A Complete Beginner’s Guide to How Foreign Exchange Works

Foreign Exchange

For beginners, the inner workings of the foreign exchange market can seem like a mystery. You know that different currencies have different values, and that those values change according to economic factors. But why do they change? And why do “good” economic events sometimes bode well for the currency, while at other times they have the opposite effect?

Then there are the finer details. When does the market operate? How do businesses and individual traders take advantage of it? Can it be rigged?

This guide should give you a working idea of how the Forex market operates, and how you can ensure you don’t lose out due to unexpected changes in the exchange rate.

What is the Forex market?

The Forex market is the global marketplace for trading currencies. It is decentralised – in other words, it does not operate in one particular place as stock exchanges do. Anyone who buys or sells a particular currency is accessing the Forex market. So, if you’re taking your salary or pension from the UK to Switzerland, you’ll be using the Forex market to sell your pounds for Swiss francs.

Of course, expats are far from the only people who need to exchange currency. International trade requires big and small businesses alike to spend billions in foreign currencies on a daily basis. Banks too work on an international scale, trading huge amounts of currency every day. For these reasons, the Forex market is the biggest in the world, trading over $5 trillion a day.

Forex traders use the changing exchange rates to their advantage. They buy a currency which they think will soon strengthen, and then, if successful, sell it once it is worth more. The best traders are those who can accurately predict economic events and how they influence the currency rates.

When does it operate?

The Forex market is unique in that it operates 24 hours a day, 5 days a week. This is because it is always daytime somewhere in the world. Whereas a stock exchange operates according to its local office hours, the Forex market is not time bound in the same way. It closes on weekends, but throughout the week it is always open.

This does not mean that the average person can not exchange currencies on the weekend. However, the brokers behind the scenes who do the transaction for you will only actually make the exchange during operating hours. Therefore, the prices don’t fluctuate until the market reopens.

How are currency rates determined?

This is the all-important question for traders. You can only make good trading decisions if you know how the a currency rate rises or falls. It might surprise you how simple the answer is.

Currencies are priced in the same way that goods have traditionally been priced since the first cultures started bartering thousands of years ago. They work on the premise of supply and demand.

Certain economic events make a currency more attractive, and suddenly everyone wants to buy it. There is a limited amount of that particular currency, and with high demand it can therefore command a higher price. For example, when the US economy is strong, European investors might decide to invest in dollars. Dollars become the sought after currency, and you will therefore have to pay more euros to get hold of them.

On the other hand, another currency becomes less attractive. Owners of that currency want to offload it as soon as possible, but there is a shortage of buyers. There is more supply than demand, and buyers will not spend as much of their currency on it. For example, the same European investors now recognise that the US dollar is at risk. They don’t want to be stuck with their dollars, but no one will buy at the high price they originally paid. The US dollar is consequently worth less in euros.

Of course, currencies do not rise and fall independently of one another. Say, for example, that there is currently high demand for the US dollar, and at the same time people are selling off their euros. A cost of a dollar in this case will inevitably be proportionally higher when buying in euros.

Which economic factors affect it (and why)?

According to the supply/demand paradigm, this question essentially asks what makes a currency more or less in demand. The answers are not always straightforward. While it is tempting to equate the strength of an economy with the strength of its currency, don’t fall into the trap of oversimplifying it. Certain economic crises can actually strengthen a currency, while sometimes economic strength takes a toll on it.

The following 3 factors are especially significant in the strength or weakness of a country’s currency.

Inflation

inflation

Inflation plays a major part in the value of a currency. The general rule is, higher inflation sees a depreciation in the currency value, while lower inflation sees an appreciation. The reasons for this are tied in with interest rates.

Inflation and interest rates are connected as: with lower interest rates, people are able to borrow more, and can therefore spend more, causing inflation to increase. With higher interest rates, borrowing becomes more difficult, people can spend less, and inflation decreases.

Interest rates

Changing interest rates are highly significant for investors around the world. This is because, in a country with high interest rates, investors can earn a lot through lending. Therefore, foreign investors bring in high capital, and the exchange rate increases.

Interest rates are set by the country’s central bank, according to numerous factors. Supply and demand is significant here too. The more demand there is for credit, the higher interest lenders are able to ask. Whereas if there is little demand for credit, lenders have to settle for lower interest rates. To complicate things, while higher interest rates often lead to lower inflation, lower inflation can consequently lead to lower interest rates!

Political stability or turmoil

Currency strength is linked to a country’s political and economic stability. Generally, investors are wary of countries in political turmoil. They pull their money from the country, causing the currency to depreciate. In turn, they invest in a country with more political and economic stability. However, it is not always that direct.

For example, the US dollar has long been considered a “safe-haven” currency. In other words, investors buy dollars in tumultuous times, as it has consistently been more steady than any other currency. Thus, even in a time of US economic or political turmoil, the US dollar may strengthen, especially if other countries are going through their own significant instability.

How can it be rigged?

rigged market

You may have heard of the Forex market being “rigged”, especially after the scandal that ended with big banks being fined $5.6 billion in 2015. But what exactly does this mean? How can a bank rig the market, and why is it a problem?

Since it is a 24 hour market, it is difficult to see how much the Forex market is worth except when it closes for the weekend. In order to get an idea of its value, institutions take a “snapshot” of how much is being bought and sold at a certain time. Traditionally, this was done every day in the 30 seconds before and after 4PM in London. This was known as the 4PM fix.

In order to rig the markets, banks took advantage of this window. Banks have the capability to submit a massive amount of orders at once. They would do so during the fix to make the “snapshot” of the market give a very different impression from actual market events. They could make it look like there was a sudden increase in demand for a particular currency, or an increased supply of another. The market’s impression would thus be skewed, and the price would change.

This was not where the unethical activity ended. When the Financial Conduct Authority (FCA) of the UK investigated, they found that certain banks were working together, sharing clients’ confidential information, and providing intel to traders who then took advantage of the changes.

What effect does rigging the market have?

Ultimately, market rigging only caused minor changes to the market itself or to traders. The fluctuations balance themselves out and don’t make much of a difference in the long run.

However, regulators claimed that clients of the banks involved could have had the values of their pension funds and investments compromised. But perhaps most importantly, rigging undermines trust in a financial system which has already seen many scandals.

Who is rigging it?

In May 2015, six major banks were fined $5.6 billion over rigging the Forex market. Those most affected were Barclays ($2.32 billion), Citigroup ($1.27 billion) and JPMorgan ($892 million).

In addition to the financial impact on these banks, their reputations were damaged significantly. With revelations of their conduct coming to the fore, they lost some of their already precarious public trust. Information that they colluded, even naming their alliances, will make anyone uneasy. Statements such as “If you ain’t cheating, you ain’t trying,” written by a Barclays trader in a 2010 chat, are particularly ominous.

While the implicated parties have owned up to their misconduct and paid up their fines, it would be foolish to assume similar types of misconduct does not continue within their systems. Banks have the size and wherewithal to keep it quiet and jump through loopholes to clinch as much profit as possible.

Can it still be rigged?

In order to prevent banks and other parties from rigging the Forex market, the 4PM fix has been widened from 30 seconds to 5 minutes before and after 4PM. This makes it near impossible to skew the picture in the same way as before. It will almost certainly not affect you, even if a bank manages to find another method of rigging, and it is a matter for the central banks to worry about.

Staying stable

If you’ve been transferring large amounts of money abroad, you’ll know how big a difference small changes can make. This is especially true if you’re making these transfers every month. So if you’re receiving a pension or a salary in the UK while living somewhere else, you can’t be sure you’ll always receive the same amount.

This is where commercial Forex companies come into the picture. To solve this very common problem, various options have been set up. The forward contract, for example, allows you to peg the exchange rate at a certain level for up to two years. While you won’t benefit from fluctuations in your favour, you can relax about the possibility of it going in the other direction for too long.

Such options are worthwhile not only when you’re receiving an income from abroad, but if you’re paying off an asset in another currency. Fluctuations can make one payment bigger than the next, and fixing the exchange rate will ensure you pay what you expect to.

Conclusion

The foreign exchange market can be very confusing for beginners. We all know that exchange rates fluctuate, and that certain economic and political factors are involved, but the reasons behind it are sometimes a mystery to the layman. When the exchange rates affect you, it becomes more important to find out why this is so, especially if you are exchanging currency on a monthly basis.

Simply by following the rules of supply and demand, you can understand the fundamentals of what increases and decreases a currency’s worth. When a country provides attractive investment opportunities, its currency is in higher demand and vice versa.

There’s no way to ensure exchange rates always move in your favour, and sometimes improved rates have a negative impact on the economy anyway, meaning your gains are offset by your losses. But there are ways to work with the system, using options such as forward contracts to guarantee you always receive or pay the same sum of money, no matter what is happening in the Forex market.