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A brief history of foreign exchange trading (Copyright © 1996 - 2005Saxo Bank)
Initially, the value of goods was expressed in terms of other goods, i.e. an economy based on barter between individual market participants. The obvious limitations of such a system encouraged establishing more generally accepted means of exchange at a fairly early stage in history, to set a common benchmark of value. In different economies, everything from teeth to feathers to pretty stones has served this purpose, but soon metals, in particular gold and silver, established themselves as an accepted means of payment as well as a reliable storage of value.
Originally, coins were simply minted from the preferred metal, but in stable political regimes the introduction of a paper form of governmental IOUs gained acceptance during the Middle Ages. Such IOUs, often introduced more successfully through force than persuasion were the basis of modern currencies.
Before the First World War, most central banks supported their currencies with convertibility to gold. Although paper money could always be exchanged for gold, in reality this did not occur often, fostering the sometimes disastrous notion that there was not necessarily a need for full cover in the central reserves of the government.
At times, the ballooning supply of paper money without gold cover led to devastating inflation and resulting political instability. To protect local national interests, foreign exchange controls were increasingly introduced to prevent market forces from punishing monetary irresponsibility.
In the latter stages of the Second World War, the Bretton Woods agreement was reached on the initiative of the USA in July 1944. The Bretton Woods Conference rejected John Maynard Keynes suggestion for a new world reserve currency in favour of a system built on the US dollar. Other international institutions such as the IMF, the World Bank and GATT were created in the same period as the emerging victors of WW2 searched for a way to avoid the destabilising monetary crises which led to the war. The Bretton Woods agreement resulted in a system of fixed exchange rates that partly reinstated the gold standard, fixing the US dollar at USD35/oz and fixing the other main currencies to the dollar - and was intended to be permanent.
The Bretton Woods system came under increasing pressure as national economies moved in different directions during the sixties. A number of realignments kept the system alive for a long time, but eventually Bretton Woods collapsed in the early seventies following president Nixon's suspension of the gold convertibility in August 1971. The dollar was no longer suitable as the sole international currency at a time when it was under severe pressure from increasing US budget and trade deficits.
The following decades have seen foreign exchange trading develop into the largest global market by far. Restrictions on capital flows have been removed in most countries, leaving the market forces free to adjust foreign exchange rates according to their perceived values.
But the idea of fixed exchange rates has by no means died. The EEC introduced a new system of fixed exchange rates in 1979, the European Monetary System. This attempt to fix exchange rates met with near extinction in 1992-93, when pent-up economic pressures forced devaluations of a number of weak European currencies. Nevertheless, the quest for currency stability has continued in Europe with the renewed attempt to not only fix currencies but actually replace many of them with the Euro back in 2001.
This project is fairly advanced now and the final structure and fixed levels were decided in May 1998. After this a dangerous three-year period loomed, where devaluation candidates could be attacked nearly without risk until the final introduction of the Euro in this Millennium.
The lack of sustainability in fixed foreign exchange rates gained new relevance with the events in South East Asia in the latter part of 1997, where currency after currency was devalued against the US dollar, leaving other fixed exchange rates, in particular in South America, looking very vulnerable.
But while commercial companies have had to face a much more volatile currency environment in recent years, investors and financial institutions have found a new playground. The size of foreign exchange markets now dwarfs any other investment market by a large factor. It is estimated that more than USD1,200 billion is traded every day, far more than the world's stock and bond markets combined.
How does it work? (Copyright © 1996 - 2005Saxo Bank)
FX Trading Basics
The global foreign exchange market is the biggest market in the world. The USD1.2 trillion daily turnover dwarfs the combined turnover of all the world’s stock and bond markets.
There are many reasons for the popularity of foreign exchange trading, but among the most important are the leverage available, the high liquidity 24 hours a day and the very low dealing costs associated with trading.
Of course many commercial organisations participate purely due to the currency exposures created by their import and export activities, but the main part of the turnover is accounted for by financial institutions. Investing in foreign exchange remains predominantly the domain of the big professional players in the market - funds, banks and brokers. Nevertheless, any investor with the necessary knowledge of the market’s functions can benefit from the advantages stated above.
In the following, we would like to introduce you to some of the basic concepts of foreign exchange trading. If you would like any further information, we suggest that you sign up for a FREE Membership on this website, where you will be able to exchange views with other FX traders and get answers to any questions you might have.
Margin Trading
Foreign exchange trading is normally undertaken on the basis of margin trading. A relatively small deposit is required to control much larger positions in the market. For trading the main currencies, Saxobank requires a 5 % margin deposit. This means that in order to trade one million dollars, you need to place just USD50,000 by way of security.
As a result, you will have obtained a gearing of up to twenty times. This means that a change of, say 2%, in the underlying value of your trade will result in a 40% profit or loss on your deposit. See below for specific examples. As you can see, this calls for a very disciplined approach to trading as both profit opportunities and potential risks are very large indeed. Please refer to our page Forex Rates & Conditions for current Spreads, Margins and Conditions!
Trade Currency and Price Currency
When you trade, you will always trade a combination of two currencies. For example, you will buy US dollars and sell German marks. Or buy German marks and sell Japanese yen, or any other combination of dozens of widely traded currencies. But there is always a long (bought) and a short (sold) side to a trade, which means that you are speculating on the prospect of one of the currencies strengthening and one of them weakening.
The trade currency is normally, but not always, the currency with the highest value. When trading US dollars against German marks, the normal way to trade is buying or selling a fixed amount of US dollars, i.e. USD1,000,000. When closing the position, the opposite trade is done, again USD1,000,000. The profit or loss will be apparent in the change of the amount of marks credited and debited for the two transactions. In other words, your profit or loss will be denominated in German marks, that are known as the price currency. As part of our service, Saxo Bank will automatically exchange your profits and losses into your base currency if you require this.
This way of trading is different to the futures markets, for example, where the marks, francs and yen are the fixed trade currency, resulting in a US dollar denominated profit or loss. You can, however, also choose to trade in this reciprocal manner in foreign exchange markets but it is not the norm.
Dealing Spread, but No Commissions
When trading foreign exchange, you are quoted a dealing spread offering you a buying and a selling level for your trade. Once you accept the offered price and receive confirmation from our dealers, the trade is done. There is no need to call an exchange floor. There are no other time-consuming delays. This feature is a great advantage in times of fast-moving markets: Where the market trades and you know whether you are filled or not.
The dealing spread is typically around five points in normal market conditions, e.g. USD/DEM 1.7780-85. This means that you can sell US dollars against the German mark at 1.7780 and buy at 1.7785. There are no further costs, no commissions or exchange fees.
This ensures that you can get in and out of your trades at very low slippage and many traders are therefore active intra-day traders, given that a typical day in USD/DEM presents price swings of 150-200 points.
Spot and forward trading
When you trade foreign exchange you are normally quoted a spot price. This means that if you take no further steps, your trade will be settled after two business days. Due to the fact that the EU investment directive does not presently covering spot foreign exchange trading we will, however, require you to swap your trade forward at least another two business days. This ensures that your trades are undertaken subject to supervision by regulatory authorities for your own protection and security. If you are a commercial customer, you may need the convert the currencies for international payments. If you are an investor, you will normally want to swap your trade forward to a later date. This can be undertaken on a daily basis or for a longer period at a time. Often investors will swap their trades forward anywhere from a week or two up to several months depending on the time frame of the investment.
Although a forward trade is for a future date, the position can be closed out at any time - the closing part of the position is then swapped forward to the same future value date.
Interest Rate Differentials
Different currencies pay different interest rates. This is one of the main driving forces behind foreign exchange trends. It is inherently attractive to be a buyer of a currency that pays a high interest rate while being short a currency that has a low interest rate.
Although such interest rate differentials may not appear very large, the significance is much greater in a highly leveraged position. As an example, the interest rate differential between the US dollar and the Japanese yen for much of 1997 was approximately 5 %. In a position that can be supported by a 5 % margin deposit, this results in a 100% profit on capital per annum when you buy the US dollar. Of course, an even more important factor normally is the relative move in the value of the currencies, that approximated some 20% from high to low during 1997. But still, you have an advantage of 100% per annum in your favour by being long US dollar, and an initial disadvantage of the same size by being short.
Please refer to our page Forex Rates & Conditions for current Spreads, Margins and Conditions!
Such a situation clearly benefits the high interest rate currency and as result, the US dollar was in a strong bull market all through 1997. But it is by no means a certainty that the currency with the higher interest rate will be strongest. If the reason for the high interest rate is runaway inflation, this may undermine confidence in the currency even more than the benefits perceived from the high interest rate.
Stop-loss discipline
As you can see from the description above, there are significant opportunities and risks in foreign exchange markets. Aggressive traders might experience profit/loss swings of 20-30% daily. This calls for strict stop-loss policies in positions that are moving against you.
Luckily, there are no daily limits on foreign exchange trading and no restrictions on trading hours other than the weekend. This means that there will nearly always be an opportunity to react to moves in the main currency markets and a low risk of getting caught without the opportunity of getting out. Of course, the market can move very fast and a stop-loss order is by no means a guarantee of getting out at the desired level.
But the main risk is really an event over the weekend, where all markets are closed. This happens from time to time as many important political events, such as G7 meetings, are normally scheduled for weekends.
But for speculative trading, we would always recommend the placement of protective stop-losses. With Saxo Bank Internet Trading you can easily place and change such orders while watching development graphically on your computer screen - which we believe is a unique feature in on-line trading today.
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