Foreign Exchange 401

Unbeknownst to many, the foreign exchange market is largest traded market, dwarfing more mainstream securities like equities and fixed income. With large players like governments and institutional banks in the picture, the daily volume greatly surpasses other markets by a significant multiple.

With so much money flowing, the numerous gyrations by the second can overwhelm many new traders and investors, but many are surprised to learn that daily currency fluctuations are extremely small compared to the other asset classes. To amplify the small movements, traders use leverage, or borrow on margin, to levels upward of 250:1.

For new forex traders with an equities background, one of the key concepts to grasp is the idea of relative outperformance rather than absolute performance. For example, if a trader was interested in the Japanese Yen, a key question to ask is “How will the Yen do, relative to the US dollar?”

Currencies are quoted in pairs, with a base unit preceding the quote or counter unit. Currently, for the Dollar/Yen combination, the currency pair quote would be USD/JPY = 89.64, denoting that one unit of the base (USD) can buy 89.64 units of the counter (Yen). Something you will hear quite often is a term called “pips.” A pip is simply the smallest change of a currency unit. For most pairs, it will be 0.0001, but as shown earlier a pip would be .01 in the Dollar/Yen pairing.

One way many new investors or traders view the foreign exchange market is to view the currencies as shares of some of the world's biggest companies, the countries themselves. Similarly, economic data like GDP, jobless claims, consumer confidence, etc. are like earnings data that can be used to gauge the fundamental quality of the country. Just like stocks, currencies are affected by major news and information, and some additional economic indicators are interest rates, inflation, trade and capital flow, and global macro/political.

Taking all these factors into account, one of the most popular and famous strategies is the carry trade. The carry trade involves borrowing (selling) a currency that is offered at a lower interest rate and lending (buying) a currency offered at a higher interest rate, thereby profiting from the difference in rates. The carry trade was popularized in 1999 when Japan decreased its interest rates to effectively zero. By borrowing large sums of Yen basically for free, investors used the money to buy US Treasury bonds and other assets and earn almost all the return of the US assets. While this may not seem like a big deal, with leverage, gains can be amplified almost 250 times.

The risk to this carry trade however, is that the value of the US dollar drops and wipes out the return. Since carry trades tend to be long-term in nature, investors are taking on a large risk that the exchange rate will fluctuate in the time it takes to complete the carry trade. Of course, exchange rate changes aren't bad when they move in your favor.

Even if you are not looking to invest in currencies, the sheer fact that international trade and travel pervade such a large part of our lives makes it beneficial to understand how lowering interest rates in Japan can affect the price of imported electronics in the US.