An Introduction to Foreign Exchange
Typically abbreviated as FX or forex foreign exchange is the process of converting or trading different world currencies. Foreign exchange activities usually occur in ‘foreign exchange markets’ and involve ‘foreign exchange rates.’
What are foreign exchange rates?
In the simplest sense, foreign exchange rates are financial mechanisms by which world currencies are tied together and traded in the global marketplace.
In practice, an FX rate is a cost to trade one country’s currency for another country’s currency by comparing the price and value of the currency in relation to another currency.
For instance, if you travel to France on vacation, you will probably have to pay for your hotel, meals, souvenirs, and other expenses in Euros. If your money is all in US dollars, you’ll have to utilize (sell) some of your US dollars to buy Euros at a specific rate. That rate is typically a ‘foreign exchange rate.’
What is the Foreign Exchange Market?
The Foreign exchange market is an extensive financial market that works 24 hours a day for 5 days a week where Forex is traded via electronic trading networks.
As the largest liquid financial market worldwide in terms of turnover, the foreign exchange markets can yield a turnover of approximately $6.6 trillion a day, with trading of major currencies occupying about 85% of all daily transactions. The Foreign Exchange Market is estimated to maintain over 4,600 International Banks and millions of small and large speculators who participate globally.
Before, small speculators could not enter into the forex market due to stringent financial requirements and large minimum transaction sizes.
As such, the leading players in this domain were banks, large speculators, big currency dealers who took advantage of currency exchange rates and the forex market‘s unmatched liquidity.
However, with the advancement of modern technology, small traders now have access to the benefits of Forex trading via various online trading systems as they can digitally purchase or sell any number of smaller units because Forex brokers can now break down the larger sized interbank units and offer them to individuals.
On the other hand, the Forex market is known as a highly unregulated market. Although central banking laws regulate the activities of key dealers like commercial banks, no specific standards and laws exist to govern retail Forex brokerages during their daily activities in most territories.
The Forex market is highly decentralised. Most FX trading is OTC (over-the-counter) trading, where there are no central exchanges and trades take place between counterparties. Central banking laws regulate the activities of key dealers like commercial banks.
However, there are no global standardised regulations to govern Forex brokerages given that different countries have different regulatory standards.
A brief history of foreign exchange markets
Foreign exchange traces all the way back to ancient times when traders from different countries exchanged coins. Considered the newest entrant to the financial market’s sphere, prior to 1998, the Forex markets were controlled by larger entities trading currencies for commercial and investment purposes through banks.
With the advent of the internet giving rise to online Forex trading platforms, smaller financial institutions and retail investors now have access to the FX market, and the same level of liquidity enjoyed by major foreign exchange banks.
Advantages of the foreign exchange market
- With an average daily turnover of approximately $ 1.7 trillion, the Forex market is the largest financial market in the world. – the above states 6 trillion, which is a more accurate representation
- In contrast to other equity markets, forex markets offer a high leverage ratio, which, in turn, may lead to higher profits.
- A forex trader can use leverage to maximize their returns. With a small amount of capital, a Forex trader can use leverage to control a higher amount of currency (ie. margin trading). In practice, the margin requirements for Forex are approximately 1% in comparison to those for trading futures which are around 5% of the entire value of the holding, or 50% of the total value of the stocks. This means that a smart Forex trader can play with 50 times more money than the average Stock trader.
- Forex trading is typically commission-free. However, the spread is higher than it is when one is trading futures.
- The forex market is a 24-hour market in contrast to the futures market, which is limited to a few hours every day.
How does the foreign exchange market operate?
As mentioned above, in the forex market, currencies are compared against each other via an ‘exchange rate.’ and traded in pairs like Euro/Dollar, Euro/Pound, or Dollar/Yen.
The main currencies traded in the Forex market are the British pound (GBP), Euro (EUR), United States dollar (USD), Japanese yen (JPY), and the Swiss franc (CHF). These form the most commonly traded currency pairs: EUR/USD, GBP/USD, USD/JPY, USD/CHF.
For more context, the first currency of a currency pair is called the ‘base currency’, while the second currency in a currency pair is called the ‘quote currency‘. You can think of currency pairs as a single unit where the base currency is being purchased, while the quote currency is being sold.
Unlike other financial markets, the decentralization of the Forex market permits traders to choose from an extensive number of different dealers or brokers with whom to place trades.
Furthermore, it additionally provides a base to compare prices and spreads before buying or selling. Forex traders typically use online tools to monitor the markets and perform accurate analyses to determine whether to purchase or sell a given currency pair.
For example, if news that the value of the Euro is up from previous reports generates positive sentiment, resulting in an uptick in the value of the Euro,this might cause a rally in the EUR/USD currency pair. On the other hand, if a positive announcement for USD is reported, then the EUR/USD currency pair will descend or dip.
Either scenario can deliver a profit to a trader, depending on which part of the currency pair they buy or sell.
However, as we shall later detail, the underlying value of each currency within the pair is determined by factors like changes in political leadership, economic booms or busts, or natural disasters.
What is Forex Trading?
By the most basic definition, forex trading is the act of purchasing and selling disparate currencies of the world.
What is Forex-Algo Trading?
This is a vertical of forex trading that entails employing computer algorithms to perform multiple functions to achieve the objectives of a forex trader.
With forex-Algo trading, forex traders systematically utilize different quantitative algorithms to trade several assets like Forex, commodities, and indices.
They monitor and exploit market signals like price volatility and changes in trade volume to detect market trends early and profit from them.
All these activities are powered by online forex trading systems, which are tools employed by traders to automate certain aspects of trading.
The principle of trading foreign exchange
A fundamental principle to keep in mind during Forex trading is the ‘spread’ of the cash. This compares the rate to purchase and the rate to sell the ‘cash’, represented in ‘pips‘, the smallest unit of cost of a currency: 0.0001 of a money unit. The wider the ‘spread’, which is the difference between the bid and the ask, the more the trade will cost in order to affect the transaction and thereby reducing potential profits.
For a more in-depth analysis of forex strategies, check this link out.
Common myths about Forex Trading
1. Forex trading can make you rich quickly.
Many people believe forex trading is a get-rich-quick scheme. However, it’s more of a journey. There are no ridiculously huge gains or lottery-like winnings as advanced strategies like margin trading, options, and futures require a great deal of analysis and patience.
2. The forex market is rigged.
Some new traders might lament that the ‘market is against them.’ The fact is that everyone takes a loss once in a while in the forex market; it’s part of the process.
Barring unethical brokerage platforms that might make up their own prices, due to the size of the market, it is difficult if not impossible to manipulate prices for the whole currency pair.
3. Forex markets move in a scientifically predictable way.
Anyone who sends you ‘fool-proof’ scientific formulas capable of making 100% accurate forex predictions is a snake oil salesman. Forex markets cannot be scientifically predicted though certain patterns may repeat themselves for a limited duration.
4. The experts always win.
Another myth is that experts always know best and always have the best outcome. The fact is that even new traders, with sufficient interest and passion in the currency markets, can discover new profitable trading strategies as well.
Key factors that affect foreign exchange markets
As earlier mentioned, forex markets can be affected by multiple factors. Forex rates are a result of all supply and demand forces influenced by various elements, which can be put into three categories:
1. Economic Factors
Here Forex markets are affected by economic conditions (government budget deficits or surpluses, inflation levels, balance of trade levels, and trends) and economic policies (for example, fiscal policy and monetary policy) of a territory.
For example, Zimbabwe is famously known for its experience of hyperinflation, which began in February 2007. The country was later prompted to dissolve its currency and initiate plans to completely switch to the USD by the end of 2015.
Fortunately, by 2019, the country was able to introduce the Zimbabwe RTGS Dollar.
2. Political Conditions
This is usually seen during civil wars, terrorist attacks, and elections when geopolitical tensions are heightened. In such instances of political instability, the value of a currency tends to drop.
For instance, terrorist attacks induce a higher level of uncertainty and affect Forex rates negatively, as seen during the 9/11 attacks at the World Trade Center.
3. Market Psychology
In terms of day trading, market psychology is important as Forex speculators tend to react to a specific economic event or announcement, sometimes prematurely.
Risks with Forex Trading
- Forex markets have significant uncertainty as no one can accurately predict which way exchange rates will move.
- You can lose your entire investment if your forex broker declares bankruptcy and the funds are not properly segregated.
- There is limited regulation and no centralized marketplace, unlike regulated futures exchanges.
- The forex brokers determine the execution price, so one relies on the dealer’s integrity and reputation for a fair price.
- You could become a victim of fraud, especially with Forex schemes that promise significant or guaranteed returns with little to no risk.
In summary, the forex market is the most liquid financial market globally. However, like most financial vehicles, Forex trading carries risks and may not be suitable for all investors.
As always, it is imperative to comprehensively understand the risks associated with the Forex market as it is a highly technical market.
For more information, reach out to us at Salzworth
Associate Director, FX Algorithmic Trading
Zhi Xin has spent the last 10 years across various roles in the banking and financial services sector. Prior to joining Salzworth, she was in the Vistra Alternative Investments team leading their SEA regional business development efforts, working closely with fund managers from private equity, venture capital and hedge funds to launch new fund structures and provide fund administration solutions.
Zhi Xin is part of the Salzworth FX team and is focused on sales and business development efforts for the Salzworth Global Currency Fund.