Trying to Nail Down a Few Basic Concepts

[The Catabolist 10]

The two major things I'm trying to get a mental hold of right now are (1) interest rates and (2) indirect vs. direct quotes and their implications.

 

Interest Rates

Here's my current understanding, so PLEASE correct me where I'm wrong: The interest rate of a currency is set by that country's national bank. These interest rates affect the currencies held in the forex market on a daily basis at 5pm EST. It's always relative and is the sum of the two currencies in question, so if I traded GBPAUD (which currently is 3.5% off .5% [which could be worded 350 basis points off 50 basis points]), that's net -3% interest.

 

So if I've traded and now hold (arbitrarily) 1000 GBP, at 5pm EST (excluding the weekends) I would be debited 3% interest or 30GBP, leaving me with 970GBP.

 

In an alternative scenario, if I've traded EURUSD (which is currently 25 basis points off 75 basis points so net +50 basis points) and now hold (arbitrarily) 1000 EUR, at 5pm EST (excluding weekends) I would be credited .5% interest or 5EUR. Which would result in 1005 EUR total.

 

Some of the forex concepts and dynamics as a whole seem counter-intuitive and a bit murky to me (and I've only spent about 4 actively involved months on the stock market before this). Which is also where the direct vs. indirect quotes confuse me.

 

Direct vs. Indirect Quotes

 

The very fact that a quote is set as GBPAUD seems to have odd implications. If the GBP becomes weaker to the AUD, then the AUD has become stronger to the GBP.

 

If my aim is to buy when low and sell when high (to put it very simply), then points where GBPAUD is peaking in price and is about to turn around and start dropping, a theoretical AUDGBP would be dropping to a low point and is about to turn around and start increasing. In this scenario, I'd prefer to have AUDGBP, but alas I'm stuck with GBPAUD.

 

Am I missing the concept altogether? Am I just screwed when it comes to that? Is there a forex version of selling short on a stock then buying to cover?

 

I appreciate any and all guidance you guys can offer me here.

[SIUYA 11]

briefly

Interest rates...

if you are long a currency that you are receiving the interest rate in that currency, if you are short a currency you pay the interest rate.

example; AUD 3.5%, GBP 0.5%

+AUD, -GBP

you borrow at 0.5%, and invest at 3.5%

 

Dont forget these are yearly percentage rates, calculated daily by your broker and often they might apply a small clip as well.

For more information check out currency carry trades

 

Direct Indirect Quotes.....

GBPAUD is the inverse of AUDGBP - you are simply swapping one currency for another, and the normal quote (in this case is GBPAUD) because it depends on which currency you wish to go long or short.

If you go long GBPAUD you are purchasing the first currency and swapping the second currency for it. (you are not shorting it like a stock)

 

It is a relative swap trade

 

(if you wish to think about it in terms of stocks its is a swap between cash and the stock

eg; IBMCASH - to go long IBM you use cash to pay for it, to go short IBM you sell IBM and receive cash. It would be exactly the same if you inverted it, and is merely used for convention)

hope that helps.

[The Catabolist 10]

briefly

Interest rates...

if you are long a currency that you are receiving the interest rate in that currency, if you are short a currency you pay the interest rate.

example; AUD 3.5%, GBP 0.5%

+AUD, -GBP

you borrow at 0.5%, and invest at 3.5%

 

Dont forget these are yearly percentage rates, calculated daily by your broker and often they might apply a small clip as well.

For more information check out currency carry trades

 

Direct Indirect Quotes.....

GBPAUD is the inverse of AUDGBP - you are simply swapping one currency for another, and the normal quote (in this case is GBPAUD) because it depends on which currency you wish to go long or short.

If you go long GBPAUD you are purchasing the first currency and swapping the second currency for it. (you are not shorting it like a stock)

 

It is a relative swap trade

 

(if you wish to think about it in terms of stocks its is a swap between cash and the stock

eg; IBMCASH - to go long IBM you use cash to pay for it, to go short IBM you sell IBM and receive cash. It would be exactly the same if you inverted it, and is merely used for convention)

hope that helps.

 

 

This definitely did help a lot. I did feel a bit silly after I posted this and continued to run this through my head, especially with the interest rates (I realized that was yearly interest :P).

 

Your post helped clear up all those questions completely (and then some), so thanks.

 

The other thing that crossed my mind was how I'm allowed to trade a currency when I don't own either one. That is, if I've deposited 1,000 USD into my account to trade, how am I able to do something like GBPAUD?

[zdo 20]

The other thing that crossed my mind was how I'm allowed to trade a currency when I don't own either one. That is, if I've deposited 1,000 USD into my account to trade, how am I able to do something like GBPAUD?

 

You would probably get better anwers in an FX site or at ET... but...

 

Basically, your USD “deposit” allows you to use margin to buy ( or sell ), what is in essence, CONTRACTS (not the actuals ). Later when you sell (or buy) a contract, to offset the initial contract, it produces your Realized Profit or Loss, depending upon the intervening movement in the exchange rate btwn the pair you traded.

... ie when you can think of it in terms that you are trading contracts - you got it.

 

hth

[SIUYA 11]

The other thing that crossed my mind was how I'm allowed to trade a currency when I don't own either one. That is, if I've deposited 1,000 USD into my account to trade, how am I able to do something like GBPAUD?

 

concepts in finance are some things some people never get - shorting is one of them, leverage and risk is another. So never be afraid to ask the dumb questions.....while there are a lot of smart people who work at the big banks, there are also a lot of complete tools who thought (and still think) there is no risk on some of the things they produce (maybe not for them )

 

Adding to Zdos post......

dont think of it in terms of stocks. In stocks when shorting something you dont own you have to borrow (loan) the script to deliver the script to the buyer. This is because there is a finite amount of script for that stock and each stock certificate needs to be accounted for.

 

in many other instruments on margin - while Zdo calls them contracts (they can come in various forms and this might depend on what your broker is allowing you to do and who with and how you are doing it - too detailed) you could also think of them as an agreement (basically a contract) that your PL will go up and down based on the relative prices of the two instruments in the agreement. When you terminate the agreement the moves in the PL stop. There is theoretically no limit to how many agreements you can have - so long as you can provide enough margin to cover potential losses......nothing apart from the PL might actually change based on the relative price move. (hope that did not confuse more)

 

(the various machinations behind the scene do differ depending on if you are trading a spreadbet, swap, futures contract etc; - but it is not like going to your local money changer and saying I wish to physically convert this currency USD into GBP and then convet GBP into AUD, and then to close it out, you have to reverse it)

[The Catabolist 10]

Thanks a bunch, guys! I'm starting to understand this better thanks to your posts (and playing with a demo account). I soon realized that I can buy or sell from the start, then do the reverse to close the order, finalizing the deal. Obviously it's not quite like this with stocks so I was a bit murky about that at first. I realize now that the interest only affects it while that order's open and (at least with Alpari-US), it simply adjusts the price.

 

I get the idea of contract/agreement, though it makes me wonder how exactly it works at a deeper level. It's easy to grasp the idea of, "Okay, I'm telling you this is the price I'm promising to set as the buy price," followed by, "Okay, it's been a few days and it rose in price, so I'm going to 'sell' it now, as we agreed to. I get the difference (and you get to keep the difference in the spread."

 

But, how does this actually go down? As in, where does the currency actually come into play?

[zdo 20]

"But, how does this actually go down? As in, where does the currency actually come into play?"

 

In the intervening time between when you entered the first contract and then entered the second offsetting contract - in the real world, the actual exchange rate moved between the two currencies. In commerce and business and finance, enough actual Currency2 was needed to transact trade of some sort by 'enough someones' / enough agents with actual Currency1 for them to accept higher asks, etc etc. so exchange rate changed...

(that was a 'demand' example ... won't go into fiat supply dynamics here)

The actuals exchange rate changes are the only place where the "currency actually come into play"

 

All the contracts trade independently of the actuals.

Contracts prices deviate from the actuals prices dynamically ... they have variable influence on each other.

> pulled apart from, leading or following, based on multiple crowds' projections of future value - rational and irrational, etc, etc...

> and their price deviations from the price of the actuals are limited / held in close proximity to actual prices by the threat of arbitrage, etc. etc.

 

hth

Edited September 17, 2012 by zdo

[SIUYA 11]

T

But, how does this actually go down? As in, where does the currency actually come into play?

 

you will see all reasons sprouted out - like "more buyers/sellers than sellers/buyers", but this is not what you are asking....

as zdo says, the actual currency exchanges are different to your agreement to swap the differences in the relative prices between the day you start the agreement and the day you end the agreement.

Unlike stocks where you have to deliver a piece of paper (script) in FX you dont necessarily need to. Especially these days its all electronic - and basically all a promise.

Imagine going to your bookie and placing bets using credit, or going to the casio and changing your money for chips - they are worthless without the casino willing to back them. In this case you are relying on your broker to honour your account - see MFGlobal and PFG and Madoff for when it goes wrong.

(In the days when they used to back currencies with gold - and this has constantly been abused over the centuries - a currency was backed by the government as a promise to pay - supposedly because they had a physical asset (gold) that could be used. These days its all just a promise))

Even those large firms, multinational companies dont necessarily transfer trailer loads of cash - its all electronic - and scary if you think too hard about it.