Getting to grips with foreign exchange basics

In a global world, incoming and outgoing payments often involve currency exchanges. Buying and selling increasingly happens across national borders*, making it ever more important to master the foreign exchange basics.

The $5 trillion/day foreign exchange (FX) market is one of the fastest financial markets to trade. The FX market is always moving, making it a trading playground for hedge funds, big banks, large corporations and even private individuals. With a business to run, your aim most likely isn’t to play the market or speculate in different currencies. What you want is to pay your suppliers and receive payments from your customers – without taking on too much FX risk, spending too much time on the process or losing predictability over income and costs.

How to do trades/FX Conversions?

There are several ways to trade and convert currency. You can do it via your bank, over the phone (a bit old fashioned, but you may want to ask for advice or get a second opinion), via an e-platform or via an automated solution such as an API or FX Robot. The actual trade is outsourced, but you will still benefit from understanding the basic processes and the common terminology.

Currencies

Currencies are divided into a number of categories. The major currencies include the dollar (USD), the euro (EUR), the yen (JPY), the pound (GBP) and the Swiss franc (CHF).

There are also numerous other categories including emerging-market currencies, commodities currencies and Scandies, among others as the graphic shows.

Majors

EUR USD
JPY GBP
CHF

Commodities

AUD NZD
NOK CAD

Emerging

HUF RUB
INR* ZAR
CNY** MXN

Scandies

NOK
SEK
DKK

The currency top ten

It’s no surprise that the major currencies dominate the list of biggest and most liquid currencies, with the dollar, the euro and the Japanese yen taking the top three spots. The highest placed Scandinavian currency is Sweden’s krona in eighth place followed by Norway’s krona in tenth.

The highest placed commodities currency is the Australian dollar, just ahead of the Canadian dollar.

Top 10 CurrenciesSource: Nordea Markets

Crosses

All currencies are quoted in crosses, which means that to buy one currency, you need to sell another.

In one cross, for example the EURUSD, the first currency is called ‘the base currency’ and the second is called the ‘quote currency’. In other words, how many USD (price currency) do I have to give in order to receive one EUR (base currency)?

The USD is most often the base currency in all crosses, with a few exceptions such as the EUR.

Let’s take an example to illustrate this process in practice. If the quote for EURUSD is 1.13, it means that if you want to buy 1 EUR, then you’ll need to sell 1.13 USD.

All currency crosses are quoted with two prices. The price for selling the base currency (called the bid price) and the price for buying the base currency (called the ask price).

If you want to buy or sell the EUR against the USD, it could look like the graphic below. The price you might see in newspapers, or on the TV, is called the mid-price – which is the price between the bid and ask price at a certain time.

When two currencies are traded, they are also referred to as pairs. Inevitably, some pairs are traded far more often than others. EURUSD along with USDJPY, USDGBP and EURGBP are among the most commonly traded pairs in FX.

EURUSD

BID ASK
1,1305 1,1307

What’s in a name?

Some of the more common currencies as well as currency pairs have nicknames. Here are a few you’ll come across.

  • USD: the Greenback
  • CAD: the Loonie
  • GBP: the Sterling
  • NZD: the Kiwi
  • AUD: the Aussie
  • SEK: the Stocky
  • NOK: the Nocky
  • CHF: the Swissy
  • The cross GBPUSD: Cable
  • The cross EURUSD: Fiber
  • The cross EURGBP: Chunnel

SPOT price

The price most commonly referred to in the FX market is the SPOT price. SPOT means that the bought currency and the sold currency will be settled two business days from the trade date.

If you instead want to receive your bought EUR today or tomorrow, or if you have an upcoming payment in six months and don’t want your margins to be squeezed by potential market fluctuations, you trade something called a ‘Forward’. What the forward price will be, compared to the SPOT price, depends on the interest rate differential between the two currencies involved.

Let’s take the example of buying USD and selling EUR. The USD has a higher interest rate than the EUR, and you will therefore be compensated if you prefer your newly-bought dollars to be delivered one year from now instead of in two days. That’s because USD has higher interest rates than EUR, and you could earn more interest having USD in your account instead of EUR.

Making a deal

Currencies trade on an OTC market. OTC is an acronym for ‘over the counter’, which means you cannot trade currencies on a listed exchange as you can with equities, where a buyer is directly matched with a seller.

If you for instance want to buy 100 EUR and sell USD, you need to go through the following steps:

You specify the amount and will be given the ask price (for EUR in this example) from the bank.

The bank gets back to you with the price, e.g. 1.1307, meaning you buy 100 EUR and sell 113.07 USD.

You then decide if you want to proceed with the transaction or not.

These are the theoretical steps but in practice, for example via our fully automated FX APIs or on our trading platform e-Markets, you’ll receive a price instantly and are able to trade in real-time.

Sources

1. WTO – World trade Statistical Review 2019
https://www.wto.org/english/res_e/statis_e/wts2019_e/wts19_toc_e.htm

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