An Introduction to Physical Currency Exchange and Forex

Physical Currency Exchange vs. Currency Trading

There are different ways one can make money trading currency. The value of different currencies never remains static against the US Dollar. Physical currency exchange refers to exchanging your local currency, such as the Dollar, to the currency of another country and physically owning the foreign currency. Foreign currency exchange, or forex, on the other hand, involves trading the value of one currency for another and profiting on the fluxuations in price for the varying currencies, without owning the currency physically.

1. Physical Currency Exchange: You Own the Money

You can buy physical foreign currency when the currency of another country is going to appreciate in value against the dollar, you are relocating abroad, or simply going on vacation. You can purchase foreign currency from major banks as well as from currency dealers.

Most banks do not have foreign currency on hand. For instance, at Bank of America, you can buy the foreign currency online and have it sent directly to your house or to a bank center near you.

Currency dealers are companies that specialize specifically in providing foreign currency, and the physical locations have the currency on hand. When purchasing more than $500 worth of foreign currency, it is advised to purchase the currency online. They range from well-known companies such as AAA, to other sites you can find online.

2. Physically Owning Foreign Currency as an Investment

Investing your money abroad can be a sound way to make money. You can purchase foreign CDs, bonds, or put your money into foreign bank accounts in order to gain favorable interest. These options are often less risky than forex.

3. Forex Requires a Broker

Foreign currency exchange is done through a broker, or currency dealer. You cannot trade forex without the help of a broker. Going through a broker is different from buying currency through domestic banks or currency dealers, or when investing in foreign assets abroad.

4. Forex has no Physical Location

Forex refers to the simultaneous buying of one and selling of other currencies, referred to as a currency pair. Rather than physically owning the money, you exchange the values of the currencies online through a forex broker, which is done electronically. You open an account with the broker and use leverage to trade on margin. Forex is not performed at any physical location nor is there a centralized location, such as a stock exchange.

5. Forex is Riskier

Because you are trading currency on margin with forex, there are certain risks you take. Because you trade more money in currency than you really have, you can lose your investment quickly if you are not careful. On the other hand, those sorts of risks are not as acute when you buy physical currency, because the other currency with never lose all of its value.

How to Choose a Physical Exchange Provider

There are different things to consider when choosing a physical exchange provider.

1. How much are you willing to exchange and over how much time?

Exchange Tips For example, are you looking to make weekly transactions or just one lump sum? Travelers are often hesitant in taking large sums of cash when traveling, but do not want to deal with exchanging money when they get to their location or deal with changing exchange rates. Exchanging your money domestically if often more expensive than when you are in the foreign country, where you can get cash from ATMs and your hotel.

2. Commissions

Be wary of  “No Commissions”. If you decide to exchange some currency before you travel, and decide not to deal with banks, make sure to research exchange commissions. Rates very, and range from minimum charges, flat fees, to handling fees. Even though some companies claim they are “commission free” they make up for it by giving you a worse exchange rate.

3. Mark-ups in the Exchange Rate

Banks offer Better Rates Different physical currency exchangers, banks or other companies, offer different exchange rates. Banks usually offer not only similar exchange rates but also those that are better than exchange companies offer. Also, you can experience mark ups in the exchange rate when you use your credit card abroad, some banks charging 1-3% fees. Make sure to see what charges your bank or credit card company apply.

4. When to Exchange

When to Exchange The best way to know when to exchange is to do the research and planning well before you take your trip so you can follow the exchange rates and pick the best time to convert your money. In addition, in many countries they accept Dollars as readily as their own local currencies, especially in the Caribbean, and peg their own currencies to the dollar. It might be better to pay in dollars than spending money on exchange fees.

How to Choose a Forex Broker that is Right for You

It might seem more than a little overwhelming when trying to select the right broker when venturing into the foreign exchange currency market. Because you are likely, and it is desirable, to create a long-term trading relationship with your broker, here are some helpful tips and things to keep in mind when you begin your search:

1. Reputation

• Online Broker Reviews and Ratings
• Forex Reviews

A good place to start your search is stopping at online forex forums to see what other traders are saying about various brokers. A simple search engine query will give you many forums to choose. Reputation and trader satisfaction are likely good indicators of a sound broker. In addition, it doesn’t hurt to join email groups, mailing lists, and making contacts with others in the forum community. This way you can get referrals to a broker that’s right for you.

2. Experience

In addition to good word of mouth publicity, experience is a key. In addition to references and buzz from forums, experience, track record of success, speed of trading, and the amounts of advice given are important considerations.

3. Demo Account

You will likely want to start out with a practice, or demo, account, so make sure the potential broker offers an easy to use demo program that mimics their live software. A demo account allows you to make virtual trades with imaginary money to help you learn the ropes of trading before you ever risk money of your own.

4. Accessibility of Broker

Customer Service Make sure your broker is accessible to you via email and by phone. With the new internet age, proximity of location is less important than in the past, but make sure your potential broker can be easily reached for customer support. Are there other brokers around if yours is temporarily unavailable? Is the customer service friendly and approachable?

5. Leverage Desired

Consider what sort of leverage you desire when considering brokers. Leverage refers to ways investors utilize debt to increase profits on their investments, and in forex, it specifically refers to the ways brokers loan you money to invest on margin, to use the fluctuations in currency exchange rates between two different countries to enhance profits.

6. Trading on Margin

Margin Explained Specifically, trading on margin implies that you do not have to put up the full amount of money when investing. Margin refers to your deposit, and leverage the ratio of your investment. Once you open a margin account, standard brokers will offer you 50:1, 100:1, or 200:1, all depending on the risk you are willing to take and the size of the broker.

This means when if you want to trade $100,000 of currency on 100:1, or 1%, margin, you the investor need to deposit $1000 into the account. Because currency rates fluctuate only about 1% or so during intraday trading, it is not as risky of an investment as you think, but one should still take care. Leverage amplifies your losses as it does your earnings. A good broker will help you to limit losses.

Check to see whether the margin requirement changes for different currency pairs or on different days of the week.

7. Starting Capital

As stated above, connected with leverage is starting capital, or your margin. For a novice trader, many brokers offer “mini” forex accounts that require an initial $1000 deposit or under, or a standard account for about $2000. Many new traders, however, fail because they are undercapitalized. For a standard account, one should have $100,000 in starting capital, $10,000 for a mini account, and $1000 for a micro account. Compare what sort of accounts different brokers offer.

8. Transaction Costs and Trades per Day

How many trades can you make in one day? This depends a lot on how much money you have in your margin account and the amount of leverage you are using. Leverage is connected to your transaction costs, the price you pay to make trades. Be careful when considering high leverage trades, because even though you only need a fraction of the money down, the transaction price as a percentage of your account increases. Make sure to consider carefully the fees of different brokers.

9. Trading Hours

Forex trading hours are unique in trading markets in that they run from 5 pm EST on Sunday through 4 pm EST on Friday. The best times to trade are when the markets in London and the United States overlap, a five our window between 11:00 and 16:00 GMT, which is between 7 am and noon EST, when most trades are made. Is your broker readily available during this important trading window?

10. Regulations and Registration

It is important to keep in mind that while the forex market is unregulated, brokers themselves are. If you live in the US, make sure the broker is registered as a Futures Commission Merchant (FCM) with the Commodity Futures Trading Commission (CTC) and a member of the National Futures Association. The National Futures Association’s website can verify a broker’s status with the association. In addition, it is very important you make sure clients are insured against fraud and broker bankruptcy, just in case.

In today’s diversely complex and dynamically changing financial markets, it is no time to hedge your decision to hedge your portfolio, corporation or foreign assets from potential currency exchange fluctuations.

Simply put, a hedge is a protection or defense. http://www.merriam-webster.com/dictionary/hedge The verb “to hedge” evolved from the English and Continental European practice of protecting a parcel of property and limiting its size by planting a fence of the spiny Hawthorn bush or shrub, which secured its boundaries and limited the risk of property invasion or seizure. Today, this same concept is used by hedgers and hedge funds to hedge, or manage, secure and limit exposure to unforseen market and currency movements that are outside of their control. http://www.phrases.org.uk/meanings/hedge-your-bets.html

This basic concept of limiting exposure and protecting the value of a known commodity, such as a parcel of land, has been expanded and diversified into an entire market unto itself, with hedging used defensively, such as by an individual or corporation to protect, and offensively, such as by a hedge fund or speculator, to profit.

Offense vs. Defense

An example of a hedge being used offensively is a hedge fund, which is generally a privately-owned investment fund that utilizes various securities, derivatives and market speculation strategies to profit from perceived financial market or currency inefficiencies, while at the same time employing a layer of uncorrelated protection from adverse market fluctuations. While the strategies used are vast and intricate, the combined approach of profit and protection is generally referred to as arbitrage. Arbitrage trading can also employ a myriad of trading approaches, but in its most practical form, it is the selling and buying, or vice versa, of a currency or commodity contract for profit…the adage “Sell High, Buy Low”. To illustrate, a currency arbitrage trader might “short”, or sell, a borrowed Yen futures contract, with the understanding that it must be returned at a future time. The trader believes that the Yen will depreciate over time and the short position can be “covered” by the purchase of a Yen futures contract at a later date for a price less than for what it was sold. If the “short” was sold at $10, and was covered with a “long”, or purchase, at $8, the arbitrage trade resulted in a net gain of $2. The opposite arbitrage strategy would result in a long position, or purchase, of a Yen futures contract, with the expectation that the Yen will appreciate and will be offset by a short position, or sale, at a higher price at a future date. To illustrate, the long position is taken at $10, the Yen appreciates and is covered by a short position at $12, resulting in a net gain of $2.

The goal of an arbitrage trade is offensive and intended to profit from expected changes in valuation.*

*Source: “When Genius Failed The Rise and Fall of Long-Term Capital Management” by Robert Lowenstein

In contrast, the goal of a defense hedge is to protect the current value of something owned, or something contractually owed at a future date, where the exchange of two different currencies occurs. The difference in value between currencies is determined by the foreign exchange rate, generally referred to as the FX rate, which is used to calculate how much of one currency is required to exchange it for an equal value of another. For instance, if you were a US manufacturer, you would use US dollars, or your local currency, to run your business. If you contracted with a British company to deliver a product in the future, you would likely be paid in British pounds, or their local currency. The number of British pounds required to pay for the product, which is priced in US dollars, is determined by using the US dollar to Great Britain Pound exchange rate, otherwise stated as USD/GBP FX rate. Exchange rates are determined by a number of factors, including demand for a specific currency, political environments, local, regional and global market conditions, among others. As changes occur in these areas, the value of one currency relative to another also changes and is reflected in this rate.

The process of exchanging one thing for another is called conversion. For example, when you go through the McDonald’s drive-thru, the price paid to the cashier is converted into a Big Mac. If Big Macs suddenly became more valuable due to market changes outside of your control, such as a shortage of secret sauce or a government mandate that all citizens must eat at least one Big Mac per day, the perceived value of the Big Mac would increase and the exchange rate between the menu price and your wallet would rise, resulting in a higher price and more dollars will be needed to convert into a Big Mac.

The process is the same when converting currencies. In the earlier example, the US manufacturer would convert the pounds received as payment into dollars.

Herein lies the risk and the need for a defensive hedge.

For instance, if the USD/GBP FX rate today is 2.015, it would take $2.015 USD to equal the value of 1 GBP. If a US manufacturer enters into a contract to deliver 100 units to a British company in 30 days for the equivalent of $100 USD, the British company would agree to pay 49.628 GBP ($100/2.015) in 30 days. In this case, the US manufacturer incurs the risk that the GBP may depreciate, or decrease in value, when the units are delivered and payment is received in GBP.

If, in 30 days the USD/GBP FX rate depreciated to 2.001, it would now take $2.001 USD to equal the value of 1 GBP. The British company is contractually obligated to pay 49.628 GBP. When the US manufacturer receives payment in GBP, it must exchange that currency for USD using the current FX rate. In this case, the converted USD value of the same number of GBP 30 days later is worth only $99.30 (49.628*2.001), or a loss to the US manufacturer of seventy cents.

As protection from this scenario, the US manufacturer could defensively hedge using a futures contract. The first leg would be a short, or a selling position, of a GBP futures contract. In 30 days, the second leg would be a long, or a buying position, to offset the original futures contract. If the GBP depreciates, the loss on the conversion of the actual currencies can be made up with a gain on the futures contract. For instance, if the short position is sold for 2.010, and the long position is purchased for 2.001, the defensive hedge would result in a gain of 0.009.

A defensive hedge may result in a net gain, a net loss or a complete wash, but the goal is to minimize the potential impact of future changes in the FX rate.

Source: http://www.merriam-webster.com/dictionary/conversion

Source: http://wordnetweb.princeton.edu/perl/webwn

Source: Securities Trading Corporation, Series 3, National Comodity Futures Examination

To Hedge Or Not To Hedge…That Is The Question

Who needs to consider whether defensive hedging is a prudent and appropriate strategy? The answer is any individual or corporation that may be impacted by the market conditions and interest rate environment of foreign markets, either directly through investments, real estate holdings or commitments to deliver or accept a specified good at a future date, or indirectly through foreign suppliers.

A 2006 survey by a large North American foreign exchange provider, found that 80% of corporations surveyed acknowledged that their business operations and cash flow is impacted and exposed to currency fluctuations, yet only 42% of those same corporations currently employed a defensive currency hedging strategy to manage that risk. Makes you stop and think…

Using the MSCI EAFE Index (Morgan Stanley Capital International, Europe, Australia and Far East) as a proxy, following were it’s risk/return characteristics as measured from January 1980 to June 1999:

MSCI EAFE
Jan. 1980 to June 1999
Annualized Return (%)
Volatility (1)
Unhedged % USD

13.48%
17.52%

Hedged % US

13.51%
15.29%

(1) Volatility is the relative rate at which the price of a security moves up and down. Volatility is determined by calculating the annualized standard deviation of daily changes in price. If price moves up and down rapidly over a short period of time, it has high volatility, if the price almost never changes, it has low volatility. www.investorwords.com

This simple comparison of the same non-US index on a hedged and an unhedged basis represents the marginal difference between annualized return, but highlights the risk management opportunities when implementing a defensive hedging strategy.

Source: “Using Currency Futures To Hedge Currency Risk”, by Sayee Srinivasen and Steve Youngren, Chicago Mercantile, Inc.

Insulation From Currency Exposure

Many US individuals and corporations believe their operations and cash flows are insulated from FX fluctuations because they operate their business, both domestic and offshore, in their local currency. False…

Consider a US corporation that executes all foreign contracts in USD terms, honors all obligations with suppliers in USD and accepts only USD as payment. Unfortunately, that thermal underwear theory has some holes.

For instance, the same US corporation uses a US supplier, with all transactions conducted in USD. Seems straight forward…until you incorporate that the raw materials used by the US supplier are imported from China. As the market conditions in China change, the FX rate between the Chinese yuan and the USD also changes. If the yuan appreciates, it results in more USD to equal the value of 1 yuan, in turn making it more expensive for the US supplier to purchase the raw materials from China. That loss is then passed through to the US corporation by the supplier, who may increase prices or reduce service to recoup the increased expense of the raw materials. The result is reduced profit for the US manufacturer, driven by changes in FX rates not transparently obvious.

For individuals, the theory is the same. If a portfolio includes direct investments in stocks, bonds or real estate in foreign countries, market conditions and FX fluctuations impact the purchasing power of the USD, resulting in a negative, positive or passive affect on the portfolio return, investment goals and implementation strategy.

Arguments For And Against…A Two Sided Coin

One school of thought against using short-term defensive currency hedge as a risk management tool is referred to as the mean-reversion theory. This approach argues that over the long-term, prices and returns generally move back towards the mean, or the average. The assumption is that the average can be used as a proxy when developing a long-term financial plan or business strategy. While theoretically applicable, if short-term cash flows, budgets and investment income are a material component of managing a business or portfolio, significant short-term FX or market shifts can result in insolvency while waiting for the long-term smoothing effect. Additionally, what long-term is to one is not necessarily long-term to another, and as the old saying goes, markets can remain irrational longer than most speculators can remain solvent.

For individuals, most financial planners generally advise a buy and hold strategy. If an investor is truly in for the long-term, with the patience and stomach to ride out the ups and downs of foreign markets, with no short-term cash flow concerns, mean-reversion may be an appropriate strategy.

For investment vehicles like mutual funds, the investment team’s compensation and bonus structure is generally tied to the quarterly or annual performance of the fund. Particularly for actively managed international, global and regional funds, with the potential for high trade volume and portfolio turnover, incorporating the potential impact of FX and market fluctuations into the overall portfolio’s risk/return characteristics could materially impact the performance and risk profile of the fund.

Source: “Using Currency Futures To Hedge Currency Risk”, by Sayee Srinivasen and Steve Youngren, Chicago Mercantile, Inc.

The Process And Products Used

Once it is determined that a defensive hedge is prudent, a strategy must be crafted. This strategy, typically designed with the aid of an FX trading professional, incorporates the following:

• identify potential currency exposure
• detail hedging objectives and an implementation strategy, including appropriate hedging products, to attempt to mitigate currency exposure
• determine how, when and who is responsible for acting on the potential exposures
• evaluation of the results and adjusting as appropriate

There are a number of products and services available to implement an FX policy.

1. Forward Contract

A forward contract is the most straight forward currency hedging tool. It is an over-the-counter (OTC), or non-exchange traded contract, that allows the initiator to buy or sell at today’s market price, while delaying settlement to a future point in time. Adjustments, otherwise known as “forward points”, are applied to the spot rate to compensate for the interest rate differential between two currencies and the passage of time.

The OTC inter-bank operates based on credit limits for every counter-party, opening the contract initiator to counter-party risk. BIS (Bank for International Settlements), requires banks maintain adequate levels of capital to cover forward-maturing currency transaction risk. This is waived for FX transactions booked through exchanges, where performance bonds are required and daily mark-to-market of all open positions is done.

2. FX Futures Contract

A futures contract allows for the purchase and sale of a currency on a forward-date basis. The upside is that futures contracts are standardized, exchange traded, regulated products, traded in standard amounts by currency with only the most liquid currencies offered against the USD, and four pre-determined expiry dates per calendar year. The efficiency of the FX futures market allows for continuous evaluation of open positions, which are contracts where only the first leg is executed, and ease in making changes or adjustments as risk exposures change over time.

Benefits of exchange traded FX futures contracts over OTC include bringing buyers and sellers together to determine FX prices, with enhanced transparency in trading arrangements. Additionally, whether open outcry or electronic trading, prices are disseminated worldwide by sources such as Reuters, Bloomberg and others. Exchange traded contacts also use a clearing house as the counter-party to the contract, eliminating counter-party risk and the need to evaluate the credit worthiness of multiple counter-parties.

3. Currency Overlay

A currency overlay is a strategy that manages the overall currency exposure of the portfolio separately from the underlying assets. In addition to addressing the currency exposure embedded in the decision to hold a particular, existing asset, it also aids in making a future purchase in a country where there is concern about potential short-term appreciation in the foreign currency, reducing the purchasing power of the USD.

4. FX Swaps

An FX swap is the simultaneous purchase and resale of a foreign currency for different valuation dates. The “near-leg” is dated for the same day, tomorrow or a spot. The “far-leg” is booked for valuation in the future. The difference between the rates for the two dates only applies to forward points between the two specified dates. FX swaps are also used to smooth out short-term cash flow requirements for operations in foreign countries.

5. Non-Deliverable Forwards (NDF)

NDF’s are typically available and used in countries whose currency is controlled or restricted by the central government, such as China or India. In these types of government controlled markets, the actual exchange of currency is restricted to local, resident banks, while offshore entities are generally restricted from actually affecting local currency payments.

In the case of NDF’s, the foreign customer is typically unknowingly exposed to local currency risk even if not sending payment in the local currency due to the generally constant rate of appreciation relative the USD. This results in reduced purchasing power…it takes more USD to buy 1 unit of local currency…so the price increases are passed onto the foreign customer.

A NDF is a forward hedge that cannot be delivered upon. It is closed-out, or “fixed” at expiry, resulting in a marked-to-market gain or loss, which offsets the paper gain or loss that would be achieved if purchasers actually purchased the local currency from an offshore bank.

6. New, Exotic NDFs

Over the past several years, relatively new, “exotic” NDFs have become available, which combine the hedging characteristics of traditional NDFs with the ability to deliver local currency in restricted markets. The new contracts are not materially different from standard major currency forward contracts and provide corporate entities with a means to hedge currency risk and affect local currency payments to suppliers.

Sources: “Using Currency Futures To Hedge Currency Risk”, by Sayee Srinivasen and Steve Youngren, Chicago Mercantile, Inc. and “Foreign Exchange Risk Management” white paper, by Mark Frey, VP of FX Trading at Custom House www.customhouse.com

Choosing An FX Partner

When evaluating an FX partner, look for a range of products and flexibility to change or alter the strategy depending on the corporation or portfolio’s needs. Seek a provider that employs experts in the intricacies of how, when and in what combinations of products should be employed. Ensure that the FX provider is financially stable, with an accessible and knowledgeable customer service team. Look for an on-line platform that is accessible at any time to execute transactions and provide management reporting regarding transaction status and the ability to export the information to your financial software. Also evaluate security and compliance policies to ensure the safety, accuracy and timeliness of all transactions.

When implementing an FX trading strategy, there are generally three options for individuals and corporations:

• Bank
• Dedicated FX provider
• Investment Company

When making a decision about your FX partner, take into consideration that while a bank, financial institution or investment company can likely implement your FX strategy, they may also be constrained by traditional banking hours, the diversity of internal operations, and, in the event they use offensive, and/or leveraged hedging strategies with proprietary or corporate capital, managing their own positions may not allow for a dedicated team solely focused on the intricacies of defensive hedging. They may also be limited in their ability to execute a hedge and affect local currency payment in many developing countries.

Ensure that your FX partner deals routinely with large, commercial banks as opposed to only brokers and investment banks. Your FX partner should have a team of knowledgeable, expert and easily accessible FX professionals who can provide specialized advice and help you or your corporation maintain a stable market position and avoid speculators.

Sources: “Using Currency Futures To Hedge Currency Risk”, by Sayee Srinivasen and Steve Youngren, Chicago Mercantile, Inc. and “Foreign Exchange Risk Management” white paper, by Mark Frey, VP of FX Trading at Custom House www.customhouse.com

In A Nutshell

Simply put, a thoughtfully crafted, short-term defensive FX hedging strategy is similar to an insurance policy designed to protect an investment portfolio, foreign held assets or real estate, short-term cash flow projections and commitments to deliver, or accept delivery, when conversion from one currency into another is necessary. Rather than viewing FX hedging as a complex web of decisions, consider it within the same perspective as auto, homeowners or life insurance…everyday, practical tools used to protect the value of something from unforeseen or unavoidable conditions.

While initially it may seem overwhelming, FX hedging is really not that complex…take the time, understand the upside and downside risks, identify exposures, quantify the potential impact, and work with an experienced FX professional to craft a strategy to protect your portfolio or corporation from unintended and unexpected short-term currency fluctuations and foreign market risks.