Introduction

to Forex

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What is the
FX market?

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1. Introduction to Forex

What is the FX market?

FX or Forex is an acronym for foreign exchange.
The FX market is a market where you can trade, or exchange, currencies. It is an
over-the-counter market which means the exchange does not have a central
physical place and it is decentralised.

The FX market is open 24 hours a day, 5 days a week. No trading activity takes
place on weekends, starting from midnight Friday until midnight of Sunday.

A typical forex day has three main sessions, which facilitate an endless flow of
transactions throughout the day. The Asian session is the forerunner and starts
around midnight GMT+2 time where the Sydney and Tokyo markets make an
early start. Then follows the European session which starts around nine o’clock in
the morning where the Frankfurt, and soon after, London markets opens. Finally,
the American session begins around four o’clock in the afternoon where the NY
stock exchange opens and carries us through until midnight when the next Asian
session is to start.

The foreign exchange market is by far the world’s largest market with a daily
turnover of around 6.6 trillion US dollars. Due to its enormous daily turnover
and high liquidity, it is preferred by traders across the world since there are
tremendous opportunities for profit making.

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Key Players in the
Forex Market

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2. Key Players in the Forex Market

FX Market Participants
Who is actually participating in the FX market and how is the impressive size of the
daily volume turnover being generated?

National Governments and central banks

conduct their operations through the FX market day in, day out. They might go as far
as intervening in the FX market either to strengthen or to weaken their currency by
buying it or selling it respectively and to readjust their foreign exchange reserves.

The second category

includes commercial banks and other financial institutions which settle the foreign
exchange needs of their customers. For example, settling transactions for imports
and exports, and for small-scale transfers and transactions with other banks. Other
financial institutions could include hedge funds, investment managers which may
also interact in the FX market with relatively high volumes.

The third category

includes companies repatriating profits as well as multinational corporations.
For example, Toyota has a factory in the UK and at the end of the year it wants
to repatriate the profits of the year back to the mother company in Japan. It will
have to go through the FX market to be able to convert the gains made in pounds
to Japanese Yens in order to send it back home. Or a multinational corporation
company may want to send funds from a branch in one country to a branch in
another company.

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2. Key Players in the Forex Market

The fourth category

is investors buying assets in foreign countries. For instance, if a European investor
wants to invest in a US stock-exchange, they will have to change their Euros into US
Dollars to be able to invest in anything in the US.

The fifth category is speculators.

Speculation is the practice of engaging in risky financial transactions in order
to profit from short-term fluctuations in the market value of a tradable financial
instrument.

And last but not least, tourists and travellers.

On an individual basis, tourists do not have a substantial impact on the market but
at certain points of time specific tendencies in the tourism industry could overspill
in the FX market. The seasonal effect observed over the summer period where
tourists from around the world flock popular tourist destinations in Southern Europe
for example and exchange their respective domestic currencies to Euros to spend
during their vacation.

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Currencies and
Currency Pairs

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3. Currencies and Currency Pairs

Currencies and Currency Pairs

Sorting by influence, importance and largest trade volumes, the key currencies
are the USD for the US dollar, EUR for the Euro, GBP for the UK pound, AUD for the
Australian Dollar, CAD for the Canadian Dollar and CHF for the Swiss Franc.
That being said, however, there are hundreds of other currencies in circulation, with
nearly all the countries of the world holding their own domestic currencies, with a
notable exception being the Eurozone whose most members chose to adopt the
Euro as their own.
The International Organisation for Standardisation (IOS) lists each and every
currency abbreviation and market participants are well versed when it comes to
currency abbreviations for convenience of reference.

How are currencies traded?

A viable example to conceptualise how currencies are traded is by using the
analogy of buying or selling stocks. Hence, if you are convinced that the company
A is performing well, you buy shares in the company with the expectation that the
share price will increase in value. In FX, instead of buying shares of companies, you
buy “shares” of countries, in other words, currencies. If you believe that the economy
of a specific country is doing well, you expect its currency to appreciate so you buy
the specific currency.

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Exchange rates, base
and quote currencies

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4. Exchange rates, base and quote currencies

Exchange rates, base

and quote currencies
Currencies come in pairs and when two currencies are bundled together, they
form a unique bond. This is also known as the exchange rate or FX rate. The FX
rate explains the relationship of the two currencies in terms of value, in a specific
period of time. It is the rate of which, one country’s currency can be exchanged for
another currency.

Each currency pair is made up by the base currency and the quote currency.

Example: EUR/USD
The Euro is the base currency, and the US dollar is the quote currency. The base
currency is always on the left-hand side, while the quote always lies on the right.
Another thing to note is that, the base currency is always denominated in a single
unit of the currency pair, in our case, the Euro, while the quote currency fluctuates
in value, in this case the US dollar.
The current FX rate of EUR/USD is 0.9900. This means that 1 euro can be
exchanged for 0.99 US dollars.

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Example FX pairs

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5. Example FX pairs

FX Pairs and How They Work

Example:

As mentioned before, FX pairs give rise to the rate at which we can exchange one
currency with another.

Using EUR/USD as an example, we note that currently the exchange rate is at 0.99.
This means that 1 Euro can be exchanged for 0.99 US dollars at this specific point in
time.

If you are a European citizen who wants to travel to the United States for holidays,
you will have to exchange your Euros into US Dollars, in order to be able to spend
it while you are there. Exchanging 1000 Euros given that the current rate is 0.99 will
result in 990 US Dollars.

Now, imagine you will travel again to the US in two months’ time and for the sake of
example the EUR/USD exchange rate is 0.95. That means exchanging 1000 Euros will
give you 950 US Dollars. That leaves you with 40 US Dollars less to spend, compared
to your previous trip.

This means that in our hypothetical scenario the Euro depreciated relative to the US
Dollar and the US dollar appreciated against the Euro.

US Dollar since your last visit, or in retrospect, the US dollar appreciated against the
euro.

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6
How to trade Forex

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6. How to trade Forex

How to trade Forex

Trading forex refers to buying a currency and at the same time selling another with
the expectation that the currency bought will rise in value, or the currency sold will
go down.

Note, that each currency pair has two currencies. As we mentioned previously, the
one noted on the left-hand side is the base currency and the one noted on the right-
hand side is the variable currency or the quote currency. There are two positions a
trader may open to start trading. The trader is either going to buy the pair, what the
market calls ‘go long’ which involves buying the base currency and at the same time
selling the variable currency. Alternatively, the trader can ‘go short’, which means he
is going to sell the base currency and buy the variable currency.

For example
When you buy EUR/USD you buy euros and sell dollars. On the other hand, when you
sell EUR/USD you sell euros and buy dollars. Let’s assume that you buy 1,000 Euros,
with the exchange rate of EUR/USD currently being at 1.0500. To buy 1,000 Euros,
you would require 1,050 US Dollars, given the current exchange rate. Let’s assume
that you make the transaction and after a week the EUR appreciates or the USD
depreciates, and the exchange rate goes up from 1.0500 to 1.0800. If you change
your Euros back into US Dollars that would mean that for the 1,000 Euros you are
now selling you would get 1,080 US Dollars giving you a small profit of 30 US Dollars
($1,080-$1,050=$30).

If instead of buying EUR/USD, you sold EUR/USD (i.e., bought dollars and sold euros),
then for the trade to be profitable, EUR/USD would have to go down, and to realise
profits the opposite action would have to be performed (i.e., buy EUR/USD back).

Never forget that your aim is to buy the currency that you expect will appreciate in
value and sell the currency you expect to depreciate.

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7
Classification
of FX pairs

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7. Classification of FX pairs

Classification of FX pairs
Currency pairs are split between three main categories: majors, minors and exotics.
The major currency pairs have the US Dollar on the one side, either left or right. This
is because the US Dollar is considered to be the world’s reserve currency since the
U.S. and its allies agreed, at the 1944 Bretton Woods conference to peg it to a rate of
$35 per ounce of gold. Despite the agreement being superseded by the free market
system, the US Dollar is still considered the global reserve currency. The major
currency pairs are the most frequently traded pairs in the world, and they constitute
the largest share of the foreign exchange market.
Examples of major currency pairs include the EUR (€) against the USD ($), the USD
against the JPY (¥), the GBP/USD (£), the USD/CHF (₣), the USD/CAD (C$) and the
AUD/USD (A$).

The second currency category is the cross-currency pairs or minor currency pairs.
These are currency pairs that do not include the USD and are also called “cross
rates” or “crosses”. They are also known as “minors” and the most actively traded are
derived from the three major non-USD currencies: these are the EUR (€), the JPY (¥),
and the GBP (£).
For example: EUR/GBP, GBP/JPY, EUR/CAD.

The third currency pair category is the exotic currency pairs. These currency pairs
are made up of one major currency paired with the currency of an emerging
economy or a small economy from a global perspective, such as Hong Kong or
Brazil, and several European countries outside the Eurozone. Such pairs include
the US Dollar against the South African Rand, or the US Dollar against the Turkish
Lira, or the Euro against the Czech Krona (Kč). It should be noted that although
exotic currency pairs may provide higher profits, their volatile and sometimes
unpredictable nature may prove a drawback for such trades. Also, the low liquidity
and higher spreads are other issues which traders of such pairs may have to face.

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