brokers, multinational corporations and retail traders.

Some key points for the FX market are:

  1. Trades are done in currency pairs. Eg; EUR/USD
  2. The buying price and selling price are more commonly known as Bid and Ask price.
  3. The difference in the Bid and Ask price is the Spread which is a cost of the transaction.
  4. The FX brokers may also charge commission depending on their account type offer for trading.
  5. Traders can trade in different lot sizes ranging from micro (1,000 units), mini (10,000 units), and standard (100,000 units).
  6. The trade settlements are done on a real-time basis.
  7. As brokers offer different levels of leverage the margin amount required to trade in these instruments is generally lower when compared to other financial instruments.
  8. Brokers offer Demo accounts that give traders access to the market and the ability to practice before trading any real funds.

To understand the risk and reward of the FX market I urge you to download a Demo trading account and test your trading skills.