Albert Einstein would have loved the forex market. It’s the one market where you are trading on relativity!
When you “buy” a currency on the foreign exchange you aren’t really “buying” anything. What you are doing is opening a contract in one currencies value relative to another.
The contracts on the forex are quoted in the value of one currency (the “quote”) relative to another (the “base”).
For example, the most actively traded currency pair is the Euro relative to the U.S. Dollar. The pair is listed as EUR/USD. In this case, the Euro is the quote currency. The U.S. Dollar is the base. So, you could look at EUR/USD quoted at 1.5929 as the Euro trading at 1.5929 US Dollars or it takes 1.5929 USD dollars to buy one Euro.
Most traders watch the economic fundamentals of the country underpinning each currency. They then look for the relative strengthening or weakening of one economy versus another. When they see one countries economy becoming stronger while another’s becoming weaker, they see the trade develop in favor of the stronger countries currency.
Here’s an example. The Australian economy has been very strong, recently because it’s economy is very much linked to the price of commodities – it is the largest exporter of gold. The demand for gold has been, and continues to be, on the increase by Chinese industry. India, too, is demanding more of the precious metal as their rising middle class is better able to afford the gold jewelry that Indian women have always desired. This has been a boon well for the Australian dollar for many reasons but one is that the Royal Bank of Australia – the Aussie equivalent of our Federal Reserve – has had to raise interest rates to keep the Australian economy from overheating and kicking off inflation.
At the same time that Australia has been raising their overnight rate, our Federal Reserve has been lowering ours. Therefore, you would expect to see a relatively stronger Australian Dollar with respect to the U.S. Dollar.
So, this is the trade. If you open a contract on the AUD/USD, you would do so in favor of the AUD. The other advantage of taking this position and another reason to expect increasing strength in favor of it is that you are paid interest every day that you hold the position. Yes, the interest differential between the two currencies gets deposited into your account every day that the market is opened!
A glance at the 5-year chart of the AUD/USD shows the trend.
This is the theory of relativity at work!