Foreign Exchange Trading

By: Mel Joelle

In the most basic terms, forex trading is the buying and selling of various currencies for the purpose of profiting from shifts in foreign exchange rates that exists between the different currencies around the globe. Generally considered the most liquid market in the world, forex is most commonly undertaken by two types of market participants – entities who produce goods and wish to hedge their currency exposure and entities who wish to profit by speculating on shifting rates. The composition of this market is similar to the one that exists in the commodities market – the speculators provide the liquidity that makes the market seamless and liquid. An additional common feature is that both market employ contracts that utilize large amounts of leverage to allow participants to control significant positions with limited capital. The most closely tracked currencies are the British pound, the U.S. dollar, the Euro, the Australian dollar, the Canadian dollar, the Japanese yen, and the Swiss franc.

Foreign exchange rates describe the relative value of one currency to another within the global community. While there is no central location or clearing house for forex trading, tens of thousands of traders make millions of trades per day. The basis for describing this as the most liquid market in the world is that over a trillion dollars change hands each day; the forex market is often said to be the only example of perfect competition currently in practice. In addition to futures trading, spot trades (trades done at existing rates), and forward trades (private transaction done between large institutions) there are other vehicles through which currencies change hands daily.

Some factors that influence the foreign exchange relationships between various currencies are the interest rates in each of the respective countries involved, levels of GDP, and both the observed and expected levels of inflation.

Relative interest rates help a trader determine the relative return available in each currency; this rate is most often reflected in the rate paid by long-term government securities in each country. The securities that pay the higher effective rate are the more attractive of the two. Acting as a countervailing force is inflation – where the interest received on an investment increases the amount of purchasing power an individual has over time, inflation erodes that purchasing power.

The interplay between interest rates and inflation act against each other within a given currency’s strength in the market, and across currencies. Essentially, a trader is in the business of shifting his or her assets into the currency that is believed to be the best and most reliable store of purchasing power over time.

Inflation expectations can be as, if not more, powerful than measured inflation. This is largely due to the fact that the trader is interested in what will happen while he or she owns the currency, not what has already happened. Similarly, GDP is an important factor because it speaks to the overall health and outlook on the country in which a trade is being placed. Stability is critical to the long-term success of a given trade.

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