1.16 A Forex transaction under the Lens

Forex trading example - how to make money
 
We make money in Forex by buying and selling currencies, in the hope that the price at which we sold would be higher than at the price we bought, netting us a profit. Let’s go back to the example in our earlier chapter of a traveler who in the first instance sold his clutch of Euros and bought U.S. dollars for the expenses on his trip to the Hawaii, through a foreign currency dealer. Let's call him Bond (yes, our James Bond travels a lot - for a change let's take him to Hawaii for a surfing trip). Assume Bond exchanged euro 10,000 for $14,000 because the exchange rate on that day was 1 euro = 1.4000 U.S. dollars (i.e. EUR/USD = 1.4000). The calculation was euro 10,000*US$ 1.4000 = US$14,000.
 
Unfortunately, Bond has to cancel the trip three days later due to unforeseen difficulties, and has no use for the dollars – he wants his euros back. He returns to the dealer and presents the $14,000 for conversion to euros. The dealer takes his dollars and pays him back EUR 10,144.92 at that day’s exchange rate of 1 EUR=USD 1.3800 (i.e. EUR/USD=1.3800). The calculation was $14,000/1.3800 = EUR 10,144.92.
 
What happened here? James Bond made an unexpected profit of 144.92 euro because of the difference in exchange rate prevailing at the time he bought the dollars and when he sold them.
 
Here’s how we can show this transaction in a tabular form:
 

What James Bond did

U.S. Dollars

Euros

The Math

1.  James Bond purchased $14,000 at the exchange rate of EUR/USD = 1.4000

+14,000

-10,000

Euro 10,000*1.4000

 = $14,000

2.  He sold back the $14,000 at the exchange rate of EUR/USD=1.3800

-14,000

+10,144.92

$14,000 / 1.3800 
= Euro 10,144.92

3.  He earned an unexpected profit of euro 144.92!

0

+144.92

(2) – (1)

 
Bond bought $14,000 @ 1 euro=1.4000 USD and sold them @ 1.3800, giving him a profit of euro (1/1.3800-1/1.4000) x $14,000 = euro 144.92.
 
Let’s check the same scenario and calculation for another currency pair.
 
Let’s say the conversion had taken place from Japanese yen to dollars and then back to yen. 
 

Assumptions:

  1. 100,000 yen were converted into dollars when USD/JPY=100.00 (1 USD = 100.00 yen). He gets 1,000 USD
  2. Then 1,000 USD were converted back into yen when USD/JPY was 110.00. He gets 110,000 yen.
  3. Profit in this case was (110-100)*1000 yen = 10,000 yen.
 
The above calculation will be a bit different if the base currency changes.  Base currency, when we say EUR/USD is EUR, the first one. Let's say it was USD/JPY (base currency for this pair is USD - the first one). Please do check the next chapter to know about "Base Currency and Quote Currencies".
 

The difference in calculation was because in the first example the base currency (first currency i.e. euro) was converted into second currency while in the second example the second currency i.e. JPY was converted into the base currency i.e. USD. 

 
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