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Foreign Exchange

(Fe)
• Contents :
• Foreign Exchange ,History
of Foreign Exchange ,
Economic Reforms,
Appreciation and
Depreciation of
currency ,Market
participants,
Determinants of
FE,Financial instruments
& Speculation.
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 help
international 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, even
though the business's income is in
U.S. dollars.
How it works???
• In a typical foreign exchange transaction a party purchases a quantity of
one currency by paying a quantity of another currency. The modern
foreign exchange market started forming during the 1970s when
countries gradually switched to floating exchange rates from the previous
exchange rate regime
• According to the Bank for International Settlements,average daily
turnover in global foreign exchange markets is estimated at $3.98 trillion.
Trading in the world's main financial markets accounted for $3.21 trillion
of this. This approximately $3.21 trillion in main foreign exchange market
turnover was broken 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
Foreign Exchange
• The main trading center is London, but New York, Tokyo,
Hong Kong and Singapore are all important centers as well. Banks
throughout the world participate. Currency trading happens
continuously throughout the day; as the Asian trading session ends,
the European 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 monetary
flows caused by changes in gross domestic product (GDP) growth,
inflation (purchasing power parity theory), interest rates (
interest rate parity, Domestic Fisher effect,
International Fisher effect), budget and trade deficits or surpluses,
large cross-border M&A deals and other macroeconomic conditions
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 exchange
and 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 and 2008.[3]
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 Banks :
• At the top is the inter-bank The interbank market caters for both the
majority of commercial turnover and
market, which is made up of large amounts of speculative trading
the largest investment every day. A large bank may trade
billions of dollars daily. Some of this
banking firms 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 large amounts 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.
Market participants
• Commercial companies: An important part of this market comes
from the financial activities of companies seeking foreign exchange
to pay for goods or services. Commercial companies often trade
fairly small amounts compared to those of banks or speculators, and
their trades often have little short term impact on market rates.
• Central banks: National central banks play an important role in the
foreign exchange markets. They try to control the money supply,
inflation, and/or interest rates and often have official or unofficial
target rates for their currencies.
• Investment management firms: Investment management firms (who
typically manage large accounts on behalf of customers such as
pension 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 to
private individuals and companies. These are also known as foreign
exchange brokers but are distinct in that they do not offer
speculative trading but currency exchange with payments.
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 based on
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 capital
flows. 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.
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
people’s willingness to hold the
existing quantities of assets, which in
turn depends on their expectations on
the future worth of these assets. The
asset 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.”
• None of the models developed so far succeed to
explain FX rates levels and volatility in the longer
DETERMINANTS OF time frames. For shorter time frames (less than a
few days) algorithm can be devised to predict
FOREIGN EXCHANGE: prices. Large and small institutions and
The foreign exchange market is unique professional individual traders have made
because of consistent profits from it. It is understood from
its trading volumes,
above models that many macroeconomic factors
affect the exchange rates and in the end
the extreme liquidity of the market, currency prices are a result of dual forces of
its geographical dispersion, demand and supply. The world's currency
its long trading hours: 24 hours a day markets can be viewed as a huge melting pot: in
except on weekends (from 22:00 UTC a large and ever-changing mix of current events,
on Sunday until 22:00 UTC Friday), supply and demand factors are constantly
the variety of factors that affect shifting, and the price of one currency in relation
exchange rates. to another shifts accordingly. No other market
the low margins of profit compared encompasses (and distills) as much of what is
with other markets of fixed income going on in the world at any given time as
(but profits can be high due to very foreign exchange.
large trading volumes) • Supply and demand for any given currency, and
the use of leverage thus its value, are not influenced by any single
element, but rather by several. These elements
generally fall into three categories: economic
factors, political conditions and
market psychology.
• Government budget deficits or surpluses The market
usually reacts negatively to widening government
budget deficits, and positively to narrowing budget deficits.
The impact is reflected in the value of a country's currency.
ECONOMIC FACTORS:
• Balance of trade levels and trends The trade flow between
•Economic policy comprises countries illustrates the demand for goods and services,
government fiscal policy which in turn indicates demand for a country's currency to
(budget/spending practices) and conduct trade. Surpluses and deficits in trade of goods and
monetary policy (the means by which
services reflect the competitiveness of a nation's economy.
For example, trade deficits may have a negative impact on
a government's central bank a nation's currency.
influences the supply and "cost" of • Inflation levels and trends Typically a currency will lose
money, which is reflected by the level value if there is a high level of inflation in the country or if
of interest rates). inflation levels are perceived to be rising [. This is because
•Economic conditions include: inflation erodes purchasing power, thus demand, for that
particular currency. However, a currency may sometimes
strengthen when inflation rises because of expectations
that the central bank will raise short-term interest rates to
combat rising inflation.
• Economic growth and health Reports such as GDP,
employment levels, retail sales, capacity utilization and
others, detail the levels of a country's economic growth and
health. Generally, the more healthy and robust a country's
economy, the better its currency will perform, and the
more demand for it there will be.
• Productivity of an economy Increasing productivity in an
economy should positively influence the value of its
currency. Its effects are more prominent if the increase is in
the traded sector
POLITICAL CONDITIONS:
Internal, regional, and international
political conditions and events can
have a profound effect on currency
markets.
All exchange rates are susceptible to
political instability and anticipations
about the new ruling party. Political
upheaval and instability can have a
negative impact on a nation's
economy. For example, destabilization
of coalition governments in India,
Pakistan and Thailand can negatively
affect the value of their currencies.
Similarly, in a country experiencing
financial difficulties, the rise of a
political faction that is perceived to be
fiscally responsible can have the
opposite effect. Also, events in one
country in a region may spur positive
or negative interest in a neighboring
country and, in the process, affect its
currency.
• Flights to quality Unsettling international events can lead to a "
flight to quality," with investors seeking a "safe haven." There will
be a greater demand, thus a higher price, for currencies perceived
as stronger over their relatively weaker counterparts. The
Swiss franc has been a traditional safe haven during times of
political or economic uncertainty.
MARKET PSYCHOLOGY: • Long-term trends Currency markets often move in visible long-term
Electronic trading is growing in the FX trends. Although currencies do not have an annual growing season
like physical commodities, business cycles do make themselves felt.
market, and algorithmic trading is Cycle analysis looks at longer-term price trends that may rise from
becoming much more common. economic or political trends.
According to financial consultancy • "Buy the rumor, sell the fact" This market truism can apply to many
currency situations. It is the tendency for the price of a currency to
Celent estimates, by 2008 up to 25% of reflect the impact of a particular action before it occurs and, when
all trades by volume will be executed the anticipated event comes to pass, react in exactly the opposite
using algorithm, up from about 18% in direction. 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 an
2005. example of the cognitive bias known as anchoring, when investors
An algorithmic trader needs to be focus too much on the relevance of outside events to currency
prices.
mindful of potential fraud by the • Economic numbers While economic numbers can certainly reflect
broker. Part of the weekly algorithm economic policy, some reports and numbers take on a talisman-like
should include a check to see if the effect: the number itself becomes important to market psychology
amount of transaction errors when the and may have an immediate impact on short-term market moves.
"What to watch" can change over time. In recent years, for
trader is losing money occurs in the example, money supply, employment, trade balance figures and
same proportion as when the trader inflation numbers have all taken turns in the spotlight.
would have made money. • Technical trading considerations As in other markets, the
accumulated price movements in a currency pair such as EUR/USD
can form apparent patterns that traders may attempt to use. Many
traders study price charts in order to identify such patterns
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 usually
three 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 the
second largest turnover by volume
after Swap transactions among all FX
transactions in the Global FX market.
NNM
Future
Foreign currency futures are exchange
FINANCIAL INSTRUMENTS: traded forward transactions with standard
contract sizes and maturity dates — for
Forward:
example, $1000 for next November at an
One way to deal with the foreign
agreed rate . Futures are standardized and
exchange risk is to engage in a forward
are usually traded on an exchange created
transaction. In this transaction, money for this purpose. The average contract
does not actually change hands until length is roughly 3 months. Futures
some agreed upon future date. A contracts are usually inclusive of any
buyer and seller agree on an exchange interest amounts.
rate for any date in the future, and the
transaction occurs on that date, Swap
regardless of what the market rates The most common type of forward
are then. The duration of the trade can transaction is the currency swap. In a swap,
be a one day, a few days, months or two parties exchange currencies for a
years. Usually the date is decided by
both parties
certain length of time and agree to reverse
the transaction at a later date. These are
not standardized contracts and are not
traded through an exchange.
• Option
• A foreign exchange option (commonly shortened
FINANCIAL INSTRUMENTS: to just FX option) is a derivative where the owner
has the right but not the obligation to exchange
money denominated in one currency into
Controversy about currency another currency at a pre-agreed exchange rate
speculators and their effect on on a specified date. The FX options market is the
currency devaluations and national deepest, largest and most liquid market for
economies recurs regularly. options of any kind in the world..
Nevertheless, economists including • Exchange-Traded Fund
Milton Friedman have argued that
speculators ultimately are a stabilizing
• Exchange-traded funds (or ETFs) are open ended
influence on the market and perform investment companies that can be traded at any
the important function of providing a time throughout the course of the day. Typically,
market for hedgers and transferring ETFs try to replicate a stock market index such as
risk from those people who don't wish the S&P 500 (e.g., SPY), but recently they are
to bear it, to those who do now replicating investments in the currency
markets with the ETF increasing in value when
the US Dollar weakens versus a specific currency,
such as the Euro. Certain of these funds track the
price movements of world currencies versus the
US Dollar, and increase in value directly counter
to the US Dollar, allowing for speculation in the
US Dollar for US and US Dollar denominated
investors and speculators
• The aim of the implementation of the gold
standard was to guarantee any currency, to
HISTORY OF FOREIGN set amount of gold. Currency was now
EXCHANGE: backed by gold, measured in ounces.
Countries needed large gold reserves to
The Forex trading history started in back the demand for currency. The price
1875 with the birth of the gold
standard monetary. Prior to 1875,
difference of an ounce of gold between two
countries primarily used gold and different currencies now became the
silver as a form of international foreign exchange rate for those two
payment. Payment using gold and currencies. This History of Forex was
silver were hampered by their changed by the birth of an international
devaluation according to external standard by which foreign exchange could
factors such as an increase in the take place between countries. The gold
discovery of new deposits, which
would lead to a change in supply and
standard monetary broke down during the
demand. This factor would change the start of the First World War Political turmoil
Forex trading history forever. with Germany forced the larger European
powers to focus on military projects. This
financial drain on Europe gave way to a lack
of gold to back the excess printing of
currency and would determine a new
change in the FX trading history.
APPRECIATION OF CURRENCY
Happens because of change in
Definition: Exchange Rates!
• 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.
The impact of currency appreciation
on developing economies
• The first is that exports are hurt.  Most developing countries have
economies based largely on exports that are competitive in global
markets because of low prices.  When those countries' currency
gains value, they are no longer able to offer exports to the global
market at the same low prices that they planned to. 
• The second impact of rapid currency appreciation is that it hurts the
value of repatriated profits from a country's international economic
activity.  Whether that be an army of domestic servants traveling to
a wealthier country and sending regular remittances home or a
country'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.
Depreciation of currency
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 it
appears 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, the
exchange 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).
Depreciation of currency
Demand & Supply of
Foreign Exchange
Demand and Supply of Foreign
Exchange influences the
determination of exchange rates and
vice versa. The demand for foreign
exchange is inversely proportional to
the rise of exchange rate. As the
exchange rate goes up the demand for
foreign exchange declines. The
quantity of foreign exchange
demanded falls. The supply of foreign
exchange shifts depending on demand
and not on the exchange rate. If the
supply aspect of transaction is plotted
on a graph it will be vertical since the
supply of foreign currency deposits
available at any time is fixed.

If the supply of a country’s currency


increases the value of the currency
decreases in relation to other
currencies and more money is
required to buy the foreign exchanges.
Fixed Exchange Rate

• A fixed exchange rate, sometimes called a pegged exchange rate, is


a type of exchange rate regime wherein a currency's value is
matched to the value of another single currency or to a basket of
other 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 and
investments between the two countries easier and more
predictable, and is especially useful for small economies where
external trade forms a large part of their GDP.
• It is also used as a means to control inflation. However, as the
reference value rises and falls, so does the currency pegged to it. In
addition, a fixed exchange rate prevents a government from using
domestic monetary policy in order to achieve macroeconomic
stability.
Floating Exchange Rate
• A floating exchange rate or fluctuating exchange rate is a
type of exchange rate regime wherein a currency's value is
allowed to fluctuate according to the foreign exchange
market. A currency that uses a floating exchange rate is
known as a floating currency. It is not possible for a
developing country to maintain the stability in the rate of
exchange for its currency in the exchange market. There
are two options open for them- [1] Let the exchange rate
be allowed to fluctuate in the open market according to the
market conditions, or [2] An equilibrium rate may be fixed
to be adopted and attempts should be made to maintain it
as far as possible. But, if there is a fundamental change in
the circumstances, the rate should be changed accordingly
Recent Exchange Graphs.
GLOBAL MARKET PRODUCTS

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