Concept of Foreign Currency Exchange
Let's begin like a Top Bloke, with an example
China is a huge exporter of goods to America. So huge that US economy sustains net trade deficit from this huge import. How does exchange rate come into play here?
a) Jackie from China is a producer of goods. Chuck from America imports goods from Jackie.
b) The currency of China is Renminbi (Jackie’s Currency) and currency of USA is Dollars (Chuck’s Currency).
c) Chuck pays Jackie in Dollars and Jackie exchanges those Dollars with Renminbi.
d) In Foreign Exchange Market, this created a demand for Renminbi and Dollar was spend against this demand.
e) Renminbi is a scarse item (so is Dollars) so demand against it would led to raised value of Renminbi.
g) China having an export led economy, Renminbi surely rises in value by this reason.
What if I quote the transaction in third country currency?
Okay so, What if I quote the transaction in third country currency. Will it still have the same demand/supply effect on the currencies of the countries involved in the transaction?
Yes, irrespective of which currency is used to quote the transaction the demand/supply effect on the currencies of the countries involved in the transaction will be the same. Lets say in the above transaction Jackie had quoted the transaction in EURO, the following would happen:
a) Chuck would exchange his Dollars for Euro (Euro ↑, Dollar ↓) and pay to Jackie
b) Jackie would exchange his Euros for Renminbi (Renminbi ↑, Euro ↓)
Net Result is (Renminbi ↑, Dollar ↓)
Eventually, the parking currency (Euro) would not have other push/pull contribution in the currency demand other than those caused by transaction delay, transaction costs and other frictions associated in a perfect market.
Key takeaway from above example
- Currency, just like any other economic resource, is in scarse quantity.
- The demand for the local currency is created when we have to exchange foreign currency against local currency.
- If you hold foreign currency account, this exchange takes place at the point when you convert foreign currency into local currency, This exchange is executed by your bank for you.
- If you do not hold foreign currency account, this exchange takes place at the point of amount being credited to your local currency account. This exchange is also executed by your bank for you.
- The aforesaid demand for currency is created by following activities: (also known as forces of demand for local currency)
- Purchase of local goods/services by foreigners (i.e. Export)
- Inflow of Foreign Direct Investments, that are translated into local currency for expenditure
- Inflow of foreign tourists who translate their foreign currencies into local currency for expenditure
- Remittance income received from foreign employment that are translated into local currencies for expenditure
- Gifts and grants received from foreign nations that are translated into local currency for expenditure
How do people come together to forex trade?
It chips some life away from you. This is scary. The whole world of forex trading being run by a bunch of speculators. It averages to 7 trillion dollars of trade daily.
They could be self disciplined people with high conduct standards or they could be the bandit’s club in the electronic chatroom. We will have difficulty knowing this. There has been huge forex scandals and currency manipulation scandals and all huge banks around the world like BofA, Barclays, Citibank, HSBC, JPMorgan, RBS, UBS has been fined by the financial commission of their countries.
There is no point in comparing the forex market with stock market. They differ in so many ways:
1. Order Placing: In stock market orders are placed though stock brokers. In case of forex markets orders can be placed by the customer themselves or though their banks to the broker. The broker patches the deal with other person involved in the trade.
2. Counterparty Risk: Exchange associated body charged with ensuring the financial integrity of the counterparties to the trade and maintenance of the deposit and speculation margins. Every stock buy/purchase contract between the traders of stock is substituted by two contracts so that clearing house becomes buyer to every seller and seller to every buyer. This way, the clearing house bears the counterparty risk to the trade. Central Depository System and Clearing (CDSC) is the clearing agent for transactions of capital market in Nepal. There are no such equivalent of clearing body engaged in managing counterparty risk of forex trade.
3. Comparison with other dynamics of stock market: Unlike stock market, the forex market runs 24/7 in several places of the world and the order placed and demand created has worldwide demand/supply impact.
The major countries involved in forex trade are: United States, Eurozone (the ones to watch are Germany, France, Italy and Spain), Japan, United Kingdom, Switzerland, Canada, Australia, New Zealand.
The major institutions involved in forex trade are: JP Morgan (USA), Deutsche Bank (Germany), Citi (USA), XTX Markets (UK), UBS (Switzerland), State Street Corporation (USA), HCTech (USA), HSBC (UK), Bank of America Merrill Lynch (USA), Goldman Sachs (USA). In total these institutions comprise 70% of the total forex tradings.
Some nuances of Forex Trade Market
The Forex Market
Cited from the The Forex Market by Kevin Kotzé
The foreign exchange market consists of a number of different aspects and is the largest and most liquid market in the world, measured by dollar volume of trade. It is open around the clock (i.e. 24 hours) as the major financial centres where currencies are traded have different geographic locations. Major trading centres, which have been arranged according to relative opening times, include Wellington, Sydney, Tokyo, Osaka, Hong Kong, Singapore, Copenhagen, Frankfurt, Zurich, Paris, London, New York, Chicago and Los Angeles. This market incorporates a multiplicity of heterogeneous market participants and as such it is not surprising to find that the behaviour of exchange rates is relatively complex. The most important aspect of this market includes the interbank market, which comprises of the wholesale part of the foreign exchange market where banks manage inventories of currencies. This diverse, over-the-counter (OTC) market, does not have a physical trading place where buyers and sellers gather to agree on a price to exchange currencies. Rather, traders, who are employees of financial institutions in the major financial cities around the world, deal with each other via computer or over the phone, with back-office confirmations of transactions occurring at a later point in time. Since most transactions on the interbank market are made up of large trades with values of $1 million or more, most retail investors and small businesses do not have direct access to this part of the foreign exchange market. As a result, many in need of foreign exchange deal with small regional banks or branches of banks that quote less advantageous rates than those that prevail on the interbank market. Retail investors also participate in the foreign exchange markets through their stockbrokers, who place orders on derivative markets that trade in futures and options contracts.
One interesting feature of this market is that the volume of trading activity has increased rapidly since the 1970s. For example, during 1973 the estimated daily volume of currency trading was between $10 and $20 billion. By the late 1980s, the daily volume had increased to around $500 billion, while in September 1993, the estimated daily volume in all currencies had increased to over $1 trillion. This figure then increased to almost $2 trillion in 2004 and it had almost doubled again in April 2010 when the daily turnover reached $3.9 trillion.1 The Bank for International Settlements (BIS) has since estimated that daily trading volume in 2016 was $5.1 trillion per day,2 and as of April 2019, it had increased to approximately $6.6 trillion per day. This dollar volume of trade dwarfs the corresponding dollar volume of transactions on stock markets such as the New York Stock Exchange (NYSE), where average daily dollar volume was roughly $87 billion in 2015. In addition, it also dwarfs the annual Gross Domestic Product (GDP) of a country like South Africa, which in 2016 was about ± $232 billion3 for the calendar year and $359 billion for 2019.
Communications and funds transfers
The enormous volume of trade in the foreign exchange market requires an extensive communication network between traders and a sophisticated settlement system to transfer payments in different currencies between the buyers and sellers of different currencies. Traders are able to obtain information that is provided by major commercial distributors such as Reuters and Bloomberg. The traders are then able to contact each other, to obtain actual prices and negotiate deals. In addition, they could approach a foreign exchange broker to broker a deal, or they can trade on an electronic brokerage system, where quotes on a screen are transactable. When a trade is agreed upon, banks communicate and transfer funds electronically, using systems such as the Society of Worldwide Interbank Financial Telecommunications (SWIFT), which confirm trades and facilitate payment.
Counterparty Risk / Herstatt risk / Settlement Risk
As Cross-Currency transactions may involve the simultaneous exchange of currencies, there is a risk that only one leg of the transaction may be completed, due to the possibility that parties use different systems in different countries that operate out of different time zones. This is known as cross-currency settlement risk, or Herstatt risk. Recently, foreign exchange dealers, encouraged by the BIS, have developed a number of practices to limit settlement risk. These measures include: firstly, banks now have strict limits on the amount of transactions they are willing to settle with a single counterparty on a given day. Secondly, banks have started to engage in a variety of netting arrangements, in which they agree to wire the net traded amounts only at the end of a trading day. Thirdly, settlement risk is eliminated if the exchange of the two monies occur simultaneously in a process known as payment versus payment (PvP). More recently, we have witnessed the foundation of the Continuous Linked Settlement (CLS) Bank, which is owned by the world’s largest financial groups. CLS is the largest multi-currency cash settlement system, eliminating settlement risk for over half of the worlds foreign exchange payment instructions and its members include central banks, large commercial banks and other large corporations. The CLS daily settlement cycle operates with settlement and funding occurring during a five-hour window when all real time gross settlement systems are able to make and receive payments. This enables simultaneous settlement of the payments on both sides of a foreign exchange transaction. Each member holds a single multicurrency account with CLS, which has a zero balance at the start and the end of trading day. Note that the settlement of the payment instructions and the associated payments are final and irrevocable.
Dealers, Brokers and ECNs
Traditionally, the main participants in the foreign exchange market are the commercial banks, investment banks, and brokerage firms in the major financial cities around the world. Traders at these banks and firms function as foreign exchange dealers, who seek to purchase a foreign currency at a low rate and sell at a higher rate to make a profit. Through this process dealers are simultaneously responsible for “making-a-market” in the currencies in which they specialise. For example, by standing ready to transact with retail customers or other dealers, they provide liquidity to the market, which makes it easier and less costly to match buyers and sellers. When there are large numbers of buyers and sellers, markets are usually very liquid, and transaction costs are low, which would be of benefit to those who would like to make use of the market.
While the brokers continue to play an important role in foreign exchange trading, a large part of the brokering business now happens through computerised trading systems. In the early 1990s, Reuters (now Thomson Reuters), a large financial information provider, and Electronic Brokering Service (EBS), launched the first anonymous electronic brokering systems for trading foreign exchange in the spot market. Trading is then carried out through a network of linked computer terminals among the participating foreign exchange dealers. When using this system currency prices are displayed on computer screens, and deals are completed by keystroke or by automatic deal matching within the system. Before a trade gets executed, either the systems check for mutual credit availability between the initiator of the deal and the counterparty; or each counterparty must have its creditworthiness pre-screened.
There are three different categories of eFX: single bank-sponsored platforms (e.g. Deutsche Bank’s Autobahn), multi-bank portals (e.g. FXConnect and FXall), and independent companies offering electronic trading (e.g. HotSpot and Currenex). In addition, retail aggregators also provide intermediary services, by aggregating bid-offer quotes from the top foreign dealing banks and electronic platforms, which are then streamed to customers on an online platform. These retail aggregators cater to the relatively small accounts and a well-known example is Oanda.
Why such a huge volume of Forex Transaction?
In most instances, a foreign exchange trader is typically responsible for buying and selling a particular currency or a small group of currencies. They would usually hold an inventory or portfolio of positions in those currencies. One reason for this activity in the interbank market is that foreign exchange traders at one bank use foreign exchange traders at other banks to adjust their portfolios in response to transactions that arise from their customers in the corporate market (to maintain an inventory of a particular currency or portfolio position). The repeated passing of inventory imbalances among dealers has been dubbed “hot potato trading” and may be one reason for the large trade volumes that we see on the interbank market.
Mathematical model for valuation of foreign exchange rate?
The scary picture
Okay understood that it is run on free market basis with little to no regulatory intervention, but what is the mathematical model for valuation of foreign exchange rate? Is surely isn’t just the economic sentiment of demand and supply of a scarse quantity? Or is it?
Actually it is. Scary it might sound, but there aren’t any international regulation governing the foreign exchange trading other than the conduct standards of the people involved in the market. People involved in the market are: large companies and institutional investors, foreign exchange brokers, derivative markets, major banks and interbank market, online trading eFX, stock brokers, local and smaller banks and customers (small corporations and institutions). They work together to establish the forex market but in fact there are no regulatory or monitoring organization to oversee this. This is a bunch of highly speculative people involved in trading who derive their information from market cues and reports.
Theories that model the forex trade
Interest Rate Parity Theory
Interest rate parity theory states that no arbitrage gain can be achieved from investment in local market and foreign market merely by the reason of interest rate differential. Any interest rate advantage in the foreign country will be offset by the discount on the forward.
exchange rate differential = interest rate differential
future forex rate / current forex rate = (1+local interest rate) / (1+foreign interest rate)
International Fisher Effect Theory is just an slight simplification of Interest Rate Parity Theory. This theory states that if the real rate of return expected by both the local and foreign investors are same, then interest rate differential is equal to differential of expected inflation rates. According to Fisher Hypothesis, relation between nominal interest rate (i), real interest rate (ri) and expected inflation rate (ei) is given by: (1+i)=(1+ri)×(1+ei)
exchange rate differential = interest rate differential
future forex rate / current forex rate = (1+local inflation rate) / (1+foreign inflation rate)
Purchasing Power Parity Theory
The purchasing power parity theory states that exchange rate is the ratio between price level in local market is and foreign market.
forex rate = price level in local market / price level in foreign market
Relative Purchasing Power Parity Theory is just a slight simplification of Purchasing Power Parity Theory. It takes into considerations of market imperfections like transportation costs, tariffs and quotas, termed as sectoral price constant. Mathematically,
forex rate = price level in local market / price level in foreign market × sectoral price constant
Which model is used practically to determine the forex rates?
The factors that influence the forex rate
Most people are surprised why countries that are economically strong and also operate in net trade surplus (e.g. China, Japan, Germany, Russia, Saudi Arabia) do not have the most expensive currency and exchange rates or at least trend in that direction. Well there could be a number of reasons for this:
- Firstly, the reason is, exchange rates are just the hangover of the rates that prevailed during the gold standard time. The time when central bank were liable to provide you the equivalent worth of gold when the money (essentially a promissory note) was presented for payment). The expensiveness of the currency is not exactly relatable to the strength of trade and economy of the country.
- Secondly, the other factors influencing the forex are at play as well. So, despite having the strong economy and trade surplus, other factors like interest rates, public debt, terms of trade and asset backing of the currency influence the exchange rates.
- Thirdly, currency could have been manipulated to establish the currency as inexpensive one. China in particular does currency manipulation to influence and inorganically enhance its export led growth.
What are the inputs for Foreign Exchange Aggregator?
Since the early 2000s the forex deals are made though the use of computer software termed as Foreign Exchange Aggregator. These software run in electronic communication network and they allows forex traders to view price, bid, offer and liquidity information from traders all around the world. These software are Currenex, FXall or Hotspot FX. FXall developed by Thompson Reuters is the most popular among them all. Practically, these software handle all the transaction data and model the prices based on principle that drive the forex trade like discussed above. These software are so sophisticated and complex as the technology needs to be fast (latencies in microseconds) and flexible.
The aggregators use Consumer Price Index (CPI) as a broad guide for the economic activity and achievement of the country. The CPI calculates the weighted average of prices of a basket of consumer goods and services, including costs of transportation, food, and energy. Economists use this CPI figure to assess price changes in individuals’ cost of living. Markets typically refer to the CPI indicator as “headline inflation.” This CPI data is critical in the currency markets because inflation dramatically impacts the decisions made by central banks regarding monetary policy. The Consumer Price Index (CPI) is a critical indicator of pricing pressures in an economy and provides a gauge of inflation. Forex traders monitor the CPI, as it can lead to changes in monetary policy by the central bank that will either strengthen or weaken the currency against rivals in the markets. The strength or weakness of a currency can also have a significant impact on the earnings performance of companies with a presence in many global markets.
CPI is assumed to be a general guide for the various factors that influence the exchange rate.
1. Hangover of Gold Standard: Depending upon how strongly the currency was backed by Gold in the Gold Standard Time, the price level of consumer expenses is set in any country. Japan’s currency doesn’t have to be expensive to indicate its strength of economy. It is very well represented by employment rate, GDP and trade surpluses. The currency value that prevailed from historical time is embedded on how consumer spends money. So there is no point in influencing the expensiveness of currency to indicate economic dominance. Countries like South Korea, Indonesia who tried to do this have failed flat because it challenges the consumer expectations and spending behaviors. This factor is very well embedded in the CPI.
2. Differential in Inflation Rate: Inflation means there is a sustained increase in the price level. The main causes of inflation are either excess aggregate demand (economic growth too fast) or cost push factors (supply-side factors). Cut in interest rates, increased money supply, higher wages and cost of production, declining productivity, increase in indirect taxes etc. This factor is very well embedded in the CPI.
3. Differential in Interest Rate: There is a general tendency for interest rates and the rate of inflation to have an inverse relationship. In general, when interest rates are low, the economy grows and inflation increases. Conversely, when interest rates are high, the economy slows and inflation decreases. In general, as interest rates are reduced, more people are able to borrow more money. The result is that consumers have more money to spend, causing the economy to grow and inflation to increase. The opposite holds true for rising interest rates. As interest rates are increased, consumers tend to save as returns from savings are higher. With less disposable income being spent as a result of the increase in the interest rate, the economy slows and inflation decreases. This is also termed as Quantity Theory of Money. This factor is very well embedded in the CPI.
4. Current Account Deficit: A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is issuing its currency to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country’s exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests. This leads to inflation in the domestic economy due to the lower value of the currency. This factor is very well embedded in the CPI.
5. Public Debt: Public debt means the debts raised by the GoN. When the central bank invests in these public debts, which they usually do, the debt appears as investment in the central banks’ books. This is how money gets issued. The higher level of public debt leads the issuance of more currency and consequently inflation rises. This factor is very well embedded in the CPI.
NPR and its basket of Relevant Currencies
Nepal’s trade figures for FY 2017/2018 is as follows. Pretty much same ratio holds true for FY 2018/2019 and FY 2019/2020.
Total exports amounts to only 6.5% of the total imports. What a miserable records. This vast trade deficit is sustained by the remittance income from Nepalese in foreign employment.
Based on these trade figures we could easily say how the foreign currency assets (that backs the Nepalese Currency) is composed of. It contains 60% of INR Reserves or investment in GoI treasuries and rest is composed of USD Reserves or investment in USD denominated treasuries. Basically NPR’s basket of currency would comprise of INR and USD majorly. The strength of NPR is backed by the strength of these currencies. Should Nepal head into trade deficit, the current asset backing of USD and INR will be replaced by GoN treasury bills and there will be unexpected diminish in the value of NPR. Any volatility in the income generated from foreign income will cause volatility in the NPR currency.
Important things here
Forex Rate by Traders and Forex Fixings by NRB
Foreign exchange fixing is the daily monetary exchange rate fixed by the national bank of each country. The idea is that central banks use the fixing time and exchange rate to evaluate the behavior of their currency. Fixing exchange rates reflect the real value of equilibrium in the market. Banks, dealers, and traders use fixing rates as a market trend indicator. The mere expectation or rumor of a central bank foreign exchange intervention might be enough to stabilize the currency. Unlike Forex Fixings by the central bank the commercial banks and other institutions involved in the trade get their rates from deals of bid and offer in the Forex Market. Its quite different but the principle laid to determine both Forex Rate and Forex Fixings is basically the same.
Central banks may be involved in various exchange rate arrangements. More specifically, one can list the exchange rate arrangements into
- Clean Float: A clean float, also known as a pure exchange rate, occurs when the value of a currency, or its exchange rate, is determined purely by supply and demand in the market.
- Managed or Dirty Float: Managed Float occurs when government rules or laws affect the pricing of currency. Further discussed in Currency Manipulation below.
- Adjustable Peg: An adjustable peg is an exchange rate policy in which a currency is pegged or fixed to a major currency such as the U.S. dollar or euro, but which can be readjusted to account for changing market conditions or macroeconomic trends.
- Crawling Peg: A crawling peg is a system of exchange rate adjustments in which a currency with a fixed exchange rate is allowed to fluctuate within a band of rates.
- Currency Board: A currency board is a monetary authority which is required to maintain a fixed exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exchange rate target
- Dollarization: Dollarization is when a country begins to recognize the U.S. dollar as a medium of exchange or legal tender alongside or in place of its domestic currency.
- Monetary Union: A currency/monetary union is an intergovernmental agreement that involves two or more states sharing the same currency. These states may not necessarily have any further integration.
Currency Manipulation vis-à-vis USA/China Trade
Theory of Comparative Advantage is the basic economic principle that makes countries to foster by doing what they do best.
China has a world’s most largest export led economic growth and China wants this to continue for as long. China is engaged in the practice of intervening the Forex Market to keep its currency inexpensive. Basically it does this by these methods:
1. Keep issuing money to devalue the currency and spend such money in huge government led projects.
2. Secondly it buys dollars by selling its currencies and creating artificial demand for Dollars against Renminbi.
3. Investing in USA Treasury Bills
The concept is when China artificially suppresses the increase in value of its currency, exports become cheaper to foreign consumers, more industrial development and investment incentive in home country, more jobs and capital, more competitive and efficient.
The effect of having Chinese Central Bank buying USA Treasury Bill: More the people is willing to invest in debt raised by you, the lower will be your interest rate. Meaning, The USA Treasury Bill’s cost goes down, all debt in USA gets cheaper, will lead to people in America having more money in pocket but it is financed with debt, economy of USA also increases and America prospers but it is dependent in the prosperity of china, they will buy cheap Chinese products, and the debt trap is circle made. Chinese are essentially lending to Americans to go ahead and buy Chinese products.
As soon as the Chinese unwind or sell Dollar reserves then the Chinese currency will go up and dollar will go down as it was supposed to be without artificial distortion (which will be horrible situation for both China and USA). Interest rate in USA will go up, and borrowing in USA becomes more expensive, economy slows.
The concept is: I don’t want my currency to appreciate also, it will make my export supplies expensive to foreign consumers, not good for export leading industry and foreign loan dependent countries. I don’t want my currency to depreciate also, it will make my import supplies expensive to domestic consumers. For example, China and Japan engaged for many years in a program of buying massive volume of US dollar (USD) in order to keep the Chinese Yuan (CNY)/USD or Japanese Yen (JPY)/USD exchange rate lower, so as to make their exports more competitive in the United States market. To remain competitive in the world market, many developing countries with high inflation rates made steep devaluations to reverse changes in real exchange rates.