Basic Terms Related to Forex and their Meaning
Forex basically means trading on currencies. Most currencies in the world are constantly changing, albeit in small measure.
Forex bankers usually buy large amounts of a currency and then sell it when it becomes more expensive. Such trading is usually on a large scale as the changes in currency value are quite small. Like the stock market, the forex industry is not free of risk either. You have no way of telling which way the currency is going other than taking educated guesses. Returns are not assured.
There is no fixed price for a currency. It’s price depends where its being traded and against which currency. For example, traded against the euro, the rupee trades at around 57 per euro. At the same time, the rupee trades at around 48 for a dollar. Hence the rate varies from market to market.
The following are some common terms associated with forex trading. I have tried to explain a bit so you not only know what the term means, but also how and why it exists so you have a better understanding of forex trade.
- Bid – You bid when you want to buy a particular currency at a particular price.
- Ask – You ask when you want to sell a currency you are holding. An ask is basically informing people you are selling.
- Liquidity – Liquidity means how easily a currency can be converted into another currency of your choice. Liquidity directly depends on the number of buyers and sellers for the currency. If there a high number of sellers and low amount of buyers, then the currency is not very liquid as it’s tough to find a buyer for your currency. Alternately, if there are a large number of buyers for limited sellers, liquidity is high. However, it is preferred that there are approximately equal number of buyers and sellers.
- Trading volume – Trading volume refers to the number of transactions that have taken place. It means the total number of times the currency has been traded. High volumes indicate high liquidity.
- Bid/ask spread – This refers to the gap between the price that has been quoted and the price it has been actually sold at.
- OTC – Almost self explanatory, it means over the counter. It’s a simplified form of banking that is very fast, allowing quick transactions to take place.
- Exchange rate – Exchnage rate refers to the value of one currency versus another. For example, if the rupee trades at 48 for a dollar, the exchange rate of the rupee versus the dollar is 48. Similarly, if 1 euro fetches 1.25 dollars, the exchange rate is 1.25.
- Hedge funds – These are banks which operate large mutual funds which are able to change the value of currencies just by predicting what direction the currency will take in the future (speculation).
- Central bank – It is the state run bank of a country which decides the value of a currency. In most countries today, a floating exchange rate is maintained. This means that the value of a currency is determined by the forces of demand and supply rather than by the bank itself. It however, retains the power to fix the value of the currency if needed. It is mainly fixed only when the value of a currency appreciates or depreciates to a large extent. This entails very expensive imports or very expensive imports and needs to be reigned in. In such a case, the central bank fixes the value of the currency till external factors settle down.
