Introduction to Currency Exchange and the FX Market
What is Currency
Currency exchange is the trading of one currency against another. Professionals
refer to this as foreign exchange, but may also use the acronyms Forex or FX.
The Need for Currency
Currency exchange is necessary in numerous circumstances.
Consumers typically come into contact with currency exchange when they
travel. They go to a bank or currency exchange bureau to convert one currency
(typically, their "home currency") into another (i.e. the currency of the country
they intend to travel to) so they can pay for goods and services in the foreign
country. Consumers may also purchase goods in a foreign country or via the Internet
with their credit card, in which case they will find that the amount they paid
in the foreign currency will have been converted to their home currency on their
credit card statement. Although each such currency exchange is a relatively
small transaction, the aggregate of all such transactions is significant.
Businesses typically have to convert currencies when they conduct business
outside their home country. For example, if they export goods to another country
and receive payment in the currency of that foreign country, then the payment
must often be converted back to the home currency. Similarly, if they have to
import goods or services, then businesses will often have to pay in a foreign
currency, requiring them to first convert their home currency into the foreign
currency. Large companies convert huge amounts of currency each year; for example,
a company such as General Electric (GE) converts tens of billions of dollars
each year. The timing of when they convert can have a large affect on their
balance sheet and "bottom line.
Investors and speculators require currency exchange whenever they trade
in any foreign investment, be that equities, bonds, bank deposits, or real estate.
For example, when a Swedish investor buys shares in Sun Microsystems on the
NASDAQ, she will have to pay for the shares in U.S. Dollars and likely have
to convert Swedish Krona to U.S. Dollars. Similarly, a Japanese real estate
investor who sells a New York property may well want to convert the proceeds
of the sale in U.S. Dollars to Japanese Yen.
Investors and speculators also trade currencies directly in order to benefit
from movements in the currency exchange markets. For example, if an American
investor believes that the Japanese economy is strengthening and as a result
expects the Japanese Yen to appreciate in value (i.e. go up relative to other
currencies), then she may want to buy Japanese Yen and take what is referred
to as a long position. Similarly, if an American investor believes that the
Euro will go down over time, then she may want to sell Euro to take a short
position. Interestingly, investors and speculators can profit equally from currencies
becoming stronger (by taking a long position) or from currencies becoming weaker
(by taking a short position). Speculators are often day traders, trying to take
advantage of market movements in very short time periods; buying a currency
and then selling it again may happen within hours or even minutes. They are
attracted to currency trading for numerous reasons, including (i) the size and
daily volatility of the market, which gives them unparalleled excitement, (ii)
the almost perfect liquidity of the currency exchange market, (iii) the fact
that the currency exchange market is "open" 24 hours a day market, and (vi)
the fact that currencies can be traded with no brokerage charges.
Commercial and Investment Banks trade currencies as a service for their
commercial banking, deposit and lending customers. These institutions also generally
participate in the currency market for hedging and proprietary trading purposes.
Governments and central banks trade currencies to improve trading conditions
or to intervene in an attempt to adjust economic or financial imbalances. Although
they do not trade for speculative reasons --- they are a non-profit organization
--- they often tend to be profitable, since they generally trade on a long-term
Currency Exchange Rates
Currency exchange rates are determined by the currency exchange market. (The
currency exchange market is described further below.) A currency exchange
rate is always quoted for a currency pair using
ISO code abbreviations.
For example, EUR/USD refers to the two currencies Euro (the European currency)
and U.S. Dollar. The first is referred to as the base currency, while
the second as the quote currency. The EUR/USD exchange rate specifies
how many US Dollars you have to pay to buy one Euro, or conversely how many
US Dollars you obtain when you sell one Euro. More generally, if buying, an
exchange rate specifies how much you have to pay in the quote currency to obtain
one unit of the base currency, and if selling, the exchange rate specifies how
much you get in the quote currency when selling one unit of the base currency.
A currency exchange rate is typically given as a pair consisting of a bid
price and an ask price. The ask price applies when buying a currency
pair and represents what has to be paid in the quote currency to obtain one
unit of the base currency. The bid price applies when selling and represents
what will be obtained in the quote currency when selling one unit of the base
currency. The bid price is always lower than the ask price.
In the currency market, the following abbreviation for the currency exchange
rate pair is used:
The first component (before the slash) refers to the bid price (what you obtain
in USD when you sell EUR), and in this case includes four digits after the decimal
point. The second component (after the slash) is used to obtain the ask price
(what you have to pay in USD if you buy EUR). The ask price is obtained by increasing
the first component until the last two decimal places are equal to the digits
in the second component. In this example, the ask price is 0.8428. As another
example, 0.8498/08 refers to a bid price of 0.8498 and an ask price of 0.8508.
(Note that for some exchange rates it is customary to quote rates in units of
100, as is the case with USD/JPY.)
The difference between the bid and the ask price is referred to as the spread.
When trading large amounts of $1M or higher, the spread obtained in a quote is
typically 5 to 6 basis points or PIPs, with each basis point referring
to 0.0001 (or 0.01 when, say, the Yen is involved). In the example above, the
spread is 0.0010 or 10 PIPs. When trading smaller amounts, the spread may be
larger; for example, when trading less than $100,000, spreads of 50-200 PIPs
are common. Credit card companies typically apply a spread of 200-300 PIPs.
Banks and exchange bureaus typically use a spread in the range of 200-1000 PIPs
(in addition to charging a commission). For investors and speculators, a lower
spread translates into easier profit taking due to movements in exchange rates.
| The Currency Exchange Market
The currency exchange market is an inter-bank or inter-dealer market
that was established in 1971 when floating exchange rates began to materialize.
In addition, it is an Over-The-Counter market, meaning that transactions are
conducted between any two counter parties that agree to trade via the telephone
or electronic network. Trading is thus not centralized, as is the case with
many stock markets (i.e. NYSE, ASE, CME) or as the case for currency futures
and currency options, which trade on special exchanges. Dealers often "advertise"
exchange rates using a distribution network, such as the one provided by Reuters or Bridge. Dealers then use the
information obtained there (or directly) to "agree" to a rate and a trade.
The major dealing centers today are: London, with about 30% of the market,
New York, with 20%, Tokyo, with 12%, Zurich, Frankfurt, Hong Kong and Singapore,
with about 7% each, followed by Paris and Sydney with 3% each.
In terms of trading volume, the currency exchange market is the worlds largest
market, with daily trading volumes in excess of $1.5 trillion US dollars.
This is orders of magnitude larger than the bond or stock market. For example,
the New York Stock Exchange has a daily trading volume of approximately $60
billion. Thus, the currency exchange market is by far the most liquid market
in the world today. Because of the volume in trading, it is impossible for individuals
or companies to affect the exchange rates. In fact, even central banks and governments
find it increasingly difficult to affect the exchange rates of the most liquid
currencies, such as the US dollar, Japanese Yen, Euro, Swiss Frank, Canadian
Dollar or Australian Dollar.
The currency exchange market is a true 24-hour market, 5 days a week.
There are dealers in every major time zone. Trading begins Monday morning in
Sydney (which corresponds to 3pm EST, Sunday) and then daily moves around the
globe through the various trading centers until closing Friday evening at 4:30pm
EST in New York.
Today, over 85% of all currency exchange transactions involve a few major currencies:
the US Dollar (USD), Japanese Yen (JPY), Euro (EUR), Swiss Frank (CHF), British
Pound (GBP), Canadian Dollar (CAD), and Australian Dollar (AUD). In the currency
exchange market, most of the currencies are traded only against the US Dollar.
The term cross rate refers to an exchange rate between two non-dollar
currencies. Trading between two non-dollar currencies usually occurs by first
trading one against the US Dollar and then trading the US Dollar against the
second non-dollar currency. Because of this, the spread in the exchange rate
between two non-dollar currencies is often higher. (There are a few non-dollar
currencies that are traded directly, such as GBP/EUR or EUR/CHF.) The following
directly traded currency pairs make up the vast majority of the trading volume
and are thus considered to be the most important ones: EUR/USD, USD/JPY, EUR/JPY,
USD/CAD, EUR/GBP, GBP/USD, USD/CHF, AUD/USD, and AUD/JPY.
How currency trading is done traditionally
Currency trading is always done with currency pairs, such as EUR/USD, and so
it is useful to consider the currency pair as an instrument, which can be bought
- Buying the currency pair implies buying the first, base currency and selling
(short) an equivalent amount of the second, quote currency (to pay for the
base currency). (It is not necessary for the trader to own the quote currency
prior to selling, as it is sold short.) A speculator buys a currency pair,
if she believes the base currency will go up relative to the quote currency,
or equivalently that the corresponding exchange rate will go up.
- Selling the currency pair implies selling the first, base currency (short),
and buying the second, quote currency. A speculator sells a currency pair,
if she believes the base currency will go down relative to the quote currency,
or equivalently, that the quote currency will go up relative to the base currency.
After buying a currency pair, the trader will have an open position in the
currency pair. Right after such a transaction, the value of the position will
be close to zero, because the value of the base currency is more or less equal
to the value of the equivalent amount of the quote currency. In fact, the value
will be slightly negative, because of the spread involved.
In todays currency market, a trade goes through a three-step process:
- the trader communicates the currency pair and the amount he/she would like
to trade with another dealer.
- the dealer responds with a bid and an ask price
- the trader responds to the bid and ask price with one of:
- buy (by saying "Mine" or "I buy" or "I take")
- sell (by saying "yours" or "I give you" or "I sell")
The transaction occurs if the final response is either a buy or a sell. The
dealer is required to quote a "good" market price, since he does not know whether
the trader will buy or sell.
The currency exchange market described above is referred to as the spot
market and the transaction described is referred to as a spot deal.
A spot deal consists of a bilateral contract between a party delivering a specified
amount of a given currency against receiving a specified amount of another currency
from a second counter party, based on an agreed exchange rate, within two business
days of the deal date, which is referred to as the settlement date. (The
settlement date for USD/CAD is one business day after the deal date.) Speculators
rarely deliver, however. Instead, they use what is referred to as a rollover
swap. The rollover swap is designed to allow the changing of an old deal
date to the current date by simultaneously closing an open position for todays
date and opening the same position for the next day at a price reflecting the
interest rate differential between the two currencies.
When a trader buys or sells a currency pair,
the value of the currency pair, as an instrument, initially is close to zero.
This is because (in the case of a buy) the quote currency is sold to buy an
equivalent amount of the base currency. As the market rates fluctuate, however,
the value of the currency pair position held will also fluctuate. Thus, if the
rate for the currency pair goes down, the speculators long position will lose
in value and become negative. To ensure that the speculator can carry the risk
for the case where the position results in a loss, banks or dealers typically
require sufficient collateral to cover those losses. This collateral is typically
referred to as margin.
To limit down-side risk, traders often specify a Stop-Loss rate for
each open trade. The Stop-Loss specifies that the trade should be closed automatically
when the currency exchange rate for the currency pair in question reaches a
certain threshold. For long positions, the Stop-Loss rate is always lower than
the current exchange rate; for short positions, it is always higher. Traders,
at times, also specify a Take-Profit rate for their trades in order to
lock in a profit when the exchange rate reaches a certain threshold. For long
positions, the Take-Profit rate must be above the current rate, while for short
positions, it must be below the current rate.
A trader may also leave an order with a bank, broker or dealer. These so called
leave orders are orders that a trade should be executed (in the future)
when certain market conditions occur. There are three types of leave orders:
- entry orders: specifies that a currency pair should be traded when
it reaches a certain exchange rate. Entry orders are used when the trade would
not offset a current position.
- take-profit orders: are used to clear a position by buying (or selling)
the currency pair of the position when the exchange rate reaches a specified
- stop-loss orders: are used to clear a position by buying (or selling)
the currency pair of the position when the exchange rate reaches a specified