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Forex - Foreign Currency Exchange

Foreign Exchange - FX

Forex or FX for short means foreign exchange. Up until a few years ago, foreign currencies were usually traded by corporations, central banks, hedge funds, large financial institutions, and very wealthy individual traders. But like many things, foreign exchange changed dramatically with the Internet. Now, individual investors are able to buy and sell currencies much more easily than before.

Often, pairs of currencies fluctuate only around 1% or less per day, so foreign exchange is often considered to be a relatively stable market. Speculators sometimes use enormous leverage to try to make money off of these small fluctuations. Leverage in foreign markets can be as high as 250 to 1. With leverage of course comes risk, and high leverage, such as 250 to 1, can be extremely risky.

Foreign currency markets are often open around the clock, 24 hours a day, during most business days. Markets are relatively liquid. Investors are often able to open and close positions within minutes, or hold those positions for months. Because the currency markets are so large, even the largest players, such as central banks, are often unable to move prices it will.

Although the Forex market provides investors with plenty of opportunity, currency traders have to understand the basics of currency trading in order to be successful.

People need foreign currency in order to conduct foreign business and trade with other countries. For example, if you're living in Japan and want to buy wine from California, you would have to change your Japanese yen to US dollars to purchase the wine. The same thing happens when you travel abroad. If you want to buy cheese from a supermarket in France you most likely won't be able to pay with US dollars.

Now imagine all of the international trade that occurs in the world and you'll see why the size of the Forex market is so large. In April of 2007, the Bank for International Settlements reported that daily turnover was over $3.2 trillion.

One thing that is unusual about the currency market is that there is no central marketplace. Transactions occur electronically over computer networks between traders all around the world in places like London, Tokyo, New York, Frankfurt, Paris, Hong Kong, Singapore and Sydney. The market is usually open around the clock, 5 1/2 days a week.

The futures market, the forwards market, and the spot market are three ways that corporations, institutions and individuals trade Forex. The underlying real asset is the spot market. The spot market is also the largest market. The futures markets and forwards markets are based on the spot market. When people talk about the Forex market they are usually talking about the spot market. The forwards and futures markets are usually more often traded by companies in order to hedge foreign exchange risks to a specific time in the future.

The spot market is where supply and demand meet and where currencies are bought and sold. The spot market price is based on many things including economic performance, current interest rates, local and international political situations, and a belief in the future performance of one currency against another. When a currency transaction is finalized it's called a spot deal. In a spot deal, one party agrees to deliver a certain amount of a certain currency to a counterpart and receives a certain amount of another currency at a certain exchange rate. The settlement is made in cash after the position is closed. Trades in the spot market usually take two days for settlement.

Forwards markets and futures markets are different from the spot market in that they do not trade actual currencies. They instead deal contracts. These contracts represent claims to specific currency types, specific future dates for settlement, and specific prices per unit. Contracts in the forwards market are bought and sold over-the-counter at the terms that the buyer and seller agreed to between themselves. Futures contracts are bought and sold in the futures market based on standard sizes and settlement dates. The National Futures Association regulates the futures market in the United States. Specific details in futures contracts include the number of units traded, delivery date and settlement date. The minimum price increments in futures contracts cannot be customized. The exchange provides clearance and settlement by acting as a counterpart into the trader.

Before they expire contract can be bought and sold. However, contracts are typically settled for cash when they expire. Both types of contract are binding. The futures markets and forwards markets can offer a degree of protection against currency trading risks. Large multinational companies often use the forwards and futures markets as a hedge against fluctuations in future exchange rates. Speculators also are known to take part in these markets.

Reading Quotes
Here is a currency quote, also called a currency pair: USD/JPY=95.50. The currency on the left-hand side of the slash is called the base currency. In this case the US dollar is the base currency. The currency on the right-hand side of the slash is called the quote currency or counter currency. In this case the quoted currency is the Japanese yen. The base currency is always equal to one unit so in this case one US dollar. This quote means that one US dollar can buy 95.50 Japanese yen.

The two ways to quote a currency pair are directly and indirectly. In a direct quote, the domestic currency is the base currency. In an indirect quote, the domestic currency is the quoted currency.

Nearly all currency exchange rate quotes are carried out to four digits after the decimal place. An important exception is the Japanese yen, which is carried out to two decimal places.

Cross Currency
A cross currency is a currency quote that doesn't have the US dollar as one of its components. Common cross currency pairs include EUR/JPY, EUR/GBP and EUR/CHF. Although these currency pairs aren't as actively traded as pairs that include the US dollar, they do expand currency tradersf options in the Forex market.

Trading a Currency
When trading a currency pair there is a bid price and an ask price. When going long or buying a currency pair, the ask price is the amount of the quoted currency to be paid in order to buy one unit of the base currency.

When going short or selling a currency pair the bid price is how much of the quoted currency will be obtained when selling one unit of the base currency.

The bid price is the quote before the slash. The last two digits after the slash are the ask price. Often, only the last two digits of the full price or quoted. Generally, the bid price is smaller than the ask price. Here's an example:


Let's say that you wanted to buy this currency pair. In other words, you plan to buy the base currency and are watching the ask price to determine how much in Canadian dollars the market charges for US dollars. According to the example, one US dollar can be bought for 1.0005 Canadian dollars.

Now let's say you wanted to sell this currency pair. In other words, you plan to sell the base currency in exchange for the quoted currency. In this case, you would look at the bid price. According to the bid price, the market will buy one US dollar for 1.0000 Canadian dollars.

Transactions are conducted in whichever currency is quoted first. In other words, transactions are conducted in the base currency. You purchase the base currency or sell the base currency.

Pips and Spreads
A pip can be defined as the smallest amount that a price can move in a currency quote. A spread is the difference between the bid price and the ask price. Here's the previous example again:


In this case the spread would be 0.0005 or 5 pips. Pips are also sometimes called points. One pip equals 0.0001 units when talking about US dollars, British Pounds, Swiss Franc, or Euro. One pip equals 0.01 units when talking about the Japanese yen.

Currencies are quoted differently on the forwards and futures markets. Foreign exchange is quoted against the US dollar in the forwards and futures markets. In other words, pricing shows how many US dollars you need to buy one unit of a given foreign currency. This contrasts with the spot market where in some cases currencies are quoted against the US dollar and in other cases the US dollar is quoted against the foreign currency.

Forex versus Equities
The Forex market has very few traded instruments. This is a major difference between the Forex market and the equities markets. The equities market has thousands of stocks for traders to research and choose from, however most Forex trades revolve around seven major currency pairs. The seven major pairs are USD/JPY, GBP/USD, EUR/USD, USD/CHF, USD/CAD, NZD/USD and AUD/USD.

In the equities market it is sometimes difficult for traders to make money when the market declines. There are specific rules and regulations regarding short-selling US equities. However in the Forex market traders have the opportunity to profit in either rising or declining market. In the Forex market, short-selling is inherent in every transaction because traders are buying and selling simultaneously. Also, the Forex market is generally more liquid than the equities market so traders don't have to wait for an uptick before they enter a short position.

Margins are low and leverage is high on the Forex market, a result of its high level of liquidity. Such low margin rates are extremely difficult to find in the equities markets, where margin traders often need to maintain at least 50% of the value of the investment as margin. Forex traders on the other hand sometimes need only 1% equity. Commissions in the Forex market tend to be lower than in the equities market.

History of Currency Exchange
The gold standard monetary system was created in 1875. It was one of the most important events in the history of the Forex market. Previously, countries used to use gold and silver to make international payments. However, the value of gold and silver was affected by external supply and demand, which created problems. For example, if a new gold mine was discovered the price of gold would go down.

With the gold standard governments around the world agreed that they would convert currency into specific amounts of gold. To do this governments were required to have large gold reserves to meet the demand to make exchanges. By the end of the 19th century, most of the countries with large economies had defined a certain amount of currency as being equal to one ounce of gold. As time went on, the amount of each currency that was required to purchase one ounce of gold became exchange rates between two currencies. This was the beginning of currency exchange.

Around the beginning of World War I the gold standard broke down. European powers believed it was necessary to complete large military projects because of political pressure from Germany. The cost of these military projects was so high that there wasn't enough gold to exchange for all the currency that the governments were printing.

The gold standard returned briefly after World War I, however most countries went off the gold standard again before World War II.

Near the end of World War II the Allied nations decided to set up a monetary system to replace the gold standard. Over 700 Allied representatives met in Bretton Woods, New Hampshire, in July of 1944 to discuss the Bretton Woods system of international monetary management. Some of the main ideas that came out of the meeting were that the US dollar would replace the gold standard and become a primary reserve currency, that there would be fixed exchange rates and that there would be three international agencies to oversee economic activity would be created. These agencies were the international monetary fund (IMF), the General Agreement on Tariffs and Trade (GATT), and the International Bank for Reconstruction and Development.

The US dollar replacing gold as the primary standard for world currency conversions was one of the main ideas brought about by Bretton Woods. At the time the US dollar was the only currency that was backed by gold.

Over the next few decades, in order to remain the world's reserve currency, the United States had to have a series of balance of payment deficits. However, in the early 1970s, US gold reserves had become so depleted that the United States treasury lacked enough gold to cover the large number of US dollars that foreign central banks had in reserve. So on August 15, 1971, the United States effectively declared that it would no longer exchange gold for US dollars that were held in foreign reserves when US President Richard Nixon closed the gold window. President Nixon's actions brought the Bretton Woods system to an end.

In 1976, the world decided to use floating foreign exchange rates in what was called the Jamaica agreement. This agreement abolished the gold standard. However, not all governments have adopted a free floating exchange rate system. In fact, most governments still use one of three exchange-rate systems. They are Dollarization, a pegged rate, and managed floating rate.

Dollarization occurs if a country chooses to not issue its own currency and instead uses of foreign currency as its national currency. One advantage of dollarization is that the country may be seen as a relatively stable place for investment. Two disadvantages of dollarization are that the country's central bank can no longer make monetary policy nor print money.

Pegged rates happen if a country chooses to directly fix its exchange rates to a foreign currency. Pegged rates usually allow the country to have more stability than a normal float. The country's currency may be pegged at a fixed rate to a single currency or to a specific basket of foreign currencies. The currency only fluctuates when there are changes in the pegged currencies. An obvious example of a pegged currency is the Chinese yuan. Between 1997 and July 21, 2005 the Chinese Yon was pegged to the US dollar at a rate of 8.28 yuan.

Managed floating rates are created when a country's exchange rate changes freely and the currencyf value is subject to the forces of supply and demand in the market. With managed floating rates the country's central bank or government may intervene when there are extreme fluctuations in exchange rates. If, for example, a country's currency depreciates too much, the government could increase short-term interest rates, which would likely cause the currency to appreciate. Central banks generally have a wide variety of tools that they can use to manage their currency.

Participants in the Forex Market

Market participants in the equities market are often limited to investors who trade with either other investors or institutional investors like mutual funds. On the Forex market, however, there are market participants who are not investors.

Governments and central banks are probably the most influential participants in the currency exchange market. Many countries use their central banks as an extension of the government to conduct monetary policy. Other countries seem to believe their central banks would be more effective in finding a balance between keeping interest rates low and curbing inflation if they were more independent, and free of government control. In both cases, though, representatives from the government usually have regular meetings and discussions with the representatives of the central banks, leading, often, to similar ideas on monetary policy.

Reserve volumes are often manipulated by central banks in attempts to meet economic goals. China, for example, has been purchasing millions of dollars of United States treasury bills to keep the Chinese Yuan at its target exchange rate, a result of China pegging its currency to the US dollar. Central banks adjust their reserve volumes by participating in the foreign exchange market. Because these banks have a great deal of purchasing and selling power, they have a large influence on the direction of the currency markets.

Banks and other financial institutions are some of the largest participants in Forex transactions. The interbank market is where large banks conduct transactions amongst themselves. These transactions determine the currency. The interbank market is huge in volume when compared to the exchange individuals make when they need small-scale foreign currency transactions. Credit is the basis of the electronic brokering systems that allow the banks to transact with each other. The only banks that can engage in transactions are ones that have great relationships with each other. Larger banks generally have a wider array of credit relationships and therefore can access better pricing for their customers. On the other hand, small banks with fewer credit relationships often have lower priority in pricing. We can think of banks as being dealers because they are willing to buy or sell a currency at the ask or bid price. Banks are able to make money by charging a premium to exchange currency on the Forex market. The Forex market is decentralized so frequently different banks have slightly different exchange rates for a given currency.

About the author

Mark McCracken

Author: Mark McCracken is a corporate trainer and author living in Higashi Osaka, Japan. He is the author of thousands of online articles as well as the Business English textbook, "25 Business Skills in English".

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