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Forex 101

What Are Currency Swaps?

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What Are Currency Swaps?

As you gain experience trading the forex market, you will come across an increasing number of terms. One such term is a currency swap. These kind of transactions actually make up for a large amount of the volume traded on the markets, and they are commonly applied in a few situations when you are trading forex. Here we will explain in more detail exactly what currency swaps are, how they usually occur, and why they can be beneficial to certain types of traders in the sector.

The Basics of a Currency Swap

In the most simple of terms, a currency swap does exactly as the name implies. It is an exchange of currency between two parties of the equivalent amount of money in another currency. There is then a contract in place to repay this money at a specified date, and exchange rate in the future. In essence, this is a currency swap. A currency swap can bear some similarity to that of currency futures, though they differ in the sense that they are held until settlement, and considered to be a large part of forex trading, whereas currency futures are traded on other exchanges.

Currency Swap Example:

Party A, and Party B enter an agreement to swap €1,000,000 for $1,150,000. This fills the need for the counter currency for both parties, and creates an implied EUR/USD exchange rate of $1.15.

The transaction is then completed at a future defined date, using either the original exchange rate of $1.15, or another agreed upon exchange rate. Essentially, the two parties are loaning a particular foreign currency to each other. In some cases with currency swaps, this can include the payment of interest or principal amounts on loans, though this will depend on the details of the individual agreement.

Who Typically Engages in Currency Swaps?

Currency swaps used to be the preserve of those in countries where the foreign exchange rates were extremely volatile, or as where they could be used as a mechanism to overcome currency restrictions.

While this is still the case on a more limited basis, the use of currency swaps has increased around the world as investors and companies become increasingly multinational. Here are a couple of examples of where currency swaps are most often used to good impact in today’s forex market.

Companies Doing Business Abroad: Currency swaps may be particularly beneficial to businesses who have interests abroad and need to borrow in order to conduct this business. They may not necessarily benefit from favorable loan terms from banks outside their home country. Therefore, if they can borrow money in their home country at the best terms, and conduct a currency swap with a similar company in the country they are seeking to invest, then this trade could be of benefit to all involved.

Volatile Currencies: A currency swap may be beneficial, an almost essential in some cases, for institutional and retail investors in nations where the local currency is known to be volatile. This is one of the main purposes behind engaging in a currency swap, to guard against currency risk with more volatile currencies. By engaging in a currency swap, both parties can set the terms, and have a certainty around the cost of their trade.

As we can see with these examples, currency swaps are most often used by companies, and other types of institutional investors. This is certainly a more common situation than the use of currency swaps by retail investors, although in some situations, retail forex traders can be impacted.

Risks Involved in Currency Swaps

While currency swaps can be beneficial in the most part for the points noted above, just like any form of trading, they are not completely without risk. If you are engaging in a currency swap, here are a couple of the primary risks you can expect to encounter.

Interest Rate Fluctuation: One of the main purposes of engaging in a currency swap may be to take advantage of better interest rates in the currency that you are borrowing as part of the deal. These interest rates though are often left floating in contracts. Therefore, there is a chance that a change in the exchange rate could negate any of the cost-saving benefits you hoped to derive from the currency swap in the first instance.

Exchange Rates: With currency swaps, perhaps the most important element is the exchange rate. This is often pre-defined within the swap contract to be a set rate at the future time when the deal reaches maturity. Here again, there is a chance that the future rate is worse for one party than the original or current rate. In this case, there may be a slight loss on the swap.

Forex Trading Swap Fees

The term swap fee, or forex swap is something you will also encounter if you are an online forex trader. This can also be known as the overnight fee, or rollover fee, and may sometimes be confused with the currency swap.

This is a “fee”, though it can be either positive, or negative, that is applied to positions you hold open overnight when trading through your forex broker. This amount is constantly changing, and basically represents the difference in interest rates on the currency pair which you are holding. Therefore, holding a long position in certain currency pairs will see you credited with the positive interest difference, while short positions will see this fee deducted from your balance.

Final Thoughts

Although it is typically an area of more concern for more experienced, and institutional traders, the currency swap still plays a huge role in forex trading overall, and is a very useful trade to be aware of. This is particularly true if you are looking for one of the most secure ways to deal in a large amount of foreign currency and in a situation where you wish to add some degree of security or control to the trade over a long period of time.

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Anthony is a financial journalist and business advisor with several years’ experience writing for some of the most well-known sites in the Forex world. A keen trader turned industry writer, he is currently based in Shanghai with a finger on the pulse of Asia’s biggest markets.

Forex 101

What is Algorithmic Trading in Forex?

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What is Algorithmic Trading in Forex?

Trading in the forex market has been steadily evolving over decades since it first began. This has particularly been evident in recent years with the continuing emergence of new trading strategies and methods. These have generally advanced trading to become both more convenient, and more efficient.

One such method which has experienced a sharp growth in popularity of late, is algorithmic trading. Here we will examine what exactly algorithmic trading in forex is, the methods available, and how it could be an effective tool in your trading arsenal moving forward.

The Algorithmic Trading Basics

Algorithmic trading at its core, is trading based on a computer program. This computer program follows a preset collection of instructions, an algorithm, to perform a number of functions for you as a forex trader. Typically, within forex trading, this algorithm would be set to execute trades at certain points, or to follow a defined trading strategy in a certain way based on market changes. To this end then, algorithmic trading, also known as algo-trading, can do exactly that. It can automate trading based on a strategy which you desire to implement. This strategy is then made into an algorithm and put to work on your behalf.

As technology continues to advance, not only are an increasing number of traders turning to algorithmic trading methods as a means of trading, but the algorithms themselves, are becoming more and more advanced.

In the current market, there are an endless number of options available in this market space. These range from forex robot trading which you can purchase and implement directly, to community based automated trading strategies which you can take and implement yourself through many trading platforms if your forex broker allows algorithmic trading.

Different Types of Algorithmic Trading

Broadly speaking, we can break algorithmic trading into four different types based on the desired results. We will then define this further into the most common strategies used by trader who engage in algorithmic trading.

Looking at the overview when it comes to algo-trading, we can define four general strategies, or functions, that can be performed within algorithmic trading.

Statistical Algo-Trading – This type of algorithmic trading searches through historical market data in order to identify trends and opportunities based on the data it finds, versus the current market data and trends.

Algorithmic Trade Execution – This type of strategy is used to increase the speed and efficiency of trading, typically by executing trades as quickly as possible. This type of high-frequency trading is used to great effect by scalpers within the forex trading sector.

Algorithmic HedgingThe purpose of this type of algorithmic trading is to balance your exposure to certain areas of the market, under specific conditions. This type of strategy is typically engaged by many in hedging their portfolios, or in many automated portfolio rebalancing services which have become very popular.

Ways in Which You May Use Algorithmic Trading

If we take the strategies above as general functions which algorithmic trading can perform, then this enables you to implement a number of different solutions or times when you may want to use algorithmic trading. Some of the following may be made possible when you engage the strategies mentioned above.

Price Action/ Trend Following – This is one of the primary purposes for which algorithmic trading is used. It is also one of the most simple. Using the algorithm, both the previous market trend, and the current market trend can be compared and used to identify profitable trading opportunities.

Arbitrage – Particularly in forex trading, algorithms can be used to identify opportunities in various markets to exploit price differences. To employ this strategy, you will typically need to have two or more forex broker accounts. You could then potentially exploit price differentials between the two by employing algorithmic trading.

Forex ScalpingForex scalping is the act of moving in and out of trading positions very quickly throughout the day. In doing this, scalpers aim to profit from very small market movements at any given time. These may represent tiny profits to some traders, but using algorithmic trading, it is possible to engage in thousands of these trades per day at a much faster rate that you would if trading manually.

Benefits of Algo-Trading in Forex

With a basic grounding in what algorithmic trading is, and how it functions, you may wonder what benefits it can ultimately bring to you as a trader. Here are a few of the major benefits associated with algorithmic trading in forex.

Better Trade Prices – Since algorithmic trading is preset to execute trades at certain levels, this is done almost automatically, or at least at a much faster pace than you could possible achieve through manual trading. This typically means that you have a much higher possibility of executing trades at your best desired price.

Time Saving – If you have employed an algorithmic trading strategy, then you can just set it up, and leave it to work. You do not need to be there to monitor it. This means you save yourself an untold amount of time behind the screen and executing trades.

No Emotion – Algorithmic trading is completely systematic. It is essentially a computer program which will follow the data, precisely as you instruct. This leave no room for either human error, or emotional decision making, both of which can often be costly if you are trading in any market.

Final Thoughts

When it comes to algorithmic trading, where previously you may need to have had advanced computer programming knowledge to implement some of the strategies, now that is simply not the case. Though it would be helpful, you really can get started with algorithmic trading very easily through using codes from other members of the community, or trying out some other dedicated forex robot services which can make the whole thing very easy.

Ultimately, if you want to take a more hands-off approach to forex trading which will definitely save you time, and has the potential to increase your returns, then algorithmic trading is something well worth considering.

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Forex 101

What is Interest Rate Parity?

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What is Interest Rate Parity?

As you become more and more involved in the forex market, you will realize that there are a wide number of factors which can influence the exchange rates at any one time. This can include an array of both internal, and external factors. One of the biggest factors in determining currency exchange rates, is the interest rate of a country. The two are interwoven and looking at the difference between the interest rates of two countries, can even help you plot the future course of the exchange rate. This is according to the theory of interest rate parity which we will explain and examine in further detail here.

The Basics of the Concept and What it Means

At the most basic of levels, what interest rate parity means is that you should not be in a situation where you can benefit more from exchanging money in one country and investing it in another, than you would from earning that money and investing it in your own country and then converting the profits to the other currency.

Before looking at an example to illustrate this point, it is important to note that the forward exchange rate is integral to the theory of interest rate parity, so let’s quickly recap the difference between the spot rate, and the forward rate, in forex trading.

Spot Rate: This is the current exchange rate for a currency if you are trading right now on the forex market. As a regular forex trader, this is the rate you will almost always see posted by your broker.

Forward Rate: This is the rate that a bank or other party to the agreement agrees to pay for a currency at a certain time in the future. This is the rate you will also see if you are trading in forex futures.

Interest Rate Parity Example

The forward rate is important when we are talking about the theory of interest rate parity. As a very simplified example, you should not benefit from exchanging US Dollars to Euros and then investing it in Europe, and exchanging it back to Dollars, more than you would from investing the money in the US and then exchanging the resulting profits to Euro.

Detailing the example further, presuming that the spot rate is €0.75 for every dollar, you will receive €7,500 for a $10,000 exchange. Also presuming the interest rate In Europe is 3%, your return after 1 year would be €7,720.

Now, if you were to keep this money invested in the US at a higher interest rate, then exchange your return to Euro at the end of one year, you would be availing of the forward rate. This would, according to the theory of interest rate parity, net you the same result of €7,720 when the formula is applied.

In essence, what the theory, and example should demonstrate is that the interest rate difference between two countries, should also match the difference between the spot and forward currency exchange rate.

Covered or Uncovered Interest Rate Parity

When we talk about interest rate parity, we can actually divide it into two different types. These are covered interest parity, and uncovered interest parity. In the most simple of terms, covered interest parity is said to exist when there is a forward contract in place which has locked in the forward interest rate. This should leave no room for any difference at all between what is contracted, and what actually happens.

Uncovered interest rate parity is exactly the opposite in that there are typically no contracts in place here to lock in the forward interest rate. The parity in this case is simply based on the expected spot rate in the future. With this, there may be room for error and possibly a slight difference between the result of the formula, and the actual outcome. With that said though, forecasts on spots rates in the future tend to be quite accurate.

Why is Interest Rate Parity Important?

There are a couple of key reasons why interest rate parity is important. The first of these is to stop actions like arbitrage happening on a large scale. Now, this kind of thing does certainly still occur, but the scope for it to happen is greatly tightened. This is the simultaneous purchase and sale of currency or assets in two different markets or areas, exploiting a short-term difference.

More broadly speaking, it prevents not only retail, but also more powerful traders from exploiting gaps in the market which would leave them with a guaranteed, no-risk return. In the bigger picture, what this would do is actually remove the integrity from the forex market and others in entire countries or regions. A by-product of this would be that as traders moved to exploit these gaps, there would be huge and volatile swings in the market. Interest rate parity provides for a degree of assurance that this will not happen, and thus a stability that traders can rely on.

There are still some situations in which the theory of interest rate parity can be challenged. These include in certain arbitrage situations particularly as technology and algorithmic forex trading continue to advance, and the carry trade has long posed a challenge to the formula of interest rate parity, though this can be mitigated depending on if it is covered, or uncovered.

Final Thoughts

The concept and formula behind interest rate parity can be one which many in forex trading, even those with more experience, find to be complex. This is true at least at face value. With a pragmatic approach though, it becomes clear that the core of the concept is relatively simple, and it can even help you to accurately forecast future currency rates if correctly applied. If you are getting involved in more complex trading situations, particularly involving multiple currencies, and regions, having the formula, and a clear understanding of the concept of interest rate parity becomes essential to reaching your forex trading goals.

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Forex 101

What are Carry Trades in Forex?

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What are Carry Trades in Forex?

As you continue increasing your knowledge about forex trading and the market in general, more and more new concepts and ideas will pop up. This includes a growing range of trading technique and strategies. One such trading strategy which has been around for a very long time in the industry, is the carry trade. Here we will take a closer look at exactly what a carry is in forex, and provide all the information you need to decide if carry trading is a good strategy for you as you move forward on your trading journey.

The Basics of How a Carry Trade Works

In its most simple form, a carry trade in forex, is borrowing one currency, and using it to buy another. For example, you may borrow (sell) $100,000 Australian Dollars, and use those funds to purchase the same amount of JPY. Placing a carry trade is one of the most popular trading strategies in the entire sector, and used by many traders to benefit from the position of currencies around the world.

So, what is the benefit in borrowing one currency and using it to buy another? This comes from the difference in interest rates between the two currencies. Let’s look again at our example in more detail.

Presuming the interest rate on the Australian Dollar was 4%, and the interest rate on the JPY was 0.1%, a carry trade would be where you buy the AUD/JPY market, as here, what you are effectively doing is selling (borrowing) Japanese Yen, to purchase Australian Dollars. In the most simple of ways, you will now have placed a carry trade. Here you will earn 4% interest on the Australian Dollars you are holding, while paying 0.1% interest on the Japanese Yen you have borrowed. This should leave you in a profitable position if the rate does not change, and is known as a positive carry trade at +3.9%.

Why is Carry Trading in Forex So Popular?

From an outside perspective, even looking at our hypothetical example where there is quite a gap between the interest rates, you may wonder why placing carry trades is so popular when the potential profit may seem quite small. There are two main elements at play in the forex market though which make this a very attractive type of trading strategy.

Currency Pairs: The fact that currencies are traded in pairs make a carry trade very accessible, and convenient for all traders. The difference in interest rates has never been so easy to take advantage of as it is in forex trading, where you can directly trade low and high interest currencies in pairs.

Leverage: The availability of extensive leverage in forex makes it the ideal place to carry trade. Many forex brokers can make leverage of up to 500:1 available on certain currency pairs. This basically means that even a relatively small deposit of $1,000 can open up huge buying power of $100,000 at 100:1 leverage, or more. Dealing with such large numbers, even low percentage profits are very meaningful.

Popular Forex Pairs to Carry Trade

Given the fundamentals of how a carry trade works, borrowing a low interest currency, to buy a high interest currency, then this is precisely what traders are on the lookout for in the forex market when it comes to placing a carry trade. There are a couple of currencies in particular that are most popular in this regard.

As a selling currency, the Japanese Yen is always a very popular choice. This is thanks to the historically very low cost of borrowing in Japan. The country has not had an interest rate of above 0.5% in more than 20-years. Another popular choice as a selling currency may be the Swiss Franc (CHF).

On the buying side, popular choices include both the Australian, and New Zealand Dollar as countries which typically hold slightly higher interest rates, yet are recognized as quite stable currencies.

Benefits of a Carry Trade

A carry trade in forex can be an excellent long-term investment strategy. You will have the potential to benefit from a carry trade even if the rates do not change at all thanks to the difference in interest rates. This makes it perfect for an investor who intends to hold the position for a long time.

Added to that, if the rate does change in your favor, then you can potentially have a sizable profit when added to the interest rate difference, and factoring in the leverage used. The fact that many brokers nowadays also cater for trading with very competitive fees and low spreads also plays to your advantage if placing a carry trade, and is something that many look out for.

Risks Involved in a Carry Trade

With every form of trading, there is always a certain element of risk. With a carry trade, though it is seen as a low-risk strategy, there are still a couple of things to be mindful of.

The market can still move against you. A change in the market can certainly negate any benefits you have gained from the positive interest rate difference. Particularly if you decide to trade in minor, or exotic currency pairs which are less common, you should note that these markets can be highly volatile, and subject to change in a very swift fashion. Some examples include trading with the MXN (Mexican Peso), or NGN (Nigerian Naira). Both may appear attractive for a carry trade, but can be subject to intense volatility. This risk can be amplified even further if you are trading with a lot of leverage.

You should also remember that, just because there may be a positive rate difference at the moment, the monetary policy in every country is subject to change at different times. The perfect example of this would be right now, in the midst of the coronavirus pandemic, many nations have moved to cut interest rates. This has the possibility to really change the dynamics of your carry trade.

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