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8/7/2019 -Unlicensed-Foreign Exchange

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Foreign Exchange

(Fe) Contents :

Foreign Exchange ,History

of Foreign Exchange ,

Economic Reforms,Appreciation and

Depreciation of currency

,Market participants,

Determinants ofFE,Financial instruments

& Speculation.


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What is Foreign

Exchange???

The foreign exchange market

(currency, forex, or FX) trades

currencies. It lets banks and other

institutions easily buy and sell

currencies.

The purpose of the foreign

exchange market is to helpinternational trade and

investment. A foreign exchange

market helps businesses convert

one currency to another. For

example, it permits a U.S.

business to import European

goods and pay Euros, eventhough the business's income is in

U.S. dollars.


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How it works???

In a typical foreign exchange transaction a party purchases a quantity ofone currency by paying a quantity of another currency. The modernforeign exchange market started forming during the 1970s when countriesgradually switched to floating exchange rates from the previous exchangerate regime

According to the Bank for International Settlements,average daily turnoverin global foreign exchange markets is estimated at $3.98 trillion. Trading inthe world's main financial markets accounted for $3.21 trillion of this. Thisapproximately $3.21 trillion in main foreign exchange market turnover wasbroken down as follows:

$1.005 trillion in spot transactions

$362 billion in outright forwards

$1.714 trillion in foreign exchange swaps

$129 billion estimated gaps in reporting


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Foreign Exchange

The main trading center is London, but New York, Tokyo, Hong Kongand Singapore are all important centers as well. Banks throughoutthe world participate. Currency trading happens continuouslythroughout the day; as the Asian trading session ends, theEuropean session begins, followed by the North American session

and then back to the Asian session, excluding weekends. Fluctuations in exchange rates are usually caused by actual

monetary flows as well as by expectations of changes in monetaryflows caused by changes in gross domestic product (GDP) growth,inflation (purchasing power parity theory), interest rates (interestrate parity, Domestic Fisher effect, International Fisher effect),

budget and trade deficits or surpluses, large cross-border M&Adeals and other macroeconomic conditions


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FOREX -

Presently, the foreign exchange

market is one of the largest and most

liquid financial markets in the world.

Traders include large banks, central

banks, currency speculators,

corporations, governments, and other

financial institutions. The average daily

volume in the global foreign exchangeand related markets is continuously

growing. Daily turnover was reported

to be over US$3.2 trillion in April 2007

by the Bank for International

Settlements. [2] Since then, the market

has continued to grow. According to

Euro money's annual FX Poll, volumes

grew a further 41% between 2007 and2008.[3]


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Unlike a stock market, where all participants have

access to the same prices, the foreign exchange market

is divided into levels of access.Biggest Market Participant

At the top is the inter-bank

market, which is made up of

the largest investmentbanking firms

Banks :

The interbank market caters for both

the majority of commercial turnover

and large amounts of speculative

trading every day. A large bank maytrade billions of dollars daily. Some of

this trading is undertaken on behalf

of customers, but much is conducted

by proprietary desks, trading for the

bank's own account. Until recently,

foreign exchange brokers did largeamounts of business, facilitating

interbank trading and matching

anonymous counterparts for small

fees. Today, however, much of this

business has moved on to more

efficient electronic systems.


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Market participants

Commercial companies: An important part of this market comesfrom the financial activities of companies seeking foreign exchangeto pay for goods or services. Commercial companies often tradefairly small amounts compared to those of banks or speculators, andtheir trades often have little short term impact on market rates.

Central banks: National central banks play an important role in the

foreign exchange markets.T

hey try to control the money supply,inflation, and/or interest rates and often have official or unofficialtarget rates for their currencies.

Investment management firms: Investment management firms (whotypically manage large accounts on behalf of customers such aspension funds and endowments) use the foreign exchange market to

facilitate transactions in foreign securities. Non-bank Foreign Exchange Companies: Non-bank foreign exchange

companies offer currency exchange and international payments toprivate individuals and companies. These are also known as foreignexchange brokers but are distinct in that they do not offerspeculative trading but currency exchange with payments.


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DETERMINANTS OF

EXCHANGE RATES :

(a) International parity conditions viz;

purchasing power parity, interest rate

parity, Domestic Fisher effect,

International Fisher effect. Though to

some extent the above theories

provide logical explanation for the

fluctuations in exchange rates, yet

these theories falter as they are basedon challengeable assumptions [e.g.,

free flow of goods, services and

capital] which seldom hold true in the

real world.

(b) Balance of payments model . This

model, however, focuses largely on

tradable goods and services, ignoring

the increasing role of global capitalflows. It failed to provide any

explanation for continuous

appreciation of dollar during 1980s

and most part of 1990s in face of

soaring US current account deficit.


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DETERMINANTS OF

EXCHANGE RATES :

(c) Asset market model - views

currencies as an important asset class

for constructing investment portfolios.

Assets prices are influenced mostly by

peoples willingness to hold the

existing quantities of assets, which in

turn depends on their expectations on

the future worth of these assets. Theasset market model of exchange rate

determination states that the

exchange rate between two currencies

represents the price that just balances

the relative supplies of, and demand

for, assets denominated in those

currencies.


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DETERMINANTS OF

FOREIGNEXCHANGE:

None of the models developed so far succeed toexplain FX rates levels and volatility in the longertime frames. For shorter time frames (less than afew days) algorithm can be devised to predictprices. Large and small institutions andprofessional individual traders have madeconsistent profits from it. It is understood fromabove models that many macroeconomic factorsaffect the exchange rates and in the endcurrency prices are a result of dual forces ofdemand and supply. The world's currencymarkets can be viewed as a huge melting pot: in

a large and ever-changing mix of current events,supply and demand factors are constantlyshifting, and the price of one currency in relationto another shifts accordingly. No other marketencompasses (and distills) as much of what isgoing on in the world at any given time as foreignexchange.

Supply and demand for any given currency, andthus its value, are not influenced by any singleelement, but rather by several. These elementsgenerally fall into three categories: economicfactors, political conditions and marketpsychology.

The foreign exchange market is unique

because of

its trading volumes,

the extreme liquidity of the market,

its geographical dispersion,

its long trading hours: 24 hours a day

except on weekends (from 22:00 UT

Con Sunday until 22:00 UTC Friday),

the variety of factors that affect

exchange rates.

the low margins of profit compared

with other markets of fixed income

(but profits can be high due to very

large trading volumes)

the use ofleverage


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ECONOMIC FACTORS:

Government budget deficits or surpluses The marketusually reacts negatively to widening government budgetdeficits, and positively to narrowing budget deficits. Theimpact is reflected in the value of a country's currency.

Balance of trade levels and trends The trade flow betweencountries illustrates the demand for goods and services,which in turn indicates demand for a country's currency toconduct trade. Surpluses and deficits in trade of goods andservices reflect the competitiveness of a nation's economy.For example, trade deficits may have a negative impact ona nation's currency.

Inflation levels and trends Typically a currency will losevalue if there is a high level ofinflation in the country or if

inflation levels are perceived to be rising [. This is becauseinflation erodes purchasing power, thus demand, for thatparticular currency. However, a currency may sometimesstrengthen when inflation rises because of expectationsthat the central bank will raise short-term interest rates tocombat rising inflation.

Economic growth and health Reports such as GDP,employment levels, retail sales, capacity utilization andothers, detail the levels of a country's economic growth

and health. Generally, the more healthy and robust acountry's economy, the better its currency will perform,and the more demand for it there will be.

Productivity of an economy Increasing productivity in aneconomy should positively influence the value of itscurrency. Its effects are more prominent if the increase isin the traded sector

Economic policy comprises

government fiscal policy

(budget/spending practices) and

monetary policy (the means by which

a government's central bank

influences the supply and "cost" of

money, which is reflected by the level

ofinterest rates).Economic conditions include:


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POLITICAL CONDITIONS:

Internal, regional, and internationalpolitical conditions and events canhave a profound effect on currencymarkets.

All exchange rates are susceptible topolitical instability and anticipationsabout the new ruling party. Politicalupheaval and instability can have a

negative impact on a nation'seconomy. For example, destabilizationof coalition governments in India,Pakistan and Thailand can negativelyaffect the value of their currencies.Similarly, in a country experiencingfinancial difficulties, the rise of apolitical faction that is perceived to befiscally responsible can have theopposite effect. Also, events in onecountry in a region may spur positiveor negative interest in a neighboringcountry and, in the process, affect itscurrency.


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MARKET PSYCHOLOGY:

Flights to quality Unsettling international events can lead to a"flight to quality," with investors seeking a "safe haven." There willbe a greater demand, thus a higher price, for currencies perceivedas stronger over their relatively weaker counterparts. The Swissfranc has been a traditional safe haven during times of political oreconomic uncertainty.

Long-term trends Currency markets often move in visible long-termtrends. Although currencies do not have an annual growing seasonlike physical commodities, business cycles do make themselves felt.Cycle analysis looks at longer-term price trends that may rise fromeconomic or political trends.

"Buy the rumor, sell the fact" This market truism can apply to manycurrency situations. It is the tendency for the price of a currency toreflect the impact of a particular action before it occurs and, whenthe anticipated event comes to pass, react in exactly the oppositedirection. This may also be referred to as a market being "oversold"or "overbought".[14] To buy the rumor or sell the fact can also be anexample of the cognitive bias known as anchoring, when investorsfocus too much on the relevance of outside events to currencyprices.

Economic numbersWhile economic numbers can certainly reflecteconomic policy, some reports and numbers take on a talisman-likeeffect: the number itself becomes important to market psychologyand may have an immediate impact on short-term market moves."What to watch" can change over time. In recent years, forexample, money supply, employment, trade balance figures andinflation numbers have all taken turns in the spotlight.

Technical trading considerationsAs in other markets, theaccumulated price movements in a currency pair such as EUR/USDcan form apparent patterns that traders may attempt to use. Manytraders study price charts in order to identify such patterns

Electronic trading is growing in the FX

market, and algorithmic trading is

becoming much more common.

According to financial consultancy

Celent estimates, by 2008 up to 25%

of all trades by volume will be

executed using algorithm, up from

about 18% in 2005.An algorithmic trader needs to be

mindful of potential fraud by the

broker. Part of the weekly algorithm

should include a check to see if the

amount of transaction errors when the

trader is losing money occurs in the

same proportion as when the trader

would have made money.


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FINANCIAL INSTRUMENTS:

Spot

A spot transaction is a two-day

delivery transaction (except in the

case of trades between the US Dollar,

Canadian Dollar, Turkish Lira and

Russian Ruble, which settle the next

business day), as opposed to the

futures contracts, which are usuallythree months. This trade represents a

direct exchange between two

currencies, has the shortest time

frame, involves cash rather than a

contract; and interest is not included

in the agreed-upon transaction. The

data for this study come from the spot

market. Spot transactions has thesecond largest turnover by volume

after Swap transactions among all FX

transactions in the Global FX market.

NNM


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Future

Foreign currency futures are exchangetraded forward transactions with standardcontract sizes and maturity dates for

example, $1000 for next November at anagreed rate . Futures are standardized andare usually traded on an exchange createdfor this purpose. The average contractlength is roughly 3 months. Futurescontracts are usually inclusive of anyinterest amounts.

Swap

The most common type of forwardtransaction is the currency swap. In a swap,two parties exchange currencies for acertain length of time and agree to reversethe transaction at a later date. These are

not standardized contracts and are nottraded through an exchange.

Forward:

One way to deal with the foreign

exchange risk is to engage in a forward

transaction. In this transaction, money

does not actually change hands until

some agreed upon future date. A

buyer and seller agree on an exchange

rate for any date in the future, and thetransaction occurs on that date,

regardless of what the market rates

are then. The duration of the trade can

be a one day, a few days, months or

years. Usually the date is decided by

both parties


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Option

A foreign exchange option (commonly shortenedto just FX option) is a derivative where the ownerhas the right but not the obligation to exchange

money denominated in one currency intoanother currency at a pre-agreed exchange rateon a specified date. The FX options market is thedeepest, largest and most liquid market foroptions of any kind in the world..

Exchange-Traded Fund

Exchange-traded funds (or ETFs) are open endedinvestment companies that can be traded at anytime throughout the course of the day. Typically,ETFs try to replicate a stock market index such asthe S&P 500 (e.g., SPY), but recently they arenow replicating investments in the currencymarkets with the ETF increasing in value whenthe US Dollar weakens versus a specific currency,such as the Euro. Certain of these funds track the

price movements of world currencies versus theUS Dollar, and increase in value directly counterto the US Dollar, allowing for speculation in theUS Dollar for US and US Dollar denominatedinvestors and speculators

Controversy about currency

speculators and their effect on

currency devaluations and national

economies recurs regularly.

Nevertheless, economists including

Milton Friedman have argued that

speculators ultimately are a stabilizing

influence on the market and performthe important function of providing a

market for hedgers and transferring

risk from those people who don't wish

to bear it, to those who do


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HISTORY OF FOREIGN

EXCHANGE:

The aim of the implementation of the goldstandard was to guarantee any currency, toset amount of gold. Currency was nowbacked by gold, measured in ounces.

Countries needed large gold reserves toback the demand for currency. The pricedifference of an ounce of gold between twodifferent currencies now became theforeign exchange rate for those twocurrencies. This History of Forex waschanged by the birth of an international

standard by which foreign exchange couldtake place between countries. The goldstandard monetary broke down during thestart of the First WorldWar Political turmoilwith Germany forced the larger Europeanpowers to focus on military projects. Thisfinancial drain on Europe gave way to a lack

of gold to back the excess printing ofcurrency and would determine a newchange in the FX trading history.

The Forex trading history started in

1875 with the birth of the gold

standard monetary. Prior to 1875,

countries primarily used gold and

silver as a form of international

payment. Payment using gold and

silver were hampered by their

devaluation according to externalfactors such as an increase in the

discovery of new deposits, which

would lead to a change in supply and

demand. This factor would change the

Forex trading history forever.


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APPRECIATION OF CURRENCYDefinition:

An increase in the value of

one currency relative to

another currency.Appreciation occurs when,

because of a change in

exchange rates, a unit of

one currency buys more

units of another currency.

Happens because of change inExchange Rates!


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The impact of currency appreciation

on developing economies

The first is that exports are hurt. Most developing countries haveeconomies based largely on exports that are competitive in globalmarkets because of low prices. When those countries' currencygains value, they are no longer able to offer exports to the globalmarket at the same low prices that they planned to.

The second impact of rapid currency appreciation is that it hurts thevalue of repatriated profits from a country's international economicactivity. Whether that be an army of domestic servants traveling toa wealthier country and sending regular remittances home or acountry's entrepreneurial class making global investments -currency appreciation at home means that money made elsewhere

won't stretch as far in supporting the domestic economy.


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Currency depreciation is the loss of

value of a country's currency with

respect to one or more foreign

reference currencies, typically in a

floating exchange rate system. It is

most often used for the unofficial

increase of the exchange rate due to

market forces, though sometimes itappears interchangeably with

devaluation. Its opposite is called

appreciation.

The depreciation of a country's

currency refers to a decrease in the

value of that country's currency. For

instance, if the Canadian dollar

depreciates relative to the euro, theexchange rate (the Canadian dollar

price of euros) rises - it takes more

Canadian dollars to purchase 1 euro (1

EUR=1.5CAD 1 EUR=1.7CAD).


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Demand & Supply of

Foreign Exchange

Demand and Supply of ForeignExchange influences thedetermination of exchange rates andvice versa. The demand for foreignexchange is inversely proportional tothe rise of exchange rate. As theexchange rate goes up the demand forforeign exchange declines. The

quantity of foreign exchangedemanded falls. The supply of foreignexchange shifts depending on demandand not on the exchange rate. If thesupply aspect of transaction is plottedon a graph it will be vertical since thesupply of foreign currency depositsavailable at any time is fixed.

If the supply of a countrys currencyincreases the value of the currencydecreases in relation to othercurrencies and more money isrequired to buy the foreign exchanges.


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Fixed Exchange Rate

A fixed exchange rate, sometimes called a pegged exchange rate, isa type ofexchange rate regime wherein a currency's value ismatched to the value of another single currency or to a basket ofother currencies, or to another measure of value, such as gold.

A fixed exchange rate is usually used to stabilize the value of a

currency, against the currency it is pegged to. This makes trade andinvestments between the two countries easier and morepredictable, and is especially useful for small economies whereexternal trade forms a large part of their GDP.

It is also used as a means to control inflation. However, as thereference value rises and falls, so does the currency pegged to it. In

addition, a fixed exchange rate prevents a government from usingdomestic monetary policy in order to achieve macroeconomicstability.


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Floating Exchange Rate

A floating exchange rate or fluctuating exchange rate is atype ofexchange rate regime wherein a currency's value isallowed to fluctuate according to the foreign exchangemarket. A currency that uses a floating exchange rate is

known as a floating currency. It is not possible for adeveloping country to maintain the stability in the rate ofexchange for its currency in the exchange market. There aretwo options open for them- [1] Let the exchange rate beallowed to fluctuate in the open market according to themarket conditions, or [2] An equilibrium rate may be fixed

to be adopted and attempts should be made to maintain itas far as possible. But, if there is a fundamental change inthe circumstances, the rate should be changed accordingly


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Recent Exchange Graphs.


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