One, two, three, forex

Basics of foreign exchange


During the United States occupation of Iraq, at the American coffeehouse Starbucks, Bill Burbank made money by selling the same. From Middle Eastern suppliers, he bought 950 units of the Iraqi currency, the dinar, for a dollar – and sold them to Americans at the café to the tune of 500 dinar for a buck.  That was nearly double the original price.

Even amid the bloody occupation, speculators bought the dinar because they anticipated that Iraq would someday regain its feet and export oil, expanding its economy. As spending on Iraqi goods rose, demand for the dinar would increase, propelling its international price and blessing those who had bought it cheap.

That cunning typifies the market for foreign exchange (forex): Most currency trades are not to buy foreign goods but to take profits. In Kazakhstan’s stock exchange, dollar-and-tenge trades account for 99% of the forex market, averaging $4.8 billion (710 billion tenge) per month. Trading has been volatile but rising throughout 2012, according to data from the National Bank of Kazakhstan.

Most forex consists of bank deposits that traders swap – for example, a dollar account for a euro account.  Swaps are easy in such a gargantuan market. By 1998, daily trading in traditional forex products alone, such as spot trades, was already $1.5 trillion. Future market growth will depend on whether expansion of world trade will offset the tendency to simplify transactions by adopting a major currency. The euro reduced forex trading between European countries, but entry of post-Soviet nations into world markets increased it, noted the New York branch of the U.S. central bank, the Federal Reserve.

Getting a head in the forex market

Half of all trades occur in the United Kingdom or the United States. Traders prefer London for its time zone; its morning corresponds to the late hours of Asian and Middle East markets, and its afternoon overlaps the morning hours of North American markets. By trading through London, a seller can find as many buyers as is possible, and vice versa, said the New York Fed.

Almost 90 percent of all trades involve the dollar, partly because it offers thick markets. Suppose that you would like to sell Kazakhstani tenge for Philippine pesos. Probably you will trade the tenge for dollars, then the dollars for pesos. The market for either currency in dollars is thicker than is the market of tenge for pesos, so the exchange rates for the dollar reflect better information. The dollar is a vehicle currency.

Between the two world wars, the dollar and the British pound sterling – so called because it was originally a pound of silver – were vehicle currencies. But as America's economy waxed and Britain's waned, the dollar supplanted the pound. Momentum for the dollar reinforced itself. As fewer people used the pound, it became harder to find someone who would sell it at the price you sought, so you would buy the dollar instead, explained the former Fed chairman Alan Greenspan. Someday (but certainly not today), the euro may challenge the dollar as the vehicle of choice, suggested Mark Wynne.

The dollar also plays a riskier role. In 2004 – and, for that matter, in 2012 -- speculators took advantage of low interest rates in the U.S. to borrow dollars in order to buy currencies that paid a higher rate of return. The dollar is a funding currency.

Since it is widely accepted, the dollar is convenient in black-market transactions such as drug deals. Here the euro may supplant the dollar. The largest U. S. denomination is the $100 bill, which is mostly held overseas, reported Michael Lambert and Kristin Stanton. The Europeans offer a 500-euro bill, worth about $650, which would enable black marketers to carry their ill-gotten gains inconspicuously.

International transactions both demand and supply foreign exchange. The Kazakhstani importer of a Japanese car must pay for it with yen. To obtain them, he pays tenge to his bank, which then cuts a check denominated in yen for the Japanese bank. The Kazakhstani bank’s yen come from Japanese importers of our oil, who pay their home currency to obtain tenge.

A generation or so ago, most forex trades paid for imports and exports. Today, financial transactions dominate the market. Mutual funds trade forex to improve their rates of return. So, speculators may plague any nation that tries to steady its exchange rate. When they assailed the franc in 1992, the finance minister recalled -- with a twinge of nostalgia --  that they had been decapitated during the French Revolution. Moral for risk lovers: Don’t lose your head. –Leon Taylor, tayloralmaty@gmail.com

Good reading

Federal Reserve Bank of New York. The foreign exchange market in the United States. Online. A worthy primer.

Robert L. Hetzel. German monetary history in the second half of the twentieth century: From the deutsche mark to the euro. Federal Reserve Bank of Richmond, Economic Quarterly. Spring 2002. Online.  The source of the story about the French Revolution.

Craig Karmin, Bullish on Iraq: Average Joes place bets on the dinar. Wall Street Journal. April 23, 2004.  Page A1. The source of the Starbucks story.

Mark Wynne. European Economic and Monetary Union (EMU). Federal Reserve Bank of Dallas, Expand Your Insight. February 1, 1999. Online.


References

Alan Greenspan. The euro as an international currency. Federal Reserve Board. November 30, 2001. Online.

Steve Johnson, Dollar drifting dangerously on overseas capital flows. Financial Times. March 19, 2004.

Michael J. Lambert and Kristin D. Stanton. Opportunities and challenges of the U.S. dollar as an increasingly global currency. Federal Reserve Board, Federal Reserve Bulletin. January 8, 2003. Online.