Spot Currencies

OVERVIEW

Foreign exchange is the simultaneous buying of one currency and selling of another. Currencies are traded through a broker or dealer and are executed in pairs, for example, the Euro and the U.S. dollar (EUR/USD) or the British pound and the Japanese yen (GBP/JPY). The foreign exchange market (Forex) is the largest financial market in the world, with a volume of over $2 trillion daily. This is more than three times the total amount of the stocks, options, and futures markets combined.

Unlike other financial markets, the Forex spot market has no physical location, nor a central exchange. It perates through an electronic network of banks, corporations, and individuals trading one currency for another. The lack of a physical exchange enables the Forex to operate on a 24-hour basis, spanning from one time zone to another across the major financial centers. This fact has a number of ramifications that we will discuss throughout

this book.

A spot market is any market that deals in the current price of a financial instrument. Futures markets, such as the Chicago Board of Trade (CBOT), offer commodity contracts whose delivery date may span several months into the future. Settlement of Forex spot transactions usually occurs within two business days.

CURRENCY PAIRS

Every Forex trade involves the simultaneous buying of one currency and the selling of another currency. These two currencies are always referred to as the currency pair in a trade.

BASE CURRENCY

The base currency is the first currency in any currency pair. It shows how much the base currency is worth, as measured against the second currency. For example, if the USD/CHF rate is 1.6215, then one U.S. dollar is worth 1.6215 Swiss francs. In the Forex markets, the U.S. dollar normally is considered the base currency for quotes, meaning that quotes are expressed as a unit of US$1 per the other currency quoted in the pair. The primary exceptions to this rule are the British pound, the Euro, and the Australian dollar.

QUOTE CURRENCY

The quote currency is the second currency in any currency pair. This is frequently called the pip currency, and any unrealized profit or loss is expressed in this currency.

PIPS AND TICKS

A pip is the smallest unit of price for any foreign currency. Nearly all currency pairs consist of five significant digits, and most pairs have the decimal point immediately after the first digit; that is, EUR/USD equals 1.2812. In this instance, a single pip equals the smallest change in the fourth decimal place, that is, 0.0001. Therefore, if the quote currency in any pair is USD, then one pip always equals 1/100 of a cent. One notable exception is the USD/JPY pair, where a pip equals US$0.01 (one U.S. dollar equals approximately 107.19 Japanese yen). Pips sometimes are called points. Just as a pip is the smallest price movement (the y axis), a tick is the smallest interval of time along the x axis that occurs between

two trades. (Occasionally, the term tick is also used as a synonym for pip.) When trading the most active currency pairs (such as EUR/USD and USD/JPY) during peak trading periods, multiple ticks may (and will) occur within the span of one second. When trading a low-activity minor cross-pair (such as the Mexican peso

and the Singapore dollar), a tick may occur only once every two or three hours (Figure 1-1). Ticks, therefore, do not occur at uniform intervals of time. Fortunately, most historical data vendors will group sequences of

streaming data and calculate the open, high, low, and close over regular time intervals (1, 5, and 30 minutes, 1 hour, daily, and so forth).

BID PRICE

The bid is the price at which the market is prepared to buy a specific currency pair in the Forex market. At this price, the trader can sell the base currency. The bid price is shown on the left side of the quotation. For example, in the quote USD/CHF 1.4527/32, the bid price is 1.4527, meaning that you can sell one U.S. dollar

for 1.4527 Swiss francs.

ASK PRICE

This ask is the price at which the market is prepared to sell a specific currency pair in the Forex market. At this price, the trader can buy the base currency. The ask price is shown on the right side of the quotation. For example, in the quote USD/CHF 1.4527/32, the ask price is 1.4532, meaning that you can buy one U.S. dollar for 1.4532 Swiss francs. The ask price is also called the offer price.

BID/ASK SPREAD

The difference between the bid price and ask price is called the spread. The big-figure quote is a dealer expression referring to the first few digits of an exchange rate. These digits often are omitted in dealer quotes. For example, a USD/JPY rate might be 117.30/117.35 but would be quoted verbally without the first three digits as 30/35. The critical characteristic of the bid/ask spread is that it is also the transaction cost for a round-turn trade. Round turn means both a buy (or sell) trade and an offsetting sell (or buy) trade of the same size in the same currency pair. In the case of the EUR/USD rate above, the transaction cost is 3 pips (Figure 1-2).

FORWARDS AND SWAPS

Outright forwards are structurally similar to spot transactions in that once the exchange rate for a forward deal has been agreed, the confirmation and settlement procedures are the same as in the cash market. Forwards are spot transactions that have been held over 48 hours but less than 180 days when they mature and are

liquidated at the prevailing spot price.

Forex swaps are transactions involving the exchange of two currency amounts on a specific date and a reverse exchange of the same amounts at a later date. Their purpose is to manage liquidity and currency risk by executing foreign exchange transactions at the most appropriate moment. Effectively, the underlying

amount is borrowed and lent simultaneously in two currencies, for example, by selling U.S. dollars for the Euro for spot value and agreeing to reverse the deal at a later date. Since currency risk is replaced by credit risk, such transactions are different conceptually from Forex spot transactions. They are, however, closely linked because Forex swaps often are initiated to move the delivery date of a foreign currency originating from spot

or outright forward transactions to a more optimal moment in time. By keeping maturities to less than a week and renewing swaps continuously, market participants maximize their flexibility in reacting to market events. For this reason, swaps tend to have shorter maturities than outright forwards. Swaps with maturities of up to one week account for 71 percent of deals, compared with 53 percent for outright forwards. For additional information, see www.aforextrust.com/spot-forex-forex-forwards-forex-swaps.htm.