Forex Investment and Currency Trading

An option is another type of derivative. Currency options allow but do not require an investor to buy or sell a specified amount of foreign currency at a specified price at any time up to a specified date.

Call and Put Options
The buyer of a call option is given the right to buy a foreign currency at a specified price, the strike price.

A buyer of a put option has the right to sell a foreign currency at a specified strike price. For acquiring the right to buy at a specified price on a call option, die buyer has to pay premium to the seller of that option. The same holds for a put option: The buyer of a put option pays a premium to the seller to acquire the right to sell at a specified strike price.

These options are traded on organized exchanges worldwide as well as in the interbank market. There are markets for options on futures, forwards, and spot contracts. Options on futures are traded on the Chicago Mercantile Exchange, and options on the spot contracts are traded on the Philadelphia Exchange, One is considered a futures contract, the other a security. Options account for approximately 5% of the total foreign exchange market activity. Derivatives such as foreign market currency futures and options enable financial institutions 10 protect themselves by hedging or reducing their risk (and their return) on their underlying currency positions.

Arbitrage 
Arbitrage is one of the single most important aspects of currency trading.

Arbitrage is simply the risk-free buying of a currency in one market for immediate or simultaneous resale in a second market in order to profit from the price discrepancy. Arbitrage is the driving force in maintaining prices within a certain band and maintaining consistency of currency prices with their theoretical value. There is arbitrage, and then there is forward market arbitrage. An example of arbitrage is simply the arbitrage of spot prices. Two different locations might be offering two different prices.

Purchasing Power Parity—the Law of One Price 
One of the most common forms of arbitrage in theoretical terms is the arbitrage of goods for currency, which is the concept behind purchasing power parity. Commodities or similar products, even though bought and sold in different currencies, should maintain the same price. For example, if the amount of euros to U.S. dollars is 1.37 euros to one U.S. dollar, then a $1 candy bar in the United States should be equal to 1.37 euros in Germany. If (here is a discrepancy between the price of a candy bar in the United States versus a candy bar in Germany and the exchange rate, then theoretically someone could buy the candy bar in the cheaper location and sell it in the more expensive location, making it a risk-free, automatic process. This does not include certain factors such as transportation cost, transaction cost, taxes, and the time factor of going from one country to another. But all those factors aside, theoretically, the product should cost the same in one country as in another country. If the two objects aren’t the same in price—meaning that the $1 candy bar is not equal to 1.37 EUR in Germany, the law of one price says that arbitrage will continue until the two prices coincide.

The price of tradable goods when expressed in the common currencies will tend to equalize across countries as a result of exchange rate changes. The theory behind purchasing power parity doesn’t necessarily focus on the products but rather on the flow of currencies. For example, in the case of the candy bar,  if it is cheaper to buy the candy bar in Germany in euros than it is in the United States in U.S. dollars, the flows of money will move to the United States. People will then sell U.S. dollars and buy euros. The buying of euros will increase their value against the U.S. dollar until the two prices reach a level of parity. Obviously, this theory is not intended for just one item, such as a candy bar, but rather is considered as a way to look at goods as a whole. 

Big Mac Example Probably one of the best examples of purchasing power parity is the Big Mac example. Economists periodically publish the prices of McDonald’s Big Mac around the world. The value of the Big Mac around the world differs depending on the country in which the restaurant is located. Obviously, in certain locations the Big Mac has a higher or lower value depending on factors such as supply and demand.

One of the reasons why people look at the Big Mac example, or the examples of purchasing power parity, is that it gives a quick view of the value or the possible misalignment of exchange prices between one country and another. It may signal a new coming change in exchange rates. The Big Mac example or the candy bar example might not show the exact differences or an upcoming and pending dip in the euro. However, looking at goods and services as a whole by comparing the standards of living from one country to another becomes very relevant.

When using purchasing power parity, it is interesting to look at the standard of living in Germany versus the standard of living in the United States. The value of a house in Germany versus the value of a house in the United States on average increases and decreases. This may show a shift in inflation and a shift in the exchange rates. Therefore, many international economists follow purchasing power parity in arbitrage of goods as an important factor for valuing the spot rates of different currencies. But probably the most important factor for valuing currencies is the arbitrage of money.