The currency market

The FINANCIAL — The worldwide currency market is a very unusual one.

The FINANCIAL — The worldwide currency market is a very unusual one. By far most of the trading activity that takes place is of a speculative nature, and is conducted by traders at big banks and asset management firms. In these transactions, the traders hope to profit from changes in the relative prices of these currencies. Then there are players in this market who are exposed to currency risk, and try to hedge this risk. Others have a certain amount of money in one currency that they need to exchange into another one.

In this article, I’ll discuss the different types of trading activity in the currency market, and what you can do to protect yourself from swings in the relative value of currencies.

The currency market is mostly an over-the-counter (OTC) market, which means that there is no central clearinghouse, such as the New York Stock Exchange for stocks, or the Chicago Mercantile Exchange for commodities. Transactions take place directly between two parties, which are usually a client and his broker. Most trading takes place electronically nowadays, but some of it is also done over the phone.

As mentioned earlier, in speculative currency trading, traders try to realize a profit betting on changes in the relative prices of currencies. Currencies are always traded in pairs that are denoted with their currency symbols. For example EURUSD is the euro-dollar pair, while AUDNZD (pronounced ozzie – kiwi) denotes how many New Zealand Dollars you can buy for one Australian Dollar.

Because currencies trade in pairs, when you buy one currency, you always sell another. For example, if I believe that the Euro is going to increase in value relative to the United States Dollar, I can go into the currency market, buy euros, and sell dollars. This is the most common method for currency traders to make (or lose) money.

Another method is called the “carry trade”, in which you buy a high interest rate currency and sell a low interest rate currency, and pocket the difference in interest rate. If you keep a carry trade for a long time, the profits can be significant, even if the relative prices of the currencies don’t change.

Other players use the currency market to hedge currency risks that they might have. For example, if all your income is in United States Dollars, but all your expenses are in Swiss Francs, you are exposed to changes in the CHFUSD exchange rate. If the Swiss Franc appreciates (increases in value), your income will go down relative to your payment obligations. To insure yourself against this risk (in finance, this is called “hedging”) you can buy a forward contract or a futures contract, which is basically an obligation to buy a currency pair at some point in the future, at a price determined today. In this case you would enter into a futures or forward contract to sell USD and buy CHF at some date in the future when your payment obligations are due, which would “hedge” your currency risk.

The most common use of the currency market for retail customers is to exchange one currency for another, called a “spot transaction”. These are the kinds of transactions you see taking place at foreign exchange bureaus across Georgia thousands of times every day. This is what you do when you have money in one currency, for example Dollars, and you want to exchange that  into currency, for example Georgian Laris. The best rates on the street are usually smaller exchange bureaus, while the banks charge slightly higher spreads (the difference between the buying price and the selling price).

Most Georgian banks also offer you the opportunity to have multi-currency accounts: usually the basic currencies are the Dollar, the Euro, and the Lari, with more exotic currency such as the Hong Kong Dollar available on request. However, when you transfer money from one account to another account in a different currency, be aware of the fact that you will lose a little bit of money on the exchange rate. Especially with internet banking, it  can be tempting to continuously transfer money between different currency accounts, but this might actually cost you quite a bit of money because of the exchange rate losses.

The question you are probably asking is: there is a lot of fluctuation in the currency market, what can I do to protect myself? First of all, if your income is in the same currency as your expenses, you probably won’t have any problems. For example, if you live in Georgia, and your income is in Lari, you will be immune to most currency shocks. Only really large fluctuations in the Dollar-Lari exchange rate will eventually impact Lari prices. If you are afraid of a large depreciation (loss of value) of the Lari, you can move your money into a USD bank account, although those accounts often pay lower interest rates. The Dollar is widely seen as the safety currency of choice, and during times of economic distress, it usually increases in value.

If you have a business that has a large exposure to foreign currencies, for example the Dollar or Euro, talk to your bank about possible hedging solutions. You may be able to insure yourself against some of this risk.

In general, it is wise to keep your money in the currency in which your expenses are denominated. However, if you have a big pile of money that you don’t really need to spend – and don’t we all want this luxury – there are different strategies that you can use. Usually local currencies – such as the Lari – have higher interest rates than “safe” currencies such as the Dollar. By putting your money in Laris, your pile will grow faster. But be aware that this strategy also carries risk – these currencies typically pay higher interest rates because the inflation rates in these countries are higher, so they will often lose value relative to the safe currency.

The world of currencies is a peculiar world, full of possible risks. While you might not be able to avoid all risks, understanding them is a crucial step in creating a more stable financial future for yourself and your company.