Uses of the Forex Markets

Uses of the Forex Markets

Forex for Hedging

When businesses transact business outside of their home markets, they run the risk of losing money owing to volatility in currency values. By establishing a rate at which the transaction will be executed, foreign exchange markets offer a mechanism to mitigate currency risk.

To achieve this, a trader can lock in an exchange rate by purchasing or selling currencies in advance on the forward or swap markets. Imagine, for instance, that a business intends to market American-made blenders in Europe at a parity exchange rate between the euro and the dollar (EUR/USD).

The U.S. company hopes to sell the blender for $150, which is competitive with other blenders built in Europe and costs $100 to produce. The corporation will generate $50 in profit on each sale if this strategy is successful due to the even EUR/USD exchange rate. Sadly, the U.S. dollar starts to appreciate against the euro and continues to do so until the EUR/USD exchange rate reaches 0.80, meaning that it now costs $0.80 to buy one euro.

The company’s issue is that it can only sell the product at the competitive price of €150, which, when converted back into dollars, is just $120 (€150 0.80 = $120), even though it still costs $100 to build the blender. The profit was substantially lower than anticipated due to the rising dollar.

By shorting the euro and acquiring the dollar at parity, the blender company may have minimized this risk. In this manner, if the value of the U.S. dollar increased, the gains from trading would make up for the decreased profit from the sale of blenders. If the value of the U.S. dollar declined, the better exchange rate would boost sales revenue for blenders, offsetting any losses in the transaction.

Such hedging is possible in the currency futures market. The fact that futures contracts are standardized and cleared by a centralized body is advantageous to the trader. The forwards markets, which are decentralized and operate globally inside the interbank system, may, nevertheless, be less liquid than currency futures.

Forex for Speculation

Currency supply and demand are influenced by a number of variables, including interest rates, trade flows, tourism, economic strength, and geopolitical risk, which leads to daily volatility in the foreign exchange markets. Profits can be made from shifts that could elevate or depreciate the value of one currency in relation to another. Because currencies are traded in pairs, predicting that one currency would weaken is practically the same as predicting that the other currency in the pair will strengthen.

Consider a trader who anticipates higher interest rates in the US than in Australia at a time when the AUD/USD exchange rate is 0.71 (i.e., $0.71 USD is required to purchase $1.00 AUD). According to the trader, rising U.S. interest rates will result in greater demand for USD, which will lead to a decline in the AUD/USD exchange rate as fewer, stronger USDs are needed to purchase a AUD.

In the event that the trader is right and interest rates increase, the AUD/USD exchange rate will drop to 0.50. Accordingly, $0.50 USD is needed to purchase $1.00 AUD. The investor would have made money from the value move if they had shorted the AUD and gone long on the USD.

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