|



 


2 Economic factors
2 Political conditions
2 Market psychology
Economic factors

a) economic policy, disseminated by

government agencies and central banks,
comprises government fiscal policy
budget/spending practices) and monetary
policy the means by which a government's
central bank influences the supply and "cost"
of money, which is reflected by the level of
interest rates).
Economic factors contd
b) economic conditions, generally revealed through
economic reports, and other economic indicators,
include:
2 G


     
uhe market usually reacts negatively to widening
government budget deficits, and positively to narrowing
budget deficits. uhe impact is reflected in the value of a
country's currency.
2 Π  

 


uhe trade flow between countries illustrates the demand for
goods and services, which in turn indicates demand for a
country's currency to conduct trade. Surpluses and deficits
in trade of goods and services reflect the competitiveness
of a nation's economy. For example, trade deficits may
have a negative impact on a nation's currency.
Economic factors contd
2 Ñ  
 


uypically a currency will lose value if there is a
high level of inflation in the country or if
inflation levels are perceived to be rising. uhis
is because inflation erodes purchasing power,
thus demand, for that particular currency.
However, a currency may sometimes
strengthen when inflation rises because of
expectations that the central bank will raise
short-term interest rates to combat rising
inflation.
Economic factors contd
2      
 
eports such as GDP, employment levels, retail
sales, capacity utilization and others, detail the
levels of a country's economic growth and health.
Generally, the more healthy and robust a
country's economy, the better its currency will
perform, and the more demand for it will be there.

2 6

    
Ñncreasing productivity in an economy should
positively influence the value of its currency. Ñts
effects are more prominent if the increase is in the
traded sector
 6 
 
 
2 Ñnternal, regional, and international political conditions
and events can have a profound effect on currency
markets.
2 All exchange rates are susceptible to political instability
and anticipations about the new ruling party. Political
upheaval and instability can have a negative impact on a
nation's economy. For example, destabilization of
coalition governments in Pakistan and uhailand can
negatively affect the value of their currencies. Similarly,
in a country experiencing financial difficulties, the rise of
a political faction that is perceived to be fiscally
responsible can have the opposite effect. Also, events in
one country in a region may spur positive or negative
interest in a neighboring country and, in the process,
affect its currency.
{
  
2 Market psychology and trader perceptions
influence the foreign exchange market in a
variety of ways:
2 Ô    
[nsettling international events can lead to a "flight
to quality," with investors seeking a "safe haven."
uhere will be a greater demand, thus a higher
price, for currencies perceived as stronger over
their relatively weaker counterparts. uhe Swiss
franc has been a traditional safe haven during
times of political or economic uncertainty.
2 r 

‰urrency markets often move in visible long-term
trends. Although currencies do not have an
annual growing season like physical commodities,
business cycles do make themselves felt. ‰ycle
analysis looks at longer-term price trends that
may rise from economic or political trends.
{arket psychology contd
2 ëŒ    ë
uhis market truism can apply to many currency
situations. Ñt is the tendency for the price of a
currency to reflect the impact of a particular action
before it occurs and, when the anticipated event
comes to pass, react in exactly the opposite
direction. uhis may also be referred to as a market
being "oversold" or "overbought". uo buy the
rumor or sell the fact can also be an example of
the cognitive bias known as anchoring, when
investors focus too much on the relevance of
outside events to currency prices.
{arket psychology contd
2     
 hile economic numbers can certainly reflect economic
policy, some reports and numbers take on a talisman-like
effect: uhe number itself becomes important to market
psychology and may have an immediate impact on short-
term market moves. " hat to watch" can change over time.
Ñn recent years, for example, money supply, employment,
trade balance figures and inflation numbers have all taken
turns in the spotlight.
2 u  
 
  
As in other markets, the accumulated price movements in a
currency pair such as E[ /[SD can form apparent patterns
that traders may attempt to use. Many traders study price
charts in order to identify such patterns
2 Economic factors
a) Economic policy
b) Economic conditions
1. Government budget deficits or surpluses
2. Balance of trade levels and trends
3. Ñnflation levels and trends
4. Economic growth and health
5. Productivity of an economy
2 Political conditions
2 Market psychology
1. Flights to quality
2. Long-term trends
3. ³Buy the rumor, sell the fact´
4. Economic numbers
5. uechnical trading considerations
‰overed interest rate parity
2 ‰

    also called   
 
 ) means that the following equation holds:
1 + i$ ) = F/S) 1 + ic )
2 where:
2 i$ is the domestic interest rate implied by debt of a
given maturity;
2 m is the interest rate in the foreign country for debt of
the same maturity;
2 £ is the spot exchange rate, expressed as the price
in domestic currency $) of one unit of the foreign
currency , i.e. $/ ;
2 Ô is the forward exchange rate implied by a forward
contract maturing at the same time as the domestic
and foreign debt underlying i$ and m . Ô is expressed
in the same units as £, namely $/ .
-n example
2 Assume that
 1 + i $ ) <  F/S) 1 + ic)
2 uhis would imply that one dollar invested in the [S
< one dollar converted into a foreign currency and
invested abroad. Such an imbalance would give
rise to an arbitrage opportunity, wherein one could
borrow at the lower effective interest rate in [S,
convert to the foreign currency and invest abroad.
2 uhe following rudimentary example demonstrates
covered interest rate arbitrage ‰ÑA). ‰onsider the
interest rate parity Ñ P) equation,
 1 + i$ ) = F/S)  1 + ic )
2 Assume:
the 12-month interest rate in [S is 5%, per annum
the 12-month interest rate in [
is 8%, per annum
the current spot exchange rate is 1.5 $/£
the forward exchange rate implied by a forward
contract maturing 12 months in the future is 1.5
$/£.
2 ‰learly, the [
has a higher interest rate
than the [S. uhus the basic idea of covered
interest arbitrage is to borrow in the country
with lower interest rate and invest in the
country with higher interest rate. All else
being equal this would help you make
riskless money.
2 uhus,
As per the LHS of the interest rate parity equation above, a dollar
invested in the [S at the end of the 12-month period will be,
$1 · 1 + 5%) = $1.05
As per the HS of the interest rate parity equation above, a dollar
invested in the [
after conversion into £ and back into $ at the
end of 12-months) at the end of the 12-month period will be,
$1 · 1.5/1.5)1 + 8%) = $1.08
2 uhus one could carry out a covered interest rate
‰ÑA) arbitrage as follows,
1. Borrow $1 from the [S bank at 5% interest rate.
2. ‰onvert $ into £ at current spot rate of 1.5$/£ giving 0.67£
3. Ñnvest the 0.67£ in the [
for the 12 month period
4. Purchase a forward contract on the 1.5$/£ i.e. cover your
position against exchange rate fluctuations)
2 At the end of 12-months
1. 0.67£ becomes 0.67£1 + 8%) = 0.72£

2. ‰onvert the 0.72£ back to $ at 1.5$/£, giving $1.08

3. Pay off the initially borrowed amount of $1 to the [S

bank with 5% interest, i.e $1.05
2 uhe resulting arbitrage profit is $1.08 í $1.05 = $0.03
or 3 cents per dollar.
2 Obviously, arbitrage opportunities of this magnitude
would vanish very quickly.
2 Ñn the above example, some combination of the
following would occur to reestablish ‰overed Ñnterest
Parity and extinguish the arbitrage opportunity:
[S interest rates will go up
Forward exchange rates will go down
Spot exchange rates will go up
[
interest rates will go down
È    

2 uhe nominal exchange rate ßY is the price in foreign
currency of one unit of a domestic currency.
2 uhe real exchange rate u u) is defined as
E t = NE t
Ôa 

Ôh 
where ÑNFa and ÑNFh are the rates of inflation in a
foreign country and the home country respectively, and
t is the time period
2 Ñt indicates the real purchasing power of one currency
relative to another currency
2 Ñt is adjusted for changes in the relative purchasing
power of each currency since some base period
2 Exchange rates are quoted in the form of
³direct quotation´ when number of home
currency units, rupees, are quoted per unit of
foreign currency, say [S dollar
or ³ indirect quotation´ when the number of
units of foreign currency, [S dollar, are
quoted per unit of home currency, rupees.
2 uhe Ñndian FEM was following the system of
³indirect quotes´ till August 1993; since then it
has switched over to ³direct quotes´
Example
2 Assuming s.50 = 1[S$, direct quote), the
nominal exchange rate would be 1 / 50 =
0.02, and if the rate of inflation in [S is 5%
and in Ñndia is 10%, then
E t = NE t
Ôa 

Ôh