A Complete Guide to Foreign Exchange
Every day, hundreds of billions of pounds worth of foreign exchange transactions are carried out on the international foreign exchange market. Often abbreviated to Forex (or simply, FX), the market operates every hour of every business day meaning that regardless of the time, you can be sure that millions of pounds worth of currency are being traded in at least one location somewhere around the world. Big-time investors such as Hungarian-born George Soros have made billions trading on the international foreign exchange market and in 1992, he become known as “the man who broke the bank of England” when a currency trade of $10 billion worth of Pounds (GBP) left him with a profit of $1 billion during the UK currency crisis. However, it’s not just multi-millionaire investors trading on the foreign exchange. These days – as long as you have an Internet connection – anyone can trade on the international foreign exchange from the comfort of his or her home. But what exactly is the international foreign exchange market, how does it work and how can you make money from it? Keep reading and we’ll explain everything.
INTERNATIONAL FOREIGN EXCHANGE (FOREX) EXPLAINE
The International Foreign Exchange market is nothing more than a decentralised global market allowing for the trading of various currencies against one another. Essentially, it is the mechanism that allows a person or firm to make the trade. It’s also the market that determines the overall rate of exchange between two different currencies. For example, if you’ve ever visited a country with a different currency, you might have traded one currency for another before embarking on your trip. This is usually done either online or at the travel agents but the rate at which your currency is converted will be determined by the international foreign exchange market.
HOW BIG IS THE INTERNATIONAL FOREIGN EXCHANGE MARKET?
The International Foreign Exchange is by far – in terms of the volume of trading – the largest market in the world. In 1992, the Bank of International Settlements (BIS) estimated that the daily volume of trading on the market was more than $1 trillion. Just last year in 2013, the Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity showed that in April, the average daily trading on the foreign exchange market averaged a staggering $5.3 trillion. To put this in perspective, the average daily trading figure for the New York Stock Exchange in 2013 was $169 billion; nothing compared to the volumes traded on the foreign exchange market.
WHERE IS THE FOREIGN EXCHANGE MARKET?
As briefly mentioned earlier in this guide, the international foreign exchange market is decentralised. This essentially means that the market spans the entire globe and every day, traders from countries all around the world trade currencies. Despite round-the-clock trading (on business days, at least), the market is said to be at its “deepest” – meaning that the prices are most volatile - during the early morning on the U.S. East Coast. This is because at this time, both the U.S. and European markets are open and trading. Conversely, the market is said to be “thinnest” near the end of the day in California (U.S. West Coast) as traders in Tokyo and other parts of Asia are just getting started for the day.
THE DIFFERENT TYPES OF TRANSACTIONS
Unfortunately, the international foreign exchange market is quite complex and has a number of different transactions for different purposes. These transactions are: spot transactions; outright forward transactions; and swap transactions. Here’s an easy-to-understand definition of all three:
Spot transactions are the most important type of transactions on the foreign exchange market. Sometimes referred to as “cash trades”, spot transactions are an almost immediate delivery of a foreign exchange. The sale or purchase of a foreign currency is carried out “on the spot” rather than at a date in the future (see outright forward transactions). This type of transaction is typically carried out electrically and is therefore virtually instantaneous. Spot transactions account for an estimated 43% of all transactions.
An outright forward transaction basically allows an investor to “lock-in” an exchange rate in order to buy or sell a currency on a specified date in the future. This is typically used by businesses that make large purchases from foreign companies (i.e. businesses trading in a different currency). As an example, imagine that you’re a U.S. based electronics company. You may wish to order components from China. Because it’s a big order, the Chinese company asks for half of the payment now and the other half of the payment in six months. The first half of the payment can be carried out using a spot trade (see above) but the second part of the payment would require an outright forward transaction. Basically, the U.S. based company would lock-in the exchange rate six months in advance in order to protect itself against currency risk (i.e. the risk that the currency may cost more to purchase in six months time due to fluctuating currency trading prices).
Swap transactions make use of both a spot transaction and a forward transaction. Basically, a swap transaction is where a dealer will purchase X amount of one currency in a spot transaction whilst simultaneously selling the same amount (X) back to into the forward market. Usually, this is a tactic used by companies who are looking to expand into certain geographic areas where a traditional loan would have a high interest rate. For example, a U.S. company may wish to expand into Mexico, but getting a loan from a bank in Mexico might have a high interest rate (e.g. 15%) due to the fact that the company isn’t based in Mexico. At the same time, a Mexican company might have the same problem expanding into the U.S. However, both companies could borrow money from their home countries at a lower interest rate (e.g. 5%). A swap transaction basically allows the two companies to swap loans and pay the lower rate of interest to their respective banks.
HOW TO MAKE MONEY ON THE INTERNATIONAL EXCHANGE MARKET
You can make money on the international currency exchange market by trading various currencies back and forth at varying exchange rates. For example, you can from the image above that if you traded $10,000 for Pounds (GBP) on the 8th December 2014 at an exchange rate of $1/£0.64327, you’d end up with £6,432.70. Then, just a couple of days later, you can see that the exchange rate has fluctuated to $1/£0.63509. If you traded your £6,432.70 back into U.S. Dollars at this new exchange rate, you’d end up with $10,128.80. This is a profit of $128.80 (minus any trading fees).