Report on foreign exchange market

ACKNOWLEDGEMENT

‘‘In the name of Allah most merciful and beneficent’’ “We

raise in degree of rank whom so ever we pleased; and our
every pressure of knowledge is one, most knowing”.

(Al-Quran)

We are very thankful to ALLAH Almighty who gave us the opportunity, courage and
confidence to explore more knowledge to complete this project and for His (ALLAH)
blessings that have brightened every part of our lives, and our parents whose prayers
always supported us in every task of our life. While working on this project, we were
guided by our experience, knowledge and interest in the subject ‘‘International
Finance”. Beyond of all the material available we are very thankful to our respected
and honorable resource person “Miss. Izza Ahmad” for giving us such knowledge
about the subject that make ‘‘International Finance’’ a very motivating subject. This
become possible only due to her very unique style of teaching we ever experienced
during our academics lives. And through her motivational behavior we are able to
complete this complex task.

Besides this we would like to thank our seniors who showed their kind concern
toward the completion of this final project of ‘‘International Finance’’.

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Report on foreign exchange market

PREFACE

Research reports are very important part of MBA program. Keeping this thing in view
we were assigned a report to elaborate “Foreign Exchange Market”

We wish to thank our learned instructor Miss Izza Ahmad whose kind and informative
guidance transforms the research material into a worth reading report. Her scholarly
touch had imprinted on our minds to last through out our career. She really leads a
lasting impression in novice minds.

Maximum efforts have been exerted to complete the report and we hope that a reader
will find it useful and beneficial.

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Report on foreign exchange market

Foreign Exchange Market

The foreign exchange market (currency, Forex, or FX) market is where currency
trading takes place. It is where banks and other official institutions that facilitate the
buying and selling of foreign currencies. FX transactions typically involve one party
purchasing a quantity of one currency in exchange for paying a quantity of another.
The foreign exchange market that we see today started evolving during the 1970s
when worldover countries gradually switched to floating exchange rate from fixed as
per the Bretton Woods system till 1971.

Today, the FX market is one of the largest and most liquid financial markets in the
world, and includes trading between large banks, central banks, currency speculators,
corporations, governments, and other institutions. The average daily volume in the
global foreign exchange and related markets is continuously growing. Traditional
daily turnover was reported to be over US$3.2 trillion in April 2007 by the Bank for
International Settlements. Since then, the market has continued to grow. According to
Euromoney's annual FX Poll, volumes grew a further 41% between 2007 and 2008.

The purpose of FX market is to facilitate trade and investment. The need for a foreign
exchange market arises because of the presence of multifarious international
currencies such as US Dollar, Pound Sterling, etc., and the need for trading in such
currencies.

Market size and liquidity

The foreign exchange market is unique because of

• its trading volumes,

• the extreme liquidity of the market,
• its geographical dispersion,
• its long trading hours: 24 hours a day except on weekends
• the variety of factors that affect exchange rates.
• the low margins of profit compared with other markets of fixed income
(but profits can be high due to very large trading volumes)
• the use of leverage

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As such, it has been referred to as the market closest to the ideal perfect competition,
notwithstanding market manipulation by central banks. According to the Bank for
International Settlements, average daily turnover in global foreign exchange markets
is estimated at $3.98 trillion. Trading in the world's main financial markets accounted
for $3.21 trillion of this. This approximately $3.21 trillion in main foreign exchange
market turnover was broken down as follows:

• $1.005 trillion in spot transactions

• $362 billion in outright forwards
• $1.714 trillion in foreign exchange swaps
• $129 billion estimated gaps in reporting

Of the $3.98 trillion daily global turnover, trading in London accounted for around
$1.36 trillion, or 34.1% of the total, making London by far the global center for
foreign exchange. In second and third places respectively, trading in New York
accounted for 16.6%, and Tokyo accounted for 6.0%. In addition to "traditional"
turnover, $2.1 trillion was traded in derivatives. Exchange-traded FX futures contracts
were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded
relative to most other futures contracts. Several other developed countries also permit
the trading of FX derivative products (like currency futures and options on currency
futures) on their exchanges. All these developed countries already have fully
convertible capital accounts. Most emerging countries do not permit FX derivative
products on their exchanges in view of prevalent controls on the capital accounts.
However, a few select emerging countries (e.g., Korea, South Africa, India) have
already successfully experimented with the currency futures exchanges, despite
having some controls on the capital account. FX futures volume has grown rapidly in
recent years, and accounts for about 7% of the total foreign exchange market volume,
according to The Wall Street Journal Europe (5/5/06, p. 20).

Foreign exchange trading increased by 38% between April 2005 and April 2006 and
has more than doubled since 2001. This is largely due to the growing importance of
foreign exchange as an asset class and an increase in fund management assets,
particularly of hedge funds and pension funds. The diverse selection of execution
venues such as retail trading platforms platforms offered by companies such as
ParagonEX, First Prudential Markets and Saxo Bank have made it easier for retail
traders to trade in the foreign exchange market. In 2006, retail traders constituted over
2% of the whole FX market volumes with an average daily trade volume of over
US$50-60 billion (see retail trading platforms).[5] Because foreign exchange is an
OTC market where brokers/dealers negotiate directly with one another, there is no
central exchange or clearing house. The biggest geographic trading centre is the UK,
primarily London, which according to IFSL estimates has increased its share of global
turnover in traditional transactions from 31.3% in April 2004 to 34.1% in April 2007.
The ten most active traders account for almost 80% of trading volume, according to
the 2008 Euromoney FX survey. These large international banks continually provide
the market with both bid (buy) and ask (sell) prices. The bid/ask spread is the
difference between the price at which a bank or market maker will sell ("ask", or
"offer") and the price at which a market-maker will buy ("bid") from a wholesale
customer. This spread is minimal for actively traded pairs of currencies, usually 0–3

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pips. For example, the bid/ask quote of EUR/USD might be 1.2200/1.2203 on a retail
broker. Minimum trading size for most deals is usually 100,000 units of base
currency, which is a standard "lot".

These spreads might not apply to retail customers at banks, which will routinely mark
up the difference to say 1.2100/1.2300 for transfers, or say 1.2000/1.2400 for
banknotes or travelers' checks. Spot prices at market makers vary, but on EUR/USD
are usually no more than 3 pips wide (i.e., 0.0003). Competition is greatly increased
with larger transactions, and pip spreads shrink on the major pairs to as little as 1 to 2
pips.
Top 10 currency traders
% of overall volume, May 2008
Rank Name Volume
1 Deutsche Bank 21.70%
2 UBS AG 15.80%
3 Barclays Capital 9.12%
4 Citi 7.49%
5 Royal Bank of Scotland 7.30%
6 JPMorgan 4.19%
7 HSBC 4.10%
8 Lehman Brothers 3.58%
9 Goldman Sachs 3.47%
10 Morgan Stanley 2.86%

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Market Participants

Unlike a stock market, where all participants have access to the same prices, the
foreign exchange market is divided into levels of access. At the top is the inter-bank
market, which is made up of the largest investment banking firms. Within the inter-
bank market, spreads, which are the difference between the bid and ask prices, are
razor sharp and usually unavailable, and not known to players outside the inner circle.
The difference between the bid and ask prices widens (from 0-1 pip to 1-2 pips for
some currencies such as the EUR). This is due to volume. If a trader can guarantee
large numbers of transactions for large amounts, they can demand a smaller difference
between the bid and ask price, which is referred to as a better spread. The levels of
access that make up the foreign exchange market are determined by the size of the
“line” (the amount of money with which they are trading). The top-tier inter-bank
market accounts for 53% of all transactions. After that there are usually smaller
investment banks, followed by large multi-national corporations (which need to hedge
risk and pay employees in different countries), large hedge funds, and even some of
the retail FX-metal market makers. According to Galati and Melvin, “Pension funds,
insurance companies, mutual funds, and other institutional investors have played an
increasingly important role in financial markets in general, and in FX markets in
particular, since the early 2000s.” (2004) In addition, he notes, “Hedge funds have
grown markedly over the 2001–2004 period in terms of both number and overall size”
Central banks also participate in the foreign exchange market to align currencies to
their economic needs.

1. Banks

The interbank market caters for both the majority of commercial turnover and large
amounts of speculative trading every day. A large bank may trade billions of dollars
daily. Some of this trading is undertaken on behalf of customers, but much is
conducted by proprietary desks, trading for the bank's own account.

Until recently, foreign exchange brokers did large amounts of business, facilitating
interbank trading and matching anonymous counterparts for small fees. Today,
however, much of this business has moved on to more efficient electronic systems.
The broker squawk box lets traders listen in on ongoing interbank trading and is heard
in most trading rooms, but turnover is noticeably smaller than just a few years ago.

2. Commercial companies

An important part of this market comes from the financial activities of companies
seeking foreign exchange to pay for goods or services. Commercial companies often
trade fairly small amounts compared to those of banks or speculators, and their trades
often have little short term impact on market rates. Nevertheless, trade flows are an
important factor in the long-term direction of a currency's exchange rate. Some
multinational companies can have an unpredictable impact when very large positions

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are covered due to exposures that are ...not widely known by other market
participants.

3. Central banks

National central banks play an important role in the foreign exchange markets. They
try to control the money supply, inflation, and/or interest rates and often have official
or unofficial target rates for their currencies. They can use their often substantial
foreign exchange reserves to stabilize the market. Milton Friedman argued that the
best stabilization strategy would be for central banks to buy when the exchange rate is
too low, and to sell when the rate is too high—that is, to trade for a profit based on
their more precise information. Nevertheless, the effectiveness of central bank
"stabilizing speculation" is doubtful because central banks do not go bankrupt if they
make large losses, like other traders would, and there is no convincing evidence that
they do make a profit trading.

The mere expectation or rumor of central bank intervention might be enough to

stabilize a currency, but aggressive intervention might be used several times each year
in countries with a dirty float currency regime. Central banks do not always achieve
their objectives. The combined resources of the market can easily overwhelm any
central bank. Several scenarios of this nature were seen in the 1992–93 ERM collapse,
and in more recent times in Southeast Asia.

4. Hedge funds as speculators

About 70% to 90% of the foreign exchange transactions are speculative. In other
words, the person or institution that bought or sold the currency has no plan to
actually take delivery of the currency in the end; rather, they were solely speculating
on the movement of that particular currency. Hedge funds have gained a reputation
for aggressive currency speculation since 1996. They control billions of dollars of
equity and may borrow billions more, and thus may overwhelm intervention by
central banks to support almost any currency, if the economic fundamentals are in the
hedge funds' favor.

5. Investment management firms

Investment management firms (who typically manage large accounts on behalf of

customers such as pension funds and endowments) use the foreign exchange market
to facilitate transactions in foreign securities. For example, an investment manager
bearing an international equity portfolio needs to purchase and sell several pairs of
foreign currencies to pay for foreign securities purchases.

Some investment management firms also have more speculative specialist currency
overlay operations, which manage clients' currency exposures with the aim of
generating profits as well as limiting risk. Whilst the number of this type of specialist
firms is quite small, many have a large value of assets under management (AUM),
and hence can generate large trades.

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6. Retail foreign exchange brokers

There are two types of retail brokers offering the opportunity for speculative trading:
retail foreign exchange brokers and market makers. Retail traders (individuals) are a
small fraction of this market and may only participate indirectly through brokers or
banks. Retail brokers, while largely controlled and regulated by the CFTC and NFA
might be subject to foreign exchange scams. At present, the NFA and CFTC are
imposing stricter requirements, particularly in relation to the amount of Net
Capitalization required of its members. As a result many of the smaller, and perhaps
questionable brokers are now gone. It is not widely understood that retail brokers and
market makers typically trade against their clients and frequently take the other side
of their trades. This can often create a potential conflict of interest and give rise to
some of the unpleasant experiences some traders have had. A move toward NDD (No
Dealing Desk) and STP (Straight Through Processing) has helped to resolve some of
these concerns and restore trader confidence, but caution is still advised in ensuring
that all is as it is presented.

7. Other

Non-bank foreign exchange companies offer currency exchange and international

payments to private individuals and companies. These are also known as foreign
exchange brokers but are distinct in that they do not offer speculative trading but
currency exchange with payments. i.e., there is usually a physical delivery of currency
to a bank account.

It is estimated that in the UK, 14% of currency transfers/payments are made via
Foreign Exchange Companies. These companies' selling point is usually that they will
offer better exchange rates or cheaper payments than the customer's bank. These
companies differ from Money Transfer/Remittance Companies in that they generally
offer higher-value services.

Money transfer/remittance companies perform high-volume low-value transfers

generally by economic migrants back to their home country. In 2007, the Aite Group
estimated that there were $369 billion of remittances (an increase of 8% on the
previous year). The four largest markets (India, China, Mexico and the Philippines)
receive $95 billion. The largest and best known provider is Western Union with
345,000 agents globally.

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Trading Characteristics

There is no unified or centrally cleared market for the majority of FX trades, and there
is very little cross-border regulation. Due to the over-the-counter (OTC) nature of
currency markets, there are rather a number of interconnected marketplaces, where
different currencies instruments are traded. This implies that there is not a single
exchange rate but rather a number of different rates (prices), depending on what bank
or market maker is trading, and where it is. In practice the rates are often very close,
otherwise they could be exploited by arbitrageurs instantaneously. Due to London's
dominance in the market, a particular currency's quoted price is usually the London
market price. A joint venture of the Chicago Mercantile Exchange and Reuters, called
Fxmarketspace opened in 2007 and aspired but failed to the role of a central market
clearing mechanism.

The main trading center is London, but New York, Tokyo, Hong Kong and Singapore
are all important centers as well. Banks throughout the world participate. Currency
trading happens continuously throughout the day; as the Asian trading session ends,
the European session begins, followed by the North American session and then back
to the Asian session, excluding weekends.

Fluctuations in exchange rates are usually caused by actual monetary flows as well as
by expectations of changes in monetary flows caused by changes in gross domestic
product (GDP) growth, inflation (purchasing power parity theory), interest rates
(interest rate parity, Domestic Fisher effect, International Fisher effect), budget and
trade deficits or surpluses, large cross-border M&A deals and other macroeconomic
conditions. Major news is released publicly, often on scheduled dates, so many people
have access to the same news at the same time. However, the large banks have an
important advantage; they can see their customers' order flow.

Currencies are traded against one another. Each pair of currencies thus constitutes an
individual product and is traditionally noted XXX/YYY, where YYY is the ISO 4217
international three-letter code of the currency into which the price of one unit of XXX
is expressed (called base currency). For instance, EUR/USD is the price of the euro
expressed in US dollars, as in 1 euro = 1.5465 dollar. Out of convention, the first
currency in the pair, the base currency, was the stronger currency at the creation of the
pair. The second currency, counter currency, was the weaker currency at the creation
of the pair.

The factors affecting XXX will affect both XXX/YYY and XXX/ZZZ. This causes
positive currency correlation between XXX/YYY and XXX/ZZZ.

On the spot market, according to the BIS study, the most heavily traded products
were:

• EUR/USD: 27%

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• USD/JPY: 13%
• GBP/USD (also called sterling or cable): 12%

and the US currency was involved in 86.3% of transactions, followed by the euro
(37.0%), the yen (16.5%), and sterling (15.0%) (see table). Note that volume
percentages should add up to 200%: 100% for all the sellers and 100% for all the
buyers.

Trading in the euro has grown considerably since the currency's creation in January
1999, and how long the foreign exchange market will remain dollar-centered is open
to debate. Until recently, trading the euro versus a non-European currency ZZZ would
have usually involved two trades: EUR/USD and USD/ZZZ. The exception to this is
EUR/JPY, which is an established traded currency pair in the interbank spot market.
As the dollar's value has eroded during 2008, interest in using the euro as reference
currency for prices in commodities (such as oil), as well as a larger component of
foreign reserves by banks, has increased dramatically. Transactions in the currencies
of commodity-producing countries, such as AUD, NZD, CAD, have also increased.

Most traded currencies

Currency distribution of reported FX market turnover
ISO 4217 code % daily share
Rank Currency
(Symbol) (April 2007)
1  United States dollar USD ($) 86.3%
2  Euro EUR (€) 37.0%
3  Japanese yen JPY (¥) 16.5%
4  Pound sterling GBP (£) 15.0%
5  Swiss franc CHF (Fr) 6.8%
6  Australian dollar AUD ($) 6.7%
7  Canadian dollar CAD ($) 4.2%
8-9  Swedish krona SEK (kr) 2.8%
8-9  Hong Kong dollar HKD ($) 2.8%
10  Norwegian krone NOK (kr) 2.2%
11  New Zealand dollar NZD ($) 1.9%
12  Mexican peso MXN ($) 1.3%
13  Singapore dollar SGD ($) 1.2%
14  South Korean won KRW (₩) 1.1%
Other 14.5%
Total 200%

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Determinants of FX Rates

The following theories explain the fluctuations in FX rates in a floating exchange rate
regime (In a fixed exchange rate regime, FX rates are decided by its government):

(a) International parity conditions viz; purchasing power parity, interest rate parity,
Domestic Fisher effect, International Fisher effect. Though to some extent the above
theories provide logical explanation for the fluctuations in exchange rates, yet these
theories falter as they are based on challengeable assumptions [e.g., free flow of
goods, services and capital] which seldom hold true in the real world.

(b) Balance of payments model This model, however, focuses largely on tradable
goods and services, ignoring the increasing role of global capital flows. It failed to
provide any explanation for continuous appreciation of dollar during 1980s and most
part of 1990s in face of soaring US current account deficit.

(c) Asset market model views currencies as an important asset class for constructing
investment portfolios. Assets prices are influenced mostly by people’s willingness to
hold the existing quantities of assets, which in turn depends on their expectations on
the future worth of these assets. The asset market model of exchange rate
determination states that “the exchange rate between two currencies represents the
price that just balances the relative supplies of, and demand for, assets denominated in
those currencies.”

None of the models developed so far succeed to explain FX rates levels and volatility
in the longer time frames. For shorter time frames (less than a few days) algorithm
can be devised to predict prices. Large and small institutions and professional
individual traders have made consistent profits from it. It is understood from above
models that many macroeconomic factors affect the exchange rates and in the end
currency prices are a result of dual forces of demand and supply. The world's currency
markets can be viewed as a huge melting pot: in a large and ever-changing mix of
current events, supply and demand factors are constantly shifting, and the price of one
currency in relation to another shifts accordingly. No other market encompasses (and
distills) as much of what is going on in the world at any given time as foreign
exchange.

Supply and demand for any given currency, and thus its value, are not influenced by
any single element, but rather by several. These elements generally fall into three
categories: economic factors, political conditions and market psychology.

1. Economic factors

These include: (a)economic policy, disseminated by government agencies and central

banks, (b)economic conditions, generally revealed through economic reports, and
other economic indicators.

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1. Economic policy comprises government fiscal policy (budget/spending

practices) and monetary policy (the means by which a government's central
bank influences the supply and "cost" of money, which is reflected by the level
of interest rates).
2. Economic conditions include:

Government budget deficits or surpluses

The market usually reacts negatively to widening government budget deficits,
and positively to narrowing budget deficits. The impact is reflected in the
value of a country's currency.
Balance of trade levels and trends
The trade flow between countries illustrates the demand for goods and
services, which in turn indicates demand for a country's currency to conduct
trade. Surpluses and deficits in trade of goods and services reflect the
competitiveness of a nation's economy. For example, trade deficits may have a
negative impact on a nation's currency.
Inflation levels and trends
Typically a currency will lose value if there is a high level of inflation in the
country or if inflation levels are perceived to be rising . This is because
inflation erodes purchasing power, thus demand, for that particular currency.
However, a currency may sometimes strengthen when inflation rises because
of expectations that the central bank will raise short-term interest rates to
combat rising inflation.
Economic growth and health
Reports such as GDP, employment levels, retail sales, capacity utilization and
others, detail the levels of a country's economic growth and health. Generally,
the more healthy and robust a country's economy, the better its currency will
perform, and the more demand for it there will be.
Productivity of an economy
Increasing productivity in an economy should positively influence the value of
its currency. It affects are more prominent if the increase is in the traded
sector.

2. Political conditions

Internal, regional, and international political conditions and events can have a
profound effect on currency markets.

All exchange rates are susceptible to political instability and anticipations about the
new ruling party. Political upheaval and instability can have a negative impact on a
nation's economy. For example, destabilization of coalition governments in India,
Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in
a country experiencing financial difficulties, the rise of a political faction that is
perceived to be fiscally responsible can have the opposite effect. Also, events in one
country in a region may spur positive or negative interest in a neighboring country
and, in the process, affect its currency.

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3. Market psychology

Market psychology and trader perceptions influence the foreign exchange market in a
variety of ways:

Flights to quality
Unsettling international events can lead to a "flight to quality," with investors
seeking a "safe haven". There will be a greater demand, thus a higher price, for
currencies perceived as stronger over their relatively weaker counterparts. The
Swiss franc has been a traditional safe haven during times of political or
economic uncertainty.
Long-term trends
Currency markets often move in visible long-term trends. Although currencies
do not have an annual growing season like physical commodities, business
cycles do make themselves felt. Cycle analysis looks at longer-term price
trends that may rise from economic or political trends.
"Buy the rumor, sell the fact"
This market truism can apply to many currency situations. It is the tendency
for the price of a currency to reflect the impact of a particular action before it
occurs and, when the anticipated event comes to pass, react in exactly the
opposite direction. This may also be referred to as a market being "oversold"
or "overbought". To buy the rumor or sell the fact can also be an example of
the cognitive bias known as anchoring, when investors focus too much on the
relevance of outside events to currency prices.
Economic numbers
While economic numbers can certainly reflect economic policy, some reports
and numbers take on a talisman-like effect: the number itself becomes
important to market psychology and may have an immediate impact on short-
term market moves. "What to watch" can change over time. In recent years,
for example, money supply, employment, trade balance figures and inflation
numbers have all taken turns in the spotlight.
Technical trading considerations
As in other markets, the accumulated price movements in a currency pair such
as EUR/USD can form apparent patterns that traders may attempt to use.
Many traders study price charts in order to identify such patterns.

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Financial instruments

1. Spot

A spot transaction is a two-day delivery transaction (except in the case of the

Canadian dollar and the Mexican Nuevo Peso, which settle the next day), as opposed
to the futures contracts, which are usually three months. This trade represents a
“direct exchange” between two currencies, has the shortest time frame, involves cash
rather than a contract; and interest is not included in the agreed-upon transaction. The
data for this study come from the spot market. Spot transactions has the second largest
turnover by volume after Swap transactions among all FX transactions in the Global
FX market.

2. Forward

One way to deal with the foreign exchange risk is to engage in a forward transaction.
In this transaction, money does not actually change hands until some agreed upon
future date. A buyer and seller agree on an exchange rate for any date in the future,
and the transaction occurs on that date, regardless of what the market rates are then.
The duration of the trade can be a one day, a few days, months or years.

3. Future

Foreign currency futures are exchange traded forward transactions with standard
contract sizes and maturity dates — for example, $1000 for next November at an
agreed rate. Futures are standardized and are usually traded on an exchange created
for this purpose. The average contract length is roughly 3 months. Futures contracts
are usually inclusive of any interest amounts.

4. Swap

The most common type of forward transaction is the currency swap. In a swap, two
parties exchange currencies for a certain length of time and agree to reverse the
transaction at a later date. These are not standardized contracts and are not traded
through an exchange.

5. Option

A foreign exchange option (commonly shortened to just FX option) is a derivative

where the owner has the right but not the obligation to exchange money denominated
in one currency into another currency at a pre-agreed exchange rate on a specified
date. The FX options market is the deepest, largest and most liquid market for options
of any kind in the world.

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6. Exchange Traded Fund

Exchange-traded funds (or ETFs) are open ended investment companies that can be
traded at any time throughout the course of the day. Typically, ETFs try to replicate a
stock market index such as the S&P 500 (e.g., SPY), but recently they are now
replicating investments in the currency markets with the ETF increasing in value
when the US Dollar weakens versus a specific currency, such as the Euro. Certain of
these funds track the price movements of world currencies versus the US Dollar, and
increase in value directly counter to the US Dollar, allowing for speculation in the US
Dollar for US and US Dollar denominated investors and speculators.

7. Speculation

Controversy about currency speculators and their effect on currency devaluations and
national economies recurs regularly. Nevertheless, economists including Milton
Friedman have argued that speculators ultimately are a stabilizing influence on the
market and perform the important function of providing a market for hedgers and
transferring risk from those people who don't wish to bear it, to those who do. Other
economists such as Joseph Stiglitz consider this argument to be based more on
politics and a free market philosophy than on economics

Large hedge funds and other well capitalized "position traders" are the main
professional speculators.

Currency speculation is considered a highly suspect activity in many countries. While

investment in traditional financial instruments like bonds or stocks often is considered
to contribute positively to economic growth by providing capital, currency
speculation does not; according to this view, it is simply gambling that often interferes
with economic policy. For example, in 1992, currency speculation forced the Central
Bank of Sweden to raise interest rates for a few days to 500% per annum, and later to
devalue the krona. Former Malaysian Prime Minister Mahathir Mohamad is one well
known proponent of this view. He blamed the devaluation of the Malaysian ringgit in
1997 on George Soros and other speculators.

Gregory Millman reports on an opposing view, comparing speculators to "vigilantes"

who simply help "enforce" international agreements and anticipate the effects of basic
economic "laws" in order to profit.

In this view, countries may develop unsustainable financial bubbles or otherwise

mishandle their national economies, and foreign exchange speculators allegedly made
the inevitable collapse happen sooner. A relatively quick collapse might even be
preferable to continued economic mishandling. Mahathir Mohamad and other critics
of speculation are viewed as trying to deflect the blame from themselves for having
caused the unsustainable economic conditions. Given that Malaysia recovered quickly
after imposing currency controls directly against IMF advice, this view is open to
doubt.

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Exchange rate

In finance, the exchange rates (also known as the foreign-exchange rate, forex
rate or FX rate) between two currencies specifies how much one currency is
worth in terms of the other. It is the value of a foreign nation’s currency in terms
of the home nation’s currency”

For example an exchange rate of 102 Japanese yen (JPY, ¥) to the United States dollar
(USD, $) means that JPY 102 is worth the same as USD 1. The foreign exchange
market is one of the largest markets in the world. By some estimates, about 3.2 trillion
USD worth of currency changes hands every day.

The spot exchange rate refers to the current exchange rate. The forward exchange
rate refers to an exchange rate that is quoted and traded today but for delivery and
payment on a specific future date.

Quotations

An exchange system quotation is given by stating the number of units of "term

currency" (or "price currency" or "quote currency") that can be bought in terms of 1
"unit currency" (also called "base currency"). For example, in a quotation that says the
EURUSD exchange rate is 1.4320 (1.4320 USD per EUR), the term currency is USD
and the base currency is EUR.

There is a market convention that determines which is the base currency and which is
the term currency. In most parts of the world, the order is: EUR – GBP – AUD – NZD
– USD – others. Thus if you are doing a conversion from EUR into AUD, EUR is the
base currency, AUD is the term currency and the exchange rate tells you how many
Australian dollars you would pay or receive for 1 euro. Cyprus and Malta which were
quoted as the base to the USD and others were recently removed from this list when
they joined the euro. In some areas of Europe and in the non-professional market in
the UK, EUR and GBP are reversed so that GBP is quoted as the base currency to the
euro. In order to determine which is the base currency where both currencies are not
listed (i.e. both are "other"), market convention is to use the base currency which
gives an exchange rate greater than 1.000. This avoids rounding issues and exchange
rates being quoted to more than 4 decimal places. There are some exceptions to this
rule e.g. the Japanese often quote their currency as the base to other currencies.

Quotes using a country's home currency as the price currency (e.g., EUR 1.00 = USD
1.58) are known as direct quotation or price quotation (from that country's
perspective) and are used by most countries.

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Quotes using a country's home currency as the unit currency (e.g., AUD 0.97 = USD
1.00) are known as indirect quotation or quantity quotation and are used in British
newspapers and are also common in Australia, New Zealand and the eurozone.

• direct quotation: 1 foreign currency unit = x home currency units

• indirect quotation: 1 home currency unit = x foreign currency units

Note that, using direct quotation, if the home currency is strengthening (i.e.,
appreciating, or becoming more valuable) then the exchange rate number decreases.
Conversely if the foreign currency is strengthening, the exchange rate number
increases and the home currency is depreciating.

When looking at a currency pair such as EURUSD, the first component (EUR in this
case) will be called the base currency. The second is called the term currency. For
example : EURUSD = 1.5877, means EUR is the base and USD the term, so 1 EUR =
USD 1.5877.

Market convention from the early 1980s to 2006 was that most currency pairs were
quoted to 4 decimal places for spot transactions and up to 6 decimal places for
forward outrights or swaps. (The fourth decimal place is usually referred to as a
"pip.") An exception to this was exchange rates with a value of less than 1.000 which
were usually quoted to 5 or 6 decimal places. Although there is no fixed rule,
exchange rates with a value greater than around 20 were usually quoted to 3 decimal
places and currencies with a value greater than 80 were quoted to 2 decimal places.
Currencies over 5000 were usually quoted with no decimal places (e.g. the former
Turkish Lira). e.g. (GBPOMR : 0.765432 - EURUSD : 1.5877 - GBPBEF : 58.234 -
EURJPY : 165.29). In other words, quotes are given with 5 digits. Where rates are
below 1, quotes frequently include 5 decimal places.

In 2006 Barclays Capital broke with convention by offering spot exchange rates with
5 or 6 decimal places. The contraction of spreads (the difference between the bid and
offer rates) arguably necessitated finer pricing and gave the banks the ability to try
and win transaction on multibank trading platforms where all banks may otherwise
have been quoting the same price. A number of other banks have now followed this.

Free or pegged

If a currency is free-floating, its exchange rate is allowed to vary against that of other
currencies and is determined by the market forces of supply and demand. Exchange
rates for such currencies are likely to change almost constantly as quoted on financial
markets, mainly by banks, around the world. A movable or adjustable peg system is a
system of fixed exchange rates, but with a provision for the devaluation of a currency.
For example, between 1994 and 2005, the Chinese yuan renminbi (RMB) was pegged
to the United States dollar at RMB 8.2768 to $1. China was not the only country to do
this; from the end of World War II until 1966, Western European countries all
maintained fixed exchange rates with the US dollar based on the Bretton Woods
system.

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Nominal and real exchange rates

• The nominal exchange rate e is the price in domestic currency of one unit of a
foreign currency.
• The real exchange rate (RER) is defined as , where P * is the foreign price
level and P the domestic price level. P and P * must have the same arbitrary
value in some chosen base year. Hence in the base year, RER = e.

The RER is only a theoretical ideal. In practice, there are many foreign currencies and
price level values to take into consideration. Correspondingly, the model calculations
become increasingly more complex. Furthermore, the model is based on purchasing
power parity (PPP), which implies a constant RER. The empirical determination of a
constant RER value could never be realised, due to limitations on data collection. PPP
would imply that the RER is the rate at which an organization can trade goods and
services of one economy (e.g. country) for those of another. For example, if the price
of a good increases 10% in the UK, and the Japanese currency simultaneously
appreciates 10% against the UK currency, then the price of the good remains constant
for someone in Japan. The people in the UK, however, would still have to deal with
the 10% increase in domestic prices. It is also worth mentioning that government-
enacted tariffs can affect the actual rate of exchange, helping to reduce price
pressures. PPP appears to hold only in the long term (3–5 years) when prices
eventually correct towards parity.

More recent approaches in modelling the RER employ a set of macroeconomic

variables, such as relative productivity and the real interest rate differential.

Bilateral vs. effective exchange rate

Bilateral exchange rate involves a currency pair, while effective exchange rate is
weighted average of a basket of foreign currencies, and it can be viewed as an overall
measure of the country's external competitiveness. A nominal effective exchange rate
(NEER) is weighted with trade weights. a real effective exchange rate (REER) adjust
NEER by appropriate foreign price level and deflates by the home country price level.
Compared to NEER, a GDP weighted effective exchange rate might be more
appropriate considering the global investment phenomenon.

Uncovered interest rate parity

Uncovered interest rate parity (UIRP) states that an appreciation or depreciation of

one currency against another currency might be neutralized by a change in the interest
rate differential. If US interest rates increase while Japanese interest rates remain
unchanged then the US dollar should appreciate against the Japanese yen by an
amount that prevents arbitrage. The future exchange rate is reflected into the forward
exchange rate stated today. In our example, the forward exchange rate of the dollar is
said to be at a discount because it buys fewer Japanese yen in the forward rate than it
does in the spot rate. The yen is said to be at a premium.

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UIRP showed no proof of working after 1990s. Contrary to the theory, currencies with
high interest rates characteristically appreciated rather than depreciated on the reward
of the containment of inflation and a higher-yielding currency.

Balance of payments model

This model holds that a foreign exchange rate must be at its equilibrium level - the
rate which produces a stable current account balance. A nation with a trade deficit will
experience reduction in its foreign exchange reserves which ultimately lowers
(depreciates) the value of its currency. The cheaper currency renders the nation's
goods (exports) more affordable in the global market place while making imports
more expensive. After an intermediate period, imports are forced down and exports
rise, thus stabilizing the trade balance and the currency towards equilibrium.

Like PPP, the balance of payments model focuses largely on tradable goods and
services, ignoring the increasing role of global capital flows. In other words, money is
not only chasing goods and services, but to a larger extent, financial assets such as
stocks and bonds. Their flows go into the capital account item of the balance of
payments, thus, balancing the deficit in the current account. The increase in capital
flows has given rise to the asset market model.

Asset market model

The explosion in trading of financial assets (stocks and bonds) has reshaped the way
analysts and traders look at currencies. Economic variables such as economic growth,
inflation and productivity are no longer the only drivers of currency movements. The
proportion of foreign exchange transactions stemming from cross border-trading of
financial assets has dwarfed the extent of currency transactions generated from
trading in goods and services.

The asset market approach views currencies as asset prices traded in an efficient
financial market. Consequently, currencies are increasingly demonstrating a strong
correlation with other markets, particularly equities.

Like the stock exchange, money can be made or lost on the foreign exchange market
by investors and speculators buying and selling at the right times. Currencies can be
traded at spot and foreign exchange options markets. The spot market represents
current exchange rates, whereas options are derivatives of exchange rates

Fluctuations in exchange rates

A market based exchange rate will change whenever the values of either of the two
component currencies change. A currency will tend to become more valuable
whenever demand for it is greater than the available supply. It will become less
valuable whenever demand is less than available supply (this does not mean people no

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longer want money, it just means they prefer holding their wealth in some other form,
possibly another currency).

Increased demand for a currency is due to either an increased transaction demand for
money, or an increased speculative demand for money. The transaction demand for
money is highly correlated to the country's level of business activity, gross domestic
product (GDP), and employment levels. The more people there are unemployed, the
less the public as a whole will spend on goods and services. Central banks typically
have little difficulty adjusting the available money supply to accommodate changes in
the demand for money due to business transactions.

The speculative demand for money is much harder for a central bank to accommodate
but they try to do this by adjusting interest rates. An investor may choose to buy a
currency if the return (that is the interest rate) is high enough. The higher a country's
interest rates, the greater the demand for that currency. It has been argued that
currency speculation can undermine real economic growth, in particular since large
currency speculators may deliberately create downward pressure on a currency in
order to force that central bank to sell their currency to keep it stable (once this
happens, the speculator can buy the currency back from the bank at a lower price,
close out their position, and thereby take a profit).

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Bibliography:
1- Brown, C.V. (1984); Forex Market ; Oxford: Basil Black
Well (Ltd.)
2- Hamid Shahid, A. (2001); Data On Forex; Lahore:
Manzoor Printing Press
3- Mc. Campbell R, Brue, Stanley L. (2002);
4- Sinclair, Peter. (1987);
5- Todaro, Micheal. L ;
6- www.pakistanecomomist.com ; Waheed, Abdul, Noreen,
Mujahid ; “Industry and Economy”
7- www.nation.com ; Arif, Rauf, “
8- www.nation.com ;

Book:
International Finance by Maurice. D. Levi

Websites:
Google

Fx.com

Currency.com

Fxcm.com

Pakpoll.com

Journals and Articles:

Emerald

Jstore

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