About Forex And Learn

Spot Rate

Spot rate is today’s market price of one currency measured in terms of another, for example, the price of one US dollar in Swiss Francs. The spot rates of all currencies against the US dollar (USD) are basic ones, the rest are considered cross rates.

Some of the existing currencies are considered major; these include the US Dollar (USD), the Euro (EUR), the British Pound (GBP), the Swiss Franc (CHF) and the Japanese Yen (JPY).

When you ask dealers for a quote, for example EUR/USD, they will provide you with two different prices, e.g. 1.0643 – 1.0647. From the dealer’s perspective, the difference between the two numbers “buy” and “sell” is called spread. If you want to buy 1 Euro, you have to pay theoretically 1.0647 USD for it, but if you want to sell 1 Euro you are going to be paid 1.0643 by your dealer. In this case, the difference between “buy” and “sell” in the spread is 0.0004, or 4 pips. In fact, buying one currency is the action of selling another. Alternatively, selling one currency actually means that you are buying the other.

Spot Date

The spot date in the foreign exchange market is the normal settlement day for a transaction done today. It normally takes two banking days to process all necessary documents and carry out all transactions, keeping in mind that usually the countries which currencies take part in the deal are in different time zones and payments need to be synchronized. The spot date cannot be Saturday, Sunday or any official holiday for both of the countries. In such cases, the spot date is the next working day.

There is an option for the deal to be negotiated with a value date prior to the spot date, for example the same day as the date of the deal or the next day. In the first case, the value date is today’s date and in the second it is tomorrow’s date. In these two cases, the exchange rate is different from the exchange rate on the spot date. The difference arises because of the variance in the interest rate.

Direct and Indirect Quotes

On the currency exchange market in every country, the local currency is quoted directly or indirectly against the US Dollar and other foreign currencies.

• The direct quoting is the amount of local currency needed to buy one unit of the foreign currency and the amount of local currency respectively due to be received when one unit of foreign currency is being sold. For instance, in Japan:
  
  120.44 – 120.52 USD/JPY
  
  

  This means that dealers are buying one dollar for 120.44 yen, but are selling it for 120.52 yen.

• On the other hand, the indirect quote is the amount of foreign currency needed to buy one unit of the local currency. For instance, the following indirect quote is used for quoting the British Pounds versus the US Dollar:
  
  1.3600 – 1.3610 GBP/USD
  

  This means you have to pay 1.3610 USD to buy 1 GBP and if you want to sell 1 GBP, you will receive 1.3600 USD for it.

Quoted and Basic Currencies

The spot exchange rate is the price of one currency in terms of another. In the example above, 120.44 – 120.52 USD/JPY, USD is the basic currency and JPY is the quoted currency. This is not the case in our second example, 1.3600 – 1.3610 GBP/USD, where USD is the quoted currency because it is second in the GBP/USD expression.

Pips and Figures

The following example demonstrates what pips and figures are:

Currencies are quoted using four positions after the decimal point, which means that one pip is 1/10,000 of the currency unit. In the example above, EUR/USD, there is a difference of 4 pips between “buy” and “sell”, but there is no difference in the value of the figures.

This is not the case when the Japanese Yen is the quoted currency. Due to the high denomination of the Yen against the USD, e.g. 121.23 – 121.39, the yen is quoted only two positions after the decimal point. In this case, one pip is equal to 1/100 of the Japanese currency unit.

The dealer will only quote the pip value over the phone, presuming that you are aware of the market and know the value of figures. If you are not sure about the figure, do not hesitate to ask.

Positions

The main goal of the Forex market is gaining profit from your position through buying and selling different currencies. For example, you have bought a currency, and this particular currency rises in value. In this case you gain profit if you quickly close your position. If you close your position and sell the currency back for fixing your profit, you are in fact buying the counter currency in this pair. That's how a rate of worth has been discovered - it's one currency value compared to another while operating with currency pairs. In the end, currency of any country has value only compared to another country's currency.

The forex position is the netted sum commitment in a particular currency. The position can be flat or square, long or short. We call the position square when there's no exposure, it's long if more currency is being bought than sold, and the position is short if more currency is being sold than bought.

What affects the prices of currencies?

Currency prices (exchange rates) are affected by a variety of economic and political conditions, especially interest rates, inflation and political stability. Moreover, governments sometimes participate in the FX market to influence the value of their currencies, either by flooding the market with their domestic currency in an attempt to lower the price, or conversely by buying in order to increase the price. This is known as Central Bank intervention. Any of these factors, as well as large market orders, can cause high volatility in currency prices. However, the size and volume of the FX market make it impossible for any entity to “drive” the market for a particular length of time.

How do I manage risk when I trade currencies?

The most common risk management tools in FX trading are the limit profit and the stop loss orders. A limit order places restriction on the maximum price to be paid or the minimum price to be received. A stop loss order ensures that a particular position is automatically closed at a predetermined price in order to limit potential losses if the market moves against the investor's positions.

Key fundamentals impacting the US dollar

Federal Reserve Bank (Fed): The US Central Bank has full independence in setting monetary policy to achieve maximum non-inflationary growth. The Fed’s chief policy signals are: open market operations, the Discount Rate and the Fed Funds rate.

Federal Open Market Committee (FOMC): The FOMC is responsible for making decisions on monetary policy, including the crucial interest rate announcements, made eight times per year. The 12-member committee consists of seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and the remaining four seats carry a one-year term each in a rotating selection of the presidents of the 11 other Reserve Banks.

Interest Rates: Fed Funds Rate: Clearly the most important interest rate. It is the rate that depositary institutions charge each other for overnight loans. The Fed announces changes in the Fed Funds rate when it wishes to send clear monetary policy signals. These announcements normally have a large impact on all stocks, bonds and currency markets.

Discount Rate: The interest rate at which the Fed charges commercial banks for emergency liquidity purposes. Although this is more of a symbolic rate, changes in it imply clear policy signals. The Discount Rate is almost always less than the Fed Funds Rate.

30-year Treasury Bond: The 30-year US Treasury Bond, also known as the long bond, or bellwether treasury. It is the most important indicator of markets’ expectations on inflation. Markets most commonly use the yield (rather than the price) when referring to the level of the bond. As in all bonds, the yield on the 30-year treasury is inversely related to the price. There is no clear-cut relationship between the long bond and the US dollar. But the following usually holds: A fall in the value of the bond (a rise in the yield) due to inflationary concerns may put pressure on the dollar. These concerns could arise from strong economic data.

Nevertheless, as the supply of 30-year bonds began to shrink following the US Treasury's refunding operations (buying back its debt), the 30-year bond’s role as a benchmark had gradually given way to its ten-year counterpart. Depending on the stage of the economic cycle, strong economic data could have varying impacts on the dollar. In an environment where inflation is not a threat, strong economic data may boost the dollar. But at times when the threat of inflation (higher interest rates) is most urgent, strong data normally hurts the dollar because of the resulting sell-off in bonds.

Being a benchmark asset-class, the long bond is normally impacted by the shifting capital flows which are triggered by global considerations. Financial/political turmoil in emerging markets could be a possible booster for US treasuries due to their safe character, thereby helping the dollar.

Three-month Eurodollar Deposits: Eurodollar deposits are bank accounts deposited in a currency other than the country’s currency. For example, Japanese Yen accounts deposited outside Japan are called “Euroyen.” Similarly, euro-denominated accounts deposited outside the Eurozone are called “EuroEuros.” The interest rate on three-month dollar-denominated deposits held in banks outside the US is known as Eurodollar rate. It serves as a valuable benchmark for determining interest rate differentials to help estimate exchange rates. To illustrate USD/JPY as a theoretical example, the greater the interest rate differential in favor of the Eurodollar versus the Euroyen deposit, the more likely USD/JPY will receive a boost. Sometimes, this relation does not hold due to the confluence of other factors.

Ten-year Treasury Note: FX markets usually refer to the ten-year note when comparing its yield with that of similar bonds overseas, namely the euro (German ten-year bund), Japan (ten-year JGB) and the UK (ten-year gilt). The spread differential (the difference in yields) between the yield on ten-year US Treasury notes and that on non-US bonds impacts the exchange rate. A higher US yield usually benefits the US dollar against foreign currencies.

Treasury: The US Treasury is responsible for issuing government debt and making decisions on the fiscal budget. The Treasury has no impact on monetary policy, but its statements regarding the dollar have a major influence on the currency.

Economic Data: The most important economic data items released in the US are: Labor reports (payrolls, unemployment rate and average hourly earnings), CPI, PPI, GDP, international trade, ECI, NAPM, productivity, industrial production, housing starts, housing permits, and consumer confidence.

Stock Market: The three major stock indices are the Dow Jones Industrials Index (Dow), S&P 500, and NASDAQ. The Dow is the index which is most likely to influence the dollar. Since the mid-1990s, the index has shown a strong positive correlation with the greenback as foreign investors purchased US equities. Three major forces affect the Dow: 1) Corporate earnings, forecast and actual; 2) Interest rate expectations; and 3) Global considerations. Consequently, these factors channel their way through the dollar.

Cross Rate Effect: The dollar’s value against one currency is sometimes influenced by another currency pair (exchange rate) that may not involve the dollar. To illustrate, a sharp rise in the Yen versus the Euro (falling EUR/JPY) could cause a general decline in the Euro, including a fall in EUR/USD.

Fed Funds Rate Futures Contract: There is the option to form interest rate expectations through the Fed Funds rate in the futures market. The contract’s value shows what the Fed Funds interest rate (overnight rate) is expected to be in the future, depending on the contract maturity. Hence, the contract is a valuable indicator of market expectations vis-à-vis Federal Reserve policy. The rate is obtained by subtracting the contract’s value from 100.

Three-month Eurodollar Futures Contract: Similar to the Fed Funds futures contract which reflects Fed Funds rate expectations into the future, the three-month Eurodollar futures contract reflects the Eurodollar rate. To illustrate, the difference between futures contracts on the three-month Eurodollar and Euroyen deposits is an essential variable in determining USD/JPY expectations.

Factors affecting USD/JPY

Ministry of Finance: The MoF is the single most important political and monetary institution in Japan. Its influence in guiding the currency is more significant than the ministries of finance of the US, UK or Germany, despite the gradual measures to decentralize decision-making. MoF officials often make statements regarding the economy that have notable impacts on the Yen. These statements include verbal intervention aimed at avoiding undesirable appreciation/depreciation of the Yen.

Bank of Japan (BoJ): In 1998 Japan passed new laws providing the central Bank (BoJ) operational independence from the government (MoF). While complete control over monetary policy has shifted to the BoJ, the MoF remains in charge of foreign exchange policy.

Interest Rates: The Overnight Call Rate is the key short-term inter-bank rate. The call rate is controlled by the BoJ’s open market operations aimed at managing liquidity. The BoJ uses the call rate to signal monetary policy changes, which impact the currency.

Japanese Government Bonds (JGBs): The BoJ buys ten and 20-year JGBs every month to inject liquidity into the monetary system. The yield on the benchmark ten-year JGB serves as a key indicator of long-term interest rates. The spread or the difference between ten-year JGB yields and those on US ten-year treasury notes is an important driver of the USD/JPY exchange rates. Falling JGBs (rising JGB yields) usually boost the Yen and impact USD/JPY.

Economic and Fiscal Policy Agency: Since January 6, 2001 it officially replaces the powerful Economic Planning Agency (EPA). It is a government agency responsible for formulating economic planning programs and coordinating economic policies such as employment, international trade, and foreign exchange.

Ministry of International Trade and Industry (MITI): A government institution aimed at supporting the interests of the Japanese industry and defending the international trade competitiveness of Japanese corporations. MITI’s power and transparency is not as significant as it used to be back in the 1980s and early 1990s, when US-Japan trade issues were the “hottest” topic in FX markets.

Economic Data: The most important economic data items from Japan are: GDP, Tankan survey (quarterly business sentiment and expectations survey), international trade, unemployment, industrial production, and money supply (M2+CDs).

Nikkei-225: Japan’s leading stock index. A reasonable decline in the yen usually lifts stocks of export-oriented companies, which tends to boost the overall stock index. The Nikkei-yen relationship is sometimes reversed, where a strong open market in the Nikkei tends to boost the Yen (weighs on USD/JPY) as investor funds flow into yen-denominated stocks.

Cross Rate Effect: The USD/JPY exchange rate is sometimes impacted by movements in cross exchange rates (non-dollar exchange rates) such as EUR/JPY. To illustrate: A rising USD/JPY (rising dollar and a falling yen) could be the result of appreciating EUR/JPY, rather than direct strength in the Dollar. This rise in the cross rate could be highlighted due to contrasting sentiments between Japan and the Eurozone.

Another example: Both EUR/JPY and EUR/USD rally because of a general strengthening in the Euro. For some particular factors (such as better prospects in Japan), this could have a larger impact on the Dollar than it does on the Yen. As a result, USD/JPY weakens since the Yen is relatively less hurt by the appreciating Euro.

Factors affecting EUR/USD

The Eurozone: The 12 countries that have adopted the Euro in order of GDP: Germany, France, Italy, Spain, the Netherlands, Belgium, Austria, Finland, Portugal, Ireland, Luxembourg and Greece.

European Central Bank: Controls monetary policy for the Eurozone. The decision-making body is the Governing Council, which consists of the Executive Board and the governors of the national central banks. The Executive Board consists of the ECB President, Vice-President, and four other members.

ECB Policy Targets: The primary objective of ECB is price stability consisting of two main "pillars" of monetary policy. The first one is the outlook for price developments and risks to price stability. Price stability is defined as an increase of the Harmonized Index of Consumer Prices (HICP) of below 2%. While the HICP is important, a broad number of indicators and forecasts are used to determine the medium-term threat to price stability. The second pillar is monetary growth as measured by M3. The ECB has a "reference value" of 4.5% annual growth for M3.

The ECB holds a Council meeting every other Thursday to make announcements on interest rates. At each first meeting of the month, the ECB holds a press conference in which it gives its outlook on monetary policy and the economy as a whole.

Interest Rates: The ECB’s refinancing rate is the Bank’s key short-term interest rate used for managing liquidity. The difference between the refinancing rate and the US Fed Funds rate is a good indicator for the EUR/USD.

Three-month Eurodeposit (Euribor): Eurodollar deposits are bank accounts deposited in a country other than the country of the currency; e.g. Japanese Yen accounts deposited outside Japan are called “Euroyen.” Similarly, euro-denominated accounts deposited outside the Eurozone are called "EuroEuros". The interest rate on three-month Euribor deposits held in banks outside the Eurozone. It serves as a valuable benchmark for determining interest rate differentials to help estimate exchange rates. Using a theoretical example on EUR/USD, the greater the interest rate differential in favor of the Euribor against the Eurodollar deposit, the more likely EUR/USD is to rise. Sometimes, this relation does not hold due to the confluence of other factors.

Ten-Year Government Bonds: Another key factor of the EUR/USD exchange rate is the difference in interest rates between the US and the Eurozone. The German ten-year Bond is normally used as a benchmark. Since the rate on the ten-year Bond is below the US ten-year note, a spread narrowing (i.e. a rise in German yields or a fall in US yields, or both) is theoretically expected to favor the EUR/USD rate. A widening in the spread will act against the exchange rate. So the ten-year US-German spread is an important number to remember. The trend in this number is usually more significant than the absolute value. Naturally, the interest rate differential is usually related to the growth outlook of the US and the Eurozone, which is another fundamental factor of the exchange rate.

Economic Data: The most important economic data comes from Germany, the largest economy, and from the euro-wide statistics still in their infancy. Key data are usually GDP, inflation (CPI and HICP), industrial production, and unemployment. From Germany in particular, a key piece of data is the IFO survey, which is a widely accepted indicator of business confidence. Also important are budget deficits of the separate countries, which according to the Stability and Growth Pact, must be kept below 3% of GDP. Countries also have targets for reducing their deficits further and failure to meet these targets will likely be detrimental to the Euro (as we observed Italy’s loosening of budget deficit guidelines).

Cross Rate Effect: The EUR/USD exchange rate is sometimes impacted by movements in cross exchange rates (non-dollar exchange rates) such as EUR/JPY or EUR/JPY. For example, EUR/USD could fall as a result of significantly favorable news in Japan that filters through a falling EUR/JPY rate. On the contrary, USD/JPY may be declining, Euro weakness spills onto a falling EUR/USD.

Three-Month Euro Futures Contract (Euribor): The contract reflects market expectations on three-month EuroEuro deposits (Euribor) into the future. The difference between futures contracts on the three-month cash Eurodollar and on the EuroEuro deposit is an essential variable in determining EUR/USD expected rate.

Other Indicators: There is a strong negative correlation between EUR/USD and USD/CHF, reflecting a steadily similar relationship between the Euro and the Swiss Franc. This is because the Swiss economy is largely affected by the Eurozone economies. In most cases, a spike (dip) in EUR/USD is accompanied by a dip (spike) in EUR/CHF. The inverse also usually holds. This relationship sometimes fails to hold in the event of data or factors pertaining solely to either one of the currencies.

Political Factors: Similar to all exchange rates, EUR/USD is susceptible to political instability such as a threat to coalition governments in France, Germany or Italy. Political or financial instability in Russia is also a red flag for EUR/USD because of the substantial amount of German investments in Russia.

Factors affecting GBP/USD (Cable)

Bank of England (BoE): Under the Bank of England Act of June 1997, the BoE obtained operational independence in setting monetary policy to deliver price stability and to support the government’s growth and employment objectives. The price stability objective is set by the government's inflation target, defined as 2.5% annual growth in Retail Prices Index excluding mortgages (RPI-X). Hence, despite its independence in setting monetary policy, the BoE remains dependent on having to meet the inflation target set by the Treasury.

Monetary Policy Committee (MPC): The BoE's Committee responsible for making decisions on interest rates.

Interest Rates: The Central Bank's main interest rate is the minimum lending rate (base rate), which it uses to send clear signals on monetary policy changes in the first week of every month. Changes in base rate usually have a large impact on the Sterling. The BoE also sets monetary policy through its daily market operations used to change the dealing rates at which it buys government bills from discount houses (specialized institutions in trading money market instruments).

Gilts: Government bonds known as gilt-edged securities. The spread differential (difference in yields) between the yield on the ten-year gilt and that on the ten-year US Treasury note usually impacts the exchange rate. The spread differential between gilts and German bonds is also important, as it impacts the EUR/GBP exchange rate, which could affect GBP/USD (see cross-rate effect).

Three-month Eurosterling Deposits: Eurodollar deposits are bank accounts deposited in a country other than the country of the currency, e.g. Japanese Yen accounts deposited outside Japan are called "Euroyen". Similarly, sterling-denominated accounts deposited outside the UK are called "Eurosterling" deposits. The interest rate on three-month sterling-denominated deposits held in banks outside the UK, serves as a valuable benchmark for determining interest rate differentials to help estimate exchange rates. Following a theoretical example on GBP/USD, the greater the interest rate differential in favor of the Eurodollar against the Eurosterling deposit, the more likely GBP/USD is to fall. Sometimes, this relation does not apply due to the confluence of other factors.

Treasury: The Treasury’s role in setting monetary policy diminished markedly since the Bank of England Act of June 1997. Nevertheless, the Treasury still sets the inflation target for the BoE and makes key appointments at the Central Bank.

Economic Data: The most important economic data items released in the UK are: claimant unemployment (the number of unemployed), claimant unemployment rate, average earnings, RPI-X, retail sales, supply (M4), balance of payments, and housing prices.

Three-Month Eurosterling Futures Contract (Short Sterling): The contract reflects market expectations on three-month Eurosterling into the future. The difference between futures contracts on the three-month Eurodollar and Eurosterling deposits is an essential variable in determining GBP/USD expectations.

FTSE-100: Britain's leading stock index. Unlike in the US or Japan, Britain’s main stock index has a lesser influence on the currency. Nevertheless, the positive correlation between the FTSE-100 and the Dow Jones Industrial Index is one of the strongest in global markets.

Cross Rate Effect: GBP/USD is sometimes impacted by movements in cross exchange rates (non-dollar exchange rates) such as EUR/GBP. For instance, a rise in EUR/GBP (fall in sterling), triggered by strengthening expectations of UK’s membership into the Euro, could lead to a decline in GBP/USD (cable). Conversely, reports indicating that the UK may not join the single currency will hurt the EUR/GBP, thereby boosting cable.

What is Balance-of-Payments Position?

The exchange rate for any foreign currency depends on a multitude of factors reflecting economic and financial conditions in the country issuing the currency. One of the most important factors is the nation’s balance-of-payments position. When a country experiences a deficit in its balance of payments, it becomes a net demander of foreign currencies and is forced to sell substantial amounts of its own currency to pay for imports of goods and services. Therefore, balance-of-payments deficits often lead to top price depreciation of a nation's currency relative to the prices of other currencies.

Why is Inflation Important?

Inflation has a particularly potent effect on exchange rates, as do differences in real exchange rates between nations. When one nation’s inflation rate rises relative to others, its currency tends to fall in value. Similarly, a nation that reduces its inflation rate usually experiences a rise in the value of its currency. Moreover, countries with higher real interest rates generally experience an increase in the exchange value of their currencies.

Why are Central Bank Interventions necessary?

Overshadowing the currency market today, the apparent possibility exists that central banks will become active participants. Major central banks around the world, including the Federal Reserve System in the United States and the Bundesbank in Germany, may decide on a given day that their national currency is declining too rapidly in value relative to other key currencies. Thus, if the Dollar falls precipitously against the Euro, the Federal Reserve is likely to intervene by heavily selling Euro and buying of Dollars to stabilize the currency market. In most cases, central bank intervention is temporary, aimed at promoting a smooth adjustment in currency values toward a new equilibrium level rather than to permanently propping up a weak currency.

Cross rates

Pairings of non-US dollar currencies are known as “crosses.” We can derive cross exchange rates for the GPB, EUR, JPY and CHF from the aforementioned major pairs. Exchange rates must be consistent across all currencies, or it will be possible to “round trip” and make profits without any risk.

Example – Computing Cross Rates

Assume that the following major exchange rates are known:

EUR/USD = 1.0060/65
GBP/USD = 1.5847/52
USD/JPY = 120.25/30
USD/CHF = 1.4554/59

To calculate GPB/CHF

GBP/USD: Bid: 1.5847 Offer: 1.5852
USD/CHF: 1.4554 1.4559

GBP/USD X USD/CHF = 1.5847 X1.4554 1.5852 X 1.4559

Going Short – Going Long

When you buy a currency, you are said to be “long” in that currency. Long positions are placed at the offer price. Thus, if you are buying one GBP/USD lot quoted at 1.5847/52, then you will buy 100,000 GBP at 1.5852 USD.

When you sell a currency, you are said to be “short” in that currency. Short positions are entered into at the bid price, which is 1.5847 USD in our example.

Because of symmetry in currency transactions, you are always simultaneously long in one currency and short in another. For example, if you exchange 100,000 GBP for USD, you are short in Sterling and long in US dollars.

Closing Out

An open position is one that is live and ongoing. As long as the position is open, its value will fluctuate in accordance with the exchange rate in the market. Any profits and losses will exist on paper only and will be reflected in your margin account.

To close out your position, you conduct an equal and opposite trade in the same currency pair. For example, if you have gone long in one lot of GBP/USD at the prevailing offer price, you can close out that position by subsequently going short in one GBP/USD lot at the prevailing bid price.

Your opening and closing trades must be conducted through the same intermediary. You cannot open a GBP/USD position with Broker A and close it out through Broker B.

Betting on a Rise

Assume that you start with a clean slate and that the current GPB/USD rate is 1.5847/52.

• You expect the pound to appreciate against the US dollar, so you buy 100,000 GBP at the offer price of 1.5852 USD.
  
• The value of the contract is 100,000 X 1.5852 USD = 158, 520 USD.
  
• GBP/USD duly appreciates to 1.6000/05 and you decide to close out your position by selling your Pounds for US dollars at the bid rate. Your gain is:
  100,000 X (1.6000 – 1.5852) USD = 1,480 USD, the equivalent of 10 USD per point.
  
• You earn 1,480 USD on an exchange rate movement of less than 1%. This illustrates the positive effect of buying on margin.
  
• Had GBP/USD fallen to 1.5700/75, your loss would have been:
  
  100,000 X (1.5852 – 1.5700) USD = 1,520 USD
  

The conclusion is that margin trading magnifies your rate of profit or loss.

Betting on a Fall

You expect Sterling to fall from GBP/USD = 1.5847/52, so you decide to sell 100,000 GBP/USD.

• The value of the contract is 100,000 X 1.5847 USD = 158,470 USD. You have effectively sold 100,000 GBP and bought 158,470 USD.
  
• If your broker requires 1% of 158,470 USD as margin in US dollars, namely 1,584.70 USD in cash GBP/USD falls to 1.5555/60 and you are looking at a paper gain of:
  
  100,000 X (1.5847 – 1.5560 USD) = 2,870 USD
  
  100,000 X (1.5847 – 1.5560 USD) = 2,870 USD
  
  
• Your 2,870 USD paper gain is credited to your margin account where you now have 4,454.70 USD. This enables you to maintain open positions worth 4,454.70 USD.
  
• However, GBP/USD starts to rise. When it reaches 1.6000/05, you are looking at a paper loss of:
  
  100,000 X (1.6005 – 1.5847) USD = 1,580 USD.
  
• Your margin account is debited by 1,580 USD, taking it down to 2,874.70 USD.

Fundamental and Technical Analysis

Without making sense of the currency market, any trade represents a pure gamble. There are two broad schools of analysis, which are not mutually exclusive.

Fundamental analysis: Fundamental analysis is the application of the micro and macroeconomic theory to markets, with the aim of predicting future trends. So what fundamental forces drive currency markets?

Balance of trade: Currencies associated with long-term trade surpluses will tend to strengthen against those associated with persistent deficits, simply because there is a net buying of surplus currencies corresponding to the excess of exports over imports. Trends are also important. An improving balance of trade should cause the relevant currency to appreciate relative to those associated with a deteriorating or stable balance of trade.

Relative inflation rates: If country A is suffering a higher rate of price inflation than country B, then A’s currency ought to weaken relative to B’s in order to restore “purchasing power parity”.

Interest rates: International capital flows seek the highest inflation-adjusted returns, creating additional demand for high real interest-rate currencies and pushing up their rates of exchange.

Expectations and speculation: Markets anticipate events. Speculation on the future rate of inflation may be valuable enough to move the exchange rate, long before the actual trend becomes apparent.

It should be understood that these economic forces act in concert. However, it is an extremely difficult task to establish where the sum of interacting economic forces will take the market. The solution, some argue, lies in technical analysis.

Technical analysis: Technical analysis is concerned with predicting future price trends from historical price and volume data. The underlying axiom of technical analysis is that all fundamentals (including expectations) are factored into the market and are reflected in exchange rates.

The tools of technical analysis are now freely available to private investors in support of their trading decisions. It cannot be overly stressed that such tools are only estimators and are not infallible.

The following is the briefest of introductions to technical analytical tools used to identify trends and recurring patterns in a volatile marketplace. Aspiring FX dealers are advised to undergo proper training in technical analysis, although true proficiency comes with practice, endurance, and experience.

Charts

Line Chart: Graphic depiction of the exchange rate history of any currency pair over time. The line is constructed by connecting up daily closing prices.

Bar chart: Depiction of price performance of the currency pair, made up of vertical bars at set intra-day time intervals, e.g. every 30 minutes. Each bar has four “hooks” symbolizing the opening, closing, high and low (OCHL) exchange rates for that time interval.

Candlestick chart: Variant of the bar chart, except that it depicts OCHL prices as “candlesticks” with a wick at each end. Where the opening rate is higher than the closing rate, the candlestick is “solid”. Where the closing rate exceeds the opening rate, the candlestick is “hollow”.

Support, resistance, channels and triangles: Support and resistance thresholds are common features of all tradable financial commodities, including currencies. Breaches of such thresholds are taken as evidence of a fundamental change in market sentiment towards a currency. Support and resistance often form coherent patterns over time in the shape of channels.

Support: A support level is detected if you can connect up several under-points of the exchange rate cycle on a straight line. This is taken to indicate market reluctance to sell below certain rates of exchange. The more under-points that can be connected, the more evidence there is of a support level.

The support level may change over time. If the straight line inclines upwards, then we speak of “upward support”. We identify “sideways support” when the line is horizontal. Where the line slopes downwards, we diagnose “downward support”.

Resistance: Resistance levels indicate a reluctance to buy currencies above given exchange rates. A resistance level is detected if it is possible to connect a succession of upper points in the exchange rate cycle with a single straight line.

As you would expect, one encounters upward, sideways, and downward resistances. Channels are identified by superimposing support and resistance levels on a single line chart. Channels can slope upward, sideways or downward.

Triangles: Where resistance and support lines converge towards one another over time, “triangles” are formed which can be upward, sideways or downward sloping.

Triangles indicate declining profitability over time. Resistance and support levels superimposed on a chart will help predict the time of convergence. What we are seeking are “breakouts” that could go either way and are likely to be “explosive,” presenting opportunities for profitable trading.

The triangle slope and the pricing cycle behavior in the approach to the predicted intersection of resistance and support may indicate the likely direction of the breakout. For example, if the exchange rate cycle is in a clear upward phase, the breakout is likely to be upwards too. There are some real opportunities here, but also a high degree of risk.

Indicators

Moving averages: Moving averages smooth out the peaks and troughs of the exchange rate cycle over a rolling period and indicate the presence of a trend.

There are two main types of moving averages:

Simple: Where past and present data are assumed to be of equal importance and are weighted equally.

Weighted: Where current data is considered more important than past data and is weighted more heavily. The weighting factor takes the form of a “smoothing constant” that increases exponentially over time.
If prices lie below two or more moving averages, this is taken as a bearish signal, and vice versa.

Stochastic oscillators: Stochastic oscillators are momentum indicators that purport to tell you when to buy or sell. They are composed of two elements:

• A “%K” line that measures the difference between the most recent closing price and the deepest trough as a percentage of the difference between the highest peak and the deepest trough, measured over a given period (e.g. 14 days).
  
• A “%D” line that tracks the three-period (e.g. day) moving average of %K.

A rise in %K over %D is interpreted as a buy signal, and vice versa.

Currency is considered overbought when the oscillator touches 80. An oscillator below 20 is considered to indicate an oversold currency.

Foreign Exchange Option

In finance, a foreign exchange option (commonly shortened to just FX option or currency option) is a derivative financial instrument where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date.

The FX options market is the deepest, largest and most liquid market for options of any kind in the world. Most of the FX option volume is traded OTC and is lightly regulated, but a fraction is traded on exchanges like the International Securities Exchange, Philadelphia Stock Exchange, or the Chicago Mercantile Exchange for options on futures contracts. The global market for exchange-traded currency options was notionally valued by the Bank for International Settlements at $158,300 billion in 2005[citation needed].

Example

For example a GBPUSD FX option might be specified by a contract giving the owner the right but not the obligation to sell £1,000,000 and buy $2,000,000 on December 31. In this case the pre-agreed exchange rate, or strike price, is 2.0000 USD per GBP (or 0.5000 GBP per USD) and the notionals are £1,000,000 and $2,000,000.

This type of contract is both a call on dollars and a put on sterling, and is often called a GBPUSD put by market participants, as it is a put on the exchange rate; it could equally be called a USDGBP call, but market convention is quote GBPUSD (USD per GBP).

If the rate is lower than 2.0000 come December 31 (say at 1.9000), meaning that the dollar is stronger and the pound is weaker, then the option will be exercised, allowing the owner to sell GBP at 2.0000 and immediately buy it back in the spot market at 1.9000, making a profit of (2.0000 GBPUSD - 1.9000 GBPUSD)*1,000,000 GBP = 100,000 USD in the process. If they immediately exchange their profit into GBP this amounts to 100,000/1.9000 = 52,631.58 GBP.

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Terms

Generally in thinking about options, one assumes that one is buying an asset: for instance, you can have a call option on oil, which allows you to buy oil at a given price. One can consider this situation more symmetrically in FX, where one exchanges: a put on GBPUSD allows one to exchange GBP for USD: it is at once a put on GBP and a call on USD.

As a vivid example: people usually consider that in a fast food restaurant, one buys hamburgers and pays in dollars, but one can instead say that the restaurant buys dollars and pays in hamburgers.

There are a number of subtleties that follow from this symmetry.
Ratio of notionals
The ratio of the notionals in an FX option is the strike, not the current spot or forward. Notably, when constructing an option strategy from FX options, one must be careful to match the foreign currency notionals, not the local currency notionals, else the foreign currencies received and delivered don't offset and one is left with residual risk.
Non-linear payoff
The payoff for a vanilla option is linear in the underlying, when one denominates the payout in a given numéraire. In the case of an FX option on a rate, one must be careful of which currency is the underlying and which is the numéraire: in the above example, an option on GBPUSD gives a USD value that is linear in GBPUSD (a move from 2.0000 to 1.9000 yields a .10 * $2,000,000 / 2.0000 = $100,000 profit), but has a non-linear GBP value. Conversely, the GBP value is linear in the USDGBP rate, while the USD value is non-linear. This is because inverting a rate has the effect of , which is non-linear.
Change of numéraire
The implied volatility of an FX option depends on the numéraire of the purchaser, again because of the non-linearity of .

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Hedging with FX options

Corporations primarily use FX options to hedge uncertain future cash flows in a foreign currency. The general rule is to hedge certain foreign currency cash flows with forwards, and uncertain foreign cash flows with options.

Suppose a United Kingdom manufacturing firm is expecting to be paid US$100,000 for a piece of engineering equipment to be delivered in 90 days. If the GBP strengthens against the US$ over the next 90 days the UK firm will lose money, as it will receive less GBP when the US$100,000 is converted into GBP. However, if the GBP weaken against the US$, then the UK firm will gain additional money: the firm is exposed to FX risk. Assuming that the cash flow is certain, the firm can enter into a forward contract to deliver the US$100,000 in 90 days time, in exchange for GBP at the current forward rate. This forward contract is free, and, presuming the expected cash arrives, exactly matches the firm's exposure, perfectly hedging their FX risk.

If the cash flow is uncertain, the firm will likely want to use options: if the firm enters a forward FX contract and the expected USD cash is not received, then the forward, instead of hedging, exposes the firm to FX risk in the opposite direction.

Using options, the UK firm can purchase a GBP call/USD put option (the right to sell part or all of their expected income for pounds sterling at a predetermined rate), which will:
protect the GBP value that the firm will receive in 90 day's time (presuming the cash is received)
cost at most the option premium (unlike a forward, which can have unlimited losses)
yield a profit if the expected cash is not received but FX rates move in its favor

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Valuing FX options: The Garman-Kohlhagen model

As in the Black-Scholes model for stock options and the Black model for certain interest rate options, the value of a European option on an FX rate is typically calculated by assuming that the rate follows a log-normal process.

In 1983 Garman and Kohlhagen extended the Black-Scholes model to cope with the presence of two interest rates (one for each currency). Suppose that rd is the risk-free interest rate to expiry of the domestic currency and rf is the foreign currency risk-free interest rate (where domestic currency is the currency in which we obtain the value of the option; the formula also requires that FX rates - both strike and current spot be quoted in terms of "units of domestic currency per unit of foreign currency"). Then the domestic currency value of a call option into the foreign currency is


The value of a put option has value


where :


S0 is the current spot rate
K is the strike price
N is the cumulative normal distribution function
rd is domestic risk free simple interest rate
rf is foreign risk free simple interest rate
T is the time to maturity (calculated according to the appropriate day count convention)
and σ is the volatility of the FX rate.

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Risk Management

Garman-Kohlhagen (GK) is the standard model used to calculate the price of an FX option, however there are a wide range of techniques in use for calculating the options risk exposure, or greeks. Although the price produced by every model will agree, the risk numbers calculated by different models can vary significantly depending on the assumptions used for the properties of the spot price movements, volatility surface and interest rate curves.

After GK, the most common models in use are SABR and local volatility, although when agreeing risk numbers with a counterparty (e.g. for exchanging delta, or calculating the strike on a 25 delta option) the Garman-Kohlhagen numbers are always used.[hide]
v • d • e
Derivatives market

Derivative (finance)

Options Terms 
Credit spread · Debit spread · Expiration · Open interest · Pin risk · Risk-free rate · Strike price · The Greeks · Volatility

Vanilla options 
Bond option · Call · Employee stock option · Fixed income · FX · Option styles · Put · Warrants

Exotic options 
Asian · Barrier · Binary · Cliquet · Compound option · Forward start option · Interest rate option · Lookback · Mountain range · Rainbow option · Swaption

Options strategies 
Butterfly · Collar · Covered call · Iron condor · Naked put · Straddle · Strangle

Options spreads 
Backspread · Bear spread · Bull spread · Calendar spread · Ratio spread · Vertical spread

Valuation of options 
Binomial · Black · Black-Scholes · Finite difference · Moneyness · Option time value · Put–call parity · Simulation


Swaps 
Basis swap · Constant maturity swap · Credit default swap · Currency swap · Equity swap · Forex swap · Inflation swap · Interest rate swap · Total return swap · Variance swap · Volatility swap

Forwards and Futures 
Forward market · Forward price · Forward rate · Margin · Contango · Backwardation · Single-stock futures · Interest rate future · Financial future · Currency future · Commodity futures

Other derivatives 
CLN · CPPI · Credit derivative · ELN · Equity derivative · Foreign exchange derivative · Fund derivative · Inflation derivatives · Interest rate derivative · PRDC · Real estate derivatives · Real options

Market issues 
Tax policy · Consumer debt · Corporate debt · Sovereign debt · Climate change · Resource depletion · Late 2000s recession

Forex Swap

A currency swap (or cross currency swap) is a foreign exchange agreement between two parties to exchange principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal (regarding net present value) loan in another currency. Currency swaps are motivated by comparative advantage.

Structure

Cross-Currency swaps can be negotiated for a variety of maturities occassionaly in excess of 10 years.

Unlike interest rate swaps, currency swaps involve the exchange of the principal amount. Interest payments are not netted (as they are in interest rate swaps) because they are denominated in different currencies. Cross-Currency swaps are over-the-counter derivatives, similar to interest rate swaps.

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Uses

Currency swaps are often combined with interest rate swaps. For example, one company would seek to swap a cash flow for their fixed rate debt denominated in US dollars for a floating-rate debt denominated in Euro. This is especially common in Europe where companies shop for the cheapest debt regardless of its denomination and then seek to exchange it for the debt in desired currency.

For example, suppose a U.S.-based company needs to acquire Swiss francs and a Swiss-based company needs to acquire U.S. dollars. These two companies could arrange to swap currencies by establishing an interest rate, an agreed upon amount and a common maturity date for the exchange. Currency swap maturities are negotiable for at least ten years, making them a very flexible method of foreign exchange.

Currency swaps were originally done to get around exchange controls.

During the global financial crisis of 2008 the United States Federal Reserve System offered swaps to the Reserve Bank of Australia, the Bank of Canada, Danmarks Nationalbank, the Bank of England, the European Central Bank, the Bank of Japan, the Reserve Bank of New Zealand, the Norges Bank, the Sveriges Riksbank, and the Swiss National Bank[1] and also stable emerging economies such as South Korea, Singapore, Brazil, and Mexico.[2]

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History

Currency swaps were introduced by the World Bank in 1981 to obtain Swiss francs and German marks by exchanging cash flows with IBM. This deal was brokered by Salomon Brothers with a notional amount of $210 million dollars and a term of over ten years.[3]

Foreign Exchange Hedge

A way for companies to eliminate foreign exchange (FOREX) risk when dealing in foreign currencies. This can be done using either the cash flow or the fair value method. The accounting rules for this are addressed by both the International Financial Reporting Standards (IFRS) and by the US Generally Accepted Accounting Principles (US GAAP).

Foreign Exchange Risk

When companies conduct business across borders, they must deal in foreign currencies . Companies must exchange foreign currencies for home currencies when dealing with receivables, and vice versa for payables. This is done at the current exchange rate between the two countries. Foreign exchange risk is the risk that the exchange rate will change unfavorably before the currency is exchanged.

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Hedge

A hedge is a type of derivative, or a Financial instrument, that derives its value from an underlying asset. This concept is important and will be discussed later. Hedging is a way for a company to minimize or eliminate foreign exchange risk. Two common hedges are forwards and options. A Forward contract will lock in an exchange rate at which the transaction will occur in the future. An option sets a rate at which the company may choose to exchange currencies. If the current exchange rate is more favorable, then the company will not exercise this option.

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Accounting for Derivatives

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Under IFRS

Guidelines for accounting for financial derivatives are given under IFRS 7. Under this standard, “an entity shall group financial instruments into classes that are appropriate to the nature of the information disclosed and that take into account the characteristics of those financial instruments. An entity shall provide sufficient information to permit reconciliation to the line items presented in the balance sheet” [1]. Derivatives should be grouped together on the balance sheet and valuation information should be disclosed in the footnotes. This seems fairly straightforward, but IASB has issued two standards to help further explain this procedure. The International Accounting Standards IAS 32 and 39 help to give further direction for the proper accounting of derivative financial instruments. IAS 32 defines a “financial instrument” as “any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity” [2]. Therefore, a forward contract or option would create a financial asset for one entity and a financial liability for another. The entity required to pay the contract holds a liability, while the entity receiving the contract payment holds an asset. These would be recorded under the appropriate headings on the balance sheet of the respective companies. IAS 39 gives further instruction, stating that the financial derivatives be recorded at fair value on the balance sheet. IAS 39 defines two major types of hedges. The first is a cash flow hedge, defined as: “a hedge of the exposure to variability in cash flows that (i) is attributable to a particular risk associated with a recognized asset or liability or a highly probable forecast transaction, and (ii) could affect profit or loss” [3]. In other words, a cash flow hedge is designed to eliminate the risk associated with cash transactions that can affect the amounts recorded in net income. Below is an example of a cash flow hedge for a company purchasing Inventory items in year 1 and making the payment for them in year 2, after the exchange rate has changed.Date Spot Rate US $ value Change Fwd. Rate US $ value FV of contract Change
12/1/Y1 $1.00 $20,000.00 $0.00 $1.04 $20,800.00 $0.00 $0.00
12/31/Y1 $1.05 $21,000.00 $1,000.00 $1.10 $22,000.00 ($1,176.36) ($1,176.36)
3/2/Y2 $1.12 $22,400.00 $1,400.00 $1.12 $22,400.00 ($1,600.00) ($423.64)


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Cash Flow Hedge Example12/1/Y1 Inventory $20,000.00 To record purchase and A/P of 20000C
  A/P $20,000.00 
12/31/Y1 Foreign Exchange Loss $1,000.00 To adjust value for spot of $1.05
  A/P $1,000.00 
 AOCI $1,000.00 To record a gain on the forward contract
  Gain on Forward Contract $1,000.00 
 Forward Contract $1,176.36 To record the forward contract as an asset
  AOCI $1,176.36 
 Premium Expense $266.67 Allocate the fwd contract discount
  AOCI $266.67 
3/1/Y2 Foreign Exchange Loss $1,400.00 To adjust value for spot of $1.12
  A/P $1,400.00 
 AOCI $1,400.00 To record a gain on the forward cont.
  Gain on Forward Contract $1,400.00 
 Forward Contract $423.64 To adjust the fwd. cont. to its FV of $1600
  AOCI $423.64 
 Premium Expense $533.33 To allocate the remaining fwd. cont. discount
  AOCI $533.33 
 Foreign Currency $22,400.00 To record the settlement of the fwd. cont.
  Forward Contract $1,600.00 
  Cash $20,800.00 
 A/P $22,400.00 To record the payment of the A/P
  Foreign Currency $22,400.00 


Notice how in year 2 when the payable is paid off, the amount of cash paid is equal to the forward rate of exchange back in year 1. Any change in the forward rate, however, changes the value of the forward contract. In this example, the exchange rate climbed in both years, increasing the value of the forward contract. Since the derivative instruments are required to be recorded at fair value, these adjustments must be made to the forward contract listed on the books. The offsetting account is other comprehensive income. This process allows the gain and loss on the position to be shown in Net income.

The second is a fair value hedge. Again, according to IAS 39 this is “a hedge of the exposure to changes in fair value of a recognized asset or liability or an unrecognized firm commitment, or an identified portion of such an asset, liability or firm commitment, that is attributable to a particular risk and could affect profit or loss” [3]. More simply, this type of hedge would eliminate the fair value risk of assets and liabilities reported on the Balance sheet. Since Accounts receivable and payable are recorded here, a fair value hedge may be used for these items. The following are the journal entries that would be made if the previous example were a fair value hedge.

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Fair Value Hedge Example12/1/Y1 Inventory $20,000.00 to record purchase and A/P of 20000C
  A/P $20,000.00 
12/31/Y1 Foreign Exchange Loss $1,000.00 to adjust value for S.R of $1.05
  A/P $1,000.00 
 Forward Contract $1,176.36 to record forward contract at fair value
  Gain on Forward Contract $1,176.36 
3/1/Y2 Foreign Exchange Loss $1,400.00 to adjust value for S.R. of $1.12
  A/P $1,400.00 
 Forward Contract $423.64 to adjust the fwd. contract to its FV
  Gain on Forward Contract $423.64 
 Foreign Currency $22,400.00 to record the settlement of the fwd. cont.
  Forward Contract $1,600.00 
  Cash $20,800.00 
 A/P $22,400.00 to record the payment of the A/P
  Foreign Currency $22,400.00 


Again, notice that the amounts paid are the same as in the cash flow hedge. The big difference here is that the adjustments are made directly to the assets and not to the other comprehensive income holding account. This is because this type of hedge is more concerned with the fair value of the asset or liability (in this case the account payable) than it is with the profit and loss position of the entity.

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Under US GAAP

The US Generally Accepted Accounting Principles also include instruction on accounting for derivatives. For the most part, the rules are similar to those given under IFRS. The standards that include these guidelines are SFAS 133 and 138. SFAS 133, written in 1998, stated that a “recognized asset or liability that may give rise to a foreign currency transaction gain or loss under Statement 52 (such as a foreign-currency-denominated receivable or payable) not be the hedged item in a foreign currency fair value or cash flow hedge” [4]. Based on the language used in the statement, this was done because the FASB felt that the assets and liabilities listed on a company’s books should reflect their historic cost value, rather than being adjusted for fair value. The use of a hedge would cause them to be revalued as such. Remember that the value of the hedge is derived from the value of the underlying asset. The amount recorded at payment or reception would differ from the value of the derivative recorded under SFAS 133. As illustrated above in the example, this difference between the hedge value and the asset or liability value can be effectively accounted for by using either a cash flow or a fair value hedge. Thus, two years later FASB issued SFAS 138 which amended SFAS 133 and allowed both cash flow and fair value hedges for foreign exchanges. Citing the reasons given previously, SFAS 138 required the recording of derivative assets at fair value based on the prevailing spot rate 

Retail Forex

In financial markets, the retail forex (retail off-exchange currency trading or retail FX) market is a subset of the larger foreign exchange market. This "market has long been plagued by swindlers preying on the gullible," according to The New York Times[1]. Whilst there may be a number of fully regulated, reputable international companies that provide a highly transparent and honest service, it's commonly thought that about 90% of all retail FX traders lose money. [2] [3]

It is now possible to trade cash FX, or forex (short for Foreign Exchange[4] (FX)) or currencies around the clock with hundreds of foreign exchange brokers through trading platforms. The reason that the business is so profitable is because in many cases brokers are taking the opposite side of the trade, and therefore turning client capital directly into broker profit as the average account loses money. Some brokers provide a matching service, charging a commission instead of taking the opposite site of the trade and "netting the spread", as it is referred to within the forex "industry."

Recently forex brokers have become increasingly regulated. Minimum capital requirements of US$20m now apply in the US, as well as stringent requirements now in Germany and the United Kingdom. Switzerland now requires forex brokers to become a bank before conducting FX brokerage business from Switzerland.[citation needed]

Algorithmic (automated) trading has become increasingly popular in the FX market, with a number of popular packages allowing the customer to program his own rules.[citation needed]

The most traded of the "major" currencies is the pair known as the EUR/USD, due to its size, median volatility and relatively low "spread", referring to the difference between the bid and the ask price. This is usually measured in "pips", normally 1/100 of a full point.[citation needed]

According to the October 2008 issue of e-Forex Magazine, the retail FX market is seeing continued explosive growth despite, and perhaps because of, losses in other markets like global equities in 2008.
While forex has been traded since the beginning of financial markets, on-line retail trading has only been active since about 1996 . From the 1970s, larger retail traders could trade FX contracts at the Chicago Mercantile Exchange.[1]

By 1996 on-line retail forex trading became practical. Internet-based market makers would take the opposite side of retail trader’s trades. These companies also created retail forex platform that provided a quick way for individuals to buy and sell on the forex spot market.[citation needed]

In online currency exchange, few or no transactions actually lead to physical delivery to the client; all positions will eventually be closed. The market makers offer high amounts of leverage. While up to 4:1 leverage is available in equities and 20:1 in Futures, it is common to have 100:1 leverage in currencies.[1] In the typical 100:1 scenario, the client absorbs all risks associated with controlling a position worth 100 times his capital.

Currencies are quoted in pairs, for example EUR/USD (euro versus United States dollar). The first currency is the base currency and the second currency is the quote currency. A person who is short the EUR/USD will have a loss if the USD loses value and make a profit if the EUR loses value. A person who is long the EUR/USD will make a profit if the USD loses value and have a loss if the EUR loses value.


Key Concepts Behind a Retail Forex Trade

Currency Pairs

Currency prices can only fluctuate relative to another currency, so they are traded in pairs. Two of the most common currency pairs are the EUR/USD (the price of US dollars quoted in euros) and the GBP/USD (the price of US dollars quoted in British pounds).


High Leverage

The idea of margin (leverage) and floating loss is another important trading concept and is perhaps best understood using an example. Most retail Forex market makers permit 100:1 leverage, but also, crucially, require you to have a certain amount of money in your account to protect against a critical loss point. For example, if a $100,000 position is held in EUR/USD on 100:1 leverage, the trader has to put up $1,000 to control the position. However, in the event of a declining value of your positions, Forex market makers, mindful of the fast nature of forex price swings and the amplifying effect of leverage, typically do not allow their traders to go negative and make up the difference at a later date. In order to make sure the trader does not lose more money than is held in the account, forex market makers typically employ automatic systems to close out positions when clients run out of margin (the amount of money in their account not tied to a position). If the trader has $2,000 in his account, and he is buying a $100,000 lot of EUR/USD, he has $1,000 of his $2,000 tied up in margin, with $1,000 left to allow his position to fluctuate downward without being closed out.

Typically a trader's retail forex platform will show him three important numbers associated with his account: his balance, his equity, and his margin remaining. If trader X has two positions: $100,000 long (buy) in EUR/USD, and $100,000 short (sell) in GBP/USD, and he has $10,000 in his account, his positions would look as follows: Because of the 100:1 leverage, it took him $1,000 to control each position. This means that he has used up $2,000 in his margin, out of a $10,000 account, and thus he has $8,000 of margin still available. With this margin, he can either take more positions or keep the margin relatively high to allow his current positions to be maintained in the event of downturns. If the client chooses to open a new position of $100,000, this will again take another $1,000 of his margin, leaving $7,000. He will have used up $3,000 in margin among the three positions. The other way margin will decrease is if the positions he currently has open lose money. If one of his 3 positions of $100,000 decrease by $5,000 in value (which is fairly common), he now has, of his original $7,000 in margin, only $2,000 left.[original research?]

If you have a $10,000 account and only open one $100,000 position, this has committed only $1,000 of your money plus you must maintain $1,000 in margin. While this leaves $9,000 free in your account, it is possible to lose almost all of it if the speculation loses money.[original research?]


Transaction Costs and Market Makers

Market makers are compensated for allowing clients to enter the market. They take part or all of the spread in all currency pairs traded. In a common example, EUR/USD, the spread is typically 3 pips (percentage in point) or 3/100 of a cent in this example. Thus prices are quoted with both bid and offer prices (e.g., Buy EUR/USD 1.4900, Sell EUR/USD 1.4903).[citation needed]

That difference of 3 pips is the spread and can amount to a significant amount of money. Because the typical standard lot is 100,000 units of the base currency, those 3 pips on EUR/USD translate to $30 paid by the client to the market maker. However, a pip is not always $10. A pip is 1/100th of a cent (or whatever), and the currency pairs are always purchased by buying 100,000 of the base currency.

For the pair EUR/USD, the quote currency is USD; thus, 1/100th of a cent on a pair with USD as the quote currency will always have a pip of $10. If, on the other hand, your currency pair has Swiss francs (CHF) as a quote instead of USD, then 1/100th of a cent is now worth around $9, because you are buying 100,000 of whatever in Swiss francs.


Financial Instruments

There are several types of financial instruments commonly used.
Forwards
One way to deal with the Forex risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a few days, months or years.
Futures
Foreign currency futures are forward transactions with standard contract sizes and maturity dates — for example, 500,000 British pounds for next November at an agreed rate. Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.
Swaps
The most common type of forward transaction is the currency swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not contracts and are not traded through an exchange.
Spot
A spot transaction is a two-day delivery transaction for most currency pairs (but one-day for USD/CAD and some others), as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction. The data for this study come from the Spot market.

Algorithmic Trading In Foreign Exchange

Electronic trading is growing in the FX market, and algorithmic trading is becoming much more common. According to financial consultancy Celent estimates, by 2008 up to 25% of all trades by volume will be executed using algorithm, up from about 18% in 2005.[citation needed]

An algorithmic trader needs to be mindful of potential fraud by the broker. Part of the weekly algorithm should include a check to see if the amount of transaction errors when the trader is losing money occurs in the same proportion as when the trader would have made money.

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Fundamental trading in foreign exchange

Fundamental trading is determined on the basis on regulatory,statutory and economic changes which occur with-in various countries, FX traders are more concerned if central governments will raise rates on its particular currency. Likewise traders also to look to countries which are dependent on commodities or commodity driven such ie. Australian dollar or Canadian dollar which are heavily influenced by commodities prices.

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Technical Analysis in foreign exchange

Technical Analysis trading is utilized in the FX markets as a way to determine future price movements of a particular currency. Traders utilize technical indicators to measure overbought and oversold levels. The common use indicator being the Bollinger band or RSI (relative strength index) which measures the particular strength of movement built in a current pairs trending direction. A new wave of measurement tool being utilized amongst traders is VSA or volume spread analysis.The success with the VSA method is that your looking to follow the volume,whether tick volume or not is still a relevant substitute to utilize in determining when professional money is buying or selling. Adair,L,:"Trading Volume Spread Analysis""Free Press Release": Retrieved on 2009-07-27

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Financial instruments

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Spot

A spot transaction is a two-day delivery transaction (except in the case of trades between the US Dollar, Canadian Dollar, Turkish Lira and Russian Ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction. The data for this study come from the spot market. Spot transactions has the second largest turnover by volume after Swap transactions among all FX transactions in the Global FX market. NNM

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Forward
See also: forward contract

One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a one day, a few days, months or years. Usually the date is decided by both parties.

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Future
Main article: currency future

Foreign currency futures are exchange traded forward transactions with standard contract sizes and maturity dates — for example, $1000 for next November at an agreed rate [4],[5]. Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.

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Swap
Main article: foreign exchange swap

The most common type of forward transaction is the currency swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not standardized contracts and are not traded through an exchange.

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Option
Main article: foreign exchange option

A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world.

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Exchange-Traded Fund
Main article: exchange-traded fund

Exchange-traded funds (or ETFs) are open ended investment companies that can be traded at any time throughout the course of the day. Typically, ETFs try to replicate a stock market index such as the S&P 500 (e.g., SPY), but recently they are now replicating investments in the currency markets with the ETF increasing in value when the US Dollar weakens versus a specific currency, such as the Euro. Certain of these funds track the price movements of world currencies versus the US Dollar, and increase in value directly counter to the US Dollar, allowing for speculation in the US Dollar for US and US Dollar denominated investors and speculators.

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Speculation

Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly. Nevertheless, economists including Milton Friedman have argued that speculators ultimately are a stabilizing influence on the market and perform the important function of providing a market for hedgers and transferring risk from those people who don't wish to bear it, to those who do.[16] Other economists such as Joseph Stiglitz consider this argument to be based more on politics and a free market philosophy than on economics.[17]

Large hedge funds and other well capitalized "position traders" are the main professional speculators. According to some economists, individual traders could act as "noise traders" and have a more destabilizing role than larger and better informed actors [18].

Currency speculation is considered a highly suspect activity in many countries.[where?] While investment in traditional financial instruments like bonds or stocks often is considered to contribute positively to economic growth by providing capital, currency speculation does not; according to this view, it is simply gambling that often interferes with economic policy. For example, in 1992, currency speculation forced the Central Bank of Sweden to raise interest rates for a few days to 500% per annum, and later to devalue the krona.[19] Former Malaysian Prime Minister Mahathir Mohamad is one well known proponent of this view. He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators.

Gregory J. Millman reports on an opposing view, comparing speculators to "vigilantes" who simply help "enforce" international agreements and anticipate the effects of basic economic "laws" in order to profit.[20]

In this view, countries may develop unsustainable financial bubbles or otherwise mishandle their national economies, and foreign exchange speculators allegedly made the inevitable collapse happen sooner. A relatively quick collapse might even be preferable to continued economic mishandling. Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the blame from themselves for having caused the unsustainable economic conditions. Given that Malaysia recovered quickly after imposing currency controls directly against IMF advice, this view is open to doubt.

Determinants Of FX Rates

The following theories explain the fluctuations in FX rates in a floating exchange rate regime (In a fixed exchange rate regime, FX rates are decided by its government):

(a) International parity conditions viz; purchasing power parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world.

(b) Balance of payments model (see exchange rate). This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous appreciation of dollar during 1980s and most part of 1990s in face of soaring US current account deficit.

(c) Asset market model (see exchange rate) views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by people’s willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that “the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.”

None of the models developed so far succeed to explain FX rates levels and volatility in the longer time frames. For shorter time frames (less than a few days) algorithm can be devised to predict prices. Large and small institutions and professional individual traders have made consistent profits from it. It is understood from above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces of demand and supply. The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange.

Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology.

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Economic factors

These include: (a)economic policy, disseminated by government agencies and central banks, (b)economic conditions, generally revealed through economic reports, and other economic indicators.
Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).
Economic conditions include: 
Government budget deficits or surpluses
The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency.
Balance of trade levels and trends
The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency.
Inflation levels and trends
Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising [. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.
Economic growth and health
Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be.
Productivity of an economy
Increasing productivity in an economy should positively influence the value of its currency. Its effects are more prominent if the increase is in the traded sector [3].

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Political conditions

Internal, regional, and international political conditions and events can have a profound effect on currency markets.

All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation's economy. For example, destabilization of coalition governments in India, Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive or negative interest in a neighboring country and, in the process, affect its currency.

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Market psychology

Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:
Flights to quality
Unsettling international events can lead to a "flight to quality," with investors seeking a "safe haven." There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The Swiss franc has been a traditional safe haven during times of political or economic uncertainty.[12]
Long-term trends
Currency markets often move in visible long-term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends. [13]
"Buy the rumor, sell the fact"
This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought".[14] To buy the rumor or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices.
Economic numbers
While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. "What to watch" can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight.
Technical trading considerations
As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns.[15]

Trading Characteristics

There is no unified or centrally cleared market for the majority of FX trades, and there is very little cross-border regulation. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currencies instruments are traded. This implies that there is not a single exchange rate but rather a number of different rates (prices), depending on what bank or market maker is trading, and where it is. In practice the rates are often very close, otherwise they could be exploited by arbitrageurs instantaneously. Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. A joint venture of the Chicago Mercantile Exchange and Reuters, called Fxmarketspace opened in 2007 and aspired but failed to the role of a central market clearing mechanism.

The main trading center is London, but New York, Tokyo, Hong Kong and Singapore are all important centers as well. Banks throughout the world participate. Currency trading happens continuously throughout the day; as the Asian trading session ends, the European session begins, followed by the North American session and then back to the Asian session, excluding weekends.

Fluctuations in exchange rates are usually caused by actual monetary flows as well as by expectations of changes in monetary flows caused by changes in gross domestic product (GDP) growth, inflation (purchasing power parity theory), interest rates (interest rate parity, Domestic Fisher effect, International Fisher effect), budget and trade deficits or surpluses, large cross-border M&A deals and other macroeconomic conditions. Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time. However, the large banks have an important advantage; they can see their customers' order flow.

Currencies are traded against one another. Each pair of currencies thus constitutes an individual product and is traditionally noted XXX/YYY, where YYY is the ISO 4217 international three-letter code of the currency into which the price of one unit of XXX is expressed (called base currency). For instance, EUR/USD is the price of the euro expressed in US dollars, as in 1 euro = 1.5465 dollar. Out of convention, the first currency in the pair, the base currency, was the stronger currency at the creation of the pair. The second currency, counter currency, was the weaker currency at the creation of the pair.

The factors affecting XXX will affect both XXX/YYY and XXX/ZZZ. This causes positive currency correlation between XXX/YYY and XXX/ZZZ.

On the spot market, according to the BIS study, the most heavily traded products were:
EUR/USD: 27%
USD/JPY: 13%
GBP/USD (also called sterling or cable): 12%

and the US currency was involved in 86.3% of transactions, followed by the euro (37.0%), the yen (17.0%), and sterling (15.0%) (see table). Note that volume percentages should add up to 200%: 100% for all the sellers and 100% for all the buyers.

Trading in the euro has grown considerably since the currency's creation in January 1999, and how long the foreign exchange market will remain dollar-centered is open to debate. Until recently, trading the euro versus a non-European currency ZZZ would have usually involved two trades: EUR/USD and USD/ZZZ. The exception to this is EUR/JPY, which is an established traded currency pair in the interbank spot market. As the dollar's value has eroded during 2008, interest in using the euro as reference currency for prices in commodities (such as oil), as well as a larger component of foreign reserves by banks, has increased dramatically. Transactions in the currencies of commodity-producing countries, such as AUD, NZD, CAD, have also increased.

Market Participants

Unlike a stock market, where all participants have access to the same prices, the foreign exchange market is divided into levels of access. At the top is the inter-bank market, which is made up of the largest investment banking firms. Within the inter-bank market, spreads, which are the difference between the bid and ask prices, are razor sharp and usually unavailable, and not known to players outside the inner circle. The difference between the bid and ask prices widens (from 0-1 pip to 1-2 pips for some currencies such as the EUR). This is due to volume. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the foreign exchange market are determined by the size of the "line" (the amount of money with which they are trading). The top-tier inter-bank market accounts for 53% of all transactions. After that there are usually smaller investment banks, followed by large multi-national corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail FX-metal market makers. According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s.” (2004) In addition, he notes, “Hedge funds have grown markedly over the 2001–2004 period in terms of both number and overall size” Central banks also participate in the foreign exchange market to align currencies to their economic needs.

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Banks

The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account. Until recently, foreign exchange brokers did large amounts of business, facilitating interbank trading and matching anonymous counterparts for small fees. Today, however, much of this business has moved on to more efficient electronic systems. The broker squawk box lets traders listen in on ongoing interbank trading and is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago.

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Commercial companies

An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants.

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Central banks

National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Milton Friedman argued that the best stabilization strategy would be for central banks to buy when the exchange rate is too low, and to sell when the rate is too high—that is, to trade for a profit based on their more precise information. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading.

The mere expectation or rumor of central bank intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank.[7] Several scenarios of this nature were seen in the 1992–93 ERM collapse, and in more recent times in Southeast Asia.

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Hedge funds as speculators

About 70% to 90%[citation needed] of the foreign exchange transactions are speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency. Hedge funds have gained a reputation for aggressive currency speculation since 1996. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor.

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Investment management firms

Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases.

Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. Whilst the number of this type of specialist firms is quite small, many have a large value of assets under management (AUM), and hence can generate large trades.

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Retail foreign exchange brokers

There are two types of retail brokers offering the opportunity for speculative trading: retail foreign exchange brokers and market makers. Retail traders (individuals) are a small fraction of this market and may only participate indirectly through brokers or banks. Retail brokers, while largely controlled and regulated by the CFTC and NFA might be subject to foreign exchange scams.[8][9] At present, the NFA and CFTC are imposing stricter requirements, particularly in relation to the amount of Net Capitalization required of its members. As a result many of the smaller, and perhaps questionable brokers are now gone. It is not widely understood that retail brokers and market makers typically trade against their clients and frequently take the other side of their trades. This can often create a potential conflict of interest and give rise to some of the unpleasant experiences some traders have had. A move toward NDD (No Dealing Desk) and STP (Straight Through Processing) has helped to resolve some of these concerns and restore trader confidence, but caution is still advised in ensuring that all is as it is presented.

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Non-bank Foreign Exchange Companies

Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but currency exchange with payments. I.e., there is usually a physical delivery of currency to a bank account.

It is estimated that in the UK, 14% of currency transfers/payments[10] are made via Foreign Exchange Companies.[11] These companies' selling point is usually that they will offer better exchange rates or cheaper payments than the customer's bank. These companies differ from Money Transfer/Remittance Companies in that they generally offer higher-value services.

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Money Transfer/Remittance Companies

Money transfer companies/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country. In 2007, the Aite Group estimated that there were $369 billion of remittances (an increase of 8% on the previous year). The four largest markets (India, China, Mexico and the Philippines) receive $95 billion. The largest and best known provider is Western Union with 345,000 agents globally.