Lecture 4

Types of exchange arrangements, rate of exchange

The major part of speculations is executed on Forex market.

Being a global market, Forex does not have settled place of trading and represents huge army of traders connected by communication channels. Trading is executed by means of phones and computers at the same time all over the world. Consequently trading does not stop because there are always people or organizations who want to buy or sell currency. Being an interbank market, Forex is in the lead among all others segments of the currency exchange market by the volume of deals. Exactly conversion operations (exchange deals of some amount of monetary unit of one country for the currency of another country for the concerted exchange rate at certain date) because of its high profitability in comparison with deposit-credit operations (short-term operations of allocation and attracting missing funds in international currencies for a specified time with fixed interest) attract the most important traders. Almost all the trading instruments are traded on Forex but the most popular are USD, EUR, JPY, GBP and SHF, owing to it they are called “Major currencies”. These currencies compose major currency pairs of Forex market – EUR/USD, GBP/USD, USD/CHF, USD/JPY.

Exchange rate of one currency against another one on Forex market fixes as a result of bid and ask. Process of exchange rate fixing is called price quotations. They can be direct or reversal.

Exchange rate of one currency against another one on Forex market fixes as a result of bid and ask. Process of exchange rate fixing is called price quotations. They can be direct or reversal.

Direct quotation is a price expression of foreign currency through the national one. Most of currency exchange rates are direct quotation of US Dollar to currencies of different countries.

Example:

USD/RUR – 33.70 means that 1 US Dollar values or equals to 33.70 Rubles;

USD/UAH – 6.05 means that 1 US Dollar equals to 6 hryvnia 5 kopeck;

USD/CHF – 1.2350 this means that 1 US Dollar equals to 1.2350 Swiss Franc.

Reversal quotation is a price expression of national currency through foreign one. His-torically English and Irish pound, Euro, Australian and New Zealand dollar and some other cur-rency have reversal quotation.

For instance, quotation EUR/USD – 1.2570 means that 1 Euro equals to 1.2570 US Dol-lars, and if you see this quotation – GBP/USD – 1.8420 – then in this case 1 English pound equals to 1.8420 US Dollars, etc.

Moreover there exists such conception as “Cross quotation”. It is exchange quotations where USD is not base currency and not currency of the pair – EUR/JPY, GBP/CHF, EUR/GBP and others.

There is also quotations by time of executing, i.e. settlement date. Settlement date is a date when a real exchange of funds by way of bought currency receipt and sold currency deli-very to the agent of a deal. In this case quotations can be with settlement date “spot” and “for-ward”. All current market quotations are “spot” prices. While “spot” quotation maturity date is the second working day after “operation date”, for instance, if operation was executed on Tues-day, then settlement date would Thursday, but if deal was executed on Friday, then settling would be on Tuesday of the next week. While “forward” quotation settlement date would be in three or more working days after date of deal execution. We will talk in details about “forward” quotations and deals at the other lectures of this course.

It is important to remember that currency which is the first in pair is called base currency, or quoted currency, value of which is presented, and the second one is evaluation currency, or currency of a deal (in its unit base currency is evaluated).

Let us consider currency pair USD/RUR. USD is base currency and RUR is currency of a deal. Value of US Dollar is Ruble-denominated.

What is the importance of this case? The thing is that while deals with any currency pair execution, exactly base currency is being sold or bought, it is asset. That is why if you want to open EUR/USD order (pic.1), you should understand that you will buy or sell EUR. Many people think that if I sold Euro versus US Dollar it is the same that if I sold US Dollar versus Eu-ro. In general, it is fair but it can lead to unwanted mistakes while opening or closing position.

You should remember – base currency is being sold or bought, currency which is first in currency pair. Notion of base currency will be useful also while considering such case as price move plotting. Value of 1 unit of base currency is changing versus evaluated one. For instance, curren-cy pair EUR/USD quotation will be plotted as value of 1 EUR for some amount of US Dollars. If Euro price is rising, i.e. absolute value of US Dollar is increasing, then consequently, Euro goes up, or “strengthens” and chart moves up. If Euro price is falling, US Dollar absolute value is de-creasing, it means Euro becomes cheaper and chart moves down. Considering currency pair USD/CHF then all said above is true for USD. In this case US Dollar is rising and chart is mov-ing up as well, if absolute value of Swiss Franc is increasing. US Dollar is falling and chart is moving down, if absolute value of Swiss Franc is decreasing.

It means that if chart moves up – base currency rises in price, if chart moves down, then base currency becomes cheaper.

Picture 2 shows example of rising and falling of Euro versus US Dollar. At the left side we can see that absolute value of US Dollar is increasing. It means that for 1 Euro one pays more US Dollars. At the right side it is decreasing, which means that Euro is becoming cheaper.

There is example of rising and falling of US Dollar versus Swiss franc at the picture 3. In this case base currency is Dollar and chart reflects the price movement of 1 US Dollar versus Swiss franc.

It is common to display quotations by five-digit number on currency market. For instance, EUR/USD - 1,2724, USD/CHF - 1,2045, USD/JPY - 106,74, GBP/USD - 1,8560, etc. The last digit reflects points. The least possible quotation change is called change in 1 point. Change of USD/JPY from 106,74 to 106,75, and GBP/USD from 1,8560 to 1,8561 shows that Yen became cheaper versus US Dollar in 1 point, and pound rose in price 1 point.

The major market makers, as it was said before, are commercial banks, central bank, bro-kerage companies, private persons, investment foundations and exchange markets, but basiс market quotations are formed on basis of demand and supply as a result of major market makers interaction (they are banks, investment foundations, etc.). Every market maker while every single deal acts as a seller or customer. Banks and financial companies trading market always give bilateral quotation, left side of quotation is called bid, and right one is ask. If you are going to sell base currency then you act as a seller and would make a deal by bid price; if you decided to buy one, then you are client and order is opened at ask price. Bid price is always less than ask price because dealer is obliged to buy base currency at bid price and sell at ask price. Difference between buying price and selling price is called Spread which is often the main dealer’s basis of income. Let us consider the examples, please pay attention that given below situation is similar to exchange office. If you are going to sell traded currency then it will be bought at bid price, and you are going to buy then deal will be executed at ask price, difference between these prices (Spread) is an income of exchange office.

Spread – ask – bid

InstaForex Company provides fixed spread by major currency pairs equals to 3 points

By market maker work on Forex market it means qualitative or quantitative change of its currency position. Currency position is correlation of requirements and reliabilities by quoted currencies on market. It can be opened and closed. Closed currency position supposes coinci-dence of requirements and reliabilities by every currency pair. It means that market maker doe not buy or sell anything at the moment. Opened currency position appears while divergence of requirements and reliabilities by any currency and can be long and short. We are not going to enter into details about origin of this notions, they arose from the peculiarities of banker’s dis-count and bank balance sheet, just remember that buying of base currency is a long position and selling of it is a short position. Principal of “buy cheaper, sell higher” underlies. It is usual buying of base currency in hope of its rising in price versus evaluated currency. Opening long position happens while buying, closing – while reversal operation, its selling.

Initial selling of base currency is in basis of short position, idea “sell higher, buy cheaper”. Sequence of processes of buying and selling was changed. If dealer suppose that quotation of some currency will fall, he/she sells it. When quotation falls he will buy it cheaper, deriving profit from difference between buying and selling price. Opening of short position happens by selling the currency, closing the buying.

Simplified scheme of short and long orders balance

1. Scheme of order balance with initial opening long position. InstaForex company has reduced lot volume which equals to 10000, it allows trading with minimal deposit 1 USD

Opening of long position – buy EUR (volume 10000 Euro) at the price 1.2728 USD for 1 Euro.

Balance of long position

Closing of long position by selling EUR (volume 10000 Euro) at the price 1.2750

Balance changes

Final balance

1. Scheme of order balance with initial opening short position.

Opening of short position – sell EUR (volume, 10000 Euro) at the price 1.2725 USD for 1 Euro.

Balance of short position

Closing of short position by reversal buy-out EUR (volume 10000 Euro) at the price 1.2728

Balance changes

Final balance

Useful information for InstaTrader terminal user

Forex market is Interbank market, the main source of quotations of which is banks market-makers (banks which “make” market). On basis of their quotations level-sensitive pricing is occurring. These banks are interacting actively with markets not only by customers’ requests but also carry on their own strategies.
These quotations enter the specialized informational systems (Reuters, Bloomberg, Tenfor, DBC, etc.), and then go all over the world – to clients of informational systems (back to banks, individuals and corporate bodies and everybody who connected to the systems).