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How Currencies Interconnect

Most sovereign nations have their own currencies, each backed by the full faith and credit of the issuing nation. Currencies used to be backed by precious metals but now currencies float in value relative to those of other nations, rising or falling based on a multitude of factors. Gone are the simple days of demand notes backed by precious metals. Back then the currency represented a promise to convert that note into a fixed amount of the precious metal. You could literally go to the bank with paper and walk out with a bag of gold!

The reality today is that a currencies value is determined by the push and pull of market forces. The market forces represent the forecasts, wills and needs of every market participant. Individual participants make their own decisions based on business needs, economic expectations, geopolitical events and other factors. These participants can be speculators (like hedge funds or institutional investors), national banks or sometimes large businesses that have overseas operations or suppliers. 

Understanding today’s currency markets can be a daunting task but an important one nonetheless. This is true whether your business interests stretch over national borders, you are investing in such businesses or if you are interested in speculating in currencies yourself. One thing you can be sure of is that the market is growing. It is estimated that trading has increased over 200% between 2004 and 2010, and is up 20% since 2007 alone. The sheer enormity of it is breathtaking. The latest data shows that there are almost $4 trillion in currency trades placed every day. On top of that, the instruments used by currency traders can be devilishly complex and even the jargon used to describe the currency markets can be intimidating to the uninitiated. 

Corporations and national banks are in the markets because they have to be just based on who they are and what they do. Many investors flock to the currency markets because it seems like they were tailor made for speculation. Currency markets enjoy such an incredible volume and they trade 24 hours a day, seven days a week so currency is literally the most liquid of liquid investments. This is important because a big player with lots of capital can make an unwelcome splash in relatively small markets. The currency markets are deep and wide enough to provide plenty of opportunities for the big players. Speculators also enjoy the volatility of this asset class as the frequent ups and downs provide more opportunity for profit.

Market participants stake their positions using a variety of instruments. A spot transaction is a direct exchange between two currencies at the current exchange rate. A bank that offers currency conversion as a service might make spot trades to make sure it has the cash on hand in the proper denomination to satisfy customer needs. There are a number of other more complicated instruments which all project into the future. A forward contract is like a spot trade but it happens at some predetermined date in the future. A swap is an ongoing series of trades that take place at specified intervals. Both forwards and swaps are negotiated between two parties, often with the use of a broker filling the role of intermediary. For those who have less specific needs, there are currency exchanges where standardized products trade. This is called the over the counter (OTC) market. Currency futures are standardized forward contracts that typically are issued with a three month lifespan. A currency option grants the owner the right but not the obligation to buy or sell a specified amount of currency for a specified price on a specific date.

In this globalized world of ours everything is becoming increasingly connected and that trend is only going to accelerate. The interconnectedness of currencies is only another example of the path we are on. Regardless of your role in the currencies markets, it is critical to understand how they work, how different people use them and for what purposes.

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