Foreign Exchange
S
Basics of Forex
S Marketplace where currencies are exchanged
S Critical for conducting foreign business
S Largest financial market
S No centralized exchange
S Market never closes
OTC
S Over the Counter
S Channeled through market maker
S Typically a Bank or Forex Brokerage
Governance
S Not regulated by one governing body
S Prices are market determined
S No standardized pricing
S Solely based on supply and demand
Ways to Trade
S Spot Market
S Futures Market
S Forward Market
Spot Market
S Also called cash market or physical market
S Settled in cash “on the spot”
S Underlying asset delivered immediately
Futures Market
S Participants buy and sell contracts for a specific delivery
date in the future
S Set contract size and maturity
S Standardization
S Traded on exchanges
Forward Market
S OTC market
S Sets price of asset for future delivery
S Customizable
S Lack standardization
Currency Quotes
S Quoted in relation to another currency
S Example (USD/JPY)
S Base
S Counter/Quote
Direct vs. Indirect
S Direct - Currency quote in which domestic currency is the
base currency
S Indirect - Currency quote in which he domestic currency is
the quoted currency
S Most traded against dollar
S Cross Currency
Bid-Ask Spread
S Bid and Ask price just like equities
S In relation to base currency
S Long vs. Short
Breaking Down Bid-Ask
Factors That Influence
Currency Exchange
S Differentials in Inflation
S Differentials in Interest Rates
S Current Accounts Deficits
S Public Debt
S Political Stability and Economic Performance
S Supply and Demand!
Differentials in Inflation
S High vs. Low Inflation rates
S Equal inflation rates
S Purchasing power
Differential in Interest Rates
S Interest rates affect inflation and exchange rates
S High vs. Low Interest Rates
S High IR (Mitigating effect)
S Interest rates and inflation
Current Accounts Deficits
S What is current account?
S Current account deficit
S Requires greater foreign currency
S Excess demand for foreign currency
Public Debt
S Large-Scale deficit financing
S Spurs growth in domestic economy
S Unattractive to investors due to inflationary risk (TIPS)
S Monetary stimulus …
Political Stability and Economic
Performance
S Foreign investment
S Strong economic performance
S Political stability
Supply and Demand
S Comes down to supply and demand
S Factors listed above affect supply and demand
Brief History
S Gold Standard Monetary System
S Bretton Woods
Gold Standard
S One of the most important events in history of Forex
S Guaranteed the conversion of currency
S Needed to maintain reserves
S Problems
Bretton Woods
S Before the end of WWII
S Three main points
S A method of fixing exchange rates
S The Dollar replaces gold becomes reserve currency
S Creation of IMF, GATT, and International Bank for
Reconstruction and Development
Market Participants
S Governments and Central Banks
S Banks and other Financial Institutions
S Hedgers
S Speculators
Major Theories
S Purchasing Power Parity
S Interest Rate Parity
S International Fisher Effect
S Balance of Payments Theory
Purchasing Power Parity
S Price levels between two countries should be equivalent to
each other after exchange rate adjustment
Interest Rate Parity
S Two assets in two different countries should have similar
interest rates, as long as the risk is the same
International Fisher Effect
S The exchange rate between two countries should change by
an amount similar to the difference between their nominal
interest rates
Balance of Payments Theory
S Balance of payments looks at the current account to get an
idea of exchange rate directions
S Surplus or Deficit