FX International Payments

What is Forex Trading and How Does it Work?

By Phillip Silitschanu

A look at the world of Foreign Exchange and the tools of Forex Trading

Foreign exchange, also known as forex trading, is a critical part of every international business relationship, allowing businesses in every corner of the globe to send and receive payments for goods and services. In order to best take advantage of forex trading, it is important to understand how it works: from the basics of understanding currency markets, to the forex trading tools available, and how to use the markets and tools in order to execute effective transactions.

Forex Trading: How It Works

Arguably the largest and most important market in the world is the global currency market. If, hypothetically, all trading in equities, fixed income, derivatives and commodities were to suddenly cease, currency trading would still continue, as businesses in different countries would still have to pay each other for goods and services. Forex trading is the “other side of the coin” of all global trade; no goods or services move from one country to another without a corresponding foreign currency transaction.

The modern fluctuating exchange rate system emerged in the early 1970s, when the majority of countries ceased linking their currencies to the value of gold.¹ Once this international standard was removed, each currency’s value was able to shift or “float” relative to the currencies of other countries. Following the move away from gold as a pricing standard, the forex trading market blossomed. With the exponential growth in forex trading volume came a corresponding increase in liquidity and volatility, as well as a dramatic increase in trading and pricing speed. Making the forex trading market even more complex is the fact that, unlike other securities markets, it is truly a 24-hour market. Timely and accurate pricing quotes are paramount in executing profitable forex trades. When there are discrepancies in pricing, the opportunity for triangular arbitrage arises; for traders who can execute forex trades in milliseconds there are profits to be made.

Forex Trading Tools

There are some basic forex trading tools everyone should be familiar with when executing currency trades: spot contracts, forward contracts and futures contracts.

Most forex trading is based on the spot rate, which is the current exchange rate between two currencies, such as pounds sterling and Australian dollars. A spot contract is a contract for an immediate forex trade at the spot rate; however, the delivery of the purchased currencies to the buyer and seller can take up to two days.²

A forward contract is an agreement that locks in a rate for the exchange of two currencies at a specific time in the future. Forward contracts are often used to hedge a company’s currency position; they can help to insulate the company from the effect of fluctuations in exchange rates. By knowing precisely how much foreign currency it will receive (or have to pay out) in the future, a company can focus on its core business instead of fretting over cash management. Forward contracts can be executed with foreign exchange providers, who can ensure swift and seamless transfers on the settlement date. Future contracts are similar to forward contracts in that they are contracts to buy or sell currency at a predetermined price on a set date in the future. However, they differ from forward contracts in that they are financial instruments that are bought and sold on derivatives exchanges. They can be used to mitigate exchange-rate risks or to speculate on exchange-rate fluctuations.

The
Takeaway:

Forex trading is an enormous, complex and volatile market in which even a small difference in pricing can have a significant effect on a business’s profits. Therefore, it is paramount to engage with a trusted, robust, and transparent currency exchange provider that furnishes accurate, up-date information.

Read the Transcript - What is Forex Trading?

In 1971, most international currencies stopped being linked to the price of gold. And since then, with the heavy involvement of central banks and cross border businesses, the market has positively boomed.

It's a growing, liquid and very quickly moving market, and for a lot of businesses, it's an essential one. But with sheer enormity comes a very high degree of volatility.

You see, in a market that never sleeps, pricing never stops. Every second of every day, Monday to Friday, there's a live quote for every actively traded currency in the world.

This makes the ability of businesses to lock in a fixed rate for future payments and receipts a very valuable commodity.

Knowing what crucial cash flows will be in the future allows businesses to manage their money and make forecasts with more certainty.

Out of necessity, special tools have been developed for exactly this purpose.

These tools, available through foreign exchange providers, are spot contracts, forward contracts and futures contracts.

Spot contracts are the most basic method of exchange and are used to trade currency at whatever the exchange rate is at any given second on the day the trade is made.

Like buying a cow at auction, you pay the market price and take it away.

Forward contracts involve two parties agreeing on an amount and exchange rate for settlement at a future date. These are best locked in with foreign exchange providers, who can ensure swift and seamless transfers on settlement date.

Futures contracts have the same function as forwards, except they're traded on exchanges and are usually used to speculate rather than hedge transactions. It's like making a bet with someone, with a third party in the middle who holds the cash.

So those are the products, and they're offered by a wide range of exchange providers in a very crowded marketplace. But as a business, you want to ensure you're getting the best. The best deal execution, the best service, and the best market information available.

And this all boils down to two things, information and relationships.

Because in such a big, volatile market, where even a small difference in price could carve a significant slice out of your margins, working with the best information and the robust tools of a trusted and transparent provider is the best way.

The Author

Phillip Silitschanu

Phillip Silitschanu is the founder of Lightship Strategies Consulting LLC, and CustomWhitePapers.com. Phillip has nearly 20 years as a thought leader and strategy consultant in global capital markets and financial services, and has authored numerous market analysis reports, as well as co-authoring Multi-Manager Funds: Long Only Strategies. He has also been quoted in the US Financial Times, The Wall Street Journal, Barron's, BusinessWeek, CNBC, and numerous other publications. Phillip holds a B.S. in finance from Boston University, a J.D. in law from Stetson University College of Law, and an M.B.A. from Babson College.

Sources

1. “Spot Trade”, Investopedia; http://www.investopedia.com/terms/s/spottrade.asp.