Understanding Currency Quotes
One of the most difficult concepts for new traders to understand is the quote system for currencies. It can be confusing at first but it is really not that hard to understand once you work through it. We will devote an entire section to be sure you understand everything you’ll need to know about currency quotes.
Each currency has a three letter code much like most stock symbols on the New York Stock Exchange. The first two letters generally represent the name of the country while the third letter represents the currency unit. For example, the symbol for the U.S. Dollar is USD and the Japanese Yen is JPY. Some are a little less obvious such as the Swiss Franc, which is CHF. The “CH” stands for Confederation Helvetica (Helvetica comes from the Latin Helvetier, the name of the people who first inhabited Switzerland).
The most common currencies you will see are the following:
Currency quotes are always given in pairs. That’s because you’re asking for a quote (price) on a currency in terms of another currency. This is what makes currency quotes difficult to understand at first. Whenever U.S. citizens ask for a price of something, it is understood to be in dollars so we’re accustomed only having to ask “how much is it.” But when dealing with currencies, you can’t just ask how much another currency is until you state in which currency you’re going to pay for it. It doesn’t make a lot of sense to ask how much one dollar is worth in terms of dollars because we know the answer is always one dollar. But if we ask how much the dollar is worth in terms of yen we can get a quote.
For example, at the time of this writing the quote for the U.S. Dollar versus the Japanese Yen was roughly 117. Most currency quotes are given to four or five decimal place with the exception of the USD/JPY quotes, which is always given to two decimal places. But to keep the example simple, let’s assume it is exactly 117. If you were to see this quote in a financial publication or to look it up on the Internet, you’d see it written like this:
USD/JPY = 117
This notation can be confusing for new traders because it looks like it is saying the number of U.S. Dollars per Japanese Yen equals 117 but it is actually the reverse. This quote is actually telling us the number of Japanese Yen per dollar. One way to think of it is to consider it like a division problem. It’s telling you the value of the USD divided by the JPY is 117. In other words, the USD is 117 times as big as JPY. Therefore, it must take 117 Japanese Yen to equal one US Dollar.
However, to avoid confusion, it’s best to think of the slash (/) as just a separator that creates a left side and a right side. The left side shows the base currency, which is the USD in this example, and is always quoted as one unit of currency. The base currency is usually the one with the bigger and theoretically more stable economy. The most common base currencies are the U.S. Dollar, Euro, and Great British Pound.
The currency on the right side is called the quote currency (also called the counter currency). The number after the equal sign shows the number of units you need of the quote currency to equal the value of one unit of the base currency. In this example, the quote tells you that one U.S. Dollar equals 117 Japanese Yen. So when you see a quote like USD/JPY = 117 you should learn to read it as 1 USD = 117 JPY. It is simply showing you how many Japanese Yen you must pay in exchange for one US Dollar. It is the price of one U.S. Dollar in terms of Japanese Yen.
If you see a currency quote such as USD/JPY, you may hear it referred to in several ways:
U.S. Dollar vs. the Japanese Yen
U.S. Dollar in terms of Japanese Yen
Japanese Yen against the U.S. Dollar
A quote of USD/JPY = 117 means that if you were to walk in to your bank and hand them one U.S. Dollar, they would give you 117 Japanese Yen in exchange. For this reason, it is also called the exchange rate since it tells us how much of the foreign currency you can get in exchange for one dollar. Remember, the base currency on the left is always understood to be one unit. The quote currency on the right, however, will fluctuate according to market conditions.
As market conditions change, the number to the right of the equal sign changes which, in turn, means that the value of the base currency is changing. For instance, you may see the following quotes over a four-day period:
USD/JPY = 117
USD/JPY = 117.15
USD/JPY = 117.12
USD/JPY = 117.33
This just shows the market value of the base currency (USD) is changing. Some days it rises, others it falls. This is very much like stocks, options, or other financial assets you may be familiar with.
As the exchange rate increases, it is the base currency that is getting stronger. For example, if the quote USD/JPY = 117 later moves to USD/JPY = 118 then it is the USD that is getting stronger. New traders often mistake this to mean that the yen is getting stronger since the number of yen is increasing. But think about what the quote represents. It tells you that one U.S. Dollar can now buy more Japanese Yen. One dollar used to buy 117 yen but now it can buy 118. The more goods (currency) your dollar can buy, the stronger it is. If your dollar bought one apple yesterday but two apples today, it is the value of the dollar that got stronger. Similarly, when the number for the quoted currency rises, it is the base currency that is getting stronger since it is able to buy more units of the quote currency.
Quoting in Reverse
Now that you understand how to read a currency quote, you’re probably wondering if there’s a way to figure out the quote from the other country’s perspective. In the previous example, we showed that one US Dollar buys 117 Japanese Yen. That’s great information if you are holding dollars and want to convert them to yen, such as when US travelers go abroad. But what if you’re in Japan traveling to the US? In this case, you’d like to know the quote from Japan’s perspective. In other words, if we know that USD/JPY = 117 then what is the value of the Japanese Yen in terms of US Dollars, or JPY/USD?
To answer this question, it is necessary to understand the mathematical concept of “reciprocals.” The reciprocal of any number is easily found by dividing that number into one; that is, the reciprocal of x is 1/x. No matter what the number is, whether x is a whole number or a fraction, if you divide that number into one then you’ll have the reciprocal.
For example, the reciprocal of 2 is 1/2. The reciprocal of 3 is 1/3. We can also work it in reverse. The reciprocal of 1/2 is 1/(1/2) which equals 2. The reciprocal of 1/3 is 1/(1/3) which equals 3.
As stated previously, reciprocals can be found for any number not just whole numbers. The reciprocal of 2/3 is 1/(2/3), which is 3/2. The reciprocal of 3/2 is 1/(3/2) = 2/3.
By looking at these examples, you may have realized there is an easier way to find the reciprocal. For any fraction, all you have to do is flip it. The reciprocal of 1/3 is 3/1, or 3. The reciprocal of 2/3 is 3/2. Mathematically, the reciprocal inverts the number or fraction in question, which creates a very nice mathematical property about them. That is, the reciprocal of any number multiplied by the original number always equal one. You can verify it with these examples since 2 * 1/2 = 1 and 3 * 1/3 = 1 and 2/3 * 3/2 = 1.
Keeping that property in mind, if we know USD/JPY = 117, what do you suppose the quote is for the Japanese Yen in terms of Dollars, or JPY/USD? That’s easy because the problem is simply asking you to invert the quotes. All you have to do is take the reciprocal of both sides of the equal sign. The reciprocal of USD/JPY is JPY/USD. The reciprocal of 117 is 1/117, which is .008547. Therefore, if USD/JPY = 117 then JPY/USD = .008547.
So if your bank has a quote of USD/JPY = 117 you can immediately figure out the quote in the other direction. Just take your calculator and find 1/117 and you’ll immediately know that JPY/USD = .008547. Therefore, one Japanese Yen buys about .008 cents, or less than one penny. Probably a better way to state this is to say if you give your bank 100 Japanese Yen, you will get 85 cents in return.
In cases like this where the exchange rate is very small and has leading zeros, the quotes are often multiplied by 100 to get rid of the zeros. In this case, you likely see the quote written JPY/USD = 0.8547.
Once you understand reciprocals, you can move back and forth between quotes in an easier way. Just realize that division and multiplication are really two ways of expressing the same thing. In other words, dividing a number by 3 and multiplying it by 1/3 (the reciprocal) are two ways of doing the same thing. Notice that the fraction 1/3 is saying “one divided by three” so it takes care of the division for you. So if the quote is USD/JPY = 117 and you want to find JPY/USE, there really is no need to take out a calculator to find 1/117. All you have to do is divide by 117 and you’ve found the quote from the other country’s perspective.
For instance, if USD/JPY = 117, you know that one dollar equals 117 yen. In other words, if you are holding dollars and wish to convert them to yen, you multiply by the quote, which is 117 in this example. However, if you are holding yen and wish to convert to dollars, all you need to do is divide by 117 and you’ll have the answer.
On a simpler level, if you move from left to right (base currency to quote currency) then you multiply by the quote. If you move from right to left (quote currency to base currency) then you divide by the quote:
We can also get the same answer by finding the reciprocal quote. If the bank quote is USD/JPY = 117 then you know the quote for JPY/USD = .008547. If you have 117 yen, you can convert the base currency (yen) into dollars by multiplying by the quote, which gives 117 * .008547 = $1. As expected, multiplying any number by its reciprocal always equals one. Understanding reciprocals is the key to understanding how to quickly move from one currency to another.
Examples:
1) You are at the airport and just returned from Switzerland with 2,500 Swiss Francs in your wallet. You are now heading to Australia and wish to convert this currency into Australian Dollars. If the exchange rate is CHF/AUD = 1.0726, how many Australian Dollars will you have?
Notice that the problem is asking you to convert the base currency (CHF) to the quote currency (AUD), which is moving from left to right so you would multiply by the quote. You would have 2,500 Swiss Francs * 1.0726 = 2,681.50 Australian Dollars.
2) How many Euros will you have if you convert 6,000 Canadian Dollars to Euros with the exchange rate being EUR/CAD = 1.4086?
This problem is asking you to covert the quote currency (CAD) to the base currency (EUR), which is moving from right to left so you must divide by the quote. You will have 6,000/1.4086 = 4,259.55 euros.
That’s really all there is to it. Just remember that if you are converting from the base to the quote currency (moving from left to right) then you multiply by the quote. If you are moving from the quote currency to the base currency (right to left) then you must divide by the quote currency. It’s really not so bad once you understand what the quote is stating and remember your reciprocals.
Let’s now take a look at some actual currency quotes. Table 2-1 below shows a typical format for currency quotes that you may see listed on the Internet or in a financial newspaper. Notice that the same countries are listed across the top row and the far left column:
Table 2-1: Currency Quotes and Cross Rates
The row across the top designates the base currencies while the far left column provides the quote currency, which allows for quick comparisons between different currencies. For example, what is the exchange rate for the USD/JPY? All you have to do is look across the top row and find USD, which is in the first column. Next, you scroll down through that column until you’re in the row that lines up with JPY on the left. The quote for USD/JPY at this time is 117.28. One U.S. Dollar equals 117.28 Japanese Yen.
Just by knowing the USD/JPY quote, you now know that the quote for the inverse quote (JPY/USD) must be the reciprocal, or 1/117.28 = .0085266. If you look at the column for JPY and line it up with the row for USD, you’ll find that it is .85266 (again, it has been multiplied by 100 to get rid of the leading zeros.)
Notice the “….” along the diagonal. These symbols appear wherever the column and row (base and quote currencies) are the same. Obviously, any currency traded against itself has a value of one. In other words, one dollar equals one dollar and one yen equals one yen. Because of this fact, some sources use “1” for the diagonal entries. But to make the table easier to read, most leave this diagonal blank or fill them with dots just to keep fewer numbers in the table.
All quotes below the diagonal are simply inverses (reciprocals) of the quotes above the diagonal. It is for this reason that many tables will only show the quotes along the upper diagonal such as in Table 2-2:
Table 2-2: Currency quotes without the inverses
If you only know the value of the quotes above the diagonal as shown in Table 2-2, you can immediately find the missing quotes by simply taking the reciprocals of the corresponding quotes. For example, let’s find the missing value for the box in the lower right corner. That box represents AUD/USD (Australian Dollar versus the US Dollar.) To find that value, we just need to calculate the reciprocal of the corresponding quote, which is USD/AUD. That happens to be 1.3956 as shown in the upper left box. Therefore, AUD/USD = 1/1.3956 = 0.7165.
Table 2-2 shows that USD/AUD = 1.3956. If you have one US Dollar, you can exchange it for 1.3956 Australian Dollars. On the other hand, if you have Australian Dollars, you find the number of US Dollars by either multiplying by 0.7165 or, equivalently, dividing by 1.3956.
While we could calculate exact values for each of the missing boxes, that is only economic theory. After all, if one Dollar equals 117 Yen, it should follow that 117 Yen equal one Dollar. However, in the real world of currency trading, sometimes these reciprocal amounts do not match up exactly depending on the supply and demand for each currency pair. In other words, even though we found a value of 0.7165 for AUD/USD, you may find that’s not exactly accurate if you were to look up an actual quote. However, we’ll find out later why all quotes below the diagonal can’t stray too far from the theoretical values. The theoretical quote of 0.7165, although it may not be exact, will be very close to what is observed in the real world.
Currency Pairs
As we said earlier, currencies are always traded in pairs. The most common pairs you will see are:
EUR/USD (Euro vs. U.S. Dollar. Also called the “Euro”)
EUR/JPY (Euro vs. Japanese Yen. Also called the “Euro Yen”)
GBP/USD (Great British Pound vs. U.S. Dollar. Also called the “Cable”)
USD/CHF (U.S. Dollar vs. Swiss Franc. Also called the “Swissy”)
USD/JPY (U.S. Dollar vs. Japanese Yen. Also called the “Dollar Yen”)
USD/CAD (U.S. Dollar vs. Canadian Dollar. Also called the “Dollar Canada”)
AUD/USD (Australian Dollar vs. U.S. Dollar. Also called the“Aussie Dollar”)
Because of their dominance in the forex market, these pairs are called the majors.
American vs. European Quotes
We’ve just shown how any quote can be viewed from two different perspectives. We can get a quote on USD/JPY, which shows the number of yen per dollar. Conversely, we can take the reciprocal to find the JPY/USD quote, which shows the number of dollars per yen.
Whenever USD is the quote currency (listed to the right side of the slash) it is a quote in American terms. For example, the quote JPY/USD = .008547 is a quote in America terms. The quote tells us that one JPY can be exchanged for .008547 Dollars. In other words, the quoted price of .008547 is in US Dollars so that’s why we say the quote is in American terms. On the other hand, whenever USD is the base currency (listed to the left of the slash), it is a quote in European terms. As an example, the quote USD/JPY = 117 is a quote in European terms. In this case, the quote of 117 shows the number of foreign units (European) that you will get in exchange for one dollar.
Direct vs. Indirect
When dealing with quotes, you will also hear the terms direct and indirect. In most cases, banks give quotes in the home currency. For example, using the previous quotes, a U.S. bank would quote the yen as JPY/USD = .8547 (again, truncating the leading zeros). If an American institution quotes in terms of dollars (American terms) then it is called a direct quote. A direct quote always shows how much you must pay in terms of the home currency in order to exchange for the foreign currency. In this case, the direct quote shows how many dollars you must pay to get one yen.
Similarly, if you were in Japan and asked for a quote on the US Dollar, you’d get USD/JPY = 117, which is a direct quote for Japan. This quote shows how many yen you must pay in exchange for one US Dollar.
As with any convention, there are always exceptions. In England, for example, if you ask for the USD quote, you would be quoted GBP/USD = 1.7478 if using the quotes in Table 2-1. They will provide the quote with the home currency as the base currency rather than the quoted currency. This is called an indirect quote. An indirect quote shows how many units of the foreign currency you must pay in order to receive the home currency. In this example, it shows how many US Dollars you must pay in order to receive one Great British Pound. Whenever the base currency is the home currency, it is an indirect quote.
Cross Rates
Most currencies are quoted against the U.S. Dollar (USD is the base currency and to the left of the slash). If we know two quotes against the USD we can mathematically figure out the quote for the remaining two currencies. For example, Table 2-1 shows the following quotes for the Japanese Yen and Canadian Dollars against the U.S. Dollar:
USD/JPY = 117.28
USD/CAD = 1.1646
From these two quotes, we can figure out the quote for JPY/CAD, which is called the cross rate. Any currency quote that does not involve USD is called a cross rate. In order to solve this problem, you need to put both sets of quotes in terms of the common currency which, in this case, is the US Dollar. That means USD needs to be on the right hand side of the slash. Think of it like adding fractions. If you add two fractions together you must have the same denominator for both. For instance, you cannot directly add 1/2 and 3/4 since they have different denominators and you are therefore comparing apples and oranges. Before you can add them, you must find a “base” that is common to both. Here, you’d convert 1/2 to 2/4. Now that you’ve put that fraction in terms of “fourths” you are ready to add the two together and find 2/4 3/4 = 5/4. It’s the same idea when finding cross rates.
In order to find cross rates, we need to get both quotes expressed in like terms which means we must get USD on the right hand side of the quote. In this case, we’ll need to therefore take the reciprocal of both quotes; however, that will not always be so. Depending on the original quotes given, you may not need to convert any or you may only need to convert one. Once we find the reciprocals, we have the following quotes:
JPY/USD = .008527
CAD/USD = .8587
Now we have arranged the quotes so that JPY and CAD are in terms of USD. The value of JPY in terms of USD is .008527 and the value of the CAD in terms of USD is 0.8587. Both quotes are now quoted in USD so they are in like terms and we can now make comparisons.
To find the quote for JPY/CAD you just divided the dollar value of JPY by the dollar value of CAD, which is .008527/.8587 = .0099297 (or 0.99297 after multiplying by 100). Table 2-1 confirms that the quote for JPY/CAD was, in fact, 0.99297. We have indirectly found through the magic of cross rates that one Japanese Yen can be exchanged for .0099297 Canadian Dollars.
When trading currency cross rates, you must understand that they tend to be more volatile than quotes against the USD. Why is that? If you were trading the currency pair JPY/CAD you’re effectively trading JPY/USD and CAD/USD.
Let’s try another example to be sure you understand how to calculate cross rates. Table 2-1 shows EUR/AUD = 1.6880 and GBP/AUD = 2.4392. Can you find the cross rate for EUR/GBP?
This one is fairly easy since both quotes are already in like terms. That is, both are quoted in terms of AUD. Remember, you can always tell if the quotes are in like terms if the same currency is represented on the right hand side of the quote. To find the exchange rate for EUR/GBP you just need to take the value for EUR (1.6880) and divide it by the value for GBP (2.4392). This gives us 1.6880/2.4392 = 0.69203.
Table 2-1 shows the quote for EUR/GBP as 0.69204, which is pretty close. Again, the cross rates will exactly match only in theory. In the real world, there can be slight discrepancies such as we have discovered here. But as stated before, we will show you later why cross rates do not stray too far from the theoretical rates.
Calculating cross rates can appear difficult at first but they are actually quite easy once you understand what we mean when we say “in terms of.” When something is expressed in terms of something else, it just changes the units that we use to describe it. For example, if a man is six feet tall, he can express his height in many different ways. He may, for example, express it as “six” if he wants to express it in terms of feet or “72” if in terms of inches.
Whenever you see a currency quote, the first currency (base currency) is always being expressed in terms of the second currency (quote currency). For example, the quote USD/JPY = 117 represents the value of one U.S. Dollar in terms of Japanese Yen.
Once you have two currency quotes expressed in the same terms, you are now ready to make comparisons.
So once we got the original quotes expressed in like terms of USD, we can simply divide the quotes. Mathematically, we are taking the value for JPY/USD and dividing it by the value for CAD/USD:
You probably remember from basic math that when you divide two fractions you must “invert and multiply.” That is, you must invert the bottom fraction and multiply it by the top fraction so the above equation becomes:
The USD symbols cancel each other out on the diagonal and you’re just left with JPY/CAD. In other words, you’ve found the value for the Japanese Yen in terms of Canadian Dollars.
Think of cross rates as you would any relationship between two variables. For example, we all know that one foot equals 12 inches, which we could express like a currency quote as FT/IN = 12. This is just stating that if we express feet in terms of inches, then the answer is 12.
Similarly, if we express feet in terms of yards then the answer is 1/3, which we could write as FT/YD = 1/3. Now, if you are trying to find out the relationship between yards and inches, we must get both of these “quotes” expressed in the same terms. Because both have FT in common, let’s change both to:
YD/FT = 3
IN/FT = 1/12
We can now find YD/IN (yards in terms of inches) by dividing the two and find it is equal to 3/(1/12) = 36. That is, one yard, in terms of inches, is 36. This is exactly what we are doing with cross rates. Just remember to arrange the quotes in like terms and you can immediately find the cross rate between the remaining currencies.
The most common currency cross rate pairs are:
GBP/JPY (Great British Pound vs. Japanese Yen)
GBP/CHF (Great British Pound vs. Swiss Franc)
EUR/GBP (Euro vs. Great British Pound)
EUR/JPY (Euro vs. Japanese Yen)
EUR/CHF (Euro vs. Swiss Franc)
Seventy-six percent of all trades have both majors in the pair while 98% of all trades involve at least one major. The remaining trades are all cross rates. Figure 2-3 shows the distribution of the major currencies and cross rates that are traded:
Figure 2-3:
Why Trade in Pairs?
We’ve just seen how currencies are quoted in pairs. Before we can understand how to trade currencies though, we need to answer another question that new traders often find confusing. That is, why do we need to trade currencies in pairs? Why can’t we just buy the currency that we think will rise? After all, if we think IBM is going to rise in value, we just buy the shares. Why can’t we do the same thing with currencies?
The answer is that shares of stock are always expressed in like units. For the US, that means dollars so it is never stated. That is, if we feel that IBM will rise, it is automatically assumed to mean that its dollar value will rise. However, if you are bullish on the yen, we need to know in what units you’ll be paying for those yen. We must have another currency for comparison.
When trading currencies, all profits (and losses) result from the relative change between the two currencies in the pair. If you buy a currency pair, you are really buying the first currency and shorting the second one. On the other hand, if you sell a currency pair, you are doing the opposite. You are really selling (shorting) the first currency and buying the second one. Just as with stock trading, if you short a currency, you must deliver the same number of units back to the bank at a later time. If you buy a currency pair, you are effectively borrowing the second currency (the one you’re shorting) in order to pay for the base currency. This is the only way you can make money if the base currency rises against the quote currency.
For example, let’s go back to one of the previous quotes from Table 2-1 where we found the quote for the currency pair USD/JPY = 117.28. If you “buy” this pair, you are really buying USD and selling JPY. Because you’re buying the USD then you must be bullish on it relative to the JPY. If you “short” this pair, you are selling the USD and buying the JPY. Therefore, if you sell the USD/JPY pair you are bullish on the yen against the dollar.
The choice you make depends, obviously, on your outlook and we’ll talk later about why you might choose the long or short position. You always want to buy the currency on which you’re bullish (think will rise) and, by default, must short (sell) the other currency in the pair. Let’s run through a couple of examples to be sure you have the idea. Assume you are looking at the following currency pair:
EUR/USD
If you think the Euro will rise against the U.S. Dollar, you’d buy this pair since it makes you long the Euro and short the U.S. Dollar. On the other hand, if you feel the U.S. Dollar will climb against the Euro then you’d sell this pair of currency. This makes you short the EUR and long the USD. Here’s another example. Assume you are looking at the quote for this currency pair:
GBP/CHF
If you believe the Great British Pound will rise against the Swiss Franc then you would buy this currency pair, which would make you long the Great British Pound and short the Swiss Franc. If you have the opposite view and think the Swiss Franc will rise against the British Pound then you’d sell this pair thus making you short the GBP and long the CHF.
For any currency pair, the base currency (first one quoted) is the “basis” for trading. If you are bullish on that currency then you buy the pair; if bearish then you sell the pair.
As stated earlier, for any currency pair that you buy, you’d like to see the number for the quoted currency rise.
For example, let’s assume you see the current quote USD/JPY = 117.28 and you buy this currency pair because you are bullish on the U.S. Dollar against the Japanese Yen. If you buy this pair then you’d like to see the quoted number (117.28) get bigger since it tells you that the U.S. Dollar can now buy more Yen. In other words, you are now receiving more goods (currency) for your dollar so it must be stronger.
Whether you’re buying or selling the currency pair, the mechanics are the same. You’re selling units of one currency and converting them into units of the other. Hopefully that converted currency will rise in terms of the other currency and you can then covert that currency back to the original home currency at a profit.
If this sounds confusing, just remember that it’s really no different from stock investing. Let’s go back to our IBM example and show why. Imagine that IBM is trading for $100 and you have $10,000 sitting in the money market in your brokerage account. If you think IBM will rise, you’re really saying that its dollar price will rise; that is, IBM will rise in terms of dollars. If you wish to capitalize on that outlook, you must give up some dollars in exchange for IBM. Let’s say you buy 100 shares of IBM at $100 for a total cost of $10,000.
Doing so, you’re effectively selling dollars from your money market and buying shares of IBM. In order to capitalize on your bullish outlook on IBM you had to enter into a “pairs” trade by selling one asset (dollars) and buying another (shares of IBM). You have now converted your dollars into IBM shares.
If the price of IBM rises, you can enter the reverse trade at that time by selling IBM and then putting those dollars back into your money market. Assume that IBM is later trading for $105. It has now risen in terms of dollars. If you wish to collect a profit at this point, you must do the opposite set of transactions. You can sell your 100 shares and receive $10,500 cash. You then take that cash and buy shares of the money market. In essence you have sold shares of IBM and bought dollars. Your money market is now worth $10,500, up from $10,000 and you have profited by entering two pairs of trades. The first trade was buying IBM and selling dollars. The second was selling IBM and buying dollars.
The essence of any trade is to move dollars from one asset to another and then move them back into dollars at a later time hopefully at a profit. Currency trading is no different. Think of the IBM example as you step through the following currency trade.
Assume the quote for the U.S. Dollar vs. the Japanese Yen is USD/JPY = 117. If you think the Japanese Yen will rise against the dollar then you’re really saying that its dollar price will rise. You would need to sell the currency pair USD/JPY which means you’ll be selling dollars to buy yen. This is exactly what you did to transfer your money into IBM shares.
Let’s step through this trade the long way so you understand what is happening. You could enter into a trade by going to a bank and buying yen. In order to buy those yen though, you must give the bank dollars. In other words, you must sell dollars to the bank in exchange for yen. For every dollar you give the bank, they will give you 117 yen in exchange. Assume you give the bank $1,000 and are now holding 117,000 Japanese Yen.
Without realizing it, you have entered a simultaneous transaction to sell dollars and buy yen. After you walk out of the bank, you’re just holding onto 117,000 yen. If the price of yen rises in terms of dollars you can then go back to the bank and sell your yen collection and receive more dollars than what you started with. Assume that the yen does rise against the dollar and the quote is now USD/JPY = 116. (Remember, the yen is stronger since the dollar buys fewer yen at a quote of 116.) You take your 117,000 yen to the bank and they will now give you 117,000/116 = $1,008.62. To close out of the deal, you had to enter another simultaneous set of transactions with the bank and sell your yen in exchange for dollars. You have made a profit of $8.62 from fluctuations in exchange rates.
When trading through the forex market, you are doing the same set of transactions but much more quickly and efficiently. If you believe the yen will rise against the dollar, there’s no need to physically get dollars out of your account and buy yen. You simply sell the currency pair USD/JPY thus effectively selling dollars and buying yen. It’s as if you sold some of your own dollars and invested them in yen. Let’s go through the same example using the forex market this time.
Most currencies trade in 100,000 units of the base currency. Remember though that the margin is only 1% for most trades so you’ll only have to post a relatively small amount of money for margin. We’ll explain this more in detail later but, for now, let’s get through the mechanics of why we trade currencies in pairs. Assume the quote is USD/JPY = 117 and you sell this pair. You are shorting $100,000 dollars and putting those dollars into yen. Because you’re short $100,000, you must deliver that same amount back to the bank at a later time. The margin requirement will only be about one percent of the base amount thus meaning that you must deposit $1,000 for margin. By selling this pair, you are taking the $100,000 that you’re short and using that to buy $100,000 * 117 = 11,700,000 yen.
The number of yen that you own never changes but only the value of those yen in dollar terms. Think of it like buying stock. If you buy 100 shares of IBM, the number of shares that you own does not change (ignoring splits) as the stock price rises. It is only the dollar value of those shares that rises and falls with market conditions.
Keeping with the same example, we assumed the yen strengthened against the dollar and the quote is now USD/JPY = 116. If you close out the position, you’d simply buy the currency pair to transfer your profits back into dollars. Remember, if you buy the pair you will be “long” dollars and “short” yen. Our goal is to ultimately be long the home currency so that’s how we will close out the trade.
Since we have 11,700,000 yen, we will get 11,700,000/116 = $100,862.07. After paying back the $100,000 that you borrowed from the bank, you’re left with a profit of $862.07.
The same idea holds true for cross currencies. If you feel the Great British Pound will rise against the Japanese Yen, you must buy pounds and sell yen. You could go through the transaction the long way by walking into a bank. However, you probably don’t happen to have any yen lying around. So you’d have to go to the bank and ask to borrow some Japanese Yen. This is the very essence of what Milton Friedman was attempting to do with the British Pounds that we discussed at the very beginning of this course.
Once the bank loans them to you, you are “short” Japanese Yen since you have borrowed something you don’t own (just as when you short shares of stock). You take those Yen and walk over to the currency window and buy some British Pounds by handing over yen. Effectively, you have shorted yen and bought British Pounds. It is a pair of trades. If your outlook is correct and the pound rises against the yen then you can go back to the bank and exchange your British Pounds for Japanese Yen. After paying back the loan to the bank, you’d be left with a profit. Rather than go through this long, drawn out process, you can do the same thing by buying the GBP/JPY currency pair in the forex market. If the British Pound does rise against the yen, you can collect your profit at a later date by selling this currency pair. It’s a much simpler and faster way of accomplishing the identical set of trades.