Foreign currencies explained
20/May/2015 • Currency Updates•
The foreign exchange market (also known as ‘forex’ or ‘FX’) is the arena where people buy and sell currency. The value of any given currency changes on a constant basis, reacting to institutions, such as banks, buying and selling large amounts, geopolitical events and economic data releases, such as interest rate decisions and employment numbers.
At a very basic level, the value of a currency is a comment on the perception of the health of a country’s economy and political stability. An estimated $3.9 trillion is exchanged in currency every single day, making forex the largest and most liquid financial market in the world.
Currency is always traded in pairs (USD/GBP, for example), with a combination of 8 currencies making up the most common pairings:
- The US Dollar (USD)
- The British Pound (GBP)
- The Japanese Yen (JPY)
- The Canadian Dollar (CAD)
- The Swiss Franc (CHF)
- The New Zealand Dollar (NZD)
- The Australian Dollar (AUD)
- The Euro (EUR)
When watching the news or reading the paper, you may note reference to a ‘pip’. This is the smallest measure of a price movement possible, referring to one point of a currency’s value – equivalent to the final number in a price. For example, if dealing with the yen a pip will reference the second decimal place (i.e. 131.84) and for other currencies, the fourth decimal point (i.e. 1.5345).
Often, traders will describe their losses and gains by referring to these pips rather than a currency amount. For example, a change in price from 1.5345 to 1.5355 will have moved by 10 pips.
Where forex differs from other financial markets is that there is no stock exchange or clearing house for currency exchange. It is a strictly over-the-counter (OTC) market. Forex is also open throughout the day, with activity occurring throughout the 24 hour cycle as cities wake up and shut down again, from Tokyo to London to New York.
There are two main contracts that you can enter when buying or selling foreign exchange – Spot Contracts, which are the simplest type – an order set at an agreed rate over a small time period, typically 2 days – and a Forward Contract, a type of risk management tool.
Risk management is an often overlooked aspect of foreign currency management, but is in fact very simple. Essentially, a Forward Contract allows you to buy a set amount of currency at a set price either within a certain timeframe or at an agreed upon time in the contract. Any withdrawal you make from a Forward Contract before its final date is known as a ‘drawdown’.
The main benefit to agreeing upon a future rate is that this mitigates your exposure to the foreign exchange market, which has been extremely volatile over the last few years. Knowing exactly how much you’re liable to pay or how much you’ll receive at a future date as defined in the contract – no matter what happens in the market – is what risk management is all about.