Factors Affecting the Market
Currency prices are affected by a variety of economic and political conditions, most importantly interest rates, inflation and political stability. Moreover, governments sometimes participate in the Forex market to influence the value of their currencies, either by flooding the market with their domestic currency in an attempt to lower the price, or conversely buying in order to raise the price. This is known as Central Bank intervention. Any of these factors, as well as large market orders, can cause high volatility in currency prices. However, the size and volume of the Forex market makes it impossible for any one entity to "drive" the market for any length of time.
Fundamental vs. Technical Analysis
Currency traders make decisions using both technical factors and economic fundamentals. Technical traders use charts, trend lines, support and resistance levels, and numerous patterns and mathematical analyses to identify trading opportunities, whereas fundamentalists predict price movements by interpreting a wide variety of economic information, including news, government-issued indicators and reports, and even rumor.
The most dramatic price movements however, occur when unexpected events happen. The event can range from a Central Bank raising domestic interest rates to the outcome of a political election or even an act of war. Nonetheless, more often it is the expectations surrounding an event that drives the market rather than the event itself.
Foreign Exchange Market Participants
There are four types of market participants—banks, brokers, customers, and central banks.
- Banks and other financial institutions are the biggest participants. They earn profits by buying and selling currencies from and to each other. Roughly two-thirds of all FX transactions involve banks dealing directly with each other.
- Brokers act as intermediaries between banks. Dealers call them to find out where they can get the best price for currencies. Such arrangements are beneficial since they afford anonymity to the buyer/seller. Brokers earn profit by charging a commission on the transactions they arrange.
- Customers, mainly large companies, require foreign currency in the course of doing business or making investments. Some even have their own trading desks if their requirements are large. Other types of customers are individuals who buy foreign exchange to travel abroad or make purchases in foreign countries.
- Central banks, which act on behalf of their governments, sometimes participate in the FX market to influence the value of their currencies.
With more than $1.2 trillion changing hands every day, the activity of these participants affects the value of every dollar, pound, yen or euro.
The participants in the FX market trade for a variety of reasons:
- To earn short-term profits from fluctuations in exchange rates,
- To protect themselves from loss due to changes in exchange rates, and
- To acquire the foreign currency necessary to buy goods and services from other countries.
Buying and Selling
In the forex market, currencies are always priced and traded in pairs. You simultaneously buy one currency and sell another, but you can determine which pair of currencies you wish to trade. For example, if you believe the value of the euro is going to increase vis-á-vis the U.S. Dollar, then you would go long on EUR/USD instrument (currency pair). Obviously, the objective of forex currency trading is to exchange one currency for another in the expectation that the market rate or price will change so that the currency you bought has increased its value relative to the one you sold. If you have bought a currency and the price appreciates in value, then you must sell the currency back in order to lock in the profit. An open trade or position is one in which a trader has either bought / sold one currency pair and has not sold / bought back the equivalent amount to effectively close the position.
Market Conventions
Market conventions are rules and standards imposed by a governing body. In case of decentralized forex market these conventions might differ due to many national regulators (FSA, FSC, CFTC, NFA, BCSC, etc.). Since there is no central governing body that sets forex market rules and standards, we will reference only these that are universal.
Quoting Conventions
The first currency in the pair is referred to as the base currency, and the second currency is the counter or quote currency. The U.S Dollar is usually the base currency for quotes, and includes USD/JPY, USD/CHF, and USD/CAD. The exceptions are the Euro (EUR), Great Britain Pound (GBP), and Australian Dollar (AUD). As with all financial products, forex quotes include a "bid" and "ask", which is more often called "offer" in the forex market. The bid is the price at which a forex market maker is willing to buy (and you can sell) the base currency in exchange for the counter currency. The offer is the price at which a forex market maker will sell (and you can buy) the base currency in exchange for the counter currency. The difference between the bid and the offer price is referred to as the spread.
Determination of Foreign Exchange Rates
Exchange rates respond directly to all sorts of events, both tangible and psychological—
- Business cycles;
- Balance of payment statistics;
- Political developments;
- New tax laws;
- Stock market news;
- Inflationary expectations;
- International investment patterns;
- And government and central bank policies among others.
At the heart of this complex market are the same forces of demand and supply that determine the prices of goods and services in any free market. If at any given rate, the demand for a currency is greater than its supply, its price will rise. If supply exceeds demand, the price will fall.
The supply of a nation’s currency is influenced by that nation’s monetary authority, (usually its central bank), consistent with the amount of spending taking place in the economy. Government and central banks closely monitor economic activity to keep money supply at a level appropriate to achieve their economic goals.
| Too much money --> inflation --> value of money declines--> prices rise Too little money --> sluggish economic growth --> rising unemployment |
Monetary authorities must decide whether economic conditions call for a larger or smaller increase in the money supply.
Sources for currency demand on the FX market:
- The currency of a growing economy with relative price stability and a wide variety of competitive goods and services will be more in demand than that of a country in political turmoil, with high inflation and few marketable exports.
- Money will flow to wherever it can get the highest return with the least risk. If a nation’s financial instruments, such as stocks and bonds, offer relatively high rates of return at relatively low risk, foreigners will demand its currency to invest in them.
- FX traders speculate within the market about how different events will move the exchange rates. For example:
- News of political instability in other countries drives up demand for U.S. dollars as investors are looking for a "safe haven" for their money.
- A country’s interest rates rise and its currency appreciates as foreign investors seek higher returns than they can get in their own countries.
- Developing nations undertaking successful economic reforms may experience currency appreciation as foreign investors seek new opportunities
Foreign Currency Trading
Traders in the foreign exchange market make thousands of trades daily, buying and selling currencies while exchanging market information. The $1.2 trillion that is traded everyday may be used for varied purposes:
- For the import and export needs of companies and individuals
- For direct foreign investment
- To profit from the short-term fluctuations in exchange rates
- To manage existing positions or
- To purchase foreign financial instruments
In the volatile FX market, traders constantly try to predict the behavior of other market participants. If they correctly anticipate their opponents’ strategies, they can act first and beat the competition.
Traders make money by purchasing currency and selling it later at a higher price, or, anticipating the market is heading down, selling at a high price and buying back at a lower price later.
| Trader purchases a lot of currency | --> | long on the currency (e.g. long dollar, long yen) |
To predict the movements of currencies, traders often try to determine whether the currency’s price reflects its fundamental value in terms of current economic conditions. Examining inflation, interest rates, and the relative strength of the country’s economy helps them make a determination.
| Currency underpriced | --> | price will go up |
| Currency overpriced | --> | price will go down |
Currency Trading Between Banks
Banks are a major force in the FX market and employ a large number of traders. Trading between banks is done in two ways—through a broker or directly with each other.
Brokers: If a U.S. bank trades with another bank, a FX broker may be used as an intermediary. The broker arranges the transaction, matching the buyer and seller without ever taking a position and charges a commission to both the buyer and seller. About a third of transactions are arranged in this way.
Direct: Mostly banks deal with each other directly. A trader "makes a market" for another by quoting a two-way price i.e. he is willing to buy or sell the currency. The difference between the two price quotes (the spread) is usually no more than 10 pips, or hundredths, of a currency unit.
Most currencies are quoted in terms of how many units of that currency would equal $1. However, the British pound, New Zealand dollar, Australian dollar, Irish punt and the Euro are quoted in terms of how many U.S. dollars would equal one unit of those currencies.
The currencies of the world’s large, industrialized economies, or hard currencies, are always in demand and are actively traded. In terms of trading volumes, the FX market is dominated by four currencies: the U.S. dollar, the euro, the Japanese yen and the British pound. Together these account for over 80 percent of the market.
It is not always easy to find a market for all currencies. The demand for currencies of less developed countries, soft currencies, is a lot less than for the hard currencies. Weak demand internationally along with exchange controls may make these currencies difficult to convert.
Types of Transactions
There are different types of FX transactions:
- Spot transactions: This type of transaction accounts for almost a third of all FX market transactions. Two parties agree on an exchange rate and trade currencies at that rate.
Spot Transaction: How it works
This expresses only a potential interest in a deal, without the caller saying whether he wants to buy or sell.
By convention the payment is actually made two days later, but next day settlements are used as well. |
Although spot transactions are popular, they leave the currency buyer exposed to some potentially dangerous financial risks. Exchange rate fluctuations can effectively raise or lower prices and can be a financial planning ordeal for companies and individuals.
Exchange Risks in Spot Transactions Suppose a U.S. company orders machine tools from a company in Japan.
There is no guarantee that the rate will remain the same six months later. Suppose the rate drops to 100 yen per dollar:
Conversely, if the rate goes up to 140 yen to a dollar:
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One alternative for a company is to pay for the foreign good right away to avoid the exchange rate risk. But no one wants to part with money any sooner than necessary—if the company does pay the money in advance, it loses six months’ interest and risks losing out on a favorable change in exchange rates.
- Forward transaction: One way to deal with the FX risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future and the transaction occurs on that date, regardless of what the market rates are then. The date can be a few days, months or years in the future.
- Futures: Foreign currency futures are forward transactions with standard contract sizes and maturity dates — for example, 500,000 British pounds for next November at an agreed rate. These contracts are traded on a separate exchange set up for that purpose.
- Swap: The most common type of forward transaction is the currency swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date.
In all of these transactions, market rates might change. However, the buyer and seller are locked into a contract at a fixed price that cannot be affected by any changes in the market rates. These tools allow the market participants to plan more safely, since they know in advance what their FX will cost. It also allows them to avoid an immediate outlay of cash.
Swap Transaction: How it works Suppose a U.S. company needs 15 million Japanese yen for a three-month investment in Japan.
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- Options: To address the lack of flexibility in forward transactions, the foreign currency option was developed. An option is similar to a forward transaction. It gives its owner the right to buy or sell a specified amount of foreign currency at a specified price at any time up to a specified expiration date.
For a price, a market participant can buy the right, but not the obligation, to buy or sell a currency at a fixed price on or before an agreed upon future date. The agreed upon price is called the strike price.
Depending on which—the option rate or the current market rate—is more favorable, the owner may exercise the option or let the option lapse, choosing instead to buy/sell currency in the market. This type of transaction allows the owner more flexibility than a swap or futures contract.
| Option to buy currency | --> | Call option |
| Option to sell currency | --> | Put option |
Option: How it works Suppose a trader purchases a six-month call on one million euros at 0.88 U.S. dollars to a euro.
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| Floating and Fixed Exchange Rates The FX market was not always quick to respond to changing events. For most of the 20th century, the exchange rates were fixed, or kept constant, according to the amount of gold for which they could be exchanged. This was called the gold-exchange standard.
Under another system, the gold standard, U.S. households and businesses could exchange their dollars for gold. This practice was abandoned in 1933 during the Great Depression to allow freer expansion of money supply. However, foreign governments were still able to exchange their dollars for gold until 1971, when the United States terminated the gold-exchange standard entirely.
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