Introduction
In 1967, a college professor by the name of Milton Friedman asked a Chicago bank for an unusual loan. Like most bank customers, he wanted to borrow money but that wasn’t the unusual part of the story. He wanted his loan denominated in British Pound Sterling. Why did he insist on borrowing this specific foreign currency?
Friedman believed the currency’s price was too high relative to the US Dollar. If he took out a loan in British Pounds and the price of that currency did actually fall, he could pay back the loan with cheaper pounds thus making a profit.
To understand the mechanics of turning a profit from the transactions, assume the exchange rate at the time was two US Dollars per British Pound. That means a customer must give the bank two US Dollars in order to receive one British Pound. Now, the key to understanding how one makes money from the British Pound falling is to realize that any bank loan must be paid back in the same currency. For example, if Friedman borrowed, say 10,000 British Pounds, he must pay back 10,000 British Pounds (plus a little bit of interest). He does not pay back the loan in US Dollars.
Once Friedman received the 10,000 British Pounds from the bank, he would immediately convert them to 20,000 US Dollars. Remember, his contention is that the British Pound will fall in value so he therefore does not want to be holding British Pounds. Instead, he will exchange them for US Dollars. However, he still owes the bank 10,000 British Pounds.
Now assume the British Pound falls, as he expected, so that it is only worth 1.90 US Dollars. This simply means that a customer must now give the bank only $1.90 in order to receive one British Pound. Because a customer can now buy British Pounds for less money, we say the pound has fallen against the dollar; it is worth less money than at the previous $2 exchange rate.
If that happens, Friedman would be holding 20,000 US Dollars and could pay back the original 10,000 British Pound loan for less money. At an exchange rate of 1.90, he must pay 19,000 US Dollars in order to receive 10,000 British Pounds with which he can repay the loan. After repaying the loan, he’d be left holding a $1,000 profit.
Why did Friedman believe the pound would fall against the dollar? Friedman was no novice to economics; he won the Nobel Prize for his Quantity Theory of Money and there were many economic conditions lining up that led him to believe the British Pound would fall against the dollar.
Despite his credentials and sound reasoning for currency to fall, the bank refused the loan due to the Bretton Woods Agreement, which was established more than twenty years earlier. That agreement fixed national currencies against the US Dollar, and set the Dollar at a rate of $35 per ounce of gold.
The Bretton Woods Agreement was designed to create international monetary stability by preventing money from flowing across nations and restricting speculation in the world currencies. Under the gold exchange, world currencies became more stable since each had to be backed by the price of gold. Doing so eliminated a common practice used by kings and rulers of arbitrarily devaluing money and creating a heated round of inflation.
Despite the appeal of the gold standard, there were still economic forces that created boom and bust patterns. For example, if one country’s economy strengthened, it imported more goods from other countries. Naturally, this country had to pay for the goods with its currency which had to be backed by gold. Eventually, their gold reserves ran so low that it couldn’t back up its own currency. Consequently, their money supply would shrink and domestic prices would rise. As their prices rose, other countries’ products became relatively more attractive, which caused them to import more goods than export.
Countries participating under the Bretton Woods Agreement agreed to attempt to maintain the value of their currency within a narrow margin against the US Dollar along with the necessary gold to back it. Countries were only allowed to devalue their currency by less than 10% so they could not substantially devalue their currency in order to gain an unfair trade advantage. However, post-war construction created large international trade which led to massive capital movements, which ultimately destabilized foreign exchange rates as set up in Bretton Woods. The Agreement simply was not strong enough to stop the economic currency flows.
In 1971, the Agreement was finally abandoned and the US Dollar was no longer convertible into gold. As a result, major currencies were “free floating” and the prices of all currencies were dictated by the forces of supply and demand. The market deregulation led to trade liberalization. It was the birth of Forex.
What is Forex?
Forex stands for FOReign EXchange and is the market for foreign currencies. (Sometimes you will see it abbreviated as just FX.) Forex traders attempt to make money from the simultaneous buying and selling of foreign currencies much like Milton Friedman in 1967. One of the unique characteristics about Forex is that there is no centralized exchange as there is for the New York Stock Exchange (NYSE) or for the numerous futures firms such as the Chicago Board of Trade (CBOT) or Chicago Mercantile Exchange (CME). Instead, the Forex market is more along the lines of the Nasdaq market where the market is made up of computer terminals and telephone lines among thousands of institutions that trade currencies. And in the late 1990s, Forex was brought to the individual trader so it now includes home-based trading.The Forex market is the largest market in the world and approaches a dollar volume of nearly 1.9 trillion dollars per day according to a 2004 survey from the Bank of International Settlements (BIS). (Although conducted in 2004, this study wasn’t released until 2005 and is one of the most comprehensive and recent sets of data available. It involved 52 central banks and monetary authorities with information being collected from approximately 1,200 market participants.) That’s more than 20 times the dollar volume of the global equity and futures markets combined, 40 times the average daily turnover of the NYSE, and an annual turnover of more than 10 times the world GDP (Gross Domestic Product). That’s nearly $300 per day for every human on Earth.
Within the Forex market there are many types of instruments that can be used. For instance, you can trade futures contracts on currencies just like you can with commodities or with stocks. With the futures markets, traders are buying and selling currencies in the “future” and these instruments are primarily used for hedging activities among large corporations. The futures market for currencies is by far the largest in terms of daily turnover. The next largest market is the “spot” market where traders deal in buying and selling currencies at the going market rate or the price where they can buy in on the “spot.” The spot market is also referred to as the “cash” market.
While individual traders can certainly trade the futures markets, most will trade the spot market. This is very similar to buying and selling stocks. If you think IBM will rise, you buy it at the current market price (spot price). If it rises, you then sell it at the going market price for a profit. This is how the vast majority of currency traders operate.
The “forward” market is similar to the futures with the main exception that forwards are customized contracts usually between banks or other large institutions. Futures contracts are just standardized forward contracts. Individual traders have little reason to trade the forward markets. If you wish to hedge a transaction, you’re better off with the futures market.
There is also an “estimated gap” market, which is primarily used to hedge parallel shifts in the term structures of interest rates. These instruments are definitely only used by banks or other institutions whose profit and loss can be adversely affected by such shifts.
The following chart shows the average daily turnover for each of these instruments. You can see that the spot market accounts for $621 billion out of the $1.9 trillion ($1880 billion), or 33% of the daily turnover.
As previously stated, the spot market is the primary market for most Forex traders for a couple of good reasons. First, the size of futures contracts are fixed, which means there is a substantial minimum amount you must buy or sell. For traders in the spot market, there are no minimum sized lots. Second, the futures market only operates during certain hours while the spot market operates 24-hours per day. Currency dealers can be found in every major time zone with the largest being located in New York, Tokyo, Hong Kong, and Sydney. If news suddenly breaks regarding your trade, you can immediately place a trade to either minimize a loss or lock in a profit. If you have to wait for the opening bell to execute your trade, you may not be so lucky. It is for these reasons that most currency traders use the spot market over the futures market.
Advantages of Forex Trading
Forex traders also enjoy other advantages when compared to those trading stocks or futures, which are outlined below:
No Commissions: There are no brokerage fees nor government clearing fees as there are for stock or futures transactions. However, this does not mean there are no costs. The cost of trading currencies is the bid-ask spread, which we’ll talk more about in detail later. Because of the bid-ask spread, you will buy currency at a price that’s a little higher than it is worth and sell it for a little bit less it’s worth at that time. This is similar to buying retail and selling wholesale. These spreads, however, are very small, much smaller than spreads on stock or futures exchanges so the costs are very low.
High Liquidity: Because of the sheer volume in the Forex market, traders can enter and exit the market under nearly any conditions. The volume does pick up significantly when there are overlaps in time zones but it is still easy to trade regardless of the time of day or night.
Immediate Executions: The high liquidity creates another advantage for immediate executions. The second you click “buy,” you’re in!
No Cornering the Market: Because of the massive volume in the currency market, no person (or business) can corner the currency market. Although it is rare for traders to corner other markets, it does happen. A market is “cornered” when you gain a sufficient control of its supply so that you can manipulate the price. This is what the Dukes were trying to do with the Frozen Concentrate Orange Juice market in the Eddie Murphy hit movie Trading Places. Probably the most famous case was with the Hunt brothers of Texas. In 1973, they were probably the richest family in the U.S. and decided to buy precious metals as a hedge against inflation. At that time, individuals were not allowed to hold gold so the Hunt brothers decided to buy silver in massive quantities. By the late 70s, the brothers had accumulated half the world’s supply of silver. Once the market was cornered, speculators joined in to take advantage of potential large swings. The Hunt Brothers watched their holdings from as low as $1.95 per ounce rise to $54 in 1980. However, due to the Fed intervention and some rule changes at the Commodities Exchange (COMEX), the price of silver began to slide. The biggest slide occurred on March 27, 1980 with the price of silver falling 50% from 21.62 to $10.80. The Hunt brothers declared bankruptcy – along with a lot of speculators.
No Insider Trading: The Forex market is unique in that its prices cannot be manipulated by insider trading or by a corporation’s comments. The prices of currency are one of the purest forms of “perfect competition.”
Not Correlated to Stock Market: Currencies are not correlated with the overall stock market, which makes them a great tool for diversification.
Low Margin Requirements: In order to buy or sell currencies, you post a small amount of money, called margin, as collateral. By depositing a small amount of money though, you can control a very large amount. Most firms allow 100:1 leverage, which means you can control $100,000 worth of U.S. currency by only depositing $1,000. This low margin requirement provides tremendous leverage meaning that you can get large gains from very small movements in a currency’s price. Always remember though that leverage is a double-edged sword and can cut both ways. You are never required to use this much leverage but it is available for those who do. However, currencies do not usually undergo substantial changes in value so this leverage is usually necessary to make trading worthwhile.
Limited Decisions: If you trade stocks, you would have to sift through over 5,000 companies to fully determine the best investments for you. With currencies the job is much easier because there are only seven major currencies to choose from. If you include cross currencies, which we’ll talk about later, there are roughly 15 different pairs that are commonly chosen.
Now that you understand the basics of Forex, let’s take a closer look at how you can participate in this fascinating, rapidly growing market.