Any foreign exchange transaction ultimately begins with two events:
· One currency is being borrowed.
· The proceeds from the borrowed currency are used to finance the currency that is being bought.
· Currency pairs are typically traded in increments of 100,000 units of the base currency. A 100,000 unit increment in a currency trade is referred to as a lot. (For example, a trader who is trading 5 lots is trading 500,000 units of currency).
After gaining an intuitive understanding of how exchange rates move, one can begin FX trading, thereby speculating on the exchange rate so as to potentially reap profits from the fluctuating value of currencies. Essentially, clients can borrow one currency and buy another, and profit from exchange rate movements. This concept is most easily explained and understood through an example of an actual trade:
Trader A wishes to speculate on GBP/USD. Believing that the GBP will rise against the USD, or that the exchange rate will move upwards, the trader places an order to buy GBP/USD at a market rate of 1.8455. In terms of volume, let’s assume that Trader A is speculating on 100,000 units of the base currency – which is the standard lot size, or trading increment, used in the foreign exchange market. Since the base currency is the first currency in the pair, we know that Trader A is speculating on the value of 100,000 British pounds with respect to the US dollar.
In this example, Trader A is buying British pounds, since he believes the pound will rise in value with respect to the US dollar. Accordingly, he finances the transaction of buying 100,000 pounds by borrowing an equivalent amount of US dollars.
For Trader A, the value of the amount borrowed is a function of the exchange rate. Since the exchange rate at the time of the transaction was 1.8455, we know that the market cost for 1 British pound was 1.8455 US dollars. Hence, 100,000 pounds cost $184,550 (1.8455 * 100,000). This borrowed amount of 184,550 USD must be paid back when the transaction is closed. Let’s assume that Trader A is correct in assuming that the British pound would rise in value with respect to the USD, and that the exchange rate moved to 1.8555 – 100 pips above the rate at which Trader A entered. If Trader A were to close his position now, the 100,000 pounds he purchased at the onset of the transaction would be sold, and his debt of 184,550 dollars would be paid off. At an exchange rate of 1.8555, Trader A’s 100,000 pounds are now worth 185,550 US dollars (100,000 * 1.8555). After repaying the borrowed amount of 184,550, this leaves him with a profit of $1,000. A summary of the transaction is as follows: Initial transaction: Purchase of 100,000 pounds at a cost of 1.8455 US dollars per pound, or a total of 184,550 USD
Final transaction: Sale of 100,000 pounds at a price of 1.8555 US dollars per pound, or 185,550
USD
Amount of pounds initially purchased: 100,000
Amount of pounds sold through the closing transaction: 100,000
Net number of pounds: 0
Amount of dollars initially borrowed: 184,550
Amount of dollars purchased upon close of trade: 185,550
Dollars remaining after borrowed dollars are paid off: 1,000
· One currency is being borrowed.
· The proceeds from the borrowed currency are used to finance the currency that is being bought.
· Currency pairs are typically traded in increments of 100,000 units of the base currency. A 100,000 unit increment in a currency trade is referred to as a lot. (For example, a trader who is trading 5 lots is trading 500,000 units of currency).
After gaining an intuitive understanding of how exchange rates move, one can begin FX trading, thereby speculating on the exchange rate so as to potentially reap profits from the fluctuating value of currencies. Essentially, clients can borrow one currency and buy another, and profit from exchange rate movements. This concept is most easily explained and understood through an example of an actual trade:
Trader A wishes to speculate on GBP/USD. Believing that the GBP will rise against the USD, or that the exchange rate will move upwards, the trader places an order to buy GBP/USD at a market rate of 1.8455. In terms of volume, let’s assume that Trader A is speculating on 100,000 units of the base currency – which is the standard lot size, or trading increment, used in the foreign exchange market. Since the base currency is the first currency in the pair, we know that Trader A is speculating on the value of 100,000 British pounds with respect to the US dollar.
In this example, Trader A is buying British pounds, since he believes the pound will rise in value with respect to the US dollar. Accordingly, he finances the transaction of buying 100,000 pounds by borrowing an equivalent amount of US dollars.
For Trader A, the value of the amount borrowed is a function of the exchange rate. Since the exchange rate at the time of the transaction was 1.8455, we know that the market cost for 1 British pound was 1.8455 US dollars. Hence, 100,000 pounds cost $184,550 (1.8455 * 100,000). This borrowed amount of 184,550 USD must be paid back when the transaction is closed. Let’s assume that Trader A is correct in assuming that the British pound would rise in value with respect to the USD, and that the exchange rate moved to 1.8555 – 100 pips above the rate at which Trader A entered. If Trader A were to close his position now, the 100,000 pounds he purchased at the onset of the transaction would be sold, and his debt of 184,550 dollars would be paid off. At an exchange rate of 1.8555, Trader A’s 100,000 pounds are now worth 185,550 US dollars (100,000 * 1.8555). After repaying the borrowed amount of 184,550, this leaves him with a profit of $1,000. A summary of the transaction is as follows: Initial transaction: Purchase of 100,000 pounds at a cost of 1.8455 US dollars per pound, or a total of 184,550 USD
Final transaction: Sale of 100,000 pounds at a price of 1.8555 US dollars per pound, or 185,550
USD
Amount of pounds initially purchased: 100,000
Amount of pounds sold through the closing transaction: 100,000
Net number of pounds: 0
Amount of dollars initially borrowed: 184,550
Amount of dollars purchased upon close of trade: 185,550
Dollars remaining after borrowed dollars are paid off: 1,000
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