How does purchasing your own country's currency as part of a currency pair work?

Question

For instance, if the USD/JPY is trading at 99, how does a person who only holds U.S. dollars actually purchase the dollar?

For example, if someone in Japan decided to purchase a single USD for 99 yen, and then later sold their single USD for 100 yen, they will have profited one yen.

Now, how does this work for someone who doesn't originally own any yen, but wants to purchase USD?

I'm having trouble understanding what is going on when someone wants to long the USD against, say, the Japanese Yen, such as when they are longing the USD/JPY pair. What exactly is happening? How does such a trade work?

Answer 1

For instance, if the USD/JPY is trading at 99, how does a person who only holds U.S. dollars actually purchase the dollar?

I think this is a good question. I used to have this question myself once upon a time.

When you "buy" the USD/JPY, you're not converting your dollars to dollars. Even when you "buy" EUR/JPY, you're not converting dollars to euros.... what you're doing is borrowing yen and lending euros.

From http://www.dailyfx.com/forex/education/learn_forex/using_dailyfx/fundamentals/2010-01-19-2142-Understanding_Foreign_Exchange_Rollover.html

Rollover is the interest paid or earned for holding a currency spot position overnight. Each currency has an overnight interbank interest rate associated with it, and because forex is traded in pairs, every trade involves not only 2 different currencies but also two different interest rates. However, unlike what many traders think, foreign exchange rolls are not based on central bank rates. Instead, forex rolls are constructed using forward points which are mostly based on overnight interest rates at which banks borrow unsecured funds from other banks. After all, the foreign exchange market works over-the-counter. Market and spot trades need to be settled and rolled forward every day. If the interest rate on the currency you bought is higher than the interest rate of the currency you sold, you will earn a positive roll. If the interest rate on the currency you bought is lower than the interest rate on the currency you sold, then you will pay rollover.

Since interest is charged and paid, you don't buy or sell anything... you borrow and lend and the currency in your account is the collateral.

So it may be more correct to say when you "buy" the USD/JPY, you've borrow yen and lent dollars. More precisely, you've borrowed yen from an interbank, sold them for dollars, then lent the dollars to an interbank for an interest payment. The dollars in your account never move. Its just the collateral. To "buy" $1000 of USD/JPY, you need only have $20 in your account. $30 for the EUR/JPY. Why bother to convert $30 on such margin?

If you really wanted to convert your dollars to euros, you'd have to go to europe or find a bank that can make the exchange, or a private party willing to swap. Since you've taken possession of euros and haven't lent them out, you won't get paid an interest rate for holding the euros. You also won't get charged an interest rate for borrowing dollars, since you didn't borrow them, you owned them outright in the beginning.

Of course, if you wanted to find a US bank to loan you dollars, then fly to europe and convert your dollars to euros, then find someone looking to borrow euros,,, you could accomplish the same thing a forex account does by simply buying EUR/USD. In the meantime, you have nothing in your hand but an obligation to pay interest to the US bank and the expectation of an interest payment from the person who borrowed the euros from you. To close the trade, you'd have to demand full payment from the one who borrowed your euros, convert back to dollars, then pay the loan at the US bank.

Answer 2

The currency market is the most liquid and mature securities market on the planet as a result of its relative age. To that end, brokerages have automated this trading process for their clients.

To long one's own currency vs another currency, one only need to enter the proper trade. In a forex account, the distinction of one's home currency is largely lost.

As with any currency, to long a currency thus short another, a trader simply borrows the shorted currency much like with a more commonly known short stock sale and simultaneously sells it to buy the long currency all while posting a margin in excess of the loan.

As with equities, the forex market has benefited significantly from electronic trading and algorithmic market makers with collapsing round lot sizes and spreads, typically 1/2 pip and lower for larger traders and specialized brokers/exchanges. Odd lot exchanges have arisen providing trading for any size below the current conventional round lot minimum of ~$25,000, albeit for a higher minimum spread.

While one can use derivatives to trade forex, the most liquid trade is the spot market using the process described above. Because of the relative stability in the large currencies for the past few decades relative to the century before, margin rates for forex are the largest publicly available.

Indeed, a trader does pay interest on shorted currency while receiving interest on the longed currency, explaining the appeal of the so-called "carry trade", where a trader shorts a currency with lower borrowing costs to benefit from the higher interest rate of the longed currency.

---

Example Trade

In the case longing USD against JPY, a trader would select the relevant currency pair but must be careful to select the correct one since currency pairs are structured both ways to a trader for convenience, such as USDxJPY to long JPY against USD and JPYxUSD to long USD against JPY. For more flexibility, the broker allows a trader to long or short either pair, but at root there are only two transactions for the four presented: borrow USD to buy JPY or borrow JPY to buy USD.

The convention is usually to present the selling currency first, then a symbol, then the buying currency, and finally the numerical fraction only of the buying currency divided by the selling currency, but brokers may use any convention they wish and regulation can vary by jurisdiction.

To enter a long USD/short JPY trade, a trader would look for the long USD/short JPY pair and buy to open. So long as the trader has the required margin, the trade will post like any other common order on the relevant exchange, and the broker will provide the sufficient borrowed funds. To close it, the trader could select the same pair and sell to close. If a brokerage approves of shorting against the box, a trader could perfectly hedge the position by buying to open the opposite currency pair.