Previously, I asked my audience if they wanted some kind of aid in understanding financial markets. Here is part one which describes foreign currency exchange markets.

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All countries issue currency. The value of said currency can only be judged by an external reference. This reference is the exchange rate. It becomes the fundamental price in any economy. This comparison of values is the role of the foreign-exchange market.

This market affects all other financial markets. They direct foreign trade patterns, the flow of international investment, domestic interest and inflation rates.

Foreign-exchange markets are made up of four different, but linked markets.

Spot market: Currency exchanged on the spot. For example: a tourist exchanging money on vacation, a company converting a receipt from an export sale into the domestic currency. Most spot transactions are done electronically between large financial firms.

Futures market: Allows participants to lock in an exchange rate at a future date by buying or selling a futures contract. For example: a US company is expecting a payment of 10 million Swiss Francs. They would go to the Chicago Mercantile Exchange and buy a Swiss Francs futures contract. When those Francs come in, they are converted at the agreed upon rate. This prevents a loss if the Franc’s value goes down. Most currency futures expire once every quarter.

Options market: Currency options give the holder the right, but not the obligation, to acquire or sell foreign currency or foreign currency futures at a specified price during a certain period of time.

The Derivatives market: Most foreign currency exchange is done on this market. This market refers to different instruments that have different characteristics than the previously mentioned markets. Here are some examples:

– Forward contracts are similar to futures contracts, set amount + set rate + agreed date. But these are arraigned directly between a dealer and customer. This allows both parties more flexibility for amounts and length of time.

– Foreign exchange swaps are the sale or purchase of a currency on one date, and the offsetting purchase or sale of the same amount on a future date. Both dates are agreed to when the transaction is initiated.

– Forward rate agreements are when two parties are exchanging interest payments obligations. If they’re in different countries there is an exchange rate aspect to the swap.

– Barrier options and Collars are derivatives that allow a user to limit their exchange risk.

Gearing Up

This is done when an investor wishes to engage in the currency exchange market without putting up their own money. For example:  money is borrowed to purchase a foreign currency, (or more in the case of an actual economic trade taking place). If a deal of 10 million is already being done, an investor may purchase more of the expected currency, because they are expecting said currency to increase in value.

Who Participates in Exchange Markets?

Exporters/Importers: Anyone doing business internationally must purchase supplies/pay workers in the currency they operate in. Payments can also be received from many countries. Currency exchanging is inevitable in these cases.

Investors: Investing in assets, portfolios, etc that reside in another country require conversions of currency. Said investor must enter into currency markets in order to be able to make such investments. Earnings from these investments must be converted when brought home to the investor.

Speculators: Speculators buy currency when they are low in value, and expect them to rise. Currency speculation usually involves instruments like treasury bills. The point is to bet on currency prices changes, not actual economic interaction like importing and exporting.

Governments: National treasuries and central banks trade currencies in order to influence exchange rates. This is called intervention. This affects the ability to import and export. Some state enterprises have investment funds where they invest in foreign currency received from trade surpluses or natural resource sales. These are called sovereign wealth funds.

Most Traded Currencies

The US dollar obviously is the greatest at 40% TO 45% since 1989 when serious record keeping began.24% of all exchange activity is US-Euro. 18% is US-Yen. Euros and all others account for 9%. All exchanges that are not USD or Euro amount to 4%.

Settlement

Two parties enter into an agreement. The actual exchange of currencies is called settlement. Exchanges are already usually done through a clearing house. They’re a third party that holds a stockpile of the currencies. This way, if one party doesn’t give the money, the other is covered by the clearing house.

Large spot and derivatives exchanges are done differently. When two parties agree to an exchange, they go to a bank to carry out the swap. Each large bank is a member of a clearing house. The clearing houses can be government owned, or a co-operative shared among several banks to ensure rules are followed.

Herstatt Risk

Problems can arise from conflicting time zones during exchanges. Say a Japanese bank and UK bank want to make an exchange. The UK bank sends their part but will have to wait until the Japanese bank opens. The Japanese bank could fail before they live up to their end of the deal. This can cause a bank to fail and cause a chain reaction among many banks. This is called Herstatt Risk – named after a German bank that failed in 1974 with $620 million in incomplete balances.

 Why Exchange Rates Change

Rates change for all kinds of reasons. A solid healthy economy with a stable exchange rate is good for business. Instability, social unrest, unexpected economic data causes fluctuations which made business difficult and risky.

Real Interest Rates

Exchange rates are almost exclusively linked to real interest rates. A real interest rate is what an investor can expect after subtracting inflation. For example: you obtain an interest rate of 5% for the year, and guess that prices will rise 2%. This means that you earn a real interest rate of 3%.

Covered Interest Arbitrage

Real interest rates affecting exchange rates are called covered interest arbitrage. We’ll assume an investment of £100. There are two options: buy one-year British government bonds; or convert into foreign currency and use it to purchase a one year bond US bond. Which gives a better return? It depends on the spot exchange rate, the interest rate in sterling and the US dollar, inflation expectations and a forward exchange rate in 12 months.

UK INVESTMENT	US INVESTMENT
Initial capital = £100	Initial capital = £100 (£1 x 1.60) = $160
Sterling interest rate = 5%	Dollar interest rate = 7%
Capital after 1 year  = £105	Capital after 1 year  = $171.20 ($1.61) = £106.34

 In this scenario, the investor earns more profits with the US bonds if the expected inflation rates and interest rates remain as expected. The risk of buying US bonds is the same as UK bond if the investor can purchase a forward contract to convert the $171.20 into pounds at a rate of £1 = $1.61 in one year’s time. Thus there is no need to worry about exchange rate movements.

Covered Interest Parity

Opportunities like the one just described are fleeting and scarce. Computers look for such odd movements in currency values. One can look for pounds to dollars on the spot market, then save them for dollars to pounds in a forward contract. This would be to invest in the US rather than the UK. The idea is for the pound to fall on the spot market and rise on the forwards market. Eventually, market forces might lower the spot pound/dollar rate to £1 = $1.59, and push the one year forward rate to just above $1.62 = £1. At this point, such investment stops because the return from both investments would be the same. The two currencies will have reached the covered interest parity.

Managing Exchange Rates

For currency markets, government policy is most important of all. Many different regimens have been used for exchange rates. They all have advantages and disadvantages. The reason is because they are tied to the management of a country’s economy. There are three main categories when it comes to different exchange rate regimens.

 Fixed Rate Systems:

Gold Standard – The money supply is directly linked to the amount of gold contained in a central bank’s reserve. Notes and coins are exchanged for gold at any time. If several countries use a gold standard, the exchange rate will be stable. £1 = 22 troy ounces of gold. USD $100 = 4.50oz. The exchange rate is therefore: £1 = $4.86. The system, however, was terribly flawed. If an account deficient is run, gold reserves would leave the country and the money supply would shrink. A devaluation would be necessary, less gold for each dollar. Exports become more profitable, imports become too expensive. The shrinkage of the money supply would cause a recession, prolonged depressions, and panics.

Bretton Woods – An arrangement was made to base exchange rates on a combination of gold and other currencies. It allowed countries who ran deficits to devalue their currency within certain limits. This created the International monetary Fund (IMF) which lent member countries gold or foreign currencies to avoid devaluation. It created its own currency the “Special Drawing Rights” as a way t settle accounts. SDRs were given to central banks to boost their reserves. At 2013 1 SDR = .66 USD, €.423, ¥12.1, 11.1 UK pence. Thus its value fluctuates against any single currency. There was once a fixed rate, but it failed in the late 1960s to early 1970s, for many of the same reasons as gold.

Pegs – The decision to specifically set the value of a currency according to another. It is usually done according to an important trading partner. Denmark currently pegs to the Euro. This is usually done with a currency board which monitors the pegging. This replaces a central bank, issuing currency backed by the existing currency it’s pegged to. If an investor sells the domestic currency, the board’s reserve falls and reduces the domestic currency supply. This forces interest rates higher and slows the economy. Using a currency board complicates things in that changing the exchange rate requires passing a law.

The problem with fixed exchange systems is that, as long as people are free to move money in and out of the country, interest rates must be kept high enough to keep their currency for a good return. This forces a central bank to put all of its efforts into promoting stability. This prevents it from pushing other goals, like lowering interest rates to fight a recession.

A fixed exchange rate market creates a risk-free opportunity for borrowing a foreign currency with a lower interest rate. This can lead to crisis. For example:

Country A pegs its currency value to country B

Country A one year interest rate is 10%

Country B one year interest rate is 5%

An investor from country A can borrow at 5% from country B, exchange the foreign currency for its own and invest it at a 10% return. After one year they can obtain the foreign currency and use it to pay back the loan at the same exchange rate. Individually this is a good investment. Taken large scale it is very dangerous. A country may lack the foreign currency reserves to meet the demand for country B’s currency at the fixed rate. This may cause it to abandon the rate making it more expensive for borrowers to buy the foreign currency necessary to pay back those loans, forcing them into default. This was the source of the 1997 Asian crisis.

Semi-Fixed rate Systems:

Semi-fixed systems are designed to deal with exchange rate stability, but allow the government the ability to focus on other economic goals. It allows for fluctuations which stimulate foreign trading in exchange markets. This also allows a currency to change value as market forces determine, but also actively seeks to guide the market.

Bands – The European Exchange Rate Mechanism before the Euro was worked out as bands. Each currency was pegged to the German mark with an allowed space (band) with which to float. Values could change with the market, but only to a certain degree. It was allowed to float as long as it stayed in the band. If it went outside of it, the country’s central bank was under an obligation to alter interest rates to keep it in the band. This system still had problems with stability. In 1992-1993 years, the mark increased in value greatly against the other currencies. The other countries had to raise interest rates in order to stay within the band. The U.K. quit and went free floating. Others accepted large devaluations and set new bands.

Target Zones – Similar to a band but non-binding. A government will usually declare an intention to keep a currency at a particular rate against another. But, it might not stay there for various reasons. The target zone might be targeted at a particular currency, or target zones are agreed upon multilaterally by several countries.

Pegs and Baskets – A third type is to peg a currency to a basket of other currencies. If a country pegs its currency to a single currency, a rise in said currency will affect an exchange in a third one. Imports from the third country will become cheaper, and exports harder to sell. This can cause a balance-of-payments crisis. Having an exchange rate pegged to several currencies can insulate from such problems. A currency can also be managed by changing the weights assigned to each of the currencies in the basket. Most countries that do this keep the amounts secret. Some may announce which they use, but not the rate. Singapore and Kuwait don’t reveal the currencies or values. China and North Korea say what currencies, but not their weights.

Crawling Peg – This is used to alter an exchange rate in a pre-announced way. A central bank will announce that it will allow its currency to exchange with the dollar depreciating by 1% per month over the next year. This is less rigid than a fixed rate, but the central bank must use monetary policy to keep it depreciating at the particular rate. Investors can think the depreciation is too slow and may exchange en masse causing the central bank to run short of foreign reserves causing devaluation.

Floating Rates:

In a floating system, the rates are not the goal of monetary policy. They focus on other issues and allow the market to affect the currency accordingly. Most of the world’s main currencies are floating, causing a great deal of demand for currency trading. They do not float completely freely. Governments have to act to prevent a crisis, but usually, don’t announce that they are. This is usually done when a currency is too cheap or too expensive.

Comparing Currency Valuations

Judging if a currency is over or undervalued is difficult. Most data shows that foreign-exchange markets typically overshoot. When we see significant economic or political news, the market tends to overreact than a careful analysis would indicate. Investors tend to act simultaneously as other investors do. Once the markets overshoot, it realizes its error and corrects itself. We can see this with the recent Pound movements concerning the Brexit.

Indications of Incorrect Value

There are three primary ways to tell if a currency’s value is incorrect. The first indicator is a failure of its exchange rate with other currencies, and not showing a move to covered interest parity. This can mean the market expects a decent increase or decrease in the near future. Secondly, a country may be running a balance-of-payment deficient. This can indicate that a currency is too strong or weak relative to its main trending partner. The third indicator, maybe when the before tax prices of goods in one country are very different from another. This comes from purchasing power parity, which says a given amount of money should be able to purchase similar amounts of traded goods in other countries.

Managing Floating Exchange Rates

Floating exchange rates are intended to stay within a certain range to avoid a crisis. When a currency deviates outside of the range, the government moves the market in the desired direction. For example: reducing investors expectations of inflation, its currency will strengthen. If short-term interest rates are reduced while keeping inflation in check, the currency will weaken against currencies whose real interest rates have not decreased. Exchange rates can also be altered without serious alterations to economic policy. Most of these techniques are psychological. To move an exchange rate, a central bank could announce that it’s unhappy with its current interest rate. Another move can be to use its own foreign currency stocks to purchase its own currency to increase demand. Or it can drive down a currency that is rising.

Obtaining Price Information

There is no overall price unless a currency is pegged to another. Usually, you would have to go to a currency dealer. He’ll have one price for buying and another for selling. The spread between the two is the trader’s cost of operation and profit. However, recent trades may not have been carried out at those prices. This is only one trader. Media also offers information, but they’re usually the prices for large transactions.

Traded Weight Exchange Rate

This exchange rate is the one most commonly used. It is an index that compares a currency against a basket of currencies made up by its main trading partners. This weighting is done based on the share of the country’s trade that can be attributed to each trading partner.