 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