What is Forex?

:
The market in which currencies are traded. The forex market is the largest, most liquid market in
the world with an average traded value that exceeds $1.9 trillion per day and includes all of the
currencies in the world.
There is no central marketplace for currency exchange; trade is conducted over the counter. The
forex market is open 24 hours a day, five days a week and currencies are traded worldwide
among the major financial centers of London, New York, Tokyo, Zürich, Frankfurt, Hong Kong,
Singapore, Paris and Sydney.

The forex is the largest market in the world in terms of the total cash value traded, and any
person, firm or country may participate in this market.

Exchange rate definition:

The ratio at which two currencies can be traded.

OR

Price for which the currency of a country can be exchanged for another country's currency.

OR

The value of two currencies relative to each other.

OR

An exchange rate is the rate at which one nation's currency can be exchanged for that of another.

Example:
The exchange rate is essentially a price and can be analyzed in the same way we would a price.
Take a typical supermarket price, say lemons are selling at the price of 3 for a dollar or 33 cents
each. Then we can think of the dollar-to-lemon exchange rate as being 3 lemons because if we
give up one dollar, we can get three lemons in return. Similarly, the lemon-to-dollar exchange rate
is 1/3 of a dollar or 33 cents, because if you sell a lemon, you will get 33 cents in return.

Why is it important:
The level of exchange rates affects the demand for goods, and the amount of imports and
exports.

Exchange rates are important because they value of money isn't the same everywhere. If the
exchange rate in one country is higher than another, this means that the value of money is worth
more when trading to a country with money of a lower exchange rate.

Exchange rates directly affect the realized return on an investment portfolio with overseas
holdings. If you own stock in a foreign company and the local currency goes up 10%, the value of
your investment goes up 10% even if the stock price doesn't change at all.

Exchange Rates are very important for any country as they determine the level of imports and
exports. If a domestic currency appreciates with respect to a foreign currency, imported goods will
be cheaper in the domestic market and local companies would find that their foreign competitor's
goods become more attractive to customers. If the country has a strong currency then its goods
become more expensive in the international market, which results in lost competitiveness. This is
the reason that China, despite much pressure from the United States, is not letting its Yuan
appreciate.
Example:
For example, a skewed change rate can make a company's exports cheaper than their foreign
counterparts, but for a country to achieve this artificially they must sell their own currency by
borrowing against the nation's wealth to purchase another nation's currency. If exports or all
capital are in high demand, a country's currency will rise in value because of the demand for that
currency to pay for exported goods, services, and capital.

How is it determined?:
The exchange rate between two countries' currencies depends upon many factors, including the
Balance of Trade or Balance of Capital and the prevailing real interest rate in country as well as
inflation.

Balance of payment/Balance of Trade:

A record of all transactions made between one particular country and all other countries during a
specified period of time. BOP compares the dollar difference of the amount of exports and
imports, including all financial exports and imports. A negative balance of payments means that
more money is flowing out of the country than coming in, and vice versa.
Balance of payments may be used as an indicator of economic and political stability. For
example, if a country has a consistently positive BOP, this could mean that there is significant
foreign investment within that country. It may also mean that the country does not export much of
its currency.

Trade Balance, also known as net exports, measures the difference between the value of goods
a country exports and the value of the goods it imports. A positive trade balance indicates the
country has a trade surplus and a negative trade balance means the country has a trade deficit. A
country's trade balance is an essential value when calculating gross domestic product and is also
useful when measuring to degree to which a country relies on imported goods.

This is just another economic indicator of a country's relative value and, along with all other
indicators, should be used with caution. The BOP includes the trade balance, foreign investments
and investments by foreigners.

Real interest rate:

An interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of
funds to the borrower, and the real yield to the lender. The real interest rate of an investment is
calculated as the amount by which the nominal interest rate is higher than the inflation rate.

Example:
For example, if you are earning 4% interest per year on the savings in your bank account, and
inflation is currently 3% per year, then the real interest rate you are receiving is 1% (4% - 3% =
1%). The real value of your savings will only increase by 1% per year, when purchasing power is
taken into consideration.

What influences it?

1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate exhibits a rising currency
value, as its purchasing power increases relative to other currencies. During the last half of the
twentieth century, the countries with low inflation included Japan, Germany and Switzerland,
while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation
typically see depreciation in their currency in relation to the currencies of their trading partners.
This is also usually accompanied by higher interest rates.

2. Differentials in Interest Rates

Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest
rates, central banks exert influence over both inflation and exchange rates, and changing interest
rates impact inflation and currency values. Higher interest rates offer lenders in an economy a
higher return relative to other countries. Therefore, higher interest rates attract foreign capital and
cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if
inflation in the country is much higher than in others, or if additional factors serve to drive the
currency down. The opposite relationship exists for decreasing interest rates - that is, lower
interest rates tend to decrease exchange rates.

3. Current-Account Deficits
The current account is the balance of trade between a country and its trading partners, reflecting
all payments between countries for goods, services, interest and dividends. A deficit in the current
account shows the country is spending more on foreign trade than it is earning, and that it is
borrowing capital from foreign sources 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.

4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector projects and
governmental funding. While such activity stimulates the domestic economy, nations with large
public deficits and debts are less attractive to foreign investors. The reason? A large debt
encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with
cheaper real dollars in the future.

In the worst case scenario, a government may print money to pay part of a large debt, but
increasing the money supply inevitably causes inflation. Moreover, if a government is not able to
service its deficit through domestic means (selling domestic bonds, increasing the money supply),
then it must increase the supply of securities for sale to foreigners, thereby lowering their prices.
Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting
on its obligations. Foreigners will be less willing to own securities denominated in that currency if
the risk of default is great. For this reason, the country's debt rating (as determined by Moody's or
Standard & Poor's, for example) is a crucial determinant of its exchange rate.

5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current accounts
and the balance of payments. If the price of a country's exports rises by a greater rate than that of
its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater
demand for the country's exports. This, in turn, results in rising revenues from exports, which
provides increased demand for the country's currency (and an increase in the currency's value). If
the price of exports rises by a smaller rate than that of its imports, the currency's value will
decrease in relation to its trading partners.

6. Political Stability and Economic Performance

Foreign investors inevitably seek out stable countries with strong economic performance in which
to invest their capital. A country with such positive attributes will draw investment funds away
from other countries perceived to have more political and economic risk. Political turmoil, for
example, can cause a loss of confidence in a currency and a movement of capital to the
currencies of more stable countries.

Example:
The supply and demand for a currency affect exchange rates.
For example, if a Japanese firm exports goods and receives dollars, it must convert them to yen.
Selling dollars would lower or depreciate the dollar.

Types of Exchange rates:

Fixed Exchange Rates:
There are two ways the price of a currency can be determined against another. A fixed, or
pegged, rate is a rate the government (central bank) sets and maintains as the official exchange
rate. A set price will be determined against a major world currency (usually the U.S. dollar, but
also other major currencies such as the euro, the yen or a basket of currencies). In order to
maintain the local exchange rate, the central bank buys and sells its own currency on the foreign
exchange market in return for the currency to which it is pegged.
If, for example, it is determined that the value of a single unit of local currency is equal to US$3,
the central bank will have to ensure that it can supply the market with those dollars. In order to
maintain the rate, the central bank must keep a high level of foreign reserves. This is a reserved
amount of foreign currency held by the central bank that it can use to release (or absorb) extra
funds into (or out of) the market. This ensures an appropriate money supply, appropriate
fluctuations in the market (inflation/deflation), and ultimately, the exchange rate. The central bank
can also adjust the official exchange rate when necessary.

Floating Exchange Rates:

Unlike the fixed rate, a floating exchange rate is determined by the private market through supply
and demand. A floating rate is often termed "self-correcting", as any differences in supply and
demand will automatically be corrected in the market. Take a look at this simplified model: if
demand for a currency is low, its value will decrease, thus making imported goods more
expensive and stimulating demand for local goods and services. This in turn will generate more
jobs, causing an auto-correction in the market. A floating exchange rate is constantly changing.

In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also
influence changes in the exchange rate. Sometimes, when a local currency does reflect its true
value against its pegged currency, a "black market", which is more reflective of actual supply and
demand, may develop. A central bank will often then be forced to revalue or devalue the official
rate so that the rate is in line with the unofficial one, thereby halting the activity of the black
market.

In a floating regime, the central bank may also intervene when it is necessary to ensure stability
and to avoid inflation; however, it is less often that the central bank of a floating regime will
interfere.

The World Once Pegged:

Between 1870 and 1914, there was a global fixed exchange rate. Currencies were linked to gold,
meaning that the value of a local currency was fixed at a set exchange rate to gold ounces. This
was known as the gold standard. This allowed for unrestricted capital mobility as well as global
stability in currencies and trade; however, with the start of World War I, the gold standard was
abandoned.

At the end of World War II, the conference at Bretton Woods, an effort to generate global
economic stability and increase global trade, established the basic rules and regulations
governing international exchange. As such, an international monetary system, embodied in the
International Monetary Fund (IMF), was established to promote foreign trade and to maintain the
monetary stability of countries and therefore that of the global economy.

It was agreed that currencies would once again be fixed, or pegged, but this time to the U.S.
dollar, which in turn was pegged to gold at US$35 per ounce. What this meant was that the value
of a currency was directly linked with the value of the U.S. dollar. So, if you needed to buy
Japanese yen, the value of the yen would be expressed in U.S. dollars, whose value in turn was
determined in the value of gold. If a country needed to readjust the value of its currency, it could
approach the IMF to adjust the pegged value of its currency. The peg was maintained until 1971,
when the U.S. dollar could no longer hold the value of the pegged rate of US$35 per ounce of
gold.
From then on, major governments adopted a floating system, and all attempts to move back to a
global peg were eventually abandoned in 1985. Since then, no major economies have gone back
to a peg, and the use of gold as a peg has been completely abandoned.

Why Peg?
The reasons to peg a currency are linked to stability. Especially in today's developing nations, a
country may decide to peg its currency to create a stable atmosphere for foreign investment. With
a peg, the investor will always know what his or her investment's value is, and therefore will not
have to worry about daily fluctuations. A pegged currency can also help to lower inflation rates
and generate demand, which results from greater confidence in the stability of the currency.

Fixed regimes, however, can often lead to severe financial crises since a peg is difficult to
maintain in the long run. This was seen in the Mexican (1995), Asian (1997) and Russian (1997)
financial crises: an attempt to maintain a high value of the local currency to the peg resulted in the
currencies eventually becoming overvalued. This meant that the governments could no longer
meet the demands to convert the local currency into the foreign currency at the pegged rate. With
speculation and panic, investors scrambled to get their money out and convert it into foreign
currency before the local currency was devalued against the peg; foreign reserve supplies
eventually became depleted. In Mexico's case, the government was forced to devalue the peso
by 30%. In Thailand, the government eventually had to allow the currency to float, and by the end
of 1997, the Thai bhat had lost 50% of its as the market's demand and supply readjusted the
value of the local currency.

Countries with pegs are often associated with having unsophisticated capital markets and weak
regulating institutions. The peg is therefore there to help create stability in such an environment. It
takes a stronger system as well as a mature market to maintain a float. When a country is forced
to devalue its currency, it is also required to proceed with some form of economic reform, like
implementing greater transparency, in an effort to strengthen its financial institutions.

Some governments may choose to have a "floating," or "crawling" peg, whereby the government
reassesses the value of the peg periodically and then changes the peg rate accordingly. Usually
this causes devaluation, but it is controlled to avoid market panic. This method is often used in
the transition from a peg to a floating regime, and it allows the government to "save face" by not
being forced to devalue in an uncontrollable crisis.

Conclusion:
Although the peg has worked in creating global trade and monetary stability, it was used only at a
time when all the major economies were a part of it. And while a floating regime is not without its
flaws, it has proved to be a more efficient means of determining the long-term value of a currency
and creating equilibrium in the international market.

Floating vs Fixed:
A floating exchange rate is dependent on the supply and demand of the involved currencies, as
well as the amount of the currency held in foreign reserves. On the other hand, a government
may peg its currency to a certain amount in another currency or currency basket. For example,
the Qatari riyal has been worth 0.274725 dollars since 1980.

An advantage to a floating exchange rate is the fact that it tends to be more economically
efficient. However, floating exchange rates tend to be more volatile, depending on the particular
currency. Pegged exchange rates are generally more stable, but, since they are set by
government fiat, they may take political rather than economic conditions into account. For
example, some countries peg their exchange rates artificially low with respect to a major trading
partner to make their exports to that partner artificially cheap.

Arbitrage:
Suppose the Algerian dinars-to-Bulgarian leva exchange rate is 2. We would expect then that the
Bulgarian-to-Algerian exchange rate would be 1/2 or 0.5. But suppose for a second that it wasn't.
Instead assume that the current market Bulgarian-to-Algerian exchange rate is 0.6. Then an
investor could take five Algerian dinars and exchange them for 10 Bulgarian leva. She could then
take her 10 Bulgarian leva and exchange them back for Algerian dinars. At the Bulgarian-to-
Algerian exchange rate, she'd give up 10 leva and get back 6 dinars. Now she has one more
Algerian dinar than she did before. This type of exchange is known as arbitrage. Since our
investor gained a dinar, and since we're not creating or destroying any currency, the rest of the
market must have lost a dinar. This of course is bad for the rest of the market. We would expect
that the other agents in the currency exchange market will change the exchange rates that they
offer so these opportunities to get exploited are taken away. Still there is a class of investors
known as arbitrageurs who try to exploit these differences.

Arbitrage generally takes on more complex forms than this, involving several currencies. Suppose
that the Algerian dinars-to-Bulgarian leva exchange rate is 2 and the Bulgarian leva-to-Chilean
peso is 3. To figure out what the Algerian-to-Chilean exchange rate needs to be, we just multiply
the two exchange rates together:

A-to-C = (A-to-B)*(B-to-C)

This property of exchange rates is known as transitivity. To avoid arbitrage we would need the
Algerian-to-Chilean exchange rate to be 6 and the Chilean-to-Algerian exchange rate needs to be
1/6. Suppose it was only 1/5. Then our investor could again take five Algerian dinars and
exchange them for 10 Bulgarian leva. She could then take her 10 leva and get 30 Chilean pesos
at the Bulgarian-to-Chilean exchange rate of 3. If she then exchanged her 30 Chilean pesos at
the Chilean-to-Algerian rate of 1/5, she'd get 6 Algerian dinars in return. Once again our investor
has gained a dinar and the rest of the market has lost one. For any three currencies A, B, and C,
trading A for B, B for C and C for A is known as a currency cycle. The A-to-C exchange rate not
only places restrictions on the C-to-A exchange rate, but it also places restriction on the A-to-B
and B-to-C pair of exchange rates. Most of the time all the exchange rates on the market will be
synchronized like this, but occasionally they'll become out of sync and arbitrageurs can make a
profit from currency cycles.

The relative prices of currencies are not set just to ensure that profitable currency cycles do not
exist. Arbitrageurs only play a small, but important, role in the value of a currency. Currencies are
simply a commodity, like any other, which has a price. Since the exchange rate is simply a price,
it has the same basic determinants that any other price has: supply and demand.

Further division of Exchange rate:

Spot Exchange Rate:

The rate of a foreign-exchange contract for immediate delivery. Also known as "benchmark
rates", "straightforward rates" or "outright rates", spot rates represent the price that a buyer
expects to pay for a foreign currency in another currency.
Though the spot exchange rate is said to be settled immediately, the globally accepted settlement
cycle for foreign-exchange contracts is two days. Foreign-exchange contracts are therefore
settled on the second day after the day the deal is made.

Forward exchange rate:

The rate of exchange for currency exchanges that will occur at some point in the future—for
example, in 30, 90, or 180 days.

Purchasing Power Parity:

The purchasing power parity (PPP) exchange rate is the exchange rate between two currencies
which would equate the two relevant national price levels if expressed in a common currency at
that rate,so that the purchasing power of a unit of one currency would be the same in both
economies.

Why is it needed?
Goods in foreign countries must have the same price after adjusting for exchange rates, if they
don’t, speculators would buy the good where it’s cheap and sell it where it’s more expensive.

It doesnt hold:
For goods that aren’t transportable or identical. If there are tariffs, taxes, or political barriers to
trade.

Relative PPP:
If inflation in one country is greater than in another, the exchange rate must adjust over time to
maintain purchasing power parity.