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Basics
of Currency Trading
Currency exchange is the trading of one currency against another.
It is also called as foreign exchange, but may also use the acronyms
Forex or FX.
Consumers typically come into contact with currency exchange when
they travel. They go to a bank or currency exchange bureau to convert
one currency (typically, their "home currency") into another
(i.e. the currency of the country they intend to travel to) so they
can pay for goods and services in the foreign country. Consumers may
also purchase goods in a foreign country or via the Internet with
their credit card, in which case they will find that the amount they
paid in the foreign currency will have been converted to their home
currency on their credit card statement. Although each such currency
exchange is a relatively small transaction, the aggregate of all such
transactions is significant.
Businesses typically have to convert currencies when they conduct
business outside their home country. For example, if they export goods
to another country and receive payment in the currency of that foreign
country, then the payment must often be converted back to the home
currency. Similarly, if they have to import goods or services, then
businesses will often have to pay in a foreign currency, requiring
them to first convert their home currency into the foreign currency.
Large companies convert huge amounts of currency each year; for example,
a company such as General Electric (GE) converts tens of billions
of dollars each year. The timing of when they convert can have a large
affect on their balance sheet and "bottom line.
Currency traders, Investors and speculators require currency exchange
whenever they trade in any foreign investment, be that equities, bonds,
bank deposits, or real estate. Investors and speculators also trade
currencies directly in order to benefit from movements in the currency
exchange markets
Commercial and Investment Banks trade currencies as a service for
their commercial banking, deposit and lending customers. These institutions
also generally participate in the currency market for hedging and
proprietary trading purposes.
Governments and central banks trade currencies to improve trading
conditions or to intervene in an attempt to adjust economic or financial
imbalances. Although they do not trade for speculative reasons ---
they are a non-profit organization --- they often tend to be profitable,
since they generally trade on a long-term basis.
The currency exchange market determines currency exchange rates. (A
currency exchange rate is always quoted for a currency pair using
ISO code abbreviations. For example, EUR/USD refers to the two currencies
Euro (the European currency) and U.S. Dollar. The first is referred
to as the base currency, while the second as the quote currency. The
EUR/USD exchange rate specifies how many US Dollars you have to pay
to buy one Euro, or conversely how many US Dollars you obtain when
you sell one Euro. More generally, if buying, an exchange rate specifies
how much you have to pay in the quote currency to obtain one unit
of the base currency, and if selling, the exchange rate specifies
how much you get in the quote currency when selling one unit of the
base currency.
The currency exchange market is an inter-bank or inter-dealer market
that was established in 1971 when floating exchange rates began to
materialize. In addition, it is an Over-The-Counter market, meaning
that transactions are conducted between any two counter parties that
agree to trade via the telephone or electronic network. Trading is
thus not centralized, as is the case with many stock markets (i.e.
NYSE, ASE, CME) or as the case for currency futures and currency options,
which trade on special exchanges. Dealers often "advertise"
exchange rates using a distribution network, such as the one provided
by Reuters or Bridge. Dealers then use the information obtained there
(or directly) to "agree" to a rate and a trade.
The major dealing centers today are: London, with about 30% of the
market, New York, with 20%, Tokyo, with 12%, Zurich, Frankfurt, Hong
Kong and Singapore, with about 7% each, followed by Paris and Sydney
with 3% each.
In terms of trading volume, the currency exchange market is the worlds
largest market, with daily trading volumes in excess of $1.5 trillion
US dollars. This is order of magnitude larger than the bond or stock
market. For example, the New York Stock Exchange has a daily trading
volume of approximately $60 billion. Thus, the currency exchange market
is by far the most liquid market in the world today. Because of the
volume in trading, it is impossible for individuals or companies to
affect the exchange rates. In fact, even central banks and governments
find it increasingly difficult to affect the exchange rates of the
most liquid currencies, such as the US dollar, Japanese Yen, Euro,
Swiss Frank, Canadian Dollar or Australian Dollar.
The currency exchange market is a true 24-hour market, 5 days a week.
There are dealers in every major time zone. Trading begins Monday
morning in Sydney (which corresponds to 3pm EST, Sunday) and then
daily moves around the globe through the various trading centers until
closing Friday evening at 4:30pm EST in New York.
Today, over 85% of all currency exchange transactions involve a few
major currencies: the US Dollar (USD), Japanese Yen (JPY), Euro (EUR),
Swiss Frank (CHF), British Pound (GBP), Canadian Dollar (CAD), and
Australian Dollar (AUD). In the currency exchange market, most of
the currencies are traded only against the US Dollar. The term cross
rate refers to an exchange rate between two non-dollar currencies.
Trading between two non-dollar currencies usually occurs by first
trading one against the US Dollar and then trading the US Dollar against
the second non-dollar currency. Because of this, the spread in the
exchange rate between two non-dollar currencies is often higher. (There
are a few non-dollar currencies that are traded directly, such as
GBP/EUR or EUR/CHF.) The following directly traded currency pairs
make up the vast majority of the trading volume and are thus considered
to be the most important ones: EUR/USD, USD/JPY, EUR/JPY, USD/CAD,
EUR/GBP, GBP/USD, USD/CHF, AUD/USD, and AUD/JPY. |
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