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Forex, FX, Currency Trade: an Introduction

The foreign exchange market operates through a highly sophisticated network of telecommunications systems, which link the numerous FX dealers, and brokers located in all of the major cities of the world. The participants in the FX market include those who have underlying commercial and financial transactions denominated in foreign currencies. This group includes importers and exporters, and those investing or borrowing from overseas. In addition to these participants, there are speculators who buy and sell foreign currencies in the expectations of making a profit from exchange rate movements, and there are those who arbitrage exchange rate and/or international interest rate differentials. The Reserve Bank and other central banks also enter the market as buyers and sellers of foreign currency. The Reserve Bank may enter the FX market to buy or sell foreign exchange in order to meet the government’s foreign currency requirements or, alternatively, from time to time, in an attempt to influence the value of the EUR/US/AUD/GBP/WON/YEN/RMB – whatever – currency in the market.

The contracts that are traded in the FX market are distinguished by their maturity or delivery dates. Spot and forward contracts are the most common contracts traded. Spot transactions require delivery and settlement within two business days.

Because of the telephonic and screen-based nature of trading in currencies, it is important that universally understood conventions are adopted. Price quotations always provide two-way prices: the first and lower price is the one at which the dealer buys the unit of the quotation; the second and higher price is the one at which the dealer sells the unit. It is possible to derive a range of additional exchange rates on the basis of the few published rates; for example, transposed and cross-rates can be calculated.

The convention adopted in the quotation of forward rates is that the dealer quotes the forward points rather than the outright forward rates. To obtain the outright rate, the forward points are added to, or subtracted from, the spot rate. In calculating the forward point, the dealer uses the spot rate and the differential rates of interest in the money markets of the two countries of the currencies in the quote. The currency of the relatively high interest rate country will be priced at a forward discount; the relatively low interest rate currency will be quoted at a forward premium. It was noted that real-world complications, such as different ‘interest rate days’ basis (for example, the USA uses a 360 days year), interest withholding tax, two-way quotations, and the effects of compounding periods, all impact upon the calculation of forward points.

Finally, it was recognised that the European Monetary Union will have a significant impact in the future on the structure and operation of the FX markets. Initially 11 foreign currencies have been replaced by a single currency, the euro.