Has always been a crucial market for conducting business and foreign trade. How it takes place and how the currency (Foreign exchange, FOREX) market actually works interests many traders and investors. And in order to understand the essence and functions of the global currency market, one should look at the historical context, and events that led to the formation of the global currency markets as we observe them today. The history of the global currency markets (FOREX – Foreign Exchange or the “FX” market) has been shaped by two particular highly important historical events which have placed a deep stamp on its formation and development. These two historical events are the creation of Gold Standard System and the Bretton Woods agreement.
Was formed in 1875. The main idea behind it was that governments guaranteed that a currency would be backed by gold. All the major economic countries defined an amount of currency to an ounce of gold as the value of their currencies in terms of gold and the ratios for these amounts became the exchange rates for these currencies. This marked the first standardized means of currency exchange in history.
The Bretton Woods agreement of monetary management established the rules for commercial and financial relations among the U.S, Canada, Western Europe, Australia and Japan in the mid-20th century. The Bretton Woods system was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states. The chief features of the Bretton Woods system were an obligation for each country to adopt a monetary policy that maintained the exchange rate by tying its currency to gold and the creation of an entity named the International Monterey Fund the IMF to bridge temporary imbalances of payments. Preparing to rebuild the international economic system at the end of World War II, 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire, in the United States for the United Nations Monetary and Financial Conference, also known as the Bretton Woods Conference.
The United States, which controlled two thirds of the world’s gold, insisted that the Bretton Woods system rest on both gold and the U.S dollar. The key to this system (Agreement) was a fixed exchange rate between countries whose currency values were all pegged to the U.S dollar, and the U.S dollar’s convertibility to gold at a fixed rate of $35 dollars per ounce.
This effectively made the U.S dollar the world’s reserve currency as it took on the role that gold had formerly played under the gold standard. In addition to becoming the world’s currency, it’s interchangeability with gold made it the currency with the highest purchasing power. Also, the way other currencies were pegged to it, each with its own fixed rate, meant that the majority of international transactions were denominated in U.S dollars.
Taking into account that in the wake of WWII the European powers most affected by the conflict were also heavily in debt to the United States, the geopolitical and economic climate was absolutely ideal for the rise of the United States as the world’s superpower. While Britain had been the dominant economic force in the 19th and early 20th century, with the Pound Sterling taking pride of place as the world’s reserve currency during this period, the second half of the twentieth century would see dominance passing to the United States and the U.S dollar.
On 15 August 1971 in later stages of the Vietnam War (Economic costs of the war, causing the U.S large budget deficits), the United States unilaterally terminated convertibility of the U.S dollar to Gold, effectively bringing the Bretton Woods system to an end and rendering the dollar a fiat currency.
Fiat currency by definition is legal tender whose value is backed by the government that issued it. The U.S. dollar is fiat money, as are the Euro and many other major world currencies. This approach differs from money whose value is underpinned by some physical good such as gold or silver, called commodity money.
The U.S dollar’s relationship to gold proved to be the real problem that would eventually lead to dismantling of the Bretton Woods agreement. Economists foresaw this more than a decade in advance, and indeed the problem of keeping gold at U.S $35 per ounce was a real issue as far back as the late 1950’s. This action, referred to as the Nixon shock (U.S President Richard Nixon), created the situation in which the U.S dollar became a global reserve currency used by many countries. At the same time, many fixed currencies (such as the pound sterling, for example) also became free-floating (Traded on the open global markets).
The delegates by signing the Bretton Woods agreement, promoted a system of rules, institutions, and procedures to regulate the international monetary system, these accords established the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), which today is part of the World Bank Group. Essential to the agreement was an international system of payments to facilitate trade with safeguards in place to prevent large fluctuations in currencies value or competitive devaluations. For all these reasons Bretton Woods was a major milestone in the development of the foreign exchange market, and indeed the global financial system we have today.
The foreign exchange market has become the largest and most liquid of all financial markets and assets traded globally combined. Well over 1.5 trillion (One thousand five hundred Billion) U.S dollars equivalent worth of Spot currency pairs are traded daily among many market participants. The global currency derivatives market which includes Swaps, Options and Forwards trade as high as additional 3 trillion U.S dollar daily (24 hour period Monday to Friday). The total Foreign Exchange market and its derivatives have surpassed 5 trillion U.S dollars worth of transactions per day in 2016.
Foreign exchange market is composed of many different participants, (The “Currency markets”, the FOREX market or FX markets) that trade currencies with differing intentions and purpose. Each of the participants plays its own role in the global currency markets. The main participants in the global currency markets are:
- Governments and Central Banks
- Commercial banks
- Financial institutions & intermediaries
- Pension & Mutual funds
- Hedge funds
- Importers and exporters of goods and service
- Companies with various currency exposures
- Professional Speculators
- Retail (FOREX) traders and investors
The foreign exchange market or currency markets, also known as the “FOREX market” or Foreign Exchange Market or the FX market is mostly a global decentralized marketplace where global currencies are traded. Most of the currency transactions are carried out electronically over-the-counter (OTC), meaning that most if not all trading transactions are performed via computers by traders and other market participants all over the globe.
The trade that takes place in Foreign exchange market involves simultaneously the buying of one currency and the selling of another. This is because the value of one currency is relative to the other currency and is determined by their comparison. From a retail trader’s perspective FOREX trading is the speculation on the value of one currency relative to another.
Exchange rates are the relative values between currencies that belong to different countries or economic regions. When a trader is presented with an exchange rate on Sandton Capital Markets trading platforms, for example the currency pair EUR/USD the quotes provided by the platform is for the value of one currency in relation to the other (in this case the Euro against the U.S dollar). This is why the trader sees two currencies in an exchange rate quote but only one figure; the value of one is determined by how much of it you can buy with the other. It makes no sense to think in terms of absolute values when it comes to currencies as their values are interdependent. This is one of the main differences between trading FOREX (Currency Pairs) and trading equity Indices or commodities on Sandton Capital Markets. The first currency in every pair is called the base currency; this is the one that you are being given the value of. It is also the one on which you are performing the action of either buying or selling when trading currencies. The second currency in the pair is the quote or counter currency, the figure quoted in an exchange rate is denominated in this currency. Essentially when a trader sees an exchange rate they are being informed what the base currency is worth in terms of the quote currency. So when looking at an exchange rate for EUR/USD the trader is being quoted what the Euro is worth in US dollars or more accurately how many US dollars are required to purchase 1 Euro.
A EUR/USD exchange rate of 1.10 means that 1 euro is worth 1 dollar and 10 cents, or that US $1.10 is required to purchase 1 Euro. When EUR/USD rises, this means that the Euro is growing stronger and/or the US dollar is getting weaker. As a currency trader one can position themselves in different ways, taking advantage of any eventuality. A trader can buy, or go long on EUR/USD when they think the Euro is likely to rise, or when the US dollar is likely to fall. A trader can also sell, or short EUR/USD when they expect that the Euro is due to drop in value, or when they think the U.S dollar is about to rise.
Currency traders have the option to buy or sell the base currency within the pair. How exactly does a trader sells a currency pair that he or she do not actually own? The trader has to borrow it from Sandton Capital Markets (Their broker). So if the trader wants to sell, or short, 1 lot (or 100,000) of EUR/USD, then the trader essentially has to borrow it from Sandton Capital Markets before being able to sell it. Doing this means that a trader is expecting EUR/USD to drop in price (Value) so that they can then buy it back at lower price level at a later time, returning those 100,000 units to Sandton Capital Markets, and adjusting the difference in to their account.
All currencies are given a three letter abbreviation known as that currency’s ISO code, in most cases the first two letters refer to the country and the third letter refers to the name of the currency in question. These are: The U.S dollar (USD), the Euro (EUR), the South African Rand (ZAR) the Japanese Yen (JPY), the Great British Pound (GBP), the Swiss Franc (CHF), the Canadian Dollar (CAD), the Australian dollar (AUD), Indian Rupee (INR) and the New Zealand dollar (NZD).
The most commonly currencies traded (Highest daily volume or interest) are known as the majors. Currency pairs from the developed economies that involve the U.S Dollar are called Major Currency Pairs or just the “Majors” as listed below. The Majority of FOREX traders globally are trading the Major Currency Pairs (The Big Dogs). These “Majors” constitute the largest market share of the currencies traded globally over 85%. Therefore the Majors offer the best liquidity and they all are versus the US dollar.
|EUR/USD||Euro Zone/United States|
|GBP/USD||United Kingdom/United States|
|NZD/USD||New Zealand/United States|
Most Currencies and pairs have a nickname. For example, the U.S Dollar is nicknamed the “Buck”. These nicknames vary among major trading centers N.Y, London and Tokyo. Major Currencies and their name designations in the FOREX markets:
|NZD||New Zealand||New Zealand dollar||Kiwi|
Pairs that do not feature the U.S dollar as either base or quote are known as the cross pairs, or “Crosses”. The main currency cross pairs consist of any of the major currencies listed above (That are not paired with U.S dollar) crossed with each other, the most common cross pairs are those which feature the Euro, the U.K’s Pound Sterling, and the Japanese Yen. It is highly important to keep in mind that the Euro is always the base currency in any pair. The Japanese Yen when is traded against the majors is always the quote or the counter currency.
The Euro’s most popular crosses are:
|Euro Currency Crosses||Countries|
|EUR/GBP||Euro Zone /U.K|
|EUR/CHF||Euro Zone /Switzerland|
|EUR/JPY||Euro Zone /Japanese Yen|
The U.K’s Great British Pound’s most popular crosses are:
|GBP Currency Crosses||Countries|
|EUR/GBP||Euro Zone /U.K|
The Japanese Yen most popular crosses are:
|Yen Currency Crosses||Countries|
The Commodity currencies (All major Commodity currencies are named dollars, hence commodity-dolls) are currencies that belong to countries which have a variety of natural resources which dominates these countries economy. As a result, the values of these currencies are somewhat linked to the value of the commodities their economies produce, such as Oil & Natural Gas, Industrial & Precious Metals, and or Agricultural products & Livestock. All currency Commodity-dolls are named dollars.
|CAD||Canada||Oil Sands, Timber, Precious & Industrial Metals & Gems, Timbre, Fertilizers and Aluminum.|
|AUD||Australia||Iron & Metal Ores, Precious & Industrial Metals, Natural Gas, Coal, Meat, and Cereals’.|
|NZD||New Zealand||Dairy, Egg, Meat, Timber, Fruits, Fish, and Cereals’.|
Other Minor currencies are the Nordic or as better known the Scandinavian currencies.
|DKK||Danish Krone (Crown)|
It’s easy enough to reverse an exchange rate. For instance, if a trader wants to find out the value of USD/EUR (how many Euros it takes to purchase one US dollar) all they have to do is divide 1 by the EUR/USD exchange rate (1/1.10 = 0.90). In this example one US dollar can be purchased with 90 Euro cents. In addition to the majors and the crosses there are also the exotic pairs.
Exotic currencies consist of a major currency crossed with a lesser traded currency such as one belonging to an emerging or developing market. Exotic pairs are less liquid and can cost more to trade due to them having wider spreads and higher volatility.
|Exotic Currencies||Currency symbol|
|South African Rand||ZAR|
The two different prices (Bid versus Ask) that a trader sees quoted on their trading platform at Sandton capital Markets for each currency pair are the respective Bid and Ask (or Sell and Buy) prices available for that pair, the difference between these two prices is known as the spread.
The Bid: is the price on the left, this is the price at which you can sell a given currency pair and is the lower of the two prices listed.
The Ask: is the price on the right, it’s the price at which a trader can buy a given currency pair and is the higher of the two prices listed.
Essentially the Bid price tells the trader the most that buyers are prepared to pay for a currency, and the Ask price tells you the least that sellers are prepared to accept to sell a currency at that particular time. All currency transactions involve a Bid/Ask spread. Sandton Capital Markets receives Bid and Ask quotes from large international liquidity providers and by making different banks compete for your trades we select the most competitive Bid and Ask prices available and present them to our clients.
When viewing currency prices on the trading platform traders notice that they are displayed in decimal places. Most of us are accustomed to calculating our country’s currency to two decimal places. This is because as mediums of everyday exchange most currencies have 100 fractional units. There are one hundred pennies to the pound, one hundred cents to the dollar etc. On the FOREX markets changing currency values are calculated by smaller increments. A pip is the name of the smallest increment that currency values can fluctuate by. For most currencies the pip is the fourth decimal place, in the case of the Japanese yen it is the second decimal place. Pips are what will make the difference to traders account balance. This is why it is so important that traders understand them. Pips are important for a couple of reasons. Broker spreads are quoted in pips, so a 2 pips spread means that there is a difference of 2 pips between the Bid and Ask prices on a given currency pair. Once a trader has opened a position each pip moving up (Higher) or down (Lower) will be worth a certain amount of money in to their trading account, depending, of course, on the volume of their position and how much leverage they are using. Successful currency trading can be boiled down to a very simple formula. Make pips; keep pips; repeat.
If a currency pair value changes 3 times between 13:01 and 13:02, these fluctuations can be as small as a single pip but they can also be larger. It could, for instance, jump 3 pips in value from 1.1090 to 1.1093, then drop by a single pip to 1.1092, and then jump by another four pips to 1.1096. Pips are what will make the difference to traders account balance one a currency position has been opened.
The term tick is also used in reference to the direction of the price of a financial asset or product, with an uptick referring to a trade where the transaction has occurred at a price higher than the previous transaction, and a downtick referring to a transaction that has occurred at a lower price.
Trading Volume: refers to the actual size of a trade and is ordinarily calculated in lots. In FOREX a 1 lot represents 100,000 units of a currency, in other words one lot of EUR/USD is a position worth 100,000 Euros. At Sandton Capital Markets Mini and Micro lots available to all traders and are quite popular; a Mini-lot is worth 10,000 units and a Micro-lot is worth 1000 units of the currency being bought or sold. The trading platforms offered by Sandton Capital Markets a Mini Lot trade executed is equivalent to a volume of 0.1 lot (10TH of a lot) on EUR/USD is a position worth 10,000, Euros. An example of 0.01 Lot is considered a Micro-lot is a position worth 1,000 Euros which is 100th of a lot (One Lot 100,000/100).
Very much like people, the Currency pairs (Foreign Exchange, FOREX or the FX markets) have unique behaviors and traits that can be observed and studied over time. This may help us to better understand the nature of their price movements. For instance, volatility in a currency pair, captured by using the standard deviation of price movements in percentage terms, expresses the uniqueness of each pair while revealing the general heartbeat of the FX market. While shared patterns become apparent, each pair’s volatility shows distinct characteristics that can be utilized by currency traders. Analyzing these findings may not only broaden a trader’s knowledge of the FOREX market, but also improve their trading methodologies.
In the currency markets Volatility refers to the amount of uncertainty or risk involved with the size of changes in a currency exchange rate. A higher volatility means that an exchange rate can potentially be spread out over a larger range of values. High volatility means that the price of the currency can change dramatically over a short time period in either direction.
On the other hand, a lower volatility would mean that an exchange rate does not fluctuate dramatically, but changes in value at a steady pace over a period of time. Commonly, the higher the volatility, the riskier the trading of the currency pair is.
Technically, the term “Volatility” most frequently refers to the standard deviation of the change in value of a financial instrument over a specific time period. It is often used to quantify (describe in numbers) the risk of the currency pair over that time period. Volatility is typically expressed in yearly terms, and it may either be an absolute number ($0.3000) or a fraction of the initial value (8.2%). In general, volatility refers to the degree of unpredictable change over time of a certain currency pair exchange rate. It reflects the degree of risk faced by someone with exposure to that currency pair.
Volatility is often viewed as a negative in that it represents uncertainty and risk. However, higher volatility usually makes FOREX or currency trading more attractive to the market participants. The possibility for profiting in volatile markets is a major consideration for active or day traders, and is in contrast to the mid to long term investors’ view of buy and hold.
Volatility does not imply direction. It just describes the level of fluctuations (moves) of an exchange rate. A currency pair that is more volatile is likely to increase or decrease in value more than one that is less volatile.
Volatility of a currency pair changes over period of time. There are some periods when prices may move up and down rapidly (High volatility), while during other times they might not seem to move very little and with no particular direction (Low volatility).
For currency day traders, it is vital that a particular currency pair has enough movement (volatility) to allow the trader to capture intraday price swings. Adequate liquidity is also needed to avoid excessive slippage. In Currency trading, slippage occurs when an order is executed, often without a limit order, or a stop loss occurs at a less favorable rate than originally set in the order. Slippage is more likely to occur when volatility is high, perhaps due to news events, resulting in an order being impossible to execute at the desired price. Trading may be made more efficient by targeting the time of day that most consistently provides the needed amount of volatility (Spot price movement) and liquidity for a particular currency pair. Of course, these criteria need to be balanced with the trader’s unique profile and personality traits. A traders unique profile may encompass a wide array of factors including risk tolerance, trading methodologies, experience, current financial situation, and geographic position. Also personality traits like – dedication, discipline, focus, psychology and temperament. Over time, the successful FOREX trader will achieve a proper and personal balance of these elements, making FOREX trading disciplined, productive, and fulfilling.
The foreign exchange market is extremely active all day long with price quotes constantly changing. It is the only market that truly operates 24 hours a day and five days a week. Currencies are traded in the largest exchanges and marketplaces mainly through major global banks and financial institutions all over the globe: in Sydney, Tokyo, Hong Kong, Singapore, London, Zurich, Frankfurt, Paris, New York, and Chicago. This means that across almost every time zone the market is active – when the market closes in the U.S. the trading day starts in Tokyo and Hong Kong. The time flexibility can be quite convenient for traders who have a busy working schedule. They do not need to worry about market opening and closing hours.