Updated: Aug 17, 2021
The forex market is the largest financial market in the world. It is open 24/7 and as such, exchange rates are constantly changing. An exchange rate shows how much a sum of money is worth in a foreign currency.
How Foreign Exchange Works
There are essentially two foreign exchange markets:
Retail/Cash Market (i.e. money used for smaller, shorter term needs (e.g. tourism)
Specialist currency providers (mostly at Airports and tourist hotpots)
Commissions are common
Specialist providers (e.g. TransferWise, OFX, AFEX)
Where people move much larger denominations from one country to another
What is the Interbank Rate & The Importance of the Spread
The “interbank rate” refers to the foreign exchange rate paid by banks when trading currencies with other banks. It also happens to be the lowest rate available at any particular time, and it is reserved specifically for large banking institutions. Individual forex transactions have a “spread” built in. The “spread” is the difference between the forex rate you pay and the interbank rate. Foreign exchange providers make money off the spread and/or by charging a commission. The lower the spread, the more cost-efficient the conversion.
Fig 1.0 - The Spread on the AUD vs USD (July 2, 2020)
What is Meant by the Strength of a Currency?
The strength of a currency is the value of a currency compared to a basket of other currencies (e.g. US Dollar Index DXY). But, for foreign exchange transactions, we only care about the pairwise relationship to a particular currency (e.g. AUD/USD).
What makes a currency strong? → ‘demand’ for that currency is driven by:
The country’s central bank interest rates relative to others. A higher interest rate vs another country may make it more attractive to hold savings in that currency (referred to as ‘the carry trade.’)
Inflation, government debt, and political and economic stability.
Key Exports - E.g. Australia is a major exporter of iron ore and coal, the AUD/USD pair is also affected by how these commodities are valued. If their value drops, so does the Australian dollar.
A Well-Considered Foreign Exchange Strategy
Familiarity Familiarise yourself with the particular foreign exchange rate you’re interested in over the last ~24-36 months.
Clarity on Departure Date and Short Term Goals Being clear on a client’s departure/arrival date and short term funding requirements upon arriving (e.g. buying a car, rental deposit). This will inform the decision as to how much money is needed upon arrival.
Timeframe of Medium-Term Goals Know the timeframe over which you need your funds available in your foreign currency (e.g. 1 - 3 years, etc) to achieve medium-term goals (e.g. buying a house). This may also influence your conversion frequency, especially when considering investment alternatives. See our white-paper on ‘The Pros And Cons Of Managed Funds For Expat Investors’
Understand Drivers and Form a View What differences are there in each country’s prospective central bank interest rates (i.e. what policy guidance are the central banks offering)? What differing short/medium economic prospects are there?
Establish a Periodic Transfer Schedule With an eye what an attractive conversion rate would be, set up a plan for periodic transfers to mitigate your exposure to the spot price. Typically, we would recommend quarterly conversions over a two year period for a total of 8 conversions. These conversions need not necessarily be of an equal amount, rather we would try to convert slightly more than an equal amount when the rate is favourable and slightly less when it is not.
Venue for Exchange Choose the appropriate venue for exchange to get the best spread. For clients performing a limited number of transfers and/or not requiring ongoing investment management services, we would recommend an institutional conversion service such as TransferWise, OFX, and AFEX (as seen in Fig 1.0 above). For clients transferring larger sums who would also benefit from an ongoing multi-currency brokerage account, we recommend Interactive Brokers.
Limit Orders A limit order is a type of order that executes a trade only if the ‘limit’ value is reached. One super-simple and free risk management technique is to use limit orders to avoid your trade executing a rate you’re uncomfortable with or to set your price at a level you feel is likely to be reached without the need for you to be present and continually monitoring.
Risk Management Investigate whether active currency risk management strategies (forwards, option strategies) might be appropriate. Speak with a dedicated foreign exchange dealer for more insight on these strategies.