Chapter 1-1 Introduction to Forex

Many investors look to expose themselves to fluctuations in the values of currencies around the world.  This is known as Foreign Exchange, or Forex investing.  The primary objective of Forex investors is to derive a profit from the appreciation or depreciation of one currency in comparison to another from various nations around the world.  The Forex market is the largest and most heavily traded financial market in the world.  As a result, Forex investors enjoy the most liquid market around allowing them to invest much larger amounts in individual positions.  Foreign Exchange, or FX rates, can either be fixed or floating.  Fixed exchange rates are determined by governments who decide to peg the value of their country’s currency to another.  Floating rates, which are the focus of Forex investors, are determined through supply and demand in the open market.  Investor demand for specific currencies increases as economic conditions around the world improve relative to one another, thus creating fluctuations in currency valuations.

Unlike equity markets that take place on exchanges, the Forex market has no central trading location.  Trading occurs in an over-the-counter fashion at various financial centers around the world 24 hours a day, except weekends.  Every day over a trillion dollars changes hands as nations, banks, companies and corporations, and investors positions themselves for anticipated changes in value of a nation’s currency.  Although no central location exists, there are a few major centers for Forex trading.  The largest of these is London, accounting for just over a third of all Forex action.  New York, Tokyo, Zurich, Hong Kong, and Singapore are the other main exchange locations.  The US dollar is the most heavily traded currency in the world, accounting for nearly 85% of daily volume.  The Euro, Japanese yen, and pound sterling (United Kingdom) are the other most commonly traded currencies.

There are several factors that cause currency rates to change in value, generally economic and political.  The following are the most commonly considered economic factors.  Economic policy – a government’s fiscal and monetary policy (budgeting and money supply, respectively) is often the first factor an investor will consider when deciding to invest in an individual currency.  Investors seeking a long term investment tend to favor currencies backed by sound economic policies.  Budget and trade deficits and surpluses – investors favor currencies of nations with budget surpluses and a positive balance of trade.  Inflation rates – high or rising inflation hurts the purchasing power of a currency making it less desirable when compared to others with low inflation.  Economic health and productivity – GDP, GNP, housing and retail market strength, and the employment rate all influence the demand for a currency and therefore its value on the world stage.

Political factors influence currency markets in a slightly different way than economic factors.  Unlike economic factors which are often quantifiable, political factors are generally difficult, if not impossible to quantify.  Due to this fact, political conditions often provide unexpected volatility in a currency’s value.  The election of a new leader, a change in the nation’s political structure, a coup or other hostile regime change, and military actions in a nations region are all examples of political factors that will influence a currency’s value.

There are many different types of investors participating in Forex markets at any given moment in time.  Banks represent the majority of volume in the Forex market.  Commercial banks trade on behalf of their customer and for their own account, generally speculating in an effort to profit on price changes.  Central banks, or national banks, use the Forex market to control money supply, inflation, and interest rates.  A central bank is able to influence the exchange rate by buying and selling its own currency on the open market.  Commercial companies and corporations use the Forex market to pay for goods and services purchased abroad.  Finally, investment companies use the Forex markets to facilitate transactions on behalf of their clients and to speculate within their own accounts.

There are several financial instruments that allow investors to expose themselves to changes in currency values.  A spot exchange is a next day (US Dollar, Canadian Dollar, Turkish Lira, and Russian Ruble) or two day (all other currencies) cash transaction directly between two currencies.  Much like going to the money exchange at a foreign airport, spot exchanges involve converting funds denominated in one currency into another. A forward contract is a negotiated agreement between two parties to complete a transaction at a specific rate on a specific date in the future.  A common forward transaction is the swap in which two parties exchange currencies for a predetermined amount of time with the intention to reverse the transaction upon completion.  Futures are exchange traded standardized forward contracts that trade on exchanges dedicated to this purpose.  Options are derivative assets giving the option-holder the right to buy or sell a currency at a predetermined rate on a predetermined time.  FX options are the most heavily traded of all options.