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Different countries have different currencies. As the world becomes more inter-connected, so does the need to trade different currencies. The Foreign Exchange (FX) market helps the trade between various currencies.

There are various reasons why people wish to have different currencies:

(i) Commerce/Investment (eg. a company wishes to import goods and needs to pay in a different currency or an individual wishes to buy a house in a different country)
(ii) Speculation (No underlying reason to buy currency except to speculate and profit)

The rest of this article refers to trading Fx as for the purposes of Speculation.

The Market

The market includes trading between banks, corporations, central banks, currency speculators and other institutions. At the core is the inter-bank market which is trading between a few large banks. These banks in turn quote rates to corporations and retail brokers. At the end of this chain is the retail investor/speculator.

The market is extremely high volume and therefore has very narrow margins (margin being the difference between the selling price and the purchase price). Also, there is no one central institution which manages all trading in Fx therefore the market is 24x7 during weekdays.

Practical Considerations

The simplest way to get into trading Fx is to open a trading account with a retail broker/bank. Once an account is opened, the bank/institution will typically require an upfront deposit. This is to ensure that the investor does not renege on any of the trades.

Different institutions have different requirements for margin money depending on how risky the trades are.

Trading

Once the margin money is in the trading account, trades can be executed typically online or over the phone.

There are various instruments’ to trade in the Fx market. The most liquid instrument is the spot trade. In a spot trade, you simply buy/sell a currency to typically settle two days later with the counterparty.

Another instrument would be a forward where the trade is done today due the settlement only happens in the future (3months, 6months etc.). Similarly, an Option would be an instrument where a trade is done today but the buyer can have an option but not an obligation to purchase/sell at a future date. There are several derivative financial structures which can be built using one of these instruments.

Pricing/Speculation

A currency value increases/decreases for various reasons:

Economic Factors: Generally, the more healthy the country’s economy, the better its currency will perform. GDP reports, employment levels all point to a country’s economic health. High government budget deficits and trade deficits are viewed negatively as is high inflation. However, a currency may sometimes strengthen because of expectations that the central bank may raise short-term interest rates to combat rising inflation.

Uncertainty: Markets hate uncertainty and any political or other events which contribute to an uncertain environment get punished by the markets. Sometimes another currency gains in the process as speculators look for a safe haven.

Market sentiment also plays a major factor in determining Fx rates.

In Closing

Trading is stressful as is exhilarating - the trader pitted against the rest of the world with millions of other traders and engaged in a psychological game. It’s a dog-eat-dog world out there. The market can be unforgiving as well as rewarding. So, it is important to fully understand the risks involved before setting off. Do not invest/trade money you cannot afford to lose! Have a great ride!