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MODULE-7

The foreign exchange market (forex, FX, or


currency market) is a form of exchange for the
global decentralized trading of international
currencies. Financial centers around the world
function as anchors of trading between a wide
range of different types of buyers and sellers
around the clock, with the exception of
weekends. The foreign exchange market
determines the relative values of different
currencies.
[

The foreign exchange market assists
international trade and investment by enabling
currency conversion.

For example, it permits a business in the United States to
import goods from the European Union member states
especially Euro zone members and pay Euros, even
though its income is in United States dollars.
It also supports direct speculation in the value of
currencies, and the carry trade, speculation based on the
interest rate differential between two currencies.
In a typical foreign exchange transaction, a party
purchases a quantity of one currency by paying a
quantity of another currency.
The foreign exchange market is unique because of
Its huge trading volume representing the largest asset
class in the world leading to high liquidity;
Its geographical dispersion;



Its continuous operation: 24 hours a day except
weekends, i.e. trading from 20:15 GMT on
Sunday until 22:00 GMT Friday;
The variety of factors that affect exchange rates;
The low margins of relative profit compared
with other markets of fixed income; and
The use of leverage to enhance profit and loss
margins and with respect to account size.
As such, it has been referred to as the market
closest to the ideal of perfect competition,
notwithstanding currency intervention by
central banks.
Functions of Foreign Currency
Exchange Markets
The foreign currency exchange markets are where
money from different countries are bought and sold.
The focus of foreign currency exchange is the
facilitation of international commerce.
Foreign currency exchange markets can also function
as a method of making investments, can be used by
governments to impact the value of their currency
and can help companies reduce losses due to changes
in exchange rates.



Primary Function
The primary function of foreign currency exchange
markets is to convert the currency of one country into
another currency.
For example, the U.S. dollar may be changed into
Mexican Pesos or English Pounds.
The amount of currency converted depends on the
exchange rate, which can be fixed or can fluctuate.
The U.S. dollar is a currency that has a fluctuating
exchange rate that is based on market demand. Some
countries, like China, have a fixed exchange rate
determined by their central bank.


International Transactions
Foreign currency exchange markets serve to
facilitate international financial transactions.
These transactions may be the purchasing and
selling of goods, direct investment in buildings
and equipment in a foreign country or the
purchase of investment vehicles like foreign
bonds.
For example, a U.S.-based company may want to
purchase goods manufactured in China. The
foreign currency exchange market allows them
to exchange U.S. dollars and make the purchase
in Chinese RMB (renminbi, the currency of the
People's Republic of China).

Currency Value
The value of a country's currency can influence
international trade, consumers' purchasing power and
inflation.
Central banks of a county or region, like the U.S. Federal
Reserve, seek to minimize the impact of currency
fluctuations. The foreign currency exchange market
functions as a tool for central banks to control the value of
their currency by buying or selling currency, which
influences the total amount in worldwide circulation.
Investment
Fund managers and investment professionals use the
foreign currency exchange market to help diversify their
portfolios and potentially increase their returns.
Through calculated risks, investors can bet on a change in
the price or exchange rate of a currency. Just like with the
stocks, if currency is purchased at a low price and sold at a
higher price, the investor makes money.
Loss Protection
International companies that work in multiple countries
are subject to gains and losses based on exchange rate
fluctuations.
To help prevent losses, companies can make forward
transactions where they make a binding agreement to
exchange currency for another currency at a fixed rate.
This function of the foreign currency exchange market
helps a company minimize the risk of foreign exchange on
future expenses.
For example, if a U.S.-based company places an order with
a firm in Taiwan that will be ready in five months, the
company can enter a forward transaction agreement that
fixes the price based on the current exchange rate at the
time of order. The company knows the value and cost of
the purchase and will not be hit with a future loss based
on a change in exchange rates.

Nature Of The Foreign Exchange
Market
This currency exchange market is an over-the-
counter (OTC) market, meaning there is no
central exchange and clearing house where
orders are matched. With various levels of
access, currencies are traded in various market
makers:
The Inter-bank Market Large commercial
banks do business with each other through the
Electronic Brokerage System (EBS). Banks can
make their quotes available in the forex market
only to those banks that they trade. This market
isnt directly accessible to retail traders.

The Online Market Maker Retail traders can
access the FX market through online market
makers that trade primarily from the US and the
UK. These market makers routinely have a
relationship with several banks on EBS; the
greater the trading volume of the market maker,
the greater relationships it likely has.
Market Hours: Forex is really a market that
trades actively so long as there are banks open
within the major financial centers around the
globe. This is effectively from the beginning of
Monday morning in Tokyo before the afternoon
of Friday in Ny. In terms of GMT, the trading
week is carried out in Sunday night until Friday
night, or roughly Five days, 24 hours per day.

Perpetual motion in prices : One of the other
characteristics of the foreign exchange is that the
fluctuations in the exchange rate will cause one
currency to lose its monetary value, while others to
gain.
So there is a continuous motion in prices. In the
foreign exchange market, the exchange rate refers to
the exchange ratio between the currencies of two
countries. Fluctuations in the exchange rate change
will cause one currency to lose its monetary value,
and at the same time increase the monetary value of
another currency.
Unlimited Potential for Profit and Loss: The most
effective manner to illustrate the "unlimitedness" of
the market environment is to compare it to gambling.
With any gambling game you will always know exactly
how much you can win or lose each time you play.
You decide exactly how much you want to wager, you
know exactly how much you can win as well as lose, and
you may even know the mathematical odds of either
possibility. This is not the case in market environment.
In any particular trade you never really know how far
prices will travel from any given point. If you never really
know where the market may stop, it is very easy to
believe there are no limits to how much you can make on
any given trade.
Several psychological factors go into assessing the
market's potential accurately for the price movement in
any given direction. The possibility for unlimited profits
may in fact exist, but how realistic it is in any given trade
is another matter.
Going through the comprehensive guide on studying the
nature of foreign exchange above will surely help you
understand the market psychology.

TRADING MECHANISM
How much money is required for Forex trading? In
order to find out, it is necessary to study the
mechanisms of making a deal.
First, when a trader buys a currency, he doesnt buy
Euros or British pounds, he buys a currency pair, e.g.
euro-dollar (written like this: EURUSD). This means
that we are buying Euros for dollars.
The currency which is written first is called the Base
currency; the currency which is written second is
called the Quote currency.
And a trader doesnt buy the amount directly; the
forex trading is done by lots. One lot represents
100,000 units of a base currency.
How many dollars should we be paying for it?
There is a notion of currency pair exchange
rate which is a monetary denomination of the
cost of a currency pair, to be more exact, a unit
of base currency expressed in quote currency.
And when we say that a euro/dollar costs
1.3875, it actually means that for 1 euro we may
get 1 dollar and almost 39 cents.
To buy one full lot of such a currency pair we
need to pay 100,000 * 1.3875 = $ 138,750 on
Forex trading market.
Obviously, very few people have this kind of
money. And this is why traders have lately been
working on a marginal basis.
A margin is a deposit. When a bank opens a position for a trader, the
bank is actually paying for the entire lot, and the trader gives the
bank a deposit 100 times lower, i.e. the leverage mechanism is
applied.
Usually the leverage is 1:100 on forex trading market. Accordingly,
the Forex trading deposit in this example will be $ 1,387.50. When
a forex trading position is closed, the deposit is returned to the
trader in full, regardless of the result.
Because of this, in order for a trader to make a deal, he needs a
certain sum of money for a forex trading deposit, and his account
should have some extra money as a so-called safety net.
Usually, the deposit sum for various currency pairs is shown in the
Contract Specification Table. For example, in forex trading for the
currency pair British pound/dollar (denominated as GBPUSD) to
make a deal in 1 lot with the leverage 1:100, the deposit will be
1,000 GBP which is about $ 2,000, and for the currency pair New
Zealand dollar/US dollar (denominated as NZDUSD), 1,000 NZD, i.e.
about $ 600. For all other currency pairs the deposit will be almost
the same, i.e. the deposit will almost never exceed $ 2,000.
Thus, an important piece of advice for
traders:
The minimum sum required to trade in one
lot should be about $ 2,000-2,500, and the
greater the sum, the more relaxed and safe
the forex trading is.
No matter what, before opening a forex
trading position, the trader should first
analyze the market to find a profitable
situation where money can be earned.


What Currencies can be Traded at Forex Trading
Dealers in most companies work mainly in US dollars, and
very rarely in any other world leading or national currency.
It is essential to understand one very important thing: if
your forex trading account is in dollars, it doesnt mean that
you can only make deals when a currency is being bought
for dollars.
It may seem paradoxical, but you may buy dollars for some
other currency which you, naturally, dont have in your
dollar forex trading account. For example, you may buy
dollars for Euros. Such deals are made when the euro rate is
expected to fall to the dollar and is called buy dollar
against euro. You may even make a deal where the dollar is
not present at all, e.g. buy Japanese yen against Swiss
francs. Y
our forex trading account is debited in dollars in an amount
equivalent to the cost of the deal, and the currency is
automatically converted at the current exchange rate.

Most of the worlds currency market is made up of the
following currencies:

US dollar USD;
Euro EUR;
British pound of sterling GBP;
Japanese yen JPY;
Swiss franc CHF.

These currencies are the most popular for Forex trading
market.
We have already stated that when the trader buys a
currency, he does not buy Euros or British pounds, but a
currency pair, e.g. euro-dollar (EURUSD), which means that
he buys Euros for dollars.
In this example, the euro is the base currency and the dollar
is the quote currency. We say buy euro-dollar, sell euro-
dollar. The most popular currency pairs are in forex trading:
EURUSD, GBPUSD, USDCHF and USDJPY.


Position - Opening and Closing

Making a deal on the Forex trading market is
usually called, opening a position.
Subsequently, instead of saying, Im buying
Euros one should say, Im opening a position
in Euros. If the other currency is not identified,
it means that its a euro-dollar currency pair
(EURUSD), i.e. Euros are bought for US dollars.
Depending on whether you are buying or selling,
the positions are called long (bull) or
short (bear) on the Forex trading market.
So in our case, we should say, Im opening a
long position in Euros.

Here is an example of how Forex trading works. Lets
assume that the euro will grow in value, i.e. the price
will go up and we open a long position buy Euros. If
we expect the euro to fall to the dollar, we sell the
euro, i.e. open a short position.
With regard to Forex trading in currencies for which the
base currency is the US dollar, e.g. in a pair dollar-Swiss
franc (USDCHF), the situation is a little different.
If we believe that the Swiss franc will grow to the US
dollar, then the price will go down as opposed in the
situation with the euro. In this case, we open a short
position for the USDCHF currency pair.
Remember the rule that applies to any currency pair: if
we expect the price to go up we buy (open a long
position), if we expect the price to go down we sell
(open a short position) on the Forex trading market.
Along with the concept of opening a position,
there is the opposite concept on the Forex
trading, closing a position.
It means making a deal opposite to the deal
we made when opening the position.
If earlier we bought Euros for dollars, now
we sell Euros for dollars; if we sold British
pounds for Swiss francs, now we buy them
for Swiss francs.
Proceeds from the deal will hit our account,
with gains flowing into our account and
losses flowing out.

Ask and Bid

There is another way to monetarily express a
currency pair, besides the rate of a currency pair:
a quote. This is the information on the current
rate of a currency pair expressed in two figures -
Bid and Ask.
Ask is the greater price of a quote. The trader
can buy at this price.
Bid is the lower price of the quote. The trader
can sell at this price.
Lets take for example the currency pair USDCHF
1.1350/1.1353. It means that you can buy 1
dollar for 1.1350 Swiss francs. Thus, you may sell
1 dollar for 1.1353 Swiss francs on the Forex
trading market.


Spreads
The difference between bid and ask is called
the bid-ask spread. The spreads in the Forex
trading market are very small.
For most currency pairs, the spread is from 2
to 4 points, which is much smaller even than
spreads of the better performing, liquid
securities on other markets.
Spread is a hidden, integral cost of the
forex trading, and it is minimal for the
currency market. New technologies have
made these low prices available to just about
everybody.


Points

Point (Pip - price interest point) is the
minimum price fluctuation in the cost of a
currency pair.
For the majority of currencies the currency
rate is calculated up to a fourth of a decimal
figure.
Thus, 1 point is 1/10 000 or 0.0001 of the
quote currency. Change in 1 point for
GPB/USD at 1.7519 leads to a price of 1.7520.
The point value for some currency rates, such
as USD/JPY, is calculated only up to the
second decimal figure (i.e. 1/100 or 0.01).


Calculation of Profit and Loss

The majority of Forex trading platforms automatically
calculate the traders profit and loss for open
positions. This helps the trader to track profit and loss
simultaneously as the market prices constantly
change. However, the trader should know how such
calculations are made.
Examples:
Sell 5 lots EUR/USD at price 1.4625 and buy them at
price 1.4570:
In this example the client gets 55 points 5 lots = 275
points of overall profit (as the trader sells them at a
higher price than he bought them). The cost of every
point for pair EUR/USD is $ 10. Thus, the final profit is
275 points x $ 10 = $ 2,750 in forex trading.

Buy 3 lots USD/JPY at price 102.10 and sell them at price
101.80:
In this example the client gets 30 points 3 lots = 90
points of overall losses (as the client sells at a lower price
than he bought them). The cost of every point for pair
USD/JPY is 1000 JPY which in dollars represents 1,000:
101.80 (USD/JPY rate at the time of position closing) =
about $9.82. Thus, the final loss of the client is 90 points x
$9.82 = $883.80 in forex trading.
Sell 2 lots EUR/GBP at price 0.8154 and buy them at price
0.7802:
In this example the client gets 352 points 2 lots = 704
points of overall profit. The cost of every point for pair
EUR/GBP is 10 GBP which in dollars is 10 x 1.73 (lets
assume that GBP/USD rate at the time of position closing
is 1.7300) = $ 17.30. Thus, the final profit is 704 points x $
17.30 = $12,179.20 in forex trading.


Forex trading systems

Various companies and dealers offering services on the
Forex market use various trading platforms (systems),
but the most popular is the MetaTrader program.
(Other trading systems may differ not only in the
interface but also in their ideology, terminology, etc.)
Therefore, any actions regarding deals on the Forex
market place will be evaluated through examples from
MetaTrader.
The program has a multilingual interface. When first
launching the program, it will ask you to register a new
trading account.
Every dealer has its own particular registration, so
answers to potential questions which may arise during
registration can be found on your dealers web site. The
MetaTrader trading system has a simple, standardized
interface.

You can easily set it up on your own. The main
thing to learn is how to open and close
positions, also known as orders.
major part of the window is taken up by the
price chart. You may switch between different
charts by choosing the necessary currency or the
chart type. To open a position, either click New
Order or the F9 key on the keyboard.
A dialogue window will open in which you can
enter the deals parameters.
The Symbol parameter lets you choose the currency pair for the
position you are opening.
Lets review the Amount parameter in greater detail. The amount of
the deal is set in lots. Usually 1 lot is 100,000 units of one of the
currencies, although this may differ from one dealer to another. When
making a deal we indicate how many lots of currency we want to buy or
sell. For example, if you set 1, it means that you make a deal in 100,000
currency units. For Euros at the rate of, say, 1.3100 and the leverage of
1:100 to make a deal you need 100,000:100 * 1.3100 = 1,310 US dollars.
Choose the type of order Immediate Execution. Buttons Sell and
Buy in MetaTrader open short and long positions accordingly. Click
one of these buttons, wait a few seconds, and thats it. The deal has
been made.
Once the rate enters into a profitable area, the position may be closed.
In order to close it, right click on the line with the order information and
choose Close Order in the dropdown menu. The same window will
open as before, but the button Close will be accessible. Click it, wait a
few seconds, and the order is closed. In the line below the chart you will
see the status of the account.
It is highly recommended to open a virtual account and to practice with
these purely technical procedures to better understand how positions
are opened and closed. This is the essence of trading on the
international currency marketplace.

Fundamental analysis

How Economic News Affect the Currency Rate
Lets consider the effect of economic news on the currency
rate by looking at an example from January 22, 2008. Lets
assume that you have prepared for a deal and plan on buying
Euros, and you know that today major interest rate changes
will be announced by the European Central Bank (ECB).
The market has been awash with rumors and speculation
that the rate may be reduced due to a slowdown of
economic growth around the euro, and that assets in Euros
may become less attractive for investors.
That is why the euro has been falling to the dollar. But when
the decision is published, it turns out that the interest rate
remains at the former rate of 4%, the market sighs with
relief, and the rate shoots up. The traders optimism is
reinforced at the press conference by Jean-Claude Trichet,
the ECB Head, where he says that the ECB will undertake
timely measures to keep the euros rate stable.

On this chart you can see that the euro shot up at the
time of the news, and within 5 hours the price of the
euro/dollar currency pair changed by 170 points.
The cost of one point in euro/dollar currency pair is
10$, hence, in 5 hours 1700$ could have been earned.
This is how a trader may use the fundamental
analysis in forex trading.
But thats not all. Now we will consider an example of
the so-called short-term position, where your deal
lasts but a few hours. The duration of a trade
operation may last a few days, or even a few weeks.
And here you also use the fundamental analysis to
forecast the rates fluctuations.

How Political News Affect the
Currency Rate

Now lets consider an example of a political event that
affected the Forex market.
You will surely remember the scandal in the fall of 1998
whose central figures were the US President Bill Clinton
and Monica Lewinsky.
For a long time, Clinton failed to admit his relations
with Lewinsky, but in late August of 1998, there was a
court hearing when the President officially confirmed
that Lewinsky was his lover.
It shocked the American society and Clinton was under
the threat of impeachment.
In that autumn, the dollar dropped substantially in
relation to other currencies. For instance, the dollar lost
890 points to the Swiss franc in just two weeks.

EXCHANGE RATE DETERMINATION

Having endeavored to forecast exchange
rates for more than half a century, I have
understandably developed significant humility
about my ability in this area
- Alan Greenspan



I Short-Run Forecasting Tools

Short-term changes in exchange rates are the most
difficult to predict and are often determined based on
bandwagon effects, overreaction to news,
speculation, and technical analysis.

Trend-Following Behavior is the tendency for the
market to follow a trend. In other words an increase
in the exchange rate is more likely to be followed by
another increase.

Investor Sentiment is based on the consensus of the
market. For example if the market is bullish on the
dollar, then the dollar is likely to strengthen versus
other currencies.

Investor Sentiment is based on the consensus of the
market. For example if the market is bullish on the
dollar, then the dollar is likely to strengthen versus
other currencies.
The FX market is quite different from the world equity
markets in one important aspect: transparency. In
equity markets, rules ensure that volume and price
data are readily available to all parties this is NOT
the case in FX markets. In fact large FX dealers are
able to observe factors such as: shifts in risk appetite,
liquidity needs, hedging demands, and institutional
rebalancing.
Order Flow - there is evidence of a positive
correlation between spot exchange rate movements
and order flows in the inter-dealer market and with
movements in customer order flows.


II. Long-Run Forecasting Tools

Purchasing Power Parity (PPP) states that
since the prices should be the same across
countries, the exchange rate between two
countries should be the ratio of the prices in
each country.
Relative PPP states that the exchange rate will
change to offset differences in national
interest rates. In other words, if Country A has
higher inflation than Country B, you can
expect Country As currency to depreciate
versus Country Bs currency.

Structural Changes three structural changes can affect
long-term trends in exchange rates: 1) an increase in
investment spending, 2) fiscal stimulus, 3) a decline in
private savings. It is the net impact of structural changes
that determines if the countrys currency will rise or fall.
Investment spending domestic investment in a country
will help to strengthen a countrys currency. For example,
the United States experienced an investment boom in the
1990s.
Fiscal stimulus government investment in a country can
also help strengthen a countrys currency. For example,
Turkey has enjoyed fiscal stimulus and government
spending in recent years.
Private savings the citizens of a countrys tendency to
save will help strengthen a countrys currency. For
example, Japan has had a large and persistent current-
account surplus that has led to a stronger currency.

Terms of Trade is the idea that the price of a
good that trades in international markets will
have an impact of the associated countrys
currency.
This can work in terms of both imports and
exports.
For example, in countries where commodities
make up a large portion of GDP, like Australia,
Canada, and New Zealand, there is a strong
positive relationship between the price of
commodities and the strength of the associated
countrys currency.
On the other hand, in Europe, the higher prices
for oil, have led to a weaker currency.


III. Medium-Run Forecasting Tools
International Parity Conditions the key
international parity conditions are 1) purchasing
power parity, 2) covered interest-rate parity, 3)
uncovered interest-rate parity, 4) the Fisher
effect, and 5) forward exchange rates.
Current Account Trends Countries that run
persistent current-account surpluses will see
their currencies appreciate over time. Current
account imbalances are driven by structural
changes in international competitiveness,
changes in the terms of trade, and long-term
shifts in national savings-investment
Capital Flows foreign demand for a
countrys currency will lead to an increase in
the value of the domestic currency. Capital
flows can come from foreign direct
investment (FDI), a flight to quality, perceived
strength, or the existence of investment
opportunities.
Monetary Policy expansionary monetary
policy will lead to a depreciation of the
domestic currency, because lower interest
rates will generate an outflow of capital
Fiscal Policy an expansionary fiscal policy raises
domestic interest rates and increases domestic
economic activity.
Economic Growth in the short run if the economy is
growing stronger relative to other economies the
increases in economic activity that create attractive
investment opportunities will strengthen the
currency.
Central Bank Intervention central banks often
participate in foreign exchange markets the argument
most often made to justify intervention is that the
exchange rate is simply too important a price to be
left to the market. The assumption is that central
bank authorities can do a better job in the markets in
terms of driving exchange rates toward their long-
term equilibrium values.


Balance of trade

The balance of trade (or net exports, sometimes
symbolized as NX) is the difference between the
monetary value of exports and imports of
output in an economy over a certain period. It is
the relationship between a nation's imports and
exports.

A positive balance is known as a trade surplus if
it consists of exporting more than is imported; a
negative balance is referred to as a trade deficit
or, informally, a trade gap.
The balance of trade is sometimes divided into a
goods and a services balance.
The balance of trade forms part of the current account, which
includes other transactions such as income from the
international investment position as well as international aid.
If the current account is in surplus, the country's net
international asset position increases correspondingly. Equally,
a deficit decreases the net international asset position.
Measuring the balance of trade can be problematic because of
problems with recording and collecting data.
As an illustration of this problem, when official data for all the
world's countries are added up, exports exceed imports by
almost 1%; it appears the world is running a positive balance
of trade with itself. This cannot be true, because all
transactions involve an equal credit or debit in the account of
each nation.
The discrepancy is widely believed to be explained by
transactions intended to launder money or evade taxes,
smuggling and other visibility problems. However, especially
for developed countries, accuracy is likely.
Factors that can affect the balance of trade include:
The cost of production (land, labor, capital, taxes,
incentives, etc.) in the exporting economy vis--vis
those in the importing economy;
The cost and availability of raw materials,
intermediate goods and other inputs;
Exchange rate movements;
Multilateral, bilateral and unilateral taxes or
restrictions on trade;
Non-tariff barriers such as environmental, health or
safety standards;
The availability of adequate foreign exchange with
which to pay for imports; and
Prices of goods manufactured at home (influenced by
the responsiveness of supply)


Exchange Rate Stability

Methods
Countries, especially developing ones, pursue
stable exchange rates to attract foreign capital.
They usually accomplish this by fixing their
currencies to that of a more stable country, a
practice called pegging.
A country's central bank may increase or decrease
the money supply to maintain this rate.
Many countries have their currencies pegged to
the U.S. dollar, but some such as China and
Kuwait have dropped the connection in recent
years as the dollar has lost strength.



Theories/Speculation
Stable exchange rates generally are viewed as favorable, but
there can be drawbacks.
An economics principle called the Mundell-Flemming
Trilemma states that countries have three economic goals: (1)
stable exchange rates, (2) free movement of capital and (3)
independent money supply.
The Trilemma states that it is only possible to have two of
these goals at the same time.
Warning
Preoccupation with exchange rate stability can exacerbate
other economic problems. In the late 1990s, Argentina had
inflation problems that could have been eased if the
government had adjusted the money supply. But this strategy
was not pursued partly because of concerns about exchange
rate stability.





Currency Convertibility

Definition of 'Currency Convertibility:
The ease with which a country's currency can be
converted into gold or another currency. Convertibility
is extremely important for international commerce.
When a currency in inconvertible, it poses a risk and
barrier to trade with foreigners who have no need for
the domestic currency.
Government restrictions can often result in a currency
with a low convertibility. For example, a government
with low reserves of hard foreign currency often
restrict currency convertibility because the government
would not be in a position to intervene in the foreign
exchange market (i.e. revalue, devalue) to support their
own currency if and when necessary.