Currencies

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Currency Market Mechanics

Introduction

• How the currency markets operate (mechanics)
• Three main drivers of currency valuation
• How central banks guard against inflation and deflation
• How investors analyze and manage currency risk

Who Trades Currencies?

• There are 3 main entities that trade currencies (listed in order of volume):
  1. Financial investors buying and selling currencies in foreign countries (45%)
     • Commonly known as hot money
  2. Local businesses selling goods and services across borders
  3. Travelers who exchange currency for personal use

Pegged Currencies (PEG)

• Shows various currencies linked or pegged to other country’s currencies’ values
• One of the key mechanisms governments use to peg currencies are FX Reserves
  • A huge stack of cash with which to manipulate the supply of and demand for currency and therefor manipulate its value
  • USD is the most common currency used to build FX reserves as it is the most used and most liquid
• Governments also lift interest rates to defend pegs

Currency Codes (FXTF) shows list of all world currencies.

Summary of Currency Market Mechanics

• Over $5 Trillion of currencies are traded every day
• 1971 marked the dawn of the modern currency market
• Several countries peg their currencies to other currencies
• Locked exchange rates are not actually set in stone but are government aspirations
• Floating currencies (not pegged) move against one another in a matrix
• The USD is the world’s reserve currency and is the world’s most traded currency

Currency Valuation Drivers

Observing Currency Strength

• To determine the overall strength or weakness of a single currency, we use trade-weighted baskets
  • Indices that calculate the aggregate value of one currency against a basket of its main trading partners
  • Larger trading partners are weighted more heavily
• Type Trade Weighted then click “USTW$ Index” to see time series chart of the currency
• One Price Theory suggests the same good should cost the same everywhere in the world
  • Big Mac Index shows what currencies are overvalued or undervalued in terms of price of a Big Mac
  • Relative prices are long-term drivers of currency valuation

Three Main Currency Drivers

• Surprise changes in interest rates
• Surprise changes in inflation
• Surprise changes in trade

Surprise Changes in Interest Rates

• When a central bank unexpectedly changes interest rates, the government bond yields change
  • This reduces demand for that country’s currency, so the currency typically weakens
• If the interest rate decreases, the bond yields decrease, and thus currency weakens
  • And vice versa with increases

Surprise Changes in Inflation

• All else equal, surprise rises in inflation will weaken a currency

Surprise Changes in Trade

• When a country exports goods, the foreign buyer needs to buy the currency of the exporter = Buy home currency
• When a country imports goods, the importer needs to buy the currency of the foreign seller by selling the home currency = sell home currency
• Thus, net export/import alters the demand for the home currency and can affect the value of the currency

Summary - Currency Valuation Drivers

• The value of a currency is relative and not absolute
• Trade-weighted baskets express currency overall strength and weakness
• In the long run, the “law of one price” drives currency values
• In the short run, these are the main drivers of currency valuation:
  • Surprise changes in interest rates, inflation, and trade

Central Banks and Currency

Inflation Monitor (IMFO)

• The principle role among most all central banks in the world is to guard against inflation, and in rare cases, deflation
• Typical target rate of inflation for a developed economy is about 2%
• Low but positive inflation for an economy is typically a plus
  • It protects consumers’ purchasing power
  • Keeps borrowing costs low
  • And provides a stable backdrop for businesses to make investment and hiring decisions
• Inflation targeting is not so easy because inflation is psychological
  • Once expectations of price increases become engrained, they are hard to unseat

Cycle of Inflation

1. Workers expect prices to increase >
2. Workers demand pay increases >
3. Company wages go up >
4. Companies raise their prices >>
5. loop

Monitoring Inflation

Type ‘Interest rate’ (FDTR Index) into command line to pull up the Federal Funds Target Rate

• Overlay CPI, main indicator of inflation, to see comparisons for how Fed rate affects inflation

Deflation Cycle

• Deflation also acts in a vicious cycle:
  1. Prices decline >
  2. Consumers delay purchases to await lower prices >
  3. Company revenues decline >
  4. Companies let go of workers to cut costs

Summary

• Central banks control inflation which affect both inflation and international investment flows
  • Central bankers are therefore pivotal to currency valuation
• Developed economies typically target 2% inflation rate in effort to guard against inflation and deflation
• Inflation can lead to a vicious cycle of pay increases leading to price increases
• Deflation can lead to a vicious cycle of purchase deferrals and layoffs

Currency Risks

Two Tools to Assess Currency Risk

1. Historical volatility of currency pair values
2. Analyst forecasts of currency pairs

Historical Volatility of Currency Pair Values

• FX Forecast Model (FXFM) illustrates the chances of certain currencies rates in a selected future time frame
  • Derived from historic observations of the movements of currency pairs
  • A currency pair with a high volatility has a wide bell curve

Analyst Forecasts of Currency Pairs

• Examine foreign exchange forecasts accessible by (FXFC) function
• Shows different analysts forecasts of currency exchange rates
  • Can show different stats of the pairs

FX Forward Calculator (FRD)

• Shows the forward exchange rate for a selected pair at certain date
  • Used by those looking to hedge (reduce risk) or to speculate (seek risk)
• T = time column
• SP = spot price (price day it was captured)
• Ex: you are worried about a large trust, that matures in 10 years, that you have of changing currency rate and losing value
  • You can lock in at the future 10 year rate
  • You can agree to lock in at the projected 10 year rate and have that exchange in 10 years from now
  • Ex: SP = 1.35, and you want to lock in the 10 year rate which forecasts 1.52 euro for a dollar
    • With agreement: $1M / 1.52 = 658,000 Euros
    • Without agreement: $1M / 2.00 = 500,000 Euros
      • This is if euro weakened more than the project (just hypothetical scenario)
      • But benefit of 158,000 euros in this example

Gold

• Price chart for gold: type Gold (XAU)
• Seen as a safe haven for currency
• Has storage cost, so FX forward contracts are best

Summary

• Currency movements can wreak havoc on corporations and investors
• Historic volatility and currency rate forecasts shed light on currency risk
• Forward agreements lock in currency rates in the future, facilitating hedging and speculation
• The fact the gold is scarce and cannot simply be printed has meant it has retained value

Summary

Terminal Function Summary

• ECTR - interactive tradeflow map
• FXCA - currency conversion calculator
• PEG - table of currencies linked to other currencies
• BI - provides analysis and data on a series of tailored industry dashboards
• FXTF - library of all the worlds currencies
• FXC - matrix of currency exchange rates
• WCRS MAC - Big Mac index identifying potentially overvalued or undervalued currencies
• IFMO - world inflation monitor
• FXFC - displays foreign exchange rate forecasts
• FX24 - displays currency pair trading 24/7
• FXFM - an FX rate forecast model with displays a bell curve of implied volatility
• FRD - displays FX forward rates for currency pairs

Summary

• The US dollar is the heart of the world currency markets
• Economic surprises drive currency values
  • In short term
  • Long-term = law of one price
• Most major central banks target a specific inflation rate
• Investor can lock exchange rates with forward agreements