Trading Guide

A complete guide for Forex traders

The Forex currency market is the largest financial market worldwide. It exceeds the other markets by a high margin, since it has a global reach and a huge number of participants, including financial banks, institutional investors and large and small speculators from all over the world.

The Forex market offers multiple opportunities to investors and speculators who seek to obtain profits with the movements of currency prices. However, trading in the Forex market requires knowledge and preparation. Unlike other forms of investment, traders can lose all their capital in a short time, if not careful.

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For this reason, before considering the idea of ​​opening an account with a Forex broker, start trading in this market and risk real money, it is essential that the investor prepares and acquires the necessary knowledge to have the best chance of success. Due to this, in we elaborate a guide where we include the most important topics that must dominate or at least know every trader that has an interest in starting his career investing in the Forex market.

The Forex Market

What is the Forex Market?

The word Forex stands for Foreign Exchange and it refers to the Foreign Exchange Market. The Forex is a decentralized market which exists wherever one currency is traded against another such as financial centers worldwide, banks or any financial institution or company where currency transactions are conducted. Therefore it is the largest financial market in the world, especially in terms of daily trading volume.

In this market participate central banks, major financial banks and similar institutions, multinational corporations, governments, currency speculators (large, medium and small investors) and other market participants and institutions of all kinds. Small investors (those who speculate with relatively small amounts of money) are a small part of this market and they can participate directly by companies dedicated to providing trading services or indirectly through banks or brokers.

One of the most important characteristics of the Forex market is the huge volume of transactions that take place daily in this financial market. In fact each day the Foreign Exchange move about 4 billion U.S. dollars, which is substantially higher than the trading volume of any other financial market.

This has allowed that an entire industry has arisen around the Forex which produce many millions of dollars a year, which has contributed to making Forex the financial market with the greatest potential and growth in the financial world today. Thanks to advances in modern technology, particularly the Internet, Forex has gained increasing popularity among small and large private investors. This has caused that this market is no longer an exclusive domain for large companies. This is due in part to the high leverage that this market usually offers for traders (a high leverage allows large investments with little capital) and the possibility to profit from both rises and falls in currency prices.

Also the largest brokers which are established in this sector offer many advantages and services to their customers like free practice accounts or demo accounts, which enable customers to learn how to trade, practice strategies and gain confidence before risking real money in the market. Of course, as in any financial market, the risk of loss is quite high, so before investing any money is necessary to understand how work the financial instruments offered by Forex brokers. In this case the investors must identify and decide what level of risk they are willing to accept for their trades.

Unlike the stock market, the Forex market has no centralized location. By contrast, it operates through a fully globalized network of banks, financial institutions and individual speculators which operates 24 hours a day. All these big and small investors are focused on the purchase and sale of foreign currencies relative to its volatile exchange rate that varies constantly and whose movements these investors try to anticipate for profit.

Size and liquidity of the Forex market

Thus, the Forex market is unique compared to others because of the following features:

  • The extreme liquidity of the market which is superior than any other.
  • The variety and number of investors involved in this market.
  • It is geographical spread covering virtually the entire planet.
  • The extended period in which this market keeps operating, which covers 24 hours a day from Monday to Friday.
  • The wide variety of factors involved  that generate changes in the market behavior.
  • The sheer volume that is traded globally in foreign exchange, which daily average is equivalent to the total  that takes place in a month in the stock market on Wall Street.

The Forex market as such, works from the mid-70s. The currency futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and is one of the most active contracts traded. The volume of currency futures has grown rapidly in recent years, but it accounts for only about 7% of total foreign exchange market, according to The Wall Street Journal Europe (05/05/2006, P. 20).

Most of the trading volume in this market consists of direct buy/sale transactions of foreign exchange. In the Forex market, major international banks provide the market with a purchase price (bid) and a sale price (ask). The difference between these prices is called the spread and it generally constitute the fee charged by the banks or other companies to act as an intermediary between investors buying and selling currencies using their channels. Normally, the spread of the most traded currencies and under normal market conditions is only 1-3 pips or points. This value is usually higher for currencies that are less traded. Thus, if we want to negotiate with the EUR/USD and the buy price (bid) is 1.3200 and the selling price (ask) is 1.3203, we can determine that in this case the spread is 3 pips .

Forex Market Main Features

Among the implications produced for the fact that Forex is not a centralized market is that there is no single price or quote for the instruments traded in this market. Currency quotes are directly dependent on the various players that participate in the market.

While the Forex market operates and offers investors access 24 hours a day in practice it is limited by a break in operations that occurs on weekends, but even in those periods of recess, any trader can place buy or sale positions that will be activated once the market begins to work again, at the beginning of the week. An important aspect to consider when trading in the Forex market, is that the time of day in which the speculator access and trades in this market has a direct impact on the liquidity available for trading in one or more currencies. This is because during periods in which the major world markets begin to operate, is when there is greater liquidity, price movement and trading volume, although Forex is not linked directly to the nature of these stock negotiations centers since in this case it is basically an Over The Counter market. But either way, the Forex market traders should always consider the time before opening positions especially in relation to the major exchanges in the world.

Currently, the main financial centers in the world are the New York Stock Exchange, the London Stock Exchange and the Tokyo Stock Exchange. These exchanges operate daily from Monday to Friday with a fixed schedule. First the Asian markets start to operate followed by the European markets and finally the American markets.

The Forex market opens every Sunday in the afternoon (EST Time East Coast of the United States) and closes on Friday at 4:00 pm Eastern Time U.S. Thanks to this extensive schedule, investors have constant access to the market with the benefit of increased liquidity and the possibility to respond quickly to political and economic events that can positively or negatively impact the markets so that the trader can make a profit with any major event that cause movements in the Forex.

In Forex, usually the variations in the exchange rates of currencies are caused by actual monetary flows as well as the expectations of changes in these rates, due to fluctuations in economic variables of the major economies such as inflation, interest rates , GDP growth, trade deficits and surpluses, national budgets and other. In general, the major economic and political news are issued on scheduled dates, so that investors have access to the same information at the same time. However, the reality is that the big banks have a great advantage over other investors because they can see the order book of its customers, meaning that they can be aware of the market’s direction because they can check the buy /sale orders of the investors to whom they provide services.

Below are the most traded currencies in the Forex market along with its ISO 4217 code and its percentage of market share:

Currency
 ISO 4217 Symbol
% Participation in the FX Market
US Dollar
USD
86.3
Euro
EUR
37.0
Yen
JPY
17.0
Pound Sterling
GBP
15.0
Swiss Franc
CHF
6.8
Australian Dollar
AUD
6.7
Canadian Dollar
CAD
4.2
Swedish Krona
SEK
2.8
Hong Kong Dollar
HKD
2.8
Norwegian Krone
NOK
2.2
New Zealand Dollar
NZD
1.9
Mexican Peso
MXN
1.3
Singapore Dollar
SGD
1.2
South Korean Won
KRW
1.1
Other currencies
14.5

In the Forex market, currencies are traded in pairs, each of which is a product or individual instrument to trade and is usually noted as XXX/YYY, where YYY is the international three-letter code ISO 4217 for a given currency , in which the price of one unit of XXX (another currency) is expressed. To better understand this, we can use as an example the EUR/USD = 1.3200 (Quote produced in early August of 2010), in which the price of the Euro (EUR) is expressed in U.S. dollars (USD), which means i in this case that the value of 1 euro equals  to 1.3200 U.S. dollars.

According to several studies, the most traded currency pairs in the Forex market are:

  • EUR/USD: 28%.
  • USD/JPY:  17%.
  • GBP/USD: 14%

While trading volumes in euros has increased significantly since its inception in 1999, the Forex market is still dominated by the U.S. dollar as shown in the table above, which shows how the dollar has an 87% on the market by far surpassing all others currencies.

Types of Forex market instruments

Today the total value of transactions in the Forex market is around $ 4 trillion a day, which is higher than traditional derivatives whose daily trading volume is 3.7 trillion. The most common instruments that are traded in the Forex market are:
  • Spot foreign exchange transactions (spot market): These operations are commonly known as Foreign Exchange Spot Trading. In this case, these trades consist of the purchase/sale of foreign currencies with a delivery that can last up to 2 business days of the transaction contract. These are the most common transactions in the Forex market.
  • Currency based financial options: These options also known as Foreign Exchange Options are contracts that give the buyer the right but not the obligation to purchase or sell one currency for another at a specified price or rate on a date established in the contract. It is a type derivative which is traded Over The Counter (No trades at a central market, transactions are made directly between the two parties).
  • Futures contracts based on currencies: These contracts, also known as Foreign Exchange Futures, consist of an agreement to exchange currencies at a predetermined date in the future at a price specified in the contract. Unlike transactions in options, futures transactions are not performed on Over The Counter markets.
  • Currency Forwards: These instruments are also called Outright Forward and basically consist of an exchange of one currency for another at a future date price preset.
  • Not traded currency contracts: These financial products are known as Non deliverable Forwards. These are contracts which  usually are traded offshore and where settlement is made based on different currencies. They offer the possibility for the investor to have exposure to a currency without having to pay or receive the currency.
  • Currency swaps: These instruments, also known as Foreign Exchange Swaps are agreements between two counterparts (buyer and seller) for the purchase and sale of a certain amount of currency (for the change of a future stream of payments of interest and principal) in which one of the counterparts pay in a currency while the other party pays in another currency. At present there are various types of currency swaps.

Currency market participants

According to various studies, at present over 50% of transactions in the foreign exchange market are solely between banks. Also, about 30% of trades are done between banks and other financial company while the rest of the transactions are made between a broker and a  non-financial entity (non-financial companies, individual investors and others).

Below we describe the main actors and participants involved in the Forex currency market:

Commercial Banks

The interbank market today represents a high percentage of speculative transactions in the financial market. In fact, a large financial bank can negotiate even billions of dollars daily in the Forex market. Some of this trading volume is done on behalf of their clients, however the other part is made by the bank to gain direct income with the price fluctuations of one currency against another.
Until relatively recently, many of the foreign currency negotiators actively involved in this type of market operations facilitated the parties that conducted a transaction the effective executions of the orders in exchange for a commission or fee as payment for their services.
However, today a large part of the trades in the Forex market is performed using more efficient electronic systems such as:
  • Chicago Board of Trade.
  • Tradebook.
  • Bloomberg.
  • EBS.

Central Banks

Central banks such as the Fed or the ECB sometimes operate in the foreign exchange markets in order to control the supply and demand for money, interest rates in the currency of its country and even inflation. These banks regularly impose exchange rates of currencies and often employ international reserves as a resource to stabilize the market when it threatens to spiral out of control.

For these reasons, the expectation and even the rumor that a major central bank will intervene in the market can significantly alter the value of a currency. Despite this, central banks do not always achieve their goals because the market is too big and can be dominated by any bank. This happened recently in Asian markets and in the period between 1992-1993 with the collapse of the Exchange Rate Mechanism.

Commercial Companies

Firms that do not directly belong to the financial sector which operate both with international customers and suppliers are also involved in the Forex market. However, in this case the impact of these companies in the short term is small compared to other participants. Despite this, trade flows resulting from these companies are an important factor that can affect the behavior of a currency over time. Also, direct operations of some multinationals may affect significantly the currencies of countries with small economies.

Investment Funds Companies (Hedge Funds)

These are companies that operate in the foreign exchange market in order to gain access to the financial markets of different countries so that they can invest in other assets such as stocks, bonds and others on behalf of their clients and with the capital of them.

Investors (traders) through intermediaries (brokers)

Today there are companies that specialize in providing access and support services for private operators that are interested in the Forex market. These companies provide different types of services designed for this purpose.
Thus, we have the brokers or financial intermediaries, which will provide traders with the possibility to open a trading account in a particular currency (usually USD or EUR) for the purchase and sale of foreign exchange through different channels (in most cases transactions are conducted using the Internet or by telephone), in order to earn income based on fluctuations in the exchange rate of various currencies against each other (eg Euro vs US Dollar, US Dollar vs. Yen, Euro vs. Yen, etc).
Because of its importance in the financial system and the seriousness of their work, these firms generally are subject to various controls and audits depending on country of origin. However, when choosing a broker to operate in the market, the trader must investigate its reputation, strength, quality of service and the legal framework by which it is governed.

Other companies involved in the Forex market

In addition to the direct participants in the Forex market, we have other companies that offer various services that relate directly or indirectly to this financial market. For example, there are companies dedicated to account management, among which we can include mutual funds, which basically are dedicated to raise capital from a number of investors to trade in the Forex with a strong capital , which is managed by the company’s expert investors.
In this case the firm through capital investment generates returns that are distributed among investors according to the amount of their investment. Of course, these companies are subject to the inherent risk derived from capital speculation, so they can lose partially or totally the capital invested. If the investor chooses an alternative of this type, it is essential to verify if the company meets certain criteria of professionalism, experience, transparency and risk policies especially for this type of investment.
Today there are Forex brokers that offer a managed account service to their customers (PAMM accounts) in which the investor’s capital is managed by experienced traders in the market.
Finally, we have companies that provide education services to investors to participate successfully in the market and companies which develop computer type applications for Forex trading, such as those that design and sell automated trading systems. These systems are programs designed to make buy and sell transactions in the market according to various parameters that were programmed such as mathematical calculations or technical indicators designed from mathematical formulas, which help to read the movement of the market prices during certain periods. Besides these companies, there are others dedicated to Forex autotrading, Forex signals, platform development to invest in the market, etc.

The major players in the Forex market

n this article we will list the major players or participants in the Forex market. As it is understood in a market where hundreds of variables are involved as is the case of the currency market, a quote is the sum of different factors that affect in one way or another the exchange rate of the currencies.

Commercial Banks and Investment Banks

Several of the major players that influence the behavior of the foreign exchange market are commercial banks and investment banks. Specialists put them at a level above the Forex market which is known in the investment community as interbank market.It could be considered that it is a form of parallel negotiation which is stablished by different banks that have their own trading platforms and data access prices in a similar way as Forex investors who connect with their own Forex broker.

However, transactions between banks have a much higher level of liquidity, so that the interbank market is a high level market with transactions of many millions of dollars a day.The peculiarity is that banks and liquidity providers work primarily with two trading platforms to trade on the foreign exchange market:

  • Reuters Dealing
  • EBS (short for Electronic Brokerage Service).
An important fact is that depending on the liquidity and buying power of a bank, the institution can get better prices that in turn will benefit “retail” brokers or brokers for retail investors.

Central Banks

Central banks are the major players in the Forex markets because these institutions play a very important job determining the general direction of the market in the long term, as their policies may change the supply and demand of their respective currencies. The responsibility and scope of the central banks is varied depending on their own mechanisms; its scope will be higher or lower depending on how they are structured and legislated by each of the countries.

Despite what many initially think, the main task of the central banks as goverment institutions is not performing transactions to achieve own benefits, but to establish the monetary policies that favor a government or region. That is why, so central banks as major players in the Forex markets, will try through various monetary policies to control inflation by adjusting interest rates. They try to control the money supply, inflation, and interest rates. In addition, central banks can use their own foreign exchange reserves to try to stabilize the market.

Companies and Corporations

Other major players in the Forex markets are perhaps “secondary characters” but set a high volume of trading in currency trading. At this point we have companies and corporations of a certain level that generate a large cash flow thanks to their many high volume buy/sale transactions.  This is because they are businesses that have commercial orientation based on the import and export of products and services.

Online Retail Brokers

The online brokers in the Forex trading scenario could be defined as those companies that provide investors and retail traders the tools to perform operations in the market without any requirement other than the opening of their an account and the deposit of funds. Usually Forex brokers provide services like updated quotes, online trading platforms, educational resources, training and consulting services and other.

Within this category of brokers, there are several types depending on their own infrastructure and how they manage the operations of their customers through their own infrastructure and technological resources.

Individual Trader

Finally within the major players in the Forex markets we have the retail trader. The individual trader is the person that we ourselves reflect; these are people who through an trading platform which is provided by a Forex broker, can make buying and selling trades in various authorized markets and currency pairs of Forex.

Today this type of operation is fully automated and channeled through different platforms and servers through the Internet which in turn connect to the relevant markets or liquidity providers (depending on each case).

As we have explained on more than one occasion in the Forex market, being at a market that is totally decentralized, the trader has the advantage of not being limited by a schedule of market opening and closing as with the stock exchanges for example.

Trades can be performed virtually all day. But regardless of the above, we can say that there are trading venues with relative importance such as London, New York or Tokyo.

 

Forex Market vs Stock Market

Investing in the Forex market offers huge advantages over buying and selling  shares in the stock market especially if you’re a small investor who does not have a large capital to invest. Here are the main advantages of the Forex market with respect to stock trading:

The Forex market operates 24 hours a day

The Forex markets operates continuously 24 hours a day, Monday through Friday. This market opens on Sunday at 14:00 hours (New York time) and closes on Friday at 16:00 hours (New York time). In this way,  traders from around the world have the advantage of being able to react quickly to the main news of the market and can set their own schedules to trade as they have the possibility to trade during the trading sessions in the financial markets in United States, Europe and Asia.

The Forex is the most liquid financial market

The currency market has a daily trading volume 50 times larger compared with the Stock Exchange of New York. For this reason there are always brokers and agents who are willing to buy and sell currencies in the market. The high liquidity of the Forex market helps to ensure greater stability in the prices of these assets which is another of the great advantages of the currency market. With the stock market this is not the case, and there are periods in which there is not enough liquidity in the market to ensure trades with fair prices for the trader.

The Forex market offer a high leverage up to 1:500 or even more

The dealers and brokers in the Forex market will offer the investor a leverage of 1:100 or even more during their trades. Off course, this leverage is much greater  than the 1:2 margin offered by stock brokers and the 1:15 leverage offered by the brokers in the Futures market. The leverage in some Forex brokers can be up to 1:500, but usually these companies offer 1:100. With a 1:100 leverage,  the investor only has to deposit a margin of only $1,000 to open a position of $100,000 (one lot), which means a margin of only 1%.

Lower transaction costs

A basic analysis based on costs will tell us that Forex trading is more efficient than stock market taking into account trading costs and commissions that the trader must pay. In Forex, the costs are directly related to spread of buying and selling which at the same time depends on the type of broker. For example, the Market Maker brokers obtain their profits directly from the spreads while the NDD  (Non Dealing Desk)  and ECNs brokers charge fees (these fees depends on the volume) for transactions which are however much lower compared to the stock market.

Likewise, the investors trades with the spreads offered by some of the largest banking institutions in the world. With regard to the stock market, transactions without commission are typically offered only with clauses which require a fairly high minimum account or a minimum of transactions per month.

The Forex has the same potential for profit in bull and bear markets

Whether we open a bullish or bearish position, an investor in the Forex market always has a long position in one currency and a short position in the other currency (remember that in the Forex market the transactions are made with currency pairs like the EUR/USD).

A long position is one in which a trader buys foreign currency before the price rise and thus the investor profit from the rise in price in the market.In a short position occurs the opposite, the gains are obtained with the fall of the price. In the Forex there are no restrictions on short positions regardless of which direction the market is moving at the moment unlike the stock market which have more restrictions in this aspect.

As Forex trading involves buying one currency and selling another, a trader has the same possibility to negotiate in an emerging market as well as in a mature market. This is another advantage of the Forex market, the ability to sell currencies without any restriction.

The information in the Forex is more accessible and easy to interpret

In the stock market the information available about the many stocks is plentiful as the number of shares, so the trader can get overloaded with tons of information. This makes finding opportunities to trade successfully in this market means having to investigate and verify information from thousands of data on the stocks, a process that can be time consuming and tedious.

Meanwhile, in the Forex market the trader can concentrate basically on a few currency pairs to trade. While there are a lot of currency pairs in which a trader can invest, is in the EUR/USD, GBP/USD and USD/JPY in which the investor can turn his attention because it is in these assets that is concentrated most of the trading volume in the Forex market.

Furthermore, in the stock market the vital information which usually tends to move the stock price are the profits, losses, the financial statements and other factors related with the financial health of companies which often are reluctant to disclose this data. For this reason, in many cases the  investors (mainly the small investor) have to trade almost blindly without knowing what awaits them.. By contrast, the information related to the Forex market consist basically in economic and politic reports made public by governments, central banks or  related research institutions. These data are generally reported to all stakeholders at the same time.

The following is a summary which compares the market Forex with the stock market:

Main features of the Forex market

  • It is the largest financial market worldwide and it offers the highest level of liquidity compared with any other market.
  • This financial market operates 24 hours a day, Monday through Friday.
  • The trader can make profits both from a rising market and a falling market.
  • There are no restrictions to open short positions.
  • The Forex brokers trading platforms make use of high technology so that executions are made at the price indicated by the user. This applications includes many market analysis tools.
  • It offers a greater leverage which means a higher risk but at the same time increases the chances of profits. That is why the Forex is seen by many investors as more profitable.

Main features of the stock market

  • The stock market offers an acceptable level of liquidity but that liquidity depends primarily on the trading volume of each stock which can vary substantially from one stock to another. For this reason, depending of the market conditions, there are periods when liquidity is quite low, especially in low volume stocks, so traders have little opportunity to profit under these conditions.
  • This market is not open 24 hours a day. Depending on the country, the sessions last seven hours or less. The trading session of the Stock Market in New York last 7 hours.
  • The commissions to trade in the stock market are high compared to the Forex market so it is expensive to conduct small trades.
  • In many stock markets there are some restrictions to open short positions and in some cases these exchanges do not even offer that option like some stocks exchanges of Latin America and other regions.
  • In the case of the stock market, given the number of steps required to complete an order, the probability of having errors and that even the order is not executed at the price expected by the trader is higher compared with the Forex market.

The Exchange Rate

What is the exchange rate?

The exchange rate, also referred to as conversion rate or foreign exchange rate is the price at which a currency of a country can be converted (“changed”) in the currency of another country.

The system of exchange rates among currencies stems from the need of foreign currency by companies and nationals. In other words, the exchange rate comes from the movement of capital, goods, services and people across borders, that is, the existence of international trade. For example, when a company sells products to a foreign country, it is natural that this company wants to get paid in their national currency; therefore, the foreign company must buy the domestic currency of the manufacturer to pay  the products purchased. There are also many situations in which anyone may need a foreign currency, for example, when traveling need currency of the destination country. The result is a foreign exchange market in which people, companies and other participants buy and sell foreign currencies.

It is also regarded as the value of a country’s currency in terms of another currency. Exchange rates are determined in the foreign exchange market (Forex), which is open to a wide range of different types of buyers and sellers continuously 24 hours a day, except weekends, from 20:15 GMT on Sunday to Friday 22:00 GMT. The spot exchange rate refers to the current exchange rate. As in any other market, the exchange rate is set by the forces of supply and demand which may arise from the need for foreign exchange or speculation.

It is known as appreciation the increment in value of one currency against another and depreciation the opposite phenomenon.

Quote of the exchange rate: the currency pair

An exchange rate is usually quoted in terms of units of one currency that can be exchanged for one unit of another currency – for example, in the form: 1.2000 EUR/USD (meaning 1 EUR = 1.2000 USD). In this example, the US dollars are known as the “quote currency” (currency of payment) and the euro is the “base currency” (transaction currency or currency unit).

The market convention establishes an order to decide what currency must be used as the base currency and which is the quote currency in an exchange rate. In most parts of the world, the order is: EUR – GBP – AUD – NZD – USD – others. For example, in the exchange rate between the euro and the Australian dollar, the EUR is the base currency, AUD is the quote currency and the exchange rate indicates the amount of Australian dollars that would be paid or received by 1 euro.

In order to determine the base currency when the two traded currencies are not on the list of market convention (ie, both are “other”), it is used as the base currency the one with a exchange rate equal or higher to 1.000. This avoids problems of rounding. There are exceptions to this rule, for example the Japanese often use the Japanese yen as base currency.

It is known as direct quote one in which the foreign currency is used as the base currency. For example, 0.7354 USD/EUR would be a direct quote when used in the euro area, as from the local perspective it provides the direct value per unit of foreign currency. The direct quote is used by most countries locally.
On the other hand, the exchange rate which uses the currency of the country of origin as the base currency is called indirect quote. For example, the use of 1.2000 EUR/USD in the euro area would be indirect quotation (1 EUR = 1.2000 USD).
If direct quote is used and the national currency is appreciating against the foreign currency, the given number as exchange rate decreases, and vice versa if direct quotation is used and the national currency is depreciating against foreign currency, the given number as exchange rate will increase.

By market convention during the period of 1980-2006 the exchange rate of most currency pairs were given with 4 decimal places for spot transactions and up to 6 decimal places for fixed term or swaps transactions. An exception to this rule were the exchange rates with a value less than 1, which were given with 5 or 6 decimal places. Although there is no fixed rule, exchange rates with a higher value than 20 were given t with 3 decimals and the exchange rates higher than 80 were given with two decimal places.

In 2005 Barclays Capital broke with this convention by offering spot exchange rates with one more decimal in its electronic trading platform, but in the beginning this change was directed towards the interbank market. This resulted in a contraction of the spread (difference between bid and ask price) and better prices for spot transactions.

In the retail foreign exchange market transactions the exchange rate of a currency pair consists of two prices, the Bid price and the Ask price, one being the price at which the broker buys and the other the price at which the broker sells. The difference is known as spread. These prices can vary from one broker to another  and include the differential added by these companies through which they obtain their profit.

Learn more about the interpretation of the quoted price and the exchange rate of a currency pair here: Pips and Lots in the Forex market

Exchange rate systems

Each country, through different mechanisms, manages the value of its currency. As part of this function, the regime or exchange rate system to be applied to its currency is determined:
  • Fixed exchange rate: It is determined and controlled rigidly by the Central Bank. Normally the value of the national currency is fixed to a currency or basket of foreign currencies.
  • Flexible or floating exchange rate: the value of the currency is determined by supply and demand in the currency market.

Fluctuations in the exchange rate

The exchange rate determined by supply and demand in the currency market fluctuates regularly. A currency will have more value when demand exceeds supply and, conversely, a currency will depreciate when demand falls below the offer.

The growing demand for currency may be due to various reasons from an increase in monetary transactions of a purely speculative demand. Transactions demand is highly correlated with the level of commercial activity in a country, with its gross domestic product (GDP) and employment levels. The more unemployed in the country, the lower the spending on goods and services, both domestic and import. Central banks often have little difficulty adjusting the money supply available to accommodate changes in the demand for money due to commercial transactions.

Speculative demand is much harder to accommodate for central banks. Changes in the interbank interest rates is one of the tools used by central banks to influence the demand of currency for speculative purposes since a speculator will buy a currency if the expected return (the interest rate) is enough high. In general, the higher the interest rates in a country, the greater the demand for its currency. It has been argued that such speculation can undermine real economic growth since large currency speculators may deliberately create downward pressure on the currency in order to push the central bank to sell its currency to keep it stable and, thus, the speculator can buy the currency at a lower price.

Exchange rate based on the term of liquidation

The deadline for settlement of foreign exchange transactions can be cash or future. In response to this term there are two names in the exchange rate:

The purchasing power of a currency

The “real exchange rate” represents the purchasing power of one currency against another. It is based on the measuring of the GDP deflator of price level in both countries, which is set equal to 1 in a given base year chosen arbitrarily. Therefore, the level of the real exchange rate is arbitrary depending on the year chosen as the base year for the GDP deflator in both countries. The variation of the real exchange rate provides information on the evolution over time of the relative price of a unit of GDP in the foreign country in terms of units of national GDP. If all goods were freely negotiable and foreign and domestic people would buy exactly the same basket of goods and services, the purchasing power parity (PPP) would remain in the GDP deflators of the two countries, and the real exchange rate would be constant and equal to one.

Exchange rate models

Currently, the most important models to predict the exchange rates in the long term are the following:
  • The Theory of the Balance of Payments (BOP)
  • The Purchasing Power Parity (PPP)
  • The Interest Rate Parity
  • The Monetary Model
  • The Real Interest Rate Differential Model
  • The Asset Market Model.
  • The Currency Substitution model.​
In the following article we discuss about the main exchange rate models:
-Prediction models of Exchange Rates in the Forex

Intervention and manipulation of exchange rates

Countries can gain an advantage in international trade if they manipulate the value of its currency artificially influencing the exchange rate.  Usually these interventions are carried out through participation in the open market of the country’s monetary authorities (central banks).

Some countries try to devalue their currency or slow its appreciation in order to promote exports and strengthen the economy. A low exchange rate makes domestic goods and services cheaper for foreigners and therefore favors exports and, conversely, for domestic consumers the products and imported goods become more expensive.

It is argued that the People’s Republic of China has succeeded in doing this for a long time. However, in a real world situation, the Yuan has appreciated by 22% in 2005 and this was followed by an increase of 38.7% on Chinese imports to the United States.

JP Finance Trade for success

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