The purpose of this guide is to introduce the forex market to you. As
with many markets there are many derivatives of the central market
such as futures, options and forwards. In this book we will only be
discussing the main market, sometimes referred to as the Spot or
Cash market.
The word FOREX is derived from the term Foreign Exchange and is
the largest financial market in the world. Unlike many other markets
the FX market is open 24 hours a day and has an estimated $1.2
Trillion in turnover every day. This tremendous turnover is more than
the combined turnover of the main worlds' stock markets on any
given day. This tends to create a very liquid market and thus a very
desirable market to trade.
Unlike many other securities, (any financial instrument that can be
traded) the FX market does not have a fixed exchange. It is primarily
traded through banks, brokers, dealers, financial institutions and
private individuals.
Trades are executed through telephonic communications and now
increasingly through the Internet. It is only in the last few years that
the smaller investor has been able to gain access to this market.
Previously the large deposits that were required precluded the
smaller investors but with the advent of the Internet and growing
competition, it is now easily within reach of most investors.
INTERBANK
You will often hear the term INTERBANK discussed in FX
terminology. This originally, as the name implies, was simply banks
and large institutions exchanging information about the current rate at
which their clients or themselves were prepared to buy or sell a
currency.
‘INTER’ meaning between and ‘Bank’ meaning any deposit taking
institution. The market has moved on to such a degree that now the
term interbank means anybody who is prepared to buy or sell a
currency.
It could be just two individuals changing currencies or your local
travel agent offering to exchange Euros for US Dollars. You will
however find that most of the brokers and banks use centralized
feeds to insure reliability of quote.
The quotes for Bid (buy) and Offer (sell) will all be from reliable
sources. These quotes are normally made up of the top 300 or so
large institutions. This ensures that if they place an order on your
behalf, the institutions they have placed the order with will be capable
of fulfilling the order.
Now although we have spoken about orders being fulfilled, it is
estimated that anywhere from 70%-90% of the FX market is
speculative. In other words the person or institution that bought or
sold the currency has no intention of actually taking delivery of the
currency. Instead they were solely speculating on the movement of
that particular currency.
Source: Bank For International Settlements http://www.bis.org
Extract From The Triennial Central Bank Survey of Foreign Exchange
and Derivatives Market Activity. Currency 1989 1992 1995 1998 2001
US Dollar 90 82.0 83.3 87.3 90.4
Euro 37.6
Japanese Yen 27 23.4 24.1 20.2 22.7
Pound Sterling 15 13.6 9.4 11.0 13.2
Swiss Franc 10 8.4 7.3 7.1 6.1
As you can see from the above table, over 90% of all currencies are
traded against the US Dollar. The four next most traded currencies
are the Euro (EUR), Japanese Yen (JPY), Pound Sterling (GBP) and
Swiss Franc (CHF).
Because currencies are traded in pairs and exchanged one for the
other when traded, the rate at which they are exchanged is called the
exchange rate. These four currencies traded against the US Dollar
make up the majority of the market and are called major currencies or
the majors.
Market Mechanics
So now we know that the FX market is the largest in the world. Your
broker or the institution that you are trading with is collecting quotes
from a centralized feed and/or individual quotes comprising of
interbank rates.
So how are these quotes made up? Well, as we previously
mentioned, currencies are traded in pairs and are each assigned a
symbol. For the Japanese Yen it is JPY, for the Pounds Sterling it is
GBP, for Euro it is EUR and for the Swiss Frank it is CHF. So,
EUR/USD would be the Euro-Dollar pair. GBP/USD would be the
Pounds Sterling-Dollar pair and USD/CHF would be the Dollar-Swiss
Franc pair and so on.
You will always see the USD quoted first aside for a few exceptions
such as Pounds Sterling, Euro Dollar, Australia Dollar and New
Zealand Dollar. The first currency quoted is called the base currency.
When you see FX quotes you will actually see two numbers. The first
number is called the bid and the second number is called the offer
(sometimes called the ASK).
If we use the EUR/USD as an example you might see 0.9950/0.9955.
The first number 0.9950 is the bid price and is the price traders are
prepared to buy Euros against the USD Dollar. The second number
0.9955 is the offer price and is the price traders are prepared to sell
the Euro against the US Dollar.
These quotes are sometimes abbreviated to the last two digits of the
currency e.g.: 50/55. Each broker has their own convention and some
will quote the full number and others will show only the last two.
You will also notice that there is a difference between the bid and the
offer price which is called the spread. For the four major currencies
the spread is normally 5, give or take a pip (I’ll explain pips later)
To carry on from the symbol conventions and using our previous EUR
quote of 0.9950 bid, this means that 1 Euro = 0.9950 US Dollars. For
another example, if we used the USD/CAD 1.4500, that would mean
that 1 US Dollar = 1.4500 Canadian Dollars.
The most common increment of currencies is the PIP. If the
EUR/USD moves from 0.9550 to 0.9551 that is one pip. A pip is the
last decimal place of a quotation. The pip or POINT as it is
sometimes referred to, depending on context, is how we will measure
our profit or loss.
As each currency has its own value, it is necessary to calculate the
value of a pip for that particular currency. We also want a constant,
so we will assume that we want to convert everything to US Dollars.
In currencies where the US Dollar is quoted first the calculation would
be as follows.
Example: the JPY rate of 116.73 (notice the JPY only goes to two
decimal places, most of the other currencies have four decimal
places)
In the case of the JPY 1 pip would be .01 therefore
USD/JPY:
(.01 divided by exchange rate = pip value) so .01/116.73=0.0000856.
It looks like a big number but later we will discuss lot (contract) size
later.
USD/CHF:
(.0001 divided by exchange rate = pip value) so .0001/1.4840 =
0.0000673
USD/CAD:
(.0001 divided by exchange rate = pip value) so .0001/1.5223 =
0.0001522
In the case where the US Dollar is not quoted first and we want to get
to the US Dollar value we have to add one more step.
EUR/USD:
(0.0001 divided by exchange rate = pip value) so .0001/0.9887 =
EUR 0.0001011 but we want to get back to US Dollars so we add
another little calculation which is EUR X Exchange rate so
0.0001011 X 0.9887 = 0.0000999 when rounded up it would be
0.0001.
GBP/USD:
(0.0001 divided by exchange rate = pip value) so 0.0001/1.5506 =
GBP 0.0000644 but we want to get back to US Dollars so we add
another little calculation which is GBP X Exchange rate so
0.0000644 X 1.5506 = 0.0000998 when rounded up it would be
0.0001.
By this time you might be rolling your eyes back and thinking ‘do I
really need to work all this out?’, and the answer is no.
Nearly all the brokers you will deal with will work all this out for you.
They may have slightly different conventions, but it’s all done
automatically. It’s good however for you to know how they work it out.
In the next section we will be discussing how these seemingly
insignificant amounts can add up.
