Lesson #1: Fundamentals of Foreign Exchange

Foreign exchange, also known as “Forex”, “FX”, “Retail Forex” or simply “Spot” is the practice of buying and selling the currency of other countries. Currencies are usually traded through a broker or dealer and are usually in pair.

It is one of the largest and most liquid financial market in the world and transactions includes trading between individuals, large banks, corporations and other institutions and even governments. The average daily transaction expands continuously reaching a volume of more than $4 trillion.

Trading may either be "spot" or "forward" delivery. In spot transactions, buying and selling certain amount of foreign currency are based on current market rate and deliveries are made and paid for immediately. Forward transactions, on the other hand, are deals arranged for future deliveries, to be paid for on agreed dates on or after delivery.

Trading at the Marketplace

All Foreign Exchange transactions are done electronically and continuously run over the 24-hour cycle. Thus, Foreign Exchange dealings are considered an over the counter (OTC) or interbank business.

Transactions always involve two currencies or in pairs because the value of one currency is ascertained by its comparison to the other currency. The first currency is the base currency or the currency that is being purchased while the second is the counter currency or the currency that is being sold. The currency pair shows the amount of counter currency needed to purchase a unit of the base currency.

There are four major currency pairs that are traded most often in the foreign exchange market. These include the EUR/USD, USD/JPY,GBP/USD and USD/CHF.

Spot Markets and Forward Markets

Spot transaction is the simplest way of meeting foreign currency requirements. This, however, carries the highest risk of exchange rate fluctuations because of uncertainty of the rate until the transaction is finished. The spot rate is often affected by (a) current market situation; (b) the supply and demand for the currencies being traded; and, (c) the amount involved. In general, the bigger the amount dealt, the better the spot rate will be.

Settlement of a spot deal or the physical exchange of currencies will take place two days after the deal is finalized.

Unlike the Spot Market, the Forward Market has a more complicated calculation – the rate is based on the current spot rate plus (or minus) a premium (or discount) which are dictated by the interest rate differential between the currencies involved. A forward rate gives protection against unfavourable movements, however, gains will not be allowed should the exchange rate become favourable during the period of commissioning the contract and final settlement of the currency.

Currency Trading

Below are the mostly traded currencies. Currencies usually come in three letters, the first two identifying the name of the country and the last letter, the currency of the country.

Symbol Country Currency
USD United States Dollar
EUR Euro Members Euro
JPY Japan Yen
GBP Great Britain Pound
CHF Switzerland Franc
CAD Canada Dollar
AUD Australia Dollar
NZD New Zealand Dollar

Among the currencies, the US dollar is the most traded currency followed by the Euro and the yen.

Advantages of Foreign Exchange Transactions

Many people are lured to engage in foreign exchange transactions because of the following advantages:

a. Commission Free Transaction – fees such as clearing, exchange, government and brokerage fees are eliminated. Brokers’ compensation are based on the bid-ask spread

b. Direct Transactions – middleman is eliminated on spot currency transaction. This gives the leeway to transact business directly with the market responsible for setting the value of a particular currency pair

c. Round the Clock Market – foreign exchange transaction knows no time. Business can be transacted globally anytime of the day.

d. Leverage – this provides the trader the capability to secure nice profits and at the same time minimize risk capital.

e. Highly Liquid – funds in the market is readily available. With a click of a mouse, buying and selling transactions can be conducted. An online trading trading platform wherein trading automatically closed your position at your desired profit level can even be set.

f. Free online information – online forex brokers offers free demonstration accounts to practice trading together with information materials such as forex news and charting services. This helps “beginner” and “smart” traders to practice the trading with “play money” prior opening a live trading account and risk real money

Starting a Foreign Exchange Trading is quite simple. All you need is a computer with high speed internet connection and ample knowledge on the ins and outs of trading.