At its simplest, currency exchange is just the buying of the currency of one country with the currency of another country. Individuals, businesses and traders all engage in various types of foreign currency exchange transactions. Some participants in currency exchange do so as part of business dealings while others speculate on the foreign exchange (Forex) market in hopes of profiting off of exchange rate fluctuations. The main types of foreign currency exchange transactions they employ are described below.
Basic Currency Exchange
If you’ve ever traveled to a foreign country, chances are you’ve used some of your cash to buy euros, yen or whatever the local currency was. The price you paid was determined by the exchange rate between the two currencies. Your purchase is an example of the most basic type of foreign currency exchange transaction.
Currency exchange rates change continuously, mainly in response to demand for one currency relative to others. Demand for a currency in turn is affected by many factors, including differences in interest rates, inflation and monetary policy.
Financial institutions and businesses frequently want to protect themselves against possible losses due to changes in exchange rates. The forward contract is a way of doing this. A forward contract is like a futures contract except it is a private agreement, rather than an exchange-traded security. In forwards, one party agrees to buy (or sell) a foreign currency from (or to) another party. The currency is delivered at a future date at a predetermined price. A variation of this is the forward window contract. Instead of delivery on a specific date, the transaction is settled during a “window” of time between two dates.
Suppose you are a businessperson who needs euros to do some business in Europe, but all you have are U.S. dollars. You don’t want to convert to euros and run the risk of losing money if exchange rates go the wrong way. A currency swap is your solution. You simultaneously borrow euros from someone else (usually a currency dealer) and lend your dollars to the other party. You can use the euros as you see fit until a specific date. Then you return the euros and get your dollars back at a predetermined exchange rate.
Most of the volume of trading on the Forex market actually is generated by speculators, not as part of other business activity. Forex traders use forwards and swaps. The basic Forex trade, however, is a simple currency exchange but with one crucial difference. When a Forex trader buys one currency for another, it is a margin transaction. This means the trader puts up only a little money (often less than $1,000 for a $100,000 lot of currency). With extreme leverage like this, even small changes in currency exchange rates mean big profits or big losses. This makes Forex trading very attractive to many people but also very risky.
Forex options work like any other options contract. A trader pays a premium to a Forex dealer for an option to buy or sell a currency at a specific strike price. If the exchange rate moves in the trader’s favor before the option expires, she can exercise the option for a profit. If the exchange rate doesn’t move the right way enough to cover the premium paid, the option will expire and the trader loses her money. Unlike stock options, the buyer of a Forex option contract may choose the strike price and expiration date