Introduction to Currency Market

1. Introduction to Currency Market The Marketplace The Currency Exchange Trading Arena October 2008 Nordon Company

2. The Agreement • the Bretton Woods Agreements was signed during the first three weeks of July 1944. Setting up a system of rules, institutions, and procedures to regulate the international monetary system including World Bank and International Monetary Fund ratified by many countries. • The Agreement obligated each member country to adopt a monetary policy that maintained the exchange rate of its currency within a fixed value—plus or minus one percent—in terms of gold with IMF acting as an equalizer of temporary imbalances of payments. • In the face of increasing strain, the system collapsed in 1971, following the United States' suspension of convertibility from dollars to gold. The industrialized member nations were allowed to float their currency with United States Dollar as the "reserve currency". • Shortly after, in 1973, the first major currencies futures contracts were allowed to trade on Chicago Mercantile Exchange ushering a non banking market for trading currencies.

3. Terminology Foreign currency is a term used in domestic retail banking for tourism and general commerce. Currency exchange usually refers to trading of any currency pairs, used among traders. Exchange rate is used in technical analysis, modeling, etc. Market size: Nearly 2 trillion dollars are traded daily worldwide. The breakdown is roughly 40% spot, over 50% forwards and the rest futures and options The Currency grouping Major: USD, Euro, JY,GBP, and CH Commodity dependent: AUD, NZD,CAD and ZAR Exotic (mostly in Asia): limited availability for online trading. Less liquid currencies: Emerging countries. Currency Exchange Marketplace

4. Currency Exchange Regime • Floating currencies are allowed to fluctuate, without any constraints, but interventions do take place depending on government policies. • US Dollar pegged. Best example is HKD. Fluctuating in a narrowly controlled range • Currency basket. Notably, Chinese Yuan is based on a basket of USD( heavily weighted), Yen and Euro.

5. Nominal Exchange rate • The nominal* exchange rate between two currencies is the number of units of foreign currency that can be traded with one unit of the domestic currency. • Price levels provide a snapshot of prices at a given time, making it possible to review changes in the broad price level over time. The most common price level index is the Consumer Price Index (CPI). PPP exchange rate model equalizes the purchasing power of different currencies in their home countries for a given basket of goods. • For example with US as the base country (ppp = 100), the highest index value, for Bermuda, is 154, so the same goods are 54% more expensive in Bermuda than in the United States. * The real exchange rate (RER) is the number of foreign goods can be gotten in exchange for one domestic good

6. PPP model • A commonly used model of exchange rate (ER) is based on relative purchasing power parity (PPP) between two countries. • Relative PPP requires that percentage change in the exchange rate equals the difference between percentage change in prices of market basket of goods to two countries • It means there is a price parity of basket (or index) of goods in one country relative to another country as determined by rate of exchange. • A well known index used extensively here is Consumer Price Index (CPI). • The assumption of “one-price” is based on validity of PPP holding, that is, the same behavior is expected in both countries . • The reality is much different from the nominal exchange rate that put one dollar equal to 7.8 yuan which is dollar pegged; whereas the World Bank estimated that in 2003, one United States dollar was equivalent to about 1.8 Chinese yuan by purchasing power parity with USD as base country.

7. Do models Work? • Models for predicting the short term movement of exchange rate, based on fundamentals have not been proven accurate, because: • Exchange rates (ER) behave randomly or unpredictably. • Random movement means the spot rate at a given time equals that of previous instant plus an error. • This implies that changes in ER are serially correlated, suggesting that ER is driven by its own past so they appear to respond randomly to information received, but rationally.

8. Currency Trading Arena • Online trading requires no pre-requisites and mostly involves spot trading of USD versus other currencies and is easily available on Internet. • Currency futures and option on futures are traded at Chicago Mercantile Exchange (CME) through registered broker. • Currency options (equity style) are traded at Philadelphia Exchange through registered broker. • Currency forwards are available to business entities through major commercial banks only.

9. A hedging example • Assume an investor has an opportunity to make short term investment in Japan for guaranteed quarterly return of 2 million yen for investment of ( $500,000). • The currency Yen sells spot for 110 Yen to a dollar, 55 million Yen. The 90 day forward delivery is 109 yen. • Investor will sell his $ for spot Yen and buys equivalent 90 day forward Yen ( assuming he has credit arrangement with bank). • Investor is then guaranteed to receive 57,000,000/109 =$522,355. • There are three scenarios: • Rates remain unchanged at which time investor’s gain in the investment compensates the cost of currency hedge: ($4,173)=[(57,0000,000/109)-(57,000,000/110)] = (522,355-518,182) • Dollar has appreciated and Yen is now worth 115. Investor’s original investment of 55 million Yen plus gain in investment of 2 million Yen, total of 57 million Yen would now be converted to dollar= $496,700. His loss has wiped out the intended investment return if he had not hedged. • Dollar has deteriorated and the rate is now 105 yen to a dollar. The investor now receives $542,850 which would have been a reward for taking a risk if he had not hedged.

10. Related Issues • Macroeconomic Factors in Modeling • Forecasting • Forwards • FX Swaps • Trading Strategies • New currency applications