Foreign exchange market

The foreign exchange market (forex, FX, or currency market) is a global decentralized market for the
trading of currencies. The main participants in this market are the larger international banks. Financial
centers around the world function as anchors of trading between a wide range of multiple types of buyers
and sellers around the clock, with the exception of weekends. Electronic Broking Services (EBS) and
Thomson Reuters Dealing are two main interbank FX trading platforms. The foreign exchange market
determines the relative values of different currencies

The foreign exchange market works through financial institutions, and it operates on several levels. Behind
the scenes banks turn to a smaller number of financial firms known as “dealers,” who are actively involved
in large quantities of foreign exchange trading. Most foreign exchange dealers are banks, so this behind-the-
scenes market is sometimes called the “interbank market”, although a few insurance companies and other
kinds of financial firms are involved. Trades between foreign exchange dealers can be very large, involving
hundreds of millions of dollars. Because of the sovereignty issue when involving two currencies, Forex has
little (if any) supervisory entity regulating its actions.

The foreign exchange market assists international trade and investments by enabling currency conversion.
For example, it permits a business in the United States to import goods from the European Union member
states, especially Eurozone members, and pay euros, even though its income is in United States dollars. It
also supports direct speculation and evaluation relative to the value of currencies, and the carry trade,
speculation based on the interest rate differential between two currencies

In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying for
some quantity of another currency. The modern foreign exchange market began forming during the 1970s
after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system
of monetary management established the rules for commercial and financial relations among the world's
major industrial states after World War II), 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 the following characteristics:

 its huge trading volume representing the largest asset class in the world leading to high liquidity;
 its geographical dispersion;
 its continuous operation: 24 hours a day except weekends, i.e., trading from 22:00 GMT on Sunday
(Sydney) until 22:00 GMT Friday (New York);
 the variety of factors that affect exchange rates;
 the low margins of relative profit compared with other markets of fixed income; and
 the use of leverage to enhance profit and loss margins and with respect to account size.

As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding
currency intervention by central banks.

According to the Bank for International Settlements,] the preliminary global results from the 2013 Triennial
Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity show that trading in
foreign exchange markets averaged $5.3 trillion per day in April 2013. This is up from $4.0 trillion in April
2010 and $3.3 trillion in April 2007. Foreign exchange swaps were the most actively traded instruments in
April 2013, at $2.2 trillion per day, followed by spot trading at $2.0 trillion.

According to the Bank for International Settlements, as of April 2010, average daily turnover in global
foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the $3.21
trillion daily volume as of April 2007. Some firms specializing on foreign exchange market had put the
average daily turnover in excess of US$4 trillion
Determinants of exchange rates

The following theories explain the fluctuations in exchange rates in a floating exchange rate regime (In a
fixed exchange rate regime, rates are decided by its government):

1. International parity conditions: Relative Purchasing Power Parity, interest rate parity, Domestic
Fisher effect, International Fisher effect. Though to some extent the above theories provide logical
explanation for the fluctuations in exchange rates, yet these theories falter as they are based on
challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in
the real world.
2. Balance of payments model: This model, however, focuses largely on tradable goods and services,
ignoring the increasing role of global capital flows. It failed to provide any explanation for
continuous appreciation of dollar during 1980s and most part of 1990s in face of soaring US current
account deficit.
3. Asset market model: views currencies as an important asset class for constructing investment
portfolios. Assets prices are influenced mostly by people's willingness to hold the existing quantities
of assets, which in turn depends on their expectations on the future worth of these assets. The asset
market model of exchange rate determination states that “the exchange rate between two currencies
represents the price that just balances the relative supplies of, and demand for, assets denominated in
those currencies.”

None of the models developed so far succeed to explain exchange rates and volatility in the longer time
frames. For shorter time frames (less than a few days) algorithms can be devised to predict prices. It is
understood from the above models that many macroeconomic factors affect the exchange rates and in the
end currency prices are a result of dual forces of demand and supply. The world's currency markets can be
viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand
factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No
other market encompasses (and distills) as much of what is going on in the world at any given time as
foreign exchange.

Supply and demand for any given currency, and thus its value, are not influenced by any single element, but
rather by several. These elements generally fall into three categories: economic factors, political conditions
and market psychology.

Economic factors

These include: (a) economic policy, disseminated by government agencies and central banks, (b) economic
conditions, generally revealed through economic reports, and other economic indicators.

 Economic policy comprises government fiscal policy (budget/spending practices) and monetary
policy (the means by which a government's central bank influences the supply and "cost" of money,
which is reflected by the level of interest rates).
 Government budget deficits or surpluses: The market usually reacts negatively to widening
government budget deficits, and positively to narrowing budget deficits. The impact is reflected in
the value of a country's currency.
 Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods
and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and
deficits in trade of goods and services reflect the competitiveness of a nation's economy. For
example, trade deficits may have a negative impact on a nation's currency.
 Inflation levels and trends: Typically a currency will lose value if there is a high level of inflation in
the country or if inflation levels are perceived to be rising. This is because inflation erodes
purchasing power, thus demand, for that particular currency. However, a currency may sometimes
strengthen when inflation rises because of expectations that the central bank will raise short-term
interest rates to combat rising inflation.
  Economic growth and health: Reports such as GDP, employment levels, retail sales, capacity
utilization and others, detail the levels of a country's economic growth and health. Generally, the
more healthy and robust a country's economy, the better its currency will perform, and the more
demand for it there will be.
 Productivity of an economy: Increasing productivity in an economy should positively influence the
value of its currency. Its effects are more prominent if the increase is in the traded sector.[73]

Political conditions

Internal, regional, and international political conditions and events can have a profound effect on currency
markets.

All exchange rates are susceptible to political instability and anticipations about the new ruling party.
Political upheaval and instability can have a negative impact on a nation's economy. For example,
destabilization of coalition governments in Pakistan and Thailand can negatively affect the value of their
currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is
perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may
spur positive/negative interest in a neighboring country and, in the process, affect its currency.

Market psychology

Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:

 Flights to quality: Unsettling international events can lead to a "flight to quality", a type of capital
flight whereby investors move their assets to a perceived "safe haven". There will be a greater
demand, thus a higher price, for currencies perceived as stronger over their relatively weaker
counterparts. The U.S. dollar, Swiss franc and gold have been traditional safe havens during times of
political or economic uncertainty
 Long-term trends: Currency markets often move in visible long-term trends. Although currencies do
not have an annual growing season like physical commodities, business cycles do make themselves
felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends.

 "Buy the rumor, sell the fact": This market truism can apply to many currency situations. It is the
tendency for the price of a currency to reflect the impact of a particular action before it occurs and,
when the anticipated event comes to pass, react in exactly the opposite direction. This may also be
referred to as a market being "oversold" or "overbought". To buy the rumor or sell the fact can also
be an example of the cognitive bias known as anchoring, when investors focus too much on the
relevance of outside events to currency prices.

 Economic numbers: While economic numbers can certainly reflect economic policy, some reports
and numbers take on a talisman-like effect: the number itself becomes important to market
psychology and may have an immediate impact on short-term market moves. "What to watch" can
change over time. In recent years, for example, money supply, employment, trade balance figures
and inflation numbers have all taken turns in the spotlight.

 Technical trading considerations: As in other markets, the accumulated price movements in a
currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many
traders study price charts in order to identify such patterns.
Financial instruments – short notes.

Spot Foreign exchange

A spot transaction is a two-day delivery transaction (except in the case of trades between the US Dollar,
Canadian Dollar, Turkish Lira, Euro and Russian Ruble, which settle the next business day), as opposed to
the futures contracts, which are usually three months. This trade represents a “direct exchange” between two
currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in
the agreed-upon transaction. Spot trading is one of the most common types of Forex Trading. Often, a forex
broker will charge a small fee to the client to roll-over the expiring transaction into a new identical
transaction for a continuum of the trade. This roll-over fee is known as the "Swap" fee.

Forward contract

One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction,
money does not actually change hands until some agreed upon future date. A buyer and seller agree on an
exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the
market rates are then. The duration of the trade can be one day, a few days, months or years. Usually the
date is decided by both parties. Then the forward contract is negotiated and agreed upon by both parties.

Foreign exchange swap

The most common type of forward transaction is the foreign exchange swap. In a swap, two parties
exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are
not standardized contracts and are not traded through an exchange. A deposit is often required in order to
hold the position open until the transaction is completed.

Currency future

Futures are standardized forward contracts and are usually traded on an exchange created for this purpose.
The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest
amounts.

Currency futures contracts are contracts specifying a standard volume of a particular currency to be
exchanged on a specific settlement date. Thus the currency futures contracts are similar to forward contracts
in terms of their obligation, but differ from forward contracts in the way they are traded. They are commonly
used by MNCs to hedge their currency positions. In addition they are traded by speculators who hope to
capitalize on their expectations of exchange rate movements.

Foreign exchange option

A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the
right but not the obligation to exchange money denominated in one currency into another currency at a pre-
agreed exchange rate on a specified date. The options market is the deepest, largest and most liquid market
for options of any kind in the world.

Speculation

Controversy about currency speculators and their effect on currency devaluations and national economies
recurs regularly. Nevertheless, economists including Milton Friedman have argued that speculators
ultimately are a stabilizing influence on the market and perform the important function of providing a
market for hedgers and transferring risk from those people who don't wish to bear it, to those who do.
Other economists such as Joseph Stiglitz consider this argument to be based more on politics and a free
market philosophy than on economics.

Large hedge funds and other well capitalized "position traders" are the main professional speculators.
According to some economists, individual traders could act as "noise traders" and have a more destabilizing
role than larger and better informed actors.] Also to be considered is the rise in foreign exchange
autotrading; algorithmic, or automated, trading has increased from 2% in 2004 up to 45% in 2010.

Currency speculation is considered a highly suspect activity in many countries. While investment in
traditional financial instruments like bonds or stocks often is considered to contribute positively to economic
growth by providing capital, currency speculation does not; according to this view, it is simply gambling
that often interferes with economic policy. For example, in 1992, currency speculation forced the Central
Bank of Sweden to raise interest rates for a few days to 500% per annum, and later to devalue the krona. [82]
Former Malaysian Prime Minister Mahathir Mohamad is one well known proponent of this view. He blamed
the devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators.

Gregory J. Millman reports on an opposing view, comparing speculators to "vigilantes" who simply help
"enforce" international agreements and anticipate the effects of basic economic "laws" in order to profit.[83]

In this view, countries may develop unsustainable financial bubbles or otherwise mishandle their national
economies, and foreign exchange speculators made the inevitable collapse happen sooner. A relatively quick
collapse might even be preferable to continued economic mishandling, followed by an eventual, larger,
collapse. Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the blame from
themselves for having caused the unsustainable economic conditions.

Risk aversion

Risk aversion is a kind of trading behavior exhibited by the foreign exchange market when a potentially
adverse event happens which may affect market conditions. This behavior is caused when risk averse traders
liquidate their positions in risky assets and shift the funds to less risky assets due to uncertainty.

In the context of the foreign exchange market, traders liquidate their positions in various currencies to take
up positions in safe-haven currencies, such as the US Dollar. ] Sometimes, the choice of a safe haven
currency is more of a choice based on prevailing sentiments rather than one of economic statistics. An
example would be the Financial Crisis of 2008. The value of equities across the world fell while the US
Dollar strengthened .This happened despite the strong focus of the crisis in the USA.

Carry trade

Currency carry trade refers to the act of borrowing one currency that has a low interest rate in order to
purchase another with a higher interest rate. A large difference in rates can be highly profitable for the
trader, especially if high leverage is used. However, with all levered investments this is a double edged
sword, and large exchange rate fluctuations can suddenly swing trades into huge losses.

Forex signals

Forex trade alerts, often referred to as Forex Signals are trade strategies provided by either experienced
traders or market analysts. These signals which are often charged a premium fee for can then be copied or
replicated by a trader to his own live account. Forex signal products are packaged as either alerts delivered
to a user's inbox or SMS, or can be installed to a trader's trading platforms. Algorithmic trading, whereby
foreign exchange users can programme (or buy ready made software) to place trades on their behalf,
according to pre-determined rules has become very popular in recent years. This means that users can set
their 'Algos' to trade on their behalf, thus reducing the need to sit an monitor the markets continuously, plus
it can remove the element of human emotion around executing a trade.
Exchange Rate

Exchange rates between currencies have been highly unstable since the collapse of the Bretton Woods
system of fixed exchange rates, which lasted from 1946 to 1973. Under the Bretton Woods system,
exchange rates (e.g., the number of dollars it takes to buy a British pound or German mark) were fixed at
levels determined by governments. Under the "floating" exchange rates we have had since 1973, exchange
rates are determined by people buying and selling currencies in the foreign-exchange markets. The
instability of floating rates has surprised and disappointed many economists and businessmen, who had not
expected them to create so much uncertainty. The history of the pound sterling/U.S. dollar rate is instructive.
From 1949 to 1966, that rate did not change at all. In 1967 the devaluation of the pound by 14 percent was
regarded as a major economic policy decision. Since the end of fixed rates in 1973 and 1991, however, the
pound, on average, either appreciated or depreciated by 14 percent every two years.

The instability of exchange rates in the seventies and eighties would not have surprised the founders of the
Bretton Woods system, who had a deep distrust of financial markets. The previous experience with floating
exchange rates (in the twenties) had been marked by massive instability. In an influential study of that
experience, published in 1942, Norwegian economist Ragnar Nurkse argued that currency markets were
subject to "destabilizing speculation," which created pointless and economically damaging fluctuations.

During the fifties and sixties, however, as stresses built on the system of fixed exchange rates, both
economists and policymakers began to see exchange rate flexibility in a more favorable light. In a seminal
paper in 1953, Milton Friedman argued that the fear of floating exchange rates was unwarranted. Unstable
exchange rates in the twenties, he maintained, were caused by unstable policies, not by destabilizing
speculation. Friedman went on to argue that profit-maximizing speculators would always tend to stabilize,
not destabilize, the exchange rate. By the late sixties Friedman's view had become widely accepted within
the economics profession and among many businessmen and bankers. Therefore, concern over the instability
of floating exchange rates was replaced by an appreciation of the greater flexibility that floating rates would
give to macroeconomic policy. The main advantage was that nations could pursue independent monetary
policies and adjust easily to eliminate payments imbalances and offset changes in their international
competitiveness. This change in attitude helped to prepare the way for the abandonment of fixed rates in
1973.

The instability of rates since 1973 has thus been a severe disappointment. Some of the changes in exchange
rates can be attributed to differences in national inflation rates. But yearly changes in exchange rates have
been much larger than can be explained by differences in inflation rates or in other variables such as
different growth rates in various countries' money supplies.

Why are exchange rates so unstable? Economists have suggested two explanations. One, originally
expressed in a celebrated 1976 paper by MIT economist Rudiger Dornbusch, is that even without
destabilizing speculation, exchange rates will be highly variable because of a phenomenon that Dornbusch
labeled "over-shooting." Suppose that the United States increases its money supply. In the long run this must
cause the value of the dollar to be lower; in the short run it will lead to a lower interest rate on dollar-
denominated securities. But as Dornbusch pointed out, if the interest rate on dollar-denominated bonds falls
below that on other assets, investors will be unwilling to hold them unless they expect the dollar to rise
against other currencies in the future. How can the prospect of a long-run lower dollar and the need to offer
investors a rising dollar be reconciled? The answer, Dornbusch asserted, is that the dollar must fall below its
long-run value in the short run, so that it has room to rise. That is, if the U.S. money supply rises by 10
percent, which will eventually mean a 10 percent weaker dollar, the immediate impact will be a dollar
depreciation of more than 10 percent—say 20 or 25 percent—"overshooting" the long-run value. The
overshooting hypothesis helps explain why exchange rates are so much more unstable than inflation rates or
money supplies.

In spite of the intellectual appeal of the overshooting hypothesis, many economists have returned to the idea
that destabilizing speculation is the principal cause of exchange rate instability. If those who buy and sell
foreign exchange are rational, then forward exchange rates—rates today for sale of dollars some months
hence—should be the best predictors of future exchange rates. But a key study by the University of
Chicago's Lars Hansen and Northwestern University's Robert Hodrick in 1980 found that forward exchange
rates actually have no useful predictive power. Since that study many other researchers have reached the
same conclusion.

At the same time, particular exchange rate fluctuations have seemed to depart clearly from any reasonable
valuation. The run-up of the dollar in late 1984, for example, brought it to a level that priced U.S. industry
out of many markets. The trade deficits that would have resulted could not have been sustained indefinitely,
implying that the dollar would have to decline over time. Yet investors, by being willing to hold dollar-
denominated bonds with only small interest premiums, were implicitly forecasting that the dollar would
decline only slowly. Stephen Marris and I both pointed out that if the dollar were to decline as slowly as the
market appeared to believe, growing U.S. interest payments to foreigners would outpace any decline in the
trade deficit, implying an explosive and hence impossible growth in foreign debt. It was therefore apparent
that the market was overvaluing the dollar. Overall, there is no evidence supporting Friedman's assumption
that speculators would act in a rational, stabilizing fashion. And in several episodes Nurkse's fears of
destabilizing speculation seem to ring true.

What are the effects of exchange rate instability? The effects on both the prices and volumes of goods and
services in world trade have been surprisingly small. During the eighties real West German wages went
from 20 percent above the U.S. level to 25 percent below, then back to 30 percent above. One might have
expected this to lead to huge swings in prices and in market shares. Yet the effects, while there, were fairly
mild. In particular, many firms seem to have followed a strategy of "pricing to market" (i.e., keeping the
prices of their exports stable in terms of the importing country's currency). Significant examples are the
prices of imported automobiles in the United States, which neither fell much when the dollar was rising nor
rose much when it began falling. Statistical studies, notably by Wharton economist Richard Marston, have
documented the importance of pricing to market, especially among Japanese firms.

The policy implications of unstable exchange rates remain a subject of great dispute. Refreshingly, this is
not the usual debate between laissez-faire economists who trust markets and distrust governments, and
interventionist economists with the opposite instincts. Instead, both camps are divided, and advocates of
both fixed and floating rates find themselves with unaccustomed allies. Laissez-faire economists are divided
between those who, like Milton Friedman, want stable monetary growth and therefore want to leave the
exchange rate alone, and those who, like Columbia University's Robert Mundell, want the discipline of fixed
exchange rates and even a return to the gold standard. Interventionists are divided between those who, like
Yale's James Tobin, regard exchange rate instability as a price worth paying for the freedom to pursue an
activist monetary policy, and those who, like John Williamson of the Institute for International Economics,
distrust financial markets too much to trust them with determining the exchange rate.

In general, sentiment among both economists and policymakers has drifted away from belief in freely
floating rates. On the one hand, exchange rates among the major currencies have been more erratic than
anyone expected. On the other hand, the European Monetary System, an experiment in quasi-fixed rates, has
proved surprisingly durable. Taking the long view, however, attitudes about exchange rate instability have
repeatedly shifted, proving ultimately as poorly grounded in fundamentals as the rates themselves.
Determination of exchange rates
There are a number of methods that can be used to determine an exchange rate:

a. A flexible or floating exchange rate is where the market forces of supply and demand determine the
exchange rate.
b. A fixed exchange rate is where the government determines the exchange rate for a period of time
based on the value of another country’s currency such as the US dollar.
c. A managed exchange rate is where the government intervenes in the market to influence the
exchange rate or set the rate for short periods such as a day or week.

a. Flexible (or floating) exchange rates

Under a flexible or floating exchange rate the value of a country’s currency changes frequently, even
by the minute. The market rate will depend on the demand for, and supply of, that currency in the
forex markets. When there is no intervention in the free market operations by a government agency a
“clean float” is said to exist.

Figure 1

The determination of the exchange rate under a floating exchange rate is shown in figure 1.

The demand curve (DD) indicates the quantity of Australian dollars that buyers (those people who
hold US dollars) are willing to purchase at each possible exchange rate.

The supply curve (SS) shows the quantity of Australian dollars that will be offered for sale (those
people who hold Australian dollars) at each exchange rate.

At the equilibrium exchange rate of $A1.00 = $US0.50 the equilibrium quantity supplied and
demanded is Q1 Australian dollars. At an exchange rate above equilibrium, such as $A1.00 =
$US0.60, an excess supply of Australian dollars exists and market forces will force the exchange rate
down towards equilibrium.

If the exchange rate is below equilibrium, such as $A1.00 = $US0.40, an excess demand situation
exits and market forces will put upward pressure on the value of the Australian dollar.
Remember that there are many different exchange rates. The following examples illustrate
how an appreciation (increase in value) or depreciation (decrease in value) of the Australian
dollar against the US dollar has been created by changes in demand and supply conditions.

i. A currency appreciation

Figure 2

a. In Figure 2a there has been an increase in demand (DD to D1D1) for Australian
dollars. This has led to an increase (appreciation) in value of the Australian dollar
from $US0.50 to $US0.60 and the quantity of Australian dollars traded has also
increased from 0Q to 0Q1.

The shift in the demand curve could have been caused by an increase in the demand
for Australian exports, such as coal, aluminum, beef or lamb

b. In Figure 2b there has been a decrease in the supply (SS to S1S1) of Australian
dollars. This has led to an increase in the value (appreciation) of the Australian dollar
from $US0.50 to $US0.60. However the quantity of Australian dollars traded has
decreased from 0Q to 0Q1.

This decrease in the supply of Australian dollars may have been caused by a
recession, slowing the demand for imports.
 ii. A currency depreciation

Figure 3

a. In Figure 3a there has been a decrease in demand (DD to D1D1) for Australian
dollars. This has led to a depreciation in the value of the Australian dollar from
$US0.50 to $US0.40. The quantity of Australian dollars traded has also decreased
from 0Q to 0Q1.

The decrease in the price of Australian dollars in terms of US dollars could have been
generated by a slow down in global economic activity, so decreasing the demand for
Australian exports, or because of foreign investors lacking confidence in the
Australian economy and investing elsewhere.

b. Figure 3b indicates an increase in supply of Australian dollars with the supply curve
moving from SS to S1S1. Again the value of the Australian dollar has decreased from
$US0.50 to $US0.40 while the quantity of Australian dollars traded has increased
from 0Q to 0Q1.

The depreciation may have resulted from strong domestic economic growth
increasing the demand for imports, or from higher overseas interest rates, causing a
capital outflow from Australia.

b. Fixed exchange rates

The World Bank and the IMF were both established in 1944 at a conference of world leaders in
Bretton Woods, New Hampshire (USA). The aim of the two "Bretton Woods institutions" as they are
sometimes called, was to place the global economy on a sound footing after World War II. To help
reduce the economic instability that existed the conference favoured the use of a fixed exchange
rate system.

Under a fixed exchange rate system the value of a country’s currency is fixed by the
government or one of its agencies, for example the Reserve Bank of Australia (RBA) to another
currency for a specific time period or A country's exchange rate regime under which the government
or central bank ties the official exchange rate to another country's currency (or the price of gold). The
purpose of a fixed exchange rate system is to maintain a country's currency value within a very
narrow band. Also known as pegged exchange rate. Fixed rates provide greater certainty for
exporters and importers. This also helps the government maintain low inflation, which in the long
run should keep interest rates down and stimulate increased trade and investment. A fixed
exchange-rate system, also known as a pegged exchange rate system, is a currency system in
which governments try to maintain their currency value constant against one another.

OR

In a fixed exchange-rate system, a country’s government decides the worth of its currency in terms
of either a fixed weight of gold, a fixed amount of another currency or a basket of other currencies.
The central bank of a country remains committed at all times to buy and sell its currency at a fixed
price. The central bank provides foreign currency needed to finance payments imbalances

This method of determining exchange rates was to dominate until the 1970s.

In Australia the dollar was fixed (pegged) from 1946 to December 1971 to the British pound and
then to the US dollar until September 1974.

From September 1974 to November 1976 the Federal Government, in an attempt to reduce the
impact of exchange rate fluctuations on the economy pegged the Australian dollar to the trade
weighted index (TWI).

Using this system the value of the Australian dollar was allowed to adjust against each currency in
the TWI. However in reality the value of the Australian dollar remained fixed for long periods of
time.

Figure 4

In Figure 4 the official exchange rate has been fixed at a level of $A1.00 = $US0.60, which is above
the market rate of $A1.00 = $US0.50. For the exchange rate to be fixed at a level higher than the
market rate requires official intervention by the Reserve Bank of Australia.

At this level the RBA would have to buy the excess supply of Australian dollars equivalent to Q1Q2
at a price of $US0.60. To buy the surplus of Australian dollars the government would need to sell its
reserves of foreign currency.
 A fixed exchange rate system does not imply that the rate will stay at that same level all the time.
The government may decide to change the rate because of adverse effects on the economy. For
example, if the currency is overvalued exporting industries will become less internationally
competitive, affecting international trade and the balance of payments and the government might
take action to devalue the exchange rate.

A devaluation of a currency occurs under a fixed exchange rate system when there is deliberate
action taken by a government to decrease its value in the forex market.

OR

Alternatively a revaluation occurs under a fixed exchange rate system when there is deliberate
action taken by the government to increase the value of the currency in the forex market.

c. Managed exchange rates

A managed exchange rate occurs when there is official intervention by a government or an agency
such as the RBA to determination the value of a country’s exchange rate. Through such official
interventions it is possible to manage both fixed and floating exchange rates.

The Australia dollar was pegged to TWI from September 1974 to November 1976. Then in
November 1976, the government adopted a “managed flexible peg” or a “crawling peg system”.
Under this new method of determining exchange rates, the value of the Australian dollar was
changed relative to the TWI, not just relative to a single individual currency

The exchange rate was announced each morning by the RBA and remained at that rate until the next
morning. This system continued until the Australian dollar was floated in December 1983.

Under the floating exchange rate system the value of the Australian dollar is not specifically targeted
by the RBA. To intervene in the market and alter the exchange rate significantly in the long run is
beyond the financial ability of the RBA. This is because Australia’s level of foreign reserves (gold
and foreign currencies) are relatively small (A$34 billion) compared to volumes of currency trade in
the market each day.

However the RBA may decide to enter the foreign exchange market as either a buyer or seller to
stabilise any short-term fluctuation in the value of the Australian dollar. To limit a fall in the value of
the Australian dollar (depreciation) the RBA will buy Australian dollars, and to prevent a rise in the
value of the Australian dollar, the RBA will sell Australian dollars in the market.

Such intervention by the RBA is known as a “dirty float”, or more correctly a “managed float”.
What is hedging?

When a currency trader enters into a trade with the intent of protecting an existing or anticipated position from an
unwanted move in the foreign currency exchange rates, they can be said to have entered into a forex hedge. By
utilizing a forex hedge properly, a trader that is long a foreign currency pair, can protect themselves from
downside risk; while the trader that is short a foreign currency pair, can protect against upside risk.

The primary methods of hedging currency trades for the retail forex trader is through:

 Spot contracts, and

 Foreign currency options.

Spot contracts are essentially the regular type of trade that is made by a retail forex trader. Because spot contracts
have a very short-term delivery date (two days), they are not the most effective currency hedging vehicle.
Regular spot contracts are usually the reason that a hedge is needed, rather than used as the hedge itself.

Foreign currency options, however are one of the most popular methods of currency hedging. As with options on
other types of securities, the foreign currency option gives the purchaser the right, but not the obligation, to buy
or sell the currency pair at a particular exchange rate at some time in the future. Regular options strategies can be
employed, such as long straddles, long strangles and bull or bear spreads, to limit the loss potential of a given
trade
Forex hedging strategy
A forex hedging strategy is developed in four parts, including an analysis of the forex trader's risk exposure, risk
tolerance and preference of strategy. These components make up the forex hedge:

1. Analyze risk: The trader must identify what types of risk (s)he is taking in the current or proposed
position. From there, the trader must identify what the implications could be of taking on this risk un-
hedged, and determine whether the risk is high or low in the current forex currency market.
2. Determine risk tolerance: In this step, the trader uses their own risk tolerance levels, to determine how
much of the position's risk needs to be hedged. No trade will ever have zero risk; it is up to the trader to
determine the level of risk they are willing to take, and how much they are willing to pay to remove the
excess risks.
3. Determine forex hedging strategy: If using foreign currency options to hedge the risk of the currency
trade, the trader must determine which strategy is the most cost effective.
4. Implement and monitor the strategy: By making sure that the strategy works the way it should, risk
will stay minimized.

The forex currency trading market is a risky one, and hedging is just one way that a trader can help to minimize
the amount of risk they take on. So much of being a trader is money and risk management, that having another
tool like hedging in the arsenal is incredibly useful.
Eurodollars
Eurodollars are time deposits denominated in U.S. dollars at banks outside the United States, and thus are not under
the jurisdiction of the Federal Reserve. Consequently, such deposits are subject to much less regulation than similar
deposits within the U.S., allowing for higher margins. The term was originally coined for U.S. dollars in European
banks, but it expanded over the years to its present definition—a U.S. dollar-denominated deposit in Tokyo or
Beijing would be likewise deemed a Eurodollar deposit. There is no connection with the euro currency or the
eurozone.

History

Gradually, after World War II, the quantity of U.S. dollars outside the United States increased enormously,
as a result of both the Marshall Plan and imports into the U.S., which had become the largest consumer
market after World War II.

As a result, enormous sums of U.S. dollars were in the custody of foreign banks outside the United States.
Some foreign countries, including the Soviet Union, also had deposits in U.S. dollars in American banks,
granted by certificates. Various history myths exist for the first Eurodollar creation, or booking, but most
trace back to Communist governments keeping dollar deposits abroad.

In one version, the first booking traces back to Communist China, which, in 1949, managed to move almost
all of its U.S. dollars to the Soviet-owned Banque Commerciale pour l'Europe du Nord in Paris before the
United States froze the remaining assets during the Korean War

In another version, the first booking traces back to the Soviet Union during the Cold War period, especially
after the invasion of Hungary in 1956, as the Soviet Union feared that its deposits in North American banks
would be frozen as a retaliation. It decided to move some of its holdings to the Moscow Narodny Bank, a
Soviet-owned bank with a British charter. The British bank would then deposit that money in the US banks.
There would be no chance of confiscating that money, because it belonged to the British bank and not
directly to the Soviets. On 28 February 1957, the sum of $800,000 was transferred, creating the first
eurodollars. Initially dubbed "Eurbank dollars" after the bank's telex address, they eventually became known
as "eurodollars"as such deposits were at first held mostly by European banks and financial institutions.[3] A
major role was played by City of London banks, as the Midland Bank, now HSBC, and their offshore
holding companies.

In the mid-1950s, Eurodollar trading and its development into a dominant world currency began when the
Soviet Union wanted better interest rates on their Eurodollars and convinced an Italian banking cartel to give
them more interest than what could have been earned if the dollars were deposited in the U.S. The Italian
bankers then had to find customers ready to borrow the Soviet dollars and pay above the U.S. legal interest-
rate caps for their use, and were able to do so; thus, Eurodollars began to be used increasingly in global
finance.[

By the end of 1970 385,000M eurodollars were booked offshore. These deposits were lent on as US dollar
loans to businesses in other countries where interest rates on loans were perhaps much higher in the local
currency, and where the businesses were exporting to the USA and being paid in dollars, thereby avoiding
foreign exchange risk on their loans.

Several factors led Eurodollars to overtake certificates of deposit (CDs) issued by U.S. banks as the primary
private short-term money market instruments by the 1980s, including:

 The successive commercial deficits of the United States

 The U.S. Federal Reserve's ceiling on domestic deposits during the high inflation of the 1970s [5]
  Eurodollar deposits were a cheaper source of funds because they were free of reserve requirements and
deposit insurance assessments[5]

Market size

By December 1985 the Eurocurrency market was estimated by Morgan Guaranty bank to have a net size of
1,668B, of which 75% are likely eurodollars. [6] However, since the markets are not responsible to any
government agency its growth is hard to estimate. The Eurodollar market is by a wide margin the largest
source of global finance. In 1997, nearly 90% of all international loans were made this way .[7]

Futures contracts

The Eurodollar futures contract refers to the financial futures contract based upon these deposits, traded at
the Chicago Mercantile Exchange (CME). More specifically, EuroDollar futures contracts are derivatives on
the interest rate paid on those deposits. Eurodollars are cash settled futures contract whose price moves in
response to the interest rate offered on US Dollar denominated deposits held in European banks. [8]
Eurodollar futures are a way for companies and banks to lock in an interest rate today, for money it intends
to borrow or lend in the future.[9] Each CME Eurodollar futures contract has a notional or "face value" of
$1,000,000, though the leverage used in futures allows one contract to be traded with a margin of about one
thousand dollars.[10]

CME Eurodollar futures prices are determined by the market’s forecast of the 3-month USD LIBOR interest
rate expected to prevail on the settlement date. A price of 95.00 implies an interest rate of 100.00 - 95.00, or
5%. The settlement price of a contract is defined to be 100.00 minus the official British Bankers' Association
fixing of 3-month LIBOR on the day the contract is settled.

How the Eurodollar futures contract works

For example, if on a particular day an investor buys a single three-month contract at 95.00

if at the close of business on that day, the contract price has risen to 95.01 (implying a LIBOR decrease to
4.99%), US$25 will be paid into the investor's margin account; or

 if at the close of business on that day, the contract price has fallen to 94.99 (implying a LIBOR increase to
5.01%), US$25 will be deducted from the investor's margin account.

On the settlement date, the settlement price is determined by the actual LIBOR fixing for that day rather
than a market-determined contract price.

History

The Eurodollar futures contract was launched in 1981, as the first cash-settled futures contract. People
reportedly camped out the night before the contract’s open, flooding the pit when the CME opened the
doors. That trading pit was the largest pit ever, nearly the size of a football field, and quickly became one of
the most active on the trading floor, with over 1500 traders and clerks coming to work every day on what
was then known as the CME’s upper trading floor.  That floor is no longer, with the CME having moved
over to the CBOT’s trading floor and 98% of Eurodollar trading now done electronically.[11]

Eurodollar futures contract as synthetic loan

A single Eurodollar future is similar to a forward rate agreement to borrow or lend US$1,000,000 for three
months starting on the contract settlement date. Buying the contract is equivalent to lending money, and
selling the contract short is equivalent to borrowing money.
Consider an investor who agreed to lend US$1,000,000 on a particular date for three months at 5.00% per
annum (months are calculated on a 30/360 basis). Interest received in 3 months' time would be
US$1,000,000 × 5.00% × 90 / 360 = US$12,500.

 If the following day, the investor is able to lend money from the same start date at 5.01%, s/he would
be able to earn US$1,000,000 × 5.01% × 90 / 360 = US$12,525 of interest. Since the investor only is
earning US$12,500 of interest, s/he has lost US$25 as a result of interest rate moves.
 On the other hand, if the following day, the investor is able to lend money from the same start date
only at 4.99%, s/he would be able to earn only US$1,000,000 × 4.99% × 90 / 360 = US$12,475 of
interest. Since the investor is in fact earning US$12,500 of interest, s/he has gained US$25 as a result
of interest rate moves.

This demonstrates the similarity. However, the contract is also different from a loan in several important
respects:

 In an actual loan, the US$25 per basis point is earned or lost at the end of the three-month loan, not
up front. That means that the profit or loss per 0.01% change in interest rate as of the start date of the
loan (i.e., its present value) is less than US$25. Moreover, the present value change per 0.01%
change in interest rate is higher in low interest rate environments and lower in high interest rate
environments. This is to say that an actual loan has convexity. A Eurodollar future pays US$25 per
0.01% change in interest rate no matter what the interest rate environment, which means it does not
have convexity. This is one reason that Eurodollar futures are not a perfect proxy for expected
interest rates. This difference can be adjusted for by reference to the implied volatility of options on
Eurodollar futures.
 In an actual loan, the lender takes credit risk to a borrower. In Eurodollar futures, the principal of the
loan is never disbursed, so the credit risk is only on the margin account balance. Moreover, even that
risk is the risk of the clearinghouse, which is considerably lower than even unsecured single-A credit
risk.

Other features of Eurodollar futures

40 quarterly expirations and 4 serial expirations are listed in the Eurodollar contract. [12] This means that on 1
January 2011, the exchange will list 40 quarterly expirations (March, June, September, December for 2011
through 2020), the exchange will also list another four serial (monthly) expirations (January, February,
April, May 2011). This extends tradeable contracts over ten years, which provides an excellent picture of the
shape of the yield curve. The front month contracts are among the most liquid futures contracts in the world,
with liquidity decreasing for the further out contracts. Total open interest for all contracts is typically over
10 million.

The CME Eurodollar futures contract is used to hedge interest rate swaps. There is an arbitrage relationship
between the interest rate swap market, the forward rate agreement market and the Eurodollar contract. CME
Eurodollar futures can be traded by implementing a spread strategy among multiple contracts to take
advantage of movements in the forward curve for future pricing of interest rates
Commercial Bills Market or Discount Market

A Commercial Bill is one which arises out of a genuine trade transaction, i.e., credit transaction. A bill of
exchange contains a written order from the creditor to the debtor, to pay a certain sum, to a certain person,
after a certain period. It is negotiable and 'self-liquidating'. It is drawn for a short period between 2-6 months
usually.

Types of Bills

1. Demand (sight bills) and usance bills (time bills)

2. Clean bills and documentary bills
3. Inland and foreign bills
4. Export bills and import bills
5. Accomodation bills and supply bills
6. Indigenous bills (popularly known as hundis in India)

Operations in Bill Market

From operations point of view, the bill market can be classified into two markets, viz.

1. Disount market
2. Acceptance market

Discount market 

It refers to the market where short term genuine trade bills are discounted by financial intermediaries like
commercial banks. When credit sales are effected, the seller draws a bill on the buyer who accepts it
promising to pay the specified sum at the specified period. The seller would otherwise have to wait until
maturity of the bill for getting payment, but the presence of a bill market enables him to get immediate
payment. The seller can ensure payment by discounting the bill with some financial intermediary by paying
a small amount of money called ' discount rate'. On the date of maturity, the financial intermediary claims
the amount of the bill from the person who has accepted the bill. In India, such institutions are
conspicuously absent , so the commercial banks along with the DFHI undertake the work of discounting

1. Call Money Market:

The call money market deals with loans of very short duration. It mainly deals with one day loans which
may or may not be renewed the next day. The participants in call money market are mostly banks.

Therefore, it is called Inter-Bank Call Money Market. A few other financial institutions like UTI, LIC, GIC
are also allowed to operate in this market. The call loans are generally made without security and therefore
the lending banks should be very careful in judging the ability of borrower to repay the loans at call.
The rate of interest in these markets is highly variable. It fluctuates at the pressure of excess demand and
excess supply.

2. Treasury Bill Market:

Treasury bills are issued by the central government for short period loans (91 days). These bills are sold by
the Reserve Banks on behalf of the government. These bills are purchased by Reserve Bank, Commercial
Banks, non-banking financial intermediaries, the LIC, UTI and GIC.

Treasury bills are highly liquid because Reserve Bank of India is always willing to purchase or discount
them. Treasury Bills are bought and sold on discounted basis. It means that the amount of interest due on it
is paid in the form of discount in the price charged for the bill. The price is thus lower than its face value by
the amount of interest due on the bill. The interest rate on the Treasury bill is very low.

3. Commercial Bill Market:

Commercial bills are those bills which are issued by businessmen or firms in exchange of the goods
purchased or sold. The buyer using promissory notes promises to pay to the seller a specified amount at a
particular date.

On the other hand, the sellers issue commercial bills directly to the buyers to pay a specified amount at a
particular date for the goods received.

The buyer shows his acceptance by countersigning the bill. These are generally of three month’s duration.
They are like post dated cheques drawn by sellers of goods on the buyers of goods for value received.

The bill holder can get it discounted in the bill market if he wants the amount of the bill before maturity. The
bill market is not very developed in India.

Gilt-edged securities are bonds issued by certain national governments. The term is of British origin, and
originally referred to the debt securities issued by the Bank of England, which had a gilt (or gilded) edge.
Hence, they are known as gilt-edged securities, or gilts for short. Today the term is used in the United
Kingdom as well as some Commonwealth nations, such as South Africa and India. However, when
reference is made to "gilts", what is generally meant is "UK gilts," unless otherwise specified.

Colloquially, the term "gilt-edged" is sometimes used to denote high-grade securities, consequently carrying
low yields, as opposed to relatively riskier, below investment-grade securities.

The data collected by the British Office for National Statistics reveal that about two-thirds of all UK gilts are
held by insurance companies and pension funds.] Since 2009 large quantities of gilts have been created and
repurchased by the Bank of England under its policy of quantitative easing.

The term "gilt account" is also a term used by the Reserve Bank of India to refer to a constituent account
maintained by a custodian bank for maintenance and servicing of dematerialized government securities
owned by a retail customer. Or High-grade bonds that are issued by a government or firm. This type of security
originally boasted gilded edges, thus the name. In the case of a firm, a gilt-edged security is a stock or bond
issued by a company that has a strong record of consistent earnings and can be relied on to cover dividends and
interest.

Gilt-edged securities are a high-grade investment with very low risk. Typically, these are issued by blue
chip companies that dependably meet dividend or interest payments because they are well-established
and financially stable .