Forex Trading and its Financial Strategies


By

Maneesh Kumar Ahuja
Sr. Lecturer (Finance)
Rai Business School
Meadows Campus, Delhi NCR
 


Basics of Forex trading

Foreign exchange, abbreviated as FOREX, in itself, constitutes the largest financial market in the world. The trading of this foreign Exchange is called forex trading. In the process of forex trading you have to understand the terms related to it such as Exchange rate and Forex quotes, meaning thereby, the value of one currency expressed in terms of another. Foreign exchange refers to the foreign currency, which can be used in the international settlement payment means. Foreign Exchange Market is referred to as a transaction place for buying and selling foreign currency.

For any investor who wants to trade in foreign exchange along with above basic terms it is advisable that he gets familiar with some other terms including Spot Market, which means transactions at the current market rate for settlement within two business days (the value date). Next is Market Maker who is a dealer willing to make a market in a currency pair, by providing liquidity and displaying a two-way price quote. A market maker takes the opposite side of your trade. Another term that is very important is PIP, which means Price Increase Point, the smallest price increment a currency can make. It is also known as points. Yet another term, Leverage is the amount of gearing you can get from your investment expressed in terms of a ratio. e.g. 100:1 leverage implies a 1% margin requirement.

 While placing any order in forex market some other terms also exist, such as Limit Entry Order, which is an order to buy below the market or sell above the market at a pre-specified level, believing that the price will reverse direction at that point. Next being the Sell Quote which is the quote given on the left. It is the price at which you can sell currency to the dealer.  Buy Quote the quote given on the right is the price at which you can buy currency from the dealer.

In the process of forex trading the Forex market does not have a fixed exchange unlike many other financial securities. It is primarily traded through banks, brokers, dealers, financial institutions and private individuals. Trades are executed through phone and these days through the Internet. It is only in the last few years that the smaller investors have been able to gain access to this market. Previously the large amounts of deposits required precluded the smaller investors. With the advent of the Internet and growing competition, forex trading is now easily within the reach of most investors.

Financial Strategies

To get advantages in forex trading traders are required to follow different financial strategies.

Strategies for managing currency exchange rate risk

Exchange risk is the probability that a company will be unable to adjust prices and costs to offset changes in the exchange rate. There are a number of reasons that businesses need to develop strategies for managing currency exchange rate risk. One is that it often is impossible to pass along exchange rate increases in the form of higher prices. Assuming that a giant US computer retailer is purchasing notebook computers from a manufacturer in Taiwan and that cost to the US firm is $500 per unit, the machine retails for $1,000, and all invoices are payable in Taiwan Dollar. As we assume a Taiwan dollar is worth 0.0289 USD, so for every machine it purchases the retailer must pay 17,301 ($500/0.0289) Taiwan dollars.

Now assume that the USD is devalued so that the Taiwan currency is now worth $0.031 USD. If the manufacturer continues to charge 17,301 Taiwan dollars, this raises the effective purchase price for the retailer to $536.33 (17,301 x 0.031) per unit and cuts $36.33 off the merchant's profit. The question now becomes: can the company pass this $36.33 increase on to the customer? If not, the company must adjust its strategy.

One step is to negotiate a lower price with the Taiwan supplier and thus share the effects of the devaluation. A second is to pass along the price increase as much as possible and absorb the rest. A third, and complementary, approach is to take steps to minimize exchange risk. The three most common ways of doing this are exchange risk avoidance, exchange risk adaptation, and currency diversification.

Exchange risk is the elimination of exchange risk by doing business locally. For the retail firm this means buying notebook computers that are manufactured in the US. In this way, if the dollar is devalued against other currencies, it will not affect the price of labor or materials in the US. The retailer will continue to pay the same price as before the dollar devaluation.

Use of hedging to provide protection against exchange rate fluctuations: - Another method is to negotiate a fixed dollar price with the other party, such as $500 per unit for a period of 24 months. In this way a change in the exchange rate during this period will not affect unit purchase price is the spreading of financial assets across several or more currencies. For example, the computer retailer would be protected, at least initially, against dollar devaluation if it carried enough Taiwan dollars to pay for purchases through the next 12 months. Only after this time period would the dollar devaluation be felt. Moreover, if the company stopped doing business with the Taiwan firm before it had spent all of these local dollars, the retailer would profit from the currency diversification since these dollars would have cost 0.0289 cents and are now worth 0.0310 cents of these approaches, exchange risk adaptation is most commonly used.

The other most popular strategy is currency diversification; this tends to be more common only between large MNC's that have an ongoing need for these currencies. They actually diversify their demand of currency in different countries to take advantage in forex trading.
 


Maneesh Kumar Ahuja
Sr. Lecturer (Finance)
Rai Business School
Meadows Campus, Delhi NCR
 

Source: E-mail April 11, 2006

     

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