Meaning of Foreign ExchangeThe term Foreign exchange implies two things: a)foreigncurrency and b) exchange rate Foreign exchange generally refers to foreign currency, eg for india it is dollar, euro, yen, etc… & the other part of foreign exchange is exchange rate which is the price of one currency in terms of the other currency.Forex is the international market for the free trade ofcurrencies. Traders place orders to buy one currency withanother currency.
forex cntd… According to Hartly Withers, “ Foreign exchange is the art and science of international monetary exchange” The forex market is the world’s largest financial market. Over $4 trillion dollars worth of currency are traded each day. The amount of money traded in a week is bigger than the entire annual GDP of the United States! The main currency used for forex trading is the US dollar.
Foreign exchange market Foreign exchange market is that market in which national currencies are traded for one another.. The major participants in this market are commercial banks, forex brokers, and authorised dealers and the monetary authorities. Besides, transfer of funds form one country to another , speculation is an important dimension of foreign exchange market. Its where money in one currency is exchanged for another
Advantages of Forex market It’s already the world’s largest market and it’s still growing quickly It makes extensive use of information technology – making it available to everyone Traders can profit from both strong and weak economies Trader can place very short-term orders – which are prohibited in some other markets The market is not regulated Brokerage commissions are very low or non-existent The market is open 24 hours a day during weekdays
Terms related to ForeignExchange Foreign exchange reserves- holdings of other countries currencies Foreign exchange controls- controls imposed by a government on the purchase/sale of foreign currencies Retail foreign exchange platform- speculative trading of foreign exchange by individuals using electronic trading platforms Foreign exchange risk- arises from the change in price of one currency against another International trade- the exchange of goods and services across national boundaries Foreign exchange company- a broker that offers currency exchange and international payments Bureau de change- a business whose customers exchange one currency for another Currency pair- the quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market Digital currency exchanger- market makers which exchange fiat currency for electronic money
Exchange rate According to haines, “Exchange rate is the price of the currency of a country can be exchanged for the number of units of currency of another country.” Exchange rate is that rate at which one unit of currency of a country can be exchanged for the number of units of currency of another country. It’s the the price for which one currency is exchanged for another
Factors influencing ExchangeRatesAs with any market, the forex market is driven by supply and demand: If buyers exceed sellers, prices go up If sellers outnumber buyers, prices go downThe following factors can influence exchange rates: National economic performance Central bank policy Interest rates Trade balances – imports and exports Political factors – such as elections and policy changes Market sentiment – expectations and rumours Unforeseen events – terrorism and natural disastersDespite all these factors, the global forex market is more stable thanstock markets; exchange rates change slowly and by small amounts.
Fixed and Floatingexchange rates Fixed exchange rate is the official rate set by the monetary authorities of the Governance for one or more currencies. Under floating exchange rate, the value of the currency is decided by supply and demand factors
Direct and indirectexchange rates Direct method - Under this, a given number of units of local currency per unit of foreign currency is quoted. They are designated as direct/certain rates because the rupee cost of single foreign currency unit can be obtained directly. Direct quotation is also called home currency quotation. Indirect method – Under this, a given number of units of foreign currency per unit of local currency is quoted. Indirect quotation is also called foreign currency quotation
Buying and sellingExchange rates are quoted as two wayquotes – for purchase and for saletransactions by the Bank
Spot and forwardThe delivery under a foreign exchange transaction can besettled in one of the following ways Ready or cash – To be settled on the same day Tom – To be settled on the day next to the date of transaction Spot – To be settled on the second working day from the date of contract Forward – To be settled at a date farther than the spot date
Theories of exchange ratedetermination Meaning: Theories which determine the prices of forex rateconsidering inflation, interest rate, and elasticity of priceetc..Methods:a) Long run theoryb) Short run theory
Long Run Theory of ExchangerateDetermination: This are the theories which predominately take into account the fundamental changes of economy. Here fundamental changes refers to the change which are going to change the economic performance of the economy Purchasing powfor all times to come.Types of theory:Purchasing power parity. 1) Absoulte purchasing power parity. 2) Relative purchasing power parity.Interest Rate parity 1) Covered Interest Rate parity 2) UnCovered Interest Rate parity
Short Run theory of exchangerate determination This theories are based more on current information or immediate performance of economic variables. This theories try to take into account the short run factor which may be eliminated in the long run.
Purchasing power parity theoryFounder –Swedish economist Gustav Cassel in 1918. Meaning : According to this theory ,the price levels and the changes in these price levels in different countries determine the exchanges rates of these countries currencies. The basic principle of this theory is that the exchange rates between various currencies reflect the purchasing power of these currencies .This theory is based law of one price.
Absolute form of PPP Theory If the law of one price were to hold good for each and every commodity then the theory is termed as Absolute form of PPP Theory. This theory describes the link between the spot exchange rate and price levels at a particular point of time
Relative form of PPP This theory describes the link between the changes in spot exchange rate and in the price levels over a period of time. According to this theory ,changes in spot rates over a period of time reflect the changes in the price level over the same period in the concerned economies. This theory relaxes three assumptions of PPP ie Absences of transportation cost ,transaction costs and tarriffs.
Interest Rate Parity Theory Definition :The process that ensures that the annualized forwardpremium or discount equals the interest rate differential onequivalent securities in two currencies. International Fisher effect: Expected Rate of change = Interest rate of the exchange rate differential Interest Rate = Real Interest Expected Differential Rate + inflation rate
Modern theory: demand & supplytheory The most satisfactory explanation of the determination of the rate of exchange is that a free exchange rate tends to be such as to equate the demand and supply of foreign exchange.. The intersection of supply curve and demand curve gives the equilibrium price Modern theory also called balance of payments theory of foreign exchange
Foreign Exchange Risk Exposure to exchange rate movement. Any sale or purchase of foreign currency entails foreign exchange risk. Foreign exchange transaction affects the net asset or net liability position of the buyer/seller. Carrying net assets or net liability position in any currency gives rise to exchange risk.
Risk managementControlling losses You could control your losses, by mental stop or hard stop. Mental stop means that you already set you limit of your loss. A hard stop is your initiative to stop when you think you must to stop it.Using correct lot size As a beginning just use smaller lots you could stay flexible and logic than emotions while you trade.Tracking overall exposure sample: you go to short on EUR/USD and long on USD/CHF, you exposed two times for USD in the same direction. If USD goes down , you have a double dose of pain. So, keep your overall exposure limited, it keeps you for the long haul for tradingThe bottom line Trading is about opportunities, you must take action while the opportunities arise.