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Educational Article

Foreign Currency Trading Basics

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Two weeks ago, we did a column on how a preponderance of small traders (most of us) could trade foreign currencies right here in their own USA bank account. Tonight we're going to add some detail and dive deeper into the universal basics of foreign exchange as it really happens in the entire world.

For those that missed that last article, "Currency Trading Simplified, you can find it here.

http://www.optioninvestor.com/page/oin/education/opt101/2003/04-03.html

Before you tune out thinking, "This can't apply to me. I'm a small-fry", realize this stuff is really simple, and is all about profiting, or at least preserving the value of some hard-earned dollars through currency swapping.

Think currency swapping is all about smoke, lights, mirrors, derivatives, and other forms of higher math that obfuscate white-collar criminal behavior? Not so. Think of it as going to a grocery store and swapping dollars for coffee, bread, cotton swabs, plant food. . .whatever. Only instead of all those things, you are going to swap dollars for another countries currency. Pick what you like off the shelf and the rest happens at the checkout counter!

First off, let me extend full credit and a huge amount of gratitude for what I'm about to plagiarize, err, write. The following comes from OzForex, "a leading Australian foreign exchange provider".

http://www.ozforex.com/

In short, I'm going to use their words (mostly), and very few of mine. However, by no means is this a recommendation or endorsement of their services. It's just that their information was well-written and simple to understand. So here goes!

As noted above, foreign exchange is essentially about exchanging one currency for another. The complexity arises from three factors. First, what is the foreign exchange exposure? Second, what will be the rate of exchange? Third, when does the actual exchange occur?

Identification of Foreign Exchange Exposures

Foreign exchange exposures arise from many different activities. A traveler going to visit another country has the risk that if that country's currency appreciates against their own their trip will be more expensive.

An exporter who sells its product 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. An importer who buys goods priced in foreign currency has the risk that the foreign currency will appreciate thereby making the local currency cost greater than expected.

Fund Managers and companies who own foreign assets are exposed to falls in the currencies where they own the assets. This is because if they were to sell (repatriate) those assets their exchange rate would have a negative effect on the home currency value.

Other foreign exchange exposures are less obvious and relate to the exporting and importing in one's local currency, but where exchange rate movements are affecting the negotiated price.

Generally the aim of foreign exchange risk management is to stabilize the cash flows and reduce uncertainty from financial forecasts. Fortunately there are hedging instruments that achieve exactly that.

Spot and Forward Foreign Exchange Contracts

The most basics tools of FX risk management are 'spot' and 'forward' contracts. These are contracts between end users and financial institutions that specify the terms of an exchange of two currencies. In any FX contract there are a number of variables that need to be agreed upon and they are:

1. The currencies to be bought and sold - in every contract there are two currencies, the one that is bought and the one that is sold.

2. The amount of currency to be bought or sold.

3. The date at which the contract matures.

4. The rate at which the exchange of currencies will occur.

It is point three that requires further explanation. Whenever you see exchange rates advertised either in the newspapers or on the various information services, the rates of exchange assume a deal with a maturity of two business days ahead. A deal done on this basis is called a spot deal.

In a spot transaction the currency that is bought will be receivable in two days whilst the currency that is sold will be payable in two days. This applies to all major currencies with the exception of the Canadian Dollar.

However most market participants want to exchange the currencies at a time other than two days in advance but would like to know the rate of exchange now. For example if Australian firm, ABC Ltd. had contracted to purchase a machine for the price of $1 million (USD 1 mil) payable in 6 months time, but wanted to be sure that the USD would not become too strong in the interim, ABC Ltd could agree now to buy the USD for delivery in 6 months time. In other words ABC Ltd. could negotiate a rate at which it could buy USD at some time in the future, setting the amount of USD needed, the date needed etc. and hence be sure of the Australian Dollar purchasing price now.

In determining the rate of exchange in six months time there are two components:

1) The current spot rate

2) The forward rate adjustment

The spot rate is simply the current market rate as determined by supply and demand. The forward rate adjustment is a slightly more complicated calculation that involves the interest rates of the currencies involved.

Let us make a few assumptions about the markets:

AUD/USD spot rate: .6600
AUD 3-month interest rates is 6 %
USD 3-month interest rates 6.5 %

Now what is the forward adjustment that is made and why?

The forward rate can be calculated as follows: Forward rate = (.6600+(.6600*.065*90/360)) / (1+(1*.06*90/365)) = .66095 This equation may look a little complex at first. But in practice your financial institution will calculate it for you.

If you defer the value date of a spot transaction, each party will have the funds that they would have paid to invest. The person who sold Australian Dollars has those Dollars to invest for 90 days which assuming it was A$100 would equal A$ 101.4795. The person who sold US Dollars has those Dollars to invest for 90 days, which assuming it was USD 66 would equal USD 67.0725 at the interest rates above. The forward rate is calculated simply by dividing 67.0725 by 101.4795 equaling .660947. If the forward rate was not calculated as such, one party would be receiving an unfair advantage by deferring the exchange of currencies.

Purchasing Foreign Currency

The actual purchase of foreign currency is a simple procedure. If ABC Ltd knows that it will need USD 1 million in three months time and believes that the best time to buy the USD is now, all that is required is that ABC Ltd telephone or fax their foreign exchange service provider and a forward deal can be entered into.

There are two components to the price in forward transaction and they are the spot price and the forward rate adjustment.

For example:

The current market rate is 0.6600.
The forward point adjustment for 3 months is +.00095.

Therefore the forward rate would be .6600+0.00095= 0.66095.

The deals are totally flexible as to the maturity date, the size of the transaction and as to currency involved.

Also it just takes another phone call to change the payment date if there is some delay in receiving the goods.

Once the deal is done, then the rate is fixed and ABC Ltd knows the Australian Dollar cost of purchasing those materials. When it comes time for payment, the foreign exchange contract is delivered. This means that the foreign currency amount is sent to the raw materials supplier. At the same time ABC Ltd's bank sends a debit note to ABC Ltd for an Australian Dollar amount, which represents the cost of the raw materials.

That's the mechanics of the whole thing. It's really pretty simple. But, what about the market risks and daily fluctuation of various currencies? How are exchange rates actually determined?

For that, Clearview Capital Management offers the answer.

"The potentials of Forex Market are phenomenal and best realized when one understands what causes it to move. The foreign exchange market is dominated by economic conditions and political situations; these conditions and situations often result in very clear and sound fundamental economic policies. The important thing to realize is that these economic policies are not put in place for a short term (a week or a month). They are often put in place for months on end, even years. These fundamentals cause clear and well-defined trends."

"These fundamentals are not a secret - they are known and announced to the world. Because of its size, the FX market is not a subject to insider trading or manipulation. Because of its size and vast global participation, it has been called the fairest market on earth, as well as the largest."

"The strength of currencies is affected by political situations and economic factors of that country. When governments make decisions, markets react. Exchange rates rise and fall as traders around the world cast votes of confidence (or lack of it) in currencies - and in effect - countries. Foreign investments will flow into countries with prolonged economic and political stability and out of those that are rapid or uncertain."

"Indirectly, we are all passive currency investors. Every asset acquisition, product purchase or financial investment in equity, credit or money markets, places a residual value in a selected currency or group of currencies. If it's a U.S. Dollar-denominated asset, a conscious choice is made not to own assets denominated in Euro, Japanese Yen, British Pounds or Swiss Francs. Our investment choice automatically becomes dependent on the global market value of the selected currency. If we are invested in a mutual fund that invests in foreign stocks, we are already in the currency markets. That's because to buy foreign stocks, we have to use the underlined local currency. The currency is then exchanged back for Dollars when we take profits."

"There is a risk to keeping all of our assets in U.S. Dollars. If the Dollar depreciates with respect to other currencies, the value of our investment portfolio, earning capacity and purchasing power also becomes weaker."

As a point of reference, in two decades, the Dollar has lost about 75 percent of its value when compared against the Japanese YEN, Swiss Frank, and the EURO, according to CCM, which is not very reassuring.

However, we have noted in past articles on gold that competing currency devaluations will likely prevent any one currency from depreciating too far against other major currencies since there is strong desire for products denominated under any specific currency to remain competitive on the open market. Meanwhile, gold remains the only stable currency against which all others are measured. Hence the strong case for gold under competitive devaluation scenarios. But that's a whole 'nother story.

But back to currency exchange. . . it is still very possible in a micro-sense to trade one currency for another in a game of arbitrage for profit. In future columns we'll look at the relationships between currencies on the charts to see what opportunities might exist from time to time in which we might garner some profit.

Questions are always welcome. That's it for today. Until next time, make a great weekend for yourselves!

Buzz



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