Origin of Forex Markets
Bartering and trade has been a part of human society since the advent of recorded history. If someone only has corn, and a neighbor only has chickens, the two meet and decide a fair exchange rate, and both leave with some amount of chickens and corn. This system has inherent shortcomings on a broad scale, when one has to try to determine what an ear of corn or one chicken is worth. As a result, people came up with the concept of currency; a standard unit of measure that is ascribed a certain value and then used to purchase goods based on their relative value within that currency. As with many aspects of society and culture, currencies became very localized, with nations each having their own standard of measurement and their own set of physical paper and coins representing the underlying currency. With this came supply and demand, inflation, regulation, and other factors that lead to relative value differences between any two currencies. Not only could two currencies value be different relative to each other, but those relationships, much like the price of chickens or corn, fluctuate over time.
This leads to a similar situation as presented in the first paragraph, but now one person has U.S. Dollars and their neighbor has Great British Pounds. How do the two meet and decide on a fair exchange rate between the two currencies? As far back as the middle ages, such exchanges were handled by international banks. In 1875, the Gold Standard Monetary System was instituted. Gold and silver were already widely used as payment in international trade, and as underlying assets for currencies. Following World War I, however, the gold standard monetary system collapsed due to hyperinflation from the costly conflict. In 1944 the Allied powers gathered in New Hampshire where they instituted the Bretton Woods Agreement, named for the city where government representatives met. The agreement created the World Bank and the International Monetary Fund, as well as establishing the USD as the standard for the world’s currencies.
This standard also failed, as the system created increased demand for USD, causing the dollar to quickly exceed its underlying value in gold of 1 USD per 1/35 of an ounce of gold. As a result, the Bretton Woods Agreement broke down in 1971, paving the way for the birth of the modern foreign currency exchange. Instead of the USD holding the mantle as the sole standard for global currency exchange, major currencies were allowed to flow freely against one another. This inevitably led to the advent of Forex (FX) or the Foreign Currency Exchange, which is 24 hour weekday over-the-counter market where hedgers and speculators can take part in currency pair trading, the practice of trading the relative value of one currency against another.
Modern Forex Markets
Despite other trading avenues providing exposure to currencies in the futures and forwards markets, Forex (also known as the spot market) is still the highest volume cash market with billions of dollars traded per day. It addition to its high liquidity, the FX market is open 24 hours a day with sessions spread across the globe, existing in almost every time-zone. The three major Market Sessions are the Asia-Pacific to Tokyo Session, the Europe to London Session, and the North America to New York Session, matching the largest foreign exchange markets in the major global financial centers of London, New York, Singapore, Tokyo, Frankfurt, Hong Kong, and Sydney.
Originally, the exchange of foreign currency exclusively carried a concrete practical purpose. If one was traveling from the U.S. to the U.K., they would have to exchange their dollars for pounds in order to conduct business and make purchases. With the advent of the FX markets in the 1970s, combined with the connecting power of the internet that allowed electronic transactions to occur between individuals all over the world, a trader can now exchange their funds between different currencies with no intentions to spend any of the underlying currencies. The FX trader’s objective is to buy and sell currencies against one another for a profit.
Trading Forex: Currency Pairs
As alluded to before, FX trading is different from many asset classes in that the trader is not merely purchasing a single currency with plans to sell it after its value increases. All FX trades must be currency pair trades; an attempt to predict the movement of one currency relative to another.
Currency pair nomenclature is presented in the format of USD/GBP (United States Dollars & Great British Pounds), followed by the price quote for the pair, such as 1.5001.
USD/GBP 1.5001 means that it would cost 1.5001 GBP to buy 1 USD.
Using the USD/GBP 1.5001 example above, if a trader believed the British economy was going to weaken in response to Brexit, and thus believed the pound was going to fall in value relative to the dollar, they may choose to buy the USD/GBP currency pair. In executing this currency pair buy, the trader makes the simultaneous purchase of the base currency (USD) and the sale of the quoted currency (GBP), and vice-versa for a sale of the currency pair. Additionally, the trader could execute an order on the inverse currency pair of GBP/USD, where the price is now the amount of dollars needed to purchase 1 GBP.
Returning to the USD/GBP 1.5001 purchase, after a set amount of time, the USD/GBP pair has increased to 1.5422. This means that it now costs 1.5422 GBP to purchase 1 dollar. The GBP has weakened relative to the USD. If the trader executes a sale at this price, they make a profit of 0.0421, also colloquially referred to as 421 “pips”. Had this exact buy and sell been made in person, the trader would have profited 4 cents. In FX markets, however, currencies are not traded a single dollar or pound at a time, but instead in what are called lots. FX markets have micro, mini, and standard lots. A standard lot is 100,000 of the underlying currency, a mini lot is 10,000, and a micro lot is 1000. So if the example trade involved a mini lot of USD/GBP, then that 421 pip move would have resulted in a $42.10 profit.
One thing to keep in mind is that when a trader sits down to make the above purchase, the price will not appear as a simple “USD/GBP 1.5001”. This is because in order for a trade to be carried out, there must be a party on either side of the transaction: a buyer and a seller. This factor is why all FX trades are a zero sum game. The buyer is not obtaining stock from a company and then holding it, with both parties hoping that stock gains in value, but is instead entering a 1 to 1 transaction with the seller. As such, actual price quotes for currency pairs carry this dual sided nature, representing what the buyer is willing to bid and what the seller is asking. An actual USD/GBP quote would look more like 1.5001/1.5008. The first number is the bid price and the second number is the ask. The spread, 7 pips in this instance, is the difference between the bid and the ask.
Going from USD/GBP 1.5001/1.5008 to an actual executed trade between two entities requires a specialist known as a market maker who facilitates trades by ensuring there is a buyer for every seller and vice versa. If the spread is 1.5001/1.5008, the actual value at that moment of the underlying currency pair may be 1.5004 GBP for 1 USD. The bid will almost always come in a little less than that value, and the ask slightly higher. The market maker keeps the spread as profit for taking the risk and facilitating the trade. For this mini lot, the 7 pip spread represents $7.00, which doesn’t sound like much until it is multiplied over the millions of units involved in the average USD/GBP trade. For major currencies such as the US Dollar, Great British Pound, or Japanese Yen, liquidity is substantial enough to allow for narrow spreads during high volume hours. Outside of the main trading sessions, or in a minor thinly-traded currency pair, less competition can result in wider spreads.
In FX trading, leverage is often a key component. Brokers may provide leverage often ranging from 50:1 to 200:1 depending on the broker, account size, position being traded and the regulatory restrictions in the country that the broker and/or customer is based in. A 50:1 leverage ratio means that the minimum margin requirement (amount that you need to have in your account to initiate a trade) for the trader is 1/50 (2%) of the size of the position that the trader wishes to take. If a customer were to take a $100,000 position in an account with 50:1 leverage, they would then have a minimum margin requirement of $2,000, provided the broker doesn’t impose any other restrictions.
Hedgers vs Speculators
LA factor that has remained unknown thus far in the example trade is the secondary purpose of the trader. The primary purpose, of course, is to generate profit from movements in currency valuations. Within that larger umbrella, however, exist two types of traders: hedgers and speculators. A speculator is a trader who does not have an equivalent cash stake equal to or greater than the FX trade they are attempting to execute. A speculator trading a mini-lot of USD/GBP is not in a position requiring them to exchange 10,000 units between dollars and pounds. They are instead buying a currency pair, then selling at a later date, in order to speculate on potential moves in the market.
The hedger, however, approaches the market with a much different goal in mind. A hedger is someone who does in fact have an equivalent cash position equal to or greater than the position they take on in the market. With hedging in futures, the relationship between the cash position and the hedge is rather intuitive. If a farmer has corn, and worries that the price may drop, they hedge by taking a short position in corn futures to offset the potential risk. With FX hedging, this risk management is not regarding a specific good or commodity, but instead the transport of goods, commodities, or actual cash, over international borders.
If a U.S. company needs to purchase something from a company in the U.K., they will inevitably require an exchange of currency. The company’s U.S. dollars will need to be exchanged into GBP in order to conduct business in the U.K., opening the entity to risk of loss if the USD drops in value relative to the GBP before the transaction is complete. An effective hedge can be set up through trading currencies by taking on a position that would profit in the event that GBP outperformed USD, thus counteracting the losses in the cash position.
Most hedging occurs in the futures and forwards markets, however, with the bulk of FX market (spot market) devoted to speculators. The global FX market not only provides a high risk leveraged option to investors and traders seeking exposure to foreign currency fluctuations, but also serves means similar to futures of adding liquidity and easing volatility in the global economy.
Trading futures and forex involves significant risk of loss and is not suitable for everyone.
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Trading futures and forex involves significant risk of loss and is not suitable for everyone. Past performance is not necessarily indicative of future results.