foreign exchange market

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Definition

Global market in convertible currencies are traded and their conversion rates are determined. It is the world's largest financial market in which every day, on average, some one and one-half trillion dollar worth of currencies are bought and sold. Out of this only about 15 percent is traded for goods or services, the balance 85 percent is traded by the individual and institutional speculators.

The foreign exchange market (trades currencies. It lets banks and other institutions easily buy and sell currencies. [

The purpose of the foreign exchange market is to help international trade and investment. A foreign exchange market helps businesses convert one currency to another. For example, it permits a U.S. business to import European goods and pay Euros, even though the business's income is in U.S. dollars.

In a typical foreign exchange transaction a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market started forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.

The foreign exchange market is unique because of

its trading volumes, the extreme liquidity of the market,

its geographical dispersion,

its long trading hours: 24 hours a day except on weekends (from 22:00 UTC on Sunday until 22:00 UTC Friday),

the variety of factors that affect exchange rates.

the low margins of profit compared with other markets of fixed income (but profits can be high due to very large trading volumes)

the use of leverage

As such, it has been referred to as the market closest to the ideal perfect competition, notwithstanding market manipulation by central banks. According to the Bank for International Settlements,[2] average daily turnover in global foreign exchange markets is estimated at $3.98 trillion. Trading in the world's main financial markets accounted for $3.21 trillion of this. This approximately $3.21 trillion in main foreign exchange market turnover was broken down as follows:

$1.005 trillion in spot transactions $362 billion in outright forwards

$1.714 trillion in foreign exchange swaps

$129 billion estimated gaps in reporting

The spot price or spot rate of a commodity, a security or a currency is the price that is quoted for immediate (spot) settlement (payment and delivery). Spot settlement is normally one or two business days from trade date. This is in contrast with the forward price established in a forward contract or futures contract, where contract terms (price) are set now, but delivery and payment will occur at a future date. Spot rates are estimated via the bootstrapping method, which uses prices of the securities currently trading in market, that is, from the cash or coupon curve. The result is the spot curve, which exists for each of the various classes of securities.

For securities, the synonymous term cash price is more often used. [edit] Spot prices and future price expectations Depending on the item being traded, spot prices can indicate market expectations of

future price movements in different ways. For a security or non-perishable commodity (e.g., gold), the spot price reflects market expectations of future price movements. In theory, the difference in spot and forward prices should be equal to the finance charges, plus any earnings due to the holder of the security, according to the cost of carry model. For example, on a share the difference in price between the spot and forward is usually accounted for almost entirely by any dividends payable in the period minus the interest payable on the purchase price. Any other price would yield an arbitrage opportunity and riskless profit (see rational pricing for the arbitrage mechanics).

In contrast, a perishable commodity does not allow this arbitrage - the cost of storage is effectively higher than the expected future price of the commodity. As a result, spot prices will reflect current supply and demand, not future price movements. Spot prices can therefore be quite volatile and move independently from forward prices. According to the unbiased forward hypothesis, the difference between these prices will equal the expected price change of the commodity over the period.

A simple example: even if you know tomatoes are cheap in July and will be expensive in January, you can't buy them in July and take delivery in January, since they will spoil before you can take advantage of January's high prices. The July price will reflect tomato supply and demand in July. The forward price for January will reflect the market's expectations of supply and demand in January. July tomatoes are effectively a different commodity from January tomatoes (contrast contango and backwardation).

Forward price

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The forward price (or sometimes forward rate) is the agreed upon price of an asset in a forward contract. Using the rational pricing assumption, we can express the forward price in terms of the spot price and any dividends etc., so that there is no possibility for arbitrage.

Contents

1 Forward Price Formula 2 Proof of the forward price formula

3 Forward versus Futures prices

4 See also

] Forward Price Formula

The forward price is given by:

where

F is the forward price to be paid at time T

ex is the exponential function (used for calculating compounding interests)

r is the risk-free interest rate

q is the cost-of-carry

S0 is the spot price of the asset (i.e. what it would sell for at time 0)

Di is a dividend which is guaranteed to be paid at time ti where 0 < ti < T.

Proof of the forward price formula

The two questions here are what price the short position (the seller of the asset) should offer to maximize his gain, and what price the long position (the buyer of the asset) should accept to maximize his gain?

At the very least we know that both do not want to lose any money in the deal.

The short position knows as much as the long position knows: the short/long positions are both aware of any schemes that they could partake on to gain a profit given some forward price.

So of course they will have to settle on a fair price or else the transaction cannot occur.

An economic articulation would be:

(fair price + future value of asset's dividends) - spot price of asset = cost of capital

Forward price = Spot Price + cost of carry

The future value of that asset's dividends (this could also be coupons from bonds, monthly rent from a house, fruit from a crop, etc.) is calculated using the risk-free force of interest. This is because we are in a risk-free situation (the whole point of the forward contract is to get rid of risk or to at least reduce it) so why would the owner of the asset take any chances? He would reinvest at the risk-free rate (i.e. U.S. T-bills which are considered risk-free). The spot price of the asset is simply the market value at the instant in time when the forward contract is entered into. So OUT - IN = NET GAIN and his net gain can only come from the opportunity cost of keeping the asset for that time period (he could have sold it and invested the money at the risk-free rate).

let:

K = fair price

C = cost of capital

S = spot price of asset

F = future value of asset's dividend

I = present value of F (discounted using r )

r = risk-free interest rate compounded continuously

T = length of time from when the contract was entered into

Solving for fair price and substituting mathematics we get:

where:

(since where j is the effective rate of interest per time period of T )

where ci is the i th dividend paid at time t i.

Doing some reduction we end up with:

Forward versus Futures prices

There is a difference between forward and futures prices when interest rates are stochastic. This difference disappears when interest rates are deterministic.

In the language of stochastic processes, the forward price is a martingale under the forward measure, whereas the futures price is a martingale under the risk neutral measure. The forward measure and the risk neutral measure are the same when interest rates are deterministic.

See Musiela and Rutkowski's book on Martingale Methods in Financial Markets for a continuous time proof of this result. See van der Hoek and Elliott's book on Binomial Models in Finance for the discrete time version of this result.

Factors which influence the exchange rate

Inflation

If inflation in the UK is lower than elsewhere, then UK exports will become more competitive and there will be an increase in demand for £s. Also foreign goods will be less competitive and so UK citizens will supply less £s.

Therefore the rate of £ will increase from say £1=$1.4 to $1.5

Speculation

If speculators believe the sterling will rise in the future They will demand more now to be able to make a profit. This increase in demand will cause the value to rise.

Therefore movements in the exchange rate do not always reflect economic fundamentals, but are often driven by the sentiments of the financial markets

Change in competitiveness

If British goods become more attractive and competitive this will also cause the value of the ER to rise

Relative strength of other currencies

Between 1999 and 2001 the £ appreciated because the Euro was seen as a weak currency

Balance of Payments

A large deficit on the current account means that the value of imports is greater than the value of exports. If this is financed by a surplus on the financial/ capital account then this is OK. But a country who struggles to attract enough capital inflows will see depreciation in the currency.

Interest Rates

The correlation between a nation’s interest rate and its exchange rate is easy to grasp. We would expect savvy investors to invest their money where, for a given level of risk, the returns are highest.  Thus, when a disparity in interest rates exists between countries whose risk of default is equal, investors would likely lend to the country that was offering the higher interest rate.  In order to invest in or lend to another country, one must first obtain that nation’s currency.  This increases demand for that nation’s currency, and causes it to appreciate in value.         

Current-Account / Trade Balance

When a country runs a current account deficit, it typically means that the nation imports more than it exports. This tends to skew the exchange rate in favor of the country that runs a trade surplus, as foreign demand for its currency must be comparatively high. In due course, the exchange rate may adjust so as to make the first nation’s products affordable to foreigners, and bridge the gap between imports and exports.

. Public (government) debt

The relationship between government debt obligations and its exchange rate is not as cut-and-dried. Basically, government borrowing to finance deficit spending increases inflation, which literally eats into the value of that nation’s currency. In addition, if lenders believe there is any risk of default, they may sell the debt (in the United States, this debt takes the form of treasury securities) on the open market, exerting downward pressure on the exchange rate.

Political and Economic Factors

Most investors are risk-averse; accordingly, they will invest their capital where there is a certain degree of predictability. They tend to avoid investing in countries that are typified by governmental instability and/or economic stagnation. In contrast, they will invest capital in stable

countries that exhibit strong signs of economic growth. A nation whose government and economy are perennially stable will attract the most investment. This, in turn, creates demand for that nation’s currency and causes its currency to appreciate in value

Hedge Against Exchange Rate Risk

Investments in overseas instruments such as stocks and bonds can generate substantial returns and provide a greater degree of portfolio diversification, but they introduce an added risk, that of exchange rates. Since foreign exchange rates can have a significant impact on portfolio returns, investors should consider hedging this risk where appropriate. While hedging instruments such as currency futures, forwards and options have always been available, their relative complexity has hindered widespread adoption by the average investor.

On the other hand, currency ETFs, by virtue of their simplicity, flexibility and liquidity, are ideal hedging instruments for retail investors who wish to mitigate exchange rate risk. (For a background on ETFs, check out our Investopedia Special Feature: Exchange Traded Funds.)

Impact of Exchange Rates on Currency Returns

The first decade of the new millennium has so far proved to be a very challenging one for investors. U.S. investors who have chosen to restrict their portfolios to large-cap U.S. stocks have, on average, seen the value of their holdings decline by more than one-third. Over the approximately nine-and-a-half-year period from January 2000 to May 2009, the S&P 500 index fell by about 40%. Including dividends, the total return from the S&P 500 over this period was approximately -26% or an average of -3.2% annually.

Equity markets in Canada, the largest trading partner of the U.S., fared much better during this period. Fueled by surging commodity prices and a buoyant economy, Canada's S&P/TSX Composite index rose about 23%; including dividends, the total return was 49.7%, or 4.4% annually. This means that the Canadian S&P/TSX Composite index outperformed the S&P 500 by 75.7% cumulatively or about 7.5% annually.

U.S. investors who were invested in the Canadian market over this period did much better than their stay-at-home compatriots, as the Canadian dollar's 33% appreciation versus the greenback turbocharged returns for U.S. investors. In U.S. dollar terms, the S&P/TSX Composite gained 63.2%, and provided total returns including dividends of 98.3% or 7.5% annually. That represents an outperformance versus the S&P 500 of 124.3% cumulatively or 10.7% annually.

This means that $10,000 invested by a U.S. investor in the S&P 500 in January 2000 would have shrunk to $7,400 by May 2009. But $10,000 invested by a U.S. investor in the S&P/TSX Composite over the same period would have almost doubled, to $19,830.

When to Consider Hedging

U.S. investors who were invested in overseas markets and assets during the first decade of the 21st century reaped the benefits of a weaker U.S. dollar, which was in long-term or secular decline for much of this period. Hedging exchange risk was not advantageous in these circumstances, since these U.S. investors were holding assets in an appreciating (foreign) currency.

But a weakening currency can drag down positive returns or exacerbate negative returns in an investment portfolio. For example, Canadian investors who were invested in the S&P 500 from January 2000 to May 2009 had returns of -44.1% in Canadian dollar terms (compared with returns for -26% for the S&P 500 in U.S. dollar terms), because they were holding assets in a depreciating currency (the U.S. dollar, in this case).

As another example, consider the performance of the S&P/TSX Composite during the second half of 2008. The index fell 38% during this period - one of the worst performances of equity markets worldwide - amid plunging commodity prices and a global sell off in all asset classes. The Canadian dollar fell almost 20% versus the U.S. dollar over this period. A U.S. investor who was invested in the Canadian market during this period would therefore have had total returns - excluding dividends for the sake of simplicity - of -58% over this six-month period.

In this case, an investor who wanted to be invested in Canadian equities while minimizing exchange risk could have done so using currency ETFs. The following section demonstrates this concept.

Hedging Using Currency ETFs

Consider a U.S. investor who invested $10,000 in the Canadian equity market through the iShares MSCI Canada Index Fund (EWC). This ETF seeks to provide investment results that correspond to the price and yield performance of the Canadian equity market, as measured by the MSCI Canada index. The ETF shares were priced at $33.16 at the end of June 2008, so an investor with $10,000 to invest would have acquired 301.5 shares (excluding brokerage fees and commissions).

If this investor wanted to hedge exchange risk, he or she would also have sold short shares of the CurrencyShares Canadian Dollar Trust (FXC). This ETF reflects the price in U.S. dollars of the Canadian dollar. In other words, if the Canadian dollar strengthens versus the U.S. dollar, the FXC shares rise, and if the Canadian dollar weakens, the FXC shares fall. (Learn more about short selling in our Introduction to Short Selling tutorial.)

Recall that if this investor had the view that the Canadian dollar would appreciate, he or she would either refrain from hedging the exchange risk, or "double up" on the Canadian dollar exposure by buying (or "going long") FXC shares. But since our scenario assumed that the investor wished to hedge exchange risk, the appropriate course of action would have been to "short sell" the FXC units.

In this example, with the Canadian dollar trading close to parity with the U.S. dollar at the time, assume that the FXC units were sold short at $100. Therefore, to hedge the $10,000 position in the EWC units, the investor would short sell 100 FXC shares, with a view to buying them back at a cheaper price later if the FXC shares fell.

At the end of 2008, the EWC shares had fallen to $17.43, a decline of 47.4% from the purchase price. Part of this decline in the share price could be attributed to the drop in the Canadian dollar versus the U.S. dollar over this period. The investor who had a hedge in place would have offset part of this loss through a gain in the short FXC position. The FXC shares had fallen to about $82 by the end of 2008, so the gain on the short position would have amounted to $1,800.

The unhedged investor would have had a loss of $4,743 on the initial $10,000 investment in the EWC shares. The hedged investor, on the other hand, would have had an overall loss of $2,943 on the portfolio.

Currency ETFs Are Margin-Eligible

Some investors may believe that it is not worthwhile to invest a dollar in a currency ETF to hedge each dollar of an overseas investment. However, since currency ETFs are margin-eligible, this hurdle can be overcome by using margin accounts (which are brokerage accounts in which the brokerage lends the client part of the funds for an investment) for both the overseas investment and currency ETF.

An investor with a fixed amount to invest who also wishes to hedge exchange risk can make the investment with 50% margin and use the balance 50% for a position in the currency ETF. Note that making investments on margin amounts to using leverage, and investors should ensure that they are familiar with the risks involved in using leveraged investment strategies. (Read more about leverage in Leverage's "Double-Edged Sword" Need Not Cut Deep.)

The Bottom Line

Currency moves are unpredictable, and currency gyrations can have an adverse effect on portfolio returns. As an example, the U.S. dollar unexpectedly strengthened against most major currencies during the first quarter of 2009, amid the worst credit crisis in decades. These currency moves amplified negative returns on overseas assets for U.S. investors during this period. Hedging exchange risk is a strategy that should be considered during periods of unusual currency volatility. Because of their investor-friendly features, currency ETFs are ideal hedging instruments for retail investors to hedge exchange risk. (Learn about the credit crisis of 2008-2009 in our tutorial Credit Crisis: Introduction and more about currency ETFs in our article Currency ETFs Simplify Forex Trades.)