Understanding the Foreign Exchange Market can seem intimidating. Which is why many businesses and individuals seek to avoid “having to deal with FX.” In my 15 years advising corporations on FX risk the most common phrase I heard was ‘we don’t have any FX risk because only deal in US Dollars”. That’s a nice thought, but if you are doing business outside of your home country you have FX exposure. Which is why it’s important to understand the FX market.
The Importance of Understanding the Foreign Exchange Market
FX exposure comes from many places. It could be direct exposure like the rising cost of a product sourced internationally. Or indirect, like weakening demand from global customers due to the weakening value of their currency.
Some risks are easy to see and manage. Others are much harder. But the first step in taking control of your FX risks is understanding the FX market. The FX markets are the most liquid in the world. And there are a number of simple solutions for managing risk. Doing so can make life easier for you, your customers and your suppliers. In the article below we are going to provide a basic understanding of the FX markets and how they work.
Simply put, the FX market is huge. Estimates put global daily currency trading volume around $4 trillion.
Most of that volume is traded on what is known as the interbank market. The interbank market is made up mostly of (you guessed it) banks. Banks trade among themselves via a number of electronic trading platforms. And they generally on behalf of their corporate customers. The interbank market has no central exchange and is essentially open 24/7/365. Because all that’s needed to make a market are 2 banks want to agree on a trade.
More practically speaking there is generally meaningful market liquidity from 3pm ET Sunday through 5pm ET Friday.
Another important thing to know is that the FX market is incredibly liquid. The typical interbank transaction is in blocks of $1 million and a trade in the hundreds of millions of dollars can be cleared in a matter of minutes.
There are essentially three types of FX trades: Spot, forward and options.
What is a spot FX trade?
The most basic FX trade is a spot trade. A spot trade is simply the exchange of two currencies at an agreed price (rate) for settlement either one or two days after the trade date. This type of trade is done by people or businesses needing to exchange currency now.
What is an FX forward?
A forward is an obligation to buy or sell a specific currency at a specified rate for settlement in the future. The rate doesn’t change regardless of market movement and both participants have an obligation to settle as agreed.
What is an FX option?
Unlike a forward an FX option gives the holder the right but not the obligation, to buy or sell a specific amount of currency at a predetermined rate for a settlement at a specific date in the future.
Options and forwards are tools used to manage currency risk, providing more predictability of future exchange rates and limiting uncertainty.
There are many variations of both options and forwards available in the market. These variations can help companies manage unique exposures that traditional forwards or options may not adequately cover.
What if I need these services for my business?
Most large banks have currency trading desks available for their clients. These can be a good resource for managing risk and making international payments.
The FX markets are driven by many factors, which can make predicting their next move quite difficult. The most important thing to remember is that unlike other asset classes where prices are absolute, currency rates are relative to another currency. A currency may rise against one currency and fall against another. The Euro may rise against the US Dollar while simultaneously falling against the British Pound. Remember, it’s not what the market thinks of the value of one currency, it’s the value of that currency relative to another. This is why each market mover must be taken in consideration relative to another currency.
How interest rates impact currency rates
Generally speaking there are several factors that drive the currency markets. The most significant factor is interest rates and interest rate differentials. Investors prefer to borrow (sell) in low yielding currencies (countries with low interest rates) and invest (buy) in higher yielding currencies (countries with higher or rising interest rates). That’s why the currency markets watch central bank actions so closely. In the US the central bank is the Federal Reserve, in the Eurozone it’s the ECB, in the UK, the Bank of England, just to name a few.
But what drives interest rates?
Economic data is closely monitored country by country because of the impact that data can have on interest rates. And the impact of that data on interest rates can have an immediate impact on currency rates. Economic data including unemployment, GDP, and inflation (CPI, PPI) give market participants insights in to the overall direction of the economy and as a result potential future of interest rates moves.
What else can move the market?
Other factors can have an impact as well. There are currencies that are heavily dependent on their political stability or lack thereof. The US, Switzerland and Japan all benefit from traditionally stable environments and serve as a safe haven for investors during times of global unrest. Those currencies often rise in value against others during geopolitical turmoil. Other countries can see their currencies punished for political unrest, as we’ve seen recently in Turkey and see often in places like Argentina and Brazil.
The global FX market is the most liquid market in the world. It can be a powerful tool for growing your business and improving margins. Growing your business internationally has many benefits. Don’t let currency get in your way. Understanding the Foreign Exchange market is the first step in growing your business.