Forex Trading Basics
The spot rate is the price which you pay for a particular currency with delivery at the most recent possible date. The standard value date (spot date) for settlement of most spot deals is two business days.
Some currencies are considered as majors; these include the US dollar (USD), the euro (EUR), the British pound (GBP), the Swiss franc (CHF) and the Japanese yen (JPY).
When you ask a dealer for a quote, for example EUR/USD, they will give two different prices, e.g. 1.1212 - 1.1214. From the dealer’s perspective, the difference between the two numbers “buy” and “sell” is called a spread. If you want to buy 1 EUR, theoretically you have to pay 1.1214 USD for it, but if you want to sell 1 euro, you are going to be paid 1.1212 USD by your dealer. In this case, the difference between “buy” and “sell” (the spread) is equal to 0.0002, or 2 pips. In fact, buying one currency is the action of selling the other. Alternatively, selling one currency actually means that you are buying the other.
The spot date in the foreign exchange market is the normal settlement day for a transaction made today. It normally takes two business days to process all the necessary documents and carry out all transactions, keeping in mind that usually the countries whose currencies take part in the deal may be in different time zones and payments need to be synchronised. The spot date cannot be a Saturday, Sunday or any official holiday in any of the countries. In such cases, the spot date is the next business day.
There is an option for the deal to be negotiated with a value date that is different to the spot date - for example, the same day as the transaction date or the next business day. Then the exchange rate would be different from the exchange rate on the spot date - because the two countries have different interest rates.
Pips and Figures
The following example demonstrates what pips and figures are:
Usually, currencies are quoted using four digits after the decimal point, which means that one pip equals 1/10,000 of the currency unit. In the example above, EUR/USD, there is a difference of 2 pips between “buy” and “sell”, but there is no difference in the value of the figures.
This is not the case when the Japanese yen is the quote currency. Due to the high denomination of the yen against the US dollar, e.g. 102.38 – 102.40, the yen is quoted only two positions after the decimal point. In this case, one pip is equal to 1/100 of the yen.
Fractional Pips: 5-Digit Quotes
Some brokers, including Deltastock, use fractional pips to enhance precision in pricing and give traders more freedom, as prices can be further broken down. A fractional pip is equal to 1/10 of a pip and is represented by an additional 5th digit after the decimal point – e.g. EUR/USD 1.12347.
Respectively, JPY crosses are quoted to the third digit, instead of the second one.
Direct and Indirect Quotes
On the currency exchange market in every country, the local currency is quoted directly or indirectly against the US dollar and other foreign currencies.
Let us presume that the following exchange rates are valid.
- The direct quote is the amount of local currency needed to buy one unit of the foreign currency and the amount of local currency, respectively, due to be received when one unit of foreign currency is being sold:
102.38 – 102.40 USD/JPY
This means that dealers are buying one dollar for 102.38 yen, but are selling it for 102.40 yen.
- On the other hand, the indirect quote is the amount of foreign currency needed to buy one unit of the local currency. For instance, the following indirect quote is used for quoting the British Pounds versus the US Dollar:
1.3280 – 1.3283 GBP/USD
This means you have to pay 1.3283 USD to buy 1 GBP and if you want to sell 1 GBP, you will receive 1.3280 USD for it.
Base and Quote Currencies
The spot exchange rate is the price of one currency in terms of another. In the example above, 102.38 – 102.40 USD/JPY, the USD is the base currency and the JPY is the quote currency. This is not the case in our second example, 1.3280 – 1.3283 GBP/USD, where the USD is the quote currency because it is second in the GBP/USD expression.
A cross rate is the exchange rate between two currencies that are not official in the country where the rate is calculated. On the Forex market, the term ‘cross rate’ is used for non-US dollar currency pairs, also known as ‘crosses’. We can derive cross exchange rates for the GPB, EUR, JPY and CHF from the major currencies. Exchange rates must be at parity across all currencies, or else an arbitrage, or risk-free profit, would be possible.
Example: calculating cross rates
Let us presume that the following major exchange rates are valid:
EUR/USD = 1.1212/14
GBP/USD = 1.3280/83
USD/JPY = 102.38/40
USD/CHF = 0.9711/14
Now let us calculate GBP/CHF:
GBP/USD: Buy: 1.3280 / Sell: 1.3283
GBP/USD X USD/CHF = 1.3280 X 0.9711 / 1.3283 X 0.9714
Cross Rate Effect
The GBP/USD currency pair is sometimes impacted by movements in cross exchange rates (non-dollar exchange rates) such as EUR/GBP. For instance, a rise in EUR/GBP (fall in GBP), triggered by strengthening expectations of the UKleaving the European Single Market, could lead to a decline in GBP/USD. Conversely, reports indicating that the UK will not leave the European Economic Area after all could hurt the EUR/GBP, thereby boosting the GBP/USD.
What affects the prices of currencies
Currency prices (exchange rates) are affected by a variety of economic and political events – mainly by supply and demand, but also by interest rates, inflation and political stability.
Each of above factors as well as some large market orders can cause high volatility in currency prices. Nevertheless, the size and volume of the Forex market make it impossible for it to be driven in a certain direction by just one participant.
What is Balance-of-Payments
The exchange rate of any foreign currency depends on a multitude of factors that affect the economic and financial conditions in the country issuing the currency. One of the most important factors is the country’s balance-of-payments records. When a country experiences a deficit in its balance of payments, it becomes a net demander of foreign currencies and is forced to sell substantial amounts of its own currency to pay for imports of goods and services. Therefore, balance-of-payments deficits often lead to depreciation of a nation's currency relative to the other currencies.
Why are central bank interventions necessary
By implementing their monetary policies, central banks actively participate on the Forex market. This can be achieved by different means. For example, on one hand, by setting interest rates, and on the other, by increasing the supply of domestic currency on the market in order to lower its price; or vice versa: buy to raise its price. The intervention by the central banks is determined by achieving different goals: previously targeted levels of economic growth, unemployment, inflation, etc.
Why is inflation important
Inflation is a general increase in the prices of goods and services, which results in reduced purchasing power of a unit of the local currency. When one country’s inflation rate rises relative to others, its currency tends to fall in value. Similarly, a nation that reduces its inflation rate usually experiences a rise in the value of its currency. Moreover, countries with higher real interest rates generally experience an increase in the exchange rate of their currencies.
Note: Views expressed here are for education purposes only and are not the views of Deltastock or its employees. These views are not personal recommendations or investment advice. Any quotes of financial instruments displayed on this page are for reference purposes only and do not reflect the current market situation. You may wish to seek independent advice before entering into transactions.