HOW FX IS PRICED

Exchange rates respond directly to all sorts of events, both tangible and psychological:

• Business Cycles
• Balance of payment statistics
• Political developments
• New tax laws
• Stock market news
• Inflationary expectations
• International investment patterns
• Central Bank policies

At the heart of this complex market are the same forces of demand and supply that determine the prices of goods and services in any free market. In simple terms if the demand for a currency is greater than its supply, its price will rise. If supply exceeds demand, the price will fall.

The supply of each nation’s currency is influenced by that nation’s monetary authority. Usually it would be its Central Bank, consistent with the amount of spending taking place in the economy. Central banks and governments will closely monitor economic activity to keep money supply at a level appropriate to achieve their economic goals.

If too much money is in the economy then it could spiral inflation decreasing the value of money. This concept generally would increase prices. Too little money, on the other hand, would slow down economic growth thereby increasing unemployment. Monetary authorities therefore must decide whether economic conditions call for a larger or smaller increase in the money supply.

SOURCES FOR CURRENCY DEMAND ON THE FX SUPPLY

The currency of a growing economy with relative price stability and a wide variety of competitive goods and services will be more in demand than that of a country in political turmoil, with high inflation and few marketable exports. Money will flow to wherever it can get the highest return with the least risk. If a nation’s financial instruments, such as stocks and bonds, offer relatively high rates of return at relatively low risk, foreigners will demand its currency to invest in them.

FX traders speculate within the market about how different events will move the exchange rates. For example, news of political instability in other countries drives up demand for stronger currencies as investors are looking for a ‘safe haven’ for their money. A country’s interest rates rise and its currency appreciates as foreign investors seek higher returns than they can get in their own countries. Developing nations undertaking successful economic reforms may experience currency appreciation as foreign investors seek new opportunities.

Traders in the foreign exchange market make thousands of trades daily, buying and selling currencies while exchanging market information. The forex market is needed every day and may be used for varied purposes:

• For the import and export needs of companies and individuals
• For direct foreign investment
• Political developments
• To profit from the short-term fluctuations in exchange rates
• To manage existing positions
• To purchase foreign financial instruments

In the volatile FX market, traders constantly try to predict the behaviour of other market participants. If they correctly anticipate their opponents’ strategies, they can act first and beat the competition. Traders make money by purchasing currency and selling it later at a higher price, or, by anticipating the market moving lower, selling at a high price and buying back at a lower price.

To predict the movements of currencies, traders often try to determine whether the currency’s price reflects its fundamental value in terms of current economic conditions. Examining inflation, interest rates, and the relative strength of the country’s economy helps them make trading decisions.

CURRENCY TRADING BETWEEN BANKS

Banks are a major force in the FX market and employ a large number of traders. Trading between banks is done in two ways – through a broker or directly with each other.Brokers

An FX broker may be used as an intermediary if banks trade with each other. The broker arranges the transaction, matching the buyer and the seller without ever taking a position and charges a commission to transact their orders.Direct

On most occasions banks will deal with each other directly. A trader ‘makes a market’ for another by quoting a two-way price i.e. he is willing to buy or sell the currency. The difference between the two price quotes (the spread) is usually low.

Most currencies are quoted in terms of how many units of that currency would equal $1. However, the British pound, the New Zealand dollar, Australian dollar, Irish punt and the Euro are quoted in terms of how many US dollar would equal one unit of those currencies. The currencies of the world’s large, industrialized economies, or hard currencies, are always in demand and are the most actively traded. In terms of trading volumes, the FX market is dominated by four currencies: the US dollar, the Euro, the Japanese Yen and the British Pound. Together these account for the majority of the market. It is not always easy to find a market for all currencies. The demand for currencies of less developed countries, soft countries, is a lot less than for the hard currencies. Weak demand internationally along with exchange controls may make these currencies difficult to convert.

TYPES OF FOREX CONTRACTS

Here are the different types of FX transactions:Spot Transactions

Two parties agree on an exchange rate and trade currencies at that rate. Although spot transactions are popular, they often leave the currency buyer exposed to some potentially dangerous financial risks.Forward Transactions

One way to mitigate FX risk is to enter into a forward transaction. With a forward money does not actually change hands until some agreed 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 date can be a few days, weeks, months or years in the future.Futures

Foreign currency futures are forward transactions with standard contract sizes and maturity dates – for example, 250,000 British pounds for next February at an agreed rate. These contracts are traded on a separate exchange set up for that purpose.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. Suppose, a company needs 10 million Japanese Yen for a three-month investment in Japan. It may agree to a rate of 150 yen to a dollar and swap $100,000 with a company willing to swap 10 million yen for three months. After three months, the company returns the 10 million Yen to the other company and gets back $100,000 with adjustments made for interest rate differentials.Options

To address the lack of flexibility in forward transactions, the foreign currency option was developed. An option is like a forward transaction. It gives its owner the right to buy or sell a specified amount of foreign currency at a specified price at any time up to a specified expiration date. For a price, the market participant can buy the right, but not the obligation, to buy or sell a currency at a fixed price on or before an agreed upon future date. The agreed upon price is called the strike price.

Depending on whether the option rate or the current market rate is more favourable, the owner may exercise the option or let the option lapse, choosing instead to buy/sell currency in the market. This type of transaction allows the owner more flexibility than a swap or futures contract.

• An option to buy currency is called a Call option
• An option to sell currency is called a Put option

In these transactions, market rates might change. However, the buyer and seller are locked into a contract at a fixed price that cannot be affected by any changes in the market rates. These tools allow the market participants to plan more safely, since they know in advance what their FX will cost. It also allows them to avoid an immediate outlay of cash.

DELIVERY MONTHS FOR FUTURES

The contract trading months for FX futures are on the same quarterly cycle as other financial instruments. These are March (H), June (M), September (U), December (Z). They are called delivery months because the seller of the contract must be prepared to deliver the specified amount of foreign currency to the buyer if the seller has not cancelled the obligation with an offsetting purchase. The majority of market participants close out their positions before delivery.

WHERE FX IS TRADED

There are three main centres of trading, which handle the majority of all FX transactions – United Kingdom, United States and Japan.

Transactions in Singapore, Switzerland, Hong Kong, Germany, France and Australia account for most of the remaining transactions in the market. Trading goes on 24 hours a day. The London market opens when the Japanese and Hong Kong markets are about to close. While the London market is in its half-day, the New York market opens. San Francisco market opens after trading in London get over. Japan resumes trading when San Francisco market closes down.

Futures differ from Forwards, because credit or default risk can be virtually eliminated. Instead of conveying the value of a contract through a single payment at maturity, any change in the value of a futures contract is conveyed at the end of the day upon which it is realised. In futures markets, the futures contract is cash settled or marked-to-market daily. As we mentioned above, margin is posted and any gains or losses are added or deducted from the margin account at the end of the trading day. If the margin falls below an agreed minimum, the holder is required to replenish the margin account or the holder’s position will be closed out.