Forex trading for beginners Part 2: Currency, Hedge

International Currency Market and Major World Currencies

The international currency market, commonly known as FOREX (Foreign Exchange Market), can be precisely defined as a system of operations for the purchase and sale of foreign currency and the provision of loans under specific terms, including the amount, exchange rate, and interest rate, with execution on a predetermined date. The primary participants in the FOREX market include:

• Commercial banks
• Currency exchanges
• Central banks
• Companies involved in foreign trade
• Investment funds
• Brokerage firms

The direct participation of individuals in foreign exchange transactions is also steadily increasing.

The Largest Market in the World

FOREX is the largest financial market in the world, accounting for up to 90% of the global financial market. Thousands of participants, including banks, brokerage firms, investment funds, financial institutions, and insurance companies, engage in buying and selling currencies 24 hours a day. Transactions are executed within seconds, no matter the location, thanks to a global network of satellite communication channels and advanced computer systems. This system creates a turnover of foreign exchange that exceeds 10 times the annual gross national product (GNP) of all countries combined, according to estimates from just five years ago.

Why Is Such a Large Volume of Currency Movement Necessary?

Currency transactions play a crucial role in facilitating economic connections between market participants across national borders. They are essential for:

• Interstate settlements
• International trade transactions for goods and services
• Foreign investment
• Tourism
• Business travel

Without foreign exchange transactions, these vital types of economic activities would not be possible. Furthermore, in the FOREX market, money itself becomes a commodity. The supply and demand for each currency fluctuates across various global financial centers, causing the price of each currency to continuously change over time.

The International Monetary System Today

The modern international monetary system operates on a regime of floating exchange rates, where the value of a currency is primarily determined by the market. As a result, exchange rates either rise (appreciating the currency) or fall. This dynamic creates opportunities for traders to buy currencies at lower prices and sell them later at a higher value, thereby generating profit.

The global monetary system has undergone significant changes throughout history, but today it faces some of the most profound and previously unimaginable transformations. Two major developments are shaping the current face of the international monetary system:

1. Money is now completely separated from any physical commodity (such as gold or silver).
2. Advanced information and telecommunication technologies have unified the monetary systems of different countries into a global financial system that transcends borders.

In the past, money was often linked to tangible commodities like metal, giving rise to the saying, “People are dying for the metal.” Today, however, money is neither metal nor paper. The real power of money lies in digital numbers on computer screens, which influence global economies, shape nations, and even topple empires. Whether this shift is beneficial or not is beyond the scope of our analysis, but it is the reality of the modern financial system, and we must learn to operate within it.

The Evolution of the International Currency Market

The international currency market, as we know it today, took shape after 1973, but its origins can be traced back to 1944, during the Bretton Woods Conference in the United States. The outcome of World War II was already becoming clear, and the Allied powers began discussing the post-war financial structure of the world. While the economies of most major nations were devastated or focused on wartime production, the U.S. economy emerged stronger, growing significantly during the war.

The world needed food, fuel, raw materials, and equipment, and only the U.S. economy was capable of producing these goods in sufficient quantities. The challenge arose in how other countries would pay for these goods. Most war-torn nations had little of value to offer the U.S. in return, and the U.S. gold reserves were already the largest in the world, while many other countries had very little gold remaining.

If trade were conducted through currency exchange, the demand for American goods would drive the value of the U.S. dollar so high that other currencies would depreciate, making it impossible for countries to afford American products. This situation necessitated the creation of a new financial order, one that would address these challenges and help stabilize global economies.

On the other hand, while this could be seen as a problem for every country except the United States, many understood that such an approach had led to World War II. After World War I, the U.S. withdrew from international responsibilities, leaving other countries to manage global economic issues. This led to a severe dollar shortage, as gold reserves flowed into the U.S., and other currencies depreciated. Short-sighted protectionist policies further isolated economies, turning economic nationalism into strained diplomatic relations, which eventually escalated into war.

To avoid a post-war collapse of global currencies, the Bretton Woods Conference in 1944 established several financial institutions, most notably the International Monetary Fund (IMF). The IMF was initially a pooled resource of international currencies, with each country (especially the U.S.) contributing to the fund. Nations could borrow from this pool to stabilize their currencies. The U.S. dollar was fixed to gold at $35 per troy ounce, and other currencies were pegged to the dollar at fixed exchange rates.

The Dollar’s Post-War Demand

However, the post-war demand for the U.S. dollar far exceeded expectations. Many countries sold their own currencies to buy dollars, as they needed them to purchase American goods. As American exports significantly outpaced imports, the U.S. trade surplus grew, and the global dollar deficit worsened. The IMF’s resources were insufficient to provide the necessary loans to support global currencies.

In response, the Marshall Plan was introduced. Under this plan, European nations submitted lists of the material resources required to rebuild their economies, and the U.S. provided them with the necessary dollars—not as loans, but as direct transfers. These dollars prevented the devaluation of European currencies and boosted American exports by opening new markets.

Dollar Surplus and Global Presence

As the U.S. expanded its presence globally—through military bases, private investments in European businesses, and tourism—foreign banks began accumulating more dollars than needed. By the late 1950s, European businesses no longer required as many American goods and found more attractive investment opportunities than holding dollar deposits. They became increasingly reluctant to hold excess dollars.

Initially, the U.S. Treasury was willing to buy back dollars in exchange for gold, maintaining the dollar’s fixed value against other currencies. However, the demand for gold caused a drain on U.S. gold reserves, which were halved by the early 1960s.

The system of fixed exchange rates persisted until the early 1970s. By then, the U.S. no longer enjoyed a favorable trade balance, as other countries were exporting more to the U.S. while buying less from it. The excess dollars accumulating abroad became unclaimed reserves held in foreign central banks. For several years, the U.S. resisted the inevitable devaluation of the dollar and rejected the adoption of free-floating exchange rates. However, after a series of economic challenges in the early 1970s, the U.S. abandoned the dollar’s gold standard, allowing the exchange rate to be determined by market supply and demand (the free-floating exchange rate system).

By 1980, the price of gold soared to nearly $750 per troy ounce (starting in 1975, Americans were legally allowed to purchase gold as an investment). The late 1970s saw the dollar reach its post-war low, and its subsequent history has been characterized by cycles of ups and downs.

The Era of Free-Floating Currencies

Today, all major global currencies operate under a free-floating regime, where their value is determined by market forces based on the demand for that currency in international trade, investment, and interstate settlements. However, this “free float” is not entirely unregulated; each country has a central bank, tasked with ensuring the stability of its national currency, often intervening in the market when necessary.

The FOREX (Foreign Exchange) market facilitates the exchange of currencies and includes a broad array of participants, such as individuals, firms, investment institutions, commercial banks, and central banks.

Major Currencies in the FOREX Market

The main currencies that dominate FOREX transactions today are:

• US Dollar (USD)
• Euro (EUR)
• Japanese Yen (JPY)
• Swiss Franc (CHF)
• British Pound Sterling (GBP)

Before the introduction of the euro, the German Mark (DEM) held a significant share of the market. In recent years, currencies such as the Canadian Dollar (CAD), Australian Dollar (AUD), and Swedish Krona (SEK) have also gained prominence.

The Role of the US Dollar

The U.S. dollar (USD) became the leading global currency following World War II. Today, it serves as the universal means of payment in international trade, a safe-haven currency during financial and political crises, and an important object of global investment. The U.S. government’s large volume of highly reliable securities—particularly long-term government bonds—attracts both private foreign investors and foreign governments. Confidence in the stability of the U.S. economic and financial system, and the assurance that proceeds from government debt securities will be paid on time, without the risk of requisition or unexpected taxes, further bolsters this attraction.

Stock Market Growth and Dollar Strength

In recent years, the U.S. stock market has experienced unprecedented growth, drawing significant capital from both foreign and domestic investors, which has strengthened the dollar. Since the mid-1980s, American stocks have outperformed gold as an investment: stock prices have risen while the price of gold has declined. From 1993 onward, U.S. stocks have continued to surge, leading many experts, including government officials, to express concerns about the overvaluation of stocks. They warned that a sharp drop in stock prices could trigger a financial and economic crisis.

The US Dollar (USD) holds a dominant position in the global financial system. According to various estimates, the dollar comprises 50% to 61% of the international reserves of central banks, amounting to as much as $1 trillion. It serves as the base currency in the majority of foreign currency quotes. As of October 1998, the dollar participated in 87% of all transactions in the FOREX market. In exchanges involving the Japanese yen (JPY), the dollar accounted for 87% of transactions; for the German mark (DEM), it made up 64%, and for the Canadian dollar (CAD), an overwhelming 98%.

Japanese Yen (JPY)

The Japanese yen has experienced a turbulent history. After World War II, the exchange rate was fixed at 360 yen per dollar, a value set by the U.S. occupation administration. By 1995, the yen had appreciated significantly, reaching around 80 yen per dollar. However, the yen has fluctuated since then, experiencing both significant drops and periods of strengthening, particularly in the second half of 1998.

A defining feature of Japan’s financial environment today is its extremely low short-term interest rates, which the Bank of Japan maintains at nearly zero. As a result, large volumes of savings, pension funds, and other investments are directed into foreign securities, particularly U.S. government bonds and European assets. While the yen trails the dollar as a reserve currency and an instrument of international settlements, it remains one of the major currencies in the global financial market.

British Pound Sterling (GBP)

The British pound was the world’s leading currency up until World War I. Its dominance was weakened during the interwar period and was finally eclipsed by the U.S. dollar after World War II. This was due to several factors: economic challenges stemming from the war, and a loss of confidence in the currency exacerbated by counterfeiting sabotage by Germany during the conflict.

Today, up to 50% of transactions involving the pound occur in the London market, and it occupies about 14% of the global foreign exchange market. Most of this trading volume involves the dollar and, historically, the German mark. By noon, New York banks often stop quoting the pound. The GBP is highly sensitive to labor market data, inflation reports in the UK, and oil prices, leading some analysts to refer to it as a petrocurrency.

In FOREX market commentary, the British pound is commonly referred to as “cable” or simply “pound”. The term “cable” dates back to when the most up-to-date market data from the U.S. was transmitted to Europe via transatlantic telegraph cables. “Cable” is typically used when quoting the GBP/USD pair, while “pound” was historically used in GBP/DEM quotes.

Swiss Franc (CHF)

The Swiss franc plays a smaller role in global currency transactions compared to other major currencies. Historically, the franc has served as a safe-haven currency, especially in relation to the German mark—for instance, during crises such as those in Russia. In earlier years, the franc was more volatile than the German mark, but its fluctuations have stabilized in recent times.

The franc’s role as a safe haven was significantly diminished in 1999 due to the Balkan conflict, which affected its stability. Since the introduction of the euro, the volatility of the franc against the euro has become much lower than it was against the German mark. The Swiss National Bank (SNB) aligns its financial policies closely with those of the Eurozone. For example, when the European Central Bank (ECB) lowered interest rates in the spring of that year, the SNB followed suit within 20 minutes.

While most currency transactions involve the US dollar, there are also active non-dollar markets. Previously, 98% of non-dollar market transactions involved the German mark. However, following the introduction of the euro, volumes in many of these markets declined and have not yet fully recovered.

German Mark (DEM)

The German mark was second only to the US dollar in terms of its share in global foreign exchange reserves, accounting for about 25%. The mark’s stability was heavily influenced by socio-political factors in Russia, with which Germany had close economic and political ties. As Germany is a major economic force within the Eurozone, this influence has now shifted to the euro.

Euro (EUR)

The euro was introduced on January 1, 1999, and united 11 European nations into one of the world’s most powerful economic blocs. The Eurozone (also known as the “Euro-area”) accounts for nearly one-fifth of global economic output and world trade. The Eurozone includes Austria, Belgium, Germany, Ireland, Spain, Italy, Luxembourg, the Netherlands, Portugal, Finland, and France.

The Eurozone spans an area of 2.365 million square kilometers and has a population of 291 million people. For comparison, the United States has a population of 269 million, while Japan has 126 million.

TThe creation of the euro is undoubtedly one of the most significant financial experiments in human history. Prior attempts at forming major economic unions have largely been unsuccessful, and the euro is still viewed by many as an ongoing experiment with an uncertain outcome. Throughout the first half of 1999, the euro’s exchange rate steadily declined. Some interpreted this as a sign of distrust in the new currency, while others saw it as a reflection of the effective monetary policy pursued by the single European Central Bank (ECB). A weaker euro benefits European exporters, making their goods more competitive in global markets.

The Road to Monetary Unification

The path to the unification of European monetary systems was long and challenging. Not all countries were able to meet the stringent conditions for participation, and the composition of the Eurozone evolved over time. However, for several years, there existed a synthetic currency known as the European Currency Unit (ECU), which was made up of a basket of European currencies and was internationally recognized. On December 31, 1998, the ECU’s exchange rate was converted into the euro’s initial exchange rate.

The consistent efforts of key European leaders—particularly from Germany, France, and Italy—eventually culminated in the successful launch of the euro.

Hedging in Foreign Trade Operations

Companies involved in foreign trade operations, such as exporters and importers, frequently participate in the FOREX market to manage and minimize currency risks. The primary risk in international markets comes from the constant fluctuation of exchange rates, which can significantly affect the cost of goods traded in foreign currencies. A company may face a situation where the exchange rate changes, potentially turning a planned profit into a loss. While exchange rate fluctuations can occasionally bring unexpected profits, businesses whose core activity is not currency trading should prioritize ensuring stable profits from their primary operations.

The Need for Hedging

For companies that deal in exporting and importing, the ability to calculate the actual cost of goods in foreign currencies is critical for profit planning. Many large firms have analytical departments dedicated to forecasting exchange rates, which allows them to make informed decisions and aim for better prices in the market. However, while forecasting helps to anticipate favorable rates, it does not protect a company from potential losses when market conditions shift unexpectedly.

Hedging vs. Forecasting

Unlike forecasting, which provides insight but no guarantees, hedging offers a solution that can almost eliminate currency risks. By engaging in hedging operations, a company protects itself from adverse movements in the foreign exchange market, stabilizing costs and ensuring that the planned profits from trading activities remain unaffected by currency fluctuations. This way, the company can accurately set prices, plan profits, and manage its financials more predictably.

How Hedging Works

In any business, accounting is typically done in a single currency. However, when a company engages in export-import operations, the foreign exchange rate at the time of buying or selling foreign currency can significantly impact its profitability. Changes in exchange rates can result in profits or losses for the company. To mitigate this risk, companies use hedging strategies.

The Role of Hedging

Hedging eliminates the risk of exchange rate fluctuations, enabling companies to maintain financial stability. It allows businesses to:

• Plan ahead by fixing prices for goods.
• Predict financial outcomes such as profits and wages.
• Avoid the negative impact of sudden exchange rate changes, ensuring more accurate budgeting and profit forecasting.

By employing hedging, companies can lock in exchange rates for future transactions, preventing their financial results from being distorted by unfavorable market conditions.

Currency Risk Hedging

Currency risk hedging is the protection against unfavorable currency movements. It involves locking in the current value of funds by entering into FOREX transactions that secure a specific exchange rate. This strategy minimizes the risk of losing value due to future exchange rate fluctuations.

Leverage and Margin Trading

A key advantage of hedging through the FOREX market is the use of margin trading and leverage. With leverage, a company can control large positions by making only a small initial deposit (known as a margin). This allows companies to:

• Conduct large transactions with minimal capital.
• Avoid tying up large amounts of working capital needed for other business operations like purchasing raw materials or goods.

Cost-Effective Trading

By using leverage, companies can trade without the actual delivery of money, which reduces overhead costs associated with moving large amounts of funds. This makes margin trading not only a highly effective hedging tool but also a cost-efficient way to manage currency risks without depleting the company’s working capital.

In summary, hedging via the FOREX market is a powerful strategy that helps businesses manage currency risks while ensuring financial stability, predictability, and cost-effectiveness in their operations.

Types of Hedging: Buyer’s Hedging and Seller’s Hedging

In foreign trade operations, there are two primary types of hedging:

1. Buyer’s Hedging: This is used to reduce the risk associated with a potential increase in the price of a commodity. For example, an importer who expects the cost of a foreign currency to rise can use buyer’s hedging to lock in the current rate.
2. Seller’s Hedging: This hedging method is applied to limit the risk of a potential decrease in the price of goods. For example, an exporter who anticipates a fall in the value of a foreign currency can use seller’s hedging to safeguard the revenue they expect from future sales.

How Hedging Works in Practice

The general principle of hedging in foreign trade operations involves opening a currency position in a FOREX trading account aligned with the direction of a future transaction. Here’s how it works for both importers and exporters:

• For Importers: An importer, who will need to buy foreign currency in the future, opens a buy position on a FOREX trading account. This allows them to lock in a favorable rate in advance. When the time comes to make the actual foreign currency purchase at the bank, the importer closes the position, effectively eliminating the risk of unfavorable exchange rate fluctuations.
• For Exporters: Similarly, an exporter, who expects to sell foreign currency at a future date, opens a sell position on the FOREX trading account. When it’s time to sell the foreign currency at the bank, the exporter closes the position, securing the exchange rate and avoiding currency risks.

Costs Associated with Hedging

While hedging effectively protects companies from currency risks, it does come with associated costs, including:

• Spread Costs: Every transaction on the FOREX market involves a spread, which is the difference between the buying and selling price of the currency. In current market conditions, the spread typically ranges from 0.05% to 0.1% of the transaction value, a relatively small cost considering the size of the contract.
• Rollover Fees: If a position is held open overnight, it is rolled over to the following trading day. This incurs a fee based on the interest rate differential between the two currencies involved. The cost is approximately 0.01% per day, which equates to 0.3% per month. Depending on whether the position is a buy or sell, the client may either pay or receive the rollover amount.
• Security Deposit (Margin): To open a position, a security deposit (or margin) is required, usually ranging from 1% to 5% of the total transaction value. Once the position is closed, this deposit is returned to the trading account, adjusted for profit or loss.

The Value of Hedging

In summary, hedging provides significant protection against currency risks for companies engaged in foreign trade. Despite the costs involved, these expenses are minimal when compared to the potential losses that could occur due to unfavorable exchange rate fluctuations. Hedging allows businesses to operate with greater financial predictability and stability, making it an invaluable tool in international commerce. A well-designed hedging program reduces not only risk but also costs by freeing up company resources and helping the company’s management to focus on the core aspects of the business.

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