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Forex Factors

Forex Rate Systems: Factor that Influence Prices

There are basically two types of exchange rate systems:

1) Flexible Exchange Rate System, where the currency is ‘free’ to float and its value is determined by market forces and

2) Fixed Exchange Rate System, where the currency is not allowed to fluctuate freely. Instead, its value is fixed either against a single currency, such as the USD, at a specific rate, or a basket of currencies. In a fixed system, the local central bank uses its currency reserves to prevent rate movements.

Since the FX market is a pure market, rates move freely up and down, consequently, there are numerous factors that determine a free floating currency’s worth in the market, from international trade flow, economic and political conditions, and the level of interest rates to simple short-term supply and demand.

There are numerous different types of “participants” in the FX market and frequently they are looking for very different outcomes when they trade. This is why that although FX is often described as a ‘zero-sum’ game – what one investor makes is equal in theory to what another has lost – there are numerous opportunities to make money.

Below is a list of major participants:

Banks

Historically, banks have been the main participants in the FX market. They still remain the largest players in terms of market share, but transparency has made the FX market far more democratic with all participants having access to the same extremely narrow prices that are quoted in the interbank market.

Non-bank financial entities

(including real money and leveraged asset managers). New market makers, such as hedge funds and commodity trading advisors, have emerged over the past decade while international corporations have a natural interest to trade on account of their exposure to FX risk.

Central Banks

Central Banks can also play an important role in the FX market.

Retail FX

Retail FX has expanded rapidly over the past decade and while precise figures are hard to come by, this sector is believed to represent as much as 20% of the FX market.

Forex Essentials

As we discussed, one currency is always quoted against another. The “base” currency is the one that can be thought of as the reference. For instance, in a EUR/USD quote, EUR is the base currency and the quote defines how many USD it costs to buy. Similarly, in USD/JPY, USD is the base currency and the rate defines how many JPY it costs to buy. The Bid is the price the market is willing to pay for a certain FX currency pair. The offer, or ask, is the price it is prepared to sell at. For example, in a USD/CHF quote of 1.1650/1.653, the bid is 1.1650, while the offer is 1.1653. Frequently, quotes are abbreviated. In this case, a phone quote would be 50/53. The difference between the bid and the offer is known as the spread.

What is a pip?

Pip stands for "percentage in point" and is the smallest increment of trade in FX. In the FX market, prices are quoted to the fourth decimal point. For example, if a bar of soap in the drugstore was priced at $1.20, in the FX market the same bar of soap would be quoted at $1.2000. The change in that fourth decimal point is called 1 pip and is typically equal to 1/100th of 1%. Among the major currencies, the only exception to that rule is the Japanese yen. Because the Japanese yen has never been revalued since the Second World War, 1 yen is now worth approximately US$0.08; so, in the USD/JPY pair, the quotation is only taken out to two decimal points (i.e. to 1/100th of yen, as opposed to 1/1000th with other major currencies).

What is a carry?

Carry is the most popular trade in the currency market, practiced by both the largest hedge funds and the smallest retail speculators. The carry trade rests on the fact that every currency in the world has an interest rate attached to it. These short-term interest rates are set by the central banks of these countries: the Federal Reserve in the U.S., the Bank of Japan in Japan and the Bank of England in the U.K. to name a few.

Currency carry is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.

Here's an example of a "yen carry trade": a trader borrows 1,000 Japanese yen from a Japanese bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount. Let's assume that the bond pays 4.5% and the Japanese interest rate is set at 0%. The trader stands to make a profit of 4.5% as long as the exchange rate between the countries does not change. Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. If the trader in our example uses a common leverage factor of 10:1, then she can stand to make a profit of 45%.

The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, if the U.S. dollar was to fall in value relative to the Japanese yen, then the trader would run the risk of losing money. Also, these transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless the position is hedged appropriately.

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