INTRODUCTION TO CURRENCY MARKETS
2.1 BASIC FOREIGN EXCHANGE DEFINITIONS
Spot: Foreign exchange spot trading is buying one currency with a different currency for immediate delivery.
The standard settlement convention for Foreign Exchange Spot trades is T+2 days, i.e., two business days from the date of trade.
Forward Outright: A foreign exchange forward is a contract between two counterparties to exchange one currency for another on any day after spot. In this transaction, money does not actually change hands until some agreed upon future date. The duration of the trade can be a few days, months or years. For most major currencies, three business days or more after deal date would constitute a forward transaction
Base Currency / Terms Currency: In foreign exchange markets, the base currency is the first currency in a currency pair. The second currency is called as the terms currency. Exchange rates are quoted in per unit of the base currency. E.g. The expression US Dollar–Rupee, tells you that the US Dollar is being quoted in terms of the Rupee. The US Dollar is the base currency and the Rupee is the terms currency.
Exchange rates are constantly changing, which means that the value of one currency in terms of the other is constantly in flux. Changes in rates are expressed as strengthening or weakening of one currency vis-à-vis the other currency. Changes are also expressed as appreciation or depreciation of one currency in terms of the other currency. Whenever the base currency buys more of the terms currency, the base currency has strengthened / appreciated and the terms currency has weakened / depreciated. E.g. If US Dollar–Rupee moved from 43.00 to 43.25, the US Dollar has appreciated and the Rupee has depreciated.
Swaps: A foreign exchange swap is a simultaneous purchase and sale, or sale and purchase, of identical amounts of one currency for another with two different value dates. Foreign Exchange Swaps are commonly used as a way to facilitate funding in the cases where funds are available in a different currency than the one needed. Effectively, each party to the deal is given the use of an amount of foreign currency for a specific time. The Forward Rate is derived by adjusting the Spot rate for the interest rate differential of the two currencies for the period between the Spot and the Forward date. Liquidity in one currency is converted into another currency for a period of time.
2.2 EXCHANGE RATE MECHANISM
The price of one currency in terms of other currency is known as the exchange rate.
“Foreign Exchange” refers to money denominated in the currency of another nation or a group of nations. Any person who exchanges money denominated in his own nation’s currency for money denominated in another nations currency acquires foreign exchange.
This holds true whether the amount of the transaction is equal to a few rupees or to billions of rupees; whether the person involved is a tourist cashing a travelers’ cheque or an investor exchanging hundreds of millions of rupees for the acquisition of a foreign company; and whether the form of money being acquired is foreign currency notes, foreign currency-denominated bank deposits, or other short-term claims denominated in foreign currency.
A foreign exchange transaction is still a shift of funds or short-term financial claims from one country and currency to another. Thus, within India, any money denominated in any currency other than the Indian Rupees (INR) is, broadly speaking, “foreign exchange.” Foreign Exchange can be cash, funds available on credit cards and debit cards, travelers’ cheques, bank deposits, or other short-term claims. It is still “foreign exchange” if it is a short-term negotiable financial claim denominated in a currency other than INR.
Almost every nation has its own national currency or monetary unit - Rupee, US Dollar, Peso etc. - used for making and receiving payments within its own borders. But foreign currencies are usually needed for payments across national borders. Thus, in any nation whose residents conduct business abroad or engage in financial transactions with persons in other countries, there must be a mechanism for providing access to foreign currencies, so that payments can be made in a form acceptable to foreigners. In other words, there is need for “foreign exchange” transactions—exchange of one currency for another.
DETERMINATION OF EXCHANGE RATES
The market price is determined by the interaction of buyers and sellers in that market, and a market exchange rate between two currencies is determined by the interaction of the official and private participants in the foreign exchange rate market. For a currency with an exchange rate that is fixed, or set by the monetary authorities, the central bank or another official body is a participant in the market, standing ready to buy or sell the currency as necessary to maintain the authorized pegged rate or range. But in countries like the United States, which follows a complete free floating regime, the authorities are not known to intervene in the foreign exchange market on a continuous basis to influence the exchange rate. The market participation is made up of individuals, non-financial firms, banks, official bodies, and other private institutions from all over the world that are buying and selling US Dollars at that particular time.
2.3 MAJOR CURRENCIES OF THE WORLD
The US Dollar is by far the most widely traded currency. In part, the widespread use of the US Dollar reflects its substantial international role as “investment” currency in many capital markets, “reserve” currency held by many central banks, “transaction” currency in many international commodity markets, “invoice” currency in many contracts, and “intervention” currency employed by monetary authorities in market operations to influence their own exchange rates.
Other Major Currencies include:
The Euro
Like the US Dollar, the Euro has a strong international presence and over the years has emerged as a premier currency, second only to the US Dollar.
The Japanese Yen
The Japanese Yen is the third most traded currency in the world. It has a much smaller international presence than the US Dollar or the Euro. The Yen is very liquid around the world, practically around the clock.
The British Pound
Until the end of World War II, the Pound was the currency of reference. The nickname Cable is derived from the telegrams used to update the GBP/USD rates across the Atlantic. The currency is heavily traded against the Euro and the US Dollar, but it has a spotty presence against other currencies. The two-year bout with the Exchange Rate Mechanism, between 1990 and 1992, had a soothing effect on the British Pound, as it generally had to follow the Deutsche Mark's fluctuations, but the crisis conditions that precipitated the pound's withdrawal from the Exchange Rate Mechanism had a psychological effect on the currency.
The Swiss Franc
The Swiss Franc is the only currency of a major European country that belongs neither to the European Monetary Union nor to the G-7 countries. Although the Swiss economy is relatively small, the Swiss Franc is one of the major currencies, closely resembling the strength and quality of the Swiss economy and finance.
Switzerland has a very close economic relationship with Germany, and thus to the Euro zone. Typically, it is believed that the Swiss Franc is a stable currency. Actually, from a foreign exchange point of view, the Swiss Franc closely resembles the patterns of the Euro, but lacks its liquidity.
2.4 OVERVIEW OF INTERNATIONAL CURRENCY MARKETS
During the past quarter century, the concept of a 24-hour market has become a reality. Somewhere on the planet, financial centre are open for business; banks and other institutions are trading the US Dollar and other currencies every hour of the day and night, except on weekends. In financial centre around the world, business hours overlap; as some centre close, others open and begin to trade. The foreign exchange market follows the sun around the earth.
Business is heavy when both the US markets and the major European markets are open -that is, when it is morning in New York and afternoon in London. In the New York market, nearly two-thirds of the day’s activity typically takes place in the morning hours. Activity normally becomes very slow in New York in the mid-to late afternoon, after European markets have closed and before the Tokyo, Hong Kong, and Singapore markets have opened. Given this uneven flow of business around the clock, market participants often will respond less aggressively to an exchange rate development that occurs at a relatively inactive time of day, and will wait to see whether the development is confirmed when the major markets open. Some institutions pay little attention to developments in less active markets. Nonetheless, the 24-hour market does provide a continuous “real-time” market
2.5 ECONOMIC VARIABLES IMPACTING EXCHANGE RATE MOVEMENTS
Various economic variables impact the movement in exchange rates. Interest rates, inflation figures, GDP are the main variables; however other economic indicators that provide direction regarding the state of the economy also have a significant impact on the movement of a currency. These would include employment reports, balance of payment figures, manufacturing indices, consumer prices and retail sales amongst others. Indicators which suggest that the economy is strengthening are positively correlated with a strong currency and would result in the currency strengthening and vice versa. Currency trader should be aware of government policies and the central bank stance as indicated by them from time to time, either by policy action or market intervention. Government structures its policies in a manner such that its long term objectives on employment and growth are met. In trying to achieve these objectives, it sometimes has to work around the economic variables and hence policy directives and the economic variables are entwined and have an impact on exchange rate movements. Inflation and interest rates are opposites. In order to reduce inflation, which reduces the purchasing power of money, often the policy of high interest rate is followed but such a policy hinders growth therefore a policy to balance inflation and interest rates is considered ideal and the perception of the success of such a policy by the participants in the foreign exchange market will impact the movement and direction of the currency.
CH 3: INTRODUCTION TO DERIVATIVES
“By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives…These instruments enhances the ability to differentiate risk and allocate it to those investors most able and willing to take it- a process that has undoubtedly improved national productivity growth and standards of livings.”
Alan Greenspan, Former Chairman. US Federal Reserve Bank