FX Market Overview.docx

FX Market Overview.docx

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FXMarketOverview

ForexMarketOverview:

WhyCashIsKing?

ExecutiveSummary

Morepeoplehavestartedtolearnabouttheforeignexchangemarket.Thismarkethasbeengrowingatatremendousrateintermsofitsdailyturnovervolumeoftrading.

Wewilldiscussfactsabouttheforexmarketandfactorswhichhavedriventhismarket.Whatarethetransactionsthataretakingplaceinthismarketandhowkeyeconomicdatareleasedperiodicallybythecentralbanksinfluenceitsexchangerate.

Thedifferencesbetweenforexmarketandtheequityorfuturesmarketareaddressed.Andabriefhistoryontheforexmarket:

5ImportantCurrencyEventsthatChangetheWorldwillbediscussed.

Thisinformationiswrittenintheaimofeducatingpeopleonthefactsaboutforexandthekeydrivingfactorswhichmakeitoneofthefastestgrowingmarketofourtime.“Cashisking!

”–Thisphrasewillholdtrueforalongtime.

FXMarketOverview

Foreignexchangeisthelargestfinancialmarketintheworld.Itisestimatedthat$3.2trillionglobalaveragedailyvolumeistradedacrosstheworldeveryday.

DecentralisedMarket

Unlikeequityorfuturesmarket,forexmarketdoesnothaveacentralisedexchange.Tradingtheforexmarketdoesnotinvolveanexchangeandisusuallytradedinover-the-countermarketwherebuyersandsellersconductcurrencytransactions.

Around-the-Clock24HrMarket

Forexmarketisopened24houraday（about6daysaweek）wherepeoplefromdifferenttimezonescanparticipate.

InstantLiquidity

Tradingtheforexmarketismostliquidthroughouttheday.Inotherwords,youcanbuyandsellcurrenciesalmostinstantlywheneveryouwantto.Thisliquidityprovidesinvestorsandtradersminimalriskbecausetheycanexittheirinvestmentsasandwhentheywanttowithoutthepossibilityofnotfindingapotentialbuyerorsellerfortheirtransactions.

TransactionsOccurringintheForexMarket

CommercialTransactions

BuildingdeveloperspurchaserawmaterialsuchasmineraloresfromAustraliaandtradingcompanieswillimportproductsfromabroadandexportouttoothercountries.

Bothofthesetransactionsrequirethatthecompanyfirstselltheircurrencyinexchangefortheforeigncurrencytopurchasetheirproducts.Subsequently,exportinggoodsoutwillmeanthatcompaniesacceptforeigncurrencyinexchangefortheirgoods.Thereafter,convertingprofitsbacktohomecurrency.

Thesecompaniesactasbothbuyersandsellersforforeigncurrencies.

Hedging

Companieswithopencurrencyexposureswillfrequentlybuyorselltheirlocalcurrencyagainstforeigncurrencytoprotectfromalossinvalueduetopossiblecurrencyfluctuations.

PortfolioInvestments

Fundmanagersandhedgefundmanagerswillmakeforeign-basedinvestmentstoparticipateinthegrowthofdevelopingcountries.Investmentsinforeigninvestmentsrequiremoneytobepaidintheirhomecurrency.Hence,beforeinvestmentcanbemade,moneymustfirstbeconvertedtotheircurrency.

Personal

Tourists,immigrantsandemigrantsmakingmoneyremittancearethemaintransactionsinthiscategory.

Funding

Bigbanksandgovernmentcentralbankswilloftenborrowlargequantityofmoneyfromabroadbyarrangingthesaleofsecurities（governmenttreasurybondsorcommercialloans）.Moneyreceivedinforeigncurrencieswillbeconvertedintheforexmarket.

MajorParticipants

GovernmentandCentralBanks

CentralbanksmayregulatetheircountrycurrencyagainstUSdollarsbybuyingorsellingUSdollarstokeeptheircurrencywithinacertainband.Thisisalsocalleddirtyfloat.

WehavewitnessedmanytimesthattheBankofJapanintervenedintheforexmarketbysellingYenagainstUSdollartopreventYenfromappreciatingtoomuchagainstUSdollars.ThisisbecauseJapanisanexportingcountriesandpricesoftheirproductwillbecometooexpensiveforitstradingpartnersifYenappreciatetoomuchagainstUSdollar.

CommercialBanks

Theyactasprimarymarketdealersandprovideliquiditytootherparticipantsintheforexmarket.ExamplesofthesebanksareCitibank,UBSandJ.PMorgan.

Hedgers

Theseareusuallymultinationalcompaniesthatholdlargequantityofmoneyindifferentcurrencies.Theywilltakeanoppositepositionsinanticipationofcurrencymovementssoastominimisealoseinvalue.

Speculators

Therearetwogroupsofspeculators.Hedgefundsarethelargespeculatorslookingtoprofitfromchangesinmajorcurrencymovements.Thesmallergroupofspeculatoristheretailinvestors.Retailspeculatorshavesurgedoverthepast5yearsduetotheabilitytotradeelectronicallyandfromhome.

Thederegulationoftheforexmarketallowsretailinvestorstoparticipateandprofitfromtheforexmarket.Lowbrokeragefees,lowmarginrequirementsandhighlyleveragedarereasonswhymorepeopledecidedtoparticipateinforextradingforinvestmentpurposes.

KeyFactorsImpactingCurrencies

Beforewediscussthetheories,Iwillhighlightthatthesetheorieswillaffectcurrencymarkettoacertainextent,howeverthesetheorieshavelimitations.Theoriesarecalledtheoriesbecausetheymadecertainkeyassumptionswhichmaynotnecessarybethecaseinreality.

Tradingforexmarketbasedsolelyonthesetheoriesisnotrecommended.Andthesestrategiesarefundamentalsthatinfluencethelongtermdirectionsofcurrency.Theperiodforthesefactorstoinfluencecurrencydirectionsmaybe5to20years.

Itisimportantthatinvestorsunderstandthesefundamentalsthatdrivesthecurrenciesinthelongruneventhoughitmaynotnecessaryreflecttoday’sconditions.

WhatisBalanceofPaymentsTheory

BalanceofPaymentsconsistsof2accounts:

thecurrentaccountandthecapitalaccount;

Currentaccountmeasurestradeintangiblesuchasmanufacturedgoods.Surplusordeficitbetweenexportsandimportsiscalledthetradebalance.Asurplustradebalanceconsistsofexportingmorethanisimported.Atradedeficitmeansimportingmorethanits’exports.

Capitalaccountmeasuresflowsofmoneysuchasinvestmentsforstocksorbonds.

Note:

Capitalaccountisdescribedbutthismodelonlyconsidermoneyinflowandoutflowfromcurrentaccount.

BalanceofPaymentsTheory

Countriesthatimportmorethanexportshavemoremoneyoutflowthaninflow,theyaresaidtohaveatradedeficit.Whilecountriesthathavemoreexportsthanimportswillexperiencemoremoneyinflowthanoutflow,theyaresaidtohaveatradesurplus.

BalanceofPaymentstheorystatesthatcountrieswithtradedeficitswillexperiencecurrencydepreciationbecausemoreofthenation’scurrenciesaresoldinthemarkettoimportgoodsfromabroad.Thesellingpressurecausesthenation’scurrencytodepreciateagainsttheothercurrencies.

Similarly,countrieswithtradesurpluswillexperienceanappreciationofnation’scurrency.Thisisbecausemoregoodsaresoldabroad,andforeigncountrieshavetobuynation’scurrencyinordertopurchasegoods.Thebuyingpressurewillappreciatenation’scurrencyagainsttheotherforeigncurrencies.

Ingeneral,countriesmightexperiencepositiveornegativetrade.Itisimportantthatcountriesachieveabalancesuchthatthisdeficittrademaynotgoonforasubstantialperiodoftimesuchthatitisdetrimentaltothenation’seconomy.Policyshouldbecarriedouttoreverttradedeficitbacktosurplusinthenextcalendaryear.

Limitations

Thebalanceofpaymentmodelfocusesontradedgoodsandserviceswhileignoringinternationalcapitalflows.Itisuntil1990sthatcapitalflowsplaysasignificantpartininfluencingthecountry’sexchangerate.

Hence,acountrymayhaveatradedeficitbutbecauseofitlargecapitalinflow,inturnbalancesthetotalmoneyflow.Thismodelhasfailedtotakeintoaccountthecapitalmoneyflowwhichhassincebecomesignificantinthecurrentyears.

MonetaryModel

Thismodelholdsthatexchangeratesaredeterminedbynation’smonetarypolicy.

Atightmonetarypolicywillmeanthatthenation’scentralbanksellits’equityinvestmentsandbondsintheopenmarkettothepublic.Hence,theseactionswilldecreasethemoneysupplywhichwillleadtoanappreciationofnation’scurrency.

Whileaneasingofmonetarypolicybycentralbankwillmeanthatthecentralbankbuyequityandbondsbackfromthepublicintheopenmarket.Asaresult,thiswillincreasethenation’smoneysupply,leadingtodepreciationofitscurrency.

Severalfactorsthatinfluenceexchangerates:

1.Nation’smoneysupply

2.Estimatedfuturelevelsofanation’smoneysupply

3.Thegrowthrateofanation’smoneysupply

Limitations

Thismodelismoreeffectiveinpreventinganation’scurrencyfromsharplydevaluationthanpushingforcurrencyappreciation.Veryfeweconomistssolelystandbythismodelbecauseitdoesnottakeintoaccounttradeflowsandcapitalflows.

RealInterestRateDifferentialTheory

Theinterestratetheorystatescountriesthathavehighinterestrateswillseetheircurrenciesappreciateinvalue;whilecountrieswithlowinterestratesshouldseetheircurrenciesdepreciateinvalue.

BasicsoftheModel

Whenanation’sinterestratesareraised,internationalinvestorswilldiscoverthattheyieldofthatnations’currencyismoreattractiveandhencewillshifttheirmoneythere.Thisprocesswillmeanthatinvestorswillhavetobuythenation’scurrencyinordertoshifttheirmoneyovertheretotakeadvantageofitshighyields.Thiswillcausethenation’scurrencytoappreciateinvalue.

Wheninterestratesarelowered,internationalinvestorswillfindabetterplacetoputtheirmoneysothattheycanreceivebetteryields.Thiswillcauseinvestorstosellthenation’scurrencysothattheycanmoveitabr