In this video, we’ll provide you with a broad overview of the foreign exchange market, as well as who may be participating in it and for what reason.
Why would an investor trade U.S. dollars for Swiss francs, and how would you assess those influences that move one currency – either in isolation – or relative to that of another nation?
In fact, it’s that relative movement that often makes it more challenging for some investors to grasp what currency trading is all about.
To provide you with a simple picture of this market, let’s take a look at how investing in foreign currencies can compare with stocks and other assets.
When you purchase a stock, you exchange a certain number of dollars for a certain number of shares – determined by the share price. And you’re making this transaction with the hope that these shares will outperform that cash, and of course those shares may also pay a dividend.
For hard assets, such as commodities, your investment is either based on your superior specialist knowledge about energy or agricultural products or your aversion to fiat currency.
In these cases, you would rather opt to exchange your dollars for an amount of crude oil or corn, for instance, hoping that such physical assets will maintain or increase in value as an alternative to the dollar over time.
But whether you’re investing in a stock or commodity, the concept is the same, you’re typically going to give up a unit of dollars in exchange for something else.
As an investor of foreign exchange, what you surrender is one nation’s currency for another – and you do so at an agreed upon exchange rate determined by many investors acting in the currency market.
Let’s say you give up a certain number of U.S. dollars in exchange for a sum of British pounds, or a number of Japanese yen in return for some amount of Swiss francs.
But why would you do this?
Well, here are a few reasons:
Just as you would hope that the stock or physical assets you bought will outperform your cash, as a foreign currency investor, you would expect the value of the currency unit you purchase to increase relative to the one sold.
Buyers and sellers forming such expectations are either speculators or Portfolio Managers. They can be either actively trading many times during the day or once or twice per year.
But however frequently they decide to participate in the market, they will typically have an obligation in the bought unit – such as a payment due for goods and services.
Examples of these may include:
- A U.S.-domiciled corporation that needs to pay overseas call center employees on a monthly basis; or
- A UK chocolate manufacturer that buys cocoa from a Swiss refiner each quarter
Foreign currency market participants may also intend to acquire an asset priced in the purchased currency, such as:
- A German citizen who needs cash to buy a holiday home in the Swiss alps; or
- A French pension fund that wants to purchase equities on the New York Stock Exchange
Average daily turnover in the foreign exchange market runs at around $5 trillion. That makes forex trading far greater in face value than daily averages for equities or bonds.
So, what’s the big attraction of dollars, pounds and yen?
Basically, currency trading has proven both liquid and volatile, attracting many investors.
Because of many competing views, currencies have lured many speculators, as well as corporate treasurers who need to minimize fluctuations, manage cash flows, hedge profits and project trends.
Disclosure: Interactive Brokers
The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.
The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Interactive Brokers, its affiliates, or its employees.
There is a substantial risk of loss in foreign exchange trading. The settlement date of foreign exchange trades can vary due to time zone differences and bank holidays. When trading across foreign exchange markets, this may necessitate borrowing funds to settle foreign exchange trades. The interest rate on borrowed funds must be considered when computing the cost of trades across multiple markets.