FOREIGN EXCHANGE MARKET PARTICIPANTS

There are four types of market participants—banks, brokers, customers, and central banks. Banks and other financial institutions are the biggest participants. They earn profits by buying and selling currencies from and to each other. Roughly two-thirds of all FX transactions involve banks dealing directly with each other. Brokers act as intermediaries between banks. Dealers call them to find out where they can get the best price for currencies. Such arrangements are beneficial since they afford anonymity to the buyer/seller. Brokers earn profit by charging a commission on the transactions they arrange. Customers, mainly large companies, require foreign currency in the course of doing business or making investments. Some even have their own trading desks if their requirements are large. Other types of customers are individuals who buy foreign exchange to travel abroad or make purchases in foreign countries. Central banks, which act on behalf of their governments, sometimes participate in the FX market to influence the value of their currencies. With more than $1.2 trillion changing hands every day, the activity of these participants affects the value of every dollar, pound, yen or euro. The participants in the FX market trade for a variety of reasons: To earn short-term profits from fluctuations in exchange rates, To protect themselves from loss due to changes in exchange rates, and To acquire the foreign currency necessary to buy goods and services from other countries.

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FOREIGN EXCHANGE RATES

Most common contact with foreign exchange occurs when we travel or buy things in other countries. Suppose a U.S. tourist travelling in London wants to buy a sweater. Price tag is 100 pounds. Current exchange rate Price of sweater in dollars $1.45 to £1 $1.30 to £1 $1.60 to £1 Pound falls Pound rises 100 x 1.45 = $145.00 100 x 1.30 = $130.00 100 x 1.60 = $160.00 Thus, small changes in exchange rates may not seem significant. But when billions of dollars are traded, even a hundredth of a percentage point change in exchange rates becomes important. Stronger US dollar implies U.S. can buy foreign goods more cheaply è Cost of purchasing foreign goods falls Foreigners find U.S. goods more expensive and demand falls è Does not help firms that produce for exports Weaker U.S. dollar implies Foreigners buy more U.S. goods è Helps firms that rely on exports Foreign goods become more expensive è Demand for imports falls It would seem logical that if the dollar weakens, the trade balance will improve, as exports would rise. However, this does not always happen. U.S. trade balance usually worsens for a few months. The J–curve explains why the trade position does not improve soon after the weakening of a currency. Most import/export orders are taken months in advance. Immediately after a currency’s value drops, the volume of imports remains about the same, but the prices in terms of the home currency rise. On the other hand, the value of the domestic exports remains the same, and the difference in values worsens the trade balance until the imports and exports adjust to the new exchange rates. Exchange rates are an important consideration when making international investment decisions. The money invested overseas incurs an exchange rate risk. When an investor decides to "cash out," or bring his money home, any gains could be magnified or wiped out depending on the change in the exchange rates in the interim. Thus, changes in exchange rates can have many repercussions on an economy: Affects the prices of imported goods Affects the overall level of price and wage inflation Influences tourism patterns May influence consumers’ buying decisions and investors’ long-term commitments.

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BRITISH POUND RISES TO SEVEN MONTH HIGH, BUT HOLES ARE BEGINNING TO APPEAR

You may have noticed that the phrase “seven month high” appears quite frequently in recent Forex Blog posts, regardless of the currency being discussed. I offer this preface as context for Pound’s recent rally because it suggests that the factors driving the Pound are hardly unique from the factors driving other currencies. In other words, “It’s a mixture of a dollar-weakness story and a global-growth story.”

Of course, it would it be unfair to so glibly dismiss the Pound, so let’s look at the underlying picture. On the macro-level, the British economy is still anemic: “Gross domestic product dropped 1.9 percent in the latest quarter, the most since 1979, according to the Office for National Statistics. The International Monetary Fund now expects the British economy to shrink by 4.1 percent in 2009.” Without drilling too far into the data, suffice it to say that most of the indicators tell a similar story.

The only relative bright spots are the housing market and financial sector. Mortgage applications are rising, and there is evidence that housing prices are slowing in their descent, perhaps even nearing a bottom. Optimists, naturally, are arguing that this signals the entire economy is turning around. History and common sense, however, suggest that even if the most recent data is not a blip, it’s still unlikely that the UK will able to depend on the housing sector to drive future growth. Besides, there is anecdotal evidence to suggest that foreign buying (due to favorable exchange rates) is propping up real estate prices, rather than a change in market fundamentals.

The stabilization of financial markets is also good for the UK, as 1/3 of its economy is connected to the financial sector. “Sterling is basically a bet on global financial well-being…Now that the banking sector has stepped away from the Armageddon scenario, the prospects for London and the U.K. economy look better.” But as with housing, it’s unlikely that the financial sector will return to the glory days, in which case the UK will have to turn elsewhere in its search for growth.

What about the Bank of England’s heralded attempt at Quantitative easing? While it’s still to early to draw conclusions, the initial data is not good. In fact, the most recent data indicates that half of the bonds that the BOE bought last month (with freshly minted cash) were from foreign buyers, which causes inflation without any of the economic benefits from an increase in the domestic flow of money. Given that S&P recently downgraded the outlook for UK credit ratings, it’s no surprise that foreigners are moving towards the exits. In short, “With underlying weakness in money and credit - plus large gilt sales by overseas investors - we doubt that quantitative easing is playing much direct role in the economy’s possible turnaround,” summarized one analyst.

If you ask me, the Pound rally is grounded in nothing other than naive technical analysis, which relies on indicators that are largely self-fulfilling. In other words, if the Pound seems like it should rise, than it probably will, simply as a result of investor perception. “Citigroup Inc. said in a report last week the pound is ‘among the most undervalued major currencies…’ Barclays Plc predicts it will rise as much as 18 percent against the dollar and 11 percent versus the euro in the coming year. Goldman Sachs Group Inc. sees a 23 percent gain versus the dollar and 15 percent advance against the euro.” Call me skeptical, but it’s hard to understand what kind of analysis underlies these predictions other than simple intuition. Sure the Pound was probably oversold, but is a 20% rise is two months really justified?

The U.S. Commodity Futures Trading Commission data indicated a slight downtick, but “big speculative players continue to hold large net short positions in the pound versus the dollar,” which suggests that the savviest investors are not yet sold on the rally. Emerging markets offer growth and higher yield. Commodity currencies, such as the Australian and New Zealand dollars, rise in line with energy and commodity prices. Someone please tell me where the Pound fits into this?

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MARKET OF FOREIGN EXCHANGE

The foreign exchange market (currency, forex, or FX) is where currency trading takes place. It is where banks and other official institutions facilitate the buying and selling of foreign currencies.

 [1]FX transactions typically involve one party purchasing a quantity of one currency in exchange for paying a quantity of another.

The foreign exchange market that we see today started evolving during the 1970s when worldover countries gradually switched to floating exchange rate from their erstwhile exchange rate regime, which remained fixed as per the Bretton Woods system till 1971.

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