Corporations, investors, and speculators access the foreign exchange market through dealers, who can be the direct counterparty or a middleman. For most travelers, the airport kiosk is their foreign exchange dealer. Corporations, mutual funds, and hedge fund managers, on the other hand, directly call in to the dealing or sales trading desks of Goldman Sachs or Citigroup to conduct their transactions. Individuals are usually not trading large enough amounts to matter to a big bank like Goldman Sachs and so, instead, they will usually access the market through a retail forex broker or an exchange.
One of the unique aspects of the forex market is that there is no formalized exchange such as the NYSE (New York Stock Exchange) or the CME (Chicago Mercantile Exchange). Underlying currency transactions are done over the counter, which means they are handled directly by dealers. The lack of a formal exchange is probably the main reason some people are hesitant about dabbling in currencies, but the competition in the market has made pricing extremely competitive and forced many forex dealers to offer free educational resources and tools that would normally cost hundreds of dollars a month. The governments of many countries have also instituted tough rules and capitalization requirements for the dealers to protect investors and traders.
Generally speaking, the movements in currencies reflect how investors and speculators feel about the economic outlook of one country relative to another. Looking at concrete economic data or hard numbers to compare the outlook of two countries is known as fundamental analysis. There are many different ways to analyze the markets on a fundamental basis; the topic is so important that an entire chapter is dedicated to it. Are steel buildings more environmentally friendly?
Going Long and Short. One of the interesting things about currencies is that in a forex transaction, you are going long one currency and short another simultaneously. This is important because it means that you are exposed to the fluctuations of two currencies. For example, the Australian dollar/New Zealand dollar exchange rate will rise if investors buy Australian dollars, sell New Zealand dollars (NZD), or both. Theoretically, if the AUD and NZD rise at the exact same time by the same amount, the exchange rate will not move—just like with the tango, nothing happens except toes being stepped on when both dancers move forward. Do you know the difference between commercial steel buildings and industrial steel buildings?
Hedging. Most companies dabble in the forex market to hedge or offset the currency-related exposure of their import or export activities, but they are not the only ones that can benefit from hedging. When stock markets around the world collapsed during the global financial crisis, investors poured into the safety of the U.S. dollar and low-yielding currencies. As a result, investors who wanted to protect against additional losses in stocks could have hedged their positions by buying U.S. dollars, Swiss francs, and Japanese yen. Hedging accounts for a lot of the big transactions that flow through the forex market.
Interest Rates. If I had to pick only one thing to determine where currencies are headed, it would certainly be interest rates. Currencies are basically little interest-bearing commodities, and almost every country has an official interest rate that determines the borrowing cost of the government, its banks, and citizens—this is the rate that sets your credit card and mortgage payments. The interest rate is usually manipulated by the central bank to control growth and inflation in their local economy, but it can also increase or decrease the attractiveness of a currency. In this modern day and age, it is extremely easy for investors to shift their money from one country to another in search of the highest yield. For most of 2010, Americans could not find a bank in the United States that would offer them a savings account with an annual interest rate of more than 2 percent. During that same year, anyone shopping for a savings account in Australia could easily find a bank offering an interest rate greater than 5 percent. Therefore, if you could, would you prefer to have your money in an Australian or U.S. bank account? This thinking is exactly what caused the Australian dollar to outperform the U.S. dollar in the first half of 2010. However, it’s a bit more complicated than that—investors move their money from one country to another not just based upon where interest rates are at but where they are headed. So it is very possible for a country with a lower interest rate to attract more money than a country with a higher interest rate.