The Basics of Investing in the Foreign Exchange Market

The Foreign Exchange is a huge financial market with daily volumes exceeding 4.0 trillion US dollars.

 

Most Influential Players in The Foreign Exchange Market

 

The most influential players in the Forex market are central banks, commercial banks, and institutional investors. Banks and institutional investors combined account for about 50% of daily turnover. Exporters, Importers, and other similar multinational groups account for about 10% of daily turnover.

 

Central Banks

 

Central Banks play a key role in the currency market. Central Banks have the tools and incentives to control their domestic exchange rates in order to implement their monetary policies. Especially as concerns the American FED, the European ECB, the Japanese BoJ, the British BoE, and the Swiss SNB. You must never trade against these five (5) Central Banks.

 

Arsenal of Central Banks

There are a lot of tools in the arsenal of Central Banks when they need to interfere in the Foreign Exchange market. Bus as concerns the implementation of the monetary policy, central banks use four (4) major tools:

1. Adjusting the level of the basic Interest Rate

By adjusting the level of the basic interest rate central banks can control inflation, unemployment, consumption, investment, and of course growth.

2. Adjusting the Discount Rate

The discount rate is the rate that central banks charge on when they lend to commercial banks. The level of the discount rate affects directly the liquidity in the market.

3. Open Market Operations

Central banks can buy or sell securities at any time. When a central bank buys a security from a commercial bank, it adds cash to the banks' reserves and increases the overall liquidity in the market. These operations help the implementation of the monetary policy and are called open-market operations.

4. Reserve Requirement

The reserve requirement refers to the money that commercial banks are obligated to maintain overnight. A lower reserve requirement means commercial banks have more available cash for lending.

 

Fixed vs Flexible Exchange-Rate System

The choice of a flexible or a fixed-exchange-rate system belongs to the monetary authorities of each country. Western economies apply flexible exchange-rate systems.

(a) the flexible exchange-rate monetary system

A flexible exchange-rate monetary system allows the domestic exchange rate to be determined by the dynamics of demand and supply. More and more countries are adopting flexible exchange rates, which can be seen as a sign of ‘economical liberation’ for foreign investors.

(b) the fixed exchange rate

A fixed (or pegged) exchange rate system ‘fixes’ the domestic currency's value against either:

• the value of another currency (for example Euro or USD)
• the value of gold
• the value of a basket of other currencies

 

Foreign Exchange Reserves

 

All key countries worldwide built up foreign exchange reserves. Foreign-exchange reserves is money held in one or more reserve currencies, mostly the US dollar, the Euro, the Japanese Yen, the Swiss Franc, or the British Pound Sterling. Gold reserves are also incorporated in the aggregate foreign exchange reserves.

-The US Dollar accounts for 64% of all known central bank foreign exchange reserves

-The Euro accounts for 20% of all known central bank foreign exchange reserves

Monetary authorities use their foreign reserves to stabilize their domestic currencies in case of financial turmoil, but also to discourage currency speculation that may create unfavorable volatility.

 

Table: Countries with the Biggest Forex Reserves

A/A	Country	Foreign Currency Reserves (in millions USD)
1	China	$3,200,000
2	Japan	$1,250,000
3	Switzerland	$800,000
4	Saudi Arabia	$500,000
5	Russia	$460,000
6	Taiwan	$460,000
7	Hong Kong	$425,000
8	India	$405,000
9	South Korea	$400,00
10	Brazil	$380,00

Source: IMF (2018), Investopedia

 

 

 

Forex Pairs Trend Well

 

Trading the trend is maybe the smartest strategy in the Foreign Exchange market. Professional traders always say ‘The trend is your friend’. Long-term traders can combine the ‘Carry Trade Strategy’ with the ‘Trend Treading Strategy’ to maximize their profit potential.

Defining the trend:

-An uptrend means the market is constantly making higher highs and higher lows (Weekly chart)

-A downtrend means the market is making constantly lower highs and lower lows (Weekly chart)

-Alternatively, if the market is above its 200-period Moving Average can be seen as generally bullish, and if it is below as generally bearish (Daily chart)

 

Revealing Key Seasonal Forex Patterns

 

Seasonality plays an important role when trading the financial markets, and especially the Foreign Exchange market. Due to the nature of the global monetary system, currencies tend to follow seasonal patterns. The dynamics of demand/supply change in accordance with time. There are certain months of the calendar year when specific trends tend to emerge.

Take for example the British Pound Sterling:

• The British Pound Sterling is traditionally bearish in February
• The British Pound Sterling is very bullish in April (16 bullish periods out of 19 periods during 2000-2018)
• The British Pound Sterling is bearish in August

Chart: GBP against the US Dollar -Seasonality 2000-2018

 

The above GBP statistics and more statistics regarding 15 Forex pairs are included in the book:

“The Hidden Patterns Behind 15 Forex Pairs -Revealing Momentum and Seasonal Patterns Based on 18.5 Years of Daily Exchange Rates”

You can buy it in the below markets: ► The book ‘Hidden Patterns’ at Smashwords

 

Investing in the Interest Rate Differential (Carry Trade)

 

Carry trading, is a currency strategy that involves buying a high interest-rate currency and at the same time selling a low interest-rate currency. The concept is to exploit the interest-rate differential. Carry traders will go long on currencies such as the New Zeeland Dollard or the Australian dollar, and go short on the Japanese yen or the Swiss Franc.

Popular Forex pairs for carry traders: ■ AUD/JPY, NZD/JPY, USD/TRY, and GBP/CHF

Note that every Forex broker pays traders the interest rate difference for each day the position is held. The explanation for this phenomenon is that higher-yielding currencies suffer from more inflation and that means they tend to lose value in the long-term against lower-inflation currencies. ► Compare Forex Brokers and Trading Accounts

-Carry traders hold their positions for a long period of time, more than six months.

More on Carry-Trade Strategy: ► Carry Trade Strategy

 

■ The Basics of Investing in the Foreign Exchange Market

Forex-Investors.com (c)