Forex Trading

Forex market from hedging to speculation

 

Forex market and hedging :

Companies in the Forex market that do business in foreign countries are at risk due to fluctuations in currency values.

When you buy or sell goods and services outside their local markets.

Foreign exchange markets provide a way to hedge currency risk by setting the completion price.

To achieve this, a trader can buy or sell currencies in futures markets or swap currencies in advance.

Which is fixed in the exchange rate,

 for example:

Imagine a company planning to sell American mixers in Europe.

This is when the exchange rate between the euro and the dollar is from $ 1 to $ 1.

The mixer costs $ 100 to manufacture, and the American company plans to sell it for 150 euros.

It is able to compete with other mixers made in Europe.

If this plan is successful, the company will make a profit of $ 50.

Because the EUR / USD exchange rate is equal.

Unfortunately, the dollar begins to rise in value against the euro until the exchange rate reaches 0.80 EUR / USD.

This means that it now costs $ 0.80 to buy 1.00 €.

The problem the company faces is that while it still costs $ 100 to make the mixer.

The company can only sell the product at a competitive price of 150 euros, which when translated again into dollars.

It is only $ 120 (€ 150 x 0.80 = $ 120), resulting in much lower profit than expected.

The blender company would have reduced these risks by selling the euro and buying the dollar when they were equal.

In this way, if the value of the dollar increases, the profits from trade will compensate for the lower profits from the sale of mixers.

If the value of the dollar falls, the more favorable exchange rate will increase the profit from the sale of mixers, offsetting losses in trade.

Hedging of this type can be made on the currency futures market.

As the advantage for the trader is that the futures contracts are standardized and approved by a central authority.

However, currency futures may be less liquid than futures markets.

It is decentralized and is found within the interbank system all over the world. 

 

Forex speculation :

Factors such as interest rates, trade flows, tourism, economic strength, and geopolitical risks affect supply and demand for currencies.

This creates daily fluctuations in the Forex market, as there is an opportunity to take advantage of these changes.

Which may increase or decrease the value of one currency compared to another

And the expectations that one currency weakens are basically the same assumption that the other currency will strengthen because currencies are traded as pairs.

Imagine a trader expecting higher US interest rates compared to Australia.

While the exchange rate between the two currencies is 0.71, (it takes $ 0.71 USD to buy A $ 1.00).

As the trader believes

 that higher interest rates in the United States will increase the demand for the US dollar.

Thus, the Australian dollar / US dollar exchange rate will decrease.

This is because it requires less US dollars to buy the Australian dollar.

Suppose the trader is correct and interest rates rise, which reduces the AUD / USD exchange rate to 0.50.

This means that it requires US $ 0.50 to purchase A $ 1.00.

If the investor had shortened the Australian dollar and bought the US dollar for a long time.

He would have benefited from the change in value.

 

Currency as an asset class :

There are two advantages to currencies as an asset class:

You can earn the interest rate differential between two currencies.

You can benefit from changes in the exchange rate.

An investor can take advantage of the difference between two interest rates in two different economies.

This is done by buying the currency at a higher interest rate and shortening the currency at a lower interest rate.

Returning to the 2008 financial crisis, it was quite common to sell the Japanese yen and buy the British pound.

Because the interest rate differential was very large, this strategy is sometimes referred to as “carry trade“.

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