Tuesday, January 6, 2009

What is the global Forex market?

Today, the “ is a nonstop cash where currencies of nations are traded, typically via brokers. Foreign currencies are continually and simultaneously bought and sold across local and markets. The value of traders’ investments increases or decreases based on currency movements.
Foreign conditions can change at any time in response to real-time events.
The main attractions of short-term currency trading to private investors are:

  • 24-hour trading, 5 days a week with nonstop access (24/7) to dealers.
  • An enormous liquid , making it easy to trade most currencies.
  • Volatile markets offering profit opportunities.
  • Standard instruments for controlling risk exposure.
  • The ability to profit in rising as well as falling markets.
  • Leveraged trading with low margin requirements.
  • Many options for zero commission trading.

A brief history of the

The following is an overview into the historical evolution of the foreign and the roots of the international currency trading, from the days of the , through the Bretton-Woods Agreement, to its current manifestation.

The period and the Bretton-Woods Agreement

The Bretton-Woods Agreement, established in 1944, national currencies against the US , and set the at a rate of 35 per ounce of . In 1967, a Chicago refused to make a loan in pound sterling to a college professor by the name of Milton Friedman, because he had intended to use the funds to short the British currency. The ’s refusal to grant the loan was due to the Bretton-Woods Agreement.

Bretton-Woods was aimed at establishing international monetary stability by preventing money from taking flight across countries, thus curbing speculation in foreign currencies. Between 1876 and World War I, the standard had ruled over the international economic system. Under the standard, currencies experienced an era of stability because they were supported by the price of .

However, the standard had a weakness in that it tended to create boom bust economies. As an economy strengthened, it would import a great deal,
running down the reserves required to support its currency. As a result, the money supply would diminish, interest would escalate and economic
activity would slow to the point of recession. Ultimately, prices of commodities would hit rock bottom, thus appearing attractive to other
nations, would then sprint into a buying frenzy. In turn, this would inject the economy with until it increased its money supply, thus driving down
interest and restoring wealth. Such boom-bust patterns were common throughout the era of the standard, until World War I temporarily
discontinued trade flows and the free movement of .

The Bretton-Woods Agreement was founded after World War II, in order to stabilize and regulate the international . Participating countries
agreed to try to maintain the value of their currency within a narrow margin against the and an equivalent rate of . The gained a premium
position as a reference currency, reflecting the shift in economic dominance from Europe to the USA. Countries were prohibited from devaluing
their currencies to benefit export markets, and were only allowed to devalue their currencies by less than 10%. Post-war construction during the 1950s,
however, required great volumes of trading as masses of capital were needed. This had a destabilizing effect on the established in
Bretton-Woods.

In 1971, the agreement was scrapped when the US ceased to be exchangeable for . By 1973, the forces of supply and demand were in
control of the currencies of major industrialized nations, and currency now moved more freely across borders. Prices were floated daily, with volumes, speed and price volatility all increasing throughout the 1970s. New financial instruments, deregulation and trade liberalization emerged, further
stoking growth of markets.

The explosion of computer technology that began in the 1980s accelerated the pace by extending the continuum for cross-border capital
movements through Asian, European and American time zones. Transactions in foreign increased rapidly from nearly $70 billion a day in the
1980s, to more than $2 a day two decades later.

The explosion of the euro

The rapid development of the Eurodollar , which can be defined as US deposited in banks outside the US, was a major mechanism for
speeding up trading. Similarly, Euro markets are those where currencies are deposited outside their country of origin. The Eurodollar came
into being in the 1950s as a result of the Soviet Union depositing US earned from oil revenue outside the US, in fear of having these assets frozen
by US regulators. This gave rise to a vast offshore pool of outside the control of US authorities. The US government reacted by imposing laws to
restrict lending to foreigners. Euro markets were particularly attractive because they had far fewer regulations and offered higher yields. From the
late 1980s onwards, US companies began to borrow offshore, finding Euro markets an advantageous place for holding excess liquidity, providing short-
term loans and financing imports and exports.

London was and remains the principal offshore . In the 1980s, it became the key center in the Eurodollar , when British banks began
lending as an alternative to pounds in order to maintain their leading position in finance. London’s convenient geographical location
(operating during Asian and American markets) is also instrumental in preserving its dominance in the Euro . Euro- currency The euro to US rate is the price at which the world demand for US equals the world supply of euros. Regardless of geographical origin, a rise in the world demand for euros leads to an appreciation of the euro.

Factors affecting the Euro to US rate

Four factors are identified as fundamental determinants of the real euro to US
rate:

  • The international real interest rate differential between the Federal Reserve and European Central
  • Relative prices in the traded and non-traded goods sectors
  • The real oil price
  • The relative fiscal position of the US and Euro zone

The nominal bilateral US to euro is the rate that
attracts the most attention. Notwithstanding the comparative importance of

bilateral trade links with the US, trade with the UK is, to some extent, more important for the euro. The following chart illustrates the / rate over time, from the inauguration of the euro, until mid 2006. Note that each line (the /, /) is a “mirror” image of the other, since both are reciprocal to one another. This chart is illustrates the steady (general) decline of the (in terms of euro) from the beginning of 2002 until the end of 2004.

"forex-taple"

In the long run, the correlation between the bilateral US to euro rate, and different measures of the effective rate of
Euroland, has been rather high, especially when one looks at the effective real rate. As inflation is at very similar levels in the US and the Euro
area, there is no need to adjust the US to euro rate for inflation differentials. However, because the Euro zone also trades intensively with
countries that have relatively high inflation (e.g. some countries in Central and Eastern Europe, Turkey, etc.), it is more important to downplay
nominal rate measures by looking at relative price and cost developments.

The fall of the US “

The steady and orderly decline of the US from early 2002 to early 2004 against the euro, Australian , Canadian and a few other currencies
(i.e. its trade-weighted average, which is counts for purposes of trade adjustment), while significant, has still only amounted to about 20 percent.
There are two reasons why concerns about a free fall of the US may not be worth considering. Firstly, the US external deficit will stay high only if US
growth remains vigorous, and if the US continues to grow strongly, it will also retain a strong attraction for foreign capital which, in turn, should support the US “”. Secondly, attempts by the monetary authorities in Asia to keep their currencies weak will probably not work in the long run.

The basic theories underlying the US to euro rate

Law of One Price: In competitive markets, free of transportation cost barriers to trade, identical products sold in different countries must sell at the same
price when the prices are stated in terms of the same currency. Interest rate effects: If capital is allowed to flow freely, become stable at a point where equality of interest is established.

The dual forces of supply and demand

These two reciprocal forces determine euro vs. US . Various factors affect these two forces, which in turn affect the
:

The business environment: Positive indications (in terms of government

policy, competitive advantages, size, etc.) increase the demand for the currency, as more and more enterprises want to invest in its place of
origin.

Stock : The major stock indices also have a correlation with the

currency , providing a daily read of the mood of the business environment.

Political factors: All are susceptible to political instability and anticipation about new governments. For example, political instability in
Russia is also a flag for the euro to US , because of the substantial amount of German investment in Russia.

Economic data: Economic data such as labor reports (payrolls, unemployment rate and average hourly earnings), consumer price indices (CPI), producer
price indices (PPI), gross domestic product (GDP), international trade, productivity, industrial production, consumer confidence etc., also affect
currency .

Confidence in a currency is the greatest determinant of the real euro to US rate. Decisions are made based on expected future
developments that may affect the currency.

Types of rate systems
An can operate under one of four main types of rate
systems:

Fully
In a rate system, the government (or the central acting on its behalf) intervenes in the currency in order to keep the
rate close to a target. It is committed to a single rate and does not allow major fluctuations from this central rate.

Semi-
Currency can move within a permitted range, but the rate is the dominant target of economic policy-making. Interest are set to meet
the target rate.

Free floating
The value of the currency is determined solely by supply and demand in the foreign . Consequently, trade flows and capital flows are the
main factors affecting the rate. The definition of a floating rate system is a monetary system in
which are allowed to move due to forces without intervention by national governments. The of England, for example,
does not actively intervene in the currency markets to achieve a desired rate level. With floating , changes in supply and demand cause a currency to change in value. Pure free floating are rare - most governments at one time or another seek to “” the value of their currency through changes in interest and other means of controls.

Managed floating

Most governments engage in managed floating systems, if not part of a rate system.

The advantages of

provide greater certainty for exporters and importers and, under normal circumstances, there is less speculative activity - though this depends
on whether dealers in foreign markets regard a given rate as appropriate and credible.

The advantages of floating

Fluctuations in the rate can provide an automatic adjustment for countries with a large balance of payments deficit. A second key advantage of floating is that it allows the government/monetary authority flexibility in determining interest as they do not need to be used to
influence the rate.

The - has ? So !
(you can profit in any it takes, you the …)

 are the participants in today’s ?
In general, there are two main groups in the :

Hedgers account for less than 5% of the , but are the key reason futures and other such financial instruments exist. The group using these
hedging tools is primarily businesses and other organizations participating in international trade. Their goal is to diminish or neutralize the impact of
currency fluctuations.

Speculators account for more than 95% of the .
This group includes private individuals and corporations, public entities, banks, etc. They participate in the in order to create profit,
taking advantage of the fluctuations of interest and .

The activity of this group is responsible for the high liquidity of the . They conduct their trading by using leveraged investing, making it a
financially efficient source for earning.

making

Since most deals are made by (individual and organizational) traders, in conjunction with makers, it’s important to understand the role of the
in the . Questions and answers about ‘ making’

is a ?

A is the counterpart to the client. The does not operate as an intermediary or trustee. A performs the hedging
of its clients’ positions according to its policy, which includes offsetting various clients’ positions, and hedging via liquidity providers (banks) and its
equity capital, at its discretion.

are the makers in the ?

Banks, for example, or trading platforms (such as Easy-™), buy and sell financial instruments “make the ”. That is contrary to
intermediaries, which represent clients, basing their income on commission.

Do makers go against a client’s position?

By definition, a is the counterpart to all its clients’ positions, and always offers a two-sided quote (two : BUY and SELL). Therefore,
there is nothing personal between the and the customer. Generally, makers regard all of the positions of their clients as a
. They offset between clients’ positions, and hedge their net exposure according to their risk management policies and the guidelines of
regulatory authorities.

Do makers and clients have a conflict of interest?

makers are not intermediaries, portfolio managers, or advisors, represent customers (while earning commission). Instead, they buy and sell
currencies to the customer, in this case the trader. By definition, the always provides a two-sided quote (the sell and the buy price), and
thus is indifferent in regards to the intention of the trader. Banks do that, as do merchants in the markets, both buy from, and sell to, their
customers. The relationship between the trader (the customer) and the (the ; the trading platform; Easy-™; etc.) is simply
based on the fundamental forces of supply and demand.

Can a influence prices against a client’s position?

Definitely not, because the is the nearest thing to a “perfect ” (as defined by economic theory) in which no single is
powerful enough to push prices in a specific . This is the biggest in the world today, with daily volumes reaching 3 . No
is in a position to effectively manipulate the .

is the main source of earnings for makers?

The major source of earnings for makers is the spread between the bid and the ask prices. Easy-™ Trading Platform, for instance, maintains neutrality regarding the of any or all deals made by its traders; it earns its income from the spread.

How do makers their exposure?
The way most makers hedge their exposure is to hedge in . They aggregate all client positions and pass some, or all, of their net risk to their
liquidity providers. Easy-™, for example, hedges its exposure in this fashion, in accordance with its risk management policy and legal
requirements. For liquidity, Easy-™ works in cooperation with world’s leading banks providing liquidity to the : UBS (Switzerland) and RBS ( of Scotland).

1 comment:

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