Feature Stories | Jul 09 2009
(This story was originally published on July 2. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere).
A short intro to FX Markets
By Greg Peel
Once upon a time proprietary foreign exchange trading was the realm of the merchant banks, conducted by those traders who had a reputation of being the “cowboys” of the market. The cowboys’ counterparties were other merchant banks and commercial banks and, occasionally, actual corporate clients with foreign currency exposure.
Once upon a time global currencies were “pegged” to gold, implying banknotes issued were redeemable for a specific amount of gold held by the central bank of that country. Relative values of currencies were determined only by equivalent values of gold, and hence there was no “market” for currencies as such. In 1946 the US dollar became the global “reserve” currency. All other currencies were pegged to the dollar, which in turn was pegged to gold, which the US held in reserve at Fort Knox.
In 1972, the Gold Standard, as it is known, was abandoned and currencies were no longer pegged to anything, except another currency. (The Australian dollar was pegged to the US dollar until 1983). This type of currency is known as “fiat” currency, and implies the value of a banknote is only as valuable as the economy of the issuing-country is strong. Gold is gold, but economic strength is a far more esoteric concept.
One way to compare currencies is to look at something called “purchasing power parity (PPP)”, which one might call the “litre of milk index”. Let’s assume for the moment it costs one US dollar to buy one litre of milk in New York, and it costs one trillion Zimbabwean dollars to buy a litre of milk in Harare. The difference in face value is representative of the strength of the world’s biggest economy against the basket case that is Zimbabwe’s economy.
But PPP is really not that simple, given vagaries of local milk supply and so forth. Indeed, foreign exchange rates rarely reflect anything like an accurate PPP balance. What they will reflect, however, is interest rate parity.
The value of one currency will move in relation to the value of another currency dependent on comparative economic strength or weakness. A foreign exchange rate is simply a relative measure. We know, for example, that Australia’s economy is heavily weighted towards the export of natural resources. The US also boasts vast resources, but its economy is weighted to the “service” industry, such as banking and computer software. When commodity prices are strong, the Australian economy is strong.
And when the Australian economy is strong, the Reserve Bank raises its “interest rate”, being the level at which it will borrow or lend cash overnight to market participants. This “cash rate” is then reflected in interest rates applicable further up the maturity curve, all the way to ten-year government bonds. The higher the cash rate, the higher the bond rate.
The RBA raises its cash rate in boom times because it fears inflation. If the economy is strong, and everyone is making lots of money, they can afford to pay more for goods and workers demand higher wages. This leads to an inflationary spiral, and an unmanaged boom can quickly turn into a devastating bust, as we may have recently noticed. The RBA, and central banks around the globe, attempt to keep economies from becoming runaway trains by making the cost of finance more expensive – by raising interest rates.
If the RBA raises its cash rate, the interest rate (yield) on a AAA-rated government bond will also rise, making them an attractive investment for offshore markets. But one can only buy Aussie bonds with Aussie dollars. An American investor wishing to buy Aussie bonds must first exchange his US dollars for Aussie dollars. Thus a growing foreign demand for Aussie bonds (or Australian stocks, or property, or any other Aussie-dollar denominated asset) will force up the value of the Aussie dollar against other currencies, just as increasing demand for oil increases the oil price.
The relative value of currencies was clearly exemplified in the period in early 2008 when commodity prices were running rampant. The Australian economy appeared strong due to misperceived Chinese commodity demand, and in response the RBA raised its cash rate to 7.25% in March. The US economy, on the other hand, was in all sorts of trouble and the US Federal Reserve had lowered its cash rate to 2.25%. This effectively meant you could borrow US dollars at 2.25% and invest at 7.25% in a AAA-rated security. You’d do that all day, wouldn’t you?
Well no – you wouldn’t necessarily, because at the same time the Aussie dollar rose from being worth only US$0.50 not many years earlier to being almost worth US$1.00. What an American would gain on the swings of the interest rate differential, he would lose on the roundabout of exchange rate movement. Thus exchange rates should reflect “interest rate parity” such that no arbitrage is available.
(Note that exchange rates reflect both the size of the underlying economy and the amount of currency on issue. The fact the Aussie almost reached “parity” with the greenback last year does not imply the Australian economy became almost as large as the US economy. Nothing could be further from the truth. It’s just that 20 million Australians don’t need as many banknotes as 300 million Americans, so there aren’t as many Aussie dollars about. Just the same as the larger BHP trades at a lower share price to the smaller Rio Tinto – it comes down to the number of shares on issue.)
It’s never quite a perfect world however, and disparities do occur, particularly where the yen is involved. But that’s a story for another day. Suffice to say, exchange rates move in relation to interest rate differentials, which in turn reflect relative economic strength or weakness. Exchange rates will nevertheless move swiftly from minute to minute, while it takes central banks sometimes months to bring their interest rates into line, opening up the opportunity for frenetic intra-day trading.
Foreign exchange represents far and away the highest turnover financial market of all, as investors move money across borders and the day to day business of international trade is conducted, all requiring the exchange of currencies. But in reality, about 95% or so of every day’s trading will be closed out at the end of a trading “session”, in a rolling move around the globe.
Most proprietary foreign exchange traders simply open from scratch each day, play the market, and then square off at the end of the day having either won or lost. It is about a 95% zero sum game. While this knowledge might raise the hackles of those with a bone to pick about “cowboys” controlling a country’s currency, it is the liquidity provided by the forex market which ultimately allows, for example, BHP Billiton to achieve the best US dollar price for its iron ore exports or Harvey Norman to achieve the best US dollar price in importing flat screen televisions.
Note that the US dollar comes up in both examples above, even though BHP might be exporting iron ore to China and Harvey Norman importing televisions from Japan. This is because the US dollar is the “reserve” currency which, in the post Gold Standard era, means the rest of the world trusts the currency of the world’s largest economy to be the safest benchmark. You wouldn’t want to be trying to sell iron ore to China in Zimbabwean dollars for fear of hourly changes in rate.
Thus we consider the “value” of any currency to be best determined by its relative value to the US dollar. While an Australian traveling to London will be interested in the value of the pound in Aussie terms, we “quote” the Aussie as being a value in US dollars. The Aussie is currently worth about US$0.80.
Another way to look at this is as AUD/USD, or “what’s one Aussie dollar worth in US dollars?” It is a ratio. We could, if so inclined, make just as accurate a valuation of the Aussie in terms of the US dollar, such that one US dollar is worth A$1.25. This would be USD/AUD, but that is not the convention adopted by the market.
The Aussie adapts the English system of considering the pound in terms of dollars (GDP/USD), whereas the Americans preferred originally to think of their dollar in the terms of another currency. The yen, for example, is quoted as USD/JPY. This leads to a lot of confusion given inconsistencies.
The overnight movement of the US dollar is often quoted, on business television networks for example, as most relevant against four different currencies – the yen, the euro, the pound, and the Swiss franc, or USD/JPY, EUR/USD, GBP/USD and USD/CHF. Note the first and last exchange rates are quoted one way around and the middle two are the other way around (as in the AUD/USD convention). Thus if the US dollar were to rise overnight against all four currencies, the first and last exchange rates would be higher and the middle two lower.
That’s just one confusing aspect of what is, for the novice retail investor, potentially a very confusing and risky market. Yet in recent years, foreign exchange trading has become very popular amongst retail investors as another market to play in. While one is merely “exchanging” cash from one currency to another, as soon as an investor becomes exposed to a currency other than the investor’s domestic currency, that investor is exposed to ongoing exchange rate movements. Hence market parlance is that one might “buy” or “sell” US dollars, and thus live or die by exchange rate movements up or down. An investor will either receive more or less Aussie dollars back again at the end of the trade.
Forex trading is no longer just the realm of the “cowboys”.
Given the popularity of retail forex trading, FNArena has invited Matthew Corbett from yourtradingroom.com to provide a cursory introduction to the mechanics of the market.
Currency Markets: No Longer For Cowboys Only
By Matthew Corbett, yourtradingroom.com
With all the recent media coverage of government bail-outs, market crashes and tightening credit conditions, one market – the largest market on the planet – has tended to remain under the radar. That market is the global foreign exchange market, commonly known as the “forex” or “FX” market.
The foreign exchange market is simply a place whereby banks, financial institutions, official agencies and individual investors buy and sell various foreign currencies. Currencies are quoted in pairs – GBP/USD (Great British pound/US dollar), EUR/JPY (euro/Japanese yen) and AUD/USD (Australian dollar/US dollar) are a few examples.
When business is conducted outside of one’s own borders, then there must be a mechanism for providing payments in an acceptable form to the foreign person/business. Thus there is a need for “foreign exchange transactions” to occur.
In simple terms, an “exchange rate” is simply the ratio of one currency valued against another currency.
Let’s use the AUD/USD (Australian dollar vs United States dollar) exchange rate as an example. In foreign exchange, currencies are always quoted in pairs. The first currency (AUD) is the known as the “base” currency and the second currency (USD) is known as the “quote” or “counter” currency. When you wish to “buy” USD , the exchange rate at the time will tell you how much AUD (base currency) you will need to “sell” in order to “buy” USD (quote currency). Let’s use an example to illustrate:
If you want to exchange Australian dollars (AUD) for United States dollars (USD) then you have to “sell” or “exchange” Australian dollars to “buy” US dollars. If the exchange rate is AUD/USD 0.8000, then you “exchange” $1.00 Australian to “buy” $0.80 US. And vice versa – if you’re travelling from the US to Australia then you “exchange” $0.80 US to “buy” $1.00 Australian.
Movements in the value of currencies are recorded in “price interest points” or “PIPs”. 100 pips is equal to1 basis point. Let’s use an example: if the AUD/USD is trading at US$0.8000 (80c) then a move in the value of that currency pair to US$0.8001 is a move of 1 pip. If the pair moved in value to $0.8100 then that is a move of 100 pips or 1 basis point, thus the Australian dollar is now worth US$0.8100c (81c).
The number of “pips” a currency pair moves will determine how much profit or loss a trader will make on a position.
Like any other market, the price of a “currency pair” (AUD/USD) is determined by the interaction of buyers and sellers in that market. A trade only occurs when there’s a coming together of two parties – a buyer and a seller. But what does this really mean? If everyone was of the same opinion about the price of the AUD/USD then we wouldn’t have both buyers and sellers to create the market. Thus the “market” as such, whether it be foreign exchange, stock market, options market etc, is driven by the sentiment/emotions of all the participants in that market. The exchange rate between two currencies (AUD/USD) is determined by the actions of institutions, banks, official agencies and individual investors in the marketplace.
The diverse selection of execution venues such as internet trading platforms has also made it easier for retail traders to trade in the foreign exchange market. There are no restrictions in the foreign exchange market as to “short-selling” a pair. The underlying principle of “short selling” is to sell at a higher price and buy back later a lower price. This is the opposite of most people’s investment philosophy of ” buy low, sell high”. Let’s run through an example:
If you believed that the Australian Dollar will depreciate (go down in value) against the US dollar because of, say, weaker economic conditions here in Australia, then you could “short” the currency pair AUD/USD.
So the trade would be – short (sell) AUD/USD at 0.8000. One month later the Australian dollar has indeed fallen in value versus the US dollar.
The exchange rate is now 0.7900 – thus the Australian dollar has fallen 100 pips or 1 cent in value relative to the US dollar.
Therefore to close the trade you “buy back” the AUD/USD at 0.7900 (0.79c)
Profit = Sold at 0.8000 – Bought Back at 0.7900 = 100 PIPS (one US cent) Profit
Traders are able to participate in the forex market by trading in “contracts” or “lots”, as they’re known. The standard forex contract or lot has a face value of A$100,000. Typically, a one pip move equals US$10. Thus, in the above example a 100 pip profit on the AUD/USD short would equate to US$1,000 profit. Leverage on forex contracts give the trader the opportunity to make a greater percentage return per capital deployed. The flip side of this is when it goes against you! How many of you could sustain a couple of 100 pip (US$1,000) losses in a row?
To allow the “man on the street” to trade foreign exchange, foreign exchange brokers offer “Mini FX Contracts”. These Mini Contracts have a face value of A$10,000 and one pip equates to US$1.00. Therefore a 100 pip loss would only be a US$100 loss. The benefit for novice traders is that as they build their trading accounts they can start trading multiple Mini Contracts, eg two Minis (face value A$20,000 – one pip move = US$2.00), up to three Minis (face value A$30,000 - one pip move = US$3.00) and so forth. Trading Mini FX Contracts allows people to control their risk by trading smaller contract sizes versus the amount of trading capital they have. Even someone starting out with say A$10,000 as their initial capital would be able to trade one Mini Contract and limit their capital at risk to say 1-2 % a trade.
The cost of trading forex is the “spread”. This is where the foreign exchange broker makes his money, as typically you don’t pay brokerage. The “spread” is the difference between the bid (buy) price and the sell (ask) price that the foreign exchange broker offers you. BHP shares might, for example, be quoted on the exchange at $34.40-$34.50, meaning one can buy at $34.50 or sell at $34.40. Similarly, a foreign exchange might quote for you to buy AUD/USD at US$0.8095, or sell AUD/USD at US$0.8091. The difference between the buy and the sell price is the “spread”, and this is how your foreign exchange broker makes his money. Typically you don’t pay brokerage when you trade forex, you pay the spread. In this instance, the difference between getting in and getting out is four pips. Thus if you went “long” (bought) the AUD/USD at 0.8095 then price would need to move beyond that level by four pips for your position to be at breakeven. Spreads on currency pairs can be confusing for the new trader, but with time they are easy to understand.
Delving deeper into the cost of trading in the foreign exchange market, it is also important to remember that there are no government fees, clearing fees or exchange fees to pay either.
So why trade ?
People trade foreign exchange for many reasons but for traders its primarily to capture the fluctuating value of one currency versus another currency. For instance if you believed the US economic outlook was weaker compared to its European counterparts, you could buy the EUR/USD. By doing this you buy the EUR (euro) in anticipation of it appreciating against the USD. Any move by the EUR versus USD is measured in pips. If the buy price is 1.4000 and the EUR appreciates as expected to 1.4040, then that is a profitable move of 40 pips for the trader. Alternatively if the price of the EUR/USD fell to 1.3960 then the trader has suffered a loss of 40 pips.
[Note that when you choose to trade in a third party currency pair you must still get it and out of Aussie dollars, meaning you are crossing two spreads – Ed.]
Unlike the Australian Stock Exchange which has a physical presence in Sydney, the forex market has no fixed location and is a 24 hour market. At anytime, five and a half days (Monday - Early Saturday Morning) a week, you can participate. The foreign exchange market is an OTC (over-the-counter) market, in which brokers/dealers negotiate directly with one another and not through a central exchange.
The forex market literally follows the sun around the planet. Given the International Date Line is in the Pacific, New Zealand and Australia start the trading day followed by Asia, the Middle East, Europe and the US. Then a new day begins and the cycle starts again. London is the largest forex market (approx 34% of all forex turnover comes out of London) as its straddles the Asian afternoon session and the morning trading session of the US.
With the foreign exchange market being open 24 hours it also means people can trade at any time during the day. Unlike traditional stock markets which have definitive opening and closing times, the forex market allows Australian traders to participate at all hours of the day. Major economic news and events (unemployment levels, interest rate announcements, government intervention, retail sales, speeches by various heads of Central Banks etc) can be all “drivers” of price movement and many traders closely watch these announcements. Many people use sites such as www.forexfactory.com to track these events.
The foreign exchange market is dominated by several major currencies representing the major economies of the world. They are the USD (United States dollar), EUR (European Union euro), JPY (Japanese yen) and the GBP (Great British pound). The most actively traded currency pair is the EUR/USD. It accounts for approx 25% of daily global turnover. The USD/JPY is the second most traded pair in the world with 13%, followed by the GBP/USD with approximately 12% of turnover. The USD is the most heavily traded and most widely held currency on the planet.
Following the major three pairs listed above, the next most actively traded pairs are: AUD/USD, USD/CHF (Swiss franc), USD/CAD (Canadian dollar), EUR/JPY, EUR/GBP and EUR/CHF.
According to a 2007 Bank of International Settlements survey, the US dollar is involved in over 80% of all foreign exchange transactions. Average daily turnover in foreign exchange markets rose to US$3.2 trillion in April 2007. That’s the equivalent of more than US$450 in foreign exchange market transactions every day for every man, woman and child on the planet! In comparison, the New York Stock Exchange has a daily turnover between US$30-$60 billion a day in recent times. Thus you can see how enormous the foreign exchange market really is.
Closer to home, the Australian stock market on any one trading day will turnover anywhere between A$2-8 billion in value.
Global foreign exchange daily turnover is more than ten times the size of the combined daily turnover on all the world’s equity markets. Foreign exchange trading increased by 38% between April 2006 and April 2007 and has more than doubled since 2002. This is largely due to the growing importance of foreign exchange as an asset class and an increase in fund management investment, particularly from hedge funds and pension funds.
Investors choose to invest on the foreign exchange market for several reasons. First of all it’s the only truly “global market”, is massively liquid, and with the average daily turnover mentioned earlier its not possible for any one group to corner the market. Secondly, as it’s a 24 hour market it allows traders opportunities around the clock to make money.
Now with trading any financial instrument, there are a couple of points which most traders seem to ignore, and they’re trading account subsequently suffers! They are risk/money management and trading psychology. When people buy a stock – say BHP – the thought process in their head is usually “I’m going to buy BHP low and sell it at a higher price”. Most people never think “How will I get out of BHP if the share price starts to go against me?”. When you enter a trade your trading psychology should be, “How much can I lose on this trade?” and then a relative “stop loss” order should be placed (reversing the trade on a given price trigger). We don’t willingly enter a trade knowing we could lose money, but we need at ALL times to have a stop loss order in the market to protect our trading capital if the trade goes against us.
We as humans don’t like to admit we’re wrong, but as we all know the market will do its own thing and trades will go against us from time to time. Most people hold onto losing trades because they don’t want to close the position and realise the loss, and subsequently admit the fact that they got it wrong! Smart traders, especially in the forex market place their stop losses in the market as soon as they enter a trade. They know what their maximum loss is and are prepared to risk a certain amount to make a certain amount. This is known as the risk/reward ratio.
The foreign exchange market can move very quickly either up or down and a stop loss order if used properly will protect one’s account from being wiped out. Remember it’s a 24 hour market so there are always other trading opportunities.
As mentioned earlier, major news announcements/events around the world on any given day have an impact on the value of individual currencies and therefore provide traders with potential opportunities. Of late, the consensus has been that Australia is in a better economic state than some of the other First World nations. The proof of this has been the value of our Australian dollar rising in value against the US dollar from US$0.63 on March 10 to US$0.81 at the time of writing. What this means is that the Australian dollar has strengthened against the US dollar.
If we cast our minds back to before December 1983, the Australian dollar wasn’t “floating” at all. By that I mean its value wasn’t determined by the foreign exchange market, much like a company’s share price is determined by the stock market. At the time, the value of the Australian dollar was regulated by the Australian government. Floating the dollar allowed the “market” to decide what it is worth. Nowadays, the value of the Australian dollar rises and falls with the good and bad economic times, global geopolitical events, monetary policy changes and so on.
So why aren’t more people trading in the largest and most liquid market?
Traditionally, most Australian investors have been more comfortable trading/investing in something they can relate too, such as buying shares in Woolworths, Commonwealth Bank and BHP. There are some 2,000 shares listed on the Australian Stock Exchange, whereas there are only 4-6 major currency pairs to follow. So do you think it’s easier to follow, say, six currency pairs rather than the ASX100? Do you have to time to follow say the Top 20 listed securities or could you follow say four currency pairs?
Recently, retail foreign exchange houses such as IBFX, FXCM, Gain Capital and FX Solutions have all reported increasing transaction volumes, new account openings and record growth year-on-year as more people realise the trading opportunities available in the forex market.
As more retail forex brokers establish operations in Australia, the growth of forex trading looks set to increase much the same as the CFD (contracts for difference) market did some years ago
Combined with its massive liquidity, the ability to trade multiple currency pairs, ease of stop loss order placement and a 24 hour time frame in which to trade, foreign exchange trading is set to be looked at more closely by traders than it has in the past…
Matthew Corbett is shareholder/master distributor at www.YourTradingRoom.com, an online educational/training provider mainly focused on Foreign Exchange trading.
