In this post, we recap four key concepts that forex traders should know about. Understanding these features of the market will help you anticipate the market forces that can drive currency prices.
How interest rates affect currencies
There are lots of factors that can affect the value of a currency relative to other currencies. Ultimately, however, capital chases yield. In other words, currencies that pay a higher interest rate should appreciate. If all else is equal, investors would rather hold a currency that pays a higher interest rate. Because markets always look to the future, this usually has more to do with expectations about the future direction of rates, than with current rates. So, anything that may affect interest rates in the future can affect the value of a currency.
The only thing that can change this, is the rising risk of major capital outflows or devaluation for some other reason. The stable currencies of developed countries are seldom at risk of major outflows or devaluation. On the other hand, most developing-nation currencies usually have a certain degree of risk associated with them. Devaluation can occur when a central bank tries to maintain an unsustainable exchange rate. Outflows or capital flight can occur due to runaway inflation, government debt defaults, or political instability.
Analyzing forex markets, therefore, comes down to balancing the expectations for interest rates with the risk of devaluation and capital flight.
Forex quotes explained - Direct vs indirect quotes
Any forex pair can be quoted with either currency first or second. For example, the AUD/USD pair can also be quoted as USD/AUD. Each alternative is the inverse of the other and can be calculated with the formulae 1/x.
So, if the AUD/USD level is 0.6785, then the USD/AUD Level is 1/0.6785, or 1.4738.
In the first instance, we are saying that you would pay 0.6785 US dollars to buy 1 Australian Dollar. If you were in Australia, this would let you know what one unit of the local currency is worth. From an Australian perspective, this is an indirect quote.
The direct quote, from an Australian perspective, is USD/AUD = 1.47. This means that 1 USD will cost you 1.47 AUD.
Direct quotes always have the domestic currency first and tell you the number of local currency units required to buy a foreign currency unit. Indirect quotes have the foreign currency first, and the domestic currency second, and tell you the number of foreign currency units one unit of the local currency will buy.
Arbitrage opportunities exist when two trades can be executed simultaneously to lock in a risk-free profit. Forex arbitrage opportunities can potentially exist between any three currencies.
This is commonly referred to as triangular arbitrage.
The following currency levels illustrate an arbitrage opportunity. To keep things simple, let’s imagine you can buy or sell each pair at these levels.
AUD/USD = 0.67
AUD/NZD = 1.06
USD/NZD = 1.54
Now let’s look at how these rates relate to each other:
- One AUD will cost 0.67 USD. So, for USD 6,700 you can buy 10,000 AUD.
- Now, each AUD will buy 1.06 NZD, so the 10,000 AUD you just bought will buy you 10,600 NZD.
- You can buy one USD for 1.54 NZD, so the 10,600 NZD will buy you 6,883 USD (10,600/1.54).
This series of transactions, therefore, turned $6,700 into $6,883, netting a risk-free profit of $183.
This was just an example, and reality is a little different. For a start, you would need to be able to execute all three trades at the same time to avoid any risk. These currency levels are hypothetical and would never offer such a large profit in the real world. You would also have to cross the spread three times, and you may have to pay commission.
Arbitrage opportunities do exist, but usually only for a second or two. Pricing discrepancies are quickly eliminated by automated trading systems that trade large volumes to generate profits.
For individual traders, opportunities do sometimes arise with less liquid currencies, especially when volatility increases. Opportunities also arise when different market makers or brokers offer different prices in illiquid currencies.
Carry trades are a frequent feature of global markets that influence currency markets, as well as capital flows, global investment, and equity markets.
When there is a substantial difference between the interest rates of two countries, investors can borrow the currency with low rates, then exchange that currency for the higher-yielding currency. The higher-yielding currency can then be placed on deposit to earn enough to pay the interest on the original loan and generate a profit.
For years Japan has had low rates and been a source of capital for carrying trades. More recently, US rates have also offered investors a source of cheap capital
Carry trades are profitable as long as the low yielding currency doesn’t appreciate significantly against the currency with a higher yield.
Carry trades have a noticeable effect on global markets. When a large interest rate differential materializes, the low yielding currency will usually weaken, and the high yielding currency will strengthen. This can increase the profitability for those who open positions first.
Low rates mean cheap money, and cheap money makes otherwise unprofitable investments profitable. Money generated from carry trades also finds its way into equity markets and speculation in other areas of the global economy.
When the risk of a yield differential disappearing increases, the opposite occurs as carry trades get unwound. This can have a dramatic effect on currency markets. Understanding which currencies are connected to carry trades can help investors prepare for potential trends in the future.