Minggu, 23 Agustus 2009

Introduction to Term Trading

This time I want to inform some of the terms commonly used in trading. Hopefully this article can be useful.

1.Foreign exchange rates
The foreign exchange rate is the between two currencies i.e. the amount of one currency needed to sell (or buy) in order to buy (or sell) the unit of the other currency. There are two ways to express such a rate. The most common in international is the amount of any currency that corresponds to one U.S.Dollar. So when we see the USD/DEM at 1.2000 so, the one dollar can be exchanged for 1.2 Dmarks. The American way or American techniques the rates uses the opposite direction, that is it expresses the dollar amount that can be exchanged for one unit of foreign currency. So when we see for example the Dmark at 0.6625 so the one mark can be exchanged for 0.6625 dollars (or the same at 66 1/4 cents). The term "cross rate" is usually used to express the balanced between two nondollar currencies like DEM/SFR.

2. Bid and offer
The exchange rates in the practice are quoted as two-way rates. So dollar/mark quotation will read something like 1.2000/10. The bank or company which quotes this rate will understands that it buys marks (selling dollars) at 1.2010 and sells marks (buying dollars at 1.2000). In other words it buys cheaper. Of course, the opposite is true for the person that asks for a quotation. The difference between the purchase (buyers) and the sale (seller) rates is called "spread".

3. Rate direction and currency direction
One needs to keep very clear in mind the idea of market direction. The First from the other is, in the foreign extern market it is a mistake to say that the market is going up or down. In the stock market one can use this expression as stocks either go up or go down. But, in the FX market a rate as we said defines the parity of two currencies, hence at any time one goes up , so the other will going down. And, the other issue that often confuses people (even traders and bankers) is the difference between a currency moving up and its rate going up. We have to explain this in more detail as any misunderstanding can lead to painful surprises when trading in the real market. For simplicity reasons let us forget for the time being the bid/offer spread. So let us suppose that dollar/mark moves from 1.2000 to 1.2010. In this case the rate goes up whereas the value of the mark goes down (simply because the value of the dollar goes up). In other words one needs more marks at 1.2010 to exchange for one dollar.

4. Basis points or pips
The foreign exchange rate usually consists of an integer in the part and 4 decimal points (or 2 decimal points when expressed per 100 units like e.g. dollar/yen). So, that the decimals are expressed either at 10th thousands or hundreds. For the example 0.0001 or 0.01 is called basis point or pip. E.g. a 50 pips change of 1.5000 is either 1.5050 or 1.4950.

5. Spot and forward rates
Some people this concepts very easy for using and understood as cash rates and futures. As a matter of fact we would not like to use the term "futures" in here, because that will be make confusing with the typical futures contracts. Instead, let us use a more descriptive approach. A spot rate is the exchange rate which is valid for a transaction (example: purchase of currency A and sale of currency B) that must be concluded within the next two working days. Thus the value date (i.e. the day of actual delivery of currencies) of a transaction performed on a Monday is Wednesday. For Thursday it is Monday (weekend days are not counted). Besides that, a forward transaction regards a deal which is concluded today and actual effect will take place on a fixed future date In the next paragraph we describe the relationship between a spot and a forward rate.

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