Introduction to Currencies
You
don't have to be a daily trader to take advantage of the forex market -
every time you travel overseas and exchange your money into a foreign
currency, you are participating in the foreign exchange (forex) market.
According to the 2007 Triennial Central Bank Survey of Foreign Exchange
and Derivative Market Activity conducted by the Bank for International
Settlements, the forex market generated $3.2 trillion dollars worth of
transactions each day. This makes the forex market the quiet giant of
finance, dwarfing over all other capital markets in its world.
Despite
this market's overwhelming size, when it comes to trading currencies,
the concepts are simple. Let's take a look at some of the basic concepts
that all forex investors need to understand.
Eight Majors
Unlike the stock market, where investors have thousands of stocks to choose from, in the currency market, you only need to follow eight major economies and then determine which will provide the best undervalued or overvalued opportunities. These following eight countries make up the majority of trade in the currency market:
Unlike the stock market, where investors have thousands of stocks to choose from, in the currency market, you only need to follow eight major economies and then determine which will provide the best undervalued or overvalued opportunities. These following eight countries make up the majority of trade in the currency market:
1. United States
2. Eurozone (the ones to watch are Germany, France, Italy and Spain)
3. Japan
4. United Kingdom
5. Switzerland
6. Canada
7. Australia
8. New Zealand
2. Eurozone (the ones to watch are Germany, France, Italy and Spain)
3. Japan
4. United Kingdom
5. Switzerland
6. Canada
7. Australia
8. New Zealand
These
economies have the largest and most sophisticated financial markets in
the world. By strictly focusing on these eight countries, we can take
advantage of earning interest income on the most credit worthy and
liquid instruments in the financial markets.
Economic
data is released from these countries on an almost daily basis,
allowing investors to stay on top of the game when it comes to assessing
the health of each country and its economy.)
Yield and Return
When it comes to trading currencies, the key to remember is that yield drives return.
When it comes to trading currencies, the key to remember is that yield drives return.
When
you trade in the foreign exchange spot market, you are actually buying
and selling two underlying currencies. All currencies are quoted in
pairs, because each currency is valued in relation to another. For
example, if the EUR/USD pair is quoted as 1.3500 that means it takes
$1.35 to purchase one euro.
In
every foreign exchange transaction, you are simultaneously buying one
currency and selling another. In effect, you are using the proceeds from
the currency you sold to purchase the currency you are buying.
Furthermore, every currency in the world comes attached with an interest
rate set by the central bank of that currency's country. You are
obligated to pay the interest on the currency that you have sold, but
you also have the privilege of earning interest on the currency that you
have bought.
As
an example, let's look at the New Zealand dollar/Japanese yen pair
(NZD/JPY). Let's assume that New Zealand has an interest rate of 8% and
that Japan has an interest rate of 0.5% In the currency market, interest
rates are calculated in basis points. A basis point is simply 1/100th
of 1%. So, New Zealand rates are 800 basis points and Japanese rates are
50 basis points. If you decide to go long NZD/JPY you will earn 8% in
annualized interest, but have to pay 0.50% for a net return of 7.5%, or
750 basis points.
Leveraging Returns
The forex market also offers tremendous leverage - often as high as 100:1 - which means that you can control $10,000 worth of assets with as little as $100 of capital. However, leverage can be a double-edged sword; it can create massive profits when you are correct, but may also generate huge losses when you are wrong.
The forex market also offers tremendous leverage - often as high as 100:1 - which means that you can control $10,000 worth of assets with as little as $100 of capital. However, leverage can be a double-edged sword; it can create massive profits when you are correct, but may also generate huge losses when you are wrong.
Clearly,
leverage should be used judiciously, but even with relatively
conservative 10:1 leverage, the 7.5% yield on NZD/JPY pair would
translate into a 75% return on an annual basis. So, if you were to hold a
100,000 unit position in NZD/JPY using $5,000 worth of equity, you
would earn $9.40 in interest every day. That's $94 dollars in interest
after only 10 days, $940 worth of interest after three months, or $3,760
annually. Not too shabby given the fact that the same amount of money
would only earn you $250 in a bank savings account (with a rate of 5%
interest) after a whole year. The only positive over having the bank
account earn you interest is that the return would be risk-free.
The
use of leverage basically exacerbates any sort of market movements. As
easily as it increases profits, it can just as quickly cause large
losses. However, these losses can be capped through the use of stops.
Furthermore, almost all forex brokers offer the protection of a margin
watcher - a piece of software that watches your position 24 hours a day,
five days per week and automatically liquidates it once margin
requirements are breached. This process insures that your account will
never post a negative balance and your risk will be limited to the
amount of money in your account.
Carry Trades
Currency values never remain stationary and it is this dynamic that gave birth to one of the most popular trading strategies of all time, the carry trade. Carry traders hope to earn not only the interest rate differential between the two currencies, but also look for their positions to appreciate in value. There have been plenty of opportunities for big profits in the past. Let's take a look at some historical examples.
Currency values never remain stationary and it is this dynamic that gave birth to one of the most popular trading strategies of all time, the carry trade. Carry traders hope to earn not only the interest rate differential between the two currencies, but also look for their positions to appreciate in value. There have been plenty of opportunities for big profits in the past. Let's take a look at some historical examples.
Between
2003 and the end of 2004, the AUD/USD currency pair offered a positive
yield spread of 2.5%. Although this may seem very small, the return
would become 25% with the use of 10:1 leverage. During that same time,
the Australian dollar also rallied from 56 cents to close at 80 cents
against the U.S. dollar, which represented a 42% appreciation in the
currency pair. This means that if you were in this trade - and many
hedge funds at the time were - you would have not only earned the
positive yield, but you would have also seen tremendous capital gains in
your underlying investment.
 |
| Figure 1: Australian Dollar Composite, 2003-2005 |
| Source: eSignal |
The
carry trade opportunity was also seen in USD/JPY in 2005. Between
January and December of that year, the currency rallied from 102 to a
high of 121.40 before ending at 117.80. This is equal to an appreciation
from low to high of 19%, which was far more attractive than the 2.9%
return in the S&P 500 during that same year. In addition, at the
time, the interest rate spread between the U.S. dollar and the Japanese
yen averaged around 3.25%. Unleveraged, this means that a trader could
have earned as much as 22.25% over the course of the year. Introduce
10:1 leverage, and that could be as much as 220% gain.
 |
| Figure 2: Japan Yen Composite, 2005 |
| Source: eSignal |
Carry Trade Success
The key to creating a successful carry trade strategy is not simply to pair up the currency with the highest interest rate against a currency with the lowest rate. Rather, far more important than the absolute spread itself is the direction of the spread. In order for carry trades to work best, you need to be long a currency with an interest rate that is in the processes of expanding against a currency with a stationary or contracting interest rate. This dynamic can be true if the central bank of the country that you are long is looking to raise interest rates or if the central bank of the country that you are short is looking to lower interest rates.
The key to creating a successful carry trade strategy is not simply to pair up the currency with the highest interest rate against a currency with the lowest rate. Rather, far more important than the absolute spread itself is the direction of the spread. In order for carry trades to work best, you need to be long a currency with an interest rate that is in the processes of expanding against a currency with a stationary or contracting interest rate. This dynamic can be true if the central bank of the country that you are long is looking to raise interest rates or if the central bank of the country that you are short is looking to lower interest rates.
In
the previous USD/JPY example, between 2005 and 2006, the U.S. Federal
Reserve was aggressively raising interest rates from 2.25% in January to
4.25%, an increase of 200 basis points. During that same time, the Bank
of Japan sat on its hands and left interest rates at zero. Therefore,
the spread between U.S. and Japanese interest rates grew from 2.25%
(2.25% - 0%) to 4.25% (4.25% - 0%). This is what we call an expanding
interest rate spread.
The bottom line is that you want to pick carry trades that benefit not only from a positive and growing yield, but that also have the potential to appreciate in value. This is important because just as easily as currency appreciation can increase the value of your carry trade earnings, currency depreciation could erase all of your carry trade gains and then some.
The bottom line is that you want to pick carry trades that benefit not only from a positive and growing yield, but that also have the potential to appreciate in value. This is important because just as easily as currency appreciation can increase the value of your carry trade earnings, currency depreciation could erase all of your carry trade gains and then some.
Getting to Know Interest Rates
Knowing where interest rates are headed is important in forex trading and requires a good understanding of the underlying economics of the country in question. Generally speaking, countries that are performing very well, with strong growth rates and increasing inflation will probably raise interest rates to tame inflation and control growth. On the flip side, countries that are facing difficult economic conditions ranging from a broad slowdown in demand to a full recession will consider the possibility of reducing interest rates.
Knowing where interest rates are headed is important in forex trading and requires a good understanding of the underlying economics of the country in question. Generally speaking, countries that are performing very well, with strong growth rates and increasing inflation will probably raise interest rates to tame inflation and control growth. On the flip side, countries that are facing difficult economic conditions ranging from a broad slowdown in demand to a full recession will consider the possibility of reducing interest rates.
Conclusion
Thanks to the widespread availability of electronic trading networks, forex trading is now more accessible than ever. The largest financial market in the world offers a world of opportunity for investors who take the time to get to understand it and learn how to mitigate the risk of trading here.
Thanks to the widespread availability of electronic trading networks, forex trading is now more accessible than ever. The largest financial market in the world offers a world of opportunity for investors who take the time to get to understand it and learn how to mitigate the risk of trading here.
