The FX Market

Overview

The currency (or FX) market is the largest, most liquid marketplace in the world, with an average daily trading volume of over $5 trillion according to data tabulated by the BIS (Bank of International Settlements – 2015). The reason for this should be quite obvious if you consider that at some point, the proceeds of every international transaction (speculative or otherwise) must be localized to conclude a business transaction. It must be noted that all speculative activities are fraught with risk, and the currency market is no exception, but the sheer size and depth of this arena lends itself favorably to the ideal of “perfect competition”.

Currency values are expressed in pairs with the “base” currency always being the one that is on the left side of the slash and the “quote” currency being on the right. The “quote” currency is used as reference to give us the relative value of the “base” currency. (e.g. EUR/USD – EUR is the “base” / USD is the “quote” currency. ; USD/JPY – the “base” is USD / the “quote” is JPY). Currency trading is the simultaneous BUYING/SELLING of a given pair. There is no fixed exchange and trading takes place OTC (over the counter) 24 hours a day-5½ days (Sun afternoon to Fri evening EST) a week at global money market centers around the world. FX market participants include central banks, bank dealers, retail forex dealers (RFEDs), hedgers, and speculators/investors. Clients of ARCTOS will transact with a counterparty whose pricing structure is derived from inter-bank market rates. More information can be found in ARCTOS’s disclosure document.

The US Dollar only has value when it is measured against a given benchmark like another currency or commodity. As a paired asset, the value of that currency pair is driven by the relative economic health of the two entities. This is a fundamental truism. If the US Dollar rises vs. another currency, then the market is making the assessment that for some reason, the US economy is relatively stronger than that other economy, and therefore one US Dollar is worth more today than it was yesterday. Over 90% of the trading volume is generated by these seven currency pairs (listed in order of decreasing liquidity): EUR/USD, USD/JPY, GBP/USD, USD/CHF, AUD/USD, USD/CAD, & NZD/USD.


 

Some major factors affecting currency prices

Interest Rates: Comparatively high interest rates tend to attract investors to a currency. Lower interest rates, on the other hand, tend to depress a currency’s value.
Inflation/Deflation: Countries with low inflation will see their currency appreciate, as their purchasing power rises relative to other countries. High inflation, on the other hand, usually depreciates currency values.
Economic Indicators: Economic health indicators (employment data, retail sales data, GDP growth) can influence the value of a country’s currency, but these signals are often highly contextual. For example, strong employment data after a market crisis might support a currency, as it suggests economic recovery. But in a healthy economy, it could signal inflation, which would depreciate the currency’s value.
International Trade: Countries that import more than they export must sell their own currency in order to purchase the currency of their export partners, and thus will see their own currency value depreciate as a result.
Geopolitical Events: Financial crisis can greatly impact currencies as events of the past couple of years have borne out.
Commodity Prices: Some currencies (e.g. AUD/USD & Gold; USD/CAD & Oil) are correlated to commodity prices, because natural resource exports drive the bulk of these countries’ economies.

 

Is currency an asset class?

The first thing to look at when evaluating asset classes is correlations: Does the asset class provide a pattern of returns that is different from competing assets? Modern portfolio theory tells us that adding non-correlated returns to a portfolio reduces the overall volatility thereby improving its risk/reward ratio. Studies, using the Dollar Index (which is a diversified basket of major international currencies), have shown that there is either a very slight correlation(S&P500) or negative correlation (fixed income, gold) when comparing currency vs. the other major asset classes.

So the notion of including a managed currency program to diversify a portfolio does have some merit to it as it would have the effect of mitigating the risk of the entire portfolio.

*Please note, that this page briefly describes the FX inter-bank market and potential investors are strongly encouraged to consult their financial advisor before participating in these types of investments. Further information can be found in ARCTOS’s disclosure document.