What is Forex?
Foreign exchange, Forex, FX. They all mean the same thing — Converting one country’s currency into another, like the US dollar into the Mexican peso.
🤔 Understanding forex
Foreign exchange (“forex” or “FX”) is when one currency (like the US dollar) is converted into another country’s currency (like the euro). Tourists, businesses, and governments all have different needs for foreign exchange, so they go to foreign exchange markets, to banks, or to the FX counter at the airport to convert their home currency into the type of money that they need. The rate at which one currency is converted to another is called the “FX rate,” and it’s based primarily on supply and demand for the currencies, which is usually driven by the overall economy and political situation of the two countries involved. A currency’s value is usually priced in relation to another currency’s value. So 1 US dollar = 6.87 Chinese Yuan, as of June 23, 2019.
When the United Kingdom voted to exit the European Union in 2016, the value of the British pound compared to the euro or the US dollar fell because investors interpreted Brexit (short for “British Exit”) as bad for the UK economy.
Foreign exchange is the language of money…
Not everyone speaks the same language. Not everyone wants the same money. The foreign exchange market is where translations happen from one currency to another, so that we can trade things like pickup trucks, avocados, and even a ferris wheel ride across countries.
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- What is meant by “foreign exchange” or “Forex”?
- Why is foreign exchange needed?
- What are the most common currencies in the world?
- How do you value a currency?
- What causes changes in FX rates?
- What are the different ways foreign exchange can happen?
- What are the costs of foreign exchange?
- How can FX rates affect the economy?
- How can you “invest” in foreign exchange?
What is meant by “foreign exchange” or “Forex”?
Foreign exchange is the trading of one country’s currency to another, like converting South African rand to Japanese yen. The market for foreign currencies is usually open 24 hours per day, five days per week and is the largest market in the world. Governments, businesses, and people need foreign currencies for various reasons, and buyers and sellers meet up in the foreign exchange market to make a trade for the dollar or rupee or dinar they want.
Why is foreign exchange needed?
People want foreign currencies for a number of reasons. Here are a few key ones:
- Tourists demand FX so they can buy things in the country they’re visiting.
- Businesses need FX if they are buying supplies or parts from another country. For example, if US-based Chipotle wants to buy avocados from Mexico, it will need to convert its US dollars to Mexican pesos.
- Governments demand FX so they can hold reserves (like a giant rainy day fund).
- Investors can speculate by investing in foreign exchange — This means buying and selling currencies because they think their value will rise or fall. We cover more on this point below.
What are the most common currencies in the world?
Most of the countries of the world have their own national currency, issued by the country’s central bank. But some countries just use a trusted international currency like the US dollar instead of creating and monitoring their own. The most widely-held currencies are those from wealthy and stable nations — these are referred to as “hard” currencies. Poorer, less stable countries’ currencies are sometimes called “soft” currencies, and they aren’t as trusted. Hard currencies tend to be in higher demand than soft currencies because they’re considered more trustworthy stores of value. Below are some of the most widely-held currencies in the world:
- 🇺🇸 USD = $ = the US dollar, the currency of the United States of America
- 🇪🇺 EUR = € = the euro, the currency of the 19 countries in the European Union
- 🇯🇵 JPY = ¥ = the Japanese yen, Japan’s national currency
- 🇬🇧 GBP = £ = the British pound, the currency of the United Kingdom
- 🇨🇭 CHF = ₣ = the Swiss franc, Switzerland’s currency
The US dollar is the most dominant currency in the world. So it’s no surprise that conversions of the dollar to other currencies are the most common foreign exchange trades. Below are four top currency pairs (you’ll likely see these at the FX counter at the airport and in The Wall Street Journal).
How do you value a currency?
Most of us know money as a piece of paper or a metal coin. We care about money for its “extrinsic” value: the value we assign to money because we know that it can be used for other things besides the paper and the metal themselves. $13 is worth about the value of a month’s Netflix subscription (per June 20, 2019!) — that’s one example of its extrinsic value.
In the FX market, it’s less common to use a Netflix subscription as a point of reference. With foreign exchange we can determine the price of 1 US dollar (hint: the answer is not “1 US dollar”). We see how much it costs to buy one currency using the currency of another country, and we call that the FX rate. The EUR/USD rate was 0.88 as of June 23, 2019. That means 1 US dollar is worth 0.88 euros. So if you see the price of something in dollars is $10, it could also be priced at €8.80, other things being equal. And FX rates can also be quoted as an inverse. Instead of learning the price of 1 US dollar, you can calculate the price of 1 Euro by flipping the division. The USD/EUR rate is 1.14. So something that costs 10 Euros could also cost $11.40 (again, other things being equal).
Now say that the US economy is growing, and investors think it’ll continue to grow. The USD/EUR rate could decrease, meaning 1 EUR is worth fewer dollars. That means the euro has weakened (or “depreciated”) compared to the US dollar. And the Dollar has strengthened (or “appreciated”) compared to the euro.
It’s key to remember that all FX rates are relative. Whenever one currency is appreciating, you have to say compared to what. And when one side is appreciating, the other side is depreciating. Sometimes though you could hear “the US dollar is weakening” in the news. In that case, the person probably means it’s weakening compared to the other major currencies, which are overall strengthening compared to the US dollar.
What causes changes in FX rates?
Investors demand more of a currency if they think its value will increase. Some reasons investors might think a currency would rise or fall in value:
- Economic growth: If a country’s economy is expected to grow, then that country’s central bank is more likely to increase interest rates to combat inflation. Rising interest rates tend to drive a country’s currency higher (see the bullet point below!). If the country’s economy is struggling, the central bank may reduce interest rates to stimulate growth, which would lower the value of the currency.
- Interest rates: If one country’s interest rate levels are high, then investors can benefit by “parking their money” in that country’s currency. That’s because with that currency they could purchase safe government bonds or benefit from a high-yield savings account, and their money could grow faster than it would if it were “parked” in another currency.
What are the different ways foreign exchange can happen?
- Spot: This is when you simply want to convert one currency to another right now. This can happen through a bank, through a financial institution, or through anyone willing to exchange one currency for another, like the FX kiosk at the airport. Be aware of fees. Spot tends to be the only type of FX trade that involves physical money being exchanged, like dollars for pesos at the FX kiosk. But most FX trades, including spot, are handled electronically.
- Forward or Futures: If you know that you will need a certain amount of foreign exchange in the future, you may want to eliminate the uncertainty of what the FX rate will be at that time. You can “lock-in” FX rates today by engaging in futures or forwards contracts.
- Options: One way to invest in FX is to buy or sell options. Options are a more sophisticated investing tool that gives the owner of that option the right, but not the obligation, to buy or sell FX at a future date, at a certain FX rate.
What are the costs of foreign exchange?
The FX rate you see on the front page of the business news is not the same as the rate you have access to. Banks and other financial institutions that offer foreign exchange do so to make money, and the money they make is the difference between the FX rate they have access to, and the FX rate they offer you. This is called a “markup/markdown.” When considering buying a foreign currency, it’s a best practice to compare rates, and convert those rates to apples-to-apples rates so you can find the best price.
How can FX rates affect the economy?
This might sound surprising, but some politicians have reasons to want their currency to be “weak.” If a country’s currency is “cheap,” then the goods made in that country will be cheap for foreigners to buy — in other words, that country’s exports would benefit from a cheap currency. Some politicians support strong exports because demand for a country’s exports can create jobs at home (politicians love that).
One downside to a weak currency is that imports become more expensive to buy. When your currency is “weak” it means foreign currencies are “strong” relative to it. So a country that imports high levels of essential products, like oil, food, or medicine, must be careful that their currency doesn’t get too weak, or else all those imports becoming pretty expensive in their own currency.
How can you “invest” in foreign exchange?
Foreign exchange trading can be very risky and is not appropriate for all investors since it can lead to substantial losses (the only funds that should be invested in the forex market are those that the investor can afford to lose). FX investors should definitely read through the SEC’s investor bulletin about foreign exchange trading to get even more info on all the risks you can face when exchange currencies.
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Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk. To learn more about the risks associated with options trading, please review the options disclosure document entitled Characteristics and Risks of Standardized Options, available here or through https://www.theocc.com. Investors should consider their investment objectives and risks carefully before trading options. Supporting documentation for any claims, if applicable, will be furnished upon request.
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