Foreign Currency Market
To buy foreign goods or services, or to invest in other countries, individuals, companies, and other organizations will usually need to exchange their domestic currency for the foreign currency of the country with which they are doing business. Some exporters do, however, accept foreign currencies, especially the United States dollar, which is widely used in the import-export business. For instance, Saudi Arabia accepts payments in U.S. dollars (USD) for its oil, so when Canadians buy their oil, they transact the business in the USD that they receive from trading with the United States, even though the United States is not involved in the oil purchase at all.
The foreign exchange rate is simply the price of one currency in terms of another, or how much one currency can be exchanged for another, in the same way that the price of a good is determined by how much money can be exchanged for it.
The foreign exchange market – otherwise known as the FX market — consists of financial institutions, mostly banks, that stand ready to exchange one currency for another. Banks often negotiate exchange rates among themselves, but forex dealers that market their services to the public generally post bid/ask prices on the currency pairs in which they make a market.
Most FX transactions take place in the United Kingdom, United States, and Japan with most of the rest of the market centered in Hong Kong, Singapore, Australia, Switzerland, France, and Germany.
The FX market is, by far, the largest market in the world. Some statistics on the foreign exchange market can be found at Bank for International Settlements: International Financial Statistics.
Foreign Exchange Market Participants
There are several types of market participants that engage in forex transactions to hedge risk, to speculate for profits, or to facilitate business and other transactions.
- Banks and other financial institutions are the largest volume traders, where roughly 2/3 of all FX transactions involve banks trading directly with each other.
- Brokers sometimes act as intermediaries between banks. Brokers with more extensive contacts, can often find better prices for the banks than they could find themselves, and they also offer anonymity to banks seeking to buy or sell large amounts of currency. Brokers profit by charging a commission on the intermediated transactions.
- Business customers require foreign currency to transact foreign business or to make investments. Businesses with large foreign exchange requirements even have their own trading desks.
- Institutional investors, such as pension funds, hedge funds, mutual funds, and insurance companies, engage in forex trading to either hedge risk or to speculate for profits.
- Retail customers need foreign currency to travel abroad or to make online purchases from foreign-based companies. Some retail customers also engage in forex trading, using their own computers or even mobile devices, in the hope of earning profits.
- And, what are called foreign exchange interventions, central banks, which act either on behalf of their own or foreign governments, sometimes participate in the FX market to offset the influence of short-term shocks that can sometimes cause temporary large movements in the exchange rate of some currencies, such as the rapid appreciation of the yen caused by the 2011 earthquake and tsunami in Japan.
Purposes of Foreign Exchange Trading
When currency is exchanged to conduct business, to invest in foreign countries, or to hedge risk, the primary concern of the forex participants is not the short-term movements in exchange rates but to conduct business with a minimal exchange risk. Speculators, on the other hand, hope to profit from short-term movements in the exchange rates by either buying low and selling high or by selling short and buying low, usually over a period of minutes, hours, or sometimes days.
However, it is difficult to make profits by speculating in foreign transactions, since short-term movements are governed by the instantaneous supply and demand of any currency, which cannot be predicted by any trader. Traders attempt to forecast currency movements by using either fundamental analysis or technical analysis.
Fundamental analysis is used to determine long-term trends in currency prices by examining the economic factors that determine currency rates, such as the relative inflation, interest rates, and the economic strength of the countries being compared. However, fundamental analysis cannot predict short-term prices because it takes time to gather the information – information that is often revised several times over a period of months – and even if the changes in the fundamentals could be known in real-time, it would not help to predict the instantaneous supply and demand that determines short-term price movements.
Instead, most traders have turned to technical analysis, which is the examination of prices and volumes of recent forex transactions in the hope that they can be used to predict future movements. The Efficient Market Hypothesis states that future prices cannot be predicted from past prices, that all market information has already been incorporated into current prices, and, indeed, considering that most forex transactions are independent of each other, there is little reason to believe that future currency movements can be predicted from past forex transactions, even real-time transactions; nonetheless, hope for profits springs eternal. Although technical charts do exhibit patterns, the pattern details and the timing change frequently, making it difficult to profit from small movements in currency prices, even with the 100 to 1 leverage ratio or more that many forex companies offer to retail customers. What technical traders hope for, at best, is that their predictions will have an increased probability of being correct and that they will profit more often than not. Indeed, some technical traders do make a profit over a long time, but are those profits the result of skill? Or are they the proverbial monkeys that pick companies by throwing darts on a list, where if there are enough monkeys throwing darts, some will be successful by sheer chance, by being at the high-end of the statistical distribution. Another thing to consider is whether the profits from technical trading is worth the time invested.
Currency Trading Between Banks
Banks, who are the largest forex participants by volume, either trade with each other directly or use the services of a broker. Direct transactions account for 2/3 of forex trades between banks, while brokers mediate the remaining 1/3, charging a commission on the transaction. A bank that wishes to buy or sell currency directly will offer bid/ask prices – bid prices are the prices that the bank is willing to pay for a currency and ask prices are the prices that the bank is willing to sell. The dealing bank profits by the spread between the bid and the ask price.
The size of the spread depends on how frequently the currencies are traded. Hard currencies, such as the US dollar, Euro, Japanese yen, and British pound, constitute about 80% of the FX market, and thus, the spread between these currency pairs is usually quite narrow, often less than 4 pips. (1 pip = 1/10,000th of a currency unit for most currencies.) Soft currencies, such as those of less developed economies, are traded less frequently, resulting in larger spreads.
Types of FX Transactions
There are several types of FX transactions: spot transactions, forward transactions, swaps, futures, and options. Other than spot transactions, the remaining types of FX transactions span over time. These types of transactions can help to prevent or hedge FX risks that may result from changes in the exchange rate.
Spot transactions are an immediate trade in what is called the spot market, where one party agrees to exchange 1 currency for another at an agreed-upon rate.
Spot transactions are a major type of FX transaction, consisting of more than 1/3 of all FX transactions. Settlement of spot trades usually occurs in 2 business days, especially for currencies of countries located in different hemispheres. However, some currencies, such as the Canadian-United States dollar, settle in 1 business day.
In a trade not involving dealers, one party typically calls another and asks for both the bid and ask prices for a particular currency. Even though the party only wants to buy or sell, he will still ask for both prices, so that the other trader is not alerted yet to his actual intentions, since that would allow her to skew her prices in her favor. A dealer, of course, would post both bid and ask prices.
For a business or other organization that must often sign long-term contracts for a stipulated price, using spot prices of currency incurs exchange-rate risk.
Exchange Risks in Spot Transactions
Suppose a U.S. company orders machine tools from a company in Japan, which will take 6 months and cost 120 million yen. When the order is placed, the yen is trading at 120 to a dollar. The U.S. company budgets $1 million in Japanese yen to be paid when it receives the tools (120,000,000 yen with 120 yen per dollar = $1,000,000) .
However, the yen-dollar exchange rate will almost certainly be different 6 months later. Although the U.S. company could pay when the order is placed, it would lose the opportunity cost of the money during the 6-month period, when it could earn interest, for instance.
If, after the 6 months, the exchange rate is 100 yen per dollar, then the cost in U.S. dollars would increase by $200,000 (120,000,000 / 100 = $1,200,000), which would be a profit to the Japanese company but a loss for the American company.
But if the rate is 140 yen to a dollar, then the cost in U.S. dollars would decrease by over $142,000 (120,000,000 / 140 = $857,142.86), which would be a profit to the American company and a loss to the Japanese company.
Most companies eliminate this foreign exchange risk by using forward contracts.
FX risks can be prevented by forward transactions. The parties agree to a forward contract where negotiated prices are calculated using a forward exchange rate that depends on the current exchange rate, the difference in interest rates between the 2 countries, and on the settlement date, which is when payment will be made. The settlement date, like all the other contract terms of the forward contract, are negotiable, but the term of the forward contract is usually less than one year.
Forward contracts do, however, have counterparty risk, which is the risk that a party will be unable or unwilling to fulfill the contract on the settlement date. There is also business risk to a forward transaction, in that, if the needs of the parties change, the contract cannot be amended or canceled unless both parties agree. Counterparty and business risks increase with the term of the contract.
Many forward contracts are used in the import/export business, where one party is selling a good or service and the other party is paying for it. A currency swap (aka foreign exchange swap) is a simplified forward contract where the parties exchange currency when they agree to the contract and reverse the exchange when the contract terminates. Currency swaps are the most common type of forward transaction. Credit risk is limited to the difference in value of the 2 currencies on the settlement date.
Because the interest rates of the 2 countries will probably differ, an adjustment is made for the different opportunity costs of each currency, which is like the adjustment made in forward contracts.
Example: Currency Swap Transaction
An American company wants to invest €1 million in Germany for one year. It finds a European company in the over-the-counter market that is willing to exchange €1 million for $1.5 million, so the companies exchange the currencies when the agreement is signed. After one year, the American company gets its $1.5 million back and the European company gets its €1 million plus an additional adjustment for the higher interest rate in Europe.
Foreign Currency Futures
A foreign currency future (aka forex future) is a forward contract with standardized terms, including quantities and settlement dates, that is traded on organized exchanges. The exchange acts as an intermediary between the buyer and seller and takes on the credit risk of both parties. Hence, credit risk is minimized because the exchange is usually much more creditworthy than the traders and has a greater reputation. Because futures are standardized contracts, there is greater price transparency and liquidity than with forward contracts and, thus, they can be canceled or offset by purchasing or selling an offsetting contract. Indeed, most future contracts are terminated before the settlement date, because speculators have no interest in the actual delivery of currency but are only interested in the profits that they hope to make when they close out their position.
Although standardization gives futures contracts most of their advantages over forward contracts, they may not serve the needs of some parties, especially businesses with specialized needs.
Forwards and futures require performance at a settlement date. An option gives the owner the right, but not the obligation, to buy or sell a specified amount of foreign currency at a specified price, called the strike price, at any time up to a specified expiration date. A call option allows the holder to buy currency at the strike price. A put option allows the holder to sell currency at the strike price.
Options differ from currency futures because they do not have to be closed out — the option holder can just let the option expire if it is not profitable. In contrast, at the expiration of a futures contract, the futures buyer would have to accept delivery of the currency, and the futures seller would have to actually deliver the currency, unless it is a cash-settled contract, in which case the seller would have to pay to the buyer the equivalent value in a specified currency.