Introduction to Foreign Exchange: Key Concepts

The market in which participants can buy, sell, exchange, and speculate on currencies is commonly denominated as the foreign exchange (forex) market. This market is considered to be the largest and most liquid financial market trading over $250 billion every hour and an average daily turnover of $6.6 trillion (40% increase during the last decade) [1].

The forex market has no physical locations. It is opened 24 hours a day, as the major financial centres where currencies are traded have different geographic locations. The major trading centres are London, New York, Singapore, and Tokyo amongst others [2].

There are two tiers in the forex market: the interbank market and the over-the-counter (OTC) market. The interbank market is where the largest banks exchange currencies between each other. Although the number of players is reduced (i.e. ten banks control nearly 70% of all trading), the quantities being traded are very substantial and consequently have a large effect on exchange rates. The minimum traded quantity is $1 million, but trades usually oscillate between 10 and $100 million. Banks trade to profit themselves and their clients. It is called proprietary trading when banks trade solely in their own interest. Banks’ clients include governments, wealth funds, corporations, hedge funds and high net-worth individuals. On the other hand, the OTC market is where companies and individuals trade currencies [3]. Transactions are executed outside of a centralized exchange. Traders are able to buy and sell currencies through a network directly connecting various banks, dealers, and brokers. It involves a high risk as the forex industry is not too regulated and provides significant leverage.

One of the main differences between stock trading and currency trading is the fact that when trading a stock, the process consists of disbursing the cash and buying the underlying stock or vice versa for selling it. Instead, when trading a currency, whenever you buy a specific currency you are selling its pair and vice versa when selling it. This concept is very basic but crucial when speaking about the foreign exchange market.

Currencies are traded in pairs (i.e. EUR/USD). The first quoted currency is called the base currency and the second one is called the quote currency. Currency pairs compare the values of two different currencies. In other words, it indicates the amount needed of the quote currency to buy one unit of the base currency. As was previously mentioned, all forex trades involve a simultaneous purchase of one currency and sale of another. The bid price represents how much of the quoted currency is needed to buy one unit of the base currency. Contrarily, the ask price comes into place when selling the currency pair. It represents how much of the quoted currency we would get if we were to sell one unit of the base currency. The most liquid and traded currency pair is the EUR/USD. Currencies that trade the biggest volumes against the USD are denominated as major currencies. These include the Euro (EUR), the Japanese Yen (JPY), the British Pound (GBP), the Swiss Franc (CHF), the Australian Dollar (AUD) and the Canadian Dollar (CAD).

All of the major currency pairs are considered very liquid markets and therefore have very narrow spreads. When the term ‘spread’ is mentioned in forex trading, it refers to the bid-ask spread, which is the difference between the prices given for an immediate order (ask) and an immediate sale (bid). It is mainly used to measure the market liquidity and the cost of the transaction.

The Swiss Franc is considered to be the ultimate safe-haven currency. This comes as a result of its government stability, safe banking industry and low-volatility capital market [4]. Its independence from the European Union makes the country avoid any negative news affecting the European conglomerate.

The last two currencies mentioned above, AUD and CAD, are often referred to as commodity currencies. Australia and Canada are two big exporters of commodities, meaning that their respective economies have a substantial dependence on these commodities. Australia is the third largest producer of gold in the world. This implies that when gold prices increase, the Australian economy receives an added value and consequently AUD strengthens. Historically, gold and AUD/USD have had an 80% positive correlation [5]. Similarly, 37% of US oil imports come from Canada and nearly 90% of Canada’s oil exports go to the US. The immediate implication is that when US oil demand increases, so will the oil price (normally). As a result, the Canadian economy will strengthen and so will the CAD, meaning that the USD/CAD pair will debilitate. Between 2000 and 2016, oil prices and USD/CAD have had approximately a 90% correlation [6].

Currency pairs that do not include USD are called minor currency pair or crosses. The most common ones are EUR/GBP, GBP/JPY, and EUR/CHF.

Pairs that include currencies from emerging markets are called exotic currency pairs [7]. One of the most common pairs is the USD/SGD (US dollar/Singapore dollar).

How Are International Exchange Rates Set?

In order to analyse and predict international exchange rate movement, it is important to differ between floating and pegged (fixed) exchange rates.

Floating exchange rates

Floating rates are determined by supply and demand forces on global currency markets. When demand of a currency increases, so does the value and vice versa when demand decreases. There are many geopolitical and economic factors and announcements that can move exchange rates between two countries. Some of the most usual ones are interest rate changes, which will be covered in detail later on, unemployment rates, inflation reports, GDP numbers or commodities, as explained previously with the AUD and CAD.

Short-term moves in floating exchange rates come as a result of speculation, rumours, disasters and daily supply and demand. Extreme short-term moves are possible as a result of central bank interventions. When a currency is too low or too high, it can negatively affect the country economically. Therefore, although they are called floating exchange rates, central banks can have a big impact on them in order to sustain the country’s economy.

Pegged exchange rates

A pegged exchange rate is fixed by the government of the specific country through its central bank. The rate is set against another major currency. The usual ones are USD, EUR, or JPY. The main objective of pegging a currency to another one is being able to maintain the local currency to the levels the government wishes. To do this the local central bank will buy and sell its own currency against the currency to which it is pegged in order to attain the desired values. The local central bank must hold vast quantities of the foreign currency to be able to adjust their currency values [8].

Interest Rates and Foreign Exchange

Interest rates are the economic factor which has the biggest impact on forex. Central banks tend to vary their interest rates when the economy is expanding or contracting too fast. The two main objectives of a central bank are to regulate inflation (normally at 2%) and to promote stability for their country’s exchange rate. Say the country’s economy is expanding too fast and inflation is expected to grow above 2%, the central bank may raise interest rates in order to make borrowing more expensive and decrease consumer expenditure. The central bank may do the same vice versa in order to stimulate the economy.

How do interest rates affect forex trading?

Currency fluctuations are dictated by changes in interest rate expectations. In the table below, we can observe four different situations in which the consensus reached by analysts differs from the actual central bank decisions leading to currency moves (appreciation or depreciation). This table represents the usual currency moves, but it is important to understand that markets are sometimes unpredictable and currency moves may vary.

Currencies fluctuate, as mentioned previously, as a result of supply and demand forces. For example, if interest rates were on the rise in a country and you are a foreign investor who wants to invest in government bonds, you would probably choose that country whose yield is increasing (as would many other investors). The increasing demand caused by the hike in interest rates would push the local currency of that country up.

Below, we can appreciate a real-life example of change in market expectations [9]. The 3^rd May 2016 Australia’s central bank was set to announce new monetary policies. Market expectations were that interest rates would remain unchanged at 2% but surprisingly the Reserve Bank of Australia cut rates to 1.75%. In the chart, we can see the clear depreciation of the AUD/USD pair as a result of the surprise change in interest rates.

Types of Currency Markets

Spot market

This market is based on the immediate trading of currencies as per the current exchange rate. Trades usually take one or two days to settle transactions. A spot FX transaction is a bilateral agreement to physically exchange one currency against another currency.

The spot FX market is an “off-exchange” market, meaning that transactions are not listed in a central trading location like the NYSE, for example. It is also known as the OTC market, as was previously described. In an OTC market, the client trades directly with the counterparty [10].

Forward and future markets

Forward and future markets have a similar structure in terms of the actual investment vehicle. However, they do have some big differences in terms of trading.

In a forward contract, two parties agree to trade an FX pair at an established date in the future and a stated price. When the maturity date of the contract arrives, the contract will be exercised. Forward contracts are very useful in hedging and speculation. Some of the main disadvantages of the forward market is the lack of centralization of trading, the lack of liquidity (only two parties in each trade) and the counterparty risk.

In a future contract, these disadvantages are diminished. All future contracts are listed in exchanges, which implies that they are centralized and regulated [11]. There is no counterparty risk involved as these exchanges have clearing houses which guarantee the execution of the trade. Finally, the futures market is highly liquid as countless people can enter into the same trade.

Options market

A currency option is a contract which gives the buyer of the option the right but not the obligation to buy or sell the underlying currency at future established date and at a predetermined price. As currencies are traded in pairs, one currency is bought, and another sold.

[1] [2] [3] [4] [5] [6] [7] [8] [9] [10] [11]