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An Introduction to the Foreign Exchange Markets

An Introduction to the Foreign Exchange Markets

The foreign exchange markets (FOREX) have evolved from the humblest of beginnings to the world’s largest market by dollar volume. With several different entry points, speculators and hedgers can both find what they are looking for. Whether they simply want to hedge their everyday currency risk, or pursue a more complex strategy, the FOREX markets provide the liquidity and instruments for trading in currencies.

The Evolution of FOREX Trading

In the earliest of times, man traded furs and skins and eventually grains and oils, dried fish, sheep, horses, cattle, and oxen. Because of their durability, oxen became a favorite medium of exchange. In time, with division of labor and urban living came a new era in which new uses were found for metals (copper, bronze, gold and silver). Because of their added usefulness, portability, and divisibility, their value increased and they were eventually accepted as the medium of exchange. For convenience, standardized pieces of metal, known as coins, came into use. Occasionally, when coins were in short supply, substitutes were used as “promises to pay” metals on demand. As stores of metal became too cumbersome to carry, paper receipts were issued for gold and silver deposited with goldsmiths for safekeeping. As long as the goldsmith was honest and secure, such practice was preferred, and eventually led to “banks” holding deposits for their customers and transferring them by checks.

In time, people grew accustomed to using paper money as a substitute for gold and silver. The next step in the evolution of money was “legal tender” legislation, which forced people to accept paper in settlement of government debts during times of emergency (most recently in the United States during the Civil War). After many years of “emergency” use of paper money, the ability to redeem the paper for precious metals was revoked and the money became known as a fiat currency. At this point, the currency derived its value from both the ability of the issuing government to produce hard assets as back-up for its currency (through taxes, and borrowing) and the people’s willingness to recognize (accept) the currency’s value. Of course, there is no limit to the amount of paper money and credit that can be issued, which is too much for most legislators to resist. Thus, pork barreling (buying votes) has led to budget deficits, economic “stimulation” and inflation. One type of government intervention leads to another, until there is a world-wide competition among governments to stimulate their own economies relative to all others through monetary expansion.

Another consequence of legal tender laws was that each country, by requiring that its own currency be used within its borders, shut out all other currencies, thus necessitating the exchange of one currency for another by international businessmen and travelers. Thus was born the phenomenon of exchange rates and the need for determining the price of one currency relative to another.

The “price” of money is determined the same way the prices of all other commodities are determined: through supply and demand, and expectations of future supply and demand. The greater the supply and/or expected supply, given a constant demand, the lower the price. Of course, the “price” of money is relative to the goods or other currencies that it will purchase. For example, when we talk in terms of buying an ounce of silver, we may state the price in terms of U.S. dollars as $14.00 per ounce. We may also state the price of silver in terms of Euros as €10,00. From the perspective of the currency, the price is €10,00 or $14.00, but from the perspective of the silver, the price of the currency is, respectively, one-tenth or one-fourteenth of an ounce. Notice that different currencies have different prices relative to the one ounce of silver. It depends on which measuring stick or currency we use, what the stated price of one ounce of silver is. In time, either the price of the measuring stick, i.e. the currency, or the commodity price can change as a result of changing supply and demand. For example, the price of one ounce of silver could become U.S.$20.00 and €13,33. Notice that the price of one ounce of silver has increased by 42.86% in terms of the U.S. dollar, while it has increased by 33.30% in terms of the Euro. The fact that the price of one ounce of silver changed at different rates relative to the two currencies demonstrates that the “prices” of the two currencies changed relative to one another. Thus, it is apparent that the measuring stick, i.e. the currency, has changed relative to other measuring sticks (currencies), and other commodities (one ounce of silver in this case).

This phenomenon of the prices of currencies changing relative to one another can be easily seen by looking at a history of changes between the U.S. dollar and the Euro, starting on January 3, 2000. See here for the cost of one Euro in terms of U.S. dollars. It is interesting to note that on January 3, 2000, it cost $1.0155 to purchase one Euro, while on October 25, 2000, the price of one Euro hit a low of $.8270, and on October 25, 2007, it cost $1.4299 U.S. dollars to purchase one Euro.

(Each country or group of countries that controls its own currency has the power to inflate or deflate its currency relative to others. And each country does “regulate” the price of its currency by expanding or contracting its money supply, often with an eye toward other currencies. Politicians and central bankers believe that it is easier for their exporters to export goods to other countries when their own currency is “cheaper” than the currencies of the other countries promoting a more “favorable” balance of trade. Debtor nations also benefit from inflating their currencies by paying off their debts with cheaper money.)

Description of FOREX Markets

There are a number of markets in which currencies are traded. As a group, these foreign exchange markets are called the FOREX markets. They consist of: the spot market, which includes the retail market and the inter-bank market, the forward contract market (including currency swaps), the futures market, the cash options market, the futures options market, and the market for exchange traded funds (ETFs).

SPOT MARKET

Retail and Inter-bank Market

The “spot” market for foreign currencies exists on a retail level where the bills of one currency are traded for the bills of another currency. Banks, automatic tellers, money changers and credit card charges in a “foreign” country are typical examples of how retail market transactions take place. The exchange rates that are used in such transactions are determined by an informal network of banks and other financial institutions known as the inter-bank market with settlement occurring in two business days. The inter-bank market consists of large investment banking firms linked together with a computer network where members negotiate among themselves for large quantities of a given currency 24 hours a day five days a week.

FORWARD CONTRACT MARKET

A forward contract is an agreement in which two parties negotiate the following terms: which currency is involved, the quantity to be exchanged, where and when the currency will be delivered, and the exchange rate. Thus, two parties can agree, for example, to exchange $100,000.00 into Euros three months hence, to be deposited into a specific bank in Europe at an exchange rate of $1.4069 per Euro. The forward contract market is for transactions with settlement beyond two days.

Currency Swaps

Currency swaps are transactions in which two banks in the inter-bank market trade a quantity of currency with an agreement to reverse the transaction at a certain later time. The initial leg of the transaction can be either a spot transaction or a forward transaction with the closing leg being a forward transaction.

FUTURES MARKET

The futures markets have exchanges in which the terms of the contracts for the exchange of currencies are standardized by the exchanges, i.e., the exchange sets the currency to be traded, the quantity or size of the contract, and the time and place for delivery of the currency. The only contract term remaining is the price, which is negotiated between the buyers and sellers. Contracts can be relatively easily offset because of the markets’ relative liquidity. The most liquid futures markets trading currencies are: CME® Group, ICE Futures U.S., Korea Exchange (KRX), Bolsa Mercadoria y Futuros (BM&F), and NYSE/Euronext.

CASH OPTIONS MARKET

The cash options market trades calls and puts for the delivery of the cash currency. If you exercise a call, you receive the underlying currency for that call. If you exercise a put, you must deliver the underlying currency for that put. This kind of option is primarily traded in the “Over the Counter” Market (OTC) where parties negotiate directly with one another via computer or telephone to arrive at an agreement for the delivery of a currency in the future. Exchange-traded cash options are traded at the Philadelphia Stock Exchange; however, their settlement occurs in U.S. dollars.

FUTURES OPTIONS MARKET

The futures options markets usually coincide with the futures markets because the underlying asset for a futures option is a futures contract. In other words, if a futures option is exercised, the owner receives either a long or short futures position. The futures exchanges with futures options on currencies are: CME® Group, and the ICE Futures U.S.

EXCHANGE-TRADED FUNDS (ETFs).

An Exchange-Traded Fund (ETF) is an open-ended investment company that trades on a stock exchange. By investing in the components of an index or in the commodity, the ETF makes available to small investors the opportunity to invest in the index or commodity. For example, an ounce of gold may cost $800.00, but a share in a gold ETF may cost $80.00, making it a more viable investment for many more people.

Currency ETFs began trading in 2005. They are traded on the New York Stock Exchange. Currently, there are currency ETFs for the Australian Dollar, British Pound, Canadian Dollar, Euro, Mexican Peso, Swedish Krona, Swiss Franc, and Japanese Yen.

Market Participants

As international trade has grown, the sea of money has expanded. Of course, the bigger the bath tub, the easier it is to have waves and the more difficult it becomes to stop those waves. Thus, currency fluctuations have grown beyond the control of central banks and have spawned the need to protect oneself against the risk of price (exchange rate) change. This risk can be transferred from those who want to avoid it to those who seek to profit from it in the FOREX markets. Consequently, two distinct groups of traders have arisen. There are the hedgers, who want to reduce their risk of currency price fluctuations, and there are the speculators, who want to profit from the change in currency exchange rates.

Hedgers

In the world of business, hedgers are entities (individuals or businesses) wanting to reduce their risk of loss from price changes. Their risk naturally occurs because they are doing business with economic goods and/or financial instruments. In broad terms, there are two types of hedgers: short hedgers and long hedgers; i.e., hedgers who either want to protect against a price decline or a price rise, respectively.

A short hedger might be a farmer who is growing a crop and wants to protect against a decline in his crop’s price between the planting and harvesting times. It could be a banker who wants to protect against a rise in interest rates (and decline in bond prices), or it could be an exporter selling goods and being paid a fixed price in a currency with a declining price (exchange rate). To protect against losses in these situations, hedgers can enter into a “substitute sale” in an organized market that allows short selling. In this way, should the price of his/her commodity/instrument decline as feared, he/she will profit from his/her hedge while simultaneously losing money on the position in the cash market. While the hedge may not entirely offset the loss experienced in the cash market, it will hopefully reduce the loss, thus lessening the risk that he/she was originally facing.

A long hedger might be a farmer who fattens cattle and wants to protect against an increase in feed prices. It could be an insurance company looking to purchase bonds in its portfolio when the cash becomes available down the road and wanting to protect against a decline in interest rates (and an increase in bond prices). Or it could be a company planning to purchase goods in a country with an appreciating currency. To protect against rising costs in these situations, hedgers can enter into a “substitute purchase” in an organized market. In this way, should the price of his/her commodity/instrument rise as expected, he/she will profit from his/her hedge while simultaneously paying more for the commodity/instrument in the cash market. While the hedge may not entirely offset the increased costs in the cash market, it will hopefully reduce the loss, thus lessening the risk that he/she was originally facing.

Because hedgers have one foot in the cash market, they tie future prices to present prices. Thus, as we move into the future, future prices become present prices (convergence).

Example

A German automobile manufacturer (GAM) sells automobiles to dealers in the United States who pay fixed invoice amounts in U.S. dollars. Between the time the invoice is issued and the time it is paid, the manufacturer withstands the risk of exchange rate loss. Specifically, if the price of the U.S. dollar declines relative to the Euro, the manufacturer will receive fewer Euros upon exchange. This makes it more difficult to pay his employees and vendors in Europe. To hedge this risk in the futures markets, the German manufacturer buys Euro futures as a substitute purchase for the Euros he will be purchasing at a future time in the cash market. Let’s assume that GAM invoices its U.S. dealers $125 million in August, 2007 and that they are expecting to receive payment within 90 days ( November 1, 2007). GAM hedges its risk by purchasing 1,000 December 2007 Euro futures contracts on the Chicago Mercantile Exchange on August 3 at $1.3851 per Euro. The cash market exchange rate at that time was $1.3785 per Euro.

By November 1, 2007, when timely payments arrived, GAM exchanged the Dollars for Euros in the cash market at an exchange rate of $1.4435 per Euro when the December 2007 futures contract price was $1.4469 per Euro. The loss in the cash market was $8,125,000 ($1.4435 – $1.3785 = $.0650/€ x €125,000,000 = $8,125,000). Fortunately, GAM reduced its currency risk exposure by hedging its position with futures. GAM purchased 1,000 futures contracts of €125,000 each at $1.3851 per Euro and sold them on November 1, at $1.4469. This produced a gain of $7,725,000 ($1.4469 – $1.3851 = $.0618 x 1,000 contracts x €125,000/contract = $7,725,000). By hedging in the futures market, GAM reduced its net currency loss (excluding commissions) from $8,125,000 to $400,000. Way to go GAM! I bet GAM will continue to hedge its currency exchange exposure in the futures.

Because the various FOREX markets tend to move parallel to one another, it is possible to hedge currency risk. While there are both long and short hedgers providing liquidity to one another, hedging is also facilitated by speculators who provide the bulk of liquidity that makes for ease of entry and exit for hedgers.

Speculators

Speculators assume risk in the pursuit of profits. Their risks are calculated to maximize profit potential. They might speculate that prices will rise, decline, go sideways or that price differentials will widen or narrow. What’s more, speculators can handle different degrees of leverage. Some speculators prefer to hold cash while others may indulge in the futures markets with a margin requirement of 5–10% of the total contract value. Still others may prefer the 100 to 1 leverage found in the currency spot market. Of course, the more leverage used, the faster one can be taken out of the markets for lack of adequate margin.

Example

Let’s assume a speculator believes that the Euro is going to go up relative to the U.S. Dollar when the Euro costs $1.3714. He purchases €125,000 in the spot market from a market maker who requires a margin deposit of approximately $1,728 to secure the position (This is normal in the spot currency market). That’s leverage of 100 to 1, or 100:1. While a deposit of $1,728 may be the minimum amount required, it is generally a good idea to have more than the minimum on deposit in one’s account (as we’ll see shortly). Our speculator enters his trade (buys) at $1.3714 per Euro. Sometime later, the Euro goes up to $1.3824/Euro. At this point, our speculator is ahead by $1,375 ($1.3824 – $1.3714 = .0110 x €125,000 = $1,375). If he were to liquidate his position at this point, he would have a 79.6% profit on his initial $1,728 investment (excluding commissions). A week later, however, the price of the Euro declines to $1.3402/Euro, demonstrating the principle that markets can move against you. As the price declines, our speculator must add additional money to his account to cover the daily losses and maintain his position. Unfortunately, our speculator can’t stand the losses and liquidates his position at $1.3402, just before the price rises again. The decline from $1.3714 to $1.3402 has generated a loss of $3,900 ($1.3714 – $1.3402 = $0.0312 x €125,000. = $3,900) (an amount greater than his entire initial investment). Thus, his total return in the spot market is –225.69%. ($3,900/$1,728 = 2.2569 or -225.69%).

If instead of the trading in the spot market, our speculator had chosen the futures markets, entering and exiting at the same prices as above, his margin requirement would have been at least $2,025 for a contract of €125,000. Under these circumstances, his loss would have been $3,900 ($1.3714 – $1.3402 = $0.0312/Euro x €125,000 = $3,900). Thus, his total return in the futures market is –192.59%. This lower percentage loss is due to the higher margin requirement in the futures market.

Currency Symbols

The symbols that are used to designate the various currencies are standardized world-wide. They are: U.S. Dollar = USD, Canadian Dollar = CAD, Euros = EUR, British Pound = GBP, Japanese Yen = JPY, Swiss Franc = CHF and the Australian Dollar = AUD. These symbols are used by banks and exchanges alike to indicate which currency is being purchased and which is being sold. Thus, you generally see them listed in pairs. The currency to be purchased is listed first (base currency) and the currency to be sold is listed second (quote currency). Furthermore, the price that is quoted states the number of “quote currency” units needed to purchase one of the “base currency” units. Let’s consider a quote of EUR/USD with an “asked” price of 1.4469. This means that it would cost $1.4469 to purchase €1.000.

It is important to realize that while you would have to pay $1.4469 in the previous example, to buy Euros, you will receive a different price if you sell them. This is known as the “bid” price. These terms are viewing the transaction from the dealer’s perspective; i.e., the dealer “bids” a price to purchase the Euros you are selling. On the other hand, the dealer “asks” for the price you must pay him for Euros he is offering for sale. Generally, the “bid” price is lower than the “ask” price because the difference is what keeps the dealer in business (commission or profit). Nevertheless, the bid/ask spread is narrower in the spot market than elsewhere because of the extreme market liquidity making it easier to enter and exit the markets.

It is common practice to show the bid/ask price spread as follows: 1.4459/69. Please note that the bid price is $1.4459 and the ask price is $1.4469. The difference between the two prices can vary depending on the firm issuing the quote. Some firms will charge a commission and offer a narrower spread, while others charge no commission and offer a wider spread. Be sure to know how your firm charges. But then, you will learn this as part of your “due diligence” check when choosing a dealer/broker with whom to trade.

When closing a spot market or futures market position, one sells the same quantity of the same currency one purchased earlier. Conversely, when one sells short, one buys back the same quantity of the same currency one sold earlier. With futures, it is important to do this on the same exchange and in the same contract month as the opening position. In the spot market, the same settlement date must be used.

Trading Strategies

To have a strategy, or plan, we must understand what affects the market, how it affects the market, and how to profit or hedge in that market. As we mentioned earlier, supply and demand are the key actors in this play—supply of money and demand for money relative to goods. Thus, we must consider not only the supply and demand for money, but also the supply and demand for the economic goods that currencies buy. In short, we must consider the health of the economy, both physically and mentally (the market’s psychology), as well as the supply and demand for money. So how do we gauge the health of the economy? We must look at certain indicia, such as inflation, government deficits/surpluses, economic growth, balance of trade, and people’s fears/euphoria and herd instinct. When we consider all of these supply and demand factors, we are engaging in fundamental analysis.

Most people think of inflation as rising prices, rather than an expansion of the money supply, so they look at indices of rising prices such as the Consumer Price Index (CPI) and Producer Price Index (PPI). Investors often make decisions, in part based on these government reports. They also look at the trends these reports divulge to develop an expectation about future inflation rates, thus biasing the markets. In other words, when enough investors believe that housing prices, for example, will continue to rise, they may be inclined to borrow money (sometimes at higher rates than usual) and purchase second and third homes as investments. This, in turn, can cause a speculative frenzy (bubble?) with rapidly rising housing prices. Of course, should interest rates rise at some point, borrowers who still have their jobs and are over-extended with adjustable rate mortgages may have problems making their payments, which, in turn, can create a problem for the banks who lent them the money in the first place. Is this what’s known as the “domino effect?”

Government deficits/surpluses are also reported by government agencies. To see the U.S. government’s report, click here. Government debts and deficits can impact the economy because there comes a point at which a debt (and the interest payments due on the debt) becomes overburdening and makes it impossible for the government to pay off its debts without massive inflation. Massive inflation, of course, destroys the capital markets and the businesses that are dependent on them. It also reduces the price of the inflated currency relative to other currencies that are not being inflated as rapidly.

The U.S. government also measures economic growth in various reports such as: Gross Domestic Product (GDP), Employment Situation, Retail Trade, and Industrial Production and Capacity Utilization. Economic growth suggests that there is a vibrant economy and that the country will be able to raise the money needed to pay off its debts and standards of living will continue to rise. Improving economies tend to have stronger currencies than weak economies.

A long-term trade deficit/surplus can impact a county’s currency as well. Demand for a country’s goods can lead to an increased demand for its currency, thus increasing its exchange rate. Conversely, a lesser demand for a country’s goods could result in a declining currency.

The political stability of countries also affects the currency exchange rates. A country with a despotic leader ( Zimbabwe), an unopposed political party, or multiple parties that have the same monetary policies, might treat its currency as its own, to inflate it or otherwise manipulate it as it sees fit.

While we must consider all these fundamental factors, we must also be cognizant of the market’s psychology; i.e., how everyone else will react to news affecting this information. If a country mismanages its affairs, what will be the economic consequences? What perceived effect will a natural disaster have on a particular country’s economy? What effect will threats of trade embargoes, tariffs, asset seizure, and war have on the market? Investors’ reactions to these scenarios, whether rational or emotional, can drive a country’s currency up or down.

Some investors base their trading plan on technical analysis. Pure technical analysts base their decisions solely on the patterns they perceive in their price charts. They believe that the fundamental factors, which we’ve seen above, are already considered in the market prices. They need merely to interpret their chart patterns for buy and sell signals which time their entry and exit into/out of the markets. If enough technicians act in concert, market movements can be created and/or magnified.

For speculators who are seeking to profit solely from changing exchange rates, a thorough understanding of the fundamental factors affecting supply and demand, as well as a familiarity with technical indicators, is a good beginning. “Paper trading” is a smart second step toward currency trading proficiency.

Carry Trade

Implicit in trading the currency markets is the assumption that an investor will seek to earn interest on the currency he purchases. Consequently, he must be mindful of the interest paid in the currency being sold, and the interest received in the currency being purchased. For some investors, the interest differential is the motivating factor for speculating in a particular currency pair.

The central banks of major countries in the world not only print their own money, but they also set interest rates for the banks in their country. In the U.S., the Federal Reserve Bank is the central bank, and it sets the Fed funds rate. The Fed funds rate is the interest rate that banks charge one another for the use of Federal Reserve Bank funds. It is this rate that large investors receive or pay indirectly through their banks when trading in the currency markets. Each central bank determines its own interest rate, which is associated with its currency. Thus, large currency investors can borrow funds in a country with relatively low interest rates, pay that country’s rate of interest, exchange its currency for that of another country, and lend its funds at a higher rate in the second country. As long as interest rates and currency exchange rates remain unchanged, our investor earns a higher interest rate than he pays. This practice/strategy is known as the carry trade. The danger for this practice is that the borrowed currency may appreciate, making it more expensive to repay the borrowed funds.

Let’s assume that the Fed funds rate is 4.5%, while the European Union’s (E.U.) central bank’s rate on the deposit facility, which banks may use to make overnight deposits with the Eurosystem, is 3.0%. If a hedge fund were to purchase a USD/EU, it would receive 4.5% and pay 3.0%, earning a net 1.5% per year. Thus, if our hedge fund is leveraged at a ratio of 5:1, it would receive five times 1.5%, or 7.5% per annum on its trade, with the interest being deposited into its account daily. On the other hand, if the Euro were to appreciate relative to the dollar, it wouldn’t take long to wipe out the 7.5% earned on the interest rate differential. So the trick to this trade is to pick a pair of currencies where the borrowed funds depreciate while earning the carry trade interest.

Conclusion

The FOREX markets have become the world’s most liquid and continuous markets with trillions of dollars being traded daily. Whether trading in the spot market, the futures markets, or the options markets, speculators and hedgers can find an instrument and the leverage that meet their needs. From complex speculative strategies to everyday hedging techniques, the FOREX markets provide the forum for dealing with currency fluctuations.

© 2008 CreativeBusinesses.com, Inc.


Disclaimer: The information contained on these pages is from sources believed to be reliable. There is no expressed or implied warranty as to the accuracy or completeness of the material. All information is subject to change without notice. Past performance is not necessarily indicative of future results. You should read a "Risk Disclosure Statement" and/or an "Option Risk Disclosure Statement" before trading and should understand the risks associated with futures and options trading. The risk of loss may be substantial. Trading is risky, and many traders lose money. Before trading, one should be aware that with the potential for profits, there is also the potential for losses, which may be large. The information on this web site is not to be construed as trading advice, and should not be relied upon for timeliness as its availability cannot be guaranteed.