FX Trading and Exchange Rate Dynamics

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The foreign exchange market is the "place" where currencies are fx trading and exchange rate dynamics. Currencies are important to most people around the world, whether they realize it or not, because currencies need to be exchanged in order to conduct foreign trade and business. If you are living in the U. This means that the U.

The same goes for traveling. A French tourist in Egypt can't pay in euros to see the pyramids because it's not the locally accepted currency. As such, the tourist has to exchange the euros for the local currency, in this case the Egyptian pound, at the current exchange rate. The need to exchange currencies is the primary reason why the forex market is the largest, most liquid financial market in the world. It dwarfs other markets in size, even the stock market, with an average traded value of around U.

The total volume changes all the time, but as of Augustthe Bank for International Settlements BIS reported that the forex market traded in excess of U. One unique aspect of this international market is that there is no central marketplace for foreign exchange.

Rather, currency trading is conducted electronically over-the-counter OTCwhich means that all transactions occur via computer networks between traders around the world, rather than on one centralized exchange. The market is open 24 hours a day, five and a half days a week, and currencies are traded worldwide in the major financial centers of London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and Sydney - across almost every time zone.

This means that when the trading day in the U. As such, the forex market can be extremely active any time of the day, with price quotes changing constantly.

Spot Market and the Forwards and Futures Markets There are actually three ways that institutions, corporations and individuals trade forex: The forex trading in the spot market always has been the largest market because it is the "underlying" real asset that the forwards and futures markets are based on. Fx trading and exchange rate dynamics the past, the futures market was the most popular venue for traders because it was available to fx trading and exchange rate dynamics investors for a longer period of time.

However, with the advent of electronic trading and numerous forex brokersthe spot market has witnessed a huge surge in activity and now surpasses the futures market as the preferred trading market for individual investors and speculators. When people refer to the forex market, they usually are referring to the spot market. The forwards and futures markets tend to be more popular with companies that need to hedge their foreign exchange risks out to a specific date in the future.

What is the spot market? More specifically, the spot market is where currencies are bought and sold according to the current price.

That price, determined by supply and demand, is a reflection of many things, including current interest rates, economic performance, sentiment towards ongoing political situations both locally and internationallyas well as the perception of the future performance of one currency against another. When a deal is finalized, this is known as a "spot deal". It is a bilateral transaction by which one party delivers an agreed-upon currency amount to fx trading and exchange rate dynamics counter party and receives a specified amount of another currency at the agreed-upon exchange rate value.

After a position is closed, the settlement is in cash. Although the spot market is commonly known as one that deals with transactions in the present rather than the futurethese trades actually take two fx trading and exchange rate dynamics for settlement.

What are the forwards and futures markets? Unlike the spot market, the forwards and futures markets do not trade actual currencies. Instead they deal in contracts that represent claims to a certain currency type, a specific price per unit and a future date for settlement. In the forwards market, contracts are bought and sold OTC between two parties, who determine the terms of the agreement between themselves. In the futures market, futures fx trading and exchange rate dynamics are bought and sold based upon a standard size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange.

Futures contracts have specific details, including the number of units being traded, delivery and settlement dates, and minimum price increments fx trading and exchange rate dynamics cannot be customized. The exchange acts as a counterpart to the trader, providing clearance and settlement. Both types of contracts are binding and are typically settled for cash for the exchange in question upon expiry, although contracts can also be bought and sold before they expire.

The forwards and futures markets can offer protection against risk when trading currencies. Usually, big international corporations use these markets in order to hedge against future exchange rate fluctuations, but speculators take part in these markets as well.

Note that you'll see the terms: FX, forex, foreign-exchange market and currency market. These terms are synonymous and all refer to the forex market. Introduction to Currency Trading Forex Tutorial: What is Forex Trading?

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A simulation model of an exporter firm - to play and understand how the exchange rate impacts on exports and business transactions. A Thai scholars' paper quoting this work. The exchange rate expresses the national currency's quotation in respect to foreign ones. For example, if one US dollar is worth 10 Japanese Yen, then the exchange rate of dollar is 10 Yen. If something costs 30 Yen, it automatically costs 3 US dollars as a matter of accountancy.

Thus, the exchange rate is a conversion factor , a multiplier or a ratio, depending on the direction of conversion. In a slightly different perspective, the exchange rate is a price.

If the exchange rate can freely move, the exchange rate may turn out to be the fastest moving price in the economy , bringing together all the foreign goods with it. Types of exchange rate. It is customary to distinguish nominal exchange rates from real exchange rates. Nominal exchange rates are established on currency financial markets called " forex markets", which are similar to stock exchange markets. Rates are usually established in continuous quotation, with newspaper reporting daily quotation as average or finishing quotation in the trade day on a specific market.

Central bank may also fix the nominal exchange rate. Real exchange rates are nominal rate corrected somehow by inflation measures.

In fact, higher prices mean an appreciation of the real exchange rate, other things equal. Another classification of exchange rates is based on the number of currencies taken into account. Bilateral exchange rates clearly relate to two countries' currencies. They are usually the results of matching of demand and supply on financial markets or in banking transaction. In this latter case, the central bank acts usually as one of the sides of the relationship.

Other bilateral exchange rates may be simply computed from triangular relationships: If, instead,a financial market exists for yen to be exchanged with kwanza, the expectation is that actions by speculators arbitrage among markets will bring the parity of 10 kwanza per yen as an effect. Multilateral exchange rates are computed in order to judge the general dynamics of a country's currency toward the rest of the world. One takes a basket of different currencies , select a more or less meaningful set of relative weights , then computes the " effective " exchange rate of that country's currency.

Some countries impose the existence of more than one exchange rate, depending on the type and the subjects of the transaction. Multiple exchange rates then exist, usually referring to commercial vs. This situation requires always some degree of capital controls. In many countries, beside the official exchange rate, the black market offers foreign currency at another, usually much higher, rate.

When the exchange rate can freely move , assuming any value that private demand and supply jointly establish, " freely floating exchange rate" will be the name of currency institutional regime.

Equivalently, it is called " flexible " exchange rate as well. If the central bank timely and significantly intervenes on the currency market, a " managed floating exchange rate regime" takes place.

The central bank intervention can have an explicit target, for example in term of a band of currency acceptable values. In "freely" and "managed" floating regimes, a loss in currency value is conventionally called a "depreciation", whereas an increase of currency's international value will be called "appreciation". Symmetrically, the yen has undergone an 8.

But central banks can also declare a fixed exchange rate , offering to supply or buy any quantity of domestic or foreign currencies at that rate. In this case, one talks of a "fixed exchange rate". Under this regime, a loss of value, usually forced by market or a purposeful policy action, is called a "devaluation", whereas an increase of international value is a "revaluation". The most stabile fixed exchange regimes are backed by an international agreement on respective currency values, often with a formal obligation of loans among central banks in case of necessity.

A " currency crisis" is a rupture of fixed exchange rates with an unwilling devaluation or even the end of that regime in favour of a floating exchange rate.

It can dominate the attention of the public, policymakers and entrepreneurs, both in advance and after. For instance, people expecting a crisis can borrow inside the country, convert in a foreign currency, lend that money e. When the crisis comes, they sell the bonds, convert to the national currency, pay back their loans, and gain a hefty profit. An extreme national engagement to fixed exchange rates is the transformation of the central bank in a mere " currency board " with no autonomous influence on monetary stock.

The bank will automatically print or lend money depending on corresponding foreign currency reserves. Thus, exports , imports and capital inflows e. FDI will largely determine the monetary policy. Monetary unions phase out the national currencies in favour of one new or existing. Some further countries can target to join the union and put in place economic and financial policies to that aim, especially if there are explicit conditions for entering into that monetary area.

Exiting a monetary union can provoke with large devaluation of the new national currency. Depending on trade elasticities , on foreign debt of the country, on how the exit is managed and on the overall institutional conditions, this can lead to massive internal poverty or a large export led-growth. Determinants of the nominal exchange. Fixed exchange rates are chosen by central banks and they may turn out to be more or less accepted by financial markets.

Changes in floating rates or pressures on fixed rates will derive, as for other financial assets , from three broad categories of determinants: Let's see them separately for the case of the exchange rate. Exports , imports and their difference the trade balance influence the demand of currency aimed at real transactions. A rising trade surplus will increase the demand for country's currency by foreigners, so that there should be a pressure for appreciation.

A trade deficit should weaken the currency. Were exports and imports largely determined by price competitiveness and were the exchange rate very reacting to trade unbalances, then any deficit would imply depreciation, followed by booming exports and falling imports.

Thus, the initial deficit would be quickly reversed. Net trade balance would almost always be zero. This is hardly the case in contemporary world economy. Trade unbalances are quite persistent , as you can verify with these real world data. Additionally, not so seldom, exchange rates go in the opposite direction than one would infer from trade balance only.

An even more radical form of real determination of exchange rate is offered by the " one price law ", according to which any good has the same price worldwide, after taken into account nominal exchange rates. If a hamburger costs 3 US dollars in the United States and 30 yen in Japan, then the exchange rate must be 10 yen per dollar. The forex market would passively adjust to permit the functioning of the "one price law".

But in order to equalise the price of several goods, more than one exchange rate may turn out to be "necessary". Moreover the "one price law" seems to suffer from too many exceptions to be accepted as the fundamental determinant of exchange rates. Large, persistent and systematic violations of Purchasing Power Parity are connected to price-to-market decisions of firms in this paper of September Monetary and financial variables in cross-linked markets.

Interest rates on Treasury bonds should influence the decision of foreigners to purchase currency in order to buy them. In this case, higher interest rates attract capital from abroad and the currency should appreciate.

Decisive would be the difference between domestic and foreign interest rates, thus a reduction in interest rates abroad would have the same effects.

Similarly other fixed-interest financial instruments could be objects of the same dynamics. Accordingly, an increase of domestic interest rates by the central bank is usually considered a way to "defend" the currency. Nonetheless, it may happen that foreigners rather buy shares instead of Treasury bonds.

If this were the strongest component of currency demand, then an increase of interest rate may even provoke the opposite results , since an increase of interest rate quite often depresses the stock market, favouring a tide of share sales by foreigners.

In the same "reversed" direction foreign direct investments would work: If FDI are mainly attracted by sales perspectives and they constitute a large component of capital flows, then FDI inflow might stop and the currency weaken.

Needless to say, those conditions are quite restrictive and not so usually met. A matter of discussion would be whether the relevant interest rate is the nominal or the real one which, in contrast with the former, keeps into account inflation.

Usually foreign investors do not purchase bread, clothes, and the other items included in the bundle used to compute price level and its dynamics: So nominal rates are more likely to be taken into account. As a temporary conclusion, interest rates should have an important impact on exchange rate but one has to be careful to check additional conditions.

Inflation rate is often considered as a determinant of the exchange rate as well. A high inflation should be accompanied by depreciation. The more so if other countries enjoy lower inflation rates, since it should be the difference between domestic and foreign inflation rates to determine the direction and the scale of exchange rate movements.

All this would be implied by a weak version of "one price law" stating that price dynamics of a good are the same worldwide, after taking into account nominal exchange rates. Thus, here not absolute level but just the percentage differences in price are requested to be equalised. But in order to equalise the price dynamics of different goods, more than one exchange rate change may turn out to be "necessary".

In reference to the overall price level of the economy, if exchange rates would move exactly counterbalancing inflation dynamics, then real exchange rates should be constant. On the contrary, this is not true as a strict universal rule. Still, even if this weak version of the "law" does not always hold, high inflation usually give rise to depreciation , whose exact dimension need not match the inflation itself or its difference with foreign inflation rates.

The balance of payments can highlight pressures for devaluation or revaluation, reflected in large and systematic trend of foreign currency reserves at the central bank. In particular, large inflows, due for instance to a rise in the world price of main export items, tend to raise the exchange rate. Autonomous dynamics on the forex market. Past and expected values of the exchange rate itself may impact on current values of it. The activities of forex specialists and investors may turn out to be extremely relevant to the determination of market exchange rate also thanks to their complex interaction with central banks.

Sophisticated financial instruments like futures on exchange rates may play an important role. Imitation and positive feedbacks give rise to herd behaviour and financial fashions.