Learn Forex Trading: Types of Currency Pairs

Currency pairs

Hong Kong Dollar

While Hong Kong is politically part of China, its economy and monetary system are still considered separate entities. It has its own currency and an independent central bank. However, its currency—the Hong Kong dollar—has been pegged at 7.8 HKD/USD since 1983 and is permitted to fluctuate only within a tight band. Despite being the eighth most traded currency in the world, it is ironically of little interest to currency speculators. It is important to forex markets mainly because of the vast sums its central bank must spend in order to maintain the peg. It has built up foreign exchange reserves of approximately $300 billion, providing great support for the US dollar in the process.

Chinese Yuan

The Chinese yuan (or renminbi, RMB) should be one of the most important currencies in the world. The Chinese economy is already the world’s second largest, and it leads the world in the volume of international trade. Alas, the People’s Bank of China (PBOC) pegs the yuan to the US dollar at an artificially low rate in order to provide a benefit to Chinese exporters. Technically, the yuan has been allowed to float freely since 2005, as can be seen in Figure 2-11.

Figure 2-11. Recent history of CNY/USD (with exchange rate shown in reverse)

While it has risen by more than 25% against the US dollar in the ensuing years, however, its appreciation is still tightly controlled and remains an important component of China’s national economic policy. In order to maintain this peg, the PBOC must buy $40 billion in foreign currency every month. It also strictly limits the trading of yuan outside of its borders, and maintains rigid controls on the movement of capital in and out of the country.

In addition, China’s capital markets are disproportionately small, and far from transparent. Most public companies are majority-owned by the state, and a lack of accounting controls has given rise to repeated corporate scandals. As companies tend to borrow directly from banks, and municipal governments borrow from the central government (or not at all), the bond markets are similarly undeveloped. Furthermore, China’s multi-tiered market structure discriminates against foreign investors. Even in matters of foreign direct investment (FDI), foreign companies are typically required to enter into joint ventures with local partners.

The Chinese government has tried to encourage the use of the yuan to settle trade. Toward this end, it has signed swap agreements with a handful of trade partners. In the end, however, the yuan will not achieve widespread acceptance until it is truly allowed to float freely and until Chinese capital markets are liquid enough to absorb significant inflows of international capital. Thus, it may account for “about 3% to 12% of international reserves by 2035.'”

By most estimates, the yuan remains undervalued. Unfortunately, further appreciation depends more on political factors than on financial economic forces. For those that nonetheless want to bet that the yuan will be worth more in the future, there are investment vehicles that enable such speculation that will be discussed later in this chapter.

Exotic Currencies

With a handful of exceptions (Swedish krona, Norwegian krone, Singapore dollar, etc.), the rest of the lot can be broadly lumped into the category of exotic currencies. As most of these currencies also happen to be associated with emerging market economies, they are often referred to as emerging currencies or emerging market currencies. Emerging market currencies are somewhat akin to growth stocks and high-yield bonds. They are characterized by extremely high rates of growth, but also by high rates of inflation. Their capital markets are not as sophisticated and transparent as their G8 equivalents, but they are often backed by high interest rates. During boom times, their currencies typically outperform major currencies. During times of crisis or uncertainty, their currencies are likewise the biggest sufferers.

While emerging currencies account for a minority of forex turnover, their share is growing rapidly. The 14 exotic currencies depicted in Figure 2-12, for example, accounted for a combined 9% of overall volume in 2010, compared to a meager 2% in 1998.

Figure 2-12. Growing share of forex market turnover by emerging currencies

The consensus among forex market watchers is that emerging market currencies nonetheless represent the future. Their economies collectively account for more than half of the global economy and an even greater share of global growth. In 2010, emerging market economies expanded at a collective 7.1%, compared to 2.7% growth in advanced economies. The disparity in financial market returns is similarly wide. Emerging market central banks control the majority of the world’s foreign exchange reserves, and collectively add nearly $1 trillion in new reserves every year. Debt levels in advanced economies are projected to reach 114% of GDP in 2014, compared to 35% in emerging market economies.

At a certain point, the rise in emerging market currencies will become self-fulfilling. For now, liquidity is still too low and spreads are still too high to attract serious institutional interest. A handful of currencies, such as the Korean won, Mexican peso, and South African rand, are settled by the CLS Bank and are thus more attractive to speculators. Even so, trading such currencies against anything besides the US dollar or euro would be uneconomical. With a few exceptions, then, the majority of emerging currencies are suitable only for medium-term (greater than one month) and long-term (less than three months) trend trading.

Investors are often quick to lump emerging market currencies into one group, as though they move as one cohesive bunch. To be fair, sometimes this practice is indeed justified. During the credit crisis, for example, emerging currencies rose and fell in unison, in accordance with the frequent changes in investor market sentiment. During periods of normal market function, however, emerging currencies fluctuate independently. Every economy is different, and the characteristics of one currency might be completely different from the currency of a bordering country. For example, Brazilian interest rates are among the highest in the world, and the Brazilian real is a popular currency for yield-hungry carry traders. South Africa is a leading producer of gold, and the South African rand sometimes mirrors gold prices. The same can be said for Mexico (oil), Russia (natural gas) and Chile (copper). South Korea is a high-tech export powerhouse, and the Korean won can be counted on to outperform when the global economy is strong. As a result, performance can vary significantly from one emerging currency to another (Figure 2-13).

Figure 2-13. Variations in performance among emerging currencies

There is one final point that I would like to make regarding emerging market currencies: their governments pay much closer attention to them than advanced economies do to their respective currencies. Due to higher saving rates and lower domestic spending, emerging market economies are often more dependent on exports to drive growth. That means that their central banks have a vested interest in keeping their currencies as cheap as possible. Thus, you can always count on emerging markets to step in when their currencies appreciate too quickly. Sometimes, they will verbally warn speculators. Other times, they will impose capital controls (in the form of taxes or other punitive measures) in order to limit short-term investment inflows and stem the upward pressure on their currencies. As we will see in Chapter 3, such efforts are rarely successful in the long-term, but traders need to be aware of them in the short-term.

Currency Trading Instruments

Choosing a currency pair to trade represents only the tip of the currency-trading iceberg. In fact, currencies are exchanged through a wide variety of different instruments, and each one is governed by different rules and different strategies. For administrative purposes, instruments are classified as spot, forward, futures, options, or swaps. (See Figure 2-14.)

 Figure 2-14. Daily forex turnover, by instrument5

Spot Instruments

A spot transaction is defined as a “single outright transaction involving the exchange of two currencies at a rate agreed on the date of the contract for value or delivery (cash settlement) within two business days.”6 For all intents and purposes, spot refers to all real-time, actual currency trades. If you are buying and selling currency right now (as opposed to at some point in the future), you are almost certainly engaging in spot trading. While this probably sounds repetitive, consider that the vast majority of forex exchange contracts are intended for delivery in the future, or not at all!

As I explained in Chapter 1, most spot trading takes place electronically and instantaneously. Traders simply select the currency pair they want to trade and the amount of currency, key the order (along with a few other variables) into their trading platform, and voila, a spot trade is executed. This goes for both institutional and retail traders.

Exchange Traded Funds

Some retail traders will inevitably find it easier to trade currencies indirectly, through Exchange Traded Funds (ETFs) or Exchange Traded Notes (ETNs). Those of you who have invested casually in the stock market are probably familiar with ETFs. With their low expense ratios and high liquidity, they represent attractive alternatives to mutual funds.

An ETF is almost identical to a mutual fund, with the main difference that it must be listed on an exchange and hence is very easy to buy and sell. An ETN is functionally identical to an ETF, but it is structurally different. ETN investors necessarily assume the credit risk of the issuer, whereas an ETF holder bears no such risk. For this reason, ETFs are more common with investors than ETNs. Both types of securities trade on stock exchanges and are regulated by the United States Securities and Exchange Commission (SEC).

Currency ETFs run the gamut from passive exchange rate funds to actively managed strategy funds. There are already 37 such funds that trade on US exchanges, and a few dozen more that trade in London or Toronto (Table 2-2).

Table 2.2 : List of currency ETFs/ETNs Traded on US Exchanges

Of course, there are a few downsides to ETFs. They carry expense ratios (~1-2%) which eat into returns—and are subject to trading commissions. They are also never as liquid as the underlying currencies, such that spreads are higher. Stockbrokers offer lower leverage than foreign exchange brokers, and are not capable of paying interest on one’s open foreign exchange positions. Finally, currency ETFs provide only indirect exposure to currencies, and there is always a slight lag between fluctuations in the ETFs and fluctuations in the underlying currency or currencies (Figure 2-15). Still, for long term investors who wish to integrate currencies into a diversified portfolio, ETFs are an excellent choice.

Figure 2-15. EUR/USD spot rate versus comparable ETF

Investors that want to make basic directional bets in the forex market can choose between ETFs that track individual currencies and ETFs that track multiple currencies. There are currently ETFs for the US dollar, euro, Swiss franc, Australian dollar, New Zealand dollar, British pound, Canadian dollar, Japanese yen, Mexican peso, Brazilian real, Indian rupee, Russian ruble, Swedish krona, Chinese yuan, and South African rand, spread across six different issuers. For the dollar and the euro, investors can choose between multiple issuers. Some of these funds even contain built-in leverage and/or mimic a “short” investment (though all currency trades necessarily involve a short bet).

Currency investors that want diversified exposure can buy bundled-currency ETFs, such as the PowerShares DB US Dollar Bullish Fund (UUP) and Bearish Fund (UDN), which are designed, respectively, to replicate buying or selling the dollar against six major currencies. Other options include the Barclays Global Emerging Markets Strategy ETN (JEM), which is comprised of 15 equally weighted currencies, and the Emerging Market Asia Fund (AYT), which consists of 8 emerging Asian currencies.

Finally, there are actively managed funds that aim to achieve particular strategies. For example, the Barclays iPath Optimized Currency Carry Exchange Traded Note (ICI) is composed of long positions in high-yielding currencies (those with high local deposit rates) funded with low-yielding (those with cheap borrowing rates) currencies. Rather than seek to profit from currency appreciation, these funds aim to capture the spread from interest rate differentials. The PowerShares DB G10 Currency Harvest Fund (DBV) employs a similar strategy, aided by leverage. For those with a higher risk tolerance but aversion to hassle, both funds provide a great proxy for the so-called carry trade.

Forwards

A forex forward agreement is an obligation to buy or sell a specific currency (pair) on a future date for a fixed price that is set on the date of the contract. As with the other types of instruments detailed below, a forward agreement is a kind of derivative, so-called because its value is derived from some other instrument, in this case the physical currency.

Forward agreements do not generally trade on exchanges and are instead executed directly between two counterparties. That being said, forex forward volume is immense (~$500 billion per day), and it’s relatively easy to obtain forward rate quotes for certain currency pairs.

While retail traders are unlikely to ever be in a position to execute a forward agreement, it’s still worth being aware of their existence. Forwards are priced in terms of (expected) interest rate differentials between two currencies. For example, if expected Eurozone interest rates are higher than expected US interest rates for the period of time that the forward contract is outstanding, then the forward price for the EUR/USD will reflect a higher exchange rate (i.e., a more highly valued euro relative to the dollar) in the future. As (expectations of) interest rates change over time, so do forward rates. This structure makes it easy for banks to underwrite forward contracts, because they can immediately hedge their exposure through the credit markets.

The downside of this pricing mechanism is that forward prices are of limited value when it comes to forecasting exchange rate movements in the spot market. The one exception to this rule is the Non-Deliverable Forward (NDF). These contracts are used for currencies that are governed by strict capital controls and whose trading is often severely restricted. While priced in terms of exotic currencies, NDFs are settled in US dollars (or another major currency), rather than in the underlying currency. NDFs theoretically are based on interest rate differentials, but in practice, they may reflect market expectations for future exchange rates. For example, trading in the Chinese yuan —especially offshore trading—is severely restricted by the Chinese government. Those that want to speculate on or hedge exposure to the yuan are thus unable to execute traditional forward agreements because they don’t have access to enough yuan to settle the contracts. Instead, they turn to NDFs and settle the contracts in US dollars, based on the difference between the USD/CNY spot price and the contracted forward rate.

Since the parties to a Chinese yuan NDF contract also lack access to Chinese credit markets and deposit accounts, Chinese yuan NDFs (and most NDFs, for that matter) tend to reflect expectations for the future USD/CNY exchange rate rather than expected interest rates. Furthermore, since speculators are limited in their ability to bet directly on the yuan, they will often turn to NDFs as a good proxy for such a bet. Reporters often quote NDF rates in news articles (on the yuan) as an indication of market expectations for the direction of the USD/CNY rate.

Swaps

Recall from Figure 2-14 that swaps represent the bulk of all forex transactions. There are a handful of different kinds of swaps that fall under the umbrella of foreign exchange trading, but they can generally be classified as either forex swaps or currency swaps. Forex swaps involve the exchange of two currencies on a given date at a given rate and the reverse exchange of the same two currencies at a later date and a different rate (Figure 2-16).

Figure 2-16. Structure of USD/EUR forex swap

Mainly financial institutions, speculators, and central banks use forex swaps. Financial institutions enter into forex swap agreements for the primary purpose of altering the dates on their foreign currency liabilities. For example, if a financial institution already has an existing forward agreement to exchange dollars for euros, but wishes to push the maturity date back by a month, it can execute a one-month USD/EUR forex swap. Forex brokers, meanwhile, rely on forex swaps for accounting purposes. With the use of a one- day tom/next forex swap, a broker can convert all of its clients’ balances into the home currency at the end of each trading day and reconvert them (with interest) the following day. Speculators use swaps in the same way as forwards—to make bets on future exchange rates.

Central banks, finally, utilize forex swaps for liquidity purposes. During the credit crisis, for example, the Federal Reserve Bank opened swap lines with a dozen of the world’s central banks in order to ease a sudden worldwide shortage of US dollars. In this way, foreign central banks were able to obtain enough US dollars to fulfill domestic demand and reduce rapid devaluation in their home currencies. When the liquidity crisis subsided, these dollars could then be reconverted into their home currencies per the Fed’s swap agreements. Sure enough, Fed liquidity swaps have declined from a peak of $582 billion in the fall of2008 to nil today.

Currency swaps (also known as cross-currency basis swaps) are slightly more complicated, and therefore much less common than forex swaps. Per Figure 2-17, a currency swap agreement involves the exchange of principal and interest payments denominated in two different currencies between two parties.

Figure 2-17. Structure of USD/EUR currency swap

The principal function of currency swaps is to enable two entities located in two different countries to borrow in foreign currencies at home-currency interest rates. They are of the most use to multinational companies and institutional investors to fund foreign direct investments and portfolio investments, respectively. 

The credit default swap (CDS) is also relevant to currency traders (though it is not technically categorized as a forex transaction). A CDS functions as an insurance policy against the possibility of a bond default. A buyer of a CDS must pay both an upfront premium and annual premiums to the writer, who in turn is contractually obligated to pay compensation in the event of default on an underlying credit instrument. The upfront insurance premium is determined by the market, and denominated in basis points (equal to 1/100 of 1%). From this upfront premium, it is possible to deduce the market's estimation of default probability. Per Figure 2-18, a buyer of a CDS on a five-year Greek government bond would pay an upfront insurance premium of 5,900 basis points ($5.9 million) on every $10 million of debt that he wants to insure. This corresponds to a 98% probability of default. A buyer of an equivalent CDS on five-year US Treasury bonds, in contrast, would pay only 45 basis points ($45,000), implying a 4% chance of default.

Figure 2-18. Comparison of credit default swap rates, 2009–Present (Source: Bloomberg)

The CDS was originally conceived as a hedging tool, but has since evolved into a big source of income for the financial institutions that underwrite them, and is popular among speculators. CDS rates are particularly interesting to forex traders for two main reasons. First, they serve as an excellent indication of default expectations, compared to bond rates and other metrics. Second, they are useful for gauging ebbs and flows in investor risk perceptions, pertaining both to individual currencies and the overall market. Simply, when CDS rates spike upward, it is both a reflection and a driver of risk aversion.

Futures

Forex futures are conceptually similar to forex forwards in that they allow parties to lock in a future exchange rate for a particular currency pair. Unlike forwards, however, futures contracts trade through centralized exchanges (rather than directly between two parties) and are governed by a set of standardized terms. Contracts can expire only at the end of a quarter (on the third Wednesday of March, June, September, and December), notional amounts are fixed for each currency pair, and terms are virtually the same for every contract.

In addition, futures contracts are marked-to-market, which is to say that cash changes hands between counterparties every day, rather than only on the date of maturity. By way of example, consider a party that purchased a futures contract that obligates it to buy 100,000 euros at a rate of $1.40 per euro three months from today. Now let’s say that today’s rate is $1.35 per euro. If tomorrow, the EUR/USD rate appreciates to $1.36 per euro, then the value of the futures contract will change, and the buyer will receive an immediate payment from the counterparty. In contrast, an investor who makes a bet on the EUR/USD in the spot market would only realize an actual gain or loss upon selling the currency.

This kind of continuous back-and-forth system of payments eliminates credit/counterparty risk and makes futures contracts arguably safer than forwards. In addition, since money changes hands daily, both parties are implicitly “even” upon the maturity of the contract, and (in most cases) physical delivery of currency (per the terms of the agreement) is unnecessary. On the other hand, the risk that monetary losses may be experienced prior to expiration is a risk that is intrinsic to forex futures contracts and must be taken into account.

Futures are especially well suited to directional bets on exchange rates because they are priced in terms of a broad array of factors—not just in terms of interest rate differentials, as are forex forwards. In other words, if the current EUR/USD rate is 1.38 and the six-month futures price is 1.45, the implication is that the markets collectively believe that the euro will appreciate by seven cents against the US dollar over the next six months.

Forex futures are traded on a handful of exchanges, including the Tokyo Financial Exchange, Intercontinental Exchange, and NYSE Euronext. The vast majority of trading, however, is conducted electronically on the Chicago Mercantile Exchange (CME), which offers futures contracts for more than 20 different currencies and 40 unique pairs, and processes more than $100 billion in contract volume every day. Traders can also make bets on volatility and trade non-standard contract sizes using CME E-Micro Forex Futures.

Forex futures trading activity is dominated by speculators. At the same time, futures also serve an important practical function—known as hedging—for both investors and corporations. Hedging allows participants in the forex market to limit their exposure to currency fluctuations. For example, a US company that expects to receive €100 million in three months can lock in an exchange rate for that payment today. If the actual spot rate is higher than the contracted rate when the futures contract expires, then the company will have saved itself money. Of course, if the dollar declines over the next three months, the corporation must ultimately accept a less favorable exchange rate. In this case, it would have been better for the company to convert the €100 million into US dollars only after it had received the money. At the very least, however, there is something to be said for the fact that the company eliminated any uncertainty (also known as risk) by locking in an exchange rate in advance, and one could therefore argue that the hedge fulfilled its purpose.

Options

Forex options represent the smallest component of the forex market. After an explosive rise over the course of the last decade, growth in volume has slowed, and options now account for a mere 5% of overall daily forex turnover.

An option is unique in the financial world, because it carries a choice (i.e., the “right”), rather than an outright obligation, to buy or sell a given financial asset. Specifically, a forex call option gives the buyer the right to buy one currency pair, at a given exchange rate, on or before a pre-determined date. Conversely, a forex put option gives the buyer the right to sell a currency pair, again at a given rate, on or before a pre-determined date. In exchange for this right, the buyer must pay a premium to the seller of the option, who in turn has the obligation to honor the terms of the option if/when the buyer chooses to exercise his or her right.

American-style options allow the buyer to execute his or her right to buy or sell at any time on or before the expiration date. European-style options, however, only support execution at the date of expiry. With Asian-style options (which are not particularly common), the payoff depends on the average exchange rate during a given period of time. This is designed to prevent surges in volatility around the date of expiration from significantly influencing the profit/loss from the option. There are also dozens of other iterations, which, alas, are beyond the scope of this book.

Forex options are also unique in that they can inherently be seen as both put and call options, regardless of how they are denominated. While a call option to buy shares in Microsoft can only be interpreted as just that, a call option to buy euros for dollars can also be seen as a put option to sell dollars for euros. Unfortunately, this complicates pricing, because certain variables (namely interest rates) for two different assets need to be taken into account.

With most other types of forex securities, there is simply a market price. For example, if I absolutely must exchange dollars for euros in March 2013, I have no choice but to pay the market price for the corresponding futures price. If the futures rate is $1.50, then $1.50 is what I must agree to pay in the future in order to lock in a rate today.

With a forex option, in contrast, I can choose the so-called strike price. For example, if the current EUR/USD exchange rate is $1.40, I can buy a March 2013 call option for $1.30, $1.35, $1.40, $1.45, $1.50, etc. The price of the option (also known as the premium) will depend on the relationship between the strike price and the spot price. When the underlying exchange rate (also known as the spot price) exceeds the strike price for a call option, it is said that the option is in the money. When the strike price exceeds the spot price, the option is out of the money, and when the two are roughly the same, it can be said that the option is at the money. The opposite is necessarily true for a put option. Since currencies fluctuate constantly, the relationship between the exchange rate and the strike price (and hence the price of the option) must also change continuously. An option that is in the money today might be out of the money tomorrow.

These relationships should be made clear by Figure 2-19 below. One who buys an out- of-the-money call will realize a loss (in the form of the premium that he or she paid) until the underlying exchange rate exceeds the strike price by a margin equal to the premium that he or she paid. Beyond this point, the greater the appreciation of the underlying rate, the greater the value of the option will be. Naturally, the opposite is true for the party that underwrites the call option. As long as the actual exchange rate remains below the strike price, the upfront premium paid by the buyer represents profit. A massive appreciation in the underlying exchange rate, however, would expose the buyer to significant losses. Meanwhile, the buyer of a put option will only earn a profit if the exchange rate depreciates. The seller of that put option can pocket the upfront premium, but will be exposed to losses in the event of depreciation.

Figure 2-19. Profit/loss for various options

Participants in the options market typically use a variation of the Black-Scholes model (also known as the Garman Hagen model) as a basis for setting prices. Suffice it to say that this model is extraordinarily complex, and is based on the following variables: spot exchange rate, strike price, time until expiration, volatility, and interest rate differential. Alas, since volatility isn’t known in advance, traders actually must approach the model in a backwards fashion. In other words, the market will set a price for each option agreement, from which the implied volatility can be induced.

Options are naturally useful for hedging purposes. For example, let’s say you have an open USD/EUR position and you are concerned that a large downside loss would wipe out all of your profits. By paying a small “insurance” premium associated with an out- of-the money put, you could effectively protect yourself from the possibility of a sudden downside movement. A corporation might have the opposite problem, if it thinks that a surge in overseas Christmas sales might leave it with a big chunk of euros. Instead of executing a forward contract (which would leave it with the obligation to make an exchange of euros for dollars), it might instead buy a USD/EUR option. If its European sales fulfill expectations, the corporation will be protected from an adverse move in the USD/EUR by its forex options. If Christmas sales disappoint, it will have forfeited the option’s premium, but at least it won’t be forced into converting currency that it never received. As with futures contracts, the majority of forex options contracts are never exercised, and do not result in the actual delivery of the underlying currency.

Options are also attractive to speculators because they support complex trading strategies at costs that are lower than those offered in the spot market. For example, it might cost $100,000 in the spot market to bet that the US dollar will appreciate against the euro, but it might cost only $5,000 to make the same bet in the options market! Moreover, by combining options with different strike prices and different expiration dates, it’s possible to construct very particular trading strategies that target very specific price movements. For example, you can use options to bet that the market will trade flat (i.e., without volatility). Instead, you could bet on volatility and simultaneously buy/sell a put and a call option in a way that will yield profits if the exchange rate makes a big move in either direction, but a loss if the market trades flat. In Chapter 7, I will explore some of these forex trading strategies in greater detail.

Conclusion

If the possibilities seem overwhelming, consider that the majority of retail forex investors stick to trading ETFs or major currency pairs in the spot market. While such a choice curtails possibility and carries limitations, it greatly simplifies the decision making process. Ultimately, forex can be as simple or as complex as you’d like. If you want to trade exotic currency pairs, rare types of options, or even swaps, there are plenty of brokers that will be more than happy to facilitate such trades for you. If you were initially attracted to forex by its lure of simplicity, however, it’s probably best to stick to the 100 or so currency pairs that most retail brokers offer, or to a comparably- sized array of currency ETFs.