International businesses have a distinct challenge that many other organizations don’t - foreign exchange.
When you do business with countries that use a different currency than you, there are a few things you have to keep in mind.
First, you will be subject to movements in the values of currencies. Depending on how they move, your collections could be worth less (and your payments, more), from one day to another.
Another challenge with foreign exchange is complicated terminology. Forwards, futures, spots… what does it all mean?
Before you dive into the world of forex, you need to be well-prepared in the way it works. By defining terms, examining history, and looking at the way the market works, you can gain a competitive edge in forex that can save you a lot of money.
What is Forex?
Forex, or foreign exchange, is the single largest market in the entire world. Over $5 trillion (yes, that’s trillion with a “T”) change hands every. Single. Day.
The reason for this astronomical volume comes down to the frequency with which individuals and businesses use the forex market.
It starts at the consumer level - when people want to visit another country, they must trade in some of their homeland’s currency for the currency of the country they are visiting.
This is a forex transaction.
Banks trade forex as well. In fact, financial institutions have their hand in over 90% of all forex transactions. Banks trade money with consumers as well as other banks several thousand times a day, either to meet client needs or make a profit.
Another classification of forex traders is retail traders or speculators. These are people who seek to earn a profit by buying one form of currency when it is priced low, and then selling it when it gains value.
The final player in the forex market is international businesses (that’s you!). Businesses often need to exchange money in order to pay international suppliers. Or, they need to convert the money they received from a foreign buyer into their native currency.
Regardless of your reasoning for participating in forex, there are a few basic things you should know before going forward.
History of Forex
Foreign exchange has existed for longer than recorded history. As soon as there was more than one type of money in the world, people started trading it.
Money is a natural formation in human culture. Let’s say you are a grain farmer, and you have a large amount of grain from your last harvest that you need to trade away. In town, you find a pig farmer who has pork that he needs to trade away. You happen to want some pork, so you want to trade with the man.
Now, you can’t just trade all your grain for all of his pork, because then you’ll have way too much pork (and, conversely, he’ll have way too much grain.) You have to get rid of all of your grain soon, otherwise, it’ll get moldy, and the harvest will be a waste. You need an efficient way to store your wealth.
You decide to visit the town’s copper miner. He needs a ton of grain to feed his laborers, so you give him all of your grain in exchange for an amount of copper of equal value. You can hold on to this copper forever since it won’t go bad or lose value.
You visit the pig farmer, buy enough pork to feed your family and give him only a small amount of your copper. The pig farmer can now use this copper for his own similar dealings. Thus, money is formed naturally in a free market scenario.
While your local town turns to using copper as their money, a nearby town has been using emeralds. As time goes on, and these currencies are formalized, you need a way to change your copper into emeralds for use at the other town’s market.
You decide to set up a brokerage to change people’s copper into emeralds, and vice versa, for a small fee. Thus, this foreign exchange also forms naturally in a free market.
The first true modern foreign currency exchange was established in Amsterdam in the 1600's, where traders would exchange money through a broker before visiting another nation’s market. It’s believed that this forex market was also used to combat inflation.
Forex exchanges remained pretty much the same for a few centuries. In the 1990s, however, computerized trading began to take hold, allowing trades to occur instantly from thousands of miles away. This computerized trading eventually evolved into the hierarchy of the different types of traders that we see today.
Types of Forex Traders
Forex traders take a few different roles, activities, and risks, and never truly fall into a single trader persona. Here are a few types of forex traders you should be aware of should you encounter them or seek certain trading styles.
The most common type of forex trader is an individual who trades for profit with their own money. Mind you, retail traders only account for a small amount of volume in the market, despite their large numbers.
Retail trading brokerages come in two main forms: Market makers and Electronic Communications Networks (ECNs).
ECNs supply a far more “true” market than market makers. ECNs work by bringing buyers and sellers together over the internet, matching retail traders with retail traders, retail traders with banks, and banks with banks.
An ECN allows forex transactions to occur with far less interference from “middleman” forces. That brings us to market makers.
Market makers are very aptly named. They make the market by taking the other side of whatever deal their clients want. So if you shout “Hey! I want $1,000, and I’ll give you ¥100,000 for it!”, your market making broker will tell you to check your account, because it’s already done.
There’s good news and bad news with this. The good news is that you always have someone to take your deal. This is embodied in the concept of liquidity (your ability to convert an asset into cash, or in this case, foreign currency into home currency.) In ECN, you may need to wait for someone who wants to accept your deal.
The bad news is that market makers have a vested interest in making you lose money.. If you’re losing money on a trade, your market maker will make a profit. If you’re winning the trade, they’ll pass their side of the trade to another client or to a bank in order to minimize their losses.
80% to 90% of retail traders lose money in the forex market. This is because the forex market is a zero-sum game - for every winner, there must be an equivalent loser. Banks and business are, by a very wide margin, the winners in the forex market.
Banks as Forex Participants
Banks use the forex market for many, many reasons. They use the forex market to allow their clients to use debit cards overseas. Before going on an international vacation, a bank account user will notify their bank about where they’re going and when.
This prepares the bank for the foreign exchange needs of the client (it also prevents their card from being automatically frozen in anti-theft measures).
Banks also use forex to provide hedging services to their trading branches, as well as their business clients. There are a number of instruments used for this, which will be covered later.
One of the largest sources of volume in the forex is international business owners just like you. International businesses have several hands in the forex market, all relating to their different business processes.
The simplest and most common international business forex transaction is a simple currency conversion. When you receive money from an international buyer, you will be left with a large sum of their currency.
Since you can’t spend this in your country (for marketing, equipment, etc.), you must convert it to your own currency. Conversely, when paying an international supplier, you often have to convert your currency into their currency first.
Businesses and banks also use forex to hedge their positions and prices against fluctuations in currency prices. There are three main ways to do this.
Spot Contracts Vs. Forward Contracts
This act of converting currency at the current (or “spot”) market rate can be formalized in a forex spot contract.
In a forex spot contract, two parties agree to exchange their currencies at a predetermined settlement date. That can be today, or years from now. When you exchange currency at the market rate, you are essentially trading within a spot contract.
Another type of forex contract is called a forex forward contract. In a forward contract, two parties agree to change currency at a predetermined date, and at a predetermined exchange rate. Let’s walk through an example.
You own an international business. You know you’ll be receiving a payment in yen three months from now. However, you want to limit your exposure to changes in the price of yen.
You’re worried that, in three months, the yen will not be worth as much as it is now. This is a classic example of where a forex forward contract can help you protect your business and limit your exposure to fluctuations in the market.
To hedge in this situation, you would simply enter a forex forward contract (with a bank or other financial institution), agreeing to convert the yen to your home currency at today’s rate in three months.
Bear in mind that if the value of a yen increases during those three months, you will effectively have missed out on potential forex gains. This potential opportunity cost is part of the price you pay for stability of your payment’s value.
Forex Futures Contracts
Forex futures contracts are almost exactly the same as forward contracts, with one notable exception.
While forward contracts are negotiated only between the two parties, futures contracts are managed on an exchange. This means that futures are far more standardized and pass through a clearinghouse. Generally, futures contracts are safer than futures contracts, since the payment is guaranteed from and to each party. Forward contracts are very safe as well (especially when they’re constructed with a dedicated financial services company), even though they are technically vulnerable to default.
A futures contract is a great way to hedge as well, although they lack the customization and freedom of a forward contract.
Why Currencies Fluctuate In Value
The way currencies fluctuate in value is determined by a number of factors. One of them is the type of currency and how it reacts to changes in the prices of other currencies.
The first distinction to be made is between fiat and commodity currencies. Historically, money was usually printed on a commodity (gold and silver coins, for example.) This form of money is practical in that the physical monetary item has some intrinsic worth. It also means that the supply of money in a given economy cannot be easily manipulated.
Often, a country will make its monetary system more practical by having a given amount of commodity, and then issuing paper money that is backed by that commodity. An example of this is the Gold Standard, where every U.S. dollar was backed by a fixed amount of gold.
A fiat currency, by contrast, is a currency that has no intrinsic value and is not backed by any real commodity. The value of these currencies is determined by the money supply, which can be manipulated by changing interbank borrowing rates or printing more money.
This helps to combat things like inflation or deflation, but can also prove to be unsustainable in the long run with central bank abuse. Almost every modern currency is a fiat currency.
Currencies fluctuate in value because they are subject to the whims of their central banks. Depending on new policies and money supply, the value of a currency can change.
Currencies also fluctuate based on the natural laws of supply and demand. If everyone wants yen, the yen will increase in value. If Yen is not an appealing investment, or if no one needs them, they will decrease in value. Demand is dedicated to the economic status of a given country, as well as events like news and economic reports.
To keep up with turnover and fluctuations in the Forex market, reports are generated periodically that help better reveals the exact turnover for harder currencies where trades have more impact on the global economy. Here's an example.
Forex with Statrys
Foreign exchange is a very broad term. It covers everything from changing your cash for a vacation to complicated and mysterious financial derivatives that make even the most experienced financier shiver.
Statrys operates several different forex-related services that can empower your business in the international realm. We help our clients navigate the jungle of forex so they can use these tools to their advantage, rather than their detriment.
Start by checking out our comprehensive forex guide below - we walk through everything you need to know before you get started. Then, check out our forex services to see what’s right for your business.