Are Exchange Rates Foreign to You? Here's a Currency Primer

Here’s a riddle: What asset class averages about $5.1 trillion in trading each day, is available virtually 24 hours a day, 6 days a week, affects each of us pretty much whenever we open the wallet or purse and swipe that card, yet most retail investors don’t participate directly?

If you answered “foreign exchange,” congratulations. Other pseudonyms might include currencies, exchange rates, forex, or simply FX. Whatever name you choose, forex rates are what it costs to exchange one country’s currency for another country’s currency. And it’s what keeps the global system of imports, exports, and payments in balance—from the goods in our homes and shopping baskets to some of the investments in our portfolios.

"If you're a sophisticated trader in search of a different asset class to trade, a savvy investor interested in international exposure, or if you're traveling to a foreign country and want to follow its currency, it might help to learn a few things about this large and global market," says Adam Hickerson, Futures & Forex Manager, TD Ameritrade.

Currency Pairs: Understanding the Quote

Just like trading options, forex trading is subject to unique risks and isn’t suitable for everyone. It takes time to understand how the product is traded and quoted. When trading forex, you’re not just trading one product, you’re trading two currencies against each other. The quote for a forex currency pair references what it costs to convert one currency into the other.

Let’s look at the U.S dollar versus the Canadian dollar (USD/CAD) as an example. If USD/CAD is trading at 1.37, that means $1 USD is equal to $1.37 CAD. The easiest way to understand the quote of any currency pair is to read the pair from left to right. Let’s look at another example for the Euro vs the U.S dollar (EUR/USD). If EUR/USD is trading at 1.09 that means 1 Euro is equal to $1.09 USD. One last example is the British Pound vs the U. S. dollar.  If GBP/USD is trading at 1.29 that means 1 GBP is equal to $1.29 USD. 

Currency Fluctuations: It’s Relative

Currencies fluctuate for reasons similar to those of other asset classes—interest rates, inflation, economic growth, and future expectations—but with a twist. And the twist is, it's these economic dynamics relative to those same dynamics in the other half of the currency pair.

For example, in June 2016 when Britain voted to leave the European Union, the pound dropped from about $1.50 to below $1.30 within a week. Why? Because the Brexit vote lowered growth and interest rate expectations among many investors. Meanwhile, the U.S. had begun hiking its interest rates a few months earlier. So, relatively speaking, market participants saw the dollar and dollar-based investments as having a higher return profile than those based in pounds, and the exchange rate adjusted accordingly. See figure 1 below.

Although the fluctuations aren’t quite so pronounced most of the time, exchange rates do react to economic data, meetings, and speeches by central bankers, as well as anything that might affect the relative expectations of growth, interest rates, and inflation among nations and their currencies.  

Currency Platforms

The bulk of foreign exchange rate trading takes place in what's called the interbank market,  which is an Over The Counter (OTC) market that is not traded on an exchange. The interbank market consists of a web of banks, dealers, and intermediary brokers—basically institutional players. And although it's traded OTC, there are many players, which generally means tight prices and a solid price discovery system.

Retail participants, in general, don't have direct access to the interbank market, but the price information is used by retail platforms offering foreign exchange, called retail forex brokers. These platforms are generally compensated through the bid/ask spread, although some platforms offer the choice between a commission-based market (usually with a tighter bid/ask spread) or a commission-free market.

The major currencies, such as the dollar, euro, pound, and yen, have tight spreads most of the time, but the spread can fluctuate during the day. And some of the more obscure pairs (called "exotics") may have wider spreads than the major pairs. Plus, forex trading involves leverage, which means you can control a large investment with a relatively small amount of money. But leverage is a double-edged sword, as it can compound both your profits and your losses. In short, if you think forex might be right for you, the TD Ameritrade forex page may answer many of your questions.

And then there's the futures market—made up of exchange-traded, standardized contracts for future delivery of several major currencies versus the U.S. dollar. The thinkorswim platform offers qualified account holders to access this market, which is also open virtually 24 hours a day, 6 days a week.

“Futures contracts can be similar to forex trading as futures contracts allow you to control a large investment with a relatively small amount of money. However, one difference in trading forex is you can control the size of your position, as forex can be traded in 1,000, 10,000 or 100,000 lot increments.  On the contrary, the futures market uses a standardized contract with a defined size which doesn’t offer the investor the same flexibility as forex,” Hickerson says.

The bottom line? If you're a sophisticated investor looking for international exposure and see long-term or short-term opportunities in cross-border interest rate differentials, the foreign exchange market may be worth a look.  

If you'd like to take a deeper dive into the futures market and discover potential trading in one of the world's most active markets visit our futures trading page.