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Intermediate

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What is Forex Liquidity and Volatility?

Forex liquidity and volatility have a significant impact on each other. High liquidity leads to low volatility due to the less fluctuation in the prices and vice versa.

Since the foreign exchange market is one of the most liquid markets in the world, it is not too volatile due to the high liquidity. But that doesn't mean there is no volatility at all. The forex market does witness fluctuating volatility from time to time as the currency pair prices change almost everyday. Let us understand what Forex market liquidity and FX market volatility are and how important they are in the forex market.

What is liquidity in Forex?

Liquidity in Forex is the ability of a currency pair to be bought and sold in the forex market without majorly impacting its exchange rate. When a currency is easily bought and sold without a lot of fluctuation in its exchange rate, it is considered a liquid currency.

When it comes to understanding Forex liquidity, there are two things you should always remember:

  • The major currency pairs are the most liquid
  • The exotic currency pairs are the least liquid

What causes liquidity in Forex trading?

1. Expansion in a monetary policy

Any changes in the global monetary policy affect the foreign exchange rate, and hence, the liquidity. When a country decides to expand its monetary policy to increase the money flow in the nation, the incomes and demands of the citizens are increased. This leads to a lowering in the exchange rate by depreciating the domestic currency. This is a result of low-interest rates and a high money supply. The fall in the domestic currency price leads to higher liquidity for that currency in the market with a surge in buyers.

2. Increase in global credit supply

When the global credit supply increases, implying that more loans and borrowings are provided to the people, the Forex liquidity is affected positively. A higher credit supply leads to more money in the hands of traders and investors who then invest in the Forex market by buying currency pairs, increasing its liquidity.

3. Decrease in global credit demand

When there is a decrease in the global credit demand, it means that people already have enough money to invest and trade. Hence, they do not require more credit in order to invest in the foreign exchange market.

This is how a decrease in the credit demand globally leads to increased liquidity in the Forex market. However, if the credit demand increases worldwide, it poses a situation of people not having enough money to put into investment arenas, depicting less liquidity while Forex trading.

What is volatiliy in Forex trading?

Forex volatility measures the frequency of change in a currency's prices. The higher the volatility of a currency, the higher is the risk involved in trading that currency in the Forex market. However, if you trade highly volatile currency pairs, you also expose yourself to incredible returns.

  • The major currency pairs are the least volatile
  • The exotic currency pairs are the most volatile

What causes volatility in Forex?

1. Interest rate changes

Any change in the interest rate affects the Forex market's volatility. An increase in the interest rate in an economy will mean that investors are going to cut back on their spending. Hence, the domestic currency price would substantially drop, causing high volatility in the Forex market.

Similarly, a fall in the interest rate would enable the people to spend more as they will have more money in hand, leading to the domestic currency price appreciation in the market again, leading to high market volatility due to the price fluctuation.

2. Economic shocks affecting supply and demand

Certain domestic shocks like a change in the taxation policy or a sudden surge in the prices of oil can also adversely affect the Forex volatility. For example, suppose a country goes through a hefty imposition of tariffs on trade, impacting a heavy chunk of the population (consumers) negatively; in that case, it will reduce the participation of the population into the Forex market, decreasing the currency pair prices, leading to volatility.

Similarly, if the prices of oil increase in a domestic economy (due to excessive demand), it could lead to an appreciation in the prices of the gulf countries' currencies, as now they will be supplying more oil and receiving higher incomes, again leading to high Forex volatility in terms of international currencies.

3. Global changes and events

Several global changes and events like a political election, natural disasters, wars, and similar occurences can affect the Forex market volatility to a great extent. For example, if a country has elections coming up, most traders will not opt to invest in that country's currency since a government change is looked at as a change in the political sentiments of the nation which can introduce volatility in the market.

How do liquidity and volatility affect each other?

Forex market liquidity and volatility are directly related. The foreign exchange market's liquidity impacts the market prices as well, leading to a volatile or non-volatile market. When the liquidity in the Forex market is low, it results in a much more volatile market sentiment, causing prices to change rapidly.

However, when the Forex market is highly liquid, the market becomes less volatile, wherein the currency pair prices do not fluctuate as much and are considered stable and risk-free.

Bottom line

Understanding the Forex market completely is essential if you wish to invest in volatile currencies and make significant profits. However, if you are a beginner, we recommend you to invest in highly liquid and not too volatile currencies as they come with much lesser risk and decent profits. You should also keep a close eye on the regular updates to be aware of the factors that affect the Forex liquidity and volatility and make successful trades accordingly.

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