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INTRODUCTION TO CURRENCY MARKETS

INTRODUCTION TO CURRENCY MARKETS

Introduction to Currency Markets

  • Definition: The currency market, also known as the foreign exchange market, is a global marketplace where individuals, businesses, and institutions trade currencies.
  • Details: The market is open 24/5, allowing participants to buy and sell currencies at any time, except on weekends.

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Brief History of Foreign Exchange Markets

  • Evolution: The current currency rate mechanism has evolved over thousands of years, from the barter system to the use of metals, and finally, to paper currency.
  • Key Events:
    • The introduction of gold and silver coins as a medium of exchange
    • The development of paper currency, with the value of paper notes backed by gold or silver
    • The establishment of the gold standard, where currencies were pegged to the value of gold
    • The shift to floating exchange rates, where currencies are valued based on supply and demand

Major Currencies and Currency Pairs

  • Definition: A currency pair is the quotation of the relative value of a currency unit against the unit of another currency.
  • Details:
    • The most traded currency pairs are called the Majors, which include EUR/USD, USD/JPY, GBP/USD, AUD/USD, USDCAD, USDCNY, and USDCHF
    • These currency pairs follow a free-floating method of valuation
    • According to the Bank for International Settlement (BIS) survey, the share of different currency pairs in global average daily foreign exchange market turnover is as follows:
      • EUR/USD: 22.7%
      • USD/JPY: 13.5%
      • GBP/USD: 9.5%
      • AUD/USD: 5.1%
      • USD/CAD: 5.5%
      • USD/CNY: 6.6%
      • USD/CHF: 3.9%
      • USD/HKD: 2.4%
      • USD/INR: 1.6%
      • Others: 17.6% and 11.6%

Currency Classification

  • Majors: The most widely traded currencies, including EUR, USD, JPY, GBP, AUD, CAD, and CHF
  • Minors: Currency pairs that are not associated with the US dollar, such as EUR/GBP, EUR/JPY, and EUR/CHF
  • Exotics: Currency pairs that contain a major currency and a currency from a developing or emerging market, such as USD/TRY and USD/SEK

Key Concepts

  • Fiat Money: A government-issued currency that is not backed by a physical commodity, but rather by the government that issued it
  • Gold Standard: A system where currencies were pegged to the value of gold
  • Floating Exchange Rates: A system where currencies are valued based on supply and demand
  • Managed Float: An exchange rate regime where the exchange rate is neither entirely free nor fixed, and the central bank intervenes to influence the price of the currency.

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Introduction to Currency Markets

  • US Dollar (USD): The home denomination of the world's largest economy, the United States. The US Dollar is the most widely traded currency, reflecting its substantial international role as an investment currency, reserve currency, transaction currency, invoice currency, and intervention currency.
  • Key Roles of USD: The US Dollar is used as a vehicle currency in foreign exchange transactions, allowing for more efficient and liquid markets.

Major Currencies

  • Euro (EUR): The official currency of 20 of the 27 member states of the European Union, managed by the European Central Bank (ECB). The Euro has a strong international presence and is the second-largest and second-most traded currency.
  • Japanese Yen (JPY): The third most traded currency, with a smaller international presence than the US Dollar or Euro. The Yen is widely used as a funding currency for carry trades.
  • British Pound (GBP): The fourth most-traded currency, with a strong presence in the foreign exchange market. The Pound is heavily traded against the Euro and US Dollar.
  • Swiss Franc (CHF): Considered a safe-haven currency, with a strong upward pressure due to increased foreign demand. The Swiss Franc is also a popular funding currency.
  • Indian Rupee (INR): The official currency of India, with a market-determined exchange rate. The Reserve Bank of India manages the currency and intervenes in the USD/INR market to impact effective exchange rates.

International Currency Markets

  • Foreign Exchange Market (Forex): An inter-bank market that facilitates global transactions, including loans, investments, and trade. The Forex market is a 24-hour market, with business hours overlapping across financial centers.
  • Market Characteristics: The market is most active when both the US and Europe are open, with nearly two-thirds of the day's activity taking place in the morning hours. The market provides a continuous real-time assessment of currency prices and influences.
  • OTC Foreign Exchange Turnover: The average daily turnover is approximately USD 7.5 trillion, with growth in FX derivatives trading outpacing spot trading.

Currency Market Statistics

  • Currency Share in Global Average Daily Foreign Exchange Market Turnover:
    • USD: 88.4%
    • EUR: 30.5%
    • JPY: 16.7%
    • GBP: 12.9%
    • INR: 1.6%
    • Others: 49.8%
  • OTC Foreign Exchange Turnover by Instrument:
    • Spot Transactions: 2104 billion USD
    • Outright Forwards: 1163 billion USD
    • Foreign Exchange Swaps: 3810 billion USD
    • Currency Swaps: 124 billion USD
    • FX Options & Other: 304 billion USD
    • OTC Foreign Exchange Turnover: 7506 billion USD
    • Exchange Traded Derivatives: 154 billion USD

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Introduction to Currency Markets

  • Currency Pair: A currency pair is the quotation of two different currencies, with the value of one currency being quoted against the other. For example, the USD may be valued at 78 against INR, but 115 against JPY.
  • Key Characteristics:
    • The value of a currency pair can fluctuate constantly due to various economic factors.
    • Currency dealers must stay informed about the latest developments in each country to make informed decisions.
    • The currency market is considered complex due to the varying values of currency pairs.

Base Currency and Quotation Currency

  • Definition: In a currency pair, one currency is the base currency (BC) and the other is the quotation currency (QC). The BC is the currency being priced, and its amount is typically fixed at one unit.
  • Example: In the USDINR pair, USD is the base currency, and INR is the quotation currency. The price quoted in the market is the price of one USD expressed in INR.
  • Key Points:
    • The standard practice is to write the BC code first, followed by the QC code.
    • The bid price is the price at which the broker will buy the base currency, while the ask price is the price at which the broker will sell the base currency.

Forex Market

  • Segments: The foreign exchange market in India can be broadly divided into two segments: the interbank market and the merchant/retail market.
  • Interbank Market:
    • Participants include banks with Authorized Dealer (AD) licenses under the Foreign Exchange Management Act (FEMA), 1999.
    • Transactions are conducted through trading platforms provided by Clearing Corporation of India Limited (CCIL) and Refinitiv.
  • Retail Forex Market:
    • Retail customers can buy/sell foreign exchange through various avenues, including over-the-phone transactions with AD banks or electronic dealing platforms.
    • The RBI has introduced an electronic trading platform, FX-Retail, to provide transparent and fair pricing in the retail forex market.

Two-Way Quotes

  • Definition: A two-way quote includes both the bid price (the price at which the market maker will buy the base currency) and the offer price (the price at which the market maker will sell the base currency).
  • Example: A bank quotes USDINR spot price as 75.0550/75.0600, where 75.0550 is the bid price and 75.0600 is the offer price.
  • Key Points:
    • The difference between the bid and offer prices is called the spread.
    • A narrow spread indicates higher liquidity and higher efficiency of the market maker.

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Appreciation/Depreciation

  • Definition: Appreciation occurs when the base currency buys more of the quotation currency, while depreciation occurs when the base currency buys less of the quotation currency.
  • Example: If USDINR moves from 82 to 82.25, the USD has appreciated against INR, and the INR has depreciated against USD.
  • Key Points:
    • Changes in exchange rates can be expressed as strengthening or weakening of one currency vis-à-vis the other currency.
    • When buying a currency pair, it implies that the value of the pair is expected to increase, meaning the base currency will buy more of the quotation currency.

Introduction to Currency Markets (Part 4)

Appreciation and Depreciation of Currencies

  • Appreciation: The base currency strengthens when it can buy more units of the quotation currency. For example, if USD INR moves from 82 to 83, the base currency (USD) strengthens and the quotation currency (INR) weakens.
  • Depreciation: The quotation currency strengthens when the base currency buys lesser units of the quotation currency. For example, if USD INR moves from 83 to 82, the base currency (USD) weakens and the quotation currency (INR) strengthens.

Market Timing

  • Normal Market Hours: The normal market hours for FCY/INR transactions in the inter-bank forex market as well as client transactions in India are from 9:00 a.m. to 5:00 p.m. IST on all working days.
  • Extended Hours: Authorised dealers may undertake customer and inter-bank transactions beyond normal market hours.
  • Value Cash Transactions: Value cash transactions may be undertaken only up to 5:00 p.m. IST, except in case of individual persons.

Forex Rates

  • Base Rate: The base rate is the rate derived from the ongoing market rate, based on which buying/selling rates are quoted for merchant transactions.
  • Card Rates: Banks follow the practice of fixing "card rates" for various forex pairs at the beginning of the day, at which purchases and sales from/to retail customers would be made.

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Price Discovery

  • Forex Market: The forex market in India is predominantly a wholesale market, dominated by banks, forex brokers, and corporate clients.
  • Trading Venues: Major trading venues for the interbank spot market are Refinitiv D2 and FX Clear, while forex swaps are largely transacted outside platforms on a bilateral basis.

FBIL Reference Rate

  • Computation Methodology: The USD/INR Reference Rate is computed based on the data in respect of actual spot US dollar/Indian rupee transactions taking place on electronic platforms during a one-hour time window from 11:30 Hours to 12:30 Hours on each business day in Mumbai.
  • Threshold Criteria: A +/- 3 Standard Deviation (SD) rule is applied to the transaction data to remove outliers, and the Reference Rate is set equal to the volume-weighted average of the surviving transactions.

Introduction to Currency Markets (Part 5)

  • Currency Reference Rates: The reference rates for EURO and GBP are published for 1 unit of each currency, while the reference rate for JPY is published for 100 units. EUR/INR and GBP/INR reference rates are published up to 4 decimal places, and the JPY/INR reference rate is published up to 2 decimal places.
  • FBIL Reference Rates: The FBIL reference rates are published at around 13:30 hours on all business days, excluding Saturdays, Sundays, and bank holidays in Mumbai.
  • Forward Premia Curve: The FBIL announces benchmark rates for US Dollar - Indian Rupee Forward Premia for Overnight and from 1 month to 12 months tenor on a daily basis, except Saturdays, Sundays, and public holidays.

Settlement Date and Value Date

  • Spot Transactions: Spot transactions are traded at the current exchange rate for immediate delivery, which can be up to a maximum of two days.
  • Settlement Date/Value Date: The settlement date/value date is the day on which currencies are actually transferred between the buyer and seller.
  • Cash, Tom, and Spot Transactions:
    • Cash Transactions: Settled on the same day.
    • Tom Transactions: Settled on the next business day.
    • Spot Transactions: Settled after two business days.

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Exchange Rate Arithmetic - Cross Rate

  • Cross Rate: The price of a currency pair for which direct quotes are not available, derived by crossing the prices of underlying currency pairs.
  • Derivation of Cross Rate:
    • EURINR: Derived from EURUSD and USDINR.
    • GBPINR: Derived from GBPUSD and USDINR.
    • JPYINR: Derived from USDJPY and USDINR, with a market convention of quoting the price of 100 JPY in terms of INR.

Impact of Economic Factors on Currency Prices

  • Economic Factors: The price of one currency in terms of another is linked to the relative economic strength of the country in the long run.
  • Short-Term Factors: Demand-supply mismatch, global risk appetite, and important political events may determine the currency price in the short run.
  • Local and Global Factors: Factors such as GDP growth rate, balance of payment situation, deficit situation, inflation, interest rate scenario, and policies related to inflow and outflow of foreign capital can impact the value of a currency.
  • Dominating Factors: It is essential to identify the dominating factors at any point in time to decide on the likelihood of appreciation or depreciation of a currency.

Introduction to Currency Markets

  • Demand-Supply Mismatch: The extent of impact of demand-supply mismatch is very high on days when the market is illiquid or on currency pairs with thin trading volumes.
  • Economic Factors: Economic factors have considerable impact on the currency movement, and it is essential to keep track of news related to the demand and supply of different currencies.

Economic Indicators

  • Key Indicators: Some of the important economic factors that have a direct impact on currency markets are:
    • Inflation
    • Balance of Payment Position
    • Trade Deficit
    • Fiscal Deficit
    • GDP Growth
    • Policies Pertaining to Capital Flows
    • Interest Rate Scenario

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Specific Economic Indicators

  • Gross Domestic Product (GDP): A GDP growth rate higher than expected may mean relative strengthening of the currency of that country.
  • Industrial Production: A healthy Index of Industrial Production (IIP) number indicates industrial growth, which could result in relative strengthening of the currency of that country.
  • Consumer Price Index (CPI): A rising CPI means rising prices for goods and services and is an early indicator of inflation.
  • Real Interest Rate: Normally, there is a positive relationship between the real interest rates and the value of the currency.
  • Current Account and Trade Deficit: A narrowing of the trade deficit is a positive for the domestic currency.
  • Non-farm Payrolls (NFP): A rising and positive number means that the economy is adding jobs, which is good for the currency.
  • Retail Sales: A retail sales number higher than expected may mean relative strengthening of the currency of that country.
  • Central Bank Actions: The market tracks minutes of the central bank meetings and key policy decisions, including interest rate decisions and intervention in foreign exchange markets.

Importance of Indicators

  • Market Attention: It is essential to find out which indicators are getting most of the attention of the market at any given point in time.
  • Contextual Importance: The importance of indicators can vary depending on the context and the current market situation.
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