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Foreign Exchange
Have you ever gone on holiday and had to exchange your cash for the currency of the country you are going to? Say you are visiting the United States and you live in England, you will have to exchange your pounds for dollars if you wish to spend money while you're in the United States. If so, then you have already traded on the foreign exchange market (forex), as you 'traded' your pounds for dollars.
The forex market or FX market is the largest of the financial markets and in 2019 FX markets reached $6.6trillion worth of transactions per day - we call this volume. To put this into perspective, one day of FX trading beats the average daily trading in global stock markets by 28 to 1.
Why people use the forex markets:
- Utility: Those who need to get hold of a different currency to buy goods or services. This could include imported goods, stocks, bonds, and anything else denominated in a foreign currency.
- Hedging: some companies will use the forex markets to hedge against the risk in foreign exchange rates moving.
- Speculation: this is when you are looking to profit from the changes in exchange rates. For example, you may sell your domestic currency and buy a foreign currency in hopes that when you exchange it back to your domestic currency, you'll end up with more of the currency you started with.
Say the exchange rate for pounds into dollars is 1.3, so this means that I can sell 1 British pound and buy 1.3 dollars. We go through with the trade, and I now have 1.3 US dollars, the exchange rate for pounds into dollars now drops to 1.1, which means 1 British pound is equal to 1.1 dollars. If we reverse this to dollars into pounds, we can exchange 1 US dollar for 91p. As I have 1.3 dollars currently, I decide to sell my US dollars to buy (1.3 x 0.91 =) 1.18 pounds. Do you see how I now have more British pounds than I started with? However, the exchange rates could also go against you, and you could lose money when you trade back into your base currency.
Forex Markets & Prices
The foreign exchange market is an over the counter (OTC) market, so transactions are not passed through an exchange, currencies are exchanged directly between two participants. The major four forex trading centres run throughout the day, and they are the New York, London, Tokyo, and Sydney centres. How do we access the market? Typically, you will be able to access these markets through a broker or bank who will give you access through a type of online dealing platform.
On these platforms, you will find that each currency is in a pair and that each currency is denoted by a three-letter code, for example, GBP/USD, which represents the exchange rate for pounds and dollars. Typically, the first two letters of the code stand for the name of the country and the last letter stands for the country's currency, for example, GBP represents the Great British Pound and USD represents United States Dollar.
The first currency in the pair is called the primary currency and the second currency is known as the counter currency. Let's say GBP/USD is 1.3 and we expect that the pound will strengthen against the dollar, we would go long (buy) on this pair. If we thought the pound was weakening against the dollar, we would short (sell) this pair as the pound's value will decrease.
So why doesn't everyone trade forex and make money? Well, the exchange rates could also go against you, and you could lose money when you trade back into your base currency.
Trading Forex
Movement in the exchange rate is measured by what we call pips. As we are trading very small movements in the exchange rate, we need a unit to quantify these minuscule moves. The value of a pip varies depending on the pair you are trading. For example, a one-pip movement with GBP/USD would be 0.0001, so if GBP/USD was 1.1000 and rose to 1.1001 then this would be a one-pip movement. For most of the forex pairs, a pip represents a one-digit move in the fourth decimal place (0.0001). For pairs where Yen is the counter currency, the second decimal is the one to watch, 0.01 represents one pip. For example, say GBP/JPY is 160.910 and it moves to 160.945 then this would be a 3.5 pip increase.
Major Currency Pairs
| AUD/USD | Australian dollar / US dollar |
| EUR/CHF | Euro / Swiss Franc |
| EUR/GBP | Euro / Sterling |
| EUR/JPY | Euro / Japanese yen |
| EUR/USD | Euro / US dollar |
| GBP/EUR | Sterling / Euro |
| GBP/USD | Sterling / US dollar |
| USD/CAD | US dollar / Canadian dollar |
| USD/CHF | US dollar / Swiss franc |
| USD/JPY | US dollar / Japanese yen |
Minor Currency Pairs
| CAD/CHF | Canadian dollar / Swiss franc |
| CAD/JPY | Canadian dollar / Japanese yen |
| CHF/JPY | Swiss franc / Japanese yen |
| EUR/CAD | Euro / Canadian dollar |
| EUR/SGD | Euro / Singapore dollar |
| EUR/ZAR | Euro / South African rand |
| GBP/CAD | Sterling / Canadian dollar |
| GBP/CHF | Sterling / Swiss franc |
| GBP/JPY | Sterling / Japanese yen |
| GBP/ZAR | Sterling / South African rand |
| USD/SGD | US dollar / Singapore dollar |
| USD/ZAR | US dollar / South African rand |
What affects currency value?
The currency exchange rate is one of the most important determinants of a country's level of economic health in comparison to other countries. So, several factors influence whether the exchange rate appreciates or depreciates.
Generally, a stronger economy means a stronger currency and vice versa. Certain differences between one country and a different country affect the value of one currency versus the other.
Differences in Inflation
- Typically, countries with consistent lower inflation show a rising currency value.
- Typically, countries with persistent higher inflation show a falling currency value.
Differences in Interest Rates
- Higher interest rates offer better returns for lenders, so if interest rates are higher in one country compared to another this will attract foreign money and cause the relative value of the currency to rise in the higher interest rate country.
Economic Growth
- A strong growth rate in a country will show signs of growing demand for products and services, better job prospects for workers and better attraction of foreign investments and capital.
Current Account Balance (demand for imports and exports)
- A positive current account balance indicates that a country is earning more on foreign trade than it is spending and that it is lending capital to foreign borrowers. A deficit current account balance shows that a country spends more on foreign trade than it earns and borrows more from trading partners than it lends. A deficit or borrower country will see less demand for its currency generally, and when there is a low demand for a currency what happens? Its value falls.
Economic Policy
- Monetary Policy: Central banks influence exchange rates through their monetary policy decisions. By adjusting interest rates, money supply, and implementing quantitative easing or tightening, central banks can affect the attractiveness of a currency to investors. Higher interest rates, for example, can attract foreign capital and strengthen a currency, while lower rates can have the opposite effect.
- Fiscal Policy: Government fiscal policies, such as tax rates and government spending, can influence exchange rates. A government pursuing expansionary fiscal policies (increased spending and lower taxes) may lead to budget deficits, which can put downward pressure on the currency. Conversely, contractionary fiscal policies may have the opposite effect.
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