FX is a financial transaction in which different currencies are bought and sold with the aim of earning profits from fluctuations in exchange rates, swap points, and other factors.
For example, in USD/JPY, which involves trading the U.S. dollar and Japanese yen, profits or losses arise depending on whether the U.S. dollar rises or falls in value against the yen.
In FX, there is a system called “leverage,” which allows you to trade an amount larger than the funds you have actually deposited by providing margin.
Therefore, relatively large transactions can be made with a small amount of funds, but if the foreign exchange market moves in the opposite direction from what was expected, losses may also become large.
In addition, in FX, “swap points” may be received or paid based on factors such as the interest rate differential between currencies.
This article organizes the basics of what FX is, currency pairs, spreads, swap points, leverage, margin maintenance ratio, forced liquidation, the mechanism by which swaps arise from interest rate differentials, and the differences between FX and foreign currency deposits as a foundation for learning about asset management.
Note:
This article is a personal study note for learning about FX and asset management. It does not recommend any particular currency, FX company, financial institution, trading method, or the like. Exchange rates, spreads, swap points, required margin, forced liquidation conditions, and other factors may change depending on FX companies and market conditions. When actually trading, check the latest information published by the Financial Services Agency, the Financial Futures Association of Japan, individual FX companies, and other relevant organizations.
- What Is FX?
- In FX, You Can Trade Not Only by “Buying” but Also by “Selling” First
- What Is a Currency Pair?
- How Profits Are Generated in FX
- What Is a Spread?
- What Are Swap Points?
- Why Do Swap Points Arise from Interest Rate Differentials?
- Receiving Swap Points Does Not Necessarily Mean You Are Making a Profit
- What Is Leverage?
- What Happens When Leverage Is High?
- What Is Required Margin?
- What Is the Margin Maintenance Ratio?
- What Is Forced Liquidation?
- Forced Liquidation and Stop-Loss Selling Are Different
- Main Factors Related to FX Profits and Losses
- Differences Between FX and Foreign Currency Deposits
- FX Has a Different Mechanism from Foreign Currency Deposits, in Which Foreign Currency Is Actually Held
- FX and Foreign Currency Deposits Also Differ in How Interest Is Received
- Items to Check in FX
- Do Not Choose a Currency Based Only on High Swap Points
- Foreign Exchange Risk Does Not Disappear Even with Low Leverage
- FX Also Has Risks
- Differences Between FX and Stocks
- Summary
- References
What Is FX?
FX is a term used as an abbreviation for Foreign Exchange and generally refers to “foreign exchange margin trading” in Japan.
It involves buying and selling combinations of currencies from different countries with the aim of earning profits from price differences caused by fluctuations in exchange rates and other factors.
Example:
If you buy U.S. dollars when 1 dollar is ¥150 and then sell them after the rate rises to ¥160 per dollar, a capital gain of ¥10 per dollar occurs in a simplified example.
Conversely, if U.S. dollars purchased at ¥150 per dollar are settled after the rate falls to ¥140, a loss of ¥10 per dollar occurs.
In FX, You Can Trade Not Only by “Buying” but Also by “Selling” First
In FX, you can not only buy a currency and then sell it, but also sell first and buy it back later.
Concept:
If you begin a trade by selling USD/JPY at ¥150 and then buy it back after it falls to ¥140, the price difference becomes a profit in a simplified example.
Therefore, you can trade not only when you expect the foreign exchange market to rise, but also when you expect it to fall.
What Is a Currency Pair?
In FX, you do not trade a single currency by itself, but rather trade a combination of two currencies.
This combination is called a “currency pair.”
Representative currency pairs include the following.
- U.S. Dollar / Japanese Yen (USD/JPY)
- Euro / Japanese Yen (EUR/JPY)
- British Pound / Japanese Yen (GBP/JPY)
- Australian Dollar / Japanese Yen (AUD/JPY)
- Euro / U.S. Dollar (EUR/USD)
- U.S. Dollar / Swiss Franc (USD/CHF)
The Left and Right Sides of a Currency Pair
In a currency pair, the currency on the left and the currency on the right have different meanings.
Example:
If USD/JPY is ¥150, it means that 1 U.S. dollar is worth ¥150.
If USD/JPY rises from ¥150 to ¥160, this can be understood as the U.S. dollar strengthening against the Japanese yen, or the Japanese yen weakening against the U.S. dollar.
Conversely, if it falls from ¥150 to ¥140, this can be understood as the U.S. dollar weakening against the Japanese yen, or the Japanese yen strengthening against the U.S. dollar.
How Profits Are Generated in FX
There are mainly two types of profits that can arise in FX.
- Foreign exchange gains from fluctuations in exchange rates
- Swap points resulting from factors such as interest rate differentials between currencies
However, neither of these necessarily results in a profit.
If the foreign exchange market moves in the opposite direction from what was expected, a foreign exchange loss occurs, and swap points may also become payments depending on the direction of the trade and the interest rate environment.
What Is a Spread?
In FX, the price at which a currency is bought and the price at which it is sold are usually different.
The difference between the buying price and selling price is called the “spread.”
Example:
Suppose the USD/JPY selling price is ¥150.000 and the buying price is ¥150.002.
In this case, the difference between the selling price and buying price is ¥0.002, or 0.2 sen.
In FX, immediately after opening a position, the basic idea is that you have an unrealized loss equal to the spread.
The Spread Becomes an Effective Trading Cost
The narrower the spread, the smaller the difference between the selling price and buying price.
Especially when trading many times over a short period, the size of the spread can have a large effect on trading results.
However, the spread is not always constant.
The spread may widen when economic indicators are released, when important news appears, during periods with few market participants, or when the market moves sharply.
What Are Swap Points?
Swap points are amounts received or paid based on factors such as the interest rate differential between two currencies when trading them in FX.
In general, when selling a low-interest-rate currency and buying a high-interest-rate currency, you may be able to receive swap points.
Conversely, when selling a high-interest-rate currency and buying a low-interest-rate currency, you may have to pay swap points.
Concept:
If the interest rate of Currency A is high and the interest rate of Currency B is low, a position that buys Currency A and sells Currency B may generate positive swap points based on the interest rate differential.
Swap Points Are Not Fixed
Swap points do not remain at the same amount once they have been set.
They change depending on factors such as each country’s policy interest rate, short-term money market rates, conditions in the foreign exchange market, and settings determined by FX companies.
Even with a currency pair that previously generated swap receipts, changes in the interest rate environment may reduce the amount received or, in some cases, change it into a payment.
Why Do Swap Points Arise from Interest Rate Differentials?
In FX, transactions involve exchanging two currencies simultaneously.
Therefore, when the interest rates of the two currencies differ, the interest rate differential must be adjusted.
Simplified Example:
Suppose Currency A has an interest rate of 5% and Currency B has an interest rate of 1%.
In a transaction that sells Currency B and buys Currency A, the interest rate differential is 4%.
In FX, swap points are calculated based on factors such as this interest rate differential between currencies.
However, this does not mean that “the difference between policy interest rates directly becomes the swap points.”
Actual swap points are also affected by short-term market interest rates, supply and demand, adjustments by FX companies, and other factors.
Receiving Swap Points Does Not Necessarily Mean You Are Making a Profit
Even if swap points are positive every day, if losses caused by a decline in the exchange rate exceed them, the overall result will be a loss.
Example:
Even if you receive ¥30,000 per year in swap points, if an unrealized loss of ¥100,000 occurs because of exchange rate fluctuations, the overall result is a loss of ¥70,000 in a simplified example.
Therefore, it is necessary to consider not only swap points but also exchange rate fluctuations.
What Is Leverage?
Leverage is a mechanism that allows you to use margin to trade an amount larger than the funds you have deposited.
Example:
If you have ¥1 million in funds and are trading ¥1 million worth, the leverage is 1x in a simplified calculation.
If you have ¥1 million in funds and are trading ¥5 million worth, the leverage is 5x in a simplified calculation.
Leverage for Domestic Retail FX
In domestic over-the-counter FX for individual customers in Japan, it is necessary to deposit and maintain margin equal to at least 4% of the transaction amount.
In terms of leverage, this corresponds to a maximum of 25x.
However, being able to trade at up to 25x leverage and trading safely at 25x leverage are separate matters.
What Happens When Leverage Is High?
Increasing leverage allows you to make large transactions with a small amount of funds.
On the other hand, even small exchange rate movements can result in large profits or losses relative to your own funds.
Example:
If you compare trading ¥1 million worth with ¥1 million in funds and trading ¥10 million worth with the same ¥1 million in funds, the amount of profit or loss from the same 1% exchange rate movement differs greatly.
If a ¥1 million position moves by 1%, the change is approximately ¥10,000 in a simplified calculation.
If a ¥10 million position moves by 1%, the change is approximately ¥100,000 in a simplified calculation.
What Is Required Margin?
Required margin is the amount of margin necessary to hold an FX position.
The method of calculating and displaying required margin may differ depending on the FX company.
Required margin may also change as exchange rates fluctuate.
What Is the Margin Maintenance Ratio?
The margin maintenance ratio is an indicator used to see how much effective margin is currently available relative to the margin required for the positions being held.
Basic Concept:
Margin Maintenance Ratio = Effective Margin ÷ Required Margin × 100
In general, the higher the margin maintenance ratio, the more financial room you have relative to the required margin.
As unrealized losses increase, effective margin decreases, so the margin maintenance ratio also falls.
Example:
If the required margin is ¥100,000 and the effective margin is ¥1 million, the margin maintenance ratio is 1,000% in a simplified calculation.
If the effective margin falls to ¥500,000 because of unrealized losses or other factors, while the required margin remains ¥100,000, the margin maintenance ratio becomes 500%.
A High Margin Maintenance Ratio Does Not Guarantee Absolute Safety
In general, the higher the margin maintenance ratio, the greater the margin before reaching the forced liquidation level.
However, if the foreign exchange market moves sharply, unrealized losses may increase significantly in a short period.
In addition, the method of calculating required margin and the conditions for forced liquidation may differ depending on the FX company.
What Is Forced Liquidation?
Forced liquidation is a mechanism in which an FX company forcibly closes positions when losses from FX trading expand to a certain level in order to prevent further increases in losses.
FX companies settle positions according to their predetermined forced liquidation rules.
The margin maintenance ratio and other criteria used as the basis for forced liquidation differ depending on the FX company.
Concept:
If the foreign exchange market moves in the opposite direction from what was expected and unrealized losses increase, effective margin decreases.
As a result, if the margin maintenance ratio falls to the forced liquidation level set by the FX company, the position may be forcibly closed.
Forced Liquidation Does Not Necessarily Limit Losses
Forced liquidation is a mechanism designed to prevent losses from expanding, but it does not guarantee that a position will always be closed at the specified price.
If the market moves sharply or market liquidity declines significantly, the order may be executed at a price beyond the forced liquidation level.
As a result, losses greater than expected may occur.
Forced Liquidation and Stop-Loss Selling Are Different
Forced liquidation and stop-loss selling carried out by the investor are different.
| Item | Stop-Loss | Forced Liquidation |
|---|---|---|
| Party That Closes the Position | Investor | FX company |
| Purpose | To limit losses within a certain range by your own decision | To limit the expansion of losses beyond a certain level |
| Timing | Determined by the investor | Based on the FX company’s rules |
Main Factors Related to FX Profits and Losses
When considering profits and losses in FX, it is necessary to check not only exchange rates but also the following factors.
- Foreign exchange gains and losses
- Swap points
- Spread
- Trading fees, if any
- Leverage
- Required margin
- Margin maintenance ratio
- Forced liquidation conditions
Differences Between FX and Foreign Currency Deposits
FX and foreign currency deposits are both financial products related to foreign currencies, but their mechanisms differ significantly.
| Item | FX | Foreign Currency Deposits |
|---|---|---|
| Basic Mechanism | Deposit margin and trade currencies | Exchange yen or another currency into a foreign currency and deposit it |
| Leverage | Available | Basically not used |
| Trading by Selling First | Possible | Basically not done |
| Returns Related to Interest Rates | Swap points | Deposit interest |
| Exchange Rate Fluctuations | Affect profits and losses | Affect the value when converted into yen |
| Main Trading Costs | Spreads, etc. | Foreign exchange fees, etc. |
| Forced Liquidation | Yes | Normally none |
| Deposit Insurance System | Not a deposit | Foreign currency deposits are not covered by the deposit insurance system |
FX Has a Different Mechanism from Foreign Currency Deposits, in Which Foreign Currency Is Actually Held
With foreign currency deposits, the basic approach is to exchange yen into U.S. dollars or another foreign currency and deposit the foreign currency with a bank.
FX is a margin transaction in which margin is deposited and currencies are bought and sold.
Therefore, even when using the same USD/JPY price movements, the way funds are used and the method of risk management differ.
FX and Foreign Currency Deposits Also Differ in How Interest Is Received
With foreign currency deposits, you receive the deposit interest rate set for the foreign currency you have deposited.
In FX, swap points are received or paid based on factors such as the interest rate differential between two currencies.
Therefore, this does not mean that “because it is a high-interest-rate currency, you can receive the same interest rate directly in FX.”
Items to Check in FX
When considering FX trading, it is important to check the following items rather than looking only at exchange rates or swap points.
- Currency pair
- Current exchange rate
- Spread
- Buy swap
- Sell swap
- Trade size
- Required margin
- Effective leverage
- Margin maintenance ratio
- Forced liquidation level
- Policy interest rates
- Economic indicators
- Range of foreign exchange market fluctuations
Do Not Choose a Currency Based Only on High Swap Points
Currency pairs with high swap points may provide large swap income when held for a long period.
However, high-interest-rate currencies may also experience large exchange rate fluctuations.
Losses caused by declines in exchange rates may exceed profits from swap points.
In addition, future swap points may decrease due to policy interest rate cuts and other factors.
Foreign Exchange Risk Does Not Disappear Even with Low Leverage
Lowering leverage can reduce the size of a position relative to your own funds.
Therefore, in general, it is easier to maintain more financial room against exchange rate fluctuations than with high leverage.
However, even with low leverage, the risk that exchange rates themselves will fluctuate remains.
Lowering leverage does not eliminate exchange rate fluctuations; rather, it is a way of reducing the impact that exchange rate fluctuations have on your own funds.
FX Also Has Risks
While FX offers the possibility of earning foreign exchange gains and swap points, it also involves various risks.
- Foreign exchange fluctuation risk
- Expansion of losses due to leverage
- Forced liquidation through the forced liquidation system
- Slippage during sudden market movements
- Widening spreads
- Reduction or reversal of swap points
- Changes in interest rate policy
- Decline in liquidity
- Political and economic risks associated with foreign currencies
Differences Between FX and Stocks
FX and stocks can both be used to seek profits from price fluctuations, but the assets being traded and the mechanisms involved are different.
| Item | FX | Stocks |
|---|---|---|
| Main Trading Asset | Currencies | Company shares |
| Price | Exchange ratio between two currencies | Company stock price |
| Interest / Dividends | Swap points | Dividends |
| Leverage | Available | Basically not used in cash trading |
| Trading by Selling First | Possible | Possible through margin trading and other methods |
| Forced Liquidation | Yes, because it is margin trading | Normally none in cash trading |
Summary
FX is foreign exchange margin trading in which two different currencies are combined and bought and sold.
In FX, there is a possibility of earning profits from foreign exchange gains caused by exchange rate fluctuations and from swap points based on factors such as interest rate differentials between currencies.
On the other hand, if the foreign exchange market moves in the opposite direction from what was expected, foreign exchange losses occur.
Because FX allows leveraged trading using margin, you can trade amounts larger than your own funds, but the higher the leverage, the larger the profits and losses relative to your own funds.
The margin maintenance ratio is an indicator used to see how much financial room remains relative to the required margin, and it falls as unrealized losses increase.
If the margin maintenance ratio or other indicators fall to the level set by the FX company, positions may be forcibly closed through forced liquidation.
In addition, swap points do not simply equal the difference between policy interest rates, but are determined by factors such as interest rate differentials, short-term market interest rates, supply and demand, and FX company settings.
Foreign currency deposits and FX are both related to foreign currencies, but foreign currency deposits involve depositing foreign currency, while FX involves trading currencies using margin.
When considering FX, rather than looking at only one factor such as “swap points are high” or “the exchange rate looks likely to rise,” it is important to check a combination of factors such as the currency pair, exchange rate fluctuations, spread, swap points, leverage, required margin, margin maintenance ratio, and forced liquidation conditions.
References
