Understanding Currencies

Every day, trillions of dollars in currencies change hands in a highly professional interbank market, in which electronic trading platforms link currency traders from banks across the world. FX markets are effectively open 24 hours a day, thanks to global cooperation among currency traders. At the end of each business day in Asia, traders pass their open currency positions to their colleagues in Europe, who – at the end of their business day – pass their open positions to U.S. traders, who then pass positions back to Asia at the end of their business day. And the cycle begins anew. This makes FX truly global and liquid.

What determines exchange rates between currencies?

The exchange rate gives the relative value of one currency against another currency. An exchange rate GBP/USD of two, for example, indicates that two dollars will buy one pound. The U.S. dollar is the most commonly used reference currency, which means other currencies are usually quoted against the U.S. dollar.

The most common theory to explain the relationship between two currencies that can change in value is the purchasing power parity theory, which can be illustrated with the “Big Mac index” created by The Economist magazine. In a perfect world, a Big Mac should have the same value everywhere in the world, regardless of the local currency. For example, assuming the exchange rate between the British pound and the U.S. dollar is two and the price of a Big Mac is £2.50 in the United Kingdom, a Big Mac should cost $5 in the United States. If the purchasing power of the British pound increases relative to that of the U.S. dollar, the exchange rate has to adjust so that the pound buys more dollars than previously. Otherwise, consumers will start to buy goods in the cheaper country.

A similar principle applies when looking at money itself and considering interest as the price for money. If the real return (adjusted for inflation) on a financial asset differs between two countries, investors will flock to the country with the higher returns. Interest rates have to change to stop this movement. The theory behind this relationship is called the interest rate parity theory. (When looking at interest rates, it is important to distinguish between real rates and nominal rates, with the difference reflecting the rate of inflation. The higher the expected inflation in a country, the more compensation investors will demand when investing in a particular currency.)

Has currency trading always been as active as it is today?

Trading in currencies has not always been as active, mainly because exchange rates were not flexible, or “free floating,” as most major currencies are today. In the 19^th century, governments began to back their currencies with gold reserves so the value of a currency was fixed at a certain amount of gold. This gold parity provided stability in the value of the currency and gave people confidence in the currency. The United Kingdom introduced this “gold standard” in 1821, and by the beginning of the 20^th century, most major players in world trade had followed.

Under the gold standard, a government or central bank had to maintain enough gold reserves to match money supply in that country and ensure full convertibility of the currency against gold at all times.

In times of war or crisis, maintaining sufficient gold reserve levels was difficult. During World War I, many countries had to abandon the gold standard. In the late 1920s, the “gold exchange standard” was introduced, which allowed the exchange of a local currency for gold or for other currencies that were still backed by gold, such as the British pound and the U.S. dollar. Thus, the first “reserve currencies” were born. However, the economic crisis that began in 1929 took its toll; in 1931, the United Kingdom suspended the gold standard and many other countries followed.

At the end of World War II, another system of fixed – but adjustable – exchange rates was developed with the Bretton Woods agreement among 40 countries, which tied their currencies to the U.S. dollar. In return, the United States agreed to maintain a gold standard. Bretton Woods was abandoned in the 1970s after the United States gave up the gold standard.

While there are some fixed exchange rates that still exist today, most major economies have free-floating currencies, allowing exchange rates to adjust to economic and market developments. The emergence of floating currencies is often credited for improving financial stability worldwide. In many countries, an independent central bank, such as the U.S. Federal Reserve or the Bank of England, watches over the stability of the nation’s currency.

Countries in what is now the European Monetary Union agreed over the course of several decades to create a common economic area with one common currency. In January 1999, exchange rates for the new currency, the euro, were fixed for 11 participating countries. The euro began its life as an accounting currency before euro coins and notes replaced national currencies, including the Deutsche mark and the French franc, in 2002. The European Central Bank (ECB) is responsible for monetary policy in the entire eurozone and still has to consider the varying degree of economic development in the eurozone countries.

Who are the players in the FX market?

The influence of the players in the FX market has shifted over the years. Traditionally, the most important players in the FX markets were importers and exporters of goods, trading currencies through banks. International trade was thus the primary driver of supply and demand for currencies. Today, trade still influences FX markets directly through commerce and indirectly through market movements that follow official international trade and investment flow data. But over time, the importance of trade has waned as financial investors have become increasingly active in FX markets.

The driving force behind this transition to a market dominated by investors was the search for profitable investment opportunities across borders. For example, a British investor buying equities in the United States takes on currency risk by holding shares in U.S. dollars. The investor may want to hedge this risk in an attempt to insulate profits from the impact of any adverse movements in the exchange rate.

Moreover, investors have increasingly found currencies as a distinct asset class and potential source of income as they seek new, uncorrelated sources of return. Currencies can offer not only diversification but also the potential for additional returns due to inefficiencies in the FX market.

Financial institutions have become the biggest players in the FX market. Interbank business accounts for about half of FX turnover, according to the Bank for International Settlements, but the greatest growth in participation comes from other financial institutions, including insurance companies, pension funds, hedge funds, asset managers and, most of all, central banks.

How to invest in currencies

Although currencies are considered an asset class, an investor cannot simply invest in a currency. An investment requires taking a view on the value of one currency relative to another, such as the U.S. dollar relative to the euro.

Many global companies and investment management firms use the FX markets to hedge their currency exposures. Investors seeking profits through the FX markets can use different approaches to investing in currencies. Among these, the “carry trade” has made the most headlines. Also known as forward rate bias, the carry approach seeks to take advantage of different interest rate levels in two countries. In its simplest form, an investor borrows money in a low-interest rate currency and invests in a higher yielding currency, in an effort to profit from the difference in interest rates. The carry trade exposes investors to the risk that exchange rates could move adversely and unexpectedly, reducing or even eliminating the potential for profits.

The “fundamental” approach is one of the most common approaches in the FX market. Companies and investors often analyze fundamentals, such as economic growth, economic policy, and national budget deficits and surpluses, to try to identify the fair value of a currency and anticipate how the exchange rate will move. By taking direct exposure to currencies this way, investors take the risk of losing part or all of their investment if their analysis is not correct.

What are the risks?

There are many risks associated with FX trading. Currency moves can be volatile and will be impacted by domestic and international economic and political events. The volatility of different countries will also vary significantly, depending on the economic and political circumstances of a country, and the nature of its currency regime. Even currencies that are pegged to another – and which therefore exhibit lower day-to-day volatility – can be at risk of large moves if the level at which the currency is pegged changes. These risks will be amplified through the use of leveraged trades, where a small initial fee can result in substantial losses.