As in all other markets, services are being exchanged between two parties in the FX market. However, in this market monetary units, e.g. EUR against USD, are being traded against each other and not money against goods/services.
During business days FX markets are trading around the clock. Dealing commences on Sunday evening at 10 pm GMT in New Zealand and finishes on Friday evening at 9 pm GMT in New York. The course of the trading day is dominated by the geographic region in which the regional FX markets are open, the leading role is being smoothly passed over from one market to the other. The trading day is basically divided into three phases, the so called Asian session, the European session and the American session.
Pricing in FX markets is always done for currency pairs. EUR/USD is the most frequently traded currency pair, accounting for 27% of the trading volume.
The unit placed first in a currency pair is called base currency, the second unit is called the quote currency or reference currency. The name relates to quote for "quoting a price". Hence, the price for a unit of the base currency is indicated in units of the reference currency. Given an exchange rate of 1.25 for EUR/USD, one Euro can be purchased at the expense of USD 1.25.
Contract sizes are of lesser importance for the FX trader whose primary objective is to achieve a sound yield, while enterprises will require exact amounts of foreign currency in order to cover their obligations, e.g. paying for invoices. The standard contract size for FX trades is set at 1 lot, similar to the settlement of shares in the stock market. One lot will always equal 100,000 units of the base currency irrespective of the currency pair. In this way, a purchase of one lot EUR/USD translates into a purchase of EUR 100,000 against US Dollars.
FX Brokers may allow smaller contract sizes when using certain trading systems, so that the FX market will be more attractive for private persons. A mini-lot is a contract of 0.1 lot which equals to 10,000 units of the base currency, a contract of 0.01 lot - which is 1,000 units of the base currency - is called a micro-lot.
FX brokers will quote a buying price (bid) and a selling price (ask) for each currency pair. The difference between the two quote types is called spread and is measured in pips. A pip usually refers to the 4th decimal place and was originally the smallest arithmetic unit. Some FX brokers have introduced a 5th decimal place which allows price quotations in fraction of pips. If the bid for EUR/USD is 1.2745 and the ask price is 1.2748, this translates into a spread of 3 pips.
A pip always amounts to the value of 0.0001 or a ten thousandth of the contract size and will be given in the reference currency. The base currency is immaterial in this case. This means, that for 1 lot of EUR/USD as well as for 1 lot GBP/USD, a movement of the exchange rate of one pip will result into a profit or loss of USD 10 (base value 100,000 units / 10,000 = 10; reference currency USD --> USD 10).
As FX investors are not interested in a physical exchange of the currencies, but rather want to achieve profits from currency rate movements, no money is being exchanged for FX transactions. Open positions (for example purchase of 1 lot GBP/USD = purchase of GBP 100,000) are being entered on internal accounts with the FX broker. Subsequently, the positions must be closed by a counter trade (sale of 1 lot GPB/USD = sale of GBP 100,000). The profit or loss of offsetting the position will be credited or debited to the customer account.
In order to ensure that customers can fulfil their financial obligations resulting from a possible loss, a margin deposit is needed as collateral upon opening of the account. The margin required for the trade is usually considerably lower than the actual underlying value, as no money flows are exchanged for the transaction, the margin serves only as a provision against the potential exchange rate risk of the open position.
If 1 lot GBP/USD is purchased at 1.55 (purchase of GBP 100,000 against USD 155,000) and afterwards the rate drops to 1.5 (which would be a sale of GBP 100,000 against USD 150,000 when offsetting the position), the customer would experience a negative market value for this position amounting to GBP 3,333.33 (USD 5,000/1.50). In this case a margin of GBP 5.000 will be adequate in order to maintain an open position.
A margin of GBP 5,000 for an underlying value of GBP 100,000 corresponds to a leverage of 1:20, which means that an investor can "move around" in the market up to twenty times of his original funds. Since rate movements as described in above example last for several hours or even days and the margin control by the FX broker is carried out in real time, a leverage up to 1:500 is achievable. Thus a customer may need a deposit of only GBP 200 in order to open a position of 1 lot GBP/USD. If the margin is not adequate, the transaction request is being declined.
A margin call will be made if the funds falls below a certain level, e.g. 20% of the originally required margin when opening the position, which would be GBP 40 for above example. In a next step the customer can decide whether he wants to increase his margin by an additional deposit or close the position. Margin calls are less important for private clients, because permanent personal availability and fast payment instruments would be a prerequisite. As several hours may pass between a payment by credit card and the actual credit booking on the account, it may be too late in many cases.
In general, the FX broker's terms and conditions prescribe an automatic closing of an open position if funds on the account fall below a further level. However, it can happen that in exceptional market situations the account may show a negative balance.
FX trades are so called spot transactions which usually have to be settled within two business days. Since FX brokers normally do not exchange the currencies physically, - as previously mentioned -, all trades which have not been closed by the end of the business day are rolled over to the next trading day (swapped over). The basis for the swap settlement is the completion or value date (trading date + 2 business days). Is a position rolled over from Tuesday to Wednesday (value day Thursday to Friday), one interest day is being computed. If a position is rolled from Wednesday to Thursday (value date Friday to Monday), three interest day are being calculated.
The basis for the swap settlement is the interest difference between the two currencies of each currency pair. When buying one lot AUD/USD, the internal AUD of a customer is credited with AUD 100,000 while the counter value is debited on the customer's internal USD account. Rolling over this position to the next day means taking up a loan in USD in order to finance an investment in AUD. The balance resulting of the interest earnings on the AUD account and the interest expense on the USD account will be credited /debited to the customer account.
The systematic use of interest differentials between different currencies is called carry trade.
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