Currency, or foreign exchange, often abbreviated as forex or simply FX, refers to the exchange of global currencies on a decentralised market place – also known as over the counter (OTC) currency exchange. The foreign exchange market is the largest and most liquid market in the world, with an average daily trading volume of approximately $5.3 trillion. There is a lot more forex trading than other forms of investing. The size of the currency market dwarfs bond and equity markets where daily volumes are much lower.
Historically, the currency market was only accessible to large financial institutions and high net worth individuals, however, technological innovations over the last two decades have enabled investors of all sizes to buy or sell currencies on the forex market from anywhere in the world, through the use of innovative online trading platforms. Some of the main participants in the foreign exchange market include:
Major national governments and their respective central banks including the Federal Reserve, the Bank of England and the European Central Bank are some of the largest players on the forex market, using currency exchange to manage money supply and make changes to monetary policy.
Some of the world’s largest banks such as Goldman Sachs, Deutsche Bank and Citibank trade immense volumes of currency on the forex market on a daily basis, both for themselves and their clients which include major corporations, government agencies and high net worth individuals.
Forex brokers provide access to the global currency markets to retail traders of all sizes. Through online trading platforms, a broker acts as a gateway for investors to trade currency from the comfort of their own homes.
Almost one-third of the daily volume traded on the forex market is now supplied by retail traders. This means individuals are trading approximately $1.5 trillion of currency on a daily basis, gaining access to the market through the trading platforms supplied by forex brokers.
Currencies on the forex market are traded in pairs. This means that, when a trader goes to buy or sell a currency, they are simultaneously selling or buying another. For example, if a trader wishes to buy EURUSD, they will be buying euros and selling dollars at the same time. Currency pairs are often separated into three distinct categories:
Involve the U.S. dollar paired with any other major currency. Examples of major pairs include EURUSD, GBPUSD, USDJPY and USDCAD.
Pairs not featuring the U.S dollar. Crosses between other major currencies are also referred to as minors. Examples of cross currency pairs include EURGBP, EURJPY, GBPJPY and NZDCAD.
Involve a major currency paired with one from an emerging economy. Examples of exotic pairs include USDHKD, CADMXN, EURSEK and JPYSGD. Trading a nation’s currency is akin to investing in the fortunes of said nation. When the country is doing well and its economy is thriving, its currency strengthens. Conversely, when a nation is struggling, its currency will be worth less. As such, investors in the forex market are speculating that one country’s economy will outperform that of another. For example, if a trader believes that the United Kingdom’s economy will outperform that of the United States, they would buy GBPUSD (buy the pound and sell the dollar). On the other hand, if the U.S. economy is likely to perform better than that of the UK, a trader would sell GBPUSD (sell the pound and buy the dollar).
When looking to buy or sell currencies on the forex market, an investor must be aware of the factors that affect exchange rates, so that they can adapt their strategies accordingly. Two of the main factors to watch out for include:
Macroeconomic news including announcements about important data points such as inflation, unemployment, interest rates and gross domestic product can have major effects on a currency’s exchange rate. Investors watch this data closely for hints on how the markets may move.
Geopolitics also play a major role in the prices of currency. Factors including changes in government, new regulation, taxes, labour laws and trade tariffs can all cause volatility in the forex market, and significantly impact the value of national currencies.
It is important for investors to keep abreast of all upcoming events and announcements that may impact currency prices, so as not to be caught off-guard in the case of market volatility. There are numerous tools including economic calendars that can be used to monitor market-moving events, enabling traders to adapt their strategies when necessary.
Forex is the most traded market in the world and when you understand the benefits of the market, it is easy to understand why.
Unlike other markets, forex trading doesn’t have to stop when the sun goes down. Since forex is traded all over the world, trading markets are open 24 hours a day, 5 days a week, so you can trade when it is convenient for you.
The costs of trading at Pacific Union are included in the spread, there are no hidden fees or commissions, so you can be confident knowing how much your trade is costing you.
The forex market offers traders the unique advantage of trading opportunities in both rising and falling markets. And unlike other markets, there are no restrictions or additional costs for short selling.
Forex is traded with a degree of leverage, allowing you to take a position in the market with a fraction of the capital you would usually need. As much as leverage may increase your gains, it can also increase your losses so it’s important that you understand the risks of trading on margin.
With daily turnover reaching $5.3 trillion, forex is the most liquid market in the world. This liquidity often results in more actionable prices and unlike other financial markets, traders can respond almost immediately to currency fluctuations, whenever they occur – 24 hours a day, 5 days a week.
Forex trading allows you to easily gain exposure to markets around the world. While most trading is done in the world’s major currencies, you also have access to emerging markets such as Mexican Peso (MXN) and Polish Zloty (PLN).
Financial Leverage enables retail Forex traders to control market positions that are much larger than their initial investment. Effectively, financial leverage takes the form of a loan that a trader takes from their broker, helping them invest in the foreign exchange market without needing to put up a large amount of their own capital.
Traditionally, investing in the Forex market was only available to major financial institutions and high net worth individuals. This is due to the fact that, to make significant profits from the relatively small daily movements in the Forex market, a trader needs to invest a large amount of capital – something retail investors don’t usually have access to.
However, through the advent of the internet and other advances in technology, the Forex market is now accessible to anyone from the comfort of their own home. The daily trading volume on the Forex market has grown exponentially in the last decade, as an increasing number of retail traders have entered the market. The availability of derivatives on Forex, such as Contracts for Difference (CFDs), which allow traders to speculate on whether currencies will rise or fall without taking ownership of the underlying asset, have fueled this exponential growth.
Financial leverage is an important aspect of trading derivatives like CFDs, as it allows investors to enter the market with relatively small starting capital. Using financial leverage, a trade that ordinarily would have required an investment of $100,000 can be placed with only $1,000. This has enabled would-be investors that were previously unable to meet the minimum requirements for market entry to begin investing in the foreign exchange market.
Financial leverage is expressed as a ratio, for example, 1:1, 1:10, 1:100. The amount of leverage used and a trader’s initial investment determine the size of trades they will be able to control. Using an initial investment of $1,000 as an example, varying levels of financial leverage would have the following effects on the trade size available to an investor:
As can be seen from the table above, the higher the leverage used, the larger the trade size an investor can control. Although using leverage can be beneficial for a trader, it also involves risk. To gain a thorough understanding of how financial leverage can both increase profits and lead to larger losses, a trader must first understand the concept of margin.
Margin is basically the deposit required to operate using financial leverage. Essentially, this will be an amount that an investor must have in their account that will be reserved when they open a trade using leverage. The amount of margin required depends on the size of the trade being placed and the leverage being used. Using a trade size of 1 standard lot ($100,000), the margin required would change as follows based on the leverage used:
As can be seen from the table above, the higher the financial leverage used, the lower the margin required to open a position on the market. So, if an investor wanted to open a market position of 1 standard lot ($100,000) using financial leverage of 1:50, they would need to have $2,000 in their account, which would be used as margin.
As mentioned previously, financial leverage is beneficial for retail traders, especially those that have less capital with which to invest. However, although using leverage can increase the potential profit an investor may earn, it also carries a certain amount of risk and can lead to greater losses.
Traders that enter the market undercapitalised and overleveraged can quickly see their investment disappear in the smallest of market moves. Due to the margin required to guarantee a leveraged position, if a trader opts for high leverage and only invests a small amount of capital, most if not all their investment would be reserved as margin. This means that, if the market were to move against them, they could stand to lose all their invested capital on a single trade.
As such, it is of paramount importance that investors looking to enter the market for the first time have a thorough understanding of both leverage and margin, as well as how the Forex market works, before placing their first trade. A sound risk management strategy is also necessary, including the use of appropriate levels of leverage based on available capital, as well as the use of Stop Loss and Take Profit levels. Finally, it is always advised that beginners start by trading on a Demo Account before investing real money, as this will enable them to get a feel for the market and develop their trading strategy, without risking any of their own capital.
Liquidity refers to how active a market is. It is determined by how many traders are actively trading and the total volume they’re trading. One reason the foreign exchange market is so liquid is because it is tradable 24 hours a day during weekdays. It is also a very deep market, with nearly $6 trillion turnover each day. Although liquidity fluctuates as financial centres around the world open and close throughout the day, there are usually relatively high volumes of forex trading going on all the time.
Volatility is the measure of how drastically a market’s prices change. A market’s liquidity has a big impact on how volatile the market’s prices are. Lower liquidity usually results in a more volatile market and cause prices to change drastically; higher liquidity usually creates a less volatile market in which prices don’t fluctuate as drastically.
Liquid markets such as forex tend to move in smaller increments because their high liquidity results in lower volatility. More traders trading at the same time usually results in the price making small movements up and down. However, drastic and sudden movements are also possible in the forex market. Since currencies are affected by so many political, economic, and social events, there are many occurrences that cause prices to become volatile. Traders should be mindful of current events and keep up on financial news in order to find potential profit and to better avoid potential loss.
Rollovers are only applied to positions that are open at market close in New York. You can either earn or pay when a rollover is applied to your position.
When trading a currency you are borrowing one currency to purchase another. The rollover rate is typically the interest charged or earned for holding positions overnight. A rollover interest fee is calculated based on the difference between the two interest rates of the traded currencies.
If the currency you are buying has a higher interest rate than that which you are selling, you will typically earn rollover fees. If the currency you are selling has a higher interest rate than that which you are buying, you will typically pay rollover fees.
You’re trading EUR/NZD (Euro/New Zealand Dollar). The EUR has a low interest rate whereas the NZD has a relatively high interest rate. You are borrowing the high-rate currency to buy the low-rate one, so you are trading at a premium: you will pay rollover fees on this trade if held overnight. If you sell EUR (i.e. go short) to buy NZD, you will be trading at a discount and earn rollover rates on this trade.
An option is a financial derivative representing a contract wherein a buyer is given the right, but not the obligation, to buy or sell a financial instrument at an agreed upon price and on a specified date in the future. Popular markets for such contracts include Forex options trading, indices options trading and shares options trading.
Before attempting any options trading strategies, investors should ensure they are familiar with the terms involved in FX options trading and that of other assets including:
Contracts for Difference (CFDs) are financial derivatives that allow investors to speculate on whether the price of a specific instrument will rise or fall, without taking ownership of the underlying asset. Contracts for Difference have grown in popularity in recent years, enabling retail traders to invest in various financial instruments including forex, shares, indices and commodities over the internet, with minimal initial investment, through the use of financial leverage.
As Contracts for Difference are derivative instruments, profits earned are exempt from charges associated with traditional trading, such as stamp duty. CFD trading also allows investors to use higher levels of financial leverage when compared with traditional trading, meaning that a smaller initial investment is required to open a position on the market.
Another benefit is that, through online CFD brokers like Pacific Union, investors have access to multiple asset classes from a single trading account. This enables traders to take positions on a range of financial instruments, without having to juggle multiple accounts and the fees associated with each. Traders can then easily diversify their portfolios from a single account by investing in currencies, gold, oil, company shares and more.
When trading CFDs, investors are also able to profit from both rising and falling markets. This is due to the ability to both buy (go long) and sell (go short) when trading contracts for difference, providing traders with additional ways to earn profit when compared with traditional methods of investment.
Although CFD trading has numerous benefits, it also carries a certain amount of risk. Due to the nature of derivative instruments and the fact they are traded with higher levels of financial leverage, inexperienced investors could quickly lose all their invested capital.
Before beginning to trade CFDs, an investor should ensure they have a detailed understanding of how the derivative instruments work and the inherent risks involved. Formulating an appropriate risk strategy is important before entering the market, as is spending time trading on a Demo Account, which provides the opportunity to build an effective strategy in a risk-free environment.
Economic indicators, or economic releases, are vital components to consider when making trading decisions. While some releases like Employment data or Retail Sales gives us a snapshot of an economy’s strength or weakness, some are a bit more subtle in their ways and can actually serve as a leading supposition of what’s to come for the main releases. In the spirit of trying to predict how the more important indicators will fare, here are some leading economic indicators that could give you a clue of how they will turn out.
When looking at economic releases, we have to realize that everything is ultimately related to the habits and actions of consumers: Retail Sales is a direct measure of how much consumers purchase; Gross Domestic Product is a direct measure of the capital spent by businesses and consumers; Employment is directly driven by demand to make product that is purchased by consumers; the list goes on. Taking that knowledge in effect means that it is incredibly helpful to have a measure of the optimism or pessimism of consumers, and surveys deliver that to us. It is imperative to be cautious when trying to assess the impact of the surveys because they have a different time reference than the more vital reports.
Survey results are usually reported about a week or two after the surveys are conducted whereas a report like Retail Sales can be reported anywhere from two to six weeks after the month end. Therefore matching the timeframes for the various reports is an absolute necessity.
There are a variety of PMI reports that get released by a few institutions (ISM and Markit chief among them), and all have varying degrees of importance; however, among them all, the “flash,” or “preliminary,” releases are the most telling. The reasoning behind that importance is directly related to their timing. The flash reports are typically released mid-month or slightly after to measure how the month has been going so far according to purchasing and supply executives. The higher above 50 those readings are, the better the month is shaping up for them as they are showing growth. Conversely, if the figure is below 50, then that represents a majority of negative responses and could signal a pullback in that nation’s economy.
Government is slow to release their official figures due to their desire to be accurate and probably a few bureaucratic reasons, but businesses tend to be a little more expedient. For that reason, Vehicle Sales for the previous month are reported almost as soon as the month ends while the government figures are released much later. The theory is that if vehicle sales are strong then, most likely, other forms of consumerism will also be strong.
These are just a couple of the leading economic indicators you can use to help yourself get a leg up on the competition, and the more you watch them, the more comfortable you can become in utilizing their knowledge.
Day trading is the practice of buying and selling a financial asset within a single trading day. Known as day traders, investors that follow this practice usually make use of high levels of financial leverage to maximise the profit they can earn from small market movements. Day trading is most commonly seen in the foreign exchange and stock markets.
Due to the short time frame involved and the use of high levels of leverage to maximise profits, day trading is normally reserved for experienced investors that are knowledgeable about the financial markets. To be successful, an investor must develop a clear strategy and have enough discipline to stick to it.
Day traders focus their activity on only a few assets, opening their positions on the market throughout a trading day and closing them before it ends. Following the latest economic news and events is of utmost importance to a day trader, as it helps paint a picture of how a specific asset will perform over the coming day, allowing them to adjust their strategy accordingly.
Technical analysis is also central to carrying out a successful day trading strategy. Using a variety of indicators, investors can analyse the markets and develop an idea of how a given asset may move, how strong that movement may be and how long it could last. Combining technical and fundamental analysis gives experienced investors an edge over others when day trading in the financial markets.
The use of high levels of leverage is also key to many day trading strategies, as this enables investors to control larger positions on the market with a smaller initial investment. As the price movements can often be small, leverage helps investors maximise the profit they can make in a single day. This is another reason why day trading is often conducted by experienced investors, as the use of financial leverage can be risky, and requires a thorough understanding of the markets and an adequate strategy to manage the risks involved.
There are various day trading strategies that investors can follow including:
Trend trading involves studying the price chart of an asset at a longer time frame to identify the prevailing market trend. Once it has been identified, an investor will revert to a smaller time frame on the same price chart and look for trading opportunities that follow the overall trend. For example, if the EUR/USD currency pair is trending upwards on the 4-hour time frame, then an investor can switch to a 15-minute time frame and look for opportunities to go long on the pair.
Similar to trend trading, this day trading strategy involves identifying a prevailing market trend at a longer time frame and then looking for opportunities to place trades in the opposite direction at a shorter time frame. The impetus for this is to attempt to identify the end of a market trend and profit from the reversal. This is a riskier strategy but can lead to greater profits. For example, if Apple shares are in an upward trend that seems to be slowing on the 4-hour time frame, an investor can look for opportunities to short the stock on the 15-minute time frame to benefit from a potential reversal.
Breakout trading involves identifying when an asset has been in a period of consolidation, in other words, trading in a range between support and resistance lines that have been holding strong. An investor will then place trades on either side of the range, in the hopes that the asset will breakout and form a new trend. This day trading strategy is usually more effective when an asset’s price has been trading in a very tight range. Investors should target profits equal to the number of pips that had made up the earlier trading range.
There are a number of factors that affect the potential profitability of a day trading approach which investors should take into consideration before proceeding with such a strategy.
Being undercapitalised is one of the main reasons traders struggle to succeed in the market. A trading account must be sufficiently funded to guarantee an investor’s open positions in the case of market volatility. This is even more important when it comes to day trading, where positions are left open throughout a trading day. Additionally, the use of high leverage with an undercapitalised account can lead to added risks, including the loss of all invested capital.
As day trading can involve opening and closing a number of trades within a single day, transaction costs for each trade must be taken into account when formulating a strategy. Both spreads and commissions are calculated on a per trade basis, meaning that the more trades an investor makes, the more costs they will accrue. Thus, a successful day trading strategy must be one where an investor is able to earn enough from trades throughout the day to both cover the costs involved and still make a profit.
Trading psychology is of utmost importance when it comes to investing in the financial markets. In the case of day trading, there are added pressures to consider as large trades must be placed quickly and monitored throughout the day. As such, being successful requires a great deal of preparation and determination, as well as a sound risk management strategy to protect investors against potential market volatility.
Economic announcements, or new events, are a widely followed aspect of trading due to their influence on monetary as well as political policy. Therefore, it is important to know which announcements are going to create the most impact and volatility so as to take advantage of their movements. Here are some of the most widely revered events and their meaning.
Whether we’re talking about Non-Farm Payrolls (NFP) in the US or Employment Change in Australia, economic announcements about jobs are an incredibly important measure of the growth or contraction of a particular region. Many of the central banks around the world have “healthy employment” or some derivative of that as one of their mandates. So if employment isn’t performing up to the level they would prefer, they could adjust their monetary policy to boost it, therefore influencing a variety of other factors as well.
Almost always lumped in with employment on the mandates of central banks around the world is “price stability.” While there are plenty of measures for inflation including Producer Price Index (PPI), Import/Export Prices, Food Price Index (FPI), Retail Price Index (RPI), Wholesale Price Index (WPI), among others, the CPI is usually the most respected due to its proximity to the consumer. Most developed economies prefer their CPI to be around 1%-3%.
One of the reasons we watch other economic announcements so diligently is to try and predict what the central banks will be doing with their future monetary policy. Therefore it only makes sense that we play close attention to what they actually do when they make their decisions as well. Interest rate hikes or cuts, forward guidance on future policy, or even introduction of unconventional measures are things we have come to expect from these meetings and their effects are both immediate and long lasting.
The multitude of consumer and business sentiment reports that are released across the globe on a monthly basis is staggering; however, they all play their part in shaping the market’s expectation for the future. Anecdotally, businesses are usually ahead of consumers in feeling apprehensive or optimistic for the future, and if both sentiment indicators are heading in the same direction, that is typically a stronger signal.
One of the main drivers of developed economies is their propensity to consume. Retail Sales measures that consumption proclivity better than most other indicators and is widely followed because of it.
The Consumer Price Index (CPI) and Producer Price Index (PPI) are inflationary measures used to determine whether prices for goods and services are rising (inflation), falling (deflation when below zero or disinflation when falling but still above zero), or staying the same (since there is no particular term for this, let’s just call it “zinflation,” for zero inflation).
Just as the names describe, the CPI is a price measure of the consumer side of the equation, and PPI measures prices for producers.
These figures are widely used by central banks to determine the course of monetary policy (though admittedly not the only ones), and can have an overarching effect on virtually all tradable markets. So let’s take a look at the “flation” aspect of these reports to see how they are interpreted.
When prices are rising or staying consistently above the 0% level, it is called inflation. In layman’s terms, prices are being inflated higher each year just like blowing up a balloon.
Current economic belief is that a low and stable inflation rate can help reduce the severity of potential economic downturns by enabling businesses to adjust quickly.
Central banks try to keep inflation in this range by lowering interest rates when it falls below 2% working on the belief that if capital is cheap to borrow, businesses and consumers will use that ability to buy things and keep the economic engine running. Conversely, if inflation runs over 3%, raising interest rates encourages those entities to save as they get more “bang for their buck” by keeping it in the bank.
If inflation is too low (but still above zero), you could potentially see a situation arise like what happened in Japan during the 1990s and early 2000s, a time dubbed as “The Lost Decades.” During that period, inflation remained at frustratingly low levels and the nation fell into economic complacency, failing to see an increase in GDP over long stretches. In an attempt to combat that, the Bank of Japan lowered interest rates down to 0% to encourage spending over saving, but instead many businesses and individuals chose instead to borrow at the lower rates to pay off previous debts; very little of the increased available money went into consumerism or increased business activity. In later years, Japan accelerated their easy monetary policy even further by introducing Quantitative Easing (QE), which is the process of lowering interest rates further by outright purchases of government bonds or asset-backed securities by the central bank which essentially introduces more money to the current money supply. Opponents of QE argue that flooding the market with extra capital could eventually lead to…
There are times when inflation can get a little out of control, and this is defined as hyperinflation. There are many historical examples of this situation where prices rise at extraordinarily expedient rates including France during the French Revolution, the German Weimar Republic just before WWII, Russia after the fall of the Soviet Union, Zimbabwe in the mid 2000s, and even the United States during the Revolutionary War. As you can likely tell, most of these hyperinflationary episodes ended in war or were a direct result of conflict or lack of confidence in the state’s ability to govern. Needless to say, central banks try to do anything they can to prevent this from happening, including revaluating their currency and/or raising interest rates to levels where it becomes more advantageous to save rather than borrow.
If prices are declining the term deflation is used. If you were to ask the average person on the street if they think it’s a good thing that prices are falling, you would probably get a majority of affirmative responses. Who wouldn’t want the prices of the things you buy every day to be cheaper? Well, manufacturers, for one, wouldn’t like it very much. It means that the margin they make on the products they produce would go down, which means they need to find ways to make it cheaper; and that usually leads to layoffs. If more people don’t have jobs, then less stuff is being consumed which leads to even smaller margins for producers. You can see the nasty spiral that is self-preserving here, and it only gets worse over time. To combat deflation central banks will typically try to make the act of borrowing money more accessible by lowering interest rates and making it sensible to do so. The increase in money available has the effect of decreasing the value of the currency, therefore creating inflation by way of supply.
“Zinflation” is the term we are using for when interest rates stay the same over a period of time. Back in the 1990s the idea of zinflation was something that was debated as being the ultimate goal of central banks and even Federal Reserve Chairman Alan Greenspan expressed a desire to achieve it. Since then, the experience of Japan in the Lost Decades has served to make zinflation less desirable, as it would be likely synonymous with lack of growth for an economy as well. Therefore, the model of low inflation near the 2%-3% level has become the preferred model to begin the 21st century.
Non-Farm Payrolls (NFP) measures the amount of jobs gained in the U.S. during the previous month that aren’t farm related. It is typically released on the first Friday of the new month, and also includes the Unemployment Rate, Average Hourly Earnings, and the Participation Rate. While all of those releases can have an impact, NFP is the main driver of market movement and is often times the single most-watched economic event that is released on a monthly basis.
Unlike men, not all economic news events are created equal. Some events create a lot of hysteria and knee-jerk reactions, whereas others barely cause a blip on the radar. The ubiquitous Non-Farm Payroll (NFP) report out of the U.S. is an example of the former.
So much attention is paid to the NFP report that pundits from across the financial blogosphere attempt to predict its eventuality and impact across a variety of financial instruments.
The large reaction is due in part to the Dual Mandate of the Federal Open Market Committee of maximum employment and stable prices. The “maximum employment” part of that mandate means that the Fed looks at NFP to help determine what interest rates will be in the future which has an outsized impact on the health of the economy. If job growth is strong, the Fed would typically look to raise interest rates assuming inflation is in check, and vice versa if job growth is weak. However, simply determining if NFP is weak or strong is another matter altogether due to expectations.
The consensus expectation for NFP plays a large role in how the markets react to the data, with the median expectation of a group of professional analysts serving as the decision point. For instance, if consensus is 200k, and the number comes out at 205k, there may not be too much reaction to that figure as it ended up being almost exactly what the market anticipated. The further away from the consensus, though, the more significant the reaction. Two Ways to Trade NFP
If you place a trade before the figure is revealed, you are using your skills of deductive reasoning to predict which way the market will go before it actually does. Risk management is vital to using this type of strategy as an unexpected figure can create gaps in the market that could theoretically jump right over any risk-minimizing stops you have in place. Therefore, it is wise to give whatever instrument you choose to trade wide breadth to move and oscillate to give yourself a better chance. Most of the central banks around the world would like inflation to grow at an annual basis of around 2% to 3%.
Trading after the release is a little more cautious, but also comes with its own set of risks. The initial knee-jerk reaction to the NFP headline isn’t always the “end-all, be-all” of market movement for the day. It has been well documented that markets can mimic a V-shape post NFP, where the spike goes in one direction then reverses in the minutes or hours afterward.
In its simplest context, Central Banks are responsible for overseeing the monetary system for a nation (or group of nations); however, central banks have a range of responsibilities, from overseeing monetary policy to implementing specific goals such as currency stability, low inflation and full employment.
Central banks also generally issue currency, function as the bank of the government, regulate the credit system, oversee commercial banks, manage exchange reserves and act as a lender of last resort.
The balancing act of stable employment and prices is a tricky one, and the main mechanism a central bank has to regulate these levels is interest rates. Interest rates are a primary influencer of investment flows.
The reason for either raising or lowering the interest rate and why it has an influence is easy to see when you really think about it. Consider for a moment an economic environment where banks are concerned about the economy and are hesitant to loan money out of fear of not being paid back.
If interest rates are high, the safer option would be to keep the money and only loan to those whom they feel would pay back the loan at a high interest rate. An environment of this kind would make it difficult for small businesses that don’t have credit history to borrow money. Plus a higher cost to borrow may dissuade businesses from borrowing. The same would be true for individuals looking to buy houses.
If the same economic scenario were presented but interest rates were low, banks may feel that taking the risk in loaning to less-than-impeccable businesses is worth it, particularly since they could also borrow money from the central bank at extremely low rates. This would also lower the interest rates for buying a home.
Businesses borrowing money to grow their bottom line and individuals buying homes are two vital keys to a growing economy, and central banks typically try to encourage it. However, there are times when it gets a little out of control and too much risk is being taken, which can lead to painful economic downturns.
Central banks attempt to balance the needs of businesses and individuals by managing interest rates.
Traders are influenced by the rates at central banks as well. When buying one currency against another in a forex transaction, you are essentially taking ownership of that currency using the counter currency as the funds of your transaction. For instance, of you are buying the NZD/JPY (New Zealand Dollar/Japanese Yen), you are borrowing JPY to buy NZD. If you borrow, you pay the borrowing cost (interest rate) to get those funds, but on the flipside, you are earning interest on that which you bought. If the JPY has an interest rate of 0.10% and the NZD has interest rate of 2.50%, you are earning more interest than you are paying for the transaction.
Some investors take a long-term approach of borrowing low interest rate currencies and buying those with high interest rates, a strategy called the “carry trade.” While the carry trade can be profitable, when only considering the interest earned it is typically negligible. The values of the currencies against one another plays a much bigger role in the day-to-day profitability of the position, and can far outweigh any interest earned.
This is a term referring to a central bank that is either talking about or actually raising interest rates.
This is a term referring to a central bank that is either talking about or actually cutting interest rates.
This is a method of cutting interest rates where a central bank will cash in some of its holdings and buy bonds; most of the time these bonds are long term. By entering into the long-term bond market, they are increasing demand for those bonds therefore driving down the interest earned on them. The goal of such a measure is to keep interest rates low to encourage more borrowing.