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Basics of Exchange Rates

Let’s start with the basics of exchange rates. Each currency is assigned what is known as an ISO code, this refers to the International Organization for Standardization. Each code is three letters long, and is used when quoting exchange rates, for example: GBP/USD for sterling against the dollar, or USD/JPY for the dollar against the yen. 

For each exchange rate we have a base currency. This refers to the domestic currency, on the left hand side of the pair. For GBP/USD, the base currency would be: pound sterling. On the right hand side of the pair, we have the foreign currency, which is referred to as either the term, price or quote currency. 

When we refer to major pairs, we are typically talking about the exchange rates for the US dollar against its G10 counterparts (whether that be the euro, sterling, Canadian dollar or Australian dollar, for instance). 

Cross pairs do not involve the US dollar, for instance EUR/GBP, EUR/JPY or AUD/CAD. Meanwhile, exotic pairs involve currencies from emerging market or developing nations.

These exotic currencies are less liquid than the majors. Liquidity is a measure of depth and availability of an asset in the market, where high liquidity ensures that a currency can be bought or sold without a major impact on the exchange rate. 

When we’re quoting currency pairs, the US dollar is ordinarily quoted as the base currency, i.e. on the left hand side of the cross. The 4 exceptions are EUR/USD, GBP/USD and the Aussie and New Zealand dollars, where the US dollar is quoted on the right hand side of the cross. 

Bid and Offer Rates

When exchange rates are quoted in the foreign exchange market, two numbers are stated: the bid and the offer or ask rate. The bid rate is used when selling the domestic currency and buying the foreign currency. In the context of international trade, the bid rate would be used when an organisation is importing.

The offer or ask rate is used when the opposite is the case, i.e. when we’re buying the domestic currency and selling the foreign currency. This is the rate at which the dealer is willing to sell the base currency.

The bid rate is always lower than the ask rate, and the difference or gap in between the two rates is referred to as the spread. The bid/ask spread is effectively the transaction cost incurred for entering into that trade. These bid and offer rates are typically quoted to 4 decimal places, with the fourth decimal place known as a pip. Each pip, therefore, refers to 0.0001 of the exchange rate.

Types of Analysis

Now when predicting exchange rates, there are three different types of analysis used: Fundamental, technical and sentimental. Fundamental analysis, which is what we focus on during the main episodes of FX Talk, refers to looking at economic factors and interest rates that could impact currency movements. 

When we’re referring to interest rates, a hawkish bias indicates a preference for higher rates, or tighter monetary policy. This stance is generally seen as bullish for a currency, i.e. it should trigger an appreciation, or an upward move in the exchange rate. Conversely, a dovish bias indicates a preference for lower rates, or looser policy. This is generally seen as bearish for the domestic currency and usually triggers a downward move in the exchange rate, or a depreciation. 

Technical analysis is a method of attempting to predict future exchange rates by looking at patterns in past prices. The two foundational concepts here are support and resistance levels. Support levels are levels at which the exchange rate does not, or struggles to, fall below over a period of time, created by buyers entering into the market when a currency depreciates. Resistance levels are the opposite, and represent levels that an exchange rate has difficulty breaking above during a period of time. 

We then have sentimental analysis, which involves gauging a consensus as to how the market perceives the value of an asset or security.

FX Trading and Orders

Investors (or speculators) typically use one of the three aforementioned methods to trade in the market. Forex trading involves investors attempting to identify misvalued exchange rates. These traders will long (or buy) the domestic currency in the hopes that it appreciates, and short (or sell) the domestic currency if they believe that it will depreciate. 

Leverage refers to the use of borrowed money to invest in a security or currency, while margin is the difference between the value of an investment and the size of the loan. 

When entering into the market, investors can place different types of orders. An order refers to how they enter, or exit, a trade. 

A market order is an order to buy or sell a currency at the best available current price. A limit order is an instruction to buy with a restriction on a maximum price, or sell at a minimum price. Meanwhile, a stop order buys once the exchange rate hits a specified price, while a stop-loss order sells once a specified price is reached. 

When engaging in deliverable FX, which is the exchange of currencies to facilitate international trade, hedging strategies can be used in order to limit FX risk and protect from losses caused by movements in exchange rates. Be sure to keep up to date with future episodes of FX 101, as we plan to dive into these various types of FX risk, and risk management strategies in a future episode. 

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