Covering Currency Markets

Atiya Hussain

Foreign exchange, the business of trading the world’s currencies, comprises a huge, busy market that is never officially closed, not even for major holidays. The average daily turnover in April 2007 was $3.2 trillion, according to the Bank of International Settlements (BIS), the central bank of central banks. This was up about 70 per cent from the previous figure for April 2004. The BIS said this was because of a substantial increase in investor activity, much of it through hedge funds, over the previous three years.

The vast majority of foreign exchange, or forex, trading involves the currencies of the world’s biggest economies – the U.S. dollar, the Japanese yen and Europe’s single currency, the euro. In 2007, the euro/dollar currency pair was the most traded, accounting for 27 percent of the global turnover in forex markets. Dollar/yen transactions comprised another 13 percent of global turnover. Trade in currencies of emerging market countries contributed to 20 percent of total activity, up from as little as 4.5 in 2001.

For more details see the Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity published by BIS in 2007.

Foreign exchange trading continued to expand despite the credit crisis that took hold in 2008, going into 2009. The uncertainty associated with the growing economic crisis makes it difficult to know what the outlook is for the currency markets.

A Brief History

Forex deals exist because people conduct international transactions, that is, people buy and sell goods and services across national borders. It would, at first glance, seem logical to conclude that currency markets have always been a major part of the financial world. In fact, governments decided only relatively recently to let markets determine the value of their currencies. It was only in the 1970s, with the collapse of the Bretton Woods agreement and its system of keeping major currencies in fixed exchange rates, that the world moved to the financial system – and financial volatility – we are so familiar with today.

Founded in 1944 in the middle of war and after years of negotiations, the Bretton Woods system aimed to manage international finance and trade through a gold exchange standard. Exchange rates of the major currencies were fixed in terms of the dollar, and the dollar itself was pegged to gold. By pegging the value of their currency to the dollar – and, in the case of the U.S. government to gold – governments pledged to defend the pegged parity of their currency. This meant governments had to be willing and able to sell (or buy) foreign reserves whenever market demand for foreign currency was greater (or smaller) than demand for domestic currency.

Thus, the risk of currency fluctuations was borne by governments. Companies experienced little forex risk, which in turn meant there was little need for large-scale currency trading facilities that today are a major part of the banking system. The Bretton Woods system provided remarkable stability in currency markets, with only a few adjustments over about 25 years.

All that changed in 1971, when U.S. President Richard Nixon halted the Treasury’s sales and purchases of gold. The decision followed an increase in movements of speculative capital that pressured the gold-fixed exchange rate of the dollar. By the middle of the 1960s, official dollar holdings outside the United States came to exceed the value of the U.S. gold stock and the basic equation underlying the Bretton Woods agreement – that gold was worth $35 an ounce – began to be increasingly questioned.

Nixon’s decision marked the beginning of the end of the Bretton Woods system and fixed exchange rates. The pound sterling was allowed to float – trade freely in forex markets – against the dollar in 1972; the yen and major European currencies were floated the following year. Also in 1973, Canada, Germany and Switzerland abolished restrictions on the movements of capital. The United States followed suit and liberalized capital markets in 1974. Now, of course, countries that still impose controls on their domestic markets or on capital flows are seen as oddities.

Under the flexible exchange rate system that now governs most of the world’s currencies, demand and supply of currencies in the forex market determine exchange rates. Unlike in the Bretton Woods years, currency risk and financial risk have generally been privatized – individual investors must fend off or suffer financials risks themselves. International capital flows have grown exponentially since the 1970s as the new environment of financial risk (currency fluctuations, movements in international capital) has forced investors to hedge that risk even as speculators have embraced risk as a means of making money. In 1973, daily foreign exchange trading around the world ranged between $10 billion to $20 billion. Contrast that with the BIS estimate of $3.2 trillion daily turnover in 2007.

Two of the exceptions to flexible exchange rates you might encounter while covering forex markets, are currency pegs and currency boards. Neither currency management system is determined by the market, so reporters will not have to monitor the fixed rates as closely as they would track the dollar/yen currency pair, for example. Because governments must maintain the pegs and currency boards they have chosen – sometimes a costly responsibility – dealers and speculators will watch for any sign of policy shift away from the peg/board. Reporters would do well to keep an eye open for such hints, too. Speculators in currency markets have been known to act on the slightest indication that a government is having trouble living up to the task of maintaining the exchange rate it chose to fix. If currency X’s peg is considered to be at too strong a valuation, for example, speculators who are skeptical of the government’s ability to maintain the pegged rate may start selling X in anticipation of X’s devaluation. This speculative selling further pressures the peg, makes the government’s task even harder and sometimes forces devaluation in spite of the government’s best efforts to defend the peg.

Currency pegs, which fix the value of the domestic currency to another currency, became a topic of debate during and after the Asian Financial Crisis of 1997. The currency pegs of many fast-growing Asian countries came under speculative attack in foreign exchange markets, and governments that could no longer afford to maintain their pegs had to devalue their currencies. The currency turmoil was accompanied by a massive outflow of capital, which in turn had the real economic effect of a wrenching downturn in the region. While currencies such as the Thai baht were floated, other countries such as China shelved goals to make its renminbi fully convertible. The Chinese currency was informally pegged to the U.S. dollar from 1994 but in recent years has been allowed to shift slowly according to a complex formula adopted by the People’s Bank of China, the central bank.

A crawling peg system is one in which monetary authorities, sometimes in a discreet fashion and sometimes automatically, re-examine the peg and adjust it. This more flexible system allows for a gradual and less disruptive devaluation (or revaluation) of a currency.

The introduction of a currency board affords a country a particularly firm commitment to a fixed exchange rate. Under this scenario, the domestic currency is fully backed by a foreign currency such as the U.S. dollar or some other hard currency. Domestic monetary authorities set a fixed exchange rate against the foreign currency and stand ready to exchange the local currency for the foreign one at this established rate whenever the public requests it – allowing for full convertibility between the domestic and anchor currencies. The currency board system usually means a country has to maintain a level of reserves with which to ensure the convertibility of the domestic currency to the anchor.

A typical fixed exchange rate system leaves authorities some monetary policy tools – such as control of interest rates or money supply via printing new bills. But monetary authorities operating under a currency board, by contrast, can only increase money supply if they have enough foreign currency reserves to back the increase in domestic money. In a typical currency board, interest rates adjust automatically to offset changes in demand for the foreign currency. If demand for, say, dollars increases, domestic interest rates will rise till they eventually become attractive enough for investors to hold the local currency.

One that has been written about the most is Argentina’s unorthodox board. Adopted in 1991 in an effort to end a cycle of inflation and monetary instability and unorthodox because not all typical aspects of a currency board were included, Argentina’s convertibility laws fixed the peso/dollar exchange rate at one-to-one. Domestic contracts in foreign currency became legally enforceable. This effectively removed control of monetary policy from the Argentine central bank. Initially, this radical policy – part of a package of trade liberalization, deregulation and privatization – was extremely effective in bringing down inflation and boosting growth. But pressure on the system built as the dollar appreciated throughout the 1990s, making Argentine goods less competitive. After neighboring Brazil devalued its currency in 1999, Argentina found itself even worse off. Trade and investment were hurt, paving the way for four years of recession and Argentina’s ultimate abandonment of the currency peg in 2002. The relief that followed was accompanied by several years of strong export-led growth.

An even more extreme policy measure, especially attractive to governments wanting to avoid speculative attacks, is dollarization, which does away with the local currency altogether and replaces it with a hard currency such as the dollar. Following a series of economic crises, Ecuador decided in 2000 to replace the sucre with the dollar in an effort to curb rampant inflation. Unofficial dollarization can occur without formal legal approval, when a foreign currency is used extensively alongside the local currency. (See Dollarization primer on this website.)

Quoting Exchange Rates

Unlike commodity markets, where one tracks the price of a good such as gold or oil, currency transactions are always relative. In forex markets one is always quoting a pair of currencies, which means one could as easily quote the dollar/yen exchange rate as the yen/dollar rate. Typically, however, forex dealers quote the currency pair in terms of yen per U.S. dollar. In market short-hand, dollar/yen at 117.50 means a dollar is currently worth 117.50 yen.

There are two notable exceptions to this quote-convention: both the euro and the pound sterling exchange rate are quoted in terms of dollars per euro and sterling, respectively. For example, a euro/dollar at $1.1285 means that each euro is currently worth 1.1285 U.S. dollars – the dollar is thus worth less than the euro. Parity is often used to refer to a euro/dollar exchange rate of $1.00, that is, when the dollar is worth the same as the euro. A euro/dollar exchange rate of $0.9870, by contrast, would mean that the dollar is worth more than the euro. You can find out how many euros the dollar is worth by taking the inverse of the euro/dollar rate. In this case, 1/0.9870 = 1.0132, so the dollar would buy 1.0132 euros at this exchange rate.

The other currency pair that is often closely watched is the sterling/dollar exchange rate, referred to by many traders as cable. Here, too, the norm is to quote the rate in terms of dollars per sterling. Thus, cable at $1.6026 means that one British pound is currently worth 1.6026 U.S. dollars.

The sterling and euro currency pair is quoted as euro/sterling – the number of sterling that the market would be willing to exchange for a single euro. This currency pair is an example of a cross rate, an exchange rate that is less closely tracked by the general forex market and of greater interest to specialist traders. You will often hear dealers at Asian or Japanese banks talk about yen crosses, by which they mean the exchange rates of the yen against currencies such as the euro, sterling, the Australian dollar or the Swiss franc.

Spot vs forward transactions

All forex deals are agreements to buy or sell a currency at a specific rate against another currency (price) and apply to a specific date. That date can be off in the distant future, in which case the transaction is known as a forward deal. Typically, forward transactions are not more than a year ahead. Deals beyond five years are very rare.

Spot transactions are more immediate. A spot deal is an agreement to buy/sell a currency at the current exchange rate and will typically be completed within the following two business days. You will often hear references to the bid – the price a dealer is willing to pay for a currency – and the ask price, the price at which a currency is being offered for sale. The bid-ask spread, is the amount by which the ask price exceeds the bid price. A wide spread indicates illiquid trading conditions.

Derivatives

Forward deals are a form of insurance against the risk that exchange rates will change between now and the delivery date of the contract. A forward is a simple kind of a derivative – a financial instrument whose price is based on another underlying asset. The price in a forward contract is known as the delivery price and allows the investor to lock in the current exchange rate and thus avoid subsequent forex fluctuations.

Financial innovations have provided investors with new means of hedging the risk of moves in currencies or interest rates and/or to speculate on the future. Hedgers, such as producers of commodity products, seek to protect themselves from adverse changes in the underlying cash price that may impact their business. Speculators include investors and traders who want to profit from volatile prices.

Futures, another form of derivative, began to develop in the mid-1970s. A futures contract is a legal agreement to make or take delivery of an asset at a certain time in the future and at a certain price. Unlike a forward deal, an exact delivery date is usually not specified in a futures contract. A futures contract is normally traded on an exchange that specifies certain standardized features of the contract. The Chicago Mercantile Exchange (CME), for example, offers futures and options contracts on a number of currencies.

Options allow investors even greater flexibility. Although more expensive than futures contracts, options are valued because they allow investors to choose whether to exercise a futures contract or not. The option-holder is under no obligation to buy or sell the underlying asset. Call options give an investor the right, but not the obligation, to purchase the indicated asset at a specified (strike) price by a certain date. An investor who buys a call option is hoping, or betting, that the price of the asset will rise above the strike price. Put options give the option-holder the right, but not the obligation, to sell the security by a certain date. The purchaser of a put option is hoping or betting that the price of the asset will fall below the contract’s strike price.

A swap, another form of derivative, allows investors to exchange future cash flows. Swaps can be arranged with interest rates or with currencies. The simplest form of currency swap would involve exchanging payments on principal and interest in one currency for principal and interest payments in another currency.

Economic Theory Behind Exchange Rates

While financial journalists will rarely deal with long-term values of currencies in their day-to-day monitoring of the forex market, the economic theory behind exchange rates is governed by the ‘law of one price’ – if two countries produce an identical good and if transportation costs and trade barriers are low, the price of the good should be the same across national boundaries. Applying this law of one price to price levels in various countries, economists derive the theory of purchasing power parity (PPP) which is often used by analysts to estimate whether the current exchange rate of a currency is ‘overvalued’ or ‘undervalued’ relative to the long-term rate. According to PPP, if prices in Japan go up 10 percent relative to the price level in the United States, the dollar should appreciate in the long-term by 10 percent to maintain the law of one price.

The Big Mac Index published by The Economist magazine is a good example of a PPP comparison.

Using McDonald’s Big Mac as the identical good produced in more than 100 countries, the Economist publishes a list of Big Mac prices in local currencies, converts those local prices into dollars at the current exchange rate, and calculates the implied PPP (the local price of the Big Mac divided by the U.S. price of the burger). Since, according to PPP theory, a dollar should buy the same number of burgers irrespective of country, the index gauges whether a currency is too strong, or overvalued, against the dollar or too weak, or undervalued, relative to the dollar.

According to the February 2009 Big Mac index, the price of the burger in Switzerland (Swiss francs 6.50) when divided by the actual exchange rate (1.16 francs per dollar) is $5.60 – much higher than $3.54, the dollar price of the burger in the United States. This disparity can also be seen in the implied PPP – the hypothetical exchange rate at which a Big Mac would cost the same in the United States and in Switzerland – given in the index as 1.84. Because the implied PPP is higher than the actual exchange rate (1.16), it can be seen from this simplified index that the Swiss franc was overvalued relative to the dollar by 58 per cent at the time the index was constructed.

What this also shows is that forex markets do not necessarily value currencies at their long-term exchange rates. Other factors govern forex market valuations on a day-to-day basis.

Interest rates play an important role for investors looking for the best returns because they can influence investors’ expectations of future growth – lower interest rates boost investment and, therefore, should encourage economic growth. Thus, if country A has higher interest rates than country B, demand for A’s currency is likely to be higher, since investors buying assets in currency A will derive higher returns from A’s higher interest rates. Even expectations that country A is likely to raise interest rates could have the same effect of boosting demand for currency A, since investors who are fairly certain of the rate increase will prefer to buy ahead of the rate hike to ensure they get the most returns from the interest rate differentials.

Inflation is also an important factor. The nominal interest rate – which ignores inflation – is of less interest to investors looking for high returns than the real, or inflation-adjusted, interest rate. If country A’s high interest rates are eaten away by high inflation, then investors may end up preferring country B’s investments if low inflation in B means that B’s real rates are higher than A’s real rates.

Similarly, relative economic growth and expectations that one country’s economy will outperform that of another country are important in currency markets. The relative performance of other markets, such as stock or bond markets, or expectations about future market performance can also affect currency trading.

The world’s leading countries have been known to take policy decisions that can affect currencies for years, which is why forex markets always closely monitor meetings such as those of the Group of Seven (G7) most industrialized countries or bilateral summits of, say, the United States and Japan. One of the most famous examples of such multilateral action in currency markets is the Plaza Accord of September 1985, when the United States, Japan, Germany, France and the United Kingdom agreed to weaken the dollar. From September 1985 to early 1987, the dollar shed about a third of its value.

Forex markets also tend to closely monitor domestic debates on currency policy and interest rate policy, decisions to join, say, the single European currency, and outcomes of elections that might determine monetary policy. Thus, the currency market tracks a hodge-podge of macroeconomic data such as unemployment figures and industrial production as well as policy developments and relations between countries.

The profound problems in all markets during the spreading economic crisis of 2008 and beyond played havoc with the forces of the foreign exchange markets as investors fled anything that seemed in the slightest bit risky. The result was a surge in the dollar on the one hand and – as the so-called “yen carry trade” (borrowing in low-interest yen and investing in high-yielding assets elsewhere) went into reverse – a similarly large rise in the Japanese currency. The pound, on the other hand, fell precipitously as a result of the UK’s exposure to the financial sector, while the euro held its ground as the European Central Bank appeared still marginally more concerned about maintaining the currency’s value than slashing interest rates to try to restore growth.

Monitoring Currency Markets

Given the vast turnover in forex markets, currencies change valuations all the time in the spot market. Familiarizing yourself with the magnitude of a change is extremely important. Blips that keep a currency within an established trading pattern could be explained by a large deal, a modest reaction to newly released macroeconomic data or a rumor. The foreign exchange market is one where rumors are regularly floated and it is crucial to check facts very closely before reporting or spreading a rumor.

Typically, forex markets will be well-positioned before major economic data are released. Currency analysts from a range of banks will have issued their forecasts for key reports well before the economic data are actually published. Should analysts generally predict a report consistent with a strong economy, dealers are likely to buy up that country’s currency, or establish long positions, before the report is released. If the data are in line with expectations of big banks and other players in the market, the release of the data will probably not have much effect on trading. However, if most players were long and the data happened to be unexpectedly downbeat and indicative of economic weakness, the currency might fall quite sharply after the data are released as dealers dump their holdings of the currency and ‘unwind’ their long positions. The currency’s drop will depend on how aggressively positioned the currency market had been, but eventually trading should settle back down into a range that might be slightly weaker than before the data were released.

The opposite of a long position is a short position, where investors sell a currency that they do not own but have borrowed. Since investors must buy back the currency before closing out the position, a trader goes short in the hope of cashing in on a fall in the currency.

A rapid and large spike in any currency, however, MUST be investigated and quickly. As a rough gauge, a move within minutes of around $0.50 in the euro/dollar exchange rate or 1 yen in the dollar/yen or euro/yen rates is extremely large. Foreign exchange markets, even when volatile, are not likely to move that much that quickly unless some fundamental change has occurred somewhere.

Understanding the difference between a slight shift and a large jump comes with experience, but when in doubt, the best thing to do is to call a trader. Major banks will tend to see more of the activity in the market, but word gets around quickly and smaller banks may be more willing to take your call – even when things are very busy. Some smaller banks may actually be better sources if they are specialized in a particular section of the market, such as Scandinavian, or Asian currencies, for example.

The reason for a huge spike could be a speech from a major policy-maker who is, unexpectedly, giving clues about his/her country’s prospects about joining the single European currency. The reason behind a large movement could also be an explosion. It could be a terrorist attack. Even data that indicate an unexpected and decisive change in the global/regional economic climate could explain a large move.

Or it could be intervention, that most dreaded word in foreign exchange.

Intervention

Just because many governments adopted free-floating currencies after the Bretton Woods system broke down doesn’t mean they will sit by and watch their currencies become too strong or too weak. An overly strong currency makes that country’s exports relatively more expensive and, therefore, uncompetitive in the global marketplace – a development that an export-dependent economy cannot afford to leave unchecked for too long. An overly weak currency, meanwhile, is often seen as something to avoid because of political reasons such as nationalism. Inflationary pressures within a country may also be exacerbated by a weak currency that, by making imports more expensive, imports inflation.

Whatever their reasons, a country’s monetary authorities can step into foreign exchange markets to buy their own currency if they want to prop it up, or sell their currency if they are trying to offset an overly strong currency. When authorities wield their substantial reserves to buy or sell their currency, it is likely to soar/slide sharply in the blink of an eye. If a chart you are using to track minute-by-minute moves of the forex market suddenly becomes impossibly steep, you are probably seeing an intervention spike: you should seek confirmation of government action. Monetary authorities might buy/sell their currency against only one other currency, or they might buy/sell their currency against a range of other currencies. So you might see the spike in only one currency-pair’s chart, or you might see many such spikes.

Intervention is a powerful weapon, wrenching currencies out of whatever range they had been trading in. Often, monetary authorities are happy to confirm that they took action in the currency market. Intervention is a clear expression of authorities’ dislike of recent forex trends – whether it was the appreciation/depreciation of their currency relative to that of a major trading partner, or that their currency had moved too rapidly.

Nonetheless, monetary authorities may have good reasons for keeping their forex interventions quiet. A discreet operation, which leaves the market with the perception of increased demand or supply in the currencies involved, may change market positioning without requiring further intervention. Unconfirmed rumors, or a vague sense that authorities are concerned and might be acting covertly might also make forex dealers cautious of buying/selling a currency past levels that might trigger further government action, thus serving the central bank’s purpose of keeping a currency from appreciating/depreciating much more. Similarly, if an intervention operation involved a number of other countries, the authorities coordinating the intervention might be willing to confirm it while partner countries might prefer to remain quiet.

Interventions are very busy and very hectic, as traders try to react as quickly as they can to a government’s huge spurt of buying/selling. Just trying to get traders to confirm whether intervention really took place is likely to be difficult. Always try to ask a few trusted and well-placed traders ahead of time whether you can call them for confirmation at the first sign of any intervention-like spike.

You will also hear the term sterilization. Since intervening authorities end up with a huge influx of currency – domestic if the intervention was meant to shore up their own currency, foreign if the intent was to weaken the domestic currency – a country’s central bankers must also take into account the effect of intervention on the country’s monetary base. The U.S. Federal Reserve, for example, routinely sterilizes intervention to offset any impact on U.S. banking reserves. In the case of intervention to weaken the dollar, U.S. authorities’ dollar sales would add reserves to the U.S. banking system. Sterilization would then involve a reduction of banking reserves, perhaps through the sale of government securities, so that the aggregate level of bank reserves would ultimately not change.

In the United States, the Treasury has the primary responsibility for international financial policy. Thus U.S. currency policy - for example ‘the strong dollar’ policy made famous by Treasury Secretary Robert Rubin in the 1990s - is formulated in Washington, D.C. Decisions on forex market interventions, however, are made in conjunction with the Federal Reserve, the U.S. central bank.

The New York branch of the 12-bank Federal Reserve system is responsible for executing monetary policy and ensuring an elastic currency. The New York Fed is also the institution that conducts forex intervention. It has intervened to slow rapid moves in exchange rates and to signal the U.S. monetary authorities’ view that the exchange rate was out of step with fundamentals, or fundamental economic conditions. Historically, the New York Fed has intervened in spot markets and not in forwards markets or in other derivatives. The U.S. Treasury typically confirms U.S. intervention while the Fed is conducting the intervention or shortly after the intervention is over.

One should be very careful when reporting interventions, since it could well be that U.S. monetary authorities are intervening on behalf of a foreign authority, such as Japan’s Ministry of Finance. A foreign central bank can instruct the New York Fed to conduct an open intervention operation, in which case the New York Fed would deal directly with interbank dealers in the forex market. In an open intervention, the Fed would confirm it is acting on behalf of the foreign central bank while the operation was being conducted. The foreign central bank could also request a discreet operation, in which case the Fed would enter into the brokers' market through a selected interbank dealer under a confidential agreement.

Japanese law authorizes the Ministry of Finance (MOF) to conduct intervention as a means to achieve foreign exchange stability, but it does this via the Japanese central bank, the Bank of Japan (BOJ). Technically, then, it is incorrect to say the BOJ intervened, although that is what traders will tell you if indeed they see Japan’s monetary authorities buying or selling in forex markets. Japanese monetary authorities usually intervene during Tokyo trading hours but can request foreign central banks – the European Central Bank (ECB) as well as the New York Fed – to intervene using Japanese funds outside Asian trading hours on behalf of the MOF.

The European Central Bank (ECB) has also intervened when it felt that the single European currency’s value was not in line with fundamentals. The ECB has intervened alone and in conjunction with the central banks of other G7 most industrialized countries.

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