A beginner's guide to foreign exchange

What Craig Abrahams doesn't know about FX is, quite simply, not worth knowing. Read his beginner's guide.

The currency market is where you go to buy and sell money. Not a real, tangible place, it exists behind masses of computer screens found in banks the world over, where traders use a combination of research, theory and knowledge of historical performance (as well as a touch of luck) to advise their clients on how best to make profit and avoid loss from the second by second fluctuations in currency exchange rates.

It's not just about buying a few euros for a holiday or traders winning and losing fortunes, it's also fundamental to the global economy. In the age of the multi-billion dollar international M&A deal, the currency market is the only place through which money can be paid when the buyer and seller operate in countries that use different currencies. Similarly, institutional investors (pension funds, insurance companies, asset managers etc.) need foreign cash when buying equities in overseas companies to add to their portfolio. Meanwhile, wealthy individuals ("retail investors") are now starting to use internet trading platforms to trade significant volumes of currency from their own home. And finally, governments use the currency market in amassing their reserves - not only of their currency but also those of other nations.

With over $1 trillion moving through it each day, the currency market is clearly a key part of the global financial infrastructure. However, over decades, the methods by which money is made and transferred in the currency market have become more sophisticated. Today it is all about instruments, packages, derivatives and futures. Whilst the constitution of these instruments is often extremely complex, the theory behind their use is relatively simple. They are almost always implemented to lower the risk of losing money through the trade without reducing the chances of profit. This is done by hedging. Rather than putting all your eggs in one basket, exposing yourself to a huge loss if things go wrong, currency traders will tie together any number of trades which, if done well, mean that the potential losses will be far lower than the potential gains, no matter what goes on in the markets.

Hedging in this way is also useful if the sheer amount of money being traded has the power to move markets on its own. For example, when RBS bought ABN Amro in 2005, the part-cash deal involved some £94.5 billion being transferred from RBS' home currency of sterling to euros, as used by the Dutch owners of ABN Amro. Withdrawing £94.5 billion in one hit and changing it into euros would have a huge effect on both money markets to the detriment of RBS. Reduced sterling supply would make the pound more expensive, whilst increased euro supply would cheapen the euro. So the currency teams at banks will have implemented an array of hedges in order to minimise the risk of RBS having to pay increased amounts to complete the deal. On top of this, deals of such magnitude take time, during which the exchange rate can fluctuate, either to the benefit or detriment of the purchaser. By putting together packages involving futures (contracts to buy currency for a set price some time in the future) currency traders will also have ensured that RBS would be as protected as possible against future exchange rate fluctuations, minimising the risk that they would have to shell out more than they initially envisaged when it came to actually paying ABN Amro for the deal.

The currency market is at the heart of the city and is far more than the workings behind the Bureau de Change at the airport. With the currency markets burgeoning as traders look to take advantage of the fluctuations caused by the recession, it offers a great entry point into the world of finance for those who are mathematically minded and relish the chance to string together complex deals which have a real effect on the day-to-day work of companies, funds and governments.