INTRODUCTION TO THE FOREIGN EXCHANGE MARKETS
Although the foreign exchange market is the largest traded market in the world, its reach in the retail sector pales in comparison to the equity and fixed Income markets. This is in large part due to a general lack of awareness of FX in the investor community, along with a lack of understanding of how and why currencies move. Adding to the mystique of this market is the fact that there is no physical central exchange akin to the NYSE or the ASX. The FX markets operate on a 24-hour basis, beginning the trading day in New Zealand and continuing through the time zones.
Traditionally, access to the FX market was limited to the bank community, which traded large blocks of currencies for commercial, hedging or speculative purposes. The creation of firms like USG has opened the door of forex trading to such institutions as fund and money managers, as well as to the individual retail trader. This sector of the market has grown exponentially over the past several years.
WHAT IS FX TRADING?
In an FX transaction, one currency is sold in exchange for another one. The rate expresses the relative value between the two currencies. Currencies are normally identified by a three-digit ‘Swift’ code. For instance, EUR = the Euro, USD = the US Dollar, CHF = the Swiss Franc and so on. A full list of codes can be found here. A EUR/USD rate of 1.5000 means that EUR 1 is worth USD 1.5.
Sometimes, EUR/USD is referred to as a currency pair. The rate can be inverted. So a EUR/USD rate of 1.5000 is the same as a USD/EUR rate of 0.6666. In other words, USD 1 is worth EUR 0.6666. The market convention is that most currencies tend to be quoted against the dollar, but there are notable exceptions, such as with the EUR/USD already mentioned, GBP/USD (UK Pound Sterling) and AUD/USD (the Australian Dollar). This is not as confusing as it may sound.
FOREIGN CURRENCY SYMBOLS
Currencies, like equities, have their own symbols that distinguish one from another. Since currencies are quoted in terms of the value of one against the value of another, a currency pair includes the 'name' for both currencies, separated by a forward slash ('/'). The 'name' is a three-letter acronym. The first two letters are, in most cases, reserved for identification of the country. The last letter is the first letter of the unit of currency for that country.
USD = United States Dollar
GBP = Great Britain Pound
JPY = Japanese Yen
CAD = Canadian Dollar
CHF = Confederatio Helvetica (Latin for Swiss Confederation) Franc
NZD = New Zealand Dollar
AUD = Australian Dollar
NOK = Norwegian Krona
SEK = Swedish Krona
Since the European Euro has no specific country attached to it, it goes simply by the acronym EUR. By combining one currency (EUR) with another (USD), you create a currency pair - EUR/USD.
BASE AND COUNTER-CURRENCIES
One currency in a currency pair is always dominant. This is called the base currency. The base currency is identified as the first currency in a currency pair. It is also the currency that remains constant when determining a currency pair's price.
The Euro is the dominant base currency against all other global currencies. As a result, currency pairs against the EUR will be identified as EUR/USD, EUR/GBP, EUR/CHF, EUR/JPY, EUR/CAD, etc. All have the EUR acronym as the first in the sequence.
The British Pound is next in the hierarchy of currency name domination. The major currency pairs versus the GBP would therefore be identified as GBP/USD, GBP/CHF, GBP/JPY, GBP/CAD and so on. Apart from EUR/GBP, expect to see GBP as the first currency in a currency pair.
The USD is the next most dominant base currency. USD/CAD, USD/JPY, USD/CHF would be the normal currency pair convention for the major currencies. Since the EUR and the GBP are more dominant in terms of base currencies, the dollar is quoted as EUR/USD and GBP/USD. Knowing the base currency is important, as it determines the values of currencies (notional or real) exchanged when a Foreign Exchange deal is transacted. The counter-currency is the second currency in a currency pair notation.
FX MARKET PARTICIPANTS
There are many different types of participant in the FX market, and they are frequently looking for very different outcomes when they trade. This is why although FX is often described as a ‘zero-sum’ game – what one investor makes is equal, in theory, to what another has lost – there are numerous opportunities to make money. FX can be thought of as a pie from which everyone can have a decent meal.
Traditionally, banks have been the main participants in the FX market. They still remain the largest players in terms of market share, but transparency has made the FX market far more democratic. Now, virtually everyone has access to the same, extremely narrow prices that are quoted in the inter-bank market. So, banks remain the main players in the FX market, but a new breed of market maker, such as hedge fund and commodity trading advisors, has emerged over the past decade.
Central Banks can also play an important role in the FX market, while international corporations have a natural interest in trading because of their exposure to FX risk.
Retail FX has expanded rapidly over the past decade and while precise figures are hard to come by, this sector is believed to represent as much as 20% of the FX market.