Currency Market, Commodity Market, and Government Securities

Lesson -> The basics of Currency

1.1 - Module orientation

Let me start by giving you an overview of the module so you are able to set your expectations. This module will focus on three major topics.

  1. Currencies and currency trade
  2. Understanding Commodities
  3. Futures Interest Rate

Each of these topics are vast and each deserves its own module. These assets aren't as liquid as equities. The Indian market for these alternative assets is still in its infancy. This is why the idea behind this module would be to introduce you to these assets and familiarize you with their driving forces before you place your trades. In a sense, this module could be considered a "thought-starter" for trading alteanative assets. We will discuss these topics in sufficient detail to ensure you understand the basics.

The module will begin with a discussion on Currencies. We will discuss the most popular currency pairs in India, such as USD, GBP,INR and INR–JPY. Other currency pairs (not INR) are also discussed, such as EUR/USD, GBP/USD and USD/JPY. We will be discussing currencies in a number of chapters. This chapter would introduce the currency pairs and provide a basic overview of some factors that can affect them.

After this, we will move on to the next section of the module. This is the Commodities deal. This deal will follow a similar format - i.e. We'll use a similar template to introduce the commodities (both non-Agri and agri), and learn about not only the contract specifications, but also some fundamental factors that could affect the movement of these commodities. We'll discuss Gold, Silver, and Aluminum as well as Crude oil, Natural Gases, Turmeric. Cardamom. Pepper, Cotton, and others. We will also discuss the formula that determines the price of commodities such as Gold, which is determined by its price on international markets.

This module will also discuss "Interest Rate Futures" (IFR), which I find to be an interesting space. This discussion will cover topics such as RBI's borrowing patterns, issuances of sovereign bonds, NSE listing, and trading. We can touch on topics such as bond trading and strategies for bond trading depending on how we move.

We have some amazing stuff planned, as you can see. This will be an amazing learning experience for both you and me.

Note: This course requires.

  1. Futures Trading
  2. Options Theory
  3. Technical Analysis

Before learning about currencies, it is important to have a good grasp of the above topics. These topics should be reviewed before you move on to the next topic.

Let's begin this module with some basics about currencies.

1.2 - Currency

Let me tell you about an interesting conversation that I had with my 6-year old daughter before we start talking about currencies. This could be a good starting point to our discussion about currencies.

Recently, I was in Austria with my family for a vacation. The country is beautiful, as you can see. My daughter was astonished to be able to visit Europe for the first time. Needless to state, she was drawn to the tiny shops selling cute little things. One day, she forced me to go to a toy store that she saw on the street. I knew it was a bad idea. After scanning the shop for about five to ten minutes, she found a colorful wooden caterpillar and wanted me to purchase it. The caterpillar looked great, and I was ready to buy it until I saw the cost. The price for the wooden caterpillar was 25 Euros. I thought I would negotiate with her to buy her another item.

I tried to tell her it was 25 euros, which was quite high for a small wooden caterpillar. I explained my point clearly to her, but she refused to change her mind. She actually said "it's only 25 Euros", and I realized that she had equated 25 Euros with 25 Rupees. This was completely ignorant of the fact that each Euro must be multiplied by 78 to get the Rupee equivalent.

I was struck by this thought: Why isn’t one Euro or one Dollar equal to one Rupee? Is it possible for one currency unit to be different from another currency unit in country A? This may seem very simple, but some people may already know the answer. It is important to talk about this issue and understand the reasons for the inequalities between currencies. This is what allows us to trade currency pairs.

This is why it's important to understand the history of currency and how they evolved. You don't have to worry, I won't go into too many history lessons. Instead, I will just give a brief overview. Let me simplify this by breaking it down into stages based on how I understand the evolution of currency.

Stage 1 - The Barter Era

Transactions were made before the advent of currency. Barter is an ancient form of exchange that has been around for centuries. Barter is a trade in which people exchange goods or services for goods. One example is that a farmer could barter wheat for cotton by exchanging it with another farmer. A farmer could also exchange oranges with another farmer if he agrees to wash his sheep and cows.

Bartering was problematic due to its divisibility and scale. Let's say a farmer has 5 bales worth of cotton. He wants to barter with someone selling cattle. If he gets 2 bales for 1 cow, he would be left with 2 cows plus a bale. He wouldn't get half a cow in exchange for one bale of cotton. This created a divisibility problem within the system.

Scalability was another problem with the barter system. Our farmer had to travel across the country, bringing all his produce, to barter for the goods of his choice.

These issues were finally solved with an improved system, Goods for Metal.


Stage 2 - Goods and Services for the Metal Era

The barter system was plagued by problems, which eventually led to the development of the next type of transaction. Many people tried to find a common denominator that could be used for the exchange. There were many common denominators, from food grains to metals. Metals eventually thrived, for obvious reasons. Metal was easily divisible and mobile, and had a long shelf life. Gold and silver were also the most common metals. TThe use of these metals became the standard for transactions. It was possible to exchange goods directly for many centuries. However, things changed when people began to deposit silver coins in safe havens. They also issued a paper that represented the gold value. The value of this paper was derived from the gold/silver coin deposits in haven.

As time passed, safe havens became banks and paper was transformed into different currencies. This was perhaps the beginning of book-entry.

Stage 3 - The Gold Standard Era

As domestic trade flourished, so did trading across borders. Merchants realized that it was not economically sensible to produce everything locally. Cross-border trade was explored by merchants. Simple import and export of goods flourished. Merchants who transacted across borders had to pay in a currency that was accepted across borders. The banking system evolved and exchange of goods for Gold (not Silver) became the norm in the late 19 th century. The 'Gold Standard' was the method of valuing local currency against gold's value.

As the world progressed, geopolitical situations changed (world wars and civil wars as well as cold wars). The economic situation around the globe also changed. Cross-border transactions required merchants to be able to trust one currency and to value that currency against the other. The 'Bretton Woods System was born. More information is available at the Bretton Woods System.

Here is an example of the Bretton Woods System, however. The BWS was a method of defining the monetary relationships between countries. It involved currencies being pegged to USD at a fixed exchange rate, while the USD's value was marked against Gold. This system was accepted by countries with a 1% margin of error (against the fixed value). It's no surprise that the USD became the world's currency once BWS was in place. The USD was backed with Gold!

The BWS system was eventually abandoned by developed countries. The market governed the currency value, and countries adopted this market-driven approach. Based on the economic and political landscapes of each country, the market determines the currency value.

This is where we are now.

1.3 - Forex International Currency Market (International Currency Market)

The international currency trading volume is huge. It's worth taking a moment to understand the figures. According to the April 2013 survey by the 'Bank of International Settlement (BIS), the international market size stands at $5.4 Trillion. Here's theLinkFor the full report, click here. I believe we could be as close to $5.8-$6 Trillion by April 2016. This is approximately 20% more than the Indian annual GDP, which gets traded every day!

Perhaps the biggest factor in such huge trading is that currency markets chase after the Sun. Currencies can be traded on all major markets and information flows seamlessly.

Keep in mind the Indian markets to help you understand. The Australian, Japanese and Hong Kong markets were open before the Indian markets. We actually have some overlap with these markets. The Southeast market is closing, but Indian markets would have warmed up as Middle Eastern markets opened up. The European markets are now opening up, with Paris, Frankfurt, London and Frankfurt being the financial nerve centres of Europe. Indian markets are in a perfect spot because our time zones overlap with the major Southeast Asian markets as well as European markets. The US markets are finally open, followed by Japan markets. This cycle continues for 24 hours per day, 6 days per week.

However, currencies are most active when the US, UK and Japanese markets are open. This is when order flow becomes a lot more robust.

We are now left with an interesting question: who are these people trading currencies? And why is the notional value so insane? Which is the best method to trade currencies?

Forex participation isn't limited to traders and investors, unlike equity markets. There are many participants in Forex markets: Central Banks and Corporate Banks, Banks, Travelers, and traders. Every participant in Forex markets has their own agenda. The corporate might be buying/selling USD in order to hedge their order books, while a traveller may be buying USD to cover his travel expenses. The trader might also be speculating about the currency's movement. The volume of participation is driven up by the fact that it comes from many sources. Forex trading is extremely leveraged and the notional value of Forex trading appears to be high.

Forex transactions are not conducted on a single international exchange. Transactions take place at various financial institutions, such as NSE in India. Information flows between platforms making them borderless.

1.4 - Currency pairs and quotes

Trading currencies as a 'pair is the standard practice. As trades go through, the value of the pair fluctuates. The pair could look like USD INR or GBPINR. Here is an example for a currency pair.

Base Currency/Quotation Currency = value

Let's look at every 3 parts.

Base Currency -Base Currency is always 1 unit of a currency, such as 1 US Dollar, 1 Indian rupee or 1 Euro.

Quotation Currency- A currency that is equivalent to the base currency. Any other currency it can be.

Value- Indicates how much the Quotation Currency is worth in relation to the Base Currency.

Are you confused? Let's look at an example to make it simpler. Consider the following:USD/INR =67.

USD is the Base Currency. As I said earlier, 1 unit is the Base Currency. This is why it is fixed at 1 US Dollar.

Indian Rupees (INR), is the Quotation Currency

The value of 67 is 1 unit Base Currency. The equivalent currency for 1 USD is 67. In simpler terms $1 = Rs.67.

These are the most traded currency pairs around the globe and their current values as of 3 rd June 30, 2016.

SL NoBase CurrencyQuotation CurrencyPairPair Value
1EuroUS DollarEUR/USD1.11
2US DollarJapanese YenUSD/JPY108.94
3Great Britain PoundUS DollarGBP/USD1.44
4Australian DollarUS DollarUSD/AUD0.72
5UD DollarCanadian DollarUSD/CAD1.31
6US DollarSwiss FrancUSD/CHF0.99

Here's the big question: Why do the pairs move? What is the reason they move? What are the influences on their movement?

This will be the topic of our next chapter.

To Summarize

  1. Although the Gold Standard system for evaluating currencies was in existence for some time, it eventually ended up being phased out.
  2. Because of differences in political and economic policies between countries, there is currency inequality among currencies.
  3. The currency markets are the most important by volume.
  4. Currency markets are open all day, every day.
  5. Pairs are used to trade currency.
  6. Currency pairs have a standard format that includes Base Currency and Quotation Currency.
  7. The Base Currency is fixed at 1 unit.