Foreign Exchange Basics
Forex is an investing niche that may soon take off
A Basic Understanding of Forex
Forex, or foreign exchange, is the process of changing one currency into another currency for a variety of reasons — usually for commerce, trading, or tourism. On average, the market trades $5.1 trillion in daily forex trading volume. Thus, forex markets tend to be the most liquid asset markets in the world. One thing I learned from my Finance undergrad (shoutout Spring Break University) is that the Forex market never closes — we see the same thing with people trading cryptocurrencies.
In the market, currencies trade against each other as exchange rate pairs. For example, JPY/USD. Forex markets exist as spot — or cash — markets and as derivatives markets offering forwards, futures, options, and currency swaps. Market participants use forex to hedge against international currency and interest rate risk, to speculate on geopolitical events, and to diversify portfolios, among several other reasons.
Currencies play a larger role in everyday life, as currencies need to be exchanged in order to conduct foreign trade and business. We have seen the effects of currency mismanagement, like when Germany faced severe inflation as a country. There is no central marketplace for foreign exchange, which is unique. Rather, currency trading is conducted electronically over-the-counter (OTC), which means that transactions occur on different networks 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 — crossing time zones. The beauty is that when the trading day in the U.S. ends, the market is just opening for Tokyo and Hong Kong. Thus, the forex market can be extremely active at any point of time in the day, with price quotes changing constantly.
The History of Forex
Unlike stocks, which can trace their roots back centuries, the forex market as we understand it today is quite young. Of course, in its most skeletal sense — people converting one currency to another for financial gain— forex has been around since nations began minting currencies. However, modern forex markets largely appeared after the accord at Bretton Woods in 1971, when more major currencies were allowed to float freely against one another. The values of individual currencies vary, which has given rise to the need for foreign exchange services and trading.
Commercial and investment banks conduct the majority of trading in forex markets on behalf of their clients, but it has also been tried by professional and individual investors.
Mrs. Watanabe describes the archetypical Japanese housewife who seeks the best use of her family’s savings. Though historically risk-averse, Mrs. Watanabe became a surprisingly big player in currency trading during the past decade to combat low-interest rates in Japan.
The 3 Markets
There are three ways that institutions, corporations and individuals trade forex: the spot market, the forwards market, and the futures market. The spot market has always been the largest market because it is the “underlying” real asset that the forwards and futures markets are based on. Historically, the futures market was the most popular venue for traders because it was available to individual investors for a longer period of time. However, with the advent of electronic trading and brokerages, the spot market has witnessed a huge surge in activity and now surpasses the futures market as the preferred trading market for individual investors and speculators. Now, forwards and futures markets tend to serve as a hedge against foreign exchange risks for international companies with a specific project time period.
The spot market is where currencies are bought and sold according to the current price. That spot price, determined by supply and demand, is a reflection of many things, including but not limited to: interest rates, the economy, local and international affairs, and general sentiment. When a deal is finalized, this is known as a “spot deal.” It is a bilateral transaction by which one party delivers an agreed-upon currency amount to the counter party and receives a specified amount of another currency at the agreed-upon exchange rate value. After a position is closed, the settlement is in cash. Although the spot market is commonly known as one that deals with transactions in the present (rather than the future), these trades actually take two days for settlement.
Unlike the spot market, the forwards and futures markets do not trade actual currencies. Instead, they deal in contracts that represent claims to a certain currency type, a specific price per unit, and a future date for settlement.
In the forwards market, contracts are bought and sold over-the-counter between two parties, who determine the terms of the agreement between themselves.
In the futures market, futures contracts are bought and sold based upon a standard size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange. In the U.S., the National Futures Association regulates the futures market. Futures contracts have specific details, including the number of units being traded, delivery and settlement dates, and minimum price increments that cannot be customized. The exchange acts as a counterpart to the trader, providing clearance and settlement.
Both types of contracts are binding and are typically settled for cash at the exchange in question upon expiry, although contracts can also be bought and sold before they expire. The forwards and futures markets can offer protection against risk when trading currencies. Usually, big international corporations use these markets in order to hedge against future exchange rate fluctuations, but speculators take part in these markets as well.
Factors like interest rates, trade flow, tourism, economic strength, and geopolitical risk influence the supply and demand for currencies, creating daily volatility in the forex markets. Thus, an opportunity exists to profit from changes that may increase or reduce one currency’s value compared to another. A forecast that one currency will weaken is essentially the same as assuming that the other currency in the pair will strengthen because currencies are traded as pairs.
Currency as an Asset Class
Currencies have distinct features as an asset class:
- You can earn the interest rate differential between two currencies.
- You can profit from changes in the exchange rate.
A profit can result from two interest rates in two different economies by buying the currency with the higher interest rate and shorting the other. Prior to the 2008 financial crisis, it was very common to short the Japanese yen (JPY) and buy British pounds (GBP) because the interest rate differential was very large. This strategy is sometimes referred to as a “carry trade.”
Forex Trading Risks
Trading currencies can be extremely risky and complex. This article in no way constitutes any professional advice, and you should always seek counsel before making financial decisions. This market is not standardized and is, in some places, completely unregulated.
The interbank market is made up of banks trading with each other around the world. The banks themselves have to determine and accept risk, and they have established internal processes to insulate themselves. Because there are such large trade flows within the system, it is difficult for rogue traders to influence the price of a currency. This system helps create transparency in the market for investors with access to interbank dealing.
Most small retail traders trade with relatively small and semi-unregulated forex brokers/dealers, which can (and sometimes do) re-quote prices and even trade against their own customers. Depending on where the dealer exists, there may be some government and industry regulation, but those safeguards are inconsistent around the globe.
Most retail investors should spend time investigating a forex dealer to find out whether it is regulated in the U.S. or the U.K. (which has more oversight) or in a country with lax rules and oversight. It is also important to consider what would happen in a market crisis, or if a dealer becomes insolvent.
Pros and Challenges of Trading Forex
Pros: Liquidity. Speed. Availability.
Challenge: Risk. Regulation. Volatility.
The Bottom Line
Day trading or swing trading in small amounts is easier in the forex market than other markets due to its liquidity. For those with longer-term horizons and larger funds, fundamentals-based trading or a carry trade can be profitable. Focus on understanding the macroeconomic fundamentals driving currency values. Experience with technical analysis may help new forex traders to become more profitable.