What does it mean to trade foreign currency?

Beginner Questions
1

Hello,

I teach international finance to college students, and one of the toughest things for me to explain and for my students to get their arms around is what does it really [U]mean[/U] to trade foreign currency? I feel like I understand [U]how[/U] to trade currencies and what you want to happen when you take a long or short position on a currency pair, but I don’t understand [U]what[/U] you are doing when you are trading currencies.

Trading stocks is much more simple for me to explain…you simply deposit money into a brokerage account, and then agree to either buy the stock now or later, a share of stock even being somewhat tangible.

But, currency is tough for me to explain. So, you put USD in an account and then let’s say that you want to take a long position on the USD vs. the EUR. When you do that, what actually happens in the markets? I mean, we already have USD in our account, so it isn’t like you are acquiring more USD. Does this basically mean you are shorting the Euro???

It gets even more confusing to me with cross rates. So, if you put USD in an account and take a long position on the Yen vs. the Euro, you want the Yen to get stronger against the Euro…I get that. But, what is really happening behind the scenes?

I am not sure if my questions make any sense, but any help that anyone could provide would be greatly appreciated…

Thank you very much!

2

Ok here goes

  1. Open usd account with broker. You give them $1,000
  2. You think usd rising vs. Euro. So you go short .01 lots of EURUSD.
  3. Broker writes you a derivative contract such that you get the (ask0-bid1).01100,000usd proceeds. Ask0 is the ask at time of entry and bid1 the bid at close
  4. Broker nets all their derivative positions off and places a net trade with a bank - who writes the broker a derivative
  5. Bank might then net its positions with another bank, etc, though the bank will itself trade while many brokers don’t.

At no point does anyone need to handover cash or actually exchange currencies. Until of course you want to close your account when the broker has to get some of their margin funds back from the bank.

3

Thank you, that is helpful!

4

No probs.

Main point is that the net global derivatives in fx is zero. My short EURUSD position with FXCBS is net zero when added to the long EURUSD position FXcbs has with me under that same contract. Similarly for FXcbs with their Counterparty bank.

So if I profit on the EURUSD position, where do my profits come from?

Well same day I take the trade, apple has to repatriate profit from its overseas manufacturing plant. It has €100m. They buy usd from BofA, the latter capturing the spread on the transaction. BofA were the Counterparty for FXcbs so pay them on the losing long EURUSD spot derivative. FXcbs then pay me. Apple generously buying usd because they had to nudged the market in my favour and paid spread that funds my lunch.

In practice of course this is a gross simplification but hopefully the point is clear.

5

And you teach college level international finance?

6

I don’t get the answers posted so far. Meaningful currency trading happens at the big banks. As far as I know, nobody who currently works in one of them has posted on these forums. I think a few ex-employees (or so they say) have posted. You are not going to get an insightful answer on these forums.

My idea of a currency trader is somebody who works in Toronto (or New York) selling American dollars and buying CAD on behalf of the Canadian oil producers who sell crude south of the border.

7

CodeMeister

  • I have worked for several big banks
  • my previous response was re retail spot trading, not wholesale interbank
  • note that if a us ny bank needs c$ for a client it already has them since there’s a c$ bank which needs usd for one of its clients. The net flows - ie actual money changing hands - are tiny compared with the gross ‘trading’ (number of times a money centre bank is getting bid-ask on the fx from customers)
8

Nice insult. And two people like it. Classy.

Just because I don’t fully understand what goes on [U]behind the scenes [/U]with fx trading means I shouldn’t teach college level international finance?

9

just seems like if you were teaching at a college leve you would already know this stuff. Seems like foreing exchange would be a core course in getting your finance teaching degree.

Never got a masters myself. just a BBA

10

Ok forget about the currency you deposited at your broker think of it as value. You place a position of value over one side of the forex you are trading. So Usd/Jpy if you think the yen is about to be stronger you place that value by selling ie using your value to buy yen by selling Usd. If it does get stronger you make money when you buy back Usd with the yen as you get more Usd for that Yen. Place that value over the Usd and use Yen to buy Usd and so when the Usd is stronger you buy Yen with it and you get more than when you started. this is the simplistic way to understand what is going on.

It works the same as stock options. The buying and selling may not actually physically occur but the option to buy at a price followed by the option to sell the same contract at a different price will. Or the option to sell at a price followed by the option to buy at a different price. More over you trade in value.

11

I know a ton about foreign exchange, just not some of the behind the scenes aspects. I have worked in international finance for the past 15 years as well, but largely in the corporate setting with big US multinationals, where trading fx currency pairs is not very common. Most of my expertise is dealing less with the economics of international finance and more with the practical side of how to deal with fx risk. Hedging (both from a finance and accounting perspective) through forwards and swaps, acquiring capital, minimizing global WACC, capital budgeting, transfer pricing, and minimizing global taxation are more of my specialties.

So, I am constantly trying to learn more of the economic side through various resources. Most folks are helpful, some folks don’t provide help but just snide comments.

12

Insult?
What insult?
That was merely a question, and a legit one to boot … though one with a (healthy) touch of sarcasm.

I’d surely expect my eco prof to know something as basic as that … like a student of medicine would expect his prof to know how exactly the lungs convert air into oxygene that can be utilized by the human body … even without seeing those lungs hanging out of peoples’ mouths all day long.

O.

13

So you’ve actively engaged in hedging as a method to offset r.o.e. risk for a large multinational corporation without knowing how it actually works?

Interesting.

O.

14

If it is so basic, why don’t you give me your explanation?

By the way, I am not an int’l econ prof, rather an int’l finance prof. Very different. Econ profs will tell you why fx moves, but won’t be able to fully explain how to deal with those risks. I don’t look down on them for it.

My econ side is not nearly as strong as my finance side. Feel free to ask me any questions about the topics I list above and see if you think I am qualified as a prof based on my answers.

15

Thank you to the posters who give me input…it is much appreciated.

And to the posters who had nothing but insults or sarcasm to add…you must be very proud of how smart you are. How nice it must be to be so smart and never have to ask any questions. And how nice it must have been to always have college profs who knew everything about all topics and never had to ask any questions to further their learning.

As much fun as this forum is…it seems that some people who rather just rip on others as compared to providing useful/helpful information. I will find another place to hang out.

Goodbye!

17

There’s a difference between teaching the theory of forex and teaching the mechanics of trading. Academia is primarily focused on the former and not so much on the latter - and with good reason, really. The functionality of transacting changes almost continuously. Theory changes much more slowly and obviously operates at a foundational rather than practical level.

20

In retail spot forex trading (which is our tiny corner of the overall, worldwide foreign exchange market), currencies are neither bought, nor sold, despite the fact that we use the terms “buy” and “sell”. We use those terms because it’s easy, not because it’s accurate.

To pick up on the original poster’s inquiry about what really happens when a retail trader, with a USD-denominated account, trades a currency pair which does not involve the USD, let’s walk through it. Let’s use his example of the EUR/JPY, and let’s confine the discussion to what happens at the retail forex broker level.

Let’s say you have a USD-denominated account with a U.S. retail forex broker. You place a market order to “buy” EUR/JPY, and your long position is opened almost instantaneously. Let’s talk about what you did [B]not[/B] do. You did not “buy” any euro, and you did not “sell” any yen, despite the fact that countless people on forex forums will say that’s exactly what you did.

Furthermore, it’s inaccurate to say that you “bought” a currency pair. “Owning a currency pair” is a phrase without meaning.

This trade does not involve ownership of, or title to, anything. You own the available balance in your trading account, which is USD in this example. Your broker might own some euro or yen, depending on his size and specific business interests; but, he does not sell them to you, or buy them from you, in the course of any retail spot forex transaction.

So, let’s describe your transaction without resorting to the misleading idea of “buying” and “selling”.

Technically, you have entered into a currency forward contract which is specified to settle in 2 days. However, each day your broker rolls your position (your contract) forward by one day. So, the contract does not expire, and the settlement date never arrives. Instead, the contract is terminated when you close your position — in the case of our example, by taking a short EUR/JPY position equal to your previous long position. This currency forward contract can be held open for as long as you choose, even for months or years (barring account problems, such as a severe drawdown resulting in a margin call).

The other side of your position (your currency forward contract) is held by your retail forex broker. He might immediately offset his side of your position with one of his liquidity providers, or he might aggregate a batch of such positions and offset his net exposure. Regardless, he (your broker) remains the counterparty to your position. For this reason, the CFTC refuses to refer to retail forex brokers as “brokers”; the CFTC refers to them formally as Retail Foreign Exchange Dealers (RFED’s), and stresses that they function as dealers, not as brokers.

So, clearly, your currency transaction (your long EUR/JPY position), resembles a “bet”, rather than a purchase transacted through a broker. You did not “buy” a currency pair; you placed a bet that the EUR will appreciate relative to the JPY.

In taking the other side of your “bet”, your forex broker is not exactly functioning like the agent at a racetrack betting window, because (unlike the agent at the racetrack) [B]your broker is your counterparty.[/B]

Neither does your broker function exactly like a “bookie”, because (unlike a bookie) he offsets individual or aggregated retail positions, by trading upstream with his liquidity providers, in order to control or eliminate his net exposure in all currencies.

As a side note, one exception to the “bookie” distinction is the so-called “bucket shop”, a business which represents itself as a forex “broker”, but has no affiliation with any liquidity provider. Such businesses, which exist only in certain offshore locations, are the under-belly of the retail spot forex industry. They operate in the same way as the infamous stock bucket shops of the 1920’s.

I hope that clears up some of your confusion.

21

I’m no gambler, but I would suggest that bookies are actually in fact the better’s counterparty. After all, it’s the bookie who has to pay the better the winnings and to whom the losses are owed, not some other party. Also, bookies do look to be neutral and make the “spread” so to speak. They are, for all intents and purposes, market makers.

22

I am glad that at least some of these post are informational and non inflammatory. The man asked some questions where he knew his knowledge was lacking which shows that he knows what he doesn’t know and is willing to admit it. Let him get his answers without bashing. I think per usual Clint / Rhody have given good info here. I just had to chime in on the BS. I couldn’t take it any longer.

23

You are correct.

I have edited my post to separate the two sentences about (1) the track betting agent, and (2) the bookie, to try to clarify what I was saying.