Foreign Exchange Markets - Case Study Example

Foreign Exchange Markets Summary Every nation has its own national currency or monetary unit this could be the dollar, the euro or the yen. This currency is used for making and receiving payments within one’s own country and outside one’s own country i.e. cross border. This means that there must be a mechanism to provide access to foreign nationals to the currency of a certain country. Therefore a foreign exchange market came into being. Foreign exchange market is a forum where one currency is traded for another. Surprisingly, it is the largest market in the world where the cash traded surpasses that of surpasses that in any other market. It includes trading between large banks, central banks, governments, multinational companies and other foreign exchange markets. The trade happening globally in forex markets is huge; averaging $1.9 trillion a day. Retail traders are a very small part of this market and usually participate only indirectly through brokers and banks. The foreign exchange market differs from other markets in certain specific ways. First of all it differs in terms of its trading volume. The trading volume of foreign exchange markets is very high; average daily turnover in foreign exchange markets was estimated to be $1,880 billion. The market is highly liquid and its levels of liquidity are exemplary. Thirdly, there are a large number of traders in the market who all come from diverse backgrounds. Fourthly, the foreign exchange markets are characterized by long trading hours; twenty four hours trading exceopt on weekends. Lastly, foreign exchange markets are highly geographically dispersed. There are a lot of factors which influence foreign exchange rates. The foreign exchange markets can be seen as a huge melting pot; there is a mix of ever changing current events, constantly shifting supply and demand factors and so does the price of one currency in relation to another. It is a market which is influenced hugely by what is happening around it, like no other market. Three categories that specifically affect supply and demand factors in exchange markets include; economic factors, political conditions and market psychology. Economic factors encompass economic policies, economic conditions revealed through reports and economic indicators, government fiscal policy and monetary policy. Economic conditions are known to include; budget deficits which are good if narrow. This means that spending is less than revenue. Other economic conditions include inflation, balance of trade and economic growth and health. The economic growth of a country is reflected in its gross domestic product (GDP), employments levels, retail sales and capacity utilization levels. Political conditions have a marked effect on foreign currency markets. Instability and insurgence in countries may lead to worsening of political conditions thereby affecting the currency market. Also events in one country may adversely or positively affect another country which is directly linked to the other country. Market psychology on the other hand is a factor influencing exchange rates that is very difficult to define and predict. It manifests itself in many ways often influencing trader perceptions and creating a trend in the foreign currency exchange markets which is little known to outsiders. (Riehl and Rodriguez, 1977) The basic policy with respect to foreign currency exchange markets is set by senior management. They are responsible to devise a framework regarding the services the foreign exchange trading function will provide and how will those services be provided. The trading rooms are therefore trenches in which a battle is fought. Each trader confronts competitors, customers and other players. A dealer bank or any other institution undertakes a variety of tasks. These include; making markets, servicing customers and proprietary transactions. (Frankel, Galli and Giovannini, 1996) Foreign exchange trading increased by 38% between April 2005 and 2006 and has 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 internet trading platforms has also made it easier for retail traders to trade in the foreign exchange market.’( Sweeney, 2005) Functions of Foreign Exchange Markets The foreign exchange market is one where brokers and dealers deal directly and there is no central exchange or clearing house. The biggest geographic trading center is the UK primarily London. Other large centers include US, Japan and Singapore. Active foreign exchange markets also include; Germany, Switzerland, Australia, Canada, France and Hong Kong. ‘The ten most active traders account for almost 73% of trading volume according to The Wall Street Journal Europe.’ These large banks continuously provide the market with bid and ask prices. This spread is the difference between the price at which a market-maker will sell and the price at which a market-maker will buy a certain currency. The spread is minimal for actively traded currencies. Unlike a stock market where all participants have access to the same prices, the forex market is divided into levels of access. At the top is the interbank market which is composed of the largest investment banking firms. The interbank market spreads are usually unavailable and are limited to the players in the inner circle. If you go down the levels of access the bid ask spread widens due to the volume of trading being carried out. The levels of access which are a main component of the foreign exchange market are determined by the amount of money traded. (Frankel, Galli and Giovannini, 1996) The structure is such that the top-tier inter bank markets accounts for 53% of all transactions. This is followed by the investment banks, large multinational coporations and large hedge funds. “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. Foreign Exchange Trading Characteristics Foreign exchange trading is over the counter trading where there is little cross-border regulation. There are a number of interconnected market places where a number of market places where different currency instruments are traded. This implies that the rate of a certain currency for example the dollar varies with the market it is being traded in and there is no absolute rate. The rates are however normally very close. There is barely any concept of insider information in foreign exchange markets. This is because rexchange rate fluctuations are usually genuinely caused by actual monetary flows which occur due to changes in GDP growth, inflation, interest rates, budget and trade deficits as well as other macroeconomic conditions. Generally people have access to the same news at the same time because of scheduled press releases. Currencies are traded against one another. Each individual currency is therefore treated as a single product and is noted as XXX/YYY. Where Y is the ISO 4217 international code of the cureency into which the price of one unit of XXX is expressed.Eventhough trading in euro has increased the foreign exchange market is still dollar centred.( Sweeney, 2005) Foreign Exchange Instruments Used A couple of financial instruments are commonly used in foreign exchange markets. The first of these is a spot transaction which is a two day delivery transaction. This trade involves the shortes amount of time, cash transactions and the mutually decided transaction does not include the interest. Spot has the largest voloume among all other instruments used in the foreign exchange markets. Secondly, another instrument is the forwards instrument. In this type of transaction money does not change hands until at a future date. An agreement is reached between the buyer and the seller on a future date irrespective of that interest rate. Thirdly, future contract puts down agreed upon rates and the size of the transaction. This type of instrument has standardized and holds for a contract period of roughly three months. They are inclusive of any interest amount. Other than that swap, option and exchange traded fund are also instruments that could be used to trade in the foreign exchange market.( Sweeney, 2005) The gold standard is a monetary system in which the standard unit of currency is gold. Gold is therefore the economic unit of account. Britain began using the gold standard in 1825. By 1844 an act was passed to affirm the establishment of full gold standard for British money. Today, the gold standard is not used by any country or central bank. Governments today depend entirely on fiat money and the gold standard is only used for private transactions. The gold standard has been known to provide insufficient flexibility in supply and in the fiscal policy. This is because gold is finite and its supply must be carefully monitored and regulated. Therefore economists highly oppose this medium. On the other hand it is also believed that using gold medium means that the paper money will go up in value backed by the gold standard as it becomes rare. (Giovannini, 1995) When the gold standard was used as a monetary system currency exchange rates could only fluctuate between narrow limits keeping in mind the costs of shipping and insuring gold. ‘This automatic operation of the balance of payments adjustment process under the gold standard required, in theory, that in their financial policies, participating countries give an absolute priority to external adjustment over domestic objectives. This meant that in any periods of conflict between domestic and external objectives, policy tools might not be available to be used for domestic problems of recession, unemployment, or inflation.’ The lack of internal orientation when it came to solving the nation’s problems due to using the gold standard is a major drawback of using the gold standard. At present the opponents of gold standard hold the upper hand and transition to the standard seems highly unlikely. (Giovannini, 1995) References 1. Frankel.J, Galli.G and Giovannini.J (1996) The Microstructure of Foreign Exchange Markets 2. Riehl.H and Rodriguez.R. (1977). Foreign Exchange Markets: A Guide to Foreign Currency Operations. Mc-Graw Hill 3. Sweeney.R (2005) Foreign Exchange Markets. Edward Elgar 4. Giovannini.A. (1995). The Debate on Money in Europe. MIT Press Read More