An introduction to FX trading
The foreign exchange market is one of the most liquid and interesting markets in the financial system. In this article we try to give you a solid introduction to FX markets.
Introduction to FX markets
First, a quick introduction to foreign exchange (FX) markets for those of you who are not familiar with this market. As mentioned in the header for this article FX markets are some of the most liquid markets in the world. As shown in Figure 1 the FX market has been increasing in turnover over the past two decades. FX swaps are responsible for the majority of FX market turnover. (Figure 1) Figure 1 also shows the many different ways FX can be traded which we will explore now.
Spot- The FX spot rate refers to the ongoing and regularly updated quotation of exchange rates for various currency pairs. It is distinct from the forward or swap rate.
FX Swaps- A FX swap is a contractual arrangement between two parties to exchange interest rate payments on their loans denominated in different currencies. This agreement can also involve exchanging the principal amounts of the loans. Foreign currency swaps can be advantageous for companies as they allow them to borrow at a more favorable rate compared to local financial institutions. Additionally, these swaps can be utilized as a hedge for an existing investment from the potential risks arising from fluctuations in exchange rates.
Outright Forwards- An outright forward, also known as a currency forward, is a financial agreement for a specific currency that fixes the exchange rate and establishes a future delivery date that extends beyond the spot value date. The pricing of an outright forward is determined by combining the spot rate with the forward points, which are derived from the interest rate differential.
Options & other products- This one is rather self explanatory, think FX future options.
Currency swaps- A cross-currency swap is an over-the-counter derivative product commonly conducted between interest rate dealers and their clients. It involves exchanging cash flows from loans in different currencies. The swap contract specifies the initial exchange of currencies, the notional amount, and the repayment terms throughout the duration of the swap. Additionally, a cross-currency swap entails swapping the interest payments from a loan in currency A with the interest payments from a loan in currency B.
Those products make up the bulk of FX turnover, if some of the definitions went over your head do not worry. We will mostly be focusing on spot and futures FX in this article.
Now you might be wondering what exactly are some of the main drivers in FX markets price action. Well to start with FX markets price action is extremely complex with many different moving parts that affect price. With that being said we will focus on the interconnectedness of FX pricing with interest rates and inflation. This makes sense inherently when you remember a currency is a reflection of the home country’s economic conditions. (Most of the time) Interest rates both from aboard and the currencies home Central bank rate. (CB) Below in Figure 2 we can see a table that outlines a basis case for FX price action after a currencies home CB hikes, cuts or holds when compared to the market expectations. This of course is not going to happen the exact way the table layout does beecause as mentioned before there are many different possible drivers of FX price action.
Inflation and CB rates are of course interconnected with rate hikes having the goal of lowering inflation and rate cuts having the opposite goal. The anticipation of increased inflation causes shifts in the future value of a currency, generally speaking. That is all we have for our brief FX introduction, however if you are interested in learning more we have included further reading in the references section.
Quick FX takes
In the near to medium term we are bearish on the USD. However that being said we will also be watching the 98-97 level as we believe this is a decent support for DXY. (Figure 3)
References
DISCLAIMER: We are not Financial Advisors, and all information presented is for educational purposes ONLY. Financial markets can be extremely volatile, as such using good risk management is a must.