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The History of the Forex Market

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An overview into the historical evolution of the foreign exchange market

This article will follow the historical roots of the international currency trading from the days of the gold exchange, through the Bretton Woods Agreement, to its current setting.

The Gold exchange period and the Bretton Woods Agreement.

Prior to Bretton Woods, the gold exchange standard -- paramount between 1876 and World War I -- ruled over the international economic system. Under the gold exchange, currencies experienced a new era of stability because they were supported by the price of gold.

However, the gold exchange standard had a weakness of boom-bust patterns. As a country's economy strengthened, its imports would increase until the country ran down its gold reserves, which were required to support its currency. As a result, the money supply would diminish, interest rates escalate and economic activity slowed to the point of recession. Ultimately, prices of commodities would hit bottom, appearing attractive to other nations, who would rush in and amid a buying frenzy inject the economy with gold until it increased its money supply, driving down interest rates and restoring wealth into the economy. Such boom-bust patterns abounded throughout the gold standard until World War I temporarily discontinued trade flows and the free movement of gold.

The Bretton Woods Agreement, established in 1944, fixed national currencies against the dollar, and set the dollar at a rate of USD 35 per ounce of gold. The agreement was aimed at establishing international monetary steadiness by preventing money from taking flight across countries, and to curb speculation in the international currency market. Participating countries agreed to try to maintain the value of their currency within a narrow margin against the dollar and an equivalent rate of gold as needed. As a result, the dollar gained a premium position as a reference currency, reflecting the shift in global economic dominance from Europe to the USA. Countries were prohibited from devaluing their currency to benefit their foreign trade and were only allowed to devalue their currency by less than 10%. The great volume of international Forex trade led to massive movements of capital, which were generated by post-war construction during the 1950s, and this movement destabilized the foreign exchange rates established in Bretton Woods.

The year 1971 heralded the abandonment of the Bretton Woods in that the US dollar would no longer be exchangeable into gold. By 1973, the forces of supply and demand controlled major industrialized nations' currencies, which now floated more freely across nations. Prices were floated daily, with volumes, speed and price volatility all increasing throughout the 1970s, and new financial instruments, market deregulation and trade liberalization emerged.

The onset of computers and technology in the 1980s accelerated the pace of extending the market continuum for cross-border capital movements through Asian, European and American time zones. Transactions in foreign exchange increased intensively from nearly billion a day in the 1980s, to more than $1.9 trillion a day two decades later.

Glossary

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• Appreciation

An increase in the value of a currency.

• Ask

The price requested by the trader. This usually indicates the lowest price a seller will accept.

• Base currency

The currency that the investor buys or sells (i.e. EUR in EURUSD).

• Bear

Someone who believes prices are heading down. A bear market is one in which there has been a sustained fall in prices and which does not look like it will recover quickly.

• Bid

The price offered by the trader. This usually indicates the highest price a purchaser will pay.

• Bid/Ask

The Bid rate is the rate at which you can sell. The Ask (or offer) rate is the rate at which you can buy.

• Bull

Someone who is optimistic about the market. A bull market is characterised by enthusiastic and sustained buying.

• cross

When trading with currencies, the investor buys one currency with another. These two currencies form the cross: for example, EURUSD.

• Cross rate

An exchange rate that is calculated from two other exchange rates.

• Depreciation/decline

A fall in the value of a currency.

• Exchange rate

What one currency is worth in terms of another, for example the Australian dollar might be worth 58 US cents or 70 yen.

Currencies traded freely on foreign-exchange markets have a spot rate (applying to trades settled “spot”, i.e., two working days hence) and a forward rate. Countries can determine their exchange rates in a variety of ways.
1. A floating exchange rate system where the currency finds its own level in the market.
2. A crawling or flexible peg system which is a combination of an officially fixed rate and frequent small adjustments which in theory work against a build-up of speculation about a revaluation or devaluation.
3. A fixed exchange-rate system where the value of the currency is set by the government and/or the central bank.

• EURUSD

Means that you trade EUR against dollars. If you buy euro you pay in dollars and if you sell euro you receive dollars.

• FX, Forex, Foreign Exchange

All names for the transaction of one currency for another, e.g. you buy GBP 100.00 with USD 150.25 or sell USD 150.25 for GBP 100.00.

• Interbank

Short-term (often overnight) borrowing and lending between banks, as distinct from a banks business with their corporate clients or other financial institutions.

• Interest rate differential

The yield spread between two otherwise comparable debt instruments denominated in different currencies.

• Leverage (gearing)

The investor only funds part of the amount traded.

• Long

To buy.

• Long position

A position that increases its value if market prices increase.

• Liquid (-ity)

The capacity to be converted easily and with minimum loss into cash. A liquid market is one in which there is enough activity to satisfy both buyers and sellers. Ultra-short-dated treasury notes are an example of a liquid investment.

• Margin

The deposit required when entering into a position as well as to hold an open position. Your margin status can be monitored in the Account Summary.

• NYSE

The New York Stock Exchange.

• Open position

A position in a currency that has not yet been offset. For example, if you have bought 100,000 USDJPY, you have an open position in USDJPY until you offset it by selling 100,000 USDJPY, thus “closing” the position.

• Over the counter

When trading takes place directly between two parties, rather than on an exchange. Over the counter trades can be customised whereas exchange-traded products are often standardised.

• Pips

A pip is the smallest unit by which a Forex cross price quote changes. So if EURUSD bid is now quoted at 0.9767 and it moves up 2 pips, it will be quoted at 0.9769.

• Position

Traders talk of “taking a position” which simply means buying or selling currency cross. “Position” can also refer to a trader's cash/securities/currencies balance, whether he or she is short of cash, has money to lend, is overbought or oversold in a currency, etc.

• Risk

Trying to control outcomes to a known or predictable range of gains or losses. Risk management involves several steps which begin with a sound understanding of one's business and the exposures or risks that have to be covered to protect the value of that business. Then an assessment should be made of the types of variables that can affect the business and how best to protect against unwelcome outcomes. Consideration must also be given to the preferred risk profile – whether one is risk – averse or fairly aggressive in approach. This also involves deciding which instruments to use to manage risk and whether a natural hedge exists that can be used. Once undertaken, a risk-management strategy should be continually assessed for effectiveness and cost.

• Secondary currency (variable currency or counter currency)

The currency that the investor trades the base currency against (i.e. USD in EURUSD).

• Short position

A position that benefits from a decline in market prices.

• Short

To sell.

• Speculative

Buying and selling in the hope of making a profit, rather than doing so for some fundamental business-related need.

• Spot

A Spot rate is the current market price of an asset.

• Spot market

The part of the market calling for spot settlement of transactions. The precise meaning of “spot” will depend on local custom for a commodity, security or currency. In the UK, US and Australian foreign-exchange markets, “spot” means delivery two working days hence.

• Spread

The difference between the bid and the ask rate.

Trading Falling Prices

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If, on the other hand, you believe that the euro will weaken against the dollar, you'll want to sell EURUSD.

• You sell euro

We quote EURUSD at a Bid price of 0.9875 and Ask price of 0.9880 and you decide to sell euro 100,000 at a Bid price of 0.9875.

• The market moves in your favour

The euro weakens against the dollar and the EURUSD is now quoted at bid 0.9744 and ask 0.9749.

• Now you buy back your euro

You buy EUR at an ask price of 0.9749.

• Your profit/loss is then

Sell price-buy price x size of trade
(0.9875 minus 0.9749) multiplied by 100.000 = USD 1260 Profit

Remember that trading EUR 100,000 as we have done in our examples, does not mean that you have to put up euro 100,000 yourself. On a 2% margin means that you have to deposit 2.0% of euro 100,000, which is euro 2,000 on margin as a guarantee for the future performance of your position.

Trading Rising Prices

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If you believe that the euro will strengthen against the dollar you'll want to buy euro now and sell it back later at a higher price.

• You buy euro

We quote EURUSD at Bid 0.9875 and Ask 0.9878, which means that you can sell 1 euro for 0.9875 USD or buy 1 euro for 0.9878 USD.

In this example you buy euro 100,000, at the quote price of 0.9878 (ask price) per euro.

• The market moves in your favor

Later the market turns in favour of the euro and the EURUSD is now quoted at Bid 0.9894 and Ask 0.9896.

• Now you sell your euro and get the profit

You sell euro at a Bid price of 0.9894.

• The profit is calculated as follows

Sell price-buy price x size of trade
(0.9894 minus 0.9878) multiplied by 100.000 = USD 140 Profit
(Note that the profit or loss is always expressed in the secondary currency)

Pips

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A pip is the smallest unit by which a cross price quote changes. When trading Forex you will often hear that there is a 3-pip spread when you trade the majors. This spread is revealed when you compare the bid and the ask price, for example EURUSD is quoted at a bid price of 0.9875 and an ask price of 0.9878. The difference is USD 0.0003, which is equal to 3 “pips”.

On a contract or position, the value of a pip can easily be calculated. You know that the EURUSD is quoted with four decimals, so all you have to do is cancel out the four zeros on the amount you trade and you will have the value of one pip. Thus, on a EURUSD 100,000 contract, one pip is USD 10. On a USDJPY 100,000 contract, one pip is equal to 1000 yen, because USDJPY is quoted with only two decimals.

Spread

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The spread is the difference between the price that you can sell currency at (Bid) and the price you can buy currency at (Ask). The spread on majors is usually 3 pips under normal market conditions. For more information on the trading conditions at Saxo Bank, go to the Account Summary on your Client Station and open the section entitled “Trading Conditions” found in the top right-hand corner of the Account Summary.

Why Trade Forex?

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· 24 hour trading

One of the major advantages of trading Forex is the opportunity to trade 24 hours a day from Sunday evening (20:00 GMT) to Friday evening (22:00 GMT). This gives you a unique opportunity to react instantly to breaking news that is affecting the markets.

· Superior liquidity

The Forex market is so liquid that there are always buyers and sellers to trade with. The liquidity of this market, especially that of the major currencies, helps ensure price stability and narrow spreads. The liquidity comes mainly from banks that provide liquidity to investors, companies, institutions and other currency market players.

· No commissions

The fact that Forex is often traded without commissions makes it very attractive as an investment opportunity for investors who want to deal on a frequent basis.
Trading the “majors” is also cheaper than trading other cross because of the high level of liquidity. For more information on the trading conditions of Saxo Bank, go to the Account Summary on your SaxoTrader and open the section entitled “Trading Conditions” found in the top right-hand corner of the Account Summary.

· 100:1 Leverage

Leverage (gearing) enables you to hold a position worth up to 100 times more than your margin deposit. For example, a USD 10,000 deposit can command positions of up to USD 1,000,000 through leverage. You can leverage the first USD 25,000 of your investment up to 100 times and additional collateral up to 50 times.

Profit potential in falling markets

Since the market is constantly moving, there are always trading opportunities, whether a currency is strengthening or weakening in relation to another currency. When you trade currencies, they literally work against each other. If the EURUSD declines, for example, it is because the US dollar gets stronger against the euro and vice versa. So, if you think the EURUSD will decline (that is, that the euro will weaken versus the dollar), you would sell EUR now and then later you buy euro back at a lower price. In case that the EURUSD indeed declines, then you can take your profit. The opposite trading scenario would occur if the EURUSD appreciates.

Risks

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Although Forex trading can lead to very profitable results, there are risks involved: exchange rate risks, interest rate risks, credit risks, and country risks. Approximately 80% of all currency transactions last a period of seven days or less, while more than 40% last fewer than two days. Given the extremely short lifespan of the typical trade, technical indicators heavily influence entry, exit and order placement decisions.

Options

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A currency option is similar to a futures contract in that it involves a fixed currency transaction at some future date in time. However the buyer of the option is only purchasing the right but not the obligation to purchase a fixed amount of currency at a fixed price by a certain date in future. The price is known as the premium and is lost if the buyer does not exercise the option.

Forwards and Futures

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Forwards make up about 46% of currency trading. A forward transaction is an agreement between two parties whereby one party buys a currency at a particular price by a certain date that is greater than two business days (a spot transaction).

A future contract is a forward contract with fixed currency amounts and maturity dates. They are traded on future exchanges and not through the interbank foreign exchange market.