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Management of Financial Institutions

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Management of Financial Institutions - MGT 604
VU
Lecture # 32
Foreign Exchange
Factors affecting currency trading
Although exchange rates are affected by many factors, in the end, currency prices are a
result of supply and demand forces. 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 economic policy, disseminated by government agencies and central banks,
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).
Economic conditions include:
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.
Economic growth and health: Reports such as gross domestic product (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.
Political conditions
Internal, regional, and international political conditions and events can have a profound
effect on currency markets.
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Management of Financial Institutions - MGT 604
VU
For instance, political upheaval and instability can have a negative impact on a nation's
economy. 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 or 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," with
investors seeking a "safe haven". There will be a greater demand, thus a higher price, for
currencies perceived as stronger over their relatively weaker counterparts.
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 it 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
There are several types of financial instruments commonly used.
Spot
A spot transaction is a two-day delivery transaction, 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. The data for this study come from the spot
market. Spot has the largest share by volume in FX transactions among all instruments.
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Management of Financial Institutions - MGT 604
VU
Forward
One way to deal with the Forex 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 a few days, months, or years.
Future
Foreign currency futures are forward transactions with standard contract sizes and maturity
dates -- for example, 500,000 British pounds for next November at an agreed rate. Futures
are standardized 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.
Swap
The most common type of forward transaction is the currency 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.
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 FX
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, many economists (e.g. Milton Friedman)
have argued that speculators 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 (e.g. Joseph Stieglitz) however, may 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.
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 150% per annum, and later to devalue the krona.
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.
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Management of Financial Institutions - MGT 604
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Gregory 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.
In this view, countries may develop unsustainable financial bubbles or otherwise mishandle
their national economies, and forex speculators made the inevitable collapse happen sooner.
A relatively quick collapse might even be preferable to continued economic mishandling.
Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the
blame from them for having caused the unsustainable economic conditions.
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Table of Contents:
  1. Financial Environment & Role of Financial Institutions:FINANCIAL MARKETS &INSTITUTIONS
  2. FINANCIAL INSTITUTIONS:Non Banking Financial Companies
  3. CENTRAL BANK:Activities and responsibilities, Interest Rate Interventions
  4. POLICY INSTRUMENTS:Open Market Operations, Capital Requirements
  5. BALANCE OF TRADE:Balance of Payments Equilibrium, Public Policy and Financial Stability
  6. STATE BANK OF PAKISTAN:History, Regulation of Liquidity, Departments
  7. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS:Banking Inspection Department
  8. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Debt Management
  9. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Training Programs by SBP
  10. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Human Resources Department
  11. MAJOR DRIVERS OF FINANCIAL INDUSTRY:GLOBAL FINANCIAL SYSTEM, The World Bank
  12. INTERNATIONAL FINANCIAL INSTITUTIONS:ADB Projects in Pakistan, Paris Club
  13. PAKISTAN ECONOMIC AID & DEBT:Macroeconomic Stability, Strengthening Institutions
  14. INCREASING FOREIGN DIRECT INVESTMENT:Industrial Sector, Managing the Debt
  15. ROLE OF COMMERCIAL BANKS:Services Typically Offered by Banks, Types of banks
  16. ROLE OF COMMERCIAL BANKS:Types of investment banks, The Management of the Banks
  17. ROLE OF COMMERCIAL BANKS:Public perceptions of banks, Capital adequacy, Liquidity
  18. ROLE OF COMMERCIAL BANKS:Problem bank management, BANKING SECTOR REFORMS
  19. ROLE OF COMMERCIAL BANKING:Private Deposit Insurance,
  20. BRANCH BANKING IN PAKISTAN:Remittances, Online Fund Transfer
  21. ROLE OF COMMERCIAL BANKS IN MICRO FINANCE SECTOR
  22. Mutual funds:Types of international mutual funds, Mutual funds vs. other investments
  23. Mutual Funds:Criticism of managed mutual funds, Money Market Fund
  24. Mutual Funds:Balanced Funds, Growth Funds, Specialized Funds, Measuring Risks
  25. Mutual Funds:Cost of Ownership, Redemption Fee, Reports to Shareholders
  26. Mutual Funds:Internet Fraud, The Pyramid Scheme, How to Avoid Investment Fraud
  27. Mutual Funds:Investing In International Mutual Funds, How to Pre-Select a Mutual Fund
  28. Role of Investment Banks:Recent evolution of the business, Possible conflicts of interest
  29. Letter of Credit:Elements of a Letter of Credit, Commercial Invoice, Tips for Exporters
  30. Letter of Credit and International Trade:Terminology, Risks in International Trade
  31. Foreign Exchange & Financial Institutions:Investment management firms, Exchange Traded Fund
  32. Foreign Exchange:Factors affecting currency trading, Economic conditions include
  33. Leasing Companies:Basic Purpose of Leasing, Technological Benefits
  34. The Leasing Sector in Pakistan and its Role in Capital Investment
  35. Role of Insurance Companies:Indemnification, Insurer’s business model
  36. Role of Insurance Companies:Life insurance and saving
  37. Role of financial Institutions in Agriculture Sector:What is “Revolving Credit Scheme”?
  38. Agriculture Sector and Financial Institutions of Pakistan:What is SMEs
  39. Can Government of Pakistan Lay a Pivotal Role in this Sector?:Business Environment
  40. Financial Crimes:Process of Money Laundering, Terrorist Financing
  41. DFIs & Risk Management:Managing Credit Risk, Managing Operational Risk
  42. Banking Fraud & Misleading Activities:Rogue Traders, Uninsured Deposits
  43. The Collapse of ENRON:Auditing Issues, Corporate Governance Issues, Corrective Actions
  44. Classic Financial Scandals:Corruption, Discovery, Black Wednesday
  45. RECAP:FINANCIAL INSTITUTIONS, CENTRAL BANK,