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Things to know about the Forex trade

Currency is an important part of the daily life of an individual, an organization, a country, or the world at large. The essentials are bought and sold with the aid of currencies. When a trade happens between countries, currencies need to be exchanged between the countries involved to facilitate the payments in this foreign trade and business. If for example, an importer from the US has to buy goods from Japan, he cannot pay the Japanese in US dollars. Similarly, a Japanese traveling in Thailand cannot use Japanese Yen to pay for his local food and boarding. The US importer would have to pay locally usable Yen to the Japanese, while the Japanese tourist would have to pay an equivalent amount of Thai Baht. The value of a currency will vary from one country to another. To facilitate this conversion of currency, an exchange rate is set which is commonly called as foreign currency exchange rate or Forex rate.

The need to carry out business between countries has led foreign currency trading to become a marketplace in itself by facilitating the exchange of one currency into another. This helps multinational corporations to continually trade currencies for payroll, costs of goods and services, acquisitions, mergers, etc. among other business-related activities. However, Forex has grown beyond just the day-to-day corporate needs and seen as a place for investment by both individuals and financial institutions. Today, over 80% of foreign currency trading is controlled by large financial institutions, multibillion-dollar hedge funds, and wealthy individuals whose economic and geopolitical events of the day impact the forex market. All this makes foreign currency trading, the largest financial market in the world dwarfing all other markets in size.

No limits are put on the types of currencies that can be traded. The only thing to be noted is that foreign exchange happens in pairs (two types of currencies: one to be exchanged for the other). Although some retailers trade foreign currencies, there are seven currency pairs considered to be the most liquid in the world. They are as follows:

Four major pairs: USD/JPY (dollar/Japanese yen), EUR/USD (euro/dollar), GBP/USD (British pound/dollar), and USD/CHF (dollar/Swiss franc).
Three commodity pairs: USD/CAD (dollar/Canadian dollar), AUD/USD (Australian dollar/dollar), and NZD/USD (New Zealand dollar/dollar).

Around 18 pairs and crosses are actively traded by various combinations made with the above seven currency pairs. This accounts for more than 95% of the speculative trade involving forex making it seem to be more concentrated than the stock market.

The forex market is open all day, five and a half days a week, i.e., from 5 pm Sunday to 4 pm Friday. This international market does not have any metrics or a centralized marketplace for foreign exchange. Foreign currencies trading happens worldwide, in major financial centers of London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris, and Sydney in almost all the time zones. Currency is traded electronically over-the-counter (OTC). This means that traders can be anywhere from across the world working at any time zones rather than all working toward one standardized time zone or place. So, when the counter closes in the west, business would just start in the east. Hence, the forex market is active any time of the day with exchange rates changing constantly.

Unlike the stocks, futures, and options, the rates for foreign currency trading are self-regulatory. The trade entirely depends on mutual credit agreements between the participating members who need to compete and cooperate with each other to provide effective control over the market. Also, forex is a principals-only market with no commissions. The foreign currency trading firms are dealers who earn through the bid–sell spread and not brokers who take a commission for facilitating a transaction between two parties. These dealers serve as a counterparty to an investor thereby taking the market risks on them.

Some important terms used in foreign currency trading:
Percentage-in-Point (PIP): This is the smallest increment used in forex trade. Prices are quoted to the fourth decimal point, and the change in a decimal point is called 1 PIP. It is mainly equal to 1/100th of 1%. However, Japanese Yen is an exception among the major currencies. In the USD/JPY pair, for example, the price is quoted is to only two decimal points, i.e., to 1/100th of Yen contrary to 1/1000th with other major currencies.
Currency carry trade: The carry trade depends on the fact that every currency in the world has a short-term interest rate attached to it that are set by the central banks of those countries (The Federal Reserve for the US dollar, the Bank of Japan for Yen, the Bank of England for a pound, etc.). The trader goes with a currency having a high-interest rate to finance his purchase with a currency with a low-interest rate giving him maximum return just with the differentials in the interest rates. The capital appreciation is not considered for such a trade.
Spot market: With the advent of electronic trade, spot market has become the most preferred for forex trading as this more real time. The trade works with the current market value of forex at any given point of time which depends on several factors like supply and demand, interest rates, economic performance, geopolitical situations (locally and internationally), and the prediction of the future performance of a currency pair.

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