Brief History and basics, a complete guide to the Foreign Exchange Market
A conversion of one currency into another is termed as Foreign Exchange or Forex. The foreign exchange market is a global decentralized marketplace for traders to buy, sell, exchange and speculate on currencies. In the foreign exchange market, currencies are traded virtually around the clock with the largest trading centres being in London, New York, Tokyo and Singapore. The rate at which a currency can be exchanged for another is called the currency exchange rate. It is always quoted in pairs like the EUR/USD (the Euro and the US Dollar). A currency transaction that generally involves the conversion of a currency of one country with that of another is called a Foreign Exchange transaction. These transactions could be anything from buying or selling of goods and services on credit to million-dollar payments made by gigantic corporations and governments.
This financial market works as people exchange currencies, or in other words, compare it to that of their own. For these purposes, there is an exchange rate at which one currency can be exchanged for another. Just like any kind of asset, the exchange rate is the price at which you can ‘buy’ a currency. This price of a currency against another could be determined in two ways. 1) The government’s central bank could fix/peg the rate at which their currency can be exchanged. 2) They could float the currency in the FX market, hence the exchange rate would be determined by supply and demand and would constantly change.
FIXED AND FLOATED CURRENCIES:
In reality, there is no currency which is wholly fixed or floating, as the market pressure could lead to forced changes in exchange rates. Some currencies are crawling pegs, meaning that the value of the currency is allowed to fluctuate within a band of rates. Typically, crawling pegs are used to control the currency moves when there is a risk of devaluation because of economic instability. This allows the par value of the currency to remain within its designated range even when other factors are [usually] trying to devalue the currency. Crawling pegs are also very useful to smoothen the inevitable decline of a currency in order to prevent panic in the exchange market. Though the bracketed range of a pegged currency can be adjusted, there is always a risk of a broken peg, meaning that a country could fail to defend its currency, and this could result in rapid devaluation which might have a severe impact on the local economy. Britain running out of reserves in 1992 and failing to defend its British Pound is a great example of a broken peg and how it could take a toll on the economy. The British government was forced to withdraw the Pound from the European Exchange Rate Mechanism (ERM) after it failed to keep it above its agreed lower limit in the ERM.
THE WORLD ONCE PEGGED:
About a century ago, all the world currencies were pegged because they were linked to gold. This was known as the ‘gold standard’. In the gold standard, the value of a local currency was fixed according to the gold ounces. The gold standard worked out really well as currencies and trade were stabilized, but the start of World War I led to most countries abandoning the gold standard. A run on sterling forced The Bank of England, the central bank of the UK and the model on which most modern central banks have been based, to impose exchange controls that weakened the gold standard which consequently meant that gold prices no longer played the role that they did before. In financing the war and forsaking gold, many of the countries suffered huge inflation and price levels increased drastically. The exchange rates did not fluctuate much, but despite that, the small changes that did take place resulted in severe European inflations which meant that the cost of American goods was less compared to those of Europe.
The United States’ victory in the World War II meant that the currencies could once again (only if the central government wanted to do so) be fixed, but this time against the U.S. Dollar under the Bretton Woods System of fixed exchange rates. Bretton Woods was a system developed at the United Nations Monetary and Financial Conference held in New Hampshire in order to create a foreign exchange rate system, prevent competitive devaluations and promote economic growth. The U.S. dollar struggled throughout the 60s within the parity established at Bretton Woods. The system eventually dissolved in the early 70s when U.S. President Richard Nixon announced the “temporary” suspension of the dollar’s convertibility into gold and by March 1973, all major world currencies began to float against each other. Since the abandonment of global peg, no major economies since then have gone back the peg regime as the use of gold as a peg has been totally forsaken. Today, most of the economies have adopted the floating system where the strength of the local currency is determined by the supply and demand.
SUPPLY & DEMAND:
As mentioned earlier, values of floating currencies are determined through supply and demand, which form the most basic concepts of economics. Let us have a look at the way supply and demand affect the currencies floated in the Foreign Exchange market.
In economics, demand is the number of goods and services that are bought at numerous prices over a period of time. Demand is the consumer’s need to own a product or use a service. Supply is the measure of how much a particular product or service is available at a given time. In the FX market, the demand is for currencies, and this means that the value of a particular currency is directly linked to its supply. As the supply of the currency increases, the currency becomes less valuable as there is more of it available in the market. On the contrary, if the supply of the currency decreases, it becomes more valuable.
Generally, it is the country’s exports that derive the demand for currencies. Let’s use an example to understand it better. There are two manufacturers, a Chinese and a British, and both of them are selling the same machine, but for different prices. The Chinese manufacturer is selling at a cheaper price while the British is selling it at a slightly higher price. Obviously, one would want to buy it from the Chinese manufacturer in order to save money, but the person wants to receive money in Yuan, so eventually the money would get exchanged and this way, a better deal created higher demand for the Chinese currency. While demand for currencies is created by better deals, domestic demand for imports from abroad determines the supply of a currency. For example, if the U.S. buys something from Japan, they would have to pay in Yen, meaning they have to supply the Foreign Exchange market with dollars in order to obtain Yen. This way, the more U.S. imports, the greater the supply of Dollars onto the foreign exchange market.
CHINA’S CRAWLING PEG:
The Chinese Yuan is a really popular example of a currency peg in the modern world as their central government has purposefully weakened the currency so that the Chinese exports are less expensive compared to other competing countries. This weak currency rate also benefits the international corporations in other countries as it allows them to create long-term plans without having to worry about the fluctuation in the exchange rate. China is the United States’ largest import partner representing 20% of the country’s exports for the year 2016 at $462.8 Billion. This way, the Chinese economy is benefitting immensely by reducing their exchange rate as it gives them an edge over their exporting competitors. A huge currency like the Chinese Yuan being pegged means that an anti-competitive trading environment is created where a strong economy with a depreciated currency turns out to be the winner. America’s current president Mr Donald Trump raised this issue in his campaign, stating that China’s unfair dealing is costing jobs in the United States. It is disputed whether the Chinese Yuan is actually undervalued or not because some economists also claim that the Yuan is in line with the fundamentals on a trade-weighted basis and the technological advancement in the United States is actually the main reason for losing jobs.
SPOT AND FUTURE RATE:
Forex transactions take place either on spot basis, forward basis or on a future basis. The spot deal takes place in two business days (excluding weekends and public holidays of either currency of the traded pair) with the major exception being the U.S. Dollar v Canadian Dollar which is dealt with in one business day. Nowadays, forex trading in the spot market is the norm as it motivates the real asset that the forwards and futures markets are based on. Unlike a spot agreement, a future contract involves an agreement between two counterparties where the buyer is borrowing (and the seller is lending) a notional sum at a fixed interest rate (FRA rate) for a specified period of time starting at a date in the future. For instance, a company is aware that it will have to borrow €10,000 in 6 months’ time for a 6-month period. The interest rate at which it can borrow today is 0.95%, but the company’s treasurer predicts it might rise as high as 1.30% in the approaching months. The treasurer receives a quote of 1% from his bank and buys the FRA (Forward Rate Agreement) for a notional of €10,000 on (let us say) January 1st. The treasurer chooses to buy a 6×12 FRA (6 months is the effective date from now and 12 months is the termination date from now, this is written as 6×12 FRA) in order to cover the period of 6 months starting 6 months from now. Just as the treasurer anticipated, the 6-month LIBOR rose during the period and on the fixing date (July 1st), the 6-month LIBOR fixes at 1.2, which is the settlement rate for the company’s Forward Rate Agreement. The interest rate differential would be €10.1 and that is the settlement amount the company will receive from the bank. It can be calculated using the following formula:
Interest differential = | (Settlement rate − Contract rate) | × (Days in contract period/360) × Notional amount
Usually, big international corporations and speculators take part in forwards and futures market.
ECONOMIC THEORIES IN THE FX MARKET:
It is understood that a currency’s value is determined by the nation’s economic strength, which is why it is extremely important to get the idea of how some economic theories shape Foreign Exchange market, and how just a few events could go on to have a profound effect on the currency markets. Following are a few economic theories that have a huge influence on the currencies’ exchange rates.
Balance of Payments:
There are two portions involved with a nation’s Balance of Payments (BOP), which is a posting of all exchanges between one country and others amid a specific timeframe. This helps to find out if the currency is on the right track based on the trading. Adjustments to the currency rate need to be made if a country’s monetary exchange rates are unbalanced. When a country’s imports are more than their exports, their currency is typically devalued and Venezuela is an example of that. At the same time, if the country’s exports are outweighing their imports, their currency’s value would be appreciated and China is a great example of that.
Purchasing Power Parity, Interest Rate Parity & International Fisher Effect:
Purchasing Power Parity is an economics theory according to which the exchange rate between the two countries should be in proportion to their currency’s purchasing power. This means that similar things should cost the same all around the world, but if they are cheaper in a certain country, everyone would want to obtain it from that nation in order to save money. Another economic notion in the forex market that is similar to the Purchasing Power Parity is the Interest Rate Parity. This theory suggests that the interest rates for two assets in two different countries should be the same, meaning that investment in that asset would yield the same return as it would do in any other country. There is another economics theory in the FX market which is the International Fisher Effect (IFE) according to which the exchange rate between two countries should fluctuate similar to the way their nominal interest rates change. This is because the spot exchange rate is expected to change equally in the opposite direction of the interest rate differential, which is the difference in interest rate between two currencies in a pair; hence, the currency of the country that has a higher nominal interest rate is expected to be devalued against the currency of the country that has a lower nominal interest rate, as higher nominal interest rates reflect an expectation of inflation. To make things clearer, the nominal interest rate is the rate of interest before the adjustments for inflation are made.
ECONOMIC DATA AND ITS SIGNIFICANCE:
Even though the major economic theories explained above influence the currencies in the long term, but economic data has a much more significant impact on the currencies’ value in the short-term. Some very basic things like political instability, the rise in unemployment or even a slight decrease in the GDP could play a huge part in depreciating a currency within hours. Each day, economic announcements are made in different ways, usually through news and online reports, and some of the following have huge influences on the FX Market:
The inflation data shows us the fluctuation in the price levels over a certain period of time. This means that if the price level of goods in a country increases, their currency would reduce in value. For most countries, the inflation data for the previous month is released in the ongoing month by the Consumer Price Index or the CPI.
Gross Domestic Product
The Gross Domestic Product is a measure of the market price of all the finished goods and services that a country generated over a period of time. GDP is considered to be the best measure of a country’s overall economic growth or decline. An improved GDP would increase the chances of foreign investment in the country which could, in turn, possibly bump up the value of its currency as money moves into the state.
Big Events like Elections & Wars:
Significant events like elections, policy changes, wars or natural disasters could cause panic in the FX market as these events would either influence a nation’s currency in a positive or a negative way. This is because these episodes have the capacity to shift a country’s fundamentals. For example, traders view elections as a case of potential political instability which could cause unpredictable changes in the FX market. To stay prepared, forex traders keep a close eye on the pre-election polls to get a feel of what kind of government and policies they could expect. A new government would mean a change of policies so the traders would try to anticipate how those news policies would impact the national currency. If the traders feel that a “pro-economy” party has a higher chance of winning the elections, they are likely to invest in the nation’s currency. Just like elections, devastation in a country also has an enormous effect on the currency’s value. This destruction is usually caused by natural disasters or war, and both of them are mostly unexpected. These shocking events damage the infrastructure causing huge monetary losses to the government. This provokes panic in the Foreign Exchange market and investment in the national currency starts declining.
We can conclude that the Foreign Exchange Market is primarily driven by the economic factors which are the indicators of a country’s economic strength. Though the recent events involving a country also influences its currency’s exchange rate, its economic outlook is the most important determinant of its currency’s value. We also saw how companies can predict the interest rates and enter in an agreement with a counterparty (usually banks) as this provides certainty for financial planning, by allowing the interest rate risk manager to know the company’s net interest payments for the contract period. Having knowledge about the speculation in the FX market and knowing the major influencing factors and indicators will help one keep pace in the competitive and fast-moving world of forex.