Tim Bennett explains the key features of the currency markets: the influences affecting an exchange rate, what currency ‘pairs’ are, and how to trade them.
So in this video we take a look at one of the biggest markets in the world, the foreign exchange market. Lots of talk around possible crises in the Eurozone, quantitative easing in the UK and UK, lots of focus on the currency markets in general.
- What are currency markets all about?
- What does a typical currency pair look like?
- And what are the key influences that will affect and exchange rate?
The key features of the foreign exchange markets, also known as FOREX:
- This is a 24 hours market: currencies are traded all around the world in big financial centres, including NY, Tokyo, and London, and it’s the biggest market in the world.
- It’s a very liquid market: for most of the so-called major currencies, so the USD, sterling, and the euro, you can get out very quickly.
- It’s fast: exchange rates can act very quickly to pieces of data. You need to think how you can limit the damage is an exchange rate goes wrong.
A zero sum gain is when you have to decide what you’re betting against, as well as what you’re betting for; you’re always trading pairs of currencies.
Currencies are split into two: a bid rate (the rate at which the bank buys and you sell at), and an offer rate (the rate at which the bank sells and you buy at).
Currencies feature bid offer spreads, and when you buy or sell a currency, you’re always going to suffer, whatever that spread is.
In liquid currencies, the spread is very narrow. The difference between the buy rate and the sell rate is known as the PIP spread.
What are the influences on the currency markets?
- Trade balances:Countries trade with each other and bulk trade surpluses or deficits. If lots of people want to buy American stuff, they need dollars to pay for it. So, demand for a country’s goods and services will tend to drive demand for its currency as well. So a country with a successful economy will have a strong currency.
- Interest rates and inflation data:The price of a currency is dictates heavily by what you can earn if you own it. if interest rates are high, people will want whatever has a high interest rate. If interest are expected to rise in a country, that would tend to start pushing that currency up.
Some people exploit that through carry trade.So borrowing a currency with a very low interest rate, such as Yen recently, and invest in something with a much higher interest rates, such as the Australian dollar, much stronger economy and interest rates tending to rise up. Carry traders will borrow cheap currencies and try and invest in more expensive ones.
- Other: random factors e.g. politicsPoliticians make decisions that can change everything. For example, in the US, they decided to print money, known as “quantitative easing”. They release more currency into the system, which means a lower exchange rate, relative to other currencies.
The three main things to take away from this video tutorial:
- Foreign exchange markets are slightly different to other markets, such as the equity markets, and anyone wanting to trade them should understand these differences.
- Currency quotes work slightly differently in terms of jargon, to say, trading or bond quotes
- A whole raft of factors influence foreign exchange rates, so make sure you’re comfortable with them and get to know your favourite currency before diving in and trying to trade.