Foreign Exchange (ForEx)

Introduction

Exchange rates are the measure of the relative value between two currencies. Simply put, the exchange rate is the price of one unit of a country's currency expressed in another country's currency.

Currencies are usually expressed in terms of the US dollar. Sterling is the exception and it is usual to talk of dollars to the pound (sterling). Currencies may also be expressed against each other in cross rates, or against a basket of currencies represented by a trade-weighted index. For example, on 6th May 2005 at 16.39 the exchange rate between the USD and the euro was 0.77 (source www.uk.yahoo.finance.com). Therefore, at that time one dollar was worth 0.77 euro.

However, most exchange rates are continually changing due to market forces. Also, each currency has a separate exchange rate for every other currency. Currency is traded on the currency market, which is known as the ForEx, derived from the words foreign exchange. This is effectively a wholesale trading market, used primarily by governments, banks and business.

Contents: Foreign Exchange Guide

  1. Introduction
  2. ForEx Market
  3. Currency Trading
  4. Currency Brokers
  5. Currency Exchange Charges
  6. Reading the Rate

Introduction

Exchange rates are the measure of the relative value between two currencies. Simply put, the exchange rate is the price of one unit of a country's currency expressed in another country's currency.

Currencies are usually expressed in terms of the US dollar. Sterling is the exception and it is usual to talk of dollars to the pound (sterling). Currencies may also be expressed against each other in cross rates, or against a basket of currencies represented by a trade-weighted index. For example, on 6th May 2005 at 16.39 the exchange rate between the USD and the euro was 0.77 (source www.uk.yahoo.finance.com). Therefore, at that time one dollar was worth 0.77 euro.

However, most exchange rates are continually changing due to market forces. Also, each currency has a separate exchange rate for every other currency. Currency is traded on the currency market, which is known as the ForEx, derived from the words foreign exchange. This is effectively a wholesale trading market, used primarily by governments, banks and business.

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Exchange rates are the measure of the relative value between two currencies. Simply put, the exchange rate is the price of one unit of a country's currency expressed in another country's currency.

Currencies are usually expressed in terms of the US dollar. Sterling is the exception and it is usual to talk of dollars to the pound (sterling). Currencies may also be expressed against each other in cross rates, or against a basket of currencies represented by a trade-weighted index. For example, on 6th May 2005 at 16.39 the exchange rate between the USD and the euro was 0.77 (source www.uk.yahoo.finance.com). Therefore, at that time one dollar was worth 0.77 euro.

However, most exchange rates are continually changing due to market forces. Also, each currency has a separate exchange rate for every other currency. Currency is traded on the currency market, which is known as the ForEx, derived from the words foreign exchange. This is effectively a wholesale trading market, used primarily by governments, banks and business.

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ForEx Market

Most exchange rates are continually changing due to market forces. Also, each currency has a separate exchange rate for every other currency. This gives rise to the currency market, which is known as the ForEx, derived from the words foreign exchange.

The ForEx is a wholesale currency trading market, and is driven by govenments and central banks and speculative flows, as well as trade from companies and tourist requirements.

The market operates 24 hours a day, across the global time zones. The market has no physical location, but tends to be conducted from the leading financial market centres. London accounts for 33% of the global forEx market (when measured by trading volume), which is the biggest centre. A significant factor that has favoured Londons ForEx growth is its convienent time zone in relation 'in the middle' of the other developed countries time-zones.

New York is the next biggest, followed by Tokyo. Smaller trading centers include Frankfurt, Zurich, Paris, Hong Kong, Singapore and Toronto.

Currency Trading

Foreign Exchange dealers are the large commercial banks. They buy and sell currency on behalf of their clients, and they also make speculative transactions themselves - such speculative transactions may account for up to 33% of the profits of commercial banks.

The dealers agree to buy or sell currency with their counterparts worldwide, and initiate the deal by making a bid/ask offer. The 'bid' or 'buy' price is slightly lower than the exchange rate, and the 'ask' or 'sell' price is slightly higher than the exchange rate.

The difference in value covers the cost of transaction. In other words it pays the traders and covers profits and overheads. The differene in the exchange rate and its 'buy' and 'sell' rated is very small, which is a reflection of the low transaction costs in this market.

At this international dealing level, the bid/ask offer is only valid for a few seconds, and the dealers make their decisons (ie to accept or reject the bid/ask offer) immediately. Such deals may be for either Spot deals or Forward deals.

Spot deals are for currencies that are for immediate delivery, with full settlement within 2 working days. Forward deals are or currencies due to be delivered within a fixed period, normally more than one day and less than a year. In the vast majority of cases, the delivery periods are in the region of days.

Currency Brokers

Generally, ordinary retail consumers wishing to trade small amounts of currency do not interact directly with the ForEx. Instead they trade via brokers, agencies, banks or bureau de changes, normally located on the high street or online.

In a similar way to wholesale trading, the borker will offer a bid/ask price, which the customer may accept or reject.

This retail bid/ask price may not be the same as the market bid/ask, as the broker will seek to make a profit from adjusting it in his favour. Alternatively, the broker may offer the market bid/ask price to his retail customers, and charge a commission instead - either a flat rate or % rate. Indeed, in many cases, the broker will do both - ie adjust the bid/ask offer in his favour and charge a commission.

For this reason, it is important that the customer shops around for the best deal. The easiest way to compare offers from a range of brokers is to simply divide the number of units of foreign currency beien sought by the overall cost. See the example.

Broker A seems to offer the best rate, 1.78 as opposed to broker B's 1.77. They both charge a £5 flat fee as well as a % based commission. As broker B's % commission is only 1% we can see that the customer can save 90p for the $100 purchased by purchasing from broker B. The savings increase as the amount of currency purchased increases, because the £5 charge is one-off.

Currency Exchange Charges

Rather than carry out these calculations, customers simply need to call a few brokers, tell them how much currency they require, and ask for the overall cost. Providing they request the same amount from each broker, they can simply compare the cost, and select the broker accordingly.

Although brokers prices vary from the market prices, they will follow the same trajectory. However, most brokers will only vary their prices a couple of times per day. They can afford to do this on normal (non volatile) trading days, because they have comfortably covered their risks by the slewed bid/ask and commission.

Reading the Rate

Reading a foreign exchange quote may seem a bit confusing at first. However, it's really quite simple if you remember two things: 1) The first currency listed first is the base currency and 2) the value of the base currency is always 1.

The US dollar is the centerpiece of the Forex market and is normally considered the 'base' currency for quotes. In the "Majors", this includes USD/JPY, USD/CHF and USD/CAD. For these currencies and many others, quotes are expressed as a unit of $1 USD per the second currency quoted in the pair. For example, a quote of USD/JPY 110.01 means that one U.S. dollar is equal to 110.01 Japanese yen.

When the U.S. dollar is the base unit and a currency quote goes up, it means the dollar has appreciated in value and the other currency has weakened. If the USD/JPY quote we previously mentioned increases to 113.01, the dollar is stronger because it will now buy more yen than before.

The three exceptions to this rule are the British pound (GBP), the Australian dollar (AUD) and the Euro (EUR). In these cases, you might see a quote such as GBP/USD 1.7366, meaning that one British pound equals 1.7366 U.S. dollars.

In these three currency pairs, where the U.S. dollar is not the base rate, a rising quote means a weakening dollar, as it now takes more U.S. dollars to equal one pound, euro or Australian dollar.

In other words, if a currency quote goes higher, that increases the value of the base currency. A lower quote means the base currency is weakening.

Currency pairs that do not involve the U.S. dollar are called cross currencies, but the premise is the same. For example, a quote of EUR/JPY 127.95 signifies that one Euro is equal to 127.95 Japanese yen.

When trading forex you will often see a two-sided quote, consisting of a 'bid' and 'offer'. The 'bid' is the price at which you can sell the base currency (at the same time buying the counter currency). The 'ask' is the price at which you can buy the base currency (at the same time selling the counter currency).