Introduction To Foreign Exchange.pdf

Introduction To Foreign Exchange

A Little History

The purpose of this ebook is to introduce the forex market to you. As with many

markets there are many derivative of the central market such as futures, options

and forwards. For the purpose of this book we will only be discussing the main

market sometime referred to as the Spot or Cash market.

Before we begin , let's review what is now being called the "Perfect" trading platform.

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About Forex

The Forex market has quickly become the world's largest financial market, with an

estimate daily turnover of $3.2 trillion. It is a market that has great appeal to a

financial trader because of its volume which guarantees liquidity. High liquidity

means that a trader can trade whatever currencies he feels like at all times, since

there will always be someone to buy and sell any currency he wants. Another

outstanding feature of the forex market is that it is active 24 hours a day and is

closed only on the weekends. This means that unlike the stock market for example,

traders in the forex market don't need to wait for a bell to ring, but can make trading

decisions around the clock.

Enter the internet into the equation. Now the forex market is literally at your

fingertips. Most brokers offer online trading facilities which enable you to trade

simply by clicking a button, instead of the traditional phone call. The internet has

really revolutionized the industry, making the retail section of the market more

dominant than ever.

About eToro

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It's important to mention that eToro also offers an educational experience, so

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Watch Video!

What’s Different?

Unlike many other securities (any financial instrument that can be traded) the FX

market does not have a fixed exchange. It is primarily traded through banks,

brokers, dealers, financial institutions and private individuals. Trades are executed

through phone and increasingly through the Internet. It is only in the last few years

that the smaller investor has been able to gain access to this market. Previously the

large amounts of deposits required precluded the smaller investors. With the

advent of the Internet and growing competition it is now easily in the reach of

most investors.

You will often hear the term INTERBANK discussed in FX terminology. This

originally, as the name implies was simply banks and large institutions exchanging

information about the current rate at which their clients or themselves were

prepared to buy or sell a currency. INTER meaning between and Bank meaning

deposit taking institutions normally made up of banks, large institution, brokers or

even the government. The market has moved on to such a degree now that the

term interbank now means anybody who is prepared to buy or sell a currency. It

could be two individuals or your local travel agent offering to exchange Euros for

US Dollars. You will however find that most of the brokers and banks use

centralized feeds to insure reliability of quote. The quotes for Bid (buy) and Offer

(sell) will all be from reliable sources. These quotes are normally made up of the

top 300 or so large institutions. This insures that if they place an order on your

behalf that the institutions they have placed the order with is capable of fulfilling

the order.

Now although we have spoken about orders being fulfilled, it is estimated that

anywhere from 70%-90% of the FX market is speculative. In other words the

person or institution that bought or sold the currency has no intention of actually

taking delivery of the currency. Instead they were solely speculating on the

movement of that particular currency.

Source: Bank For International Settlements http://www.bis.org Extract From The

Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity.

Currency 1989 1992 1995 1998 2001

US Dollar 90 82.0 83.3 87.3 90.4

Euro . . . . 37.6

Japanese Yen 27 23.4 24.1 20.2 22.7

Pound Sterling 15 13.6 9.4 11.0 13.2

Swiss Franc 10 8.4 7.3 7.1 6.1

As you can see from the above table over 90% of all currencies are traded against

the US Dollar. The four next most traded currencies are the Euro (EUR), Japanese

Yen (JPY), Pound Sterling (GBP) and Swiss Franc(CHF). As currencies are traded in

pairs and exchanged one for the other when traded, the rate at which they are

exchanged is called the exchange rate. These four currencies traded against the US

Dollar make up the majority of the market and are called major currencies or the

majors.

Market Mechanics

So now we know that the FX market is the largest in the world and that your

broker or institution that you are trading with is collecting quotes from a

centralized feed or individual quotes comprising of interbank rates. So how are

these quotes made up. Well, as we previously mentioned currencies are traded in

pairs and are each assigned a symbol. For the Japanese Yen it is JPY, for the Pounds

Sterling it is GBP, for Euro it is EUR and for the Swiss Frank it is CHF. So, EUR/USD

would be Euro-Dollar pair. GBP/USD would be pounds Sterling-Dollar pair and

USD/CHF would be Dollar-Swiss Franc pair and so on. You will always see the USD

quoted first with few exceptions such as Pounds Sterling, EuroDollar, Australia

Dollar and New Zealand Dollar. The first currency quoted is called the base

currency. Have a look below for some example.

Currency Symbol Currency Pair

EUR/USD

Euro / US Dollar

GBP/USD

Pounds Sterling/ US Dollar

USD/JPY

US Dollar / Japanese Yen

USD/CHF

US Dollar / Swiss Franc

USD/CAD

US Dollar / Canadian Dollar

AUD/USD

Australian Dollar / US Dollar

NZD/USD

New Zealand Dollar / US Dollar

When you see FX quotes you will actually see two numbers. The first number is

called the bid and the second number is called the offer (sometimes called the

ASK). If we use the EUR/USD as an example you might see 0.9950/0.9955 the first

number 0.9950 is the bid price and is the price traders are prepared to buy Euros

against the USD Dollar. The second number 0.9955 is the offer price and is the price

traders are prepared to sell the Euro against the US Dollar. These quotes are

sometimes abbreviated to the last two digits of the currency such as 50/55. Each

broker has its own convention and some will quote the full number and others will

show only the last two. You will also notice that there is a difference between the

bid and the offer price and that is called the spread. For the four major currencies

the spread is normally 5 give or take a pip (will explain pips later)

To carry on from the symbol conventions and using our previous EUR quote of

0.9950 bid, that means that 1 Euro = 0.9950 US Dollars. In another example if we

used the USD/CAD 1.4500 that would mean that 1 US Dollar = 1.4500 Canadian

Dollars.

The most common increment of currencies is the PIP. If the EUR/USD moves from

0.9550 to 0.9551 that is one Pip. A pip is the last decimal place of a quotation. The

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