Forex: What Is It?
The foreign exchange market is the "place" where currencies are traded. Currencies are important to most people around the world, whether they realize it or not, because currencies need to be exchanged in order to conduct foreign trade and business. If you are living in the U.S. and want to buy cheese from France, either you or the company that you buy the cheese from has to pay the French for the cheese in euros (EUR). This means that the U.S. importer would have to exchange the equivalent value of U.S. dollars (USD) into euros. The same goes for traveling. A French tourist in Egypt can't pay in euros to see the pyramids because it's not the locally accepted currency. As such, the tourist has to exchange the euros for the local currency, in this case the Egyptian pound, at the current exchange rate.
The need to exchange currencies is the primary reason why the forex market is the largest, most liquid financial market in the world. It dwarfs other markets in size, even the stock market, with an average traded value of around U.S. $2,000 billion per day. (The total volume changes all the time, but as of April 2004, the Bank for International Settlements (BIS) reported that the forex market traded U.S. $1,900 billion per day.)
One unique aspect of this international market is that there is no central marketplace for currency exchange. Rather, trade is conducted electronically over-the-counter (OTC), which means that all transactions occur via computer networks between traders around the world, rather than on one centralized exchange. The market is open 24 hours a day, five and a half days a week, and currencies are traded worldwide in the major financial centers of London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and Sydney - across almost every time zone. This means that when the trading day in the U.S. ends, the forex market begins anew in Tokyo and Hong Kong. As such, the forex market can be extremely active any time of the day, with price quotes changing constantly.
Reading a Quote and Understanding the Jargon
One of the biggest sources of confusion for those new to the currency market is the standard for quoting currencies. In this section, we'll go over currency quotations and how they work in currency pair trades.
Reading a Quote When a currency is quoted, it is done in relation to another currency, so that the value of one is reflected through the value of another. Therefore, if you are trying to determine the exchange rate between the U.S. dollar (USD) and the Japanese yen (JPY), the quote would look like this:
USD/JPY = 119.50
This is referred to as a currency pair. The currency to the left of the slash is the base currency, while the currency on the right is called the quote or counter currency. The base currency (in this case, the U.S. dollar) is always equal to one unit (in this case, US$1), and the quoted currency (in this case, the Japanese yen) is what that one base unit is equivalent to in the other currency. The quote means that US$1 = 119.50 Japanese yen. In other words, US$1 can buy 119.50 Japanese yen.
Direct Quote vs. Indirect Quote There are two ways to quote a currency pair, either directly or indirectly. A direct quote is simply a currency pair in which the domestic currency is the base currency; while an indirect quote, is a currency pair where the domestic currency is the quoted currency. So if you were looking at the Canadian dollar as the domestic currency and U.S. dollar as the foreign currency, a direct quote would be CAD/USD, while an indirect quote would be USD/CAD. The direct quote varies the foreign currency, and the quoted, or domestic currency, remains fixed at one unit. In the indirect quote, on the other hand, the domestic currency is variable and the foreign currency is fixed at one unit.
For example, if Canada is the domestic currency, a direct quote would be 0.85 CAD/USD, which means with C$1, you can purchase US$0.85. The indirect quote for this would be the inverse (1/0.85), which is 1.18 USD/CAD and means that USD$1 will purchase C$1.18. In the forex spot market, most currencies are traded against the U.S. dollar, and the U.S. dollar is frequently the base currency in the currency pair. In these cases, it is called a direct quote. This would apply to the above USD/JPY currency pair, which indicates that US$1 is equal to 119.50 Japanese yen. However, not all currencies have the U.S. dollar as the base. The Queen's currencies - those currencies that historically have had a tie with Britain, such as the British pound, Australian Dollar and New Zealand dollar - are all quoted as the base currency against the U.S. dollar. The euro, which is relatively new, is quoted the same way as well. In these cases, the U.S. dollar is the counter currency, and the exchange rate is referred to as an indirect quote. This is why the EUR/USD quote is given as 1.25, for example, because it means that one euro is the equivalent of 1.25 U.S. dollars. Most currency exchange rates are quoted out to four digits after the decimal place, with the exception of the Japanese yen (JPY), which is quoted out to two decimal places.
Bid and Ask As with most trading in the financial markets, when you are trading a currency pair there is a bid price (buy) and an ask price (sell). Again, these are in relation to the base currency. When buying a currency pair (going long), the ask price refers to the amount of quoted currency that has to be paid in order to buy one unit of the base currency, or how much the market will sell one unit of the base currency for in relation to the quoted currency. The bid price is used when selling a currency pair (going short) and reflects how much of the quoted currency will be obtained when selling one unit of the base currency, or how much the market will pay for the quoted currency in relation to the base currency. The quote before the slash is the bid price, and the two digits after the slash represent the ask price (only the last two digits of the full price are typically quoted). Note that the bid price is always smaller than the ask price. Let's look at an example:
USD/CAD = 1.2000/05 Bid = 1.2000 Ask= 1.2005
If you want to buy this currency pair, this means that you intend to buy the base currency and are therefore looking at the ask price to see how much (in Canadian dollars) the market will charge for U.S. dollars. According to the ask price, you can buy one U.S. dollar with 1.2005 Canadian dollars. However, in order to sell this currency pair, or sell the base currency in exchange for the quoted currency, you would look at the bid price. It tells you that the market will buy US$1 base currency (you will be selling the market the base currency) for a price equivalent to 1.2000 Canadian dollars, which is the quoted currency. Whichever currency is quoted first (the base currency) is always the one in which the transaction is being conducted. You either buy or sell the base currency. Depending on what currency you want to use to buy or sell the base with, you refer to the corresponding currency pair spot exchange rate to determine the price.
Spreads and Pips The difference between the bid price and the ask price is called a spread. If we were to look at the following quote: EUR/USD = 1.2500/03, the spread would be 0.0003 or 3 pips, also known as points. Although these movements may seem insignificant, even the smallest point change can result in thousands of dollars being made or lost due to leverag. Again, this is one of the reasons that especulators are so attracted to the forex market; even the tiniest price movement can result in huge profit. The pip is the smallest amount a price can move in any currency quote. In the case of the U.S. dollar, euro, British pound or Swiss franc, one pip would be 0.0001. With the Japanese yen, one pip would be 0.01, because this currency is quoted to two decimal places. So, in a forex quote of USD/CHF, the pip would be 0.0001 Swiss francs. Most currencies trade within a range of 100 to 150 pips a day.
Currency Quote Overview
USD/CAD = 1.2232/37
Base Currency
Currency to the left (USD)
Quote/Counter Currency
Currency to the right (CAD)
Bid Price
1.2232
Price for which the market maker will buy the base currency. Bid is always smaller than ask.
Ask Price
1.2237
Price for which the market maker will sell the base currency.
Pip
One point move, in USD/CAD it is .0001 and 1 point change would be from 1.2231 to 1.2232
The pip/point is the smallest movement a price can make.
Spread
Spread in this case is 5 pips/points; difference between bid and ask price (1.2237-1.2232).
Now that you know a little bit about how currencies are quoted, let's move on to the benefits and risks involved with trading forex.
Forex: Benefits and Risks
In this section, we'll take a look at some of the benefits and risks associated with the forex market. We'll also discuss how it differs from the equity market in order to get a greater understanding of how the forex market works.
The Good and the Bad We already have mentioned that factors such as the size, volatility and global structure of the forex market have all contributed to its rapid success. Given the highly liquid nature of this market, investors are able to place extremely large trades without affecting any given exchange rate. These large positions are made available to traders because of the low margin requirements used by the majority of the industry's brokers. For example, it is possible for an investor to control a position of US$100,000 by putting down as little as US$1,000 up front and borrowing the remainder from his or her broker. This amount of leverage acts as a double-edged sword because investors can realize large gains when rates make a small favorable change, but they also run the risk of a massive loss when the rates move against them. Despite the risks, the amount of leverage available in the forex market is what makes it attractive for many speculators.
The currency market is also the only market that is truly open 24 hours a day with decent liquidity throughout the day. For traders who may have a day job or just a busy schedule, it is an optimal market to trade in. As you can see from the chart below, the major trading hubs are spread throughout many different time zones, eliminating the need to wait for an opening or closing bell. As
the U.S. trading closes, other markets in the East are opening, making it possible to trade at any time during the day.
Time Zone
Time (ET)
Tokyo Open
7:00 pm
Tokyo Close
4:00 am
London Open
3:00 am
London Close
12:00 pm
New York Open
8:00 am
New York Close
5:00 pm
While the forex market may offer more excitement to the investor, the risks are also higher in comparison to trading equities. The ultra-high leverage of the forex market means that huge gains can quickly turn to damaging losses and can wipe out the majority of your account in a matter of minutes. This is important for all new traders to understand, because in the forex market - due to the large amount of money involved and the number of players - traders will react quickly to information released into the market, leading to sharp moves in the price of the currency pair. Though currencies don't tend to move as sharply as equities on a percentage basis (where a company's stock can lose a large portion of its value in a matter of minutes after a bad announcement), it is the leverage in the spot market that creates the volatility. For example, if you are using 100:1 leverage on $1,000 invested, you control $100,000 in capital. If you put $100,000 into a currency and the currency's price moves 1% against you, the value of the capital will have decreased to $99,000 - a loss of $1,000, or all of your invested capital, representing a 100% loss. In the equities market, most traders do not use leverage, therefore a 1% loss in the stock's value on a $1,000 investment, would only mean a loss of $10. Therefore, it is important to take into account the risks involved in the forex market before diving in.
By now you should have a basic understanding of what the forex market is and how it works. In the next section, we'll examine the evolution of the current foreign exchange system.
Forex: History and Market Participants
Given the global nature of the forex market, it is important to first examine and learn some of the important historical events relating to currencies and currency exchange before entering any trades. In this section we’ll review the international monetary system and how it has evolved to its current state. We will then take a look at the major players that occupy the forex market - something that is important for all potential forex traders to understand.
The History of the Forex Gold Standard System The creation of the gold standard monetary system in 1875 marks one of the most important events in the history of the forex market. Before the gold standard was implemented, countries would commonly use gold and silver as means of international payment. The main issue with using gold and silver for payment is that their value is affected by external supply and demand. For example, the discovery of a new gold mine would drive gold prices down. The underlying idea behind the gold standard was that governments guaranteed the conversion of currency into a specific amount of gold, and vice versa. In other words, a currency would be backed by gold. Obviously, governments needed a fairly substantial gold reserve in order to meet the demand for exchanges. During the late nineteenth century, all of the major economic countries had defined an amount of currency to an ounce of gold. Over time, the difference in price of an ounce of gold between two currencies became the exchange rate for those two currencies. This represented the first standardized means of currency exchange in history.
The gold standard eventually broke down during the beginning of World War I. Due to the political tension with Germany, the major European powers felt a need to complete large military projects. The financial burden of these projects was so substantial that there was not enough gold at the time to exchange for all the excess currency that the governments were printing off. Although the gold standard would make a small comeback during the inter-war years, most countries had dropped it again by the onset of World War II. However, gold never ceased being the ultimate form of monetary value. (For more on this, read
The Gold Standard Revisited, What Is Wrong With Gold? and Using Technical Analysis In The Gold Markets.) Bretton Woods System Before the end of World War II, the Allied nations believed that there would be a need to set up a monetary system in order to fill the void that was left behind when the gold standard system was abandoned. In July 1944, more than 700 representatives from the Allies convened at Bretton Woods, New Hampshire, to deliberate over what would be called the Bretton Woods system of international monetary management. To simplify, Bretton Woods led to the formation of the following:
1. A method of fixed exchange rates;
2. The U.S. dollar replacing the gold standard to become a primary reserve currency; and
3. The creation of three international agencies to oversee economic activity: the International Monetary Fund (IMF), International Bank for Reconstruction and Development, and the General Agreement on Tariffs and Trade (GATT).
One of the main features of Bretton Woods is that the U.S. dollar replaced gold as the main standard of convertibility for the world’s currencies; and furthermore, the U.S. dollar became the only currency that would be backed by gold. (This turned out to be the primary reason that Bretton Woods eventually failed.) Over the next 25 or so years, the U.S. had to run a series of balance of payment deficits in order to be the world’s reserved currency. By the early 1970s, U.S. gold reserves were so depleted that the U.S. treasury did not have enough gold to cover all the U.S. dollars that foreign central banks had in reserve. Finally, on August 15, 1971, U.S. President Richard Nixon closed the gold window, and the U.S. announced to the world that it would no longer exchange gold for the U.S. dollars that were held in foreign reserves. This event marked the end of Bretton Woods. Even though Bretton Woods didn’t last, it left an important legacy that still has a significant effect on today’s international economic climate. This legacy exists in the form of the three international agencies created in the 1940s: the IMF, the International Bank for Reconstruction and Development (now part of the World Bank) and GATT, the precursor to the World Trade Organization. (To learn more about Bretton Wood, read What Is The International Monetary Fund? and Floating And Fixed Exchange Rates.) Current Exchange System After the Bretton Woods system broke down, the world finally accepted the use of floating foreign exchange rates during the Jamaica agreement of 1976. This meant that the use of the gold standard would be permanently abolished. However, this is not to say that governments adopted a pure free-floating exchange rate system. Most governments employ one of the following three exchange rate systems that are still used today:
1. Dollarization;
2. Pegged rate; and
3. Managed floating rate.
Dollarization This event occurs when a country decides not to issue its own currency and adopts a foreign currency as its national currency. Although dollarization usually enables a country to be seen as a more stable place for investment, the drawback is that the country’s central bank can no longer print money or make any sort of monetary policy. An example of dollarization is El Salvador's use of the U.S. dollar. (To read more, see Dollarization Explained.) Pegged Rates Pegging occurs when one country directly fixes its exchange rate to a foreign currency so that the country will have somewhat more stability than a normal float. More specifically, pegging allows a country’s currency to be exchanged at a fixed rate with a single or a specific basket of foreign currencies. The currency will only fluctuate when the pegged currencies change. For example, China pegged its yuan to the U.S. dollar at a rate of 8.28 yuan to US$1, between 1997 and July 21, 2005. The downside to pegging would be that a currency’s value is at the mercy of the pegged currency’s economic situation. For example, if the U.S. dollar appreciates substantially against all other currencies, the yuan would also appreciate, which may not be what the Chinese central bank wants. Managed Floating Rates This type of system is created when a currency’s exchange rate is allowed to freely change in value subject to the market forces of supply and demand. However, the government or central bank may intervene to stabilize extreme fluctuations in exchange rates. For example, if a country’s currency is depreciating far beyond an acceptable level, the government can raise short-term interest rates. Raising rates should cause the currency to appreciate slightly; but understand that this is a very simplified example. Central banks typically employ a number of tools to manage currency. Market Participants Unlike the equity market - where investors often only trade with institutional investors (such as mutual funds) or other individual investors - there are additional participants that trade on the forex market for entirely different reasons than those on the equity market. Therefore, it is important to identify and understand the functions and motivations of the main players of the forex market. Governments and Central Banks Arguably, some of the most influential participants involved with currency exchange are the central banks and federal governments. In most countries, the central bank is an extension of the government and conducts its policy in tandem with the government. However, some governments feel that a more independent central bank would be more effective in balancing the goals of curbing inflation and keeping interest rates low, which tends to increase economic growth. Regardless of the degree of independence that a central bank possesses, government representatives typically have regular consultations with central bank representatives to discuss monetary policy. Thus, central banks and governments are usually on the same page when it comes to monetary policy. Central banks are often involved in manipulating reserve volumes in order to meet certain economic goals. For example, ever since pegging its currency (the yuan) to the U.S. dollar, China has been buying up millions of dollars worth of U.S. treasury bills in order to keep the yuan at its target exchange rate. Central banks use the foreign exchange market to adjust their reserve volumes. With extremely deep pockets, they yield significant influence on the currency markets. Banks and Other Financial Institutions In addition to central banks and governments, some of the largest participants involved with forex transactions are banks. Most individuals who need foreign currency for small-scale transactions deal with neighborhood banks. However, individual transactions pale in comparison to the volumes that are traded in the interbank market.
The
interbank market is the market through which large banks transact with each other and determine the currency price that individual traders see on their trading platforms. These banks transact with each other on electronic brokering systems that are based upon credit. Only banks that have credit relationships with each other can engage in transactions. The larger the bank, the more credit relationships it has and the better the pricing it can access for its customers. The smaller the bank, the less credit relationships it has and the lower the priority it has on the pricing scale. Banks, in general, act as dealers in the sense that they are willing to buy/sell a currency at the bid/ask price. One way that banks make money on the forex market is by exchanging currency at a premium to the price they paid to obtain it. Since the forex market is a decentralized market, it is common to see different banks with slightly different exchange rates for the same currency. Hedgers Some of the biggest clients of these banks are businesses that deal with international transactions. Whether a business is selling to an international client or buying from an international supplier, it will need to deal with the volatility of fluctuating currencies. If there is one thing that management (and shareholders) detest, it is uncertainty. Having to deal with foreign-exchange risk is a big problem for many multinationals. For example, suppose that a German company orders some equipment from a Japanese manufacturer to be paid in yen one year from now. Since the exchange rate can fluctuate wildly over an entire year, the German company has no way of knowing whether it will end up paying more euros at the time of delivery. One choice that a business can make to reduce the uncertainty of foreign-exchange risk is to go into the spot market and make an immediate transaction for the foreign currency that they need. Unfortunately, businesses may not have enough cash on hand to make spot transactions or may not want to hold massive amounts of foreign currency for long periods of time. Therefore, businesses quite frequently employ hedging strategies in order to lock in a specific exchange rate for the future or to remove all sources of exchange-rate risk for that transaction. For example, if a European company wants to import steel from the U.S., it would have to pay in U.S. dollars. If the price of the euro falls against the dollar before payment is made, the European company will realize a financial loss. As such, it could enter into a contract that locked in the current exchange rate to eliminate the risk of dealing in U.S. dollars. These contracts could be either forwards or futures contracts. Speculators Another class of market participants involved with foreign exchange-related transactions is speculators. Rather than hedging against movement in exchange rates or exchanging currency to fund international transactions, speculators attempt to make money by taking advantage of fluctuating exchange-rate levels. The most famous of all currency speculators is probably George Soros. The billionaire hedge fund manager is most famous for speculating on the decline of the British pound, a move that earned $1.1 billion in less than a month. On the other hand, Nick Leeson, a derivatives trader with England’s Barings Bank, took speculative positions on futures contracts in yen that resulted in losses amounting to more than $1.4 billion, which led to the collapse of the company. Some of the largest and most controversial speculators on the forex market are hedge funds, which are essentially unregulated funds that employ unconventional investment strategies in order to reap large returns. Think of them as mutual funds on steroids. Hedge funds are the favorite whipping boys of many a central banker. Given that they can place such massive bets, they can have a major effect on a country’s currency and economy. Some critics blamed hedge funds for the Asian currency crisis of the late 1990s, but others have pointed out that the real problem was the ineptness of Asian central bankers. (For more on hedge funds, see Introduction To Hedge Funds - Part One and Part Two.)Either way, speculators can have a big sway on the currency markets, particularly big ones.
