Hi friends, today we're going big!
We're going to talk about what I think is the most complex and interesting market in economics: Foreign Exchange, or Forex.
You might be wondering:
- Why does the Japanese yen keep depreciating?
- Can someone manipulate the foreign exchange market?
- Why did the Turkish lira collapse?
- What is the future of the US dollar and the Chinese yuan?
I've always wanted to talk about Forex, but I've been hesitant to touch it. I'm telling you, it's even more complex and troublesome than the topics of interest rates and inflation that we've talked about before.
But since I, Xiaolin, have already decided to open this can of worms, I'll try my best to explain this complicated thing clearly. We'll try to cover the theoretical knowledge, make it interesting, use real-world examples, and even relate it to bubble tea shops! So, whether you find it exciting or not, I can't guarantee, but I can tell you the value here is undeniable.
If you really don't want to watch, at least give us a like and add it to your favorites before you go!
Foreign Exchange Market
The Foreign Exchange Market is generally abbreviated as Forex, or even further simplified to FX.
To understand its importance, just look at the trading volume. For example, the Shanghai Stock Exchange, when performing well, can see daily trading volume exceeding 1 trillion yuan, which is about 140 billion US dollars. This is already a huge market.
The world's highest volume stock exchanges, Nasdaq and the New York Stock Exchange, have a combined daily trading volume of over 300 billion US dollars. Do you know how much the daily trading volume of the foreign exchange market is?
7.5 trillion US dollars! That's about 15 times the combined volume of the US stock market and the Shanghai Stock Exchange. So, it is undoubtedly the market with the largest trading volume of all financial products in the world.
Let's start with the basics. Let's first talk about the basic understanding of exchange rates.
Within each country, most tradable products, such as stocks at 52 yuan per share or a watermelon at the supermarket for 10 yuan, are all priced in the local currency. The currency within this country is equivalent to a ruler, a common equivalent.
The foreign exchange market is an exchange between different rulers. Every two currencies have their own trading ratio. For example, how many US dollars can one euro be exchanged for? How many Japanese yen can one US dollar be exchanged for? It's actually similar to the most primitive barter system, like how many bags of rice a leg of lamb can be exchanged for. They are all one-to-one like this.
Therefore, Forex traders must be very clear when communicating. For example, if the Japanese yen rises, are you referring to the Japanese yen rising against the US dollar or the US dollar rising against the Japanese yen? These are completely opposite.
Generally, the industry standard is to represent each currency with three letters. For example, the most common ones are USD for US dollars, EUR for euros, GBP for British pounds, and JPY for Japanese yen. The Chinese yuan is special here. It's not RMB. There's an onshore yuan, CNY, and an offshore yuan, CNH. We'll leave the specific differences aside for now.
For example, if EUR/USD is 1.07, that means one euro is equal to 1.07 US dollars.
Let's take another simple example of a foreign exchange transaction. Suppose you buy 10,000 USD/JPY at a price of 160. What you're essentially doing is buying 10,000 US dollars and selling 1.6 million Japanese yen at the same time. If you don't have the 1.6 million yen, the intermediary investment bank or brokerage firm will usually lend it to you. From then on, you will continue to receive interest on the US dollar and will have to pay interest on the borrowed yen.
If the US dollar rises by 0.01, which is called a "pip" in professional terms, you can exchange it back for 1,600,100 yen when you sell it, making a net profit of 100 yen. This is the basic logic of a foreign exchange transaction.
This example aims to help you deeply understand that a foreign exchange transaction is an exchange between two currencies.
Of course, this is a one-dimensional understanding of exchange rates. We will elevate it to a two-dimensional space later. Let's dive deeper.
Do you know what makes Forex so troublesome and complicated? It's that there are too many participants, making it difficult to analyze.
Think about it. On a macro level, it's linked to the economies of various countries. On a micro level, it's connected to various market players.
You need to exchange foreign currency when traveling abroad. Central banks need to adjust foreign exchange to regulate the economy. Evergrande needs to trade foreign exchange to borrow foreign debt. George Soros's financial attacks also target foreign exchange.
As you can see, it's connected to every corner of the economy, covering every type of market participant. So next, let's take a look at how these major players in the foreign exchange market play the game.
This is Euromoney's ranking of the world's largest foreign exchange market traders in 2022. You see Deutsche Bank, JPMorgan Chase, UBS – the top ten are either investment banks or brokerage firms. They all fall under the first category of players we want to talk about in the foreign exchange market: market makers. They provide liquidity to the market.
You see those Wall Street movies where traders are calling the shots and making crazy trades? Ultimately, they're acting as market makers.
Speaking of which, we need to introduce a very important characteristic of the foreign exchange market. To borrow a term frequently used in blockchain, it's decentralized.
Have you ever wondered where the foreign exchange market is centrally traded? Is it on the New York Stock Exchange, major banks, or airports? In fact, there's no centralized trading venue. You can trade anywhere.
Take stocks, for example. They have a centralized trading venue. For example, let's say Xiaolin's bubble tea shop is listed on Nasdaq. After that, if you want to buy Xiaolin bubble tea shop stock, no matter which broker you go through, you have to trade on Nasdaq in the end. You can't just text me privately and say, "Xiaolin, can you sell me some stock?" I can't say yes, and then we'll make a private deal. That's not allowed, except in very special circumstances. You can't bypass Nasdaq.
But Forex is different. It doesn't have an absolutely authoritative central institution. Whether you give me 100 US dollars privately and I give you 700 yuan, or you go to a bank or an airport to exchange foreign currency, or banks trade foreign exchange among themselves, or central banks trade foreign exchange with banks – these are all possible.
Broadly speaking, what we just mentioned are all small-scale foreign exchange transactions.
Don't you think this is a bit like a used car market? Anyone can trade privately without certification.
Of course, for the convenience of everyone trading, the market will spontaneously form some kind of used car trading platform. The same goes for foreign exchange. It will also form these so-called secondary trading platforms, which are the market makers we mentioned earlier – the major investment banks and brokerage firms.
Almost all players in the entire economy, whether they are companies like Apple, Microsoft, or Tencent, or central banks, generally do not directly participate in the global foreign exchange market. They all find an intermediary, like a major investment bank.
For example, a company might approach JPMorgan Chase and say, "I have 10 million Lebanese pounds that I want to exchange for US dollars." JPMorgan Chase gives them a quote and says, "That's worth 100 US dollars." Deal, it's done.
Then, these ten or twenty largest intermediaries like JPMorgan Chase, with their huge balance sheets and risk control capabilities, will trade and hedge among themselves, forming a foreign exchange trading market with a small number of participants but a huge volume. That's why their trading volume is so large.
Currently, the world's most important foreign exchange trading center is London, followed by the United States, Singapore, and Hong Kong.
It's precisely because of the decentralized nature of the foreign exchange market that it has the advantage of being very free. You want to trade? Trade as much as you want! Five days a week, 24 hours a day, it's non-stop trading with almost no restrictions.
Look at the stock market with its closing times, circuit breakers, trading halts, and even meltdowns. The foreign exchange market has none of that. Even if the sky falls, it will continue to trade. Even if it crashes, no one can stop it.
At the same time, decentralization also means another important feature of the foreign exchange market: relatively loose regulation. For example, if you have some inside information that could affect the market, you're relatively free to act on it.
Why do you think George Soros chose the foreign exchange market as his main battlefield for attack? On the one hand, this market is indeed large enough. Another important reason is its relatively loose regulation. If you attack a country's stock or bond market, once the government is pressed, the market will be closed directly, or a policy will be introduced immediately to prohibit you from trading.
But the foreign exchange market is different. You can scold me, but you can't control me.
What Soros did was legal and compliant. However, some things are not necessarily so. With such a large trading volume in the foreign exchange market concentrated in the hands of a few market makers, whose trading volume accounts for more than one-third of the global foreign exchange market, it's very easy to hide dirt.
For example, I don't know if you remember the huge fine that shook Wall Street in 2014. Ten billion, 10 billion US dollars! The penalty was for a group of Wall Street foreign exchange traders.
Let's see what they did. Actually, it's very simple and crude. These foreign exchange traders from different investment banks would have some group chats, maybe on Bloomberg, maybe on their phones.
Note that these are traders from different investment banks. And I'm telling you, the names of these group chats are incredibly arrogant, like "The Mafia," "The Bandits' Club," and "The Cartel." You just know they're not good people when you hear them.
And what they want to manipulate and influence is a very important price in the foreign exchange market called the fixing. That is, the average price calculated from the trading volume one minute before and after 4 p.m. London time every day. It's kind of like the closing price in the stock market. A large number of global transactions and derivative product pricing are based on this fixing price, so it's actually very important.
Then, these investment bank traders would chat in their Mafia group every day and say, "Let's work together to push up the price of the euro today." Then, around 4 p.m. London time, they would only execute client orders to buy euros, working together to push up the euro's price. It's that simple and crude.
Note that this didn't just happen once or twice. It was an isolated case. They did this for seven years and no one noticed. Even later, they may have gotten used to it, thinking that the market should belong to them.
That's how the final historic fine of 10 billion US dollars came about. A total of seven investment banks were fined, with Barclays, Citigroup, and JPMorgan Chase being hit the hardest.
It was also after this that the trading floor imposed very strict controls on traders. You see, the trading floor doesn't allow the use of personal mobile phones, and work conversations are strictly monitored. If you say anything even slightly sensitive on Bloomberg, for example, the company's compliance department will come to you the next day to hold you accountable.
So, I can't say that it's completely eradicated now, but it should be much better.
Through this example, you can see how large the trading volume of these market makers is. Secondly, the entire foreign exchange market is actually very opaque.
Let's digress a little. Did you notice that there are two names that are particularly out of place in the list of the largest foreign exchange market participants we just saw? XTX Markets and Jump Trading. You probably don't know them. And you're right, you wouldn't.
In terms of the number of people, they are actually very small companies. XTX Markets has only about 200 people, and Jump Trading has less than 1,000. Can you imagine that? A small team of less than 1,000 people can handle 10% of the global foreign exchange market's trading volume, which is nearly 1 trillion US dollars per day!
Although these two are also considered market makers, they are not quite the same as those investment banks. They belong to high-frequency trading companies. They completely rely on algorithms to find tiny arbitrage opportunities between markets and provide liquidity through buying and selling. They have almost no open positions. Each transaction may only earn 0.0000001, but their volume is huge, right? So, their annual net profit can also exceed 1 billion US dollars.
Look, they've become one of the top ten foreign exchange traders in the world. But it's not easy at all. The requirements for algorithms, network speed, hardware, etc., are very, very high. We can talk more about this high-frequency trading another time.
Okay, besides market makers, the most classic players in the foreign exchange market are large companies involved in cross-border payments.
For example, Xiaolin, let's say I have a cross-border business again. This time it's not a bubble tea shop, because our bubble tea uses fresh local milk every day, so it doesn't require cross-border trade. Let's say this time I sell mobile phones. Xiaolin mobile phones are selling like hotcakes in the United States.
Assuming my supply chain headquarters is located in China, I settle accounts with upstream suppliers, and I pay my employees in yuan. But I sell my phones in the United States, and I receive US dollars. What should I do?
It's actually very simple. I just need to exchange the US dollars I earn into yuan. But it's not over yet. If it were that simple, we wouldn't need to use this example, right? Now I'm going to introduce a new dimension: time.
Think about it. To produce a mobile phone, from the time I start purchasing, processing, assembling, to finally selling it in the United States, it may take about half a year. In other words, I am spending yuan now to make phones, and it will take half a year for the US dollar revenue to be realized. And the price of this phone, when sold in US dollars, is fixed. If the US dollar plummets in the next six months, even if I sell all my goods, I may still suffer a big loss. This is actually a huge exchange rate risk for me.
So, what can I do at this time?
When I'm about to start making phones, I can find an investment bank, such as JPMorgan Chase. I'll tell them, "I expect to sell 100 million US dollars worth of mobile phones. I want to exchange them into yuan. But not now. I want to exchange them in half a year."
JPMorgan Chase says, "No problem." They will quote me the exchange rate for half a year later based on various market interest rates, telling me that the exchange rate in half a year will be 7.35 yuan to 1 US dollar. We make a deal.
Then, within this half year, no matter how the foreign exchange market fluctuates, the exchange rate between me and JPMorgan Chase will be locked at 7.35. Six months later, I give them 100 million US dollars, and they give me 735 million yuan.
In this example, I actually signed a six-month foreign exchange forward contract with JPMorgan Chase. Through this forward contract, I can hedge against the exchange rate risk at any point in the future, standing here right now.
Of course, me saying that I'll sell my phones in half a year is a simplified version. If I were to really make mobile phones, there would be so many parts, right? For example, I might need to buy chips from Singapore a year in advance, and buy steel plates from India nine months in advance. I might have to sign a one-year Singapore dollar/yuan forward contract with JPMorgan Chase, and then sign another nine-month Indian rupee/yuan forward contract.
Moreover, it's impossible for the phones to be bought all at once in half a year. There's also a cycle for payment between me and the supplier. In short, the foreign exchange of the entire supply chain is constantly and rapidly changing. The entire supply chain is in a state of continuous and dynamic change.
So you can imagine that for companies like Apple, Microsoft, Xiaolin Mobile Phones, which have a large number of cross-border transactions, or some foreign trade companies, there will actually be a massive amount of various currencies flowing in and out every day. What they need to do is to estimate the future cash flow as accurately as possible, and then hedge against this part of the risk as much as possible.
Of course, the actual situation is that it is impossible for them to accurately predict the daily cash flow and perfectly hedge against all risks, but that's the general idea.
In fact, many companies will show you these foreign exchange hedges or the profit and loss (PNL) brought about by foreign exchange risks in their financial statements. For example, I randomly flipped through the reports of two companies, Apple and Google.
You can see that in 2022, Apple lost 1.5 billion US dollars on foreign exchange, and Google lost 1.8 billion US dollars. But they all hedged against foreign exchange risk. You see, Apple made 2.1 billion US dollars from financial derivatives, and Google made 2 billion US dollars.
Of course, these derivatives are not just for hedging against exchange rate risk, but the difference is that they basically cancel each other out.
I'll expand on this a little more. Do you know why they both lost so much on foreign exchange in 2022? Of course, I don't know the specific cash flow, but I can make a bold guess.
Just think intuitively. These companies are multinational companies that sell things all over the world. What they receive is euros, yen, and yuan. These currencies ultimately need to be converted into US dollars to be reflected in the financial statements.
And just look at the trend of the US dollar in 2022 – it's skyrocketed all the way! What does this mean? This means that the income converted into US dollars has actually decreased, resulting in foreign exchange losses.
So, you see the importance of foreign exchange hedging, right? Look at how good our example is.
The real economy we just mentioned actually belongs to the more traditional and classic foreign exchange demand. This is just an appetizer.
In fact, the ones who play even wilder and have larger volumes are the capital markets. There is actually a very critical financial product here: bonds.
In the capital market, the foreign exchange market is actually very closely integrated with the bonds and interest rates of various countries.
Here's an example. Let's say Xiaolin's bubble tea shop mainly operates in mainland China, spending and earning yuan. However, many overseas investors are very interested in me. They also have money, right?
At this time, I can actually issue US dollar bonds and borrow US dollars. For example, I can issue a bond worth 100 million US dollars with a five-year maturity and an interest rate of 5%. But then what will I face?
Although I got the money I financed, in the next five years, I have to pay 5% interest in US dollars every year, and I have to repay the principal in US dollars when it matures. The exchange rate risk is too great for me, right? I can't just exchange yuan for US dollars every time the payment is due.
So, what is a common practice? I can find an investment bank, such as JPMorgan Chase, and we will conduct a cross-currency swap transaction. The general idea is that I will exchange all the money I have to repay with JPMorgan Chase into yuan.
For example, we agreed that in the next five years, JPMorgan Chase will give me 5% interest in US dollars every year, and they will give me 100 million US dollars when it matures in five years. Conversely, I need to pay JPMorgan Chase interest in yuan and repay the principal in yuan when it matures.
In this way, although I borrowed US dollar debt, after this swap agreement with JPMorgan Chase, it's actually equivalent to me borrowing yuan debt, avoiding the exchange rate risk. This is a very classic currency interest rate swap agreement based on borrowing.
This is borrowing. Conversely, it can also be based on investment. For example, I have US dollars in hand, but I want to invest in Indian bonds. However, I don't want to bear the foreign exchange risk of the Indian rupee.
Then I can find JPMorgan Chase to conduct a swap, which is equivalent to exchanging all these rupee cash flows into US dollar cash flows.
Swaps are truly a very, very important derivative in the financial market. In fact, there are not only foreign exchange swaps, but interest rate swaps are an even larger market. Their importance can even be said to have surpassed that of government bonds.
Many times, it is translated as "swap," but I will translate it as "exchange" here. I think it might sound more intuitive and easier to understand. Otherwise, I would be saying "swap, swap, swap" all the time, and I guess you would be dizzy.
You don't need to worry too much about the specific details of this swap, because there are really too many variables in it. For example, what is the interest rate in the middle? Is it floating or fixed? Including frequency, etc., can all be customized.
And I'm telling you, this kind of foreign exchange swap agreement is very complicated from the perspective of quantitative pricing.
When I was working at JPMorgan Chase, I also had exchanges with my colleagues in the foreign exchange team, so I know how abnormal this thing is. I have great respect for it. Don't think it sounds simple just because it's just us exchanging some money.
But in fact, you have to consider, for example, if it's yuan for US dollars, you have to consider the yuan interest rate curve and the US dollar interest rate curve. You also have to consider the swap spread between the yuan and the US dollar for different maturities.
At the same time, you also have to consider the counterparty's credit risk and your own financing costs. In short, it is very complicated.
Okay, you see, whether it's for a company's actual business or capital operation, why do they have to do such a large amount of foreign exchange transactions? Because it's not just about the spot exchange. It also includes the money you may receive in the future and the money you may spend in the future.
Although this part of the cash flow has not yet occurred, it also has foreign exchange risk, and this part of the risk may be even greater. This is the main battlefield of the foreign exchange market.
If you look closely at the 7.5 trillion US dollars of trading volume in the foreign exchange market every day, only 2.1 trillion is spot exchange. The vast majority of the rest are transactions for future exchange rates, with swap agreements alone accounting for half.
You see, we've been talking about swaps and forward contracts for a long time. Unknowingly, your understanding of exchange rates has risen to a new dimension.
Let's get back on track. Pay attention, everyone. Here comes the important part! Let's expand and summarize your understanding of exchange rates.
In a country, currency is actually the ruler for measuring all commodities at the moment. And we can understand the interest rate as the relationship between the future ruler and the current ruler in this currency system.
For example, an interest rate of 3%, 103 a year later, is actually equivalent to 100 now. Of course, this is purely theoretical.
In this way, the current currency ruler, combined with the interest rate curve, can measure the price and commodity at any moment in this country. This one-dimensional ruler will be extended into a two-dimensional coordinate plane.
The horizontal axis of this coordinate plane is time. Each country with an independent currency system has its own set of coordinate planes. For example, the United States measures everything in US dollars and has its own set of interest rate curves. Mainland China measures everything in yuan and has its own set of interest rate curves.
The exchange rate is the corresponding relationship between the coordinate planes of different countries. It's not just the exchange rate conversion at this point in time, but also the exchange rate conversion at any point in the future. It's kind of like a coordinate transformation in mathematics.
Therefore, foreign exchange is always tied to interest rates and time.
Let's continue talking about the main players in the foreign exchange market. The next one is definitely the one that everyone will not ignore, and even many people think that it is the dominant player in the foreign exchange market: the central banks and governments of various countries.
Central banks are obviously completely different from the players we mentioned before, because they have some privileges in their hands. They can control the circulation speed and volume of their own currency.
However, they can only control these attributes of their own currency. Foreign exchange is the ratio between two currencies, so the central bank is just a player with some privileges in its hands. It is not the dealer, let alone the referee.
I have summarized three main ways in which central banks directly regulate exchange rates:
The first is foreign exchange control, which refers to restrictions on capital flows, pegging exchange rates, and the like. But this is a huge topic, and we will discuss it later.
The second method is to regulate through the direct buying and selling of currencies. For example, if I want my currency to appreciate, then I will buy it, right? I will sell some foreign exchange reserves to buy my own currency. Conversely, if I want my currency to depreciate, then I will sell it, right? I can either directly sell the reserves of my own currency, or I can print some money and sell it in exchange for foreign currency, which will then be put into my reserves.
This is actually more intuitive, and central banks around the world are constantly engaged in similar operations.
And there's a third trick: signing swap agreements.
You must be thinking, "This is annoying, why are we talking about swap agreements again?" Sorry, it really is everywhere.
So, what is the essential difference between a central bank engaging in this swap agreement and the participants and investment banks we talked about earlier? Think about it, the central bank can print money.
When two central banks that can print money get together and sign a currency swap agreement, you can simply understand it as borrowing money from each other.
That is, you give me your money, and I can use your money to buy your things. I give you my money, and you can use my money to buy my things. When it matures, I will return your money to you, and you will return my money to me. Do you understand?
Let me say it again. You give me...
You see, when two central banks do this, it is actually completely independent of the complex foreign exchange market. There is no credit risk, and it will not disrupt the existing market.
Therefore, if two countries want to promote trade or promote the use of their own currencies in international trade – of course, in many cases, it is to bypass the US dollar – they will sign such a swap agreement.
For example, the People's Bank of China likes to sign such swap agreements with various countries. Last year, it signed a three-year swap agreement worth 50 billion yuan with the Saudi central bank. It signed a five-year agreement worth 35 billion with the United Arab Emirates. It renewed a three-year swap agreement worth 130 billion yuan with Argentina.
Of course, the one with Argentina may not be so much about de-dollarization as it is about helping Argentina repay the IMF. Argentina is quite messy, and we can talk about it another time.
Currently, the People's Bank of China has a total of over 4 trillion yuan in swap agreements with foreign countries.
Of course, signing this swap agreement is just an upper limit on the swap. It does not mean that if I sign 4 trillion, I will definitely trade 4 trillion.
It is precisely because the foreign exchange market, especially the foreign exchange swap market, is very opaque that it is actually easier to play dirty tricks here, even for central banks.
For example, Greece in the early 2000s desperately wanted to squeeze into the eurozone. However, the eurozone has something called the Maastricht Treaty, one of the requirements of which is that the government debt-to-GDP ratio cannot exceed 60%. Greece simply could not do this.
So what did they do? We have actually talked about it before, I don't know if you remember. Greece happens to know a master of tricks on Wall Street, Goldman Sachs.
Goldman Sachs said, "I have a way. You just need to sign a currency interest rate swap agreement with me to magically hide this debt from your balance sheet. See how clever I am?"
And Greece actually used this trick to hide its 2.8 billion euros of debt. Goldman Sachs made 6 billion euros from this.
And two years later, Greece's 2.8 billion euros of debt had snowballed into 5.1 billion. Of course, Goldman Sachs knew what Greece was like and had already hedged these risks in the financial market.
But I'm not telling this story to mock Goldman Sachs. After all, the 2.8 billion euros of debt is just the tip of the iceberg in Greece's trillions of dollars of debt. Don't think that it was Goldman Sachs that brought down the Greek government. They couldn't have done it. At most, they were just taking advantage of the situation.
Moreover, there were indeed many governments in Europe at that time using such financial derivatives to hide their debts. For example, JPMorgan Chase also did this for Italy.
In fact, a large number of governments and companies around the world have their debts disappearing from their balance sheets through these currency swap agreements. Most of them are very short-term, and when they mature, they sign a new one and keep rolling over. The Bank for International Settlements estimates that 80 trillion US dollars of debt worldwide is hidden in this way, even exceeding the debt on the balance sheets of these companies.
Of course, when I say that this debt is hidden, the word "hidden" may not be very appropriate. Because sometimes, these companies may not necessarily want to be discovered subjectively. It's just that there is indeed 80 trillion US dollars of debt not reflected on the balance sheet.
This is essentially because the development of financial derivatives is too fast, but the accounting rules have not kept up, making it easy for people to underestimate a company's debt level.
In short, you can see that the central bank is not a superior manager in the foreign exchange market. When forced, they have to play some tricks with Wall Street.
The last major group of participants in the foreign exchange market is speculators: those who seek to profit quickly through short-term buying and selling. Think about it, they exist in every market, let alone in such a free and loosely regulated foreign exchange market, right? The main ones are hedge funds and individual investors.
First of all, there are those who rely on pure technical analysis. For example, I directly look at the price trend chart, like KDJ, MACD. There's a golden cross, so I trade.
This kind of technical analysis is still quite popular in the foreign exchange market. Because first of all, the foreign exchange market is very liquid, so the transaction cost is relatively low. Moreover, the regulation is relatively loose, and the trading hours are long, with 24-hour trading. There are all sorts of strange things in this category, because the threshold for entry is indeed relatively low.
Look at the currency market, right? It's so complex with so many influencing factors. But with technical analysis, I can ignore all these factors. I just need to know how to look at the charts. So anyone can give it a try.
But be careful. If someone tries to fool you by saying that you can make money in foreign exchange trading just by looking at the charts, you must be careful. I think you can even ask him, "Do you know what a currency interest rate swap agreement is?"
But what we just talked about is mostly small-time stuff. If you really want to make money in the foreign exchange market, it's still mainly those institutions.
For example, like George Soros's capital attacks, or the first category we just mentioned, like investment banks and high-frequency trading market makers, they can use their user orders and information asymmetry to do some arbitrage trading.
For most speculators who participate in foreign exchange trading, foreign exchange is actually only one part of their entire trading strategy. They don't specifically speculate in foreign exchange.
For example, a Japanese investor wants to arbitrage and invest in US dollar bonds. Then they must first conduct a US dollar swap, right? So this part is also included in the trading of this foreign exchange speculator.
For example, in 1996 and 1997, the then-famous hedge fund LTCM was full of Nobel Prize winners, all top mathematicians, physicists, and quantitative geniuses. At that time, they had many strategies that claimed to be foolproof. The financing cost of this hedge fund was even lower than that of investment banks.
One of their strategies at that time was to go long on Russian government bonds. Of course, they were not purely long. They might also short some US Treasury bonds or something. It's this kind of strategy.
This strategy is also accompanied by a large number of long positions in the Russian ruble. This is actually not a big risk, because the Russian ruble is pegged to the US dollar, that is, it needs to be kept within the range of 5.3 to 7.1 rubles to 1 US dollar.
However, by the beginning of 1998, Russia was already deeply mired in a foreign debt crisis. The interest rate on its foreign debt had soared to over 100%. But LTCM's model was calculated based on historical data. They also suggested that it was okay to continue holding.
But who knew that Russia couldn't hold on any longer in August. Moreover, they chose to lie flat directly, defaulting on both domestic and foreign debt. Even the domestic debt that could have been repaid by printing money was also defaulted on.
Let's go back to foreign exchange. On the ruble side, the Russian government initially said that they could let it depreciate a little bit, but it would still be pegged to the US dollar, but it would be lowered to the range of 6.0 to 9.5 rubles to 1 US dollar. But two weeks later, it was completely out of control. They couldn't hold on any longer and announced that they would decouple from the US dollar. It directly soared to 22 rubles to 1 US dollar.
In one month, the exchange rate fell to one-third of its original value. This directly led to panic in the global financial market. The most successful hedge fund in history was wiped out just like that.
The Federal Reserve had to step in and pull 14 investment banks together to inject 36 billion US dollars just to let it go quietly and not drag the entire financial market down with it.
We have talked about this LTCM in detail in a previous episode. You definitely can't say that its downfall was entirely due to the ruble, right? This is a direct trigger. The root cause is still human nature.
Interested friends can go back and review it carefully.
Okay, in this episode, we mainly discussed from a more micro perspective what foreign exchange is all about, what the main participants are, and how they play. We also gave over a hundred examples, which I think is pretty good. But obviously, we haven't finished talking about it.
We definitely can't finish it in one go, right?
With this basic knowledge of foreign exchange, in the next episode, in our second breath, we can raise our perspective a bit. We will look at how foreign exchange affects the national economy from a macro perspective, what factors determine the price of foreign exchange, why so many countries choose to peg to the US dollar and the euro, and what basis central banks use to regulate foreign exchange, etc.
Aren't you looking forward to it?