Maybe you have heard of “foreign exchange” (forex), or maybe you haven’t. Everyone has heard of foreign exchange students who study abroad, but in financial markets forex it has quite a different meaning. Forex is simply a virtual marketplace where currencies of the world are traded. My dollar for your yen. Your pound for my swiss franc. One might wonder how useful or profitable trading money can be, but the applications are numerous.
Currencies are traded in contract denominations of $10,000 and up to $125,000. For example, NASDAQ Trader lists 7 different currencies on its exchange that can be purchased and traded. A spot rate is given in the currency the price is quoted in, and the settlement currency is what the contract is paid out in. NASDAQ Trader
Contracts don’t have to expire to be sold and often do not reach their maturity date before the holder ends the trade. In fact, a currency position can be ended almost immediately because each position must be covered by a minimum account balance (margin) to execute the trade. There are limits on the combined value of the positions and the buy vs. sell sides of active contracts on a single currency, which prevents market manipulation.
The other currency market is derivatives based. The value of these contracts is based on the exchange rate of the underlying pair of currencies. Currency futures are traded on the Chicago Mercantile Exchange (CME). The required minimum contract size for currency futures is not as large as forex positions. You could purchase a currency futures contract for as little as $1000. Very small price changes can amount to gains and losses depending on what side of the equation you are on when you sell and if the position is large enough. We are talking about making a profit on a $0.0010 buy from selling at $0.0020, a $0.0010 profit per unit of currency in a contract.
Portfolio managers buy and sell currency futures to hedge against risk on investments held in overseas markets. On another note, American Depository Receipts (ADRS) are investments in foreign equity held in US accounts which are charged fees every time they receive dividend payments. The account holder could actually estimate the average amount of dividends awarded in a year and purchase currency options to offset some of the anticipated expenses. If you planned a big trip and market prices indicate that the currency in your home country will decrease in value over the next 6 months, you could theoretically buy futures in the currency of your vacation country and sell them later if the foreign market indicates it will make gains against the dollar.
Personally, I have always been intrigued by currencies and believe we could learn a lot about how our economy in comparison to other countries by analyzing relative performance and historical data alone.