Abacus: Understanding the Market for Foreign Currencies
Most people are familiar with the necessity for currencies: they function as legal tenders that can be interchanged between buyers and sellers for the purpose of purchasing goods and services, as well as something of value that can be measured to account for debts and wealth and that can be stored away for later use.
Every day, trillions of transactions are made, many of which involve paper money. Yet, with regards to examining the many facets of currencies and, more generally, money, it is the market for currencies that primarily captures people’s attention. With more and more people interested in learning about how to trade in the foreign exchange market, some wonder whether it could be worth studying the market for future success in it, analogous to the view that risk-lovers hold as it pertains to cryptocurrencies.
While the foreign exchange market offers many advantages to that of online currencies, there exist many potential pitfalls that could hamper anyone’s trading aspirations. One such risk is investors’ inclination to overestimate the ability to earn large profits.
To better understand this feeling of overconfidence, it helps to understand how profits can be earned from buying and selling various currencies, as well as why the prices of currencies tend to change.
There is a multitude of factors that affect the value of one currency compared to others, but one of the biggest macro variables that impact currency values is the general level of interest rates in a nation, such as those on savings accounts and other interest-bearing securities.
When interest rates on assets in a particular country are relatively high, investors from around the world are intrigued by the money they could earn from putting some of their cash in that nation’s funds.
Consequently, investors would need to buy the currency used in the domestic country in order to put some of their wealth into their accounts. The resulting buying of the currency increases the value of the nation’s currency compared to those in other countries.
Conversely, when rates on interest-bearing accounts in a country fall, the demand for the country’s currency becomes meager, and, as a result, the price of that nation’s currency declines, all other factors accounted for.
This association between the demand for high interest-earning accounts in a country and the value of that country’s currency helps explain the positive correlation between interest rates and currency value.
Consider an investor who owns $1,000 which she wishes to use for currency exchanges. She believes, using her expertise, that rates in the US will eventually drop compared to those in the European Union. Accordingly, she believes that the value of the dollar will soon depreciate, or decrease, compared to the value of the euro. In order to capitalize on this potential opportunity, the investor would have to buy euros before the currency depreciation, and then use their money in euros to purchase dollars after the change in currency price.
In particular, suppose 1 dollar currently equals 1.10 euros, and, as a result of the dollar potentially depreciating against the euro, the investor expects the dollar to be worth 1.05 euros in a month.
As an example, suppose the dollar was strong against the euro; that is, 1 dollar equals more than 1 euro (in reality, the euro has been strong against the dollar for several years, but this fact does not matter in this example). In particular, suppose 1 dollar currently equals 1.10 euros, and, as a result of the dollar potentially depreciating against the euro, the investor expects the dollar to be worth 1.05 euros in a month.
She could use her $1,000 to purchase 1,100 euros ($1,000 * 1.10 = 1,100). If the investor's predictions prove correct, she could then use her 1,100 euros to buy dollars at the new exchange rate. Because each dollar is now worth less than before its depreciation against the euro (1 dollar can now be exchanged for 1.05 euros rather than 1.10), the investor would earn a profit in exchange for the currencies at the new level (the exact return can be derived by computing a reciprocal calculation, namely 1/1.05 * 1,100, which equals roughly $1,048, which implies a profit of $1,048 - $1,000, or $48).
This process of trading is much easier said than done for several reasons. For one, it requires having accurate insight into which currencies will appreciate or depreciate against others. As educated as one might be on economics, reality does not always reflect theory; even when explicit policies are implemented that should have a specific effect on certain indicators, it is not rare that investors observe anticipated outcomes that fail to materialize.
Additionally, even for those who do tend to win more than they lose on their bets, it can take large quantities of money to earn anything close to a substantial gain. In the previous example, it required precise forethought and $1,000 for an investor to earn about $48 based on a change in the exchange rate between the dollar and the euro. Based on this standpoint, the wealthy are at a sizable advantage compared to the less fortunate.
The gamble of foreign exchange is a high risk game
Perhaps the biggest impediment that keeps many traders from achieving great success in the foreign exchange market is a concept known as arbitrage.
To better understand arbitrage, consider a different scenario in which traders attempt to profit by exchanging currencies between different financial firms. For instance, one firm, say Bank of America, could set the rate between euros and dollars at 1.20 euros per 1 dollar, while some other firms, such as Citibank, could set the rate at 1.15 euros per 1 dollar. In this case, a trader may notice, in an attempt to earn a financial gain, that they could convert some of their dollars to euros at Bank of America, and then exchange those euros for dollars at Citibank.
As an example, let’s say an individual has 100 spare dollars that he converts to euros with Bank of America. As a result of the transaction, they have 120 euros ($100 * 1.20 = 120 euros). Soon afterward, he could exchange their 120 euros for dollars at Citibank. Because Citibank sets the exchange rate at 1.15 euros per dollar, the individual would receive 120 * 1/1.15 dollars, or just over $104, a higher amount than the $100 he initially had.
This sort of situation is the type that clever investors hope to take advantage of, and it’s where arbitrage comes to be realized. After all, many investors would likely notice the opportunity to profit off the pricing difference charged by the two banks, and, as a consequence of investors’ decisions to transact with Bank of America for euros, the demand for euros at the bank increases, which thus leads to a price appreciation of the euro against the dollar charged by Bank of America, which narrows the difference between the prices at the two establishments until it becomes zero, closing off any additional profit opportunities.
As a result of investors’ tendencies to quickly exploit these price dissimilarities, it can be very difficult for traders who do not have easy access to developments in foreign exchange to succeed. Nevertheless, certain edges have emerged to assist traders, and commerce in the foreign exchange market is generally less risky than doing business in other markets, such as that for online currencies.
Various applications have been created that seeks to provide information about stocks and currencies to users, as well as to allow individuals to engage in real-time trading. These apps include sending notifications about important alerts related to world news and specific assets, and some of them necessitate a rather small monetary amount to start trading.
Moreover, due to the high number of buyers and sellers in the foreign exchange market, it is comparably easy to liquidate or convert to cash, any holdings one has, especially in contrast to the cryptocurrency market, where scarce trading tends to persist for lowly assets.
Furthermore, acquiring an understanding of some of the factors that affect exchange rates, such as interest rates, inflation, and monetary policy, allow for trading in the foreign exchange market to be considered generally easier than partaking in other markets where it can be harder to evaluate assets, such the markets for certain stocks and cryptocurrencies.
While many financial advisors do not typically recommend foreign exchange trading as a practical way to build wealth, some individuals view it as an enjoyable activity that can allow young people to learn about investing and how to assess key market measures. In this regard, foreign exchange can hold up as a viable financial tool for personal growth.
