WHAT IS FOREX?
Forex is an over-the-counter (“OTC”) derivative. “Foreign exchange” generally refers
to trading in foreign exchange products (currency) in the spot (cash) markets. Margin
foreign exchange products can be differentiated from foreign currency as they allow
the investor an opportunity to trade foreign exchange on a margined basis as opposed
to paying for the full value of the currency. In other words, investors are required to
lodge funds as security (initial margins) and to cover all net debit adverse market
movement (variation margins) i.e. positions are monitored on a mark-to-market basis
to account for any market movements. When clients are making a loss to an extent
that they no longer meet the margin requirements they are required to “top up” their
accounts or to “close out” their position.
Foreign exchange is essentially about exchanging one currency for another at an
agreed rate. Accordingly, in every exchange rate quotation, there are two currencies. The exchange rate is the price of one currency (the “base” currency) in terms of
another currency (the “terms” currency) such as the price of the Australian dollar in
terms of the US dollar. For example, if the current exchange rate for the Australian
dollar as against the US dollar is AUD/USD 0.7500, this means that one Australian
dollar is equal to, or can be exchanged for 75 US cents.
HE HISTORY OF FOREX
The Forex market is a cash inter-bank or inter-dealer market, which was established
in 1971 when floating exchange rates began to appear. The foreign exchange market
is huge in comparison to other markets. For example, the average daily trading
volume of US Treasury Bonds is $300 billion and the US stock market has an average
daily volume of less than $10 billion. Ten years ago the Wall Street Journal estimated
the daily trading volume in the Forex market to be in excess of $1 trillion. Today that
figure has grown to exceed $1.8 trillion a day.
Prior to 1971 an agreement called the Bretton Woods Agreement prevented
speculation in the currency markets. The Bretton Woods Agreement was set up in
1944 with the aim of stabilising international currencies and preventing money fleeing
across nations. This agreement fixed all national currencies against the dollar and set
the dollar at a rate of $35 per ounce of gold. Prior to this agreement the gold
exchange standard had been used since 1876. The gold standard used gold to back
each currency and thus prevented kings and rulers from arbitrarily debasing money
and triggering inflation.
The gold exchange standard had its own problems however. As an economy grew it
would import goods from overseas until it ran its gold reverses down. As a result the
country’s money supply would shrink resulting in interest rates rising and a slowing of
economic activity to the extent that a recession would occur.
Eventually the recession would cause prices of goods to fall so low that they appeared
attractive to other nations.
This in turn led to an inflow of gold back into the economy and the resulting increase
in money supply saw interest rates fall and the economy strengthen.
These boom-bust patterns prevailed throughout the world during the gold exchange
standard years until the outbreak of World War I which interrupted the free flow of
trade and thus the movement of gold.
After the war the Bretton Woods reement was established, where participating
countries agreed to try and maintain the value of their currency with a narrow margin
against the dollar. A rate was also used to value the dollar in relation to gold.
Countries were prohibited from devaluing their currency to improve their trade
position by more than 10%. Following World War II international trade expanded
rapidly due to post-war construction and this resulted in massive movements of
capital. This de-stabilised the foreign exchange rates that had been set-up by the
Bretton Woods Agreement.
The agreement was finally abandoned in 1971, and the US dollar was no longer
convertible to gold. By 1973, currencies of the major industrialised nations became
more freely floating, controlled mainly by the forces of supply and demand. Prices
were set, with volumes, speed and price volatility all increasing during the 1970’s.
This led to new financial instruments, market deregulation and open trade. It also led
to a rise in the power of speculators.
In the 1980’s the movement of money across borders accelerated with the advent of
computers and the market became a continuum, trading through the Asian, European
and American time zones. Large banks created dealing rooms where hundreds of
millions of dollars, pounds, euros and yen were exchanged in a matter on minutes.
Today electronic brokers account for 70% of the $1.8 trillion a day Forex market in
London and single trades for tens of millions of dollars are priced in seconds. The
market has changed dramatically with most international financial transactions being
carried out not to buy and sell goods but to speculate on the market with the aim of
most dealers to make money out of money.
London has grown to become the world’s leading international financial centre and is
the world’s largest Forex market. This arose not only due to its location, operating
during the Asian and American markets, but also due to the creation of the Eurodollar
market. The Eurodollar market was created during the 1950’s when Russia’s oil
revenue, all in US dollars, was deposited outside the US in fear of being frozen by US
authorities. This created a large pool of US dollars that were outside the control of the
US. These vast cash reserves were very attractive to foreign investors as they had far
less regulations and offered higher yields.
Today London continues to grow as more and more American and European banks
come to the city to establish their regional eadquarters.
The sizes dealt with in these markets are huge and the smaller banks, commercial
hedgers and private investors hardly ever have direct access to this liquid and
competitive market, either because they fail to meet credit criteria or because their
transaction sizes are too small. But today market makers are allowed to break down
the large inter-bank units and offer small traders the opportunity to buy or sell any
number of these smaller units (lots).
4. THE PURPOSE OF FOREX
People who trade Forex contracts may do so for a variety of reasons. Some trade for
speculation, that is, with a view to profiting from fluctuations in the price or value of
the underlying instrument or security. For example, Forex traders may be short-term
investors who are looking to profit from intra-day and overnight market movements in
the underlying currency. Forex traders may have no need to sell or purchase the
underlying currency themselves, but may instead be looking to profit from market
movements in the currency concerned.
Others trade Forex to hedge their exposures to the underlying currency. Foreign
exchange exposures may arise from a number of different activities.
• Companies or individuals, that are dependent on overseas trade, are exposed to
currency risk. This can be to purchase (or sell) physical commodities (such as
machinery) or even financial products (such as investing in securities listed on
an international stock exchange).
• An exporter who sells its product priced in foreign currency has the risk that if
the value of that foreign currency falls then the revenues in the exporter’s home
currency will be lower; or
• An importer who buys goods priced in foreign currency has the risk that the
foreign currency will appreciate thereby making the cost, in local currency
terms, greater than expected.
• A person going on a holiday to another country has the risk that if that country’s
currency appreciates against their own, their trip will be more expensive.
In each of the above examples, the person or the company is exposed to
currency risk. Currency risk is the risk that arises from nternational business
which may be adversely affected by fluctuations in exchange rates. The Forex
market allows individuals and corporations the ability to buy or sell foreign
exchange products to manage these risks.
5. MARKET PARTICIPANTS
Private Banks play two roles in the Forex market. Firstly they facilitate transactions
between two parties wishing to exchange currency, and secondly they speculate by
buying and selling currencies. It has been estimated that international banks generate
70% of their revenues from currency speculation.
Governments through their central banks also participate in the Forex market. Central
banks such as the US Federal Reserve buy and sell currency in order to try to stabilise
their own currency and therefore strengthen or weaken their country’s financial
The Forex market is so large and is composed of so many participants that no one
player, not even a government central bank, can control the market.
Forex is not a “market” in the traditional sense. There is no centralised location for
trading and there is no exchange” like stocks or futures. Trading occurs over the
phone and through computer terminals at many locations throughout the world. The
bulk of the trading is done between approximately 300 large international banks,
which process transactions for large companies, governments and their own accounts.These banks are continually providing prices for each other and the broader market a
a buy or “bid” and a sell or “ask” The most recent quote from one of these banks is
considered the markets current price for that currency.
6. KEY FEATURES OF FOREX CONTRACTS
6.1 Currency Pairs
The first currency in the pair is referred to as the base currency and the second
currency is the counter or quote currency. The U.S. Dollar, as the world’s dominant
currency, is usually considered the ‘base’ currency for quotes and includes the
USD/JPY, USD/CHF and USD/CAD. This means that quotes are expressed as a unit of
$1 USD per the other currency quoted in the pair. The exceptions are the Euro, Great
Britain Pound, and Australian dollar. These currencies are quoted as dollars per foreign
Prices are quoted against these currency pairs.
For example if the EUR/USD is quoted at 0.9890 this means that 1 EUR is buying
0.9890USD or 98.90c. In the case of the Swiss Franc and Japanese Yen the USD is
quoted first therefore if USD/JPY is quoted at 124.15 then 1 USD is buying 124.15 JPY.
The significance of this system becomes very apparent when looking at charts and the
dealing platform. When placing orders you will be buying or selling the primary
currency against the secondary currency.
The four major currency pairs are EUR/USD, GBP/USD, USD/CHF AND USD/JPY. Other
currency pairs you may consider include USD/CAD, AUD/USD, NZD/USD as well as the
cross rates such as EUR/GBP, EUR/CHF, EUR/JPY, GBP/JPY etc.
6.2 Points (Pips)
It is arbitrary how many significant figures are used in an exchange rate quotation.
The last decimal place to which a particular exchange rate is usually quoted is referred
to as a “point” or “pip”. For example:
• In the quotation USD 1=AUD 0.7250, one point or one pip means AUD 0.0001.
• In the quotation USD 1=JPY 102.50, one point or one pip means JPY 0.01.
Of note, all points (or pips) are not of equal value.
Forex traders typically talk about moves in a currency and the profit they make by
using a term called pips. A pip refers to the last decimal digit of the quoted currency.
For instance the USDYEN might be quoted at 124.57. The movement of the 2nd
decimal is referred to as a pip. If the USDYEN moves from 124.57 to 124.71 this
represents a 14 pip move. Most other non yen quoted currencies like EURUSD,
GBPUSD, USDCAD are quoted to 4 decimal numbers, thus this 4th digit is one pip.
For example for the EURUSD the price might move from 0.8632 to 0.8639, a move of
7 pips. A movement in the GBPUSD from 1.4465 to 1.4520 is a 55 pip move. The
dollar amount that relates to one pip for each of the currencies is listed below
EURUSD, GBPUSD 1 pip = $10 USD per contract. (fixed)
USDCHF 1 pip = $8.3 USD per contract. (approx)
USDYEN 1 pip = $9 USD per contract. (approx)
As will be explained later the spread between the bid and ask price is generally 3-5
pips. Therefore upon entering a position you are down 3-5 pips. In order to get to
breakeven the currency must move 3-5 pips in your direction, and then profit is
earned after that. So in order to earn a 10 pip profit from trading long the EURUSD
(assuming a spread of 3 pips), it would need to move from 0.8977 to 0.8990 on the
Trading Forex contracts involves trading on margin. Margin allows you to purchase a
contract without the need to provide the full value of the contract. Margin
requirements vary between market makers but typically range from 1-4%. For
example, for $100,000 position on 1% margin you would be required to offer $1000
per as margin. This dollar amount is expressed in the base currency. The following
examples will show you how your margin is calculated.
A trader decides to go long JPY against USD by buying a 1,000,000 contract of
• for a 1% margin account: margin required 1,000,000 x 0.01 = $10,000 USD
• for 2% margin account: margin required 1,000,000 x 0.02 = $20,000 USD
A trader decides to go short EUR against USD by selling a 1,000,000 contract of
• for a 1% margin account: margin required 1,000,000 x 0.01 = $10,000 EUR
• for 2% margin account: margin required 1,000,000 x 0.02 = $20,000 EUR
When you place an order to buy or sell a Forex contract, the margin required for the
position is separated from the rest of your account balance. The remaining funds in
your account are often referred to as your remaining margin.
Forex market makers quote foreign exchange rates by taking into consideration the
current spot “inter bank” exchange rates. The price that you may deal at is presented
to you as a bid and an offer, much like equities markets.
The difference in price between the quoted bid and offer will include a spread in favour
of the market maker. Forex market makers make their earnings from the spreads that
are embedded in the currency rates, as the rates they deal in are more favourable.
A Forex market maker acts as an aggregator, providing liquidity to many retail trader
and offsetting the resulting risk in the inter-bank market at more favourable terms
You will be quoted different spreads depending on the currency pair being traded.
There is correlation between the liquidity of a currency pairs and the dealing spreads
offered. The more liquid pairs generally have smaller dealing spreads.
A smaller spread means that if a position is taken, the price does not have to move in
your favour as much until a position of breakeven is achieved. Spreads do vary in
small amounts from one Forex market maker to another, but it is a relatively
competitive business sector.
The target bid/ask spreads are the best possible target spreads used in normal market
conditions. In quiet market conditions, the spread may be even narrower but in
periods of volatile markets, the spread may be increased.
6.5 Calculating Profits and/or Losses
The profit or loss from a transaction is calculated by keeping the units of one of the
currencies constant (the “base” currency) and determining the difference in the
number of units of the other currency (the “terms” currency). The profit or loss will be
expressed in the units of the currency which is not kept constant.
6.6 Realised and Unrealised Profits and Losses
Profits and/or losses are realised if both the buy and the sell side of the transaction
are complete and have been matched against each other or closed out. Profits and/or
losses are unrealised if only one side of the transaction has been completed.