Fim Currency Market

8/8/2019 Fim Currency Market

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CURRENCY MARKETMBA-TECH 5 th Year

I. Financial instruments

Spot

A spot transaction is a two-day delivery transaction (except in the caseof trades between the US Dollar, Canadian Dollar, Turkish Lira, EUROand Russian Ruble, which settle the next business day), as opposed tothe futures contracts , which are usually three months. This traderepresents a direct exchange between two currencies, has theshortest time frame, involves cash rather than a contract; and interestis not included in the agreed-upon transaction.

Forward

One way to deal with the foreign exchange risk is to engage in aforward transaction. In this transaction, money does not actuallychange hands until some agreed upon future date. A buyer and selleragree on an exchange rate for any date in the future, and thetransaction occurs on that date, regardless of what the market ratesare then. The duration of the trade can be one day, a few days, monthsor years. Usually the date is decided by both parties. and forwardcontract is a negotiated and agreement between two parties

Swap The most common type of forward transaction is the currency swap . Ina swap, two parties exchange currencies for a certain length of timeand agree to reverse the transaction at a later date. These are notstandardized contracts and are not traded through an exchange.

Future

Foreign currency futures are exchange traded forward transactionswith standard contract sizes and maturity dates for example, $1000

for next November at an agreed rate. Futures are standardized and areusually traded on an exchange created for this purpose. The averagecontract length is roughly 3 months. Futures contracts are usuallyinclusive of any interest amounts.

Option
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A foreign exchange option (commonly shortened to just FX option) is aderivative where the owner has the right but not the obligation toexchange money denominated in one currency into another currencyat a pre-agreed exchange rate on a specified date. The FX optionsmarket is the deepest, largest and most liquid market for options of

any kind in the world..

II. Speculation

Controversy about currency speculators and their effect on currencydevaluations and national economies recurs regularly. Nevertheless,economists have argued that speculators ultimately are a stabilizinginfluence on the market and perform the important function of providing a market for hedgers and transferring risk from those peoplewho don't wish to bear it, to those who do.

Large hedge funds and other well capitalized "position traders" are themain professional speculators. According to some economists,individual traders could act as "noise traders" and have a moredestabilizing role than larger and better informed actors.

Currency speculation is considered a highly suspect activity in manycountries. [where? ] While investment in traditional financial instrumentslike bonds or stocks often is considered to contribute positively toeconomic growth by providing capital, currency speculation does not;according to this view, it is simply gambling that often interferes witheconomic policy. For example, in 1992, currency speculation forced theCentral Bank of Sweden to raise interest rates for a few days to 500%per annum, and later to devalue the krona. Former Malaysian PrimeMinister Mahathir Mohamad is one well known proponent of this view.He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators.

Gregory J. Millman reports on an opposing view, comparing speculatorsto "vigilantes" who simply help "enforce" international agreements andanticipate the effects of basic economic "laws" in order to profit.

In this view, countries may develop unsustainable financial bubbles orotherwise mishandle their national economies, and foreign exchangespeculators made the inevitable collapse happen sooner. A relativelyquick collapse might even be preferable to continued economicmishandling, followed by an eventual, larger, collapse. MahathirMohamad and other critics of speculation are viewed as trying todeflect the blame from themselves for having caused theunsustainable economic conditions.
http://en.wikipedia.org/wiki/Speculationhttp://en.wikipedia.org/wiki/Hedge_(finance)http://en.wikipedia.org/wiki/Hedge_fundshttp://en.wikipedia.org/wiki/Wikipedia:WikiProject_Countering_systemic_biashttp://en.wikipedia.org/wiki/Wikipedia:WikiProject_Countering_systemic_biashttp://en.wikipedia.org/wiki/Wikipedia:WikiProject_Countering_systemic_biashttp://en.wikipedia.org/wiki/Gamblinghttp://en.wikipedia.org/wiki/Sveriges_Riksbankhttp://en.wikipedia.org/wiki/Mahathir_Mohamadhttp://en.wikipedia.org/wiki/Malaysian_ringgithttp://en.wikipedia.org/wiki/George_Soroshttp://en.wikipedia.org/wiki/George_Soroshttp://en.wikipedia.org/wiki/Gregory_J._Millmanhttp://en.wikipedia.org/wiki/Economic_bubblehttp://en.wikipedia.org/wiki/Speculationhttp://en.wikipedia.org/wiki/Hedge_(finance)http://en.wikipedia.org/wiki/Hedge_fundshttp://en.wikipedia.org/wiki/Wikipedia:WikiProject_Countering_systemic_biashttp://en.wikipedia.org/wiki/Gamblinghttp://en.wikipedia.org/wiki/Sveriges_Riksbankhttp://en.wikipedia.org/wiki/Mahathir_Mohamadhttp://en.wikipedia.org/wiki/Malaysian_ringgithttp://en.wikipedia.org/wiki/George_Soroshttp://en.wikipedia.org/wiki/George_Soroshttp://en.wikipedia.org/wiki/Gregory_J._Millmanhttp://en.wikipedia.org/wiki/Economic_bubble


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III. Market participants

Unlike a stock market, the foreign exchange market is divided intolevels of access. At the top is the inter-bank market, which is made upof the largest commercial banks and securities dealers . Within the

inter-bank market, spreads, which are the difference between the bidand ask prices, are razor sharp and usually unavailable, and not knownto players outside the inner circle. The difference between the bid andask prices widens (from 0-1 pip to 1-2 pips for some currencies such asthe EUR). This is due to volume. If a trader can guarantee largenumbers of transactions for large amounts, they can demand a smallerdifference between the bid and ask price, which is referred to as abetter spread. The levels of access that make up the foreign exchangemarket are determined by the size of the "line" (the amount of moneywith which they are trading). The top-tier inter-bank market accountsfor 53% of all transactions.

After that there are usually smaller banks, followed by large multi-national corporations (which need to hedge risk and pay employees indifferent countries), large hedge funds, and even some of the retail FX-metal market makers. According to Galati and Melvin, Pension funds,insurance companies, mutual funds, and other institutional investorshave played an increasingly important role in financial markets ingeneral, and in FX markets in particular, since the early 2000s. (2004)In addition, he notes, Hedge funds have grown markedly over the20012004 period in terms of both number and overall size Centralbanks also participate in the foreign exchange market to aligncurrencies to their economic needs.

Banks

The interbank market caters for both the majority of commercialturnover and large amounts of speculative trading every day. A largebank may trade billions of dollars daily. Some of this trading isundertaken on behalf of customers, but much is conducted byproprietary desks, trading for the bank's own account. Until recently,foreign exchange brokers did large amounts of business, facilitatinginterbank trading and matching anonymous counterparts for largefees. Today, however, much of this business has moved on to moreefficient electronic systems.

Commercial companies

An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services.
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Commercial companies often trade fairly small amounts compared tothose of banks or speculators, and their trades often have little shortterm impact on market rates. Nevertheless, trade flows are animportant factor in the long-term direction of a currency's exchangerate. Some multinational companies can have an unpredictable impact

when very large positions are covered due to exposures that are notwidely known by other market participants.

Central banks (RBI in India)

RBI play an important role in the foreign exchange markets. They try tocontrol the money supply , inflation, and/or interest rates and oftenhave official or unofficial target rates for their currencies. They can usetheir often substantial foreign exchange reserves to stabilize themarket. Nevertheless, the effectiveness of RBI "stabilizing speculation"is doubtful because central banks do not go bankrupt if they make

large losses, like other traders would, and there is no convincingevidence that they do make a profit trading.

IV. Forex Fixing

Forex fixing is the daily monetary exchange rate fixed by the RBI. Theidea is that central bank use the fixing time and exchange rate toevaluate behavior of currency. Fixing exchange rates reflects the realvalue of equilibrium in the forex market. Banks, dealers and onlineforeign exchange traders use fixing rates as a trend indicator.

The mere expectation or rumor of central bank intervention might beenough to stabilize a currency, but aggressive intervention might beused several times each year in countries with a dirty float currencyregime. Central banks do not always achieve their objectives.

Hedge funds as speculators

About 70% to 90% of the foreign exchange transactions arespeculative. In other words, the person or institution that bought orsold the currency has no plan to actually take delivery of the currencyin the end; rather, they were solely speculating on the movement of that particular currency. Hedge funds have gained a reputation foraggressive currency speculation since 1996. They control billions of dollars of equity and may borrow billions more, and thus mayoverwhelm intervention by central banks to support almost anycurrency, if the economic fundamentals are in the hedge funds' favor.

Investment management firms
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Investment management firms (who typically manage large accountson behalf of customers use the foreign exchange market to facilitatetransactions in foreign securities. For example, an investment managerbearing an international equity portfolio needs to purchase and sellseveral pairs of foreign currencies to pay for foreign securities

purchases.

Some investment management firms also have more speculativespecialist currency overlay operations, which manage clients' currencyexposures with the aim of generating profits as well as limiting risk.Whilst the number of this type of specialist firms is quite small, manyhave a large value of assets under management (AUM), and hence cangenerate large trades.

Retail foreign exchange brokers

Retail traders (individuals) constitute a growing segment of thismarket, both in size and importance. Currently, they participateindirectly through brokers or banks. Retail brokers, while largelycontrolled and regulated have in the past been subjected to periodicforeign exchange scams . To deal with the issue, imposing stricterrequirements, particularly in relation to the amount of NetCapitalization required of its members was implemented. As a resultmany of the smaller, and perhaps questionable brokers are now gone.

There are two main types of retail FX brokers offering the opportunityfor speculative currency trading: brokers and dealers or market makers . Brokers serve as an agent of the customer in the broader FXmarket, by seeking the best price in the market for a retail order anddealing on behalf of the retail customer. They charge a commission ormark-up in addition to the price obtained in the market. Dealers ormarket makers , by contrast, typically act as principal in the transactionversus the retail customer, and quote a price they are willing to deal atthe customer has the choice whether or not to trade at that price.

When the service provider acts as principal, no commission is paid, butthe price offered may not be the best available in the marketsincethe service provider is taking the other side of the transaction, aconflict of interest may occur.

Non-bank foreign exchange companies

Non-bank foreign exchange companies offer currency exchange andinternational payments to private individuals and companies. Theseare also known as foreign exchange brokers but are distinct in that
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they do not offer speculative trading but currency exchange withpayments. I.e., there is usually a physical delivery of currency to abank account. Send Money Home offers an in-depth comparison intothe services offered by all the major non-bank foreign exchangecompanies.

It is estimated that in the UK, 14% of currency transfers/payments aremade via Foreign Exchange Companies. These companies' selling pointis usually that they will offer better exchange rates or cheaperpayments than the customer's bank. These companies differ fromMoney Transfer/Remittance Companies in that they generally offerhigher-value services.

Money transfer/remittance companies

Money transfer companies /remittance companies perform high-volume

low-value transfers generally by economic migrants back to their homecountry. The four largest markets ( India , China , Mexico and thePhilippines ) receive $95 billion. The largest and best known provider isWestern Union with 345,000 agents globally followed by UAE Exchange & Financial Services Ltd.

V. Determinants of FX rates

The following theories explain the fluctuations in FX rates in a floating exchange rate regime (In a fixed exchange rate regime, FX rates aredecided by its government):

(a) International parity conditions: Relative Purchasing Power Parity , interest rate parity . Though to some extent the abovetheories provide logical explanation for the fluctuations inexchange rates, yet these theories falter as they are based onchallengeable assumptions [e.g., free flow of goods, servicesand capital] which seldom hold true in the real world.

(b) Balance of payments model: This model, however, focuseslargely on tradable goods and services, ignoring theincreasing role of global capital flows. It failed to provide anyexplanation for continuous appreciation of dollar during1980s and most part of 1990s in face of soaring US currentaccount deficit.

(c) Asset market model: views currencies as an important assetclass for constructing investment portfolios. Assets prices areinfluenced mostly by peoples willingness to hold the existing
http://en.wikipedia.org/wiki/Send_Money_Homehttp://en.wikipedia.org/wiki/Money_transferhttp://en.wikipedia.org/wiki/Indiahttp://en.wikipedia.org/wiki/Chinahttp://en.wikipedia.org/wiki/Mexicohttp://en.wikipedia.org/wiki/Philippineshttp://en.wikipedia.org/wiki/Western_Unionhttp://en.wikipedia.org/wiki/UAE_Exchange_%26_Financial_Services_Ltd.http://en.wikipedia.org/wiki/UAE_Exchange_%26_Financial_Services_Ltd.http://en.wikipedia.org/wiki/Floating_exchange_ratehttp://en.wikipedia.org/wiki/Floating_exchange_ratehttp://en.wikipedia.org/wiki/Fixed_exchange_ratehttp://en.wikipedia.org/wiki/Relative_Purchasing_Power_Parityhttp://en.wikipedia.org/wiki/Relative_Purchasing_Power_Parityhttp://en.wikipedia.org/wiki/Interest_rate_parityhttp://en.wikipedia.org/wiki/Send_Money_Homehttp://en.wikipedia.org/wiki/Money_transferhttp://en.wikipedia.org/wiki/Indiahttp://en.wikipedia.org/wiki/Chinahttp://en.wikipedia.org/wiki/Mexicohttp://en.wikipedia.org/wiki/Philippineshttp://en.wikipedia.org/wiki/Western_Unionhttp://en.wikipedia.org/wiki/UAE_Exchange_%26_Financial_Services_Ltd.http://en.wikipedia.org/wiki/UAE_Exchange_%26_Financial_Services_Ltd.http://en.wikipedia.org/wiki/Floating_exchange_ratehttp://en.wikipedia.org/wiki/Floating_exchange_ratehttp://en.wikipedia.org/wiki/Fixed_exchange_ratehttp://en.wikipedia.org/wiki/Relative_Purchasing_Power_Parityhttp://en.wikipedia.org/wiki/Relative_Purchasing_Power_Parityhttp://en.wikipedia.org/wiki/Interest_rate_parity


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make themselves felt. Cycle analysis looks at longer-term pricetrends that may rise from economic or political trends.

"Buy the rumor, sell the fact": This market truism can

apply to many currency situations. It is the tendency for the priceof a currency to reflect the impact of a particular action before itoccurs and, when the anticipated event comes to pass, react inexactly the opposite direction. This may also be referred to as amarket being "oversold" or "overbought". To buy the rumor orsell the fact can also be an example of the cognitive bias knownas anchoring , when investors focus too much on the relevance of outside events to currency prices.

Economic numbers: While economic numbers can certainlyreflect economic policy, some reports and numbers take on atalisman-like effect: the number itself becomes important tomarket psychology and may have an immediate impact on short-term market moves. "What to watch" can change over time. Inrecent years, for example, money supply , employment , trade balance figures and inflation numbers have all taken turns in thespotlight.

Technical trading considerations: As in other markets,the accumulated price movements in a currency pair such asEUR/USD can form apparent patterns that traders may attemptto use. Many traders study price charts in order to identify suchpatterns.

MP/November 2010
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Fim Currency Market