FX, or forex, stands for foreign exchange. Every bank has an FX desk but it’s more important to some banks than others. Forex trades are all over-the-counter – this means that there is no centralised body or place where things are regulated and traded. The trades take place directly between two parties with no exchange house in the middle. Every country has its own central bank where currency is controlled, but there is not one global body that oversees the currency market. FX is also interesting since anyone can get involved – from someone day trading from home for fun, to global institutions making a deal ahead of an international purchase, to hedge funds speculating in more than one currency, the forex markets are open to everyone.
Some countries decide that they want more control over the value of their currency and so they have what is called pegged or fixed exchange rates. Such countries include: Venezuela, the Bahamas and the city-state of Hong Kong. Their central bank ensures that their currency is directly correlated to something else, whether that is gold or another major currency. It is helpful for controlling inflation and also used by smaller countries to ease trade, Since their currency is directly related to a major world currency or instrument. Most countries, though, have a floating exchange rate, and that rate is dictated by the markets. Some economists think this way is more helpful as it allows currencies to work themselves out in the markets and makes it easier for countries to deal with any ups and downs the currency may face. The UK, US and the Eurozone all have floating exchange rates.
FX desks have a separate group for Emerging Markets FX. These are currencies from countries that are experiencing tremendous growth. They were formerly known as less developed or Third World countries but now those terms are now outdated. These countries, such as China, Brazil, South Africa and India, are seen as having tremendous upside and potential for investment, but at the same time carrying a lot of risk.
Many large, multi-national corporations that are not necessarily in the finance sector may actually have their own trading division to help with their international business. For example, a large construction firm may employ their own forex traders so that they can handle converting one currency into another when there is a piece of equipment they need to purchase overseas.
So FX can actually reach into many different kinds of business and knowing how to trade currencies doesn’t necessarily mean that you’ll only be able to find work at a bank or fund. But besides those kinds of situations, the main hubs for FX markets are: London, New York, Singapore, Hong Kong and Tokyo. At one bank there will be FX traders spread out all over the world so that all time zones are covered and the desk can take advantage of moves that may happen when only one market is open. This is a true 24-hour business, and trading can take place any time of the day or night (only on weekdays; you’ll be happy to hear that markets are closed during weekends).
Different kinds of FX trades
There are different ways of trading foreign exchange and the most common are the following:
Spot – This is the shortest kind of trade that usually is settled in two days. It’s the most simple kind of trade as you literally trade x for y and that’s it.
Forward – We’ve covered forwards in the chapter on fixed income, but this can play a part in the FX market too. An exchange rate is agreed but the deal doesn’t actually take place until a pre-determined date in the future.
Future – Again, part of fixed income but also can be used in trading foreign exchange. It’s like a forward but more standardised and regulated.
Option – This is another fixed income instrument used in FX where you put a trade in place but then have the option to back out of it before the date where the trade would be done. You have the right, but not the obligation to go ahead with the trade until the contract expires.
Swap – An FX swap is when a trade is done but then reversed later. So you buy x, sell y and then in three months you sell x back for y. A swap is usually achieved by making a spot trade and also a forward at the same time.
How to quote an exchange rate
Every currency in the world has a three letter code. For the euro it is EUR, the code for the pound is GBP, the US dollar is USD. To quote an exchange rate between two currencies, one code will be listed directly after the other, usually as: GBP/USD. In this example we’d call GBP the base currency and USD the counter currency. After the two currency codes there will be a number, for example 5. If you saw GBP/USD 5 that means that 5 USD = 1GBP (we just used nice round numbers for this example, it’s not actually the current rate. If it were, we’d hope that all you Brits would be too busy living the good life somewhere in America to be reading this!). In these quotations it’s always “how many of the counter currency make up one of the base currency.”
What affects exchange rates?
The first thing that can make the value of a currency rise and fall is something to do with that country’s political system. This can mean anything from elections, to some kind of scandal involving government officials to a new president/prime minister/ruling party. Any new party that is expected to radically change policies or throw the country into any kind of instability will have a negative effect on the country’s currency and it will weaken. This will also be the case should there be questions about who will actually lead the country or who is in charge.
The state of a country’s economy will also affect the strength of that country’s currency. Any time a report comes out about a country’s GDP, budget deficit or surplus, or a change in economic policy, you will see the currency of that country move. Of course the nature of the announcement will determine which way the currency goes, but any change or announcement having to do with the fiscal state of a country will affect its currency.
Traders themselves can also influence forex markets. If enough traders perceive one currency to be on the decline, they might pull their investment in that and invest in another currency that they think is more stable. That will make the demand for that second currency higher, but the first one will suffer, all because of perception. This is what’s called market psychology and is a very interesting component of the FX markets – trying to figure out what people will do when an event occurs. Successfully predicting this is an important skill possessed by outstanding traders.
