Currency Trader Basics – Part 2
Its important, as far as currency trader basics, to remember that yield drives return.
Yield and Return
In a Forex spot market trade, you actually buy and sell two underlying currencies. As all currencies are paired in quotes, each currency has its value related to another. If EUR/USD is quoted at 1.3600 it will take $1.36 to buy one euro.
With all foreign exchange transactions, you simultaneously buy one currency and sell another in effect, using the proceeds gained from the currency sold to purchase currency you are now buying. Moreover, every world currency comes attached with the interest rate established by the central bank of that currency’s country. Of course, you are obliged to pay the set interest on any currency you have sold, however, you retain the privilege to earn the interest on currency you have bought.
For illustration, let’s examine the NZD/JPY pairing. We’ll assume New Zealand currently has an 8% interest rate and Japan has a 0.5% interest rate. The currency market’s interest rates reach their calculation in basis points – each basis point being equal to 1/100th of one percent. In this case then, NZ rates equal 800 basis points, the Japanese rates equal 50 basis points. Choosing to go long on NZD/JPY will earn you 8% in the calculated annualized interest, but still have to pay the 0.50% for the currency sold, giving a net return of 750 basis points or 7.5%.
Leveraging Returns
Tremendous leverage is one of the features the Forex market offers – often up to 100:1 – meaning you could control a whopping $10,000 worth of assets using only $100 of capital. Leverage can however, be the double-edged sword that creates massive profits when correct or generates huge losses when wrong.
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