Foreign Exchange

FINC 410-01 Hassan Abdalla

Foreign Exchange
Definition: !! The transaction of purchasing one currency against the sale of another at an agreed date and a specific rate. !! It is an integral part of the world of financial systems Main Reasons for FX: !! Trade !! Investment - Movement of international capital seeking the most profitable return

Types of Foreign Exchange

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Banknotes Transfers (between countries) Differences: #! Insurance Expense #! Transport Expense #! Interest Expense #! Handling Expense

FX Market Participants
1.! 2.! 3.! 4.! 5.! 6.! 7.!

Central Banks Banks FX Brokers Investment Funds Corporations Speculators Hedgers

Factors influencing FX
1.! 2.! 3.! 4.! 5.!

Fundamental Factors
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Economic factors

Political Environment People Technical Factors

1. Fundamental Factors
Concerned with economic conditions such as inflation, recession, trade, GDP growth, etc.

Economic Factors include:

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Purchasing Power Parity (PPP) Real Interest Differentials Balance of Payments Economic Growth Rate

PPP: The Theory

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Floating exchange rates should respond primarily to inflation differentials High inflation (caused by too generous a growth of money supply) would lead to the weakening of the currency to the point where the rate is again the equilibrium rate, reflecting purchasing power parity The equilibrium rate is the rate of exchange which would render the prices of goods identical in the two countries concerned.

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Shortfalls of PPP Theory

1.!

Unavailability of price indices to measure purchasing power. International competitiveness is not a matter of price only, but also of quality and after-sale service. The PPP does not take into consideration capital movements.

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Real Interest Differentials

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Real Interest Rate:

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The rate of interest an investor expects to receive after subtracting inflation Real Rate of Return = Interest Rate - Inflation Rate

Q// If we have 2 countries, Country A has a 30% interest rate and Country B has 10%, which one will you invest in? Additional Information: Country A has a 50% inflation rate Country B has 5%, Which Country would you invest in?

Balance of Payments
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The trade balance is a fairly reliable barometer of international competitiveness of the economy concerned. It consists of Imports and Exports A surplus is when foreign exchange inflows from exports exceed outflows from imports It affects exchange rates. If the demand increases on my products this will lead to an increase in the value of my currency

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Economic Growth Rate

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There are two types of indicators:

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Lagging indicators: indicate what has already happened Leading indicators: indicate what will happen in the future.

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Inflation is measured by:

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CPI: (Consumer Price Index) when I go to a consumer store, I know whether prices went up or down WPI: (Whole price producer index) same as above but for wholesale PPI: (producer price index): Same as above but for producers.

Unemployment
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A very important indicator compiled by the Labor Department Usually released the 1st Friday of the month The combination of the change in total employment and average workweek data provide the first solid evidence for estimating industrial production for the month Employment data is more important than the unemployment rate 2 methods for calculating the change in employment: #! Household Survey #! Payroll data The payroll series is more reliable and is the one used in projecting industrial production

Index of Leading Indicators

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Compiled by the Commerce Department and released on the last day of each month. Comprised of 12 component series, which combined, are expected to forecast business conditions 3-6 months forward. Receives significant attention from the market because it has historically proven to be reasonably good in forecasting recessions and recoveries Generally, the series must decline for 3 consecutive months before analysts begin to predict the onset of a recession. It must also rise for several months before they are willing to predict the end of a recession

Index of Leading Indicators

Some of the components of the index are: #! Stock prices #! Money supply #! Factory orders #! Building permits #! Growth in Inventories

PPI: Producer Price Index

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A monthly inflation measure Released by the Labor Department on the 2nd Friday of the month The PPI usually has a greater market impact than the CPI because it is more volatile and more difficult to predict.
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Food prices account for roughly 30% of the index Non-food consumer goods account for another 30%

CPI: Consumer Price Index

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Monthly inflation measure Released by the Labor Department on the 22nd of each month Measures prices at the retail level and is thus the most widely quoted measure of inflation The PPI usually has a greater market impact than the CPI because it is more volatile and more difficult to predict.
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Food price account for around 20% Housing and fuel account for around 40% Consumer goods account for the remainder

Housing Starts
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A Commerce Department series released around mid-month that reports the number of housing units that were started during the month It is expressed as a seasonally adjusted annual rate Includes single-family and multi-family dwellings
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A reading above 2 Million units is very strong A reading below 1.5 Million units is very soft

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During recessions this series often falls below 1 Million units Data for housing permits are also included in this release Permits provide some evidence as to the future pace of starts and are also a component of the index of leading indicators

Business Inventories
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Released around mid-month with a one-month lag The market judges large increases in this series as a warning of stronger demand for loans by corporations. Initially inventory accumulation is bearish for the market.

Retail Sales
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Compiled by the Commerce Department and released around the 10th of each month It is a highly erratic series that can be very difficult to forecast and quite misleading because it is revised at a later date However, consumer spending is very important, so the series always has an impact on the market When the consensus forecast of the indicator is wrong, the market may react violently to this release.

Consumer Credit
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Compiled by the Federal Reserve and released around mid-month with a one month delay Includes consumer borrowing, but not mortgage credit It is used as a measure of consumer confidence

Industrial Production
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Perhaps the best and most timely measure of business activity Compiled by the Federal Reserve and released at 9:30 am on the 15th of each month. It measures the output of the manufacturing, mining and utility sectors of the economy. The Fed would prefer a monthly increase of around 0.5%
1.0% increase is very strong, suggesting real GNP growth of 6-8% #! 0.2% increase is too weak, suggesting a slowdown in business activity that may stimulate the lowering of interest rates.
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Personal Income
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Released around mid-month by the Commerce Department Attempts to measure income gains each month and expresses them as a seasonally adjusted annual rate This series is subject to considerable revision and is influenced by changes in taxes and benefits making it of limited value
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Gains above 1% are strong Gains below 0.5% are weak During recessions, gains average around 0.1-0.2%

Real GNP
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Reported each month, but only the 1st month in the quarter release is important. Computed quarterly Measures total output of goods and services in the economy and is deflated Most comprehensive measure of economic activity Recessions are defined as 2 consecutive quarters of falling GNP THE GNP deflator is used to remove the impact of inflation. It is a very good measure of inflation, yet is only calculated quarterly.

Durable Goods Orders

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Compiled by the Commerce Department and released around the 23rd of each month Very volatile and unpredictable Measures orders received by manufacturers of durable goods such as cars, trucks, military hardware, etc. Military component is around 10%, yet is so volatile that it causes the series to move several percentage points In theory, it is a leading indicator of production data

What will be the effect of?

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CPI % Durable Goods Orders % GNP & Housing Starts % Industrial Production & Inventories %

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Leading Indicators % Oil Prices & Personal Income % Precious Metals Prices & PPI % Retail Sales % Unemployment %

2. Political Factors
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Elections Nationalization Parliament Composition

3. Environmental Factors
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Violent Storms Commodities Climate Earthquakes Harvest

4. People
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Safe Haven: ex: Gold, Treasuries, etc. Mentality Religion Saving

5. Technical Factors
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Current prices are discounting all fundamental factors. One should be influenced more by the price fluctuations and price trends. The past price trends are used to forecast future prices. Represented in the form of graphs or statistics (moving average) through which you can deduct future movements. Its based on trends, not where the real value is A stop-loss to prevent losses beyond a certain level is recommended

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Technical Factors Contd

Technical Factors Contd

Technical Factors Contd

Resistance (Sell)

Support (Buy)

Technical Factors Contd

Types of Exchange Rate Exposure

Types of Exchange Rate Exposure

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Transaction exposure: it arises whenever the firm commits (or is contractually obligated) to make or receive a payment at a future date denominated in a foreign currency (e.g: accounts receivable and payable arising from the conduct of business). Translation exposure: a cross-border firm must periodically re-measure all of its global operations into a single currency for reporting purposes. This requires that the B/S and I/S of all affiliate operations worldwide be translated and consolidated into the currency of the parent company. Economic exposure: a firm is said to have economic exposure to exchange rates when unanticipated real exchange rate changes have a non-zero effect on its expected future cash flows.

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FX Forecasting
Foreign exchange is the single most important price in an open economy affecting:
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Corporate Profits Market Shares Investment Decisions (Variability of Returns) Monetary & Fiscal Policies

WRAP UP

Monetary & Fiscal Policies

Alan Greenspan - Feb 1995

In the process of pursuing domestic objectives, central banks cannot be indifferent to the signals coming from international financial markets. Although markets can be harsh teachers at times, the constraints that they impose discipline our policy choices and remind us everyday of our longer-run responsibilities.

Getting the Currency Right

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Critical Objective of all market participants Difficult task on a consistent base Changes in macroeconomic variables take longer than changes in financial markets Short term distortions will occur Technical trading will dominate at times Numerous theories and models

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Composite Approach
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A composite approach that integrates both fundamental and technical analysis should be used in the decision making process. Total reliance on one system can prove costly An integrated approach:
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Long Term Structural Medium Term Cyclical Short Term Speculative

An Integrated Approach
FIRST: Analyze fundamental factors to determine equilibrium path and assess currency medium to long term trend SECOND: Assess short term factors and whether they will be taking rates closer to or further from the equilibrium path. A currencys long term equilibrium path plays an important role by serving as a long run anchor or magnet ensuring that FX rates would not wander aimlessly without limit, but instead will gravitate toward the long run equilibrium path

Long Term Structural

PPP: Over time, exchange rates would move to offset differences in national inflation rates

External Balances: Over time, exchange rates would adjust to ensure that a balanced current account is attained

Medium Term Cyclical

Domestic Monetary Policy: Affects inflation, currency substitution, real interest rate differentials and domestic economic activity Central Banks Reserves Domestic Fiscal Policy Real Factors

Technical Factors
Have a distinct advantage over fundamental based models when exchange rates overshoot since technical based models are not at all concerned with where values lie, but instead are concerned with where the trend is heading.

How Exchange Rates are Determined

FUNDAMENTAL FACTORS
L-Term Structural Factors Persistent Trend in Current Account Balance PPP M-Term Cyclical Factors Domestic Monetary Policy Portfolio Diversification
( CB Reserves)

TECHNICAL FACTORS

Change in Net Foreign Assets (Liabilities) Relative Inflation Rates

Real Long Run Equilibrium Exchange Rate

S-Term Speculative Factors S-Run Extrapolative Exchange Rate Expectations Equilibrium Exchange Rate L-Run Regressive Exchange Rate Expectations Central Bank Intervention Temporary Overshoot of Equilibrium Exchange Rate

Inflationary Expectations Currency Substitution Real Interest Rate Differentials Domestic Economic Activity Risk Premium

Capital Flows

Domestic Fiscal Policy Real Factors

Trade balance

Model of Short, Medium and Long Term Trend in a Domestic Currencys Value
DOMESTIC CCY VALUE
Technically Driven Short Term Overshooting Path Fundamental Equilibrium Path

Fundamentally Driven Long Term Equilibrium Path

Fundamentally Driven Medium Term Cyclical Path

TIME

Integrating Fundamental & Technical Analysis

in formulating Currency Investment Strategies

CURRENCY A B C D

FUNDAMENTAL TECHNICAL BULLISH BULLISH BEARISH BEARISH BULLISH BEARISH BEARISH BULLISH

STRATEGY OVERWEIGHT NEUTRAL UNDERWEIGHT NEUTRAL

Analysis of Imminent economic data/statistics

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Before an economic statistic is released, many economists provide a forecast indicating their expectations for it. A survey of these forecasts is carried out, to establish a market consensus for what is expected. After the release of the statistic, the market will move according to how different the actual release is to the market consensus Market reactions to a single economic release are generally short-lived

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FX Volatility
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FX prices move significantly over time Movement of FX rates affect international businesses and increase costs USD/DM USD/FRF GBP/USD 3.50 10.0 1.0 1.348 4.7 2.02

Exchange Risk
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Credit Risk (Settlement) Speculation Risk

Control Measures: "! Position Limits "! Overnight Limits "! Stop Loss Limits

USD: International Currency

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The USD was the only currency convertible into Gold in the Bretton Woods Agreement, therefore it acts as a common denominator Most currencies are quoted in relation to the USD (exceptions are GBP, EUR and Australian $) Cross rates involve the buying/selling of currency A for Dollars and the use of funds obtained to sell/buy currency B.

Spreads
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Two-way prices involve: #! Buying Rate (Bid) #! Selling Rate (Offer) Spread is the difference between these two rates: USD/DEM GBP/USD USD/FRF 1.6300/1.6310 1.5180/1.5190 5.6850/5.6900
(1/1.6300) 0.6135 O.6131

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00/10 80/90 50/00

(1/1.6310) 0.6131 0.6135

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Rate Inversion: #! DEM/USD

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Cross Rates
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1 Kilogram of Apples 1 Kilogram of Apples USD/DEM

USD 2 DEM 4 4/2 = 2

Rate in Dollars of Price CCY Rate in Dollars of Reference CCY

USD/DEM = 1.6300 USD/FRF = 5.6850 DEM/FRF = 5.6850 / 1.6300 = 3.4877

Crosses
DEM/FRF = = DEM/FRF = 5.6900 / 1.6300 5.6850 / 1.6310 3.4856 / 3.4907

GBP/DEM = = GBP/DEM =

1.5190 * 1.6310 1.5180 * 1.6300 2.4743 / 2.4775