Intl Economics – Chapter 11: Foreign Exchange

[Music] I study international economies, from the perspective of a US citizen currently livingin the USA.

I tend to state all prices and costs in USDollars.

It is my known currency, and a default currencyaround the globe.

But, as you begin to travel internationally,and work with foreign nationals who base their prices and costs on different currencies,you start to understand the need to comprehend currency exchanges, valuations, and crosscurrency exchange rates.

In this chapter we will discuss the natureand operations in foreign exchange markets.

I begin by describing the foreign exchangemarket and types of foreign exchange transactions.

Emphasis is placed on the interbank marketfor foreign exchange.

This is where the action happens.

We consider both the forward market and futuresmarket, two very related, but different terms, that you should understand and know how theydiffer.

To find out, we will explore the market forforeign currency options.

The role of the International Monetary Marketof the Chicago Mercantile Exchange is emphasized in this section.

We will discover how the determination ofthe equilibrium rate of exchange in a free market is made, using the sources of demandfor foreign exchange and supply of foreign exchange.

We make a distinction between the exchangerate of one currency in terms of another currency and the resulting trade-weighted value, alsocalled an effective exchange rate.

Finally we will examine the nature and operationof uncovered interest arbitrage and covered interest arbitrage.

The chapter concludes by examining foreignexchange market speculation.

In addition, there is a segment on ForeignExchange Trading as a career.

[Music] if you have ever traveled to a foreigncountry you may have needed to exchange your money if so you've alreadyparticipated in forex trading Forex is the short form of foreign exchange wellForex is a bit more than that for example companies buy goods from othercountries in order to buy them they need to obtain the local currency first justlike us when going on holiday the difference is they will exchange hugeamounts when these companies exchange these huge amounts they will actuallymove the price because the demand for the currency that they need increaseswhen the demand increases the price increases with all this exchanging goingon around the world the exchange rates constantly move this is how it workswhen currencies are exchanged they have a certain price the exchange rate as inany market the price of a currency is determined by the law of supply anddemand if there are many people or companies that want to change euros intodollars the price of the dollar will rise against the euro and so theexchange rate will change let's use an everyday example to explain how you canactually profit from this say you live in Europe and went on holiday to theUnited States let's say that you changed your 500 euros into US dollars at therate of 1 point 4 dollars for every euro you got seven hundred US dollars but youdo not spend any money at all so you still have 700 dollars after you comeback after the exchange rate moved from one point four to one point threeinstead of getting just 500 euros back you actually get five hundred and thirtyeight and a half euros you have gained thirty eight and a half years simplyfrom holding your money in dollars while the exchange rate changed this isessentially how we trade in the forex market we buy a certain amount of acurrency hold on to it whilst the exchange rate moves then change it backmaking money along the way how to decide when the right time to buy and sell isexactly what we teach you throughout the rest of our learning lessons as you canimagine traveling a lot and saving a bit of money on your holiday budget and thenexchanging it it's not really a practical approach to trading currenciesfortunately there is an easier way to do this you can trade currency throughonline exchange offices called brokers what this means is that you can exchangecurrencies online throughout the day and take advantage of the constantlyfluctuating exchange rates just as in the example of when you went on holidayyou can buy different currencies and make a profit as the exchange rateschange this is trading the forex market The Foreign Exchange Market commonly calledthe forex, FX, or just Currency Market, is a global decentralized market where largeinternational banks trade currencies.

In terms of the volume traded daily, it isby far the largest market in the world.

The Exchange Market is where the relativevalues of currencies are determined, through up to the minute exchange rate fixes.

The exchange of currencies by banks and tradershappens in all parts of the world, making the currency markets large and liquid, theyare believed to be the most efficient financial markets anywhere.

The Foreign Exchange Market is not a singleexchange floor, it is a global network of people and connected computers.

The main foreign exchange trading centersare in London and New York City, although Tokyo, Hong Kong and Singapore each tradesignificant volumes.

The Foreign Exchange Market is not a singlecentral trading location, like the New York Stock Exchange, or the London Stock Exchange,forex is a decentralized trading platform located in currency trading centers in everycountry, serving as anchors of trading between all types of buyers and sellers around theclock.

The foreign exchange market is where the relativevalues of different currencies are determined and reported.

These Foreign Exchange Markets operate at3 levels; commercial bank level, interbank level, and in active trading in foreign exchangewith multinational banks.

During an exchange transaction, one partypurchases a needed currency by paying with a different currency.

It might be a US business importing somethingfrom Japan, with payment required in Yen, even though its available currency is in USdollars.

The American company will make payment totheir commercial bank's foreign exchange department in Dollars, the bank's foreign exchange brokerwill perform the currency transfer at the current exchange rate between Yen and Dollarsadvancing payment to the seller, through the banking system delivering Yen.

The Seller is paid, and the buyer is charged.

In retail currency exchange markets, wheresmall sums are exchanged, a different buying rate and selling rate will be quoted by moneydealers.

Most trades are "to" or "from" the local currency.

The buying rate is the rate at which moneydealers will buy foreign currency, and the selling rate is the rate at which they willsell the currency.

The quoted rates incorporate an allowancefor a dealer's margin, their profit-risk-and-expense allowance.

Transactions reference currency pairs, suchas Euros changed for US Dollars, making the pair EUR/USD, a widely traded pair.

This makes a quotation of the relative valueof the Euro for the US Dollar.

The currency that is used as the referenceis called the Base Currency and the currency that is quoted in relation is called the QuoteCurrency or Counter Currency.

In this case, the EUR/USD 1.

1027 means thatone Euro can buy 1.

1027 US Dollars.

The Euro in this case is the Base Currencyand the US Dollar is the Quote Currency.

[Music] Exchange of currency occurs almost continuouslyas a matter of commercial commerce.

Transaction of currencies between banks isnot necessarily a physical swap of paper-money, it is an electronic exchange of up to threetypes of transactions: spot, forward, and swap.

A Spot Transaction is the fastest type ofbanking trade, normally taking two-days to complete.

This trade is a direct exchange of two currencies,requiring the shortest amount of time.

On the SPOT Transactions involve brokers exchangingcash rather than writing a contract.

Spot trading is one of the most common typesof Forex Trading.

Most often, a forex broker will charge a smallfee to the client to roll-over the expiring transaction into a new identical transactionfor the trade.

The two-day turnaround is shorter with somecurrency exchanges, such as trades between commonly traded currencies like the US dollar,Canadian dollar, and Euro, which generally settle the same day, or the next businessday.

A roll-over fee is known as the "Swap" fee,and is a variable rate charged by the broker.

If the client is trading a large sum, thefee per unit of currency can be negotiated down, but small sums, under $50,000 US Dollars,generally receive standard broker rates.

When departing from the immediacy of a Spottransaction, traders can seek time-delayed exchanges.

However, the specifics of future date transactionsleave future Spot transaction details unknown.

Risk is introduced and traders seek methodsto reduce these risks where affordable.

One way of dealing with foreign exchange risksis to engage in a Forward Transaction.

In this transaction, money is exchanged atan agreed future date by the buyer and seller.

The agreement is made for an exchange rate,at a specific date.

The duration of the trade can be one day,a few days, months or years.

Forward Transactions give flexibility to buyersand sellers to establish expectations of currency values to coincide with future commercialactivities.

Assume a Canadian export company is sellingUS$1 million worth of goods to a U.

S.

company and expects to receive payment a yearfrom now.

The Canadian exporter is concerned that theCanadian dollar may strengthen from its current rate of 1.

2730 a year from now, which meansthat it would receive fewer Canadian dollars expressed as US dollars paid on delivery.

The Canadian exporter negotiates a ForwardContract with the US buyer to sell US$1 million a year from now at a forward rate.

Let's take a look at how this is calculated:Assume the current spot rate for the Canadian dollar of USD1 = CAD1.

2730, and a one-yearinterest rate for Canadian dollars of 3%, and a one-year interest rate for US dollarsof 1.

5%.

After one year, based on interest rate parity,USD1 plus interest at 1.

5% would be equivalent to CAD1.

2730 plus interest at 3%.

Working it out, USD1.

015 = CAD1.

3112, or USD1= CAD1.

2918.

Compare that to the current Spot exchangerate at 1:1.

2730, and see the difference of the forward rate at 1:1.

2918.

The forward contract assumes the CAD willappreciate.

By locking in the forward rate and term, theexporter has benefited by CAD18,800, versus selling the USD1 million at the current spotrate of CAD1.

2730.

On the other hand, if the spot rate a yearfrom now drops to USD/CAD1.

2500, meaning the CAD weakened contrary to the US Dollar, theexporter would have lost CAD23,000 by committing to the Forward Transaction with these terms.

Currency markets are not a sure thing, sobe confident about the estimates you make into contracts; they are binding on both parties.

The most common type of forward transactionis the foreign exchange swap.

These are agreements to carry a currency exchangebetween two foreign parties.

It consists of swapping principal and interestpayments on a loan made in one currency for principal and interest payments of a loanof equal value in another currency.

These are not standardized contracts and arenot traded through an exchange.

A deposit is often required in order to holdthe position open until the transaction is completed.

These are encumbered when a company in thefirst nation loans money to a company in another nation, it may be for a business related productionexpense necessary for delivery of the exchange of goods.

The receiving company invests the capitalin their business, located in the second country, and the interest identified in the contractreflects an interest rate anticipated in that second country.

The Foreign Exchange Swap enables the forwardcontract with the exchange of the currency, and interest on the loan, denoted in expected exchange rate migrations over the contract's term.

It is more complicated than a straight ForwardContract, but it gives both parties more leverage, and more risk, in contract term negotiations.

Globally, Spot Transactions and Foreign ExchangeSwaps account for about 80% of foreign exchange transactions seen in the world.

[Music] Interbank trading is situated within bothretail and wholesale transaction levels, generally categorized based on the number of currencyunits as above or below 1 million units.

Retail banks dealing with currency exchangeare located within all commercial banks of a country.

A few large international banks in the UShave active currency trading operations with offshore branches, or active accounts withforeign banking centers.

When clients need to exchange the domesticcurrency for an equivalent amount of a different currency, the client moves deposited fundsto the local branch, the money is moved to a correspondent account at one of the largebanking centers, and converted currency is made available through reverse channels.

The result is generally a Spot Transaction,but not exclusively.

Keep in mind, the international currency exchangeplatform is the largest exchange system in the world, dealing with the equivalent ofmillions of dollars hourly.

Banks provide the service to their clientsof exchanging currencies.

These services require trained people responsiveto continuously changing situations in many locations around the globe.

The level of currency exchange sensitivityrequires constant attention.

You should treat currencies as a commoditybought and sold as if it were gasoline or automobiles.

Cross currency prices fluctuate, generallywithin small ranges, and sometimes in large swings.

Because of the high stakes involved, a systemof currency exchange parameters has been developed, allowing brokers to interact efficiently whileconducting trades.

The initiating bank will make both a Bid Rateand an Offer Rate for a currency pair on the Spot Market.

It might be USD/EUR at Bid Rate 0.

90623, Offer Rate 0.

90723, with a Spread of0.

0010.

The spread is the gap between the two rates,and allows the bank to cover expenses and turn a profit.

This price quote of USD/EUR is an exampleof bid/ask notation for USD/EUR: 0.

90623/0.

90723, the spread is 0.

0010, a narrow overhead reservedfor large exchanges.

In this example, the bank would generate a$1,000 fee on a $1 million exchange, where the bank simultaneously purchases and sellsthe foreign currency.

Brokers of currencies deal in speculationby attempting to anticipate the strengthening and weakening of currencies against each other.

A large bank may increase their bid pricefor another currency to boost their position on a target currency, thus capturing the profitswhen the cross-currency rates change.

It takes an able banking analyst to executetrades like this.

Generally, they are enhanced with up to thesecond global trading computer networks, with a commensurate number of multinational tradinganalysts.

[Music] Currency exchange rates are reported on severalonline sites, available on-demand for users.

When you find an online reporting site, makesure you verify the currency of their quotes, and that the terms are stated clearly.

Generally, the rates reported are the mid-pointbetween the bid and offer prices, so it is doubtful that you could get, or receive, exactlythat rate for your currency exchange.

On this online conversions website, the ratequoted is the Bid price for the currency pair, not the mid-range between bid and offer.

Be aware of the accuracy and your understandingwhen you conduct your transactions.

I talked about the broker who may increasepurchases of a currency because they anticipate a Currency Appreciation with respect to anothercurrency.

This happens when the anticipated exchangerate of Country 1 experiences an increase in value as compared to Country 2.

These are only seen in respect to floatingexchange rate systems.

Currency Depreciation is the opposite effect.

Keep in mind one currency may increase invalue, simultaneously with another currency.

But their relations to other currencies maydiverge in cross-currency valuation terms.

If the Canadian dollar depreciates relativeto the Euro, the exchange rate of the Canadian dollar rises: it takes more Canadian dollarsto purchase 1 Euro: we may currently be at 1 EUR=1.

40 CAD, Canadian dollars, but anticipateit to depreciate to a new exchange rate of 1 EUR=1.

50 CAD.

When the Canadian dollar depreciates relativeto the Euro, Canadian goods become more competitive on world markets because their price whenexchanged to Euros becomes lower.

This results in an increase of Canadian exports.

Simultaneously, European sellers will be lesscompetitive in Canada, because European products converted to Canadian Dollars from Euros willbe more expensive in Canada.

The Cross-Currency Exchange rate is used tomake conversions between foreign currencies, like the Canadian Dollar and the Chinese Yuan.

It is used when you have data about the exchangerates between a third currency, like the US Dollar, and each of the target currencies.

The fraction of their cross-currency ratesgenerates the exchange rates between the target currencies.

In today's interconnected world, tables likethis are available, but as always check the date and time of report.

[Music] I have talked about the Spot Markets, ForwardMarkets and Currency Swaps, and now I introduce you to the Currency Futures Market.

A Currency Futures Contract specifies theprice at which a currency can be bought or sold at a future date.

Currency future contracts allow investorsto hedge against foreign exchange risk, or to speculate in anticipated favorable currencyvalue swings.

Futures Contracts are offered by an underwriterand made available to investors.

Unlike the Forward Markets where the partiesin the exchange are linked through commerce, the Futures Market participants are speculatorswho usually exit their positions before the dates of settlement, so most contracts donot tend to last until the scheduled date of delivery.

These are investment tools.

Currency Futures contracts are marked-to-marketdaily, investors can exit, or divest, their obligation to buy or sell the currency priorto the contract's delivery date.

Currency Futures set the exchange price whenthe contract is signed, and establish a pre-determined future delivery date.

The Chicago Mercantile Exchange takes CurrencyFutures into the realm of the Commodity Futures market.

Agricultural commodities like corn, wheat,beef, and pork have been traded on the Chicago Mercantile Exchange since it opened in 1971.

In 1972, the International Monetary Market,or IMM, was introduced to formalize the futures of currencies by pioneering the trading ofinternational financial derivatives.

The IMM is especially popular with smallerbanks, domestic companies, and individuals wanting to participate in currency speculationwith a global footprint.

Here recognize the major differences betweena Forward Contract and a Futures Contract.

We have discussed a few intended uses foreach type.

One of the key characteristics between thesecontracts is that a Forward Contract contractually obligates the parties to carry out the transactionat the agreed rate and time, even if the market has substantially changed since the date ofsigning.

A Futures Contract is handled differently,and we will explore these arrangements next.

The Chicago Mercantile Exchange maintainsa reporting protocol for currency traders to view market data, updated during tradingdays.

The reports include daily criteria, like open,close, high and low exchange rates.

These are valuable for active traders buyingand selling contracts needing up to the minute reports.

People deal in futures contracts for pricediscovery, which helps predict future spot prices; hedging, which protects against futureprice declines and anticipates future rising prices; and speculation.

A speculator does not own or take possessionof the commodity, he or she only hopes to profit from the rise or fall of the priceof the contract.

Hedgers are traders that actually own theunderlying commodity, and also hope to profit from their transactions.

[Music] A Foreign Currency Option gives the holderthe right to buy or sell a fixed amount of foreign currency, at an agreed price, on anagreed date.

The holder, also called the buyer can choosethe exchange rate and term to guarantee.

The holder of the contract has the RIGHT tobuy or sell at the contracted terms, but not the OBLIGATION.

The first option is a Call Option, givingthe holder the right to buy foreign currency at the agreed rate.

The second is the Put Option, giving the holderthe right to sell the foreign currency at an identified rate.

The price of the specified currency pair iscalled the Strike Price.

While the Holder of the contract is underno obligation, the Writer of the contract is under contractual obligation and must performwithin the terms specified.

Foreign Currency Options are used by multinationalcorporations negotiating sizable deals with foreign companies who will pay in the foreigncurrency.

Often, contract terms will specify a deliverydate, and payment terms.

An American company may enter into a one-yearagreement with a Chinese firm to sell timber products, as round logs, to a Chinese lumbermill.

The agreement may be for 12 months, with weeklyshipments scheduled as an agreed-on price, payable in Chinese Yuan.

The American firm is concerned with exchangerate risk, as it considers if the Yuan devalues during the one-year period, the contract'svalue converted into Dollars will devalue as well.

In order to hedge against the loss in revenue,the American firm may purchase Put Options enabling it to sell Chinese Yuan for US Dollarsat the specified rate.

When the Put Option is secured by the US timbercompany, the risk of the Chinese Yuan dropping in value relative to the US Dollar is limitedto the cost of the initial Put Option.

On the other hand, if the Yuan rises in value,relative to the US Dollar, the Timber company can bypass the Currency Options alternativeand trade currencies on the Spot market.

This form of hedging your revenue or coststream is bounded only by the cost of the Put Option and your time.

[Music] Thinking of currencies as commodities is newterritory for many of us, but really it is not as abstract as we may think.

Once, the gold standard was globally recognizedas the monetary system in which the standard economic unit of account was based on a fixedquantity of a commodity – gold.

Now we go full circle as currencies are traded.

How do we determine the free market pricefor currencies? We will take a look.

We explored the importance of a nation's Balanceof Payments in Chapter 10, and how the debit items are tallied based on foreign demandfor domestic goods and assets.

This gives expression to the demand for foreignexchange as a derived demand.

The value of a foreign currency in the UnitedStates is influenced by the demand for foreign currency in the domestic market used to purchasegoods from other nations, using foreign currency.

While the demand side of the Balance of Paymentsledger is driven by the Debits side of the Balance of Payments, the Credits side of theledger refers to the amount of foreign exchange that will be offered to the market at variousexchange rates, driving the Supply of Foreign Exchange.

It hinges on the desire of the foreign currencyusers, to import and pay for US made goods and services, lend funds and make investmentsin the US, and repay debts to US lenders.

On this chart, we see Dollars per Pound onthe Y axis, and Pounds on the X.

British Pounds are displayed as Supply withthe schedule for the demand of foreign exchange, generated from the US Balance of Paymentsstatement.

This intersection identifies the exchangerate between the currencies, US Dollar and British Pound.

The equilibrium price shown here identifiesthe exchange rate, 2 US Dollars per Pound, with 3 billion pounds exchanged.

Foreign exchange markets, for the major currencies,are precisely cleared, leaving neither excess supply, nor excess demand.

Shifts in demand and supply happen for a varietyof economic and political reasons making new equilibrium shifts migrate the currency pairprices.

Currency pair time-series valuations are usefulfor everyone involved in currency exchange activities.

It is important to understand that two tradingpartners, in different countries, will experience socio-economic trends affecting their individualcurrency values.

These trends are realized on the currencypair exchange rate.

However, if the trading partner countriesexperience similar currency valuation shifts, their cross-currency exchange may be minimal.

At the same time, the exchange rates betweeneither country and a third country might signal the appreciation, or devaluation of the subjectcurrencies.

For this reason, it is advisable to trackcross-currency rates between several nations to understand changes to the specific valuesof the commodities called international currencies.

[Music] The Effective Exchange Rate Index is a weightedaverage of exchange rates of domestic versus foreign currencies, with the weight for eachforeign country equal to its share in trade.

These are most useful for time series trackingof the subject currency against other most-traded currencies.

Trends and cycles are identified within theserecords, generally exceeding five-year periods, extending to many decades.

The Nominal Exchange Rate index refers tothe dollar price of foreign exchange, but does not reflect changes in price levels,or inflation, for the domestic or foreign currencies.

It provides a price level comparison acrosscurrencies, based on the transactions as they happened.

When kept in these Nominal terms, index valuechanges through time periods, indicates appreciation or devaluation of the domestic currency inreference to the other currencies.

By keeping inflationary factors embedded inthe nominal values, it gives indication of how each nation's prices respond to macro-economiccycles.

A problem of interpreting the Nominal ExchangeRate Index is that prices are not constant through time.

In the US, they change in response to competition,the value of the dollar, and in response to the value of our trading partner's currency.

From this report, it is impossible to determineif the price change was unilateral, or country-specific.

The Real Exchange Rate is the relative priceof goods across countries, incorporating changes in economic factors.

Hence, changes in the real exchange rate affectthe competitiveness of traded goods.

The Real Exchange Rate is the nominal exchangerate adjusted for relative price levels.

Both price level entries are measured in unitsof domestic currency per unit of foreign currency.

This example addresses the Nominal ExchangeRate for the US Dollar and Euro was $0.

90 per euro in 2013, and $0.

80 in 2014, showinga drop in competitiveness of US Goods relative to European goods.

Now incorporating a consumer price index,we set 2013 to the base year with a cross-currency value of 100.

By 2014 the US consumer prices increased to108, while European prices increased to 102.

The Real Exchange Rate in 2014 reveals a rateof $0.

7556, indicating that US Goods are less competitive on the European market, seen becausethe US Dollar appreciated in Nominal Terms while US prices increased faster than Europeanprices.

In Nominal Terms, the US Dollar appreciatedby 11% against the Euro, with Nominal Exchange Rates moving from $0.

90 to $0.

80, but in RealTerms it appreciated by 16%.

This gives a clearer picture of the relativestrength of the currencies comingled with the change in prices.

Think of the Nominal Exchange Rate as therate you can buy another currency using your primary currency.

It might be holding US Dollars and wantingto buy Euros.

It is an exchange of currencies.

The Real Exchange Rate incorporates the abilityof each currency to purchase goods and services.

Each exchange is influenced by a broad rangeof factors, but the Real Exchange Rate generates the comparison between them through time.

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Is under way.

Today we saw the Rubel open quite weak, finallybreaching the 40 level.

It is worth noting that on Friday, late hourstrading, we already saw these levels so today this is just the natural continuation of thesetrends.

In terms of currencies, we can talk of changesas Appreciation and Depreciation in respect to what can be bought with the monetary unit.

If you are limited to only one country, inAutarky, you may not recognize your currency's purchasing power changes.

If your country is involved in internationaltrade, the effects might be seen, or they may go unnoticed.

The Real Exchange Rate gives us the measureof a currency's relative change with respect to other currencies.

These relative changes can be measured worldwide,or they can be discovered one commodity at a time.

We will take a look at one simple commodity,a bottle of milk.

Currently a liter of milk sells for $0.

90in Seattle, and €1.

23 in Paris.

For this single commodity, the Real ExchangeRate is influenced by the relative price competition between countries for the commodity specifically,and generally – by the purchasing power of the individual currencies.

We can push the numbers through our Real ExchangeRate calculator to discover how the $0.

90 that bought a liter of milk in Seattle, wouldonly get me 67.

5% of a liter of the same milk in Paris.

This 67.

5% conversion is applicable only toa liter of milk, but you can create these for the commodity you produce for internationaltrade.

When your commodity's value is less than parity,meaning it is less than one, you have profitable export opportunities.

We have been exploring several aspects ofeconomic realities to determine relationship between currencies and product prices.

This is because the Real Exchange Rate isthe relative price of goods across countries.

Hence, changes in the Real Exchange Rate affectthe competitiveness of traded goods.

Common sense tells us prices will equalizewithin a short time, and when it does we call it Purchasing Power Parity.

More on that soon! [Music] When applied to currencies, Exchange Arbitrageis seen when cross-currency exchange rates equalize across all currency markets.

With market Arbitrage in effect, brokers canfind the Spot exchange rate for US Dollars to Euros in New York for 1:0.

90481, and findthe inverse exchange rate for Euros to US Dollars in Bonn, West Germany for 1:1.

10521.

In reality, the rates will be loaded witha conversion fee, but Arbitrage gives a simultaneous currency price in all locations.

The factor underlying the uniformity of exchangerates is called Exchange Arbitrage.

Because currency markets operate as one globalmarket, exchange rate differential opportunities are rare, but possible.

I share example with you now from 1998 whenI was the CEO and General Manager, operating a logging camp in the Russian Far East, harvestingtimber from Russian forestlands.

Logs were sorted and placed on ships boundfor the west coast of Japan and to South Korea.

The buyers were Japanese companies payingin Yen and South Korean companies paying in Won.

My operation was a joint venture, Americanand Russian.

A challenge was found when converting Yenor Won into Rubles.

Very little trade was enacted immediatelyafter the collapse of the Soviet Union with Japan or South Korea, so Supply and Demandbetween these currencies was soft.

However, the Russian Federation was sellinggas to Europe in large volumes.

The Ruble/Euro exchange was active.

Substantial trade was, and still is, enactedusing the Euro/Yen and Euro/Won exchanges.

Converting Yen and Won to US Dollars was partof commonly traded pairs, so US operations were paid through existing FOREX markets andno currency arbitrage was needed.

We used the Exchange Arbitrage strategy toconvert the Yen and Won paid for timber, to exchange it favorably for Euros, which werethen exchanged for Rubles so we could pay our Russian staff their salaries, the Federaland Krai governments their taxes, and to cover the Russian costs of operations in Rubles.

At the time, it facilitated internationaltrade between these countries.

It remains a viable alternative for tradingpartners to consider, especially when political constraints are put on a country that is alsoinvolved in international trade.

Suppose that baskets of goods are producedin the US and Germany, both identical, and all goods were tradeable.

In that case, net of transportation costs,we would have the law of one price: arbitrage would insure that the dollar prices of thevarious goods would be identical across countries.

This yields a theory of exchange rate determinationknown as Purchasing Power Parity, or PPP.

We have explored how exchange rates adjustto compensate for currency movements along the valuation horizon.

Commodity prices move as well, and when theirprice movements are out of the range of the currency movements, prices can leave the rangeof parity between markets.

These events give rise to hedging opportunitiesfor traders in buy and sell decisions.

Currencies are exchanged on the basis of theirsupply and demand factors integrating the relative economic conditions of their hostnations.

Although I recommended you consider currenciesas commodities, the extension of that label reaches only so far as their entrance intoexchange markets.

Commodities enter into arbitrage opportunitiesas production costs, tax systems, and government regulations change cost profiles to producegoods.

When prices for similar commodities in differentmarkets diverge, consumer opportunities for arbitrage are available.

The same situation happens to product priceswhen countries migrate to different price levels, dragging the currency valuations askewof their former relative value.

There are several causes of this migration,but currency supply and demand factors show the relative adjustments for the Nominal ExchangeRates, and therefore affect Real Exchange Rates.

Purchasing Power Parity gaps are sometimesfound between currency markets.

These arise when traders can find price gapsbetween brokers for different currencies.

It might be in a Two-Point Arbitrage situationwhere US Dollars buy Euros in New York, and the proceeds are immediately used to sellEuros for Dollars in London.

If the prices are such that favorable differencesare available, the trader can make a risk-free profit.

These opportunities are rare.

More intricate, and potentially profitable,is a three-point arbitrage opportunity.

This happens when three currencies are tradedwithin three trading centers.

In this case US Dollars are traded for Britishpounds, in the second, British pounds are traded for Swiss francs, and in the thirdSwiss francs are traded for US Dollars.

In our theoretical example, the arbitragerstarted with US$1.

5 million and turned a cool half-million for the efforts, less any expenses.

This is not dissimilar to the example I sharedwith you from 1998 as I sold Russian timber for Yen and Won, traded it for Euros, andpurchased Rubles.

It was not a profit seeking endeavor, insteadit was a strategy to maintain currency values during transactions.

Poly-Point Arbitrage can include more currencies,and more trading centers.

This type of currency trading is not illegal,but in today's world of interconnect computer systems and optimized processing centers,opportunities like this can be found.

[Music] Participants in a Forward Market enter intoa contract to exchange currencies, not today, but at a specified date in the future, typically30, 60, or 90 days from entering the contract, and at an agreed forward exchange rate.

The exchange rate is agreed at the time ofcontract signing, but payment is not made until the actual delivery date.

These contracts are made by big-players interms of the currencies available to the Forward Market Contract, the big commercial businessesinvolved, and the large banking centers who underwrite the contracts.

These are not generally entered for less than$1 million each.

They are made profitable for the underwritingbank by initiating currency transactions between many customers and many currencies.

The banks manage the spreads on their currencies,and in effect, create their own arbitrage opportunities with minor deviations betweenbuy and sell agreements.

The banks turn a profit from these activities.

The rate of exchange used in the settlementof forward transactions is called the forward rate.

In forex, the Forward Rate specified in anagreement, is a contractual obligation that must be honored by the parties involved.

Forward rates are widely used for hedgingpurposes in the currency markets.

Currency forwards can be tailored for specificrequirements, unlike futures, which have fixed contract sizes and expiry dates and thereforecannot be customized.

Administered similar to the Spot Market interms of cross-currency value, the Forward Rates are stalled in respect to the date ofagreement and the date of execution.

When the foreign currency is worth more inthe forward market than the Spot market, the rate is said to be at a Premium.

When it is less, it is called a Discount.

The Forward Rate is calculated with the ratesapplied in reference to the Spot market on the date of agreement, adjusted for the timespan involved, usually expressed as annualized rates.

In this example, we look a one month forwardfor British pounds selling for $1.

6036, while the Spot rate was $1.

6039.

Because the forward rate was less than theSpot price, the pound was at a one-month forward discount of 0.

22% per annum against the dollar.

Here see example of one-month Forward Ratesfrom 2013 for the Yen and Pound expressed in US Dollars.

Setting of the rates is dependent on expectedmarket shifts, overhead expenses, and premiums or discounts applied by the banks.

Currency Market investors with a high risktolerance, will seek currencies where the first country currency is experiencing highinterest rates and a counter currency country is experiencing low interest rates.

It might be the UK with high inflation andthe USA with a low interest rate in comparison.

That risk-tolerant speculator will buy poundswith dollars in the spot market and sell pounds for dollars in the forward market.

Because the interest rate is high in the UK,within a short amount of time the Spot price goes from $2.

00 per pound to $2.

01 per pound.

At the same time, the Forward price of thepound falls by a similar amount to $1.

99 per pound.

The small simultaneous shifts between Spotand Forward prices enables the speculator to capture value with perfect timing.

Of course, it can be lost just as fast.

When managing international business activities,businesses will prepare proposals, develop cost and price scenario, arrange timing details,and await concurrence with their business partners.

Contracts can take days, weeks, or even monthsto complete.

Generally, cost scenarios will change withinthe time it takes to execute an agreement, and currency values will shift.

Time is on the side of the last one to theparty, because the first in the door has the oldest time sensitive values.

When the agreement is inked, contracts takeon the challenge of time of delivery and payment.

We have looked at options for commercial businessesto enter into Forward and Futures Markets, but each option costs the business money.

When should hedging be used as a risk reductiontool? When hedging against potential losses, thecompany is interested in finding the optimal operations zone of lowest costs to achievea desired risk reduction level.

You would break even if you try to save $100,000in currency devaluation changes, but the Forward Contract you bought cost $100,000.

Conversely, you would accept a $10,000 costof the same level of protection.

But the situation might also turn out thatthe currency devaluation risk turned into an appreciation event, making the $10,000cost – worthless.

It is a sunk cost, so the cost is non-refundable.

Some businesses take an aggressive protectionstance, covering their exposure to an acceptable level; others take currency changes as partof the business risk profile and live in the balance.

These decisions are economic choices, madeby a business overall, or one project at a time.

[Music] Investors make financial decisions by comparingthe rates of return of foreign investments with those of domestic investments.

Uncovered Interest Arbitrage involves switchingcurrencies from domestic tender, carrying a lower interest rate, to a foreign currencythat offers a higher rate of interest on deposits.

There is a foreign exchange risk implicitin this transaction since the investor or speculator will need to convert the foreigncurrency deposit proceeds back into the domestic currency at some point in the future.

The term "uncovered" in this arbitrage scenariorefers to the fact that this foreign exchange risk is not covered through a forward or futurescontract Covered Interest Rate Arbitrage uses favorableinterest rate differentials to invest in a higher-yielding currency, and hedging theexchange risk through a Forward or Futures Currency Contract.

The cost of hedging the exchange risk canbe less than the additional return generated by investing in a higher-yielding currency,if the higher yielding currency delivers the anticipated returns.

Such arbitrage opportunities are uncommon,since market participants will rush in to exploit an arbitrage opportunity when oneis found, and the resultant demand will quickly redress the imbalance.

An investor undertaking this strategy is makingsimultaneous spot and forward market transactions, with an overall goal of obtaining risk freeprofit through the combination of currency pairs.

Covered Interest Arbitrage is not withoutits risks, which include differing tax treatment in various jurisdictions, foreign exchangeor capital controls, transaction costs and bid-ask spreads.

As you consider these values, understand thepotential differences, shown here, result in a small-percent gap.

If you are dealing with large sums of capital,it may be attractive.

But these do not just leap onto the accountof the multi-national company, it takes concentrated time and action to position the firm to captureit.

Many businesses are focused on the goal ofmanufacturing a product or providing a service, and delivering that core business activity.

Seeking marginal gains from currency tradesis often overlooked, or shunted to specialists managing these aspects of the business' operations.

Sometimes it makes a shining marginal gain.

Other times, it is a setback to an otherwisesuccessful operation.

[Music] The foreign exchange market is often usedfor exchange rate speculation.

Speculators ultimately are a stabilizing influenceon financial markets, by stabilizing speculation and providing a market for hedgers transferringrisk from people who "don't wish to bear risk", to those who "will just do it".

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

According to some economists, individual tradersact as "noise traders" and have a more destabilizing role than larger and better-informed investmentprofessionals.

At the same time, the rise in algorithmicforeign exchange auto-trading has increased from 2% in 2004 up to 40% by 2010, makingautomated speculation precise and immediate.

Currency speculation is considered a highlysuspect activity in some countries, flirting with criminal behavior.

While investment in traditional financialinstruments like bonds or stocks is positive for economic growth by providing capital,currency speculation serves only the speculator's bank account.

It does not serve the purpose of growing aneconomy.

Antagonists see a link between speculators,who take advantage of market disruptions and destabilized economies, to the point speculatorsmay initiate destabilizing activities to reap profitable gains.

Taking a snapshot of algorithmic foreign exchangeauto-trading in YouTube, you can find hundreds of positive software solutions and opinionsabout how to make your name as a FOREX trader, with little or no experience.

This is the noise traders just mentioned,but these are also used by the well capitalized "position traders" to test their speculations.

[Music] Interested in a Foreign Exchange Trading Career? Your job prospects may be with a bank or acompany involved in foreign trading activities, or you might join the squads of day-tradersfrom the comfort of your personal computer.

Starting from home does not mean you muststay there.

But success does not mean you should leavethere either.

Entry into these positions is targeted ateither technically proficient trading specialists capable of predicting event outcomes basedon experience and economic knowledge.

Others in this industry hold specific knowledgeabout certain economic sectors, blended with economic event knowledge making speculationpossible.

Still, others are involved in the day-to-dayoperations of banking activities to make trades and exchanges on behalf of clients.

I have enjoyed a top 10 list published byequities.

Com giving the budding Foreign Exchange Trader advice about the chosen career.

If this fits your personality, you might builda career! I covered the broad topic of Foreign ExchangeMarkets, and discussed their operations.

I described the foreign exchange market andthe types of foreign exchange transactions, with emphasis placed on the interbank marketfor foreign exchange transactions.

We considered the forward market and futuresmarket and also the market for foreign currency options.

The role of the International Monetary Marketof the Chicago Mercantile Exchange was emphasized.

We spent time to understand how the equilibriumrate of exchange in a free market is determined, and identified how sources of demand for foreignexchange and the supply of foreign exchange are recognized.

We made distinction between the exchange rateof one currency in terms of another currency and the trade-weighted value of a currency,leading to the effective exchange rate.

Finally, we examined the nature and operationof uncovered interest arbitrage and covered interest arbitrage as a means of hedging againstpotential losses from currency exchanges while examining foreign exchange market speculation.

We concluded with a segment on Foreign ExchangeTrading as a career.

Multinational companies are in the positionof concentrating their businesses on making a manufactured product or providing a service,often delivering a combination of the two to companies located in other countries.

These factors are the focus of their businessenterprise and cross-currency exchange rates with Forward, Futures, interest rates, arbitrageand speculation not being the highest topics of attention.

This is where the specialist with skills andunderstanding of these events can serve the multinational enterprise to insure capitalflows are facilitated, and even increase net returns through astute planning.

It might be the trajectory you find most interestingfor your career.

[Music].

Source: Youtube

Intl Economics - Chapter 11: Foreign Exchange

We consider both the forward market and futures market, two very related, but different terms, that you should understand and know how they differ. To find out, we will explore the market for foreign currency options. The role of the International Monetary Market of the Chicago Mercantile Exchange is emphasized.
We will discover how the determination of the equilibrium rate of exchange in a free market is made, using the sources of demand for foreign exchange and supply of foreign exchange. We make a distinction between the exchange rate of one currency in terms of another currency and the resulting trade-weighted value, also called an effective exchange rate.