Foreign Exchange and Currency Trading

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Published: 28th February 2008
by Peter Kay©

What is Foreign Currency trading?

Foreign currency trading involves the buying or selling of a nation's currency. Individuals or businesses engaging in foreign currency trading almost always fall into one of the following two categories:

  • Speculators
  • Hedgers


    • A speculator will trade currencies in the hope of profiting from a change in exchange rates. For example, if the current exchange rate was £1 = $2 and an individual in the UK believed that in one years' time the exchange rate would be £1 = $1.50, they would buy as many dollars ($) as they could with the aim of selling them in the future when it takes fewer dollars to buy £1.

    Now: Initial stake of £10,000 buys $20,000 (£1 = $2)
    1 years' time: $20,000 buys £13,333.33 ($1.50 = £1)
    Profit: £3,333.33

    Of course, if the speculator was wrong with their predictions and the exchange rate moved the other way, they will make a loss on their initial £10,000. It is this risk, known amongst other things as currency risk, which hedgers seek to avoid. Hedging is done mainly by large multinational businesses who will receive payment in a currency that differs from their home currency in the future, for example a UK-based construction firm who do a project for the French government and will be paid in Euros upon completion, but will take 5 years. When deciding whether to accept to undertake the proposal the firm will convert the fee they will receive in Euros into Pounds to see if it is financially worth their while (i.e. profitable). Whilst it may be at the start of the project, when they receive the money in 5 years' time, the exchange rate may be vastly different and they find that the amount in Euros is worth much less in Pounds than they originally thought, which may mean the firm has made a loss overall on the project. To avoid this currency risk, the firm can enter into a forward contract in order to 'lock in' the current exchange rate (this is explained in more detail below). Of course, there is the flip side in that the exchange rate may move in the other direction and the firm finds the amount in Euros actually buys more Pounds than they originally anticipated 5 years ago. Some companies may choose not to enter into a forward contract to guarantee the exchange rate if they anticipate the exchange rate to move in their favour. However, many companies will sacrifice this potential for profit in order to guarantee the amount of Pounds they will receive, particularly if the amount is so large that it could have a significant negative effect on the company if the money to be received was worth much less than they anticipated. As well as hedging for money coming in, the firm can also take out a forward contract for money it has to pay out in the future, so that it does not end up costing more Pounds than anticipated if they know they have to pay out a large amount in another currency at some time in the future.

    Continued... - Foreign Exchange Transaction Types

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