8 Basic Forex Market Concepts

You don't have to be a daily trader to take advantage of the forex market - every time you
travel overseas and exchange your money into a foreign currency, you are participating in
the foreign exchange (forex) market. In fact, the forex market is the quiet giant of finance,
dwarfing all other capital markets in its world.
Despite this market's overwhelming size, when it comes to trading currencies, the concepts
are simple. Let's take a look at some of the basic concepts that all forex investors need to
understand.
Eight Majors
Unlike the stock market where investors have thousands of stocks to choose from, in the
currency market, you only need to follow eight major economies and then determine which
will provide the best undervalued or overvalued opportunities. These following eight
countries make up the majority of trade in the currency market:

United States
Eurozone (the ones to watch are Germany, France, Italy and Spain)
Japan
United Kingdom
Switzerland
Canada
Australia
New Zealand

These economies have the largest and most sophisticated financial markets in the world. By
strictly focusing on these eight countries, we can take advantage of earning interest income
on the most credit-worthy and liquid instruments in the financial markets.
Economic data is released from these countries on an almost daily basis, allowing investors
to stay on top of the game when it comes to assessing the health of each country and its
economy.

Yield and Return

When it comes to trading currencies, the key to remember is that yield drives return.
When you trade in the foreign exchange spot market, you are actually buying and selling
two underlying currencies. All currencies are quoted in pairs, because each currency is
valued in relation to another. For example, if the EUR/USD pair is quoted as 1.3500 that
means it takes $1.35 to purchase one euro.

In every foreign exchange transaction, you are simultaneously buying one currency and
selling another. In effect, you are using the proceeds from the currency you sold to purchase
the currency you are buying. Furthermore, every currency in the world comes attached with
an interest rate set by thecentral bank of that currency's country. You are obligated to pay
the interest on the currency that you have sold, but you also have the privilege of earning
interest on the currency that you have bought.
For example, let's look at the New Zealand dollar/Japanese yen pair (NZD/JPY). Let's
assume that New Zealand has an interest rate of 8% and that Japan has an interest rate of
0.5% In the currency market, interest rates are calculated in basis points. A basis point is
simply 1/100th of 1%. So, New Zealand rates are 800 basis points and Japanese rates are
50 basis points. If you decide to go long NZD/JPY you will earn 8% in annualized interest,
but have to pay 0.5% for a net return of 7.5%, or 750 basis points.
Leveraging Returns
The forex market also offers tremendous leverage - often as high as 100:1 - which means
that you can control $10,000 worth of assets with as little as $100 of capital. However,
leverage can be a double-edged sword; it can create massive profits when you are correct,
but may also generate huge losses when you are wrong.
Clearly, leverage should be used judiciously, but even with relatively conservative 10:1
leverage, the 7.5% yield on NZD/JPY pair would translate into a 75% return on an annual
basis. So, if you were to hold a 100,000 unit position in NZD/JPY using $5,000 worth of
equity, you would earn $9.40 in interest every day. That's $94 dollars in interest after only 10
days, $940 worth of interest after three months, or $3,760 annually. Not too shabby given
the fact that the same amount of money would only earn you $250 in a bank savings
account (with a rate of 5% interest) after a whole year. The only real edge the bank account
provides is that the $250 return would be risk-free. (For more insight, see Forex Leverage: A
Double-Edged Sword and Leverage's "Double-Edged Sword" Need Not Cut Deep.)
The use of leverage basically exacerbates any sort of market movements. As easily as it
increases profits, it can just as quickly cause large losses. However, these losses can be
capped through the use of stops. Furthermore, almost all forex brokers offer the protection
of a margin watcher - a piece of software that watches your position 24 hours a day, five
days per week and automatically liquidates it once margin requirements are breached. This
process insures that your account will never post a negative balance and your risk will be
limited to the amount of money in your account. (For more on managing losses, see Money
Management Matters.)

Carry Trades
Currency values never remain stationary and it is this dynamic that gave birth to one of the
most popular trading strategies of all time, the carry trade. Carry traders hope to earn not
only the interest rate differential between the two currencies, but also look for their positions
to appreciate in value. There have been plenty of opportunities for big profits in the past.
Let's take a look at some historical examples. (To learn more, read Currency Carry Trades
Deliver.)
Between 2003 and the end of 2004, the AUD/USD currency pair offered a positive
yield spread of 2.5%. Although this may seem very small, the return would become 25%
with the use of 10:1 leverage. During that same time, the Australian dollar also rallied from
56 cents to close at 80 cents against the U.S. dollar, which represented a 42% appreciation
in the currency pair. This means that if you were in this trade - and many hedge funds at the
time were - you would have not only earned the positive yield, but you would have also seen
tremendous capital gains in your underlying investment.

Figure 1: Australian Dollar Composite, 2003-2005

The carry trade opportunity was also seen in USD/JPY in 2005. Between January and
December of that year, the currency rallied from 102 to a high of 121.40 before ending at
117.80. This is equal to an appreciation from low to high of 19%, which was far more
attractive than the 2.9% return in the S&P 500 during that same year. In addition, at the

time, the interest rate spread between the U.S. dollar and the Japanese yen averaged
around 3.25%. Unleveraged, this means that a trader could have earned as much as
22.25% over the course of the year. Introduce 10:1 leverage, and that could be as much as
220% gain.

Figure 2: Japan Yen Composite, 2005

Source: eSignal
Carry Trade Success
The key to creating a successful carry trade strategy is not simply to pair up the currency
with the highest interest rate against a currency with the lowest rate. Rather, far more
important than the absolute spread itself is the direction of the spread. In order for carry
trades to work best, you need to be long a currency with an interest rate that is in the
processes of expanding against a currency with a stationary or contracting interest rate.
This dynamic can be true if the central bank of the country that you are long in is looking to
raise interest rates or if the central bank of the country that you are short in is looking to
lower interest rates.
In the previous USD/JPY example, between 2005 and 2006 the U.S.Federal Reserve was
aggressively raising interest rates from 2.25% in January to 4.25%, an increase of 200 basis
points. During that same time, the Bank of Japan sat on its hands and left interest rates at
zero. Therefore, the spread between U.S. and Japanese interest rates grew from 2.25%
(2.25% - 0%) to 4.25% (4.25% - 0%). This is what we call an expanding interest rate spread.

The bottom line is that you want to pick carry trades that benefit not only from a positive and
growing yield, but that also have the potential to appreciate in value. This is important
because just as currency appreciation can increase the value of your carry trade earnings,
currency depreciation can erase all of your carry trade gains - and then some. (discuss
the Carry Trade Strategy)
Getting to Know Interest Rates
Knowing where interest rates are headed is important in forex trading and requires a good
understanding of the underlying economics of the country in question. Generally speaking,
countries that are performing very well, with strong growth rates and increasing inflation will
probably raise interest rates to tame inflation and control growth. On the flip side, countries
that are facing difficult economic conditions ranging from a broad slowdown in demand to a
full recession will consider the possibility of reducing interest rates. (To learn more,
read Trying To Predict Interest Rates.)
The Bottom Line
Thanks to the widespread availability of electronic trading networks, forex trading is now
more accessible than ever. The largest financial market in the world offers a world of
opportunity for investors who take the time to get to understand it and learn how to mitigate
the risk of trading here.