Author Archives: adavinci

How are currencies quoted?

Currencies are always quoted as how much one unit of one currency (base currency) costs in another currency (quote currency). The most commonly used pricing convention ranks base currencies in the following order of priority: euro (EUR), British pound (GBP), Australian dollar (AUD), New Zealand dollar (NZD), U.S. dollar (USD), all other currencies. Lets take two commonly quoted currencies: the euro and the Japanese yen (JPY). Taking the above pricing convention order of priority, relative to the USD, the price quotes would be as follows: EUR/USD and USD/JPY. In plain English, this translates to: “how many U.S. dollars buys one euro” and “how many Japanese yen buys one U.S dollar”.

This may help to explain why, when the quoted price of the Japanese yen (vs. USD) moves from 90 to 95, the yen actually declines in value – because it now costs more yen to purchase one U.S. dollar (a stronger USD). Conversely, when the quoted price of the euro (vs. USD) moves from 1.40 to 1.45, this would represent a stronger euro, as it now costs more U.S. dollars to purchase one euro (a weaker USD).

Can any currency be converted into any other currency?

That depends which currency you hold and which currency you wish to acquire, but in general, this should be possible. Consider, as an example, that an investor holds euros (EUR) and wishes to convert those to Australian dollars (AUD). This investor could purchase AUD directly with their EUR; they would not have to first sell their EUR into U.S. dollars (USD) and then use the USD to purchase AUD (although they may choose to do so).

Currency prices are most commonly quoted versus the USD in the U.S., but there are many actively traded currency pairs that do not involve the USD, and many of these exhibit very high levels of liquidity. For example, the euro/British pound (EUR/GBP), euro/Swiss franc (EUR/CHF), and Australian dollar/Japanese yen (AUD/JPY) are all highly liquid currency pairs, to name but a few.

Generally speaking, the G10 currencies are very liquid and readily convertible from one to another. Some, less frequently traded currency pairs may exhibit lower liquidity and hence larger spreads and therefore transaction costs. The decision whether to convert directly, or to first sell into USD, then use the USD to purchase the desired currency, is largely dependent upon the level of liquidity the currency pair exhibits.

An exception to this is when a currency is non-convertible, such as the Chinese yuan (CNY). In a future Currency Corner we will discuss non-convertible currencies in more detail.

How can you invest in non-convertible currencies?

Non-convertible currencies, as the name implies, are currencies that cannot be readily exchanged for another currency, generally as a result of government restrictions. The Chinese yuan (CNY) is a well known non-convertible currency. The Chinese authorities do not allow convertibility, in part, as a means to facilitate the managed exchange rate of the yuan (the currency peg).

Non-convertible currencies are not freely traded in the traditional spot or forward currency markets. Rather, investors can replicate an investment in a non-convertible currency using non-deliverable forward (NDF) contracts. An NDF acts like a forward contract for non-convertible currencies, allowing investors to gain exposure to currencies they otherwise would not be able to invest in. Rather than delivering the underlying currency at expiration (as may be the case in a traditional forward currency contract), any profit or loss is settled by making a net payment in a convertible currency, such as the U.S. dollar (USD).

What is the notional value of a forward currency contract?

The notional value of a forward currency contract is the underlying amount that an investor has contracted to buy and sell (currencies always trade in pairs – by implication, when an investor contracts to buy one currency, they also contract to sell another currency). For example, an investor might enter into a contract to purchase 1 million Australian dollars (AUD) with U.S. dollars (USD) in one month’s time, at an exchange rate of 0.9000. The notional value for this contract in USD terms is therefore $900,000.

Importantly, though the notional value may be a large sum, there is often no initial outlay required to enter into such a contract. As such, an investor is free to deploy funds into various investments until the value date of the contract.

If an investor has an amount invested in assets such as cash, bonds or stocks that is equivalent to, or exceeds, the total net notional value of all forward currency contracts outstanding, that investor is deemed to have fully collateralized the notional value of their forward currency contracts with said investments.

What is the difference between forward currency contracts and futures?

The main difference is that futures are standardized and traded on a public exchange, whereas forwards can be tailored to meet the specific requirements of the purchaser or seller and are not traded on an exchange.

The standardization of futures contracts generally refers to the expiration date and the contracted amount. For example, euro (EUR) futures contracts are available with quarterly expiration dates: the months of March, June, September and December, while the contract size of each euro future is 125,000 EUR. On the other hand, forward currency contracts are not restricted by size or value date, and therefore oftentimes can meet the needs of investors more precisely.

Additionally, investors have to pay for the futures contract and may need to post certain margin requirements; whereas there is often no initial outlay needed for a forward currency contract, as in many cases collateral is not required. As such, an investor using forward currency contracts may be free to deploy funds into various investments until the value date of the contract.

What is the carry trade?

The carry trade is an investment strategy employed in the currency market. At its most basic level, the carry trade can be explained as an investment strategy where an investor takes a short position in (sells) a low yielding currency and invests the equivalent amount in (goes “long”, or buys) a high yielding currency. The currency sold is often referred to as the “funding currency”. Logically, these funding currencies are typically the lowest yielding currencies globally. Amongst popular funding currencies are the U.S. dollar (USD), the Japanese yen (JPY), and the Swiss Franc (CHF). In contrast, the currency bought is often amongst the highest yielding currencies in the world. These include the Australian dollar (AUD) and New Zealand dollar (NZD). One of the most popular carry trade strategies over recent years has been to short the Japanese yen (JPY) and go long the Australian dollar (AUD).

Foreign Exchange Market

The foreign exchange market (forex, FX, or currency market) is a global decentralized market for the trading of currencies. The main participants in this market are the larger international banks. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. EBS and Reuters’ dealing 3000 are two main interbank FX trading platforms. The foreign exchange market determines the relative values of different currencies.

The foreign exchange market works through financial institutions, and it operates on several levels. Behind the scenes banks turn to a smaller number of financial firms known as “dealers,” who are actively involved in large quantities of foreign exchange trading.  Most foreign exchange dealers are banks, so this behind-the-scenes market is sometimes called the “interbank market,”although a few insurance companies and other kinds of financial firms are involved. Trades between foreign exchange dealers can be very large, involving hundreds of millions of dollars.Because of the sovereignty issue when involving two currencies, Forex has little (if any) supervisory entity regulating its actions.

The foreign exchange market assists international trade and investment by enabling currency conversion. For example, it permits a business in the United States to import goods from the European Union member states, especially Eurozone members, and pay euros, even though its income is in United States dollars. It also supports direct speculation in the value of currencies, and the carry trade, speculation based on the interest rate differential between two currencies.

In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying some quantity of another currency. The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world’s major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.