You’ll often hear people in the business refer to foreign exchange as “forex,” or “FX” for short. Another way to describe it is the currency market. No matter what you call it, the foreign exchange market is essentially a network of people trading certain currencies for other currencies at agreed-upon prices.
The foreign exchange market is the largest, most liquid financial market in the world, trading in one typical day what Wall Street trades in a month. According to a recent estimate, the average daily turnover in global foreign exchange markets is over 5 trillion.
The US dollar is the world’s most traded currency, followed by the euro and the Japanese yen. The most important trading centres worldwide are London, New York, Hong Kong, Tokyo and Singapore. These centres serve as anchors between buyers and sellers around the clock. The FX market operates 24 hours a day, 5.5 days a week.
Good to know
Operating hours. Forex trading runs 24 hours a day, 5.5 days a week. Trading runs from 22:00 GMT on Sunday (Sydney) until 22:00 GMT Friday (New York).
Commissions and service fees. Virtually all companies specializing in foreign exchanges services make their money based on spreads. Most foreign exchange traders also receive commissions (which can also be known as service fees) as incentives on every trade you book. In contrast, Vancity Community Investment Bank Account Managers are not commission-based—so their advice is always objective and tailored to your unique circumstances.
Buying and selling currencies
Many of the same principles that apply to other investments apply to foreign exchange too—for example:
- You’re aiming to buy low and sell high.
- Prices can be volatile—that is, they can move up or down without warning.
- The markets move up and down based on demand. Rising demand leads to rising prices.
Aside from higher interest rates, other factors that can drive demand for a given currency include better return on savings, political stability, and economic output (GDP).
See Reading FX exchange rates for more about what you need to know to buy and sell currencies.
Benefits of the FX market for small businesses
Today, many businesses—even those you might not think of as international—need to buy or sell goods or services to or from other countries. Your own business might be one of them. Doing business across borders means dealing in other country’s currencies, and exposes you to fluctuations in the values of those currencies.
The foreign exchange market makes it possible for a business in one country to import goods from other countries and pay in local currencies. For example, a local supplier of high-end cosmetics may need to import its products from a European country. The foreign exchange market lets that business pay for its imported products in euros, even though its own revenues are in Canadian dollars.
Vancity Community Investment Bank Foreign Exchange can save you money by eliminating the need for your suppliers to mark up their prices to account for the foreign exchange difference between the Canadian dollar and the euro. By trading in the supplier’s currency, you can get a favourable price in real time, or lock in a rate in advance that works for you.
Getting a handle on the terminology
The FX market is associated with a number of words and terms that might be unfamiliar to people who don’t work in the investment or foreign currency worlds. Here are a few technical terms worth knowing:
- Spot rate. The “spot rate” refers to the price quoted for settlement on a currency—in other words, it’s the value of the currency at the moment of the quote. It’s based on current and anticipated market value, and can change frequently (and sometimes significantly).
- Spreads. A forex “spread” refers to the difference between the bid price and the ask price on a currency pair. The bid is the price the forex market would pay to buy the base currency in exchange for a counter currency. The ask is the price at which the market would sell it. For example, suppose you have a USD/CAD bid price of 1.1500 and an ask of 1.1505. (The first currency mentioned in a pair is the base currency—in this case, the USD.) The spread would be equal to $0.0005. To make money in currency trading, as in other investments, you aim to buy low and sell high.
In the example above, the spread is 0.0005, or 5 pips. Unlike the USD/CAD currency pair, some currency pair quotes are carried out to the second decimal place. For example, USD/JPY may be quoted at 119.45/50, where 5 pips represent a spread of 0.05.
- Pips. In foreign exchange terminology, a pip refers to the smallest amount by which a currency quote can change. This is usually $0.0001 for currency pairs involving the US dollar, and may be more often referred to as 1/100th of 1%. A change in the the EUR/USD exchange rate from 1.4550 to 1.4555 would be a 5-pip change.
Reading FX exchange rates
A currency’s value is determined by its worth compared to another currency. The first currency in a pair is called the base currency. The second is called the terms, quote or counter currency. A pairing shows how much of the counter currency is needed to purchase one unit of the base currency. For example, EUR/USD 1.2500 means you would need US$1.25 to buy one euro. Conversely, if you sell one euro, you would get US$1.25.
Major and minor currencies
There are seven “major” currency pairings in the FX market, all of which involve the US dollar. The other six major currencies are the euro, Japanese yen, British pound, Australian dollar, Canadian dollar, and Swiss franc. These are the currencies that are most actively traded. As a result, they also tend to be the most cost-effective to trade, since the spread between their buy and sell prices is usually slimmer than in the case of minor currencies.
Minor currencies are generally thought of as most other currency pairs and cross-currencies—such as the Euro vs. the Australian dollar or even the New Zealand dollar vs. the US dollar. A subset of minor currencies is referred to as exotic currencies. These are unusual crosses such as the dollar versus the Thai baht or Turkish lira. Minor and exotic currencies can be more expensive to trade, since as a general rule, the fewer participants who trade a given currency, the more costly it becomes.
All currencies have three-letter codes. The table below shows the codes for some of the more commonly traded ones. To find out codes for lesser-used currencies, try searching online using keywords like “currency conversion.”
|United Kingdom||British Pound||GBP|
The price of a currency is called a quote. There are two different types of quotes in the FX market: direct and indirect. Both involve the US dollar. The difference is whether the US dollar is the base or the counter currency.
Most currencies are traded directly against the US dollar. The market rates that are expressed for such currency pairs are called direct rates. In most cases, the US dollar is the base currency pair, and the currency quote is expressed as a certain number of units per 1 USD. For example, USD/CAD=1.4500 would mean that 1 USD= 1.4500 CAD.
For some currency pairs, the US dollar is not the base currency, but the counter or quote currency. The market rates that are expressed for such currency pairs are called indirect rates. This is the case with the British pound (GBP), New Zealand dollar (NZD), euro (EUR) and Australian dollar (AUD). For example, GBP/USD=1.5800 would indicate that 1 GBP (British pound)= 1.5800 USD.
When one currency is traded against any currency other than the USD, the market rate for this currency pair is called a cross rate. In other words, cross rate is the exchange rate between two currencies not involving the US dollar. Although US dollar rates do not appear in the final cross rate, they are usually used in the calculation, and so must be known. Trading between two non-US dollar currencies usually occurs by first trading one of them against the US dollar and then trading the US dollar against the second non-USD currency. There are a few non-USD currencies that are traded directly, such as GBP/EUR or EUR/CHF.
Heading overseas on business? If you pop into the bank today and exchange CDN $1,000 for USD $885 based on the current exchange rate, you’ve conducted a simple spot transaction: the exchange of one currency for another at the prevailing exchange rate.
However, that’s an overly simplified example. Let’s take an example from the business world. Suppose you are a local manufacturer who needs to make a payment in US dollars to an American supplier to pay for machinery you purchased in Seattle, WA. You need to pay the supplier right away to avoid delays. You would book a spot transaction and complete the payment for the exchange at the current market rate, then transfer the US dollars to the supplier. The payment might take a day or two to process, but it’s still considered a spot transaction if the trade settles at the current market rate (meaning the rate that was available when you arranged the transaction).
In another example, you own a bookstore that brings in rare books in foreign languages from overseas. You’ve ordered an unusually large shipment of books from a Swiss publisher this month for an upcoming book fair, and you need to wire the additional funds to the publisher quickly. You book a spot transaction. The exchange is made at today’s rate, and the money is sent to your supplier within two business days.
Strictly speaking, a spot transaction is one that is processed more or less “on the spot” and settles within two business days of the trade date. If it takes longer, it becomes one of several variations of a forward transaction.
In currency transactions, the trade date is the date on which you arrange the transaction. The value date is the date on which the payment for the transaction settles.
If you do business across borders, you may need to send or receive payments in US dollars or other foreign currencies. If you do so, it is useful to manage foreign exchange risk: the risk that an exchange rate will swing in a way that disadvantages you before you make an upcoming payment (or receive an amount owing) in the foreign currency. For example, if you’re a Canadian business specializing in importing fabrics from India, and you pay your suppliers large sums in Indian rupees, then you should consider managing the risk associated with fluctuation of the dollar against the rupee.
There are a number of techniques for managing currency risk. Generally, they are all considered to be “hedging” techniques.
Hedging can sound like a complicated investment term, but at its essence, it really just refers to the idea of insuring yourself against potential negative outcomes. You insure your car so you’ll have some financial protection in the event of an accident. Having insurance doesn’t prevent an accident, but it reduces the financial impact on you if one happens. Similarly, in investing and FX trading, hedging is a way of “insuring” yourself against adverse events in the markets by reducing your exposure to a variety of financial risks. However, unlike simply purchasing car insurance, hedging is slightly more complicated, and requires you to make strategic investments designed to offset the risk of other investments or price movements.
When the Canadian dollar falls in value, importers worry they’ll be squeezed by increasing costs. If demand for their product seems fragile, some businesses will absorb the cost of currency depreciation rather than risk passing it on to customers.
But business owners can protect themselves by using forward contracts. Simply put, a forward contract is an agreement you make to buy a certain currency at an agreed exchange rate at a set future date. By making this agreement, you hedge your foreign currency exposure against future exchange rate volatility.
Forward transactions are often the cornerstone of foreign exchange hedging strategies for businesses of all sizes because they are flexible and easily customized. A forward contract lets you lock in a rate today for settlement at a future point in time, and it can be booked for any amount of foreign currency and any expiry date within six months. After you’ve locked in a forward contract, you have protection from exchange rate swings that can negatively affect you. Your forward contract guarantees your ability to buy or sell a foreign currency at your specified price by the expiry date, no matter what the market does.
As promising as this sounds, there is often no need to jump into the forward market with 100 percent of the funds in question. It is perfectly okay to trade partly in spot and partly in the forward market to avoid having all of your eggs in one basket, so to speak. It’s a good idea to speak to a Vancity Community Investment Bank Account Manager about this before you make a decision, especially if you’re new to the FX market.
Types of forward contracts
- A fixed dated (outright/closed) forward contract sets an exchange rate today for a currency pair transaction that will occur at a defined future date.
- An option-dated (open) forward contract, also known as a “window contract,” sets an exchange rate today for a currency trade that will occur in the future between an established start date (usually the next business day) and an expiry date (up to three months later).
Investors use forward contracts when they are unsure of what the market will do.
When to use forward contracts
Here are a few sample situations where forward contracts might be recommended:
- You’re not sure when you’ll need to pay for a product you received.
- You’re expecting payment in foreign currency for a product you delivered, but aren’t sure when it will arrive.
- You have accounts payable in foreign currency over the next several months, and see an opportunity to take advantage of current rates in the forward market.
- You have several contract dates for payment, but want to lock in a fixed rate for your product to sell in Canada.
A take-profit order lets you specify the exact rate at which to sell through a spot or forward trade that will realize a profit. Once the currency pair position rises to that specified exchange rate, the order is executed and your profits realized.
A stop loss order protects you from losses. As opposed to a take profit order, a stop loss lets you lock in your least favorable exchange rate in case the market moves against you. Vancity Community Investment Bank Account Managers monitor the market 24 hours a day, 5.5 days a week, and automatically locks in the stop loss exchange rate set if needed.
Order cancels order
An “order cancels other” (OCO) combines a pair of orders—usually take-profit and stop-loss orders—and automatically cancels one if the other is executed. This protects you against any risk of your order being double booked.