FOREIGN EXCHANGE
Forex (FOReign EXchange market) is an inter-bank market that took shape in
1971 when global trade shifted from fixed exchange rates to floating ones. This
is a set of transactions among forex market agents involving exchange of
specified sums of money in a currency unit of any given nation for currency of
another nation at an agreed rate as of any specified date. During exchange, the
exchange rate of one currency to another currency is determined simply: by
supply and demand – exchange to which both parties agree.
The scope of transactions in the global currency market is constantly
growing, which is due to development of international trade and abolition of
currency restrictions in many nations. Global daily conversion transactions came
to $1,982 billion in mid-1998 (the London market accounted for some 32% of daily
turnover; the New York market exchanged approx. 18%, and the German market,
10%). Not only the scope of transactions but also the rates that mark the market
development are impressive: in 1977, the daily turnover stood at five billion
U.S. dollars; it grew to 600 billion U.S. dollars over ten years – to one
trillion in 1992. Speculative transactions intended to derive profit from
jobbing on the exchange rate differences make up nearly 80% of total
transactions. Jobbing attracts numerous participants – both financial
institutions and individual investors.
With the highest rates of information technology development in the last two
decades, the market itself changed beyond recognition. Once surrounded with a
halo of caste mystique, the foreign exchange dealer’s profession became almost
grasroots. Forex transactions that used to be the privilege of the biggest
monopolist banks not so long ago are now publicly accessible thanks to
e-commerce systems. And the foremost banks themselves also often prefer trade in
electronic systems over individual bilateral transactions. E-brokers now account
for 11% of the forex market turnover. The daily scope of transactions of the
biggest banks (Deutsche Bank, Barclays Bank, Union Bank of Switzerland,
Citibank, Chase Manhattan Bank, Standard Chartered Bank) reaches billions of
dollars.
The FOREX market as a place where to apply one’s personal financial,
intellectual and psychic power is not designed for attempts at catching a
bluebird there. Sometimes someone manages to do so but for a short time only.
The key advantage of a forex market is that one can succeed there just by the
strength of one’s intelligence.
Another essential feature of the FOREX market, no matter how strange it might
seem, is its stability. Everybody knows that sudden falls are very typical of
the financial market. However, unlike the stock market, the FOREX market never
falls. If shares devalue it means a collapse. But if the dollar slumps, that
only means that another currency gets stronger. For instance, the yen
strengthened by a quarter against the dollar late in 1998. On some days dollar
fell by dozens percentage points. However, the market did not collapse anywhere;
trading continued in the usual manner. It is here that the market and the
related business stability lie - currency is an absolutely liquid commodity and
will be always traded in.
The FOREX market is a 24-hour market that does not depend on certain business
hours of foreign exchanges; trade takes place among banks located in different
corners of the globe. Exchange rates àre so flexible that significant changes
happen quite frequently, which enables to make several transactions every day.
If we have an elaborate and reliable trade technology we can make a business,
which no other business can match by efficiency. It is not without reason that
the pivotal banks buy expensive electronic equipment and maintain the staffs of
hundreds of traders operating in different sectors of the FOREX market.
The starting costs of joining this business are very low now. Actually, it
costs several thousands of dollars to take a course of initial training, to buy
a computer, to purchase an information service and to create a deposit; no real
business can be established with this money. With excessive offers of services,
finding a reliable broker is also quite a real thing. The rest depends on the
trader himself or herself. Everything depends on you personally, as in no other
area of business now.
The main thing the market will require for successful
operations is not the quantity of money you will enter it with – the main thing
is the ability to constantly focus on studying the market, understanding its
mechanisms and participants’ interests; this is constant improvement of one’s
trade approaches and their disciplined implementation. Nobody has achieved
success in that market by forcing one’s way with one’s capital atilt. The market
is stronger than anything else; it is even stronger than central banks with
their huge foreign exchange reserves. George Soros, a national hero of the FOREX
market, did not win the Bank of England at all, as many of us believe – he made
the right guess that, with existing contradictions inherent in the European
financial system, there were plenty of problems and interests that would not
allow to hold the pound. That’s exactly what happened. The Bank of England,
having spent nearly $20 billion to maintain the pound rate, jacked it up, by
giving it in to the market. The market settled this problem, and Soros got his
billion.
The global monetary system has gone a long way during thousands of
years of the human history, but it is surely experiencing the most exciting and
earlier unthinkable changes. The two main changes determine a new image of the
global monetary system:
the money is fully separated from any tangible media;
powerful
information and telecommunications technologies made it possible to consolidate
monetary systems of different nations into the single global financial system
that has no boundaries.
Typical attractive features of the market:
liquidity: the market operates the enormous money supply and
gives absolute freedom in opening or closing a position in the current market
quotation. High liquidity is a powerful magnet for any investor, because it
gives him or her the freedom to open or to close a position of any size
whatever.
promptness: with a 24-hour work schedule, participants in
the FOREX market need not wait to respond to any given event, as is the case in
many markets.
availability: a possibility to trade round-the-clock; a
market participant need not wait to respond to any given event;
flexible regulation of the trade arrangement system: a
position may be opened for a pre-determined period of time in the FOREX market,
at the investor’s discretion, which enables to plan the timing of one’s future
activity in advance;
value: the Forex market has traditionally incurred no
service charges, except for the natural bid/ask market spread between the supply
and the demand price;
one-valued quotations: with high market liquidity, most
sales may be carried out at the uniform market price, thus enabling to avoid the
instability problem existing with futures and other forex investments where
limited quantities of currency only can be sold concurrently and at a specified
price;
market trend: currency moves in a quite specific direction
that can be tracked for rather a long period of time. Each particular currency
demonstrates its own typical temporary changes, which presents investment
managers with the opportunities to manipulate in the FOREX market;
margin: the credit “leverage” (margin) in the FOREX market
is only determined by an agreement between a customer and the bank or the
brokerage house that pushes it to the market and is normally equal to 1:100.
That means that, upon making a $1,000 pledge, a customer can enter into
transactions for an amount equivalent to $100,000. It is such extensive credit
“leverages”, in conjunction with highly variable currency quotations, which
makes this market highly profitable but also highly risky.
Margin Trading System
A typical transaction amounts to $10 million in inter-bank trade. However, it
is quite clear that such transaction values are not affordable for a private
investor – well, at least to the overwhelming majority of them.
Involvement of small and medium investors in the Forex market was facilitated
by intermediacy of dealing or brokerage companies. Medium and small investors
have access to the global forex market in many nations, using the sums of money
starting from $2,000 in their transactions. A dealing company provides its
customers with a credit line – a so-called dealing leverage, or a credit
leverage, that is several times as big as the deposit. Brokers providing margin
trading services require that a pledge deposit should be contributed, and
provide a customer with an opportunity of entering into forex sales and purchase
transactions for amounts that are 50, 100 and sometimes even 200 times as large
as the deposit made. The risk of losses is borne by the customer; the deposit
serves as security hedging a broker. The system of operations through a dealing
(brokerage) house, with a credit leverage, was called margin trading.
To put it simply, the essence of margin trading can be reduced to the
following: by placing pledged capital, an investor becomes able to manage target
loans provided against this pledge and to guarantee indemnification against any
potential losses on open forex positions with the deposit.
As mentioned above, unlike with forex transactions with actual delivery or
actual currency exchange, FOREX participants, especially those with little
funds, make use of trading with an insurance deposit - margin trade, or leverage
trade. In case of marginal trade, each transaction must consist of the two
stages – purchase/sales of foreign exchange at one price, and then its
compulsory sales/purchase at another (or at the same) price. The first action is
called the opening of a position; the second is the closing of a position.
Opening of a position is not accompanied with actual delivery of foreign
exchange, and a participant that opened the position contributes an insurance
deposit that serves as guarantee of indemnification against any possible losses.
Upon closing of a position, the insurance deposit is returned, and profit or
losses are calculated.
Any margin trading transaction must comprise two parts: opening of a position
and closing of a position. For instance, when forecasting the euro goes up
(looks up) vs the dollar, we want to buy a cheaper euro with dollars now and to
sell it back when it rises in price. In this case, the transaction will look as
follows: opening of a position – euro purchase; closing of a position – its
sale. All the time until the position has been closed we have an “open euro
position.” Just the same, when we believe that the euro will cheapen (look down)
vs the dollar, our transaction will consist of the following steps: opening a
position – sales of a more expensive euro; closing a position – purchase of a
cheapened euro. Therefore, we are able to generate profit whether the exchange
rate goes up or down.
You can enter FOREX through an intermediary only. A dealing center may act as
such intermediary. This agency provides you with a (computer or telephone)
communications channel with a broker who makes available forex quotations to you
and through whom you can enter into transactions. You can also operate directly
from your home PC through the Internet. The last option has been becoming
increasingly more common recently. The prices you can see on your computer’s
screen are prices of actual transactions at FOREX.
A customer concludes a contract with the company whereby the latter
undertakes, at the customer’s order and in its own name, to enter into
transactions. In this case, the company runs the risk of losses from entering
into such transactions, so the customer deposits a certain sum of money with the
bank as pledge. The amount of this deposit is determined based on the amount of
transactions entered into by the bank and on the credit lever provided to the
customer. If a dealing company makes losses from a concluded transaction, the
investor becomes liable to it in the amount of this loss, and these liabilities
are covered from the pledge deposit; if the company generates profit from a
concluded transaction, it becomes liable to the investor in the amount of this
profit. Generated profit is remitted to the customer’s pledge deposit. The
customer’s order to the company to close an open position is a must; yet the
company jobs with its own money. Otherwise the bank may close a long position
with a short one, and the customer may sustain losses. The situations when cross
rates change by more than two percentage points hardly ever happen in the global
market, and losing his or her pledge is next to impossible if a customer jobs
reasonably. If the bank’s dealer understands that potential losses, if the rate
changes for the worse, might exceed the pledge deposit amount, the dealer can
close a position independently, without waiting for the customer’s instructions,
with losses not exceeding the pledge amount.
Margin trading appeals by its affordability. Investing funds into securities
of the most developed foreign countries to generate any fixed income would
hardly be interesting for our compatriots. U.S. Treasury bonds are surely the
most reliable and stable, but, being very expensive, they have low yield
(approx. 6% p.a.) and are the object of long-term investments. Shares generate
higher yield; however, dividend amount is directly dependent on successful
operations of any particular enterprise and its shareholders’ preferences. Share
purchase for bull transactions seems more attractive but requires greater
investments. Margin trading is free from the said limitations – you can sell and
buy depending on your expectations, and 1%-3% of a transaction value will do to
enter into the transaction.
