Fundamentals of Forex

What is Forex? 

Forex refers to the foreign exchange market - the trading of one currency to another. These trades take place on the foreign exchange market AKA the Forex market for short. This market is the most liquid market in the world with trillions changing hands each day. There is no physical centralized location but instead is a electronic network of banks, brokers, institutions and individual traders (mostly trading through brokers or banks). 

Trades on the Forex markets take place for a multitude of reasons. It can be done for profit by financial traders who may bet on a currency appreciating or depreciating in value, it can be done by a treasury to ensure its business has the right amount of a currency for the right duration of time to ensure its financial health or it could be as simple as a tourist changing currencies at an airport. 

What drives decisions behind Forex? 

• Interest rate decisions made by central banks 
• This is driven by hot money -  in short, this is cash thats frequently transferred between financial institutions in an attempt to maximize interest or capital gain
• Reporting dates are also a massive factor which can lead to high level of dips and troughs in the Forex market - these can vary by country and can lead to a massive dip in a value of a currency
• The level of inflation is a key variable as monetary policy is typically seen as the instrument to control the level of inflation within an economy 
• Other macroeconomic factors that can impact on GDP - and thus, by extension, the level of inflation within an economy includes: Consumption and the level employment
• The housing market
• Since housing is a large investment, housing market indices help to monitor the overall health of the economy. 

Example of trading for profit: 

• A trader believes that the European Central Bank will cut their interest rate due to a range of macroeconomics policies. He/she books in a trade 100,000 at a rate of 1.15. 
• Over the next several weeks, the ECB signals it may indeed ease its monetary policy thus causing the currency to depreciate - the euro now falls to 1.10. 
• This means the trader creates a profit of 5,000. 
• By shorting the 100,000 the trader took in 115,000 for the short-sale. The difference between the exchange rates resulted in a profit. 
• Where the trader to miscalculate and the ECB did not cut its interest rate but instead announced it will raise the interest rate which will cause the rate to rise to 1.20 then the trader would have made a loss of 5,000. 

Breaking down basics of Forex lingo: Longing vs shorting

Longing: 

• If an investor has long positions this means the investor has bought and owns those financial instruments. For instance, if I own 1000 GBP this can be said to be 1000 GBP long. I have paid in full that amount. 
• Someone may be typically owned (or longed) because that investor sees the financial instrument to be bullish - or would rather expect the price of that financial instrument to rise. 

Shorting:

•  If an investor is short 1000 this means the investor owes 1000 GBP and is therefore short of this amount. This is a bearish position as the investor expects the value of the pound to decrease. 
• Therefore if the price decreases the investor makes profit off the difference between the price he borrowed that financial instrument vs the value of that instrument when it matures. This is demonstrated in the above example. 

Key Forex Markets: 

Spot

The spot market for most currencies takes place in two business days however the exception is the USD vs the CA$ which settles on the next business day. During periods which have multiple holidays - i.e. Easter or Christmas spot transactions can take as long as six days to settle. However, its key to note that the price is established on the trade date but money is exchanged on the value date. 

The spot market can be very volatile. Movement in the short term is dominated by technical trading, which focuses on direction and speed of movement. Long-term currency moves are driven by fundamental economic factors such as relative interest rates and economic growth. 

Forward

A forward trade is any trade that settles further in the future than spot. The forward price is a combination of the spot rate plus or minus forward points that represent the interest rate differential between the two currencies. Most have maturity less than a year in the future but longer is possible. Like a spot, the price is settled on the trading date but the money is exchanged on the maturity date. 

Futures

A futures trade is similar to that of a forward as it settles later than a spot deal but is for traded on a commodities market. The exchange acts as a the counterpart.