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Foreign Exchange

Basics of Forex

Marketplace where currencies are exchanged

Critical for conducting foreign business

Largest financial market

No centralized exchange

Market never closes

OTC

Over the Counter

Channeled through market maker

Typically a Bank or Forex Brokerage

Governance

Not regulated by one governing body

Prices are market determined

No standardized pricing

Solely based on supply and demand

Ways to Trade

Spot Market

Futures Market

Forward Market

Spot Market

Also called cash market or physical market

Settled in cash “on the spot”

Underlying asset delivered immediately

Futures Market

Participants buy and sell contracts for a specific delivery date in the future

Set contract size and maturity

Standardization

Traded on exchanges

Forward Market

OTC market

Sets price of asset for future delivery

Customizable

Lack standardization

Currency Quotes

Quoted in relation to another currency

Example (USD/JPY)

Base

Counter/Quote

Direct vs. Indirect

Direct - Currency quote in which domestic currency is the base currency

Indirect - Currency quote in which he domestic currency is the quoted currency

Most traded against dollar

Cross Currency

Bid-Ask Spread

Bid and Ask price just like equities

In relation to base currency

Long vs. Short

Breaking Down Bid-Ask

Factors That Influence Currency Exchange

Differentials in Inflation

Differentials in Interest Rates

Current Accounts Deficits

Public Debt

Political Stability and Economic Performance

Supply and Demand!

Differentials in Inflation

High vs. Low Inflation rates

Equal inflation rates

Purchasing power

Differential in Interest Rates

Interest rates affect inflation and exchange rates

High vs. Low Interest Rates

High IR (Mitigating effect)

Interest rates and inflation

Current Accounts Deficits

What is current account?

Current account deficit

Requires greater foreign currency

Excess demand for foreign currency

Public Debt

Large-Scale deficit financing

Spurs growth in domestic economy

Unattractive to investors due to inflationary risk (TIPS)

Monetary stimulus …

Political Stability and Economic Performance

Foreign investment

Strong economic performance

Political stability

Supply and Demand

Comes down to supply and demand

Factors listed above affect supply and demand

Brief History

Gold Standard Monetary System

Bretton Woods

Gold Standard

One of the most important events in history of Forex

Guaranteed the conversion of currency

Needed to maintain reserves

Problems

Bretton Woods

Before the end of WWII

Three main points A method of fixing exchange rates The Dollar replaces gold becomes reserve currency Creation of IMF, GATT, and International Bank for

Reconstruction and Development

Market Participants

Governments and Central Banks

Banks and other Financial Institutions

Hedgers

Speculators

Major Theories

Purchasing Power Parity

Interest Rate Parity

International Fisher Effect

Balance of Payments Theory

Purchasing Power Parity

Price levels between two countries should be equivalent to each other after exchange rate adjustment

Interest Rate Parity

Two assets in two different countries should have similar interest rates, as long as the risk is the same

International Fisher Effect

The exchange rate between two countries should change by an amount similar to the difference between their nominal interest rates

Balance of Payments Theory

Balance of payments looks at the current account to get an idea of exchange rate directions

Surplus or Deficit