Presentation on

Wasim Yousuf, MIB 3rd Sem., Bangalore City College.

WHAT IS FOREX?
The FOREX is the worlds biggest financial market. The FOREX or FOReign EXchange is the planets biggest most liquid financial marketplace hands down. Foreign exchange refers to money denominated in the currency of another nation or group of nations. Any person who exchanges money denominated in his own nations currency for money denominated in another nations currency acquires foreign exchange.

WHAT IS FOREX? (CONTD.)

Foreign exchange can be cash, funds available on credit cards and debit cards, travelers checks, bank deposits, or other short-term claims. It is still foreign exchange if it is a short-term negotiable financial claim denominated in a currency other than the U.S. dollar. Sam Cross The Federal Reserve Bank The Foreign Exchange is made up of anyone who exchanges the currency of one country for that of another.

The FOriegn EXchange does not have a centralized exchange like the stock market in New York or the commodities markets with centralized exchanges in cities like New York and Chicago.

WHY DO FLUCTUATIONS OCCUR IN FOREX?

There are many reasons but the most influential are:

General condition of a countrys economy and economic influences like interest rates and inflation. Political Factors Trade Balance Purchase Power Parity Social Factors Government and central bank policies and policy changes

CURRENCY TRADING VS STOCK TRADING

Many find trading currency much more attractive than trading stocks for the following reasons:: Focused Attention
When you trade stocks, there are literally tens of thousands of companies to choose from when trying to decide which ones to invest in. That is a lot of information to assimilate and keep track of. With the Foreign Exchange the number of choices is dramatically reduced making it much easier to concentrate on trading. While many countries are traded, there are five main players in this global arena...

The United States (USD)

The European Union (EURO) Great Britain (GBP) Japan (JPY) Switzerland (CHF)

CURRENCY TRADING VS STOCK TRADING: (CONTD.)

LIQUIDITY

Because FOREX is literally the biggest "market" on earth, whether you are entering or exiting, getting your order filled is almost instantaneous which is not always the case with stocks.

PROFIT POTENTIAL

You can open a currency trading account for less than $500 but the profit potential is greater than stocks, with FOREX you can profit regardless of whether or not the value of a currency is rising or falling.

CURRENCY TRADING VS STOCK TRADING: (CONTD.)

CONVENIENT

The FOReign EXchange is open for business 24 hours a day, 5 days a week offering trading opportunities for even the busiest people.

AMPLE TRADING

OPPORTUNITIES

Because the currency process are always fluctuating up and down, there are plenty of trading opportunities.

CURRENCY TRADING VS STOCK TRADING: (CONTD.)

FREE

TRADING AIDS -

There are plenty of free trading resources for anyone that wants to trade currency. Check out the resources section of this site to learn more.

PRACTICE ACCOUNT

You can open a practice account with most brokers that allow you to "play" with cyber cash until you are ready to trade real funds.

NOMINAL VS. REAL EXCHANGE RATES

Nominal Exchange Rates are value of one currency in terms of another. They do not, however, measure purchasing power, or Real Exchange Rate. Example:

Suppose you can exchange $1 for 1818 Italian lira (L). Though L1818 seems a large number, but in Rome a hamburger may cost L4500. In other words, purchasing power of lira is very less as compared to that of dollar.

NOMINAL VS. REAL EXCHANGE RATES (CONTD.)

Let a McDonald burger cost $2.56 in N.Y, U.S. and L4500 in Rome, Italy. $1 buys L1818 on foreign-exchange markets. We can find real exchange rate by comparing the cost of burgers in dollar terms. Let

EX = nominal exchange rate in foreign currency per dollar. Pf = foreign currency price of goods in foreign country. P = domestic-currency price of domestic goods. EXr = real exchange rate.

NOMINAL VS. REAL EXCHANGE RATES (CONTD.)

EXr = 1.03 Italian Thus, $2.56 will buy 1 McDonald burger in U.S. but 1.03 McDonald burger in Italy.

NOMINAL VS. REAL EXCHANGE RATES (CONTD.)

Countries produce many different goods. Real Exchange Rate computed from price indexes, which compare price of basket of goods in one country with price of it in another. The relationship between nominal and real exchange rates depends on rates of inflation in two countries. We can calculate % change in real exchange rate as % change in numerator of previous equation minus the % change in denominator.

NOMINAL VS. REAL EXCHANGE RATES (CONTD.)

The equation shows % change in nominal exchange rate has two parts:
% change in real exchange rate. difference in foreign and domestic inflation rate.

If exchange rate rises:

rise in real exchange rate. or higher foreign inflation rate, or maybe both.

If exchange rate falls:

fall in real exchange rate. or higher domestic inflation rate, or maybe both.

NOMINAL VS. REAL EXCHANGE RATES (CONTD.)

Suppose Peynolds and Barker are companies in two countries whose currencies are crown and royal. Peynolds makes ball pens sold at 2 crown each. Barker makes high-quality ink pens sold at 10 royals each. Real exchange rate between Peynolds and Barker pens is 10 ball pens per ink pen. What is the nominal Exchange rate?

FOREIGN EXCHANGE MARKETS

From perspective of individual consumers or investors, exchange rates can be used to convert one currency into another. International currencies are traded in foreignexchange-markets around the world. Market forces determine the exchange rate that prevails for consumers and investors. Exchange rates affect the cost of acquiring foreign financial assets or foreign goods and services. Major participants are importers and exporters, banks, investment portfolio managers, and central banks.

FOREIGN EXCHANGE MARKETS (CONTD.)

The worldwide volume of foreign exchange trading is enormous, and it has ballooned in recent years. New technologies, such as Internet links, are used among the major foreign exchange trading centres (London, New York, Tokyo, Frankfurt, and Singapore). The integration of financial centres implies that there can be no significant arbitrage.

The process of buying a currency cheap and selling it dear.

FOREIGN EXCHANGE MARKETS (CONTD.)

Two types of transactions take place in foreign exchange markets. 1) Spot Market Transactions:
2)

Currencies or bank deposits are exchanged immediately (two day settlement period). Spot rate is the price quote at which you can buy immediately. Currencies or bank deposits are exchanged at a set date in the future. Investors sign a contract for a given quantity of currency and exchange rate. At future date, actual exchange takes place at rate known as forward rate.

Forward Transactions:

DETERMINING LONG RUN EXCHANGE RATES

We will look at four key factors that account for long-run trends in the supply of and demand for currencies in the foreign exchange markets:
Price level differences. o Productivity differences. o Preference for domestic or foreign goods. o Trade barriers
o

DETERMINING LONG RUN EXCHANGE RATES: PRICE LEVEL DIFFERENCES

When price levels rise in U.K. relative to price levels in U.S., then U.K. goods or financial assets become more costly as compared to similar U.S. goods or financial assets. In such case where U.K. experiences higher inflation rate, pound is less useful as store of value than dollar. All else being equal, relative increase in price levels lead to depreciation of domestic currency. Example:

In late 1970s excess growth of U.K.s price levels over U.S. price levels lead pound to depreciate against dollar.

DETERMINING LONG RUN EXCHANGE RATES: PRODUCTIVITY DIFFERENCES

Productivity growth measures the increase in output level of a country for a given input level. Higher productivity leads to cheaper production of domestic goods than foreign goods. Hence domestic goods can be supplied at lower prices than foreign goods, leading to higher demand. This higher demand for domestic goods leads to higher demand for domestic currency. Thus higher productivity leads to appreciation of domestic currency. Example:

In late 1970s and early 1980s U.S. productivity level was higher than U.K. leading to appreciation of dollar against pound.

DETERMINING LONG RUN EXCHANGE RATES: PREFERENCE FOR DOMESTIC OR FOREIGN GOODS.
If U.S. consumers prefer British-made goods, they will demand more pounds to buy these goods. It will put upward pressure on pound and depreciate the dollar. Example:

In mid 1980s U.S. consumers in second half of decade They preferred U.K. goods leading to depreciation of dollar.

DETERMINING LONG RUN EXCHANGE RATES: TRADE BARRIERS

Countries do not always allow goods to be traded freely with no market intervention. Example of trade barriers are quotas and tariffs. They increase demand for domestic currency, leading to higher exchange rates in the long run for the country imposing these barriers. Example:

Suppose U.S. imposes tariff on U.K. leather goods, this will lead to higher price of the U.K. leather goods than U.S. made leather goods. There will be higher demand for domestic U.S. made leather goods leading to higher dollar demand.

LAW OF ONE PRICE AND THE PURCHASING POWER PARITY THEORY

The Law Of One Price states that identical goods should be sold at identical prices. Profit opportunities should ensure that its price is same. Lets start with an example:

Suppose a yard of cloth produced by manufacturers in U.S. sells for $10 Same type of cloth produced by British manufacturers in U.K. sells for 5 pounds. Law of one price says that exchange rate should be 5 pound per 10 dollar or 0.5 pound/dollar. Lets consider two cases if starting exchange rate is not what is supposed to be.

LAW OF ONE PRICE AND THE PURCHASING POWER PARITY THEORY

If current exchange rate is 0.25 pound /dollar. Then U.S. cloth will be cheaper as compared to the U.K. cloth. Consumers would demand dollars for purchasing U.S. cloth. This will lead to appreciation of dollar till exchange rate reaches 0.50 pound/dollar.

LAW OF ONE PRICE AND THE PURCHASING POWER PARITY THEORY

If current exchange rate is 0.75 pound /dollar. Then U.K. cloth will be cheaper as compared to the U.S. cloth. Consumers would demand dollars for purchasing U.K. cloth. This will lead to depreciation of dollar till exchange rate reaches 0.50 pound/dollar.

LAW OF ONE PRICE AND THE PURCHASING POWER PARITY THEORY

When we extend law of one price from one good to basket of goods, it becomes Purchasing Power Parity theory of exchange rate determination. The Purchasing Power Parity (PPP) theory is based on the assumption that real exchange rates are fixed. Thus it means that differences in the inflation rate in the two countries causes changes in nominal exchange rate between two countries. It states that whenever a countrys price level is expected to fall relative to other countrys price level, its currency should appreciate relative to other countrys currency.

LAW OF ONE PRICE AND THE PURCHASING POWER PARITY THEORY

Movements in exchange rates not completely consistent with PPP theory:

For differentiated products, law of one price does not hold, e.g. Kodak and Sony camera. Not all goods and services (e.g. haircut, sandwich) are internationally traded. Significant differences in prices of non-traded goods and services are not completely reflected in exchange rates. The assumption of constant real exchange rate is not reasonable. There may be shifts in preferences for domestic or foreign goods and trade barriers.

EXPECTED RETURNS ON DOMESTIC AND FOREIGN ASSETS

Suppose you want to invest $1000 for one year. You have choice between U.S. Treasury bill or a Japanese government bond. U.S. instrument pays you interest and principal in dollars with nominal interest rate of 5% per year. Japanese instrument pays you interest and principal in yen and carries nominal interest rate of 5% per year. You should invest in one which will give you higher return. To compare the returns you should compare their returns in dollar terms.

EXPECTED RETURNS ON DOMESTIC AND FOREIGN ASSETS

you invest in U.S. Treasury bill, you will receive an interest return of $50, so your investment will be worth $1050 after one year. If you want to calculate the expected return from the Japanese bond you must convert it into yen and then a year from now you must convert the interest and principal from yen into dollars. Then you can compare it with the return from U.S. Treasury bill.

EXPECTED RETURNS ON DOMESTIC AND FOREIGN ASSETS

Suppose current nominal exchange rate is 100 yen/dollar. You expect the exchange rate will rise by 5% in the next year, thus the expected future nominal exchange rate EXe will be 100*1.05 = 105 yen/dollar. Now when you convert $1000 into yen you have an investment of 100000 yen. After receiving and interest rate of 5%, your investment is worth 105000 yen after a year. At that time expected exchange rate EXe is 105 yen/dollar.

EXPECTED RETURNS ON DOMESTIC AND FOREIGN ASSETS

Thus the expected value of your investment in dollar terms will be 105000 yen/105 = $1000. !!! Hence even though Japanese bond pays you the same stated interest rate as the U.S. Treasury bill, but it carries a lower expected return: $0 instead of $50.

EXPECTED RETURNS ON DOMESTIC AND FOREIGN ASSETS

$1

Investment

Earns Interest i

(1 + i)

Yielding total $(1 + i)

EXPECTED RETURNS ON DOMESTIC AND FOREIGN ASSETS

$1

Exchanged for foreign currency. Value of investment in foreign currency. Earns foreign interest rate. Yielding this total value

EX

if

EX(1 + if )

EXPECTED RETURNS ON DOMESTIC AND FOREIGN ASSETS

EX(1 + if )

Value of investment. Convert to domestic currency. Yielding approximately

EX(1 + if )/EXe

1 + if EXe/EX

INTEREST RATE PARITY

Nominal Interest Rate Parity Condition:

When domestic and foreign assets have identical risks, liquidity and information characteristics, their nominal returns (measured in same currency) must be identical. Thus any difference between the nominal interest rates on U.S. assets and Japanese assets reflect currency appreciation and depreciation.
i = if - EXe/EX

This condition states:

When domestic interest rate is higher than the foreign interest rate, the domestic currency depreciates.

THANK YOU!
WASIM YOUSUF