Forex Tutorial: The Forex Market (3)

Forex History and Market Participants

Given the global nature of the forex exchange market, it is important to first examine and learn some of the important historical events relating to currencies and currency exchange before entering any trades. In this section we'll review the international monetary system and how it has evolved to its current state. We will then take a look at the major players that occupy the forex market - something that is important for all potential forex traders to understand. 

The History of the Forex 

Gold Standard System 

The creation of the gold standard monetary system in 1875 marks one of the most important events in the history of the forex market. Before the gold standard was implemented, countries would commonly use gold and silver as means of international payment. The main issue with using gold and silver for payment is that their value is affected by external supply and demand. For example, the discovery of a new gold mine would drive gold prices down. 

The underlying idea behind the gold standard was that governments guaranteed the conversion of currency into a specific amount of gold, and vice versa. In other words, a currency would be backed by gold. Obviously, governments needed a fairly substantial gold reserve in order to meet the demand for currency exchanges. During the late nineteenth century, all of the major economic countries had defined an amount of currency to an ounce of gold. Over time, the difference in price of an ounce of gold between two currencies became the exchange rate for those two currencies. This represented the first standardized means of currency exchange in history. 

The gold standard eventually broke down during the beginning of World War I. Due to the political tension with Germany, the major European powers felt a need to complete large military projects. The financial burden of these projects was so substantial that there was not enough gold at the time to exchange for all the excess currency that the governments were printing off. 

Although the gold standard would make a small comeback during the inter-war years, most countries had dropped it again by the onset of World War II. However, gold never ceased being the ultimate form of monetary value. (For more on this, read The Gold Standard Revisited, What Is Wrong With Gold?and Using Technical Analysis In The Gold Markets.) 

Bretton Woods System 

Before the end of World War II, the Allied nations believed that there would be a need to set up a monetary system in order to fill the void that was left behind when the gold standard system was abandoned. In July 1944, more than 700 representatives from the Allies convened at Bretton Woods, New Hampshire, to deliberate over what would be called the Bretton Woods systemof international monetary management. 

To simplify, Bretton Woods led to the formation of the following: 

1. A method of fixed exchange rates;
2. The U.S. dollar replacing the gold standard to become a primary reserve currency; and
3. The creation of three international agencies to oversee economic activity: the International Monetary Fund (IMF), International Bank for Reconstruction and Development, and the General Agreement on Tariffs and Trade (GATT).

One of the main features of Bretton Woods is that the U.S. dollar replaced gold as the main standard of convertibility for the world's currencies; and furthermore, the U.S. dollar became the only currency that would be backed by gold. (This turned out to be the primary reason that Bretton Woods eventually failed.) 

Over the next 25 or so years, the U.S. had to run a series of balance of payment deficits in order to be the world's reserved currency. By the early 1970s, U.S.gold reserves were so depleted that the U.S. treasury did not have enough gold to cover all the U.S. dollars that foreign central banks had in reserve. 

Finally, on August 15, 1971, U.S. President Richard Nixon closed the gold window, and the U.S. announced to the world that it would no longer exchange gold for the U.S. dollars that were held in foreign reserves. This event marked the end of Bretton Woods. 

Even though Bretton Woods didn't last, it left an important legacy that still has a significant effect on today's international economic climate. This legacy exists in the form of the three international agencies created in the 1940s: the IMF, the International Bank for Reconstruction and Development (now part of the World Bank) and GATT, the precursor to the World Trade Organization. (To learn more about Bretton Wood, read What Is The International Monetary Fund? and Floating And Fixed Exchange Rates.) 

Current Exchange Rates

After the Bretton Woods system broke down, the world finally accepted the use of floating foreign exchange rates during the Jamaica agreement of 1976. This meant that the use of the gold standard would be permanently abolished. However, this is not to say that governments adopted a pure free-floating exchange rate system. Most governments employ one of the following three exchange rate systems that are still used today: 

1. Dollarization;
2. Pegged rate; and
3. Managed floating rate.

Dollarization 

This event occurs when a country decides not to issue its own currency and adopts a foreign currency as its national currency. Although dollarization usually enables a country to be seen as a more stable place for investment, the drawback is that the country's central bank can no longer print money or make any sort of monetary policy. An example of dollarization is El Salvador's use of the U.S. dollar. (To read more, see Dollarization Explained.)

Pegged Rates 

Pegging occurs when one country directly fixes its exchange rate to a foreign currency so that the country will have somewhat more stability than a normal float. More specifically, pegging allows a country's currency to be exchanged at a fixed rate with a single or a specific basket of foreign currencies. The currency will only fluctuate when the pegged currencies change. 

For example, China pegged its yuan to the U.S. dollar at a rate of 8.28 yuan to US$1, between 1997 and July 21, 2005. The downside to pegging would be that a currency's value is at the mercy of the pegged currency's economic situation. For example, if the U.S. dollar appreciates substantially against all other currencies, the yuan would also appreciate, which may not be what the Chinese central bank wants. 

Managed Floating Rates 

This type of system is created when a currency's exchange rate is allowed to freely change in value subject to the market forces of supply and demand. However, the government or central bank may intervene to stabilize extreme fluctuations in exchange rates. For example, if a country's currency is depreciating far beyond an acceptable level, the government can raise short-term interest rates. Raising rates should cause the currency to appreciate slightly; but understand that this is a very simplified example. Central banks typically employ a number of tools to manage currency. 

Market Participants 

Unlike the equity market - where investors often only trade with institutional investors (such as mutual funds) or other individual investors - there are additional participants that trade on the forex market for entirely different reasons than those on the equity market. Therefore, it is important to identify and understand the functions and motivations of the main players of the forex market. 

Governments and Central Banks 

Arguably, some of the most influential participants involved with currency exchange are the central banks and federal governments. In most countries, the central bank is an extension of the government and conducts its policy in tandem with the government. However, some governments feel that a more independent central bank would be more effective in balancing the goals of curbing inflation and keeping interest rates low, which tends to increase economic growth. Regardless of the degree of independence that a central bank possesses, government representatives typically have regular consultations with central bank representatives to discuss monetary policy. Thus, central banks and governments are usually on the same page when it comes to monetary policy. 

Central banks are often involved in manipulating reserve volumes in order to meet certain economic goals. For example, ever since pegging its currency (the yuan) to the U.S. dollar, China has been buying up millions of dollars worth ofU.S. treasury bills in order to keep the yuan at its target exchange rate. Central banks use the foreign exchange market to adjust their reserve volumes. With extremely deep pockets, they yield significant influence on the currency markets. 

Banks and Other Financial Institutions 

In addition to central banks and governments, some of the largest participants involved with forex transactions are banks. Most individuals who need foreign currency for small-scale transactions deal with neighborhood banks. However, individual transactions pale in comparison to the volumes that are traded in the interbank market. 

The interbank market is the market through which large banks transact with each other and determine the currency price that individual traders see on their trading platforms. These banks transact with each other on electronic brokering systems that are based upon credit. Only banks that have credit relationships with each other can engage in transactions. The larger the bank, the more credit relationships it has and the better the pricing it can access for its customers. The smaller the bank, the less credit relationships it has and the lower the priority it has on the pricing scale. 

Banks, in general, act as dealers in the sense that they are willing to buy/sell a currency at the bid/ask price. One way that banks make money on the forex market is by exchanging currency at a premium to the price they paid to obtain it. Since the forex market is a decentralized market, it is common to see different banks with slightly different exchange rates for the same currency. 

Hedgers 

Some of the biggest clients of these banks are businesses that deal with international transactions. Whether a business is selling to an international client or buying from an international supplier, it will need to deal with the volatility of fluctuating currencies. 

If there is one thing that management (and shareholders) detest, it is uncertainty. Having to deal with foreign-exchange risk is a big problem for many multinationals. For example, suppose that a German company orders some equipment from a Japanese manufacturer to be paid in yen one year from now. Since the exchange rate can fluctuate wildly over an entire year, the German company has no way of knowing whether it will end up paying more euros at the time of delivery. 

One choice that a business can make to reduce the uncertainty of foreign-exchange risk is to go into the spot market and make an immediate transaction for the foreign currency that they need. 

Unfortunately, businesses may not have enough cash on hand to make spot transactions or may not want to hold massive amounts of foreign currency for long periods of time. Therefore, businesses quite frequently employ hedging strategies in order to lock in a specific exchange rate for the future or to remove all sources of exchange-rate risk for that transaction. 

For example, if a European company wants to import steel from the U.S., it would have to pay in U.S. dollars. If the price of the euro falls against the dollar before payment is made, the European company will realize a financial loss. As such, it could enter into a contract that locked in the current exchange rate to eliminate the risk of dealing in U.S. dollars. These contracts could be either forwards or futures contracts. 

Speculators 

Another class of market participants involved with foreign exchange-related transactions is speculators. Rather than hedging against movement in exchange rates or exchanging currency to fund international transactions, speculators attempt to make money by taking advantage of fluctuating exchange-rate levels. 

The most famous of all currency speculators is probably George Soros. The billionaire hedge fund manager is most famous for speculating on the decline of the British pound, a move that earned $1.1 billion in less than a month. On the other hand, Nick Leeson, a derivatives trader with England's Barings Bank, took speculative positions on futures contracts in yen that resulted in losses amounting to more than $1.4 billion, which led to the collapse of the company. 

Some of the largest and most controversial speculators on the forex market are hedge funds, which are essentially unregulated funds that employ unconventional investment strategies in order to reap large returns. Think of them as mutual funds on steroids. Hedge funds are the favorite whipping boys of many a central banker. Given that they can place such massive bets, they can have a major effect on a country's currency and economy. Some critics blamed hedge funds for the Asian currency crisis of the late 1990s, but others have pointed out that the real problem was the ineptness of Asian central bankers. (For more on hedge funds, see Introduction To Hedge Funds - Part One andPart Two.)Either way, speculators can have a big sway on the currency markets, particularly big ones. 

Now that you have a basic understanding of the forex market, its participants and its history, we can move on to some of the more advanced concepts that will bring you closer to being able to trade within this massive market. The next section will look at the main economic theories that underlie the forex market.

Economic Theories, Models, Feeds & Data

There is a great deal of academic theory revolving around currencies. While often not applicable directly to day-to-day trading, it is helpful to understand the overarching ideas behind the academic research. 

The main economic theories found in the foreign exchange deal with parity conditions. A parity condition is an economic explanation of the price at which two currencies should be exchanged, based on factors such as inflation and interest rates. The economic theories suggest that when the parity condition does not hold, an arbitrage opportunity exists for market participants. However, arbitrage opportunities, as in many other markets, are quickly discovered and eliminated before even giving the individual investor an opportunity to capitalize on them. Other theories are based on economic factors such as trade, capital flows and the way a country runs its operations. We review each of them briefly below. 

Major Theories: Purchasing Power Parity 

Purchasing Power Parity (PPP) is the economic theory that price levels between two countries should be equivalent to one another after exchange-rate adjustment. The basis of this theory is the law of one price, where the cost of an identical good should be the same around the world. Based on the theory, if there is a large difference in price between two countries for the same product after exchange rate adjustment, an arbitrage opportunity is created, because the product can be obtained from the country that sells it for the lowest price. 

The relative version of PPP is as follows: 

Where 'e' represents the rate of change in the exchange rate and 'π₁' and 'π₂'represent the rates of inflation for country 1 and country 2, respectively. 

For example, if the inflation rate for country XYZ is 10% and the inflation for country ABC is 5%, then ABC's currency should appreciate 4.76% against that of XYZ. 

Interest Rate Parity 

The concept of Interest Rate Parity (IRP) is similar to PPP, in that it suggests that for there to be no arbitrage opportunities, two assets in two different countries should have similar interest rates, as long as the risk for each is the same. The basis for this parity is also the law of one price, in that the purchase of one investment asset in one country should yield the same return as the exact same asset in another country; otherwise exchange rates would have to adjust to make up for the difference. 

The formula for determining IRP can be found by: 

Where 'F' represents the forward exchange rate; 'S' represents the spot exchange rate; 'i₁' represents the interest rate in country 1; and 'i₂' represents the interest rate in country 2. 

International Fisher Effect 

The International Fisher Effect (IFE) theory suggests that the exchange rate between two countries should change by an amount similar to the difference between their nominal interest rates. If the nominal rate in one country is lower than another, the currency of the country with the lower nominal rate should appreciate against the higher rate country by the same amount. 

The formula for IFE is as follows: 

Where 'e' represents the rate of change in the exchange rate and 'i₁' and 'i₂'represent the rates of inflation for country 1 and country 2, respectively. 

Balance of Payments Theory 

A country's balance of payments is comprised of two segments - the current account and the capital account - which measure the inflows and outflows of goods and capital for a country. The balance of payments theory looks at the current account, which is the account dealing with trade of tangible goods, to get an idea of exchange-rate directions. 

If a country is running a large current account surplus or deficit, it is a sign that a country's exchange rate is out of equilibrium. To bring the current account back into equilibrium, the exchange rate will need to adjust over time. If a country is running a large deficit (more imports than exports), the domestic currency will depreciate. On the other hand, a surplus would lead to currency appreciation. 

The balance of payments identity is found by: 

Where BCA represents the current account balance; BKA represents the capital account balance; and BRA represents the reserves account balance. 

Real Interest Rate Differentiation Model 

The Real Interest Rate Differential Model simply suggests that countries with higher real interest rates will see their currencies appreciate against countries with lower interest rates. The reason for this is that investors around the world will move their money to countries with higher real rates to earn higher returns, which bids up the price of the higher real rate currency. 

Asset Market Model 

The Asset Market Model looks at the inflow of money into a country by foreign investors for the purpose of purchasing assets such as stocks, bonds and other financial instruments. If a country is seeing large inflows by foreign investors, the price of its currency is expected to increase, as the domestic currency needs to be purchased by these foreign investors. This theory considers the capital account of the balance of trade compared to the current account in the prior theory. This model has gained more acceptance as the capital accounts of countries are starting to greatly outpace the current account as international money flow increases. 

Monetary Model 

The Monetary Model focuses on a country's monetary policy to help determine the exchange rate. A country's monetary policy deals with the money supply of that country, which is determined by both the interest rate set by central banks and the amount of money printed by the treasury. Countries that adopt a monetary policy that rapidly grows its monetary supply will see inflationary pressure due to the increased amount of money in circulation. This leads to a devaluation of the currency. 

These economic theories, which are based on assumptions and perfect situations, help to illustrate the basic fundamentals of currencies and how they are impacted by economic factors. However, the fact that there are so many conflicting theories indicates the difficulty in any one of them being 100% accurate in predicting currency fluctuations. Their importance will likely vary by the different market environment, but it is still important to know the fundamental basis behind each of the theories. 

Economic Data 

Economic theories may move currencies in the long term, but on a shorter-term, day-to-day or week-to-week basis, economic data has a more significant impact. It is often said the biggest companies in the world are actually countries and that their currency is essentially shares in that country. Economic data, such as the latest gross domestic product (GDP) numbers, are often considered to be like a company's latest earnings data. In the same way that financial news and current events can affect a company's stock price, news and information about a country can have a major impact on the direction of that country's currency. Changes in interest rates, inflation, unemployment, consumer confidence, GDP, political stability etc. can all lead to extremely large gains/losses depending on the nature of the announcement and the current state of the country. 

The number of economic announcements made each day from around the world can be intimidating, but as one spends more time learning about the forex market it becomes clear which announcements have the greatest influence. Listed below are a number of economic indicators that are generally considered to have the greatest influence - regardless of which country the announcement comes from. 

Employment Data 

Most countries release data about the number of people that currently are employed within that economy. In the U.S., this data is known as non-farm payrolls and is released the first Friday of the month by the Bureau of Labor Statistics. In most cases, strong increases in employment signal that a country enjoys a prosperous economy, while decreases are a sign of potential contraction. If a country has gone recently through economic troubles, strong employment data could send the currency higher because it is a sign of economic health and recovery. On the other hand, high employment can also lead to inflation, so this data could send the currency downward. In other words, economic data and the movement of currency will often depend on the circumstances that exist when the data is released. 

Interest Rates 

As was seen with some of the economic theories, interest rates are a major focus in the forex market. The most focus by market participants, in terms of interest rates, is placed on the country's central bank changes of its bank rate, which is used to adjust monetary supply and institute the country's monetary policy. In the U.S., the Federal Open Market Committee (FOMC) determines the bank rate, or the rate at which commercial banks can borrow and lend to the U.S. Treasury. The FOMC meets eight times a year to make decisions on whether to raise, lower or leave the bank rate the same; and each meeting, along with the minutes, is a point of focus. (For more on central banks read Get to Know the Major Central Banks.) 

Inflation 

Inflation data measures the increases and decreases of price levels over a period of time. Due to the sheer amount of goods and services within an economy, a basket of goods and services is used to measure changes in prices. Price increases are a sign of inflation, which suggests that the country will see its currency depreciate. In the U.S., inflation data is shown in the Consumer Price Index, which is released on a monthly basis by the Bureau of Labor Statistics. 

Gross Domestic Product 

The gross domestic product of a country is a measure of all of the finished goods and services that a country generated during a given period. The GDP calculation is split into four categories: private consumption, government spending, business spending and total net exports. GDP is considered the best overall measure of the health of a country's economy, with GDP increases signaling economic growth. The healthier a country's economy is, the more attractive it is to foreign investors, which in turn can often lead to increases in the value of its currency, as money moves into the country. In the U.S., this data is released by the Bureau of Economic Analysis once a month in the third or fourth quarter of the month. 

Retail Sales 

Retail sales data measures the amount of sales that retailers make during the period, reflecting consumer spending. The measure itself doesn't look at all stores, but, similar to GDP, uses a group of stores of varying types to get an idea of consumer spending. This measure also gives market participants an idea of the strength of the economy, where increased spending signals a strong economy. In the U.S., the Department of Commerce releases data on retail sales around the middle of the month. 

Durable Goods 

The data for durable goods (those with a lifespan of more than three years) measures the amount of manufactured goods that are ordered, shipped and unfilled for the time period. These goods include such things as cars and appliances, giving economists an idea of the amount of individual spending on these longer-term goods, along with an idea of the health of the factory sector. This measure again gives market participants insight into the health of the economy, with data being released around the 26th of the month by the Department of Commerce. 

Trade and Capital Flows 

Interactions between countries create huge monetary flows that can have a substantial impact on the value of currencies. As was mentioned before, a country that imports far more than it exports could see its currency decline due to its need to sell its own currency to purchase the currency of the exporting nation. Furthermore, increased investments in a country can lead to substantial increases in the value of its currency. 

Trade flow data looks at the difference between a country's imports and exports, with a trade deficit occurring when imports are greater than exports. In the U.S., the Commerce Department releases balance of trade data on a monthly basis, which shows the amount of goods and services that the U.S. exported and imported during the past month. Capital flow data looks at the difference in the amount of currency being brought in through investment and/or exports to currency being sold for foreign investments and/or imports. A country that is seeing a lot of foreign investment, where outsiders are purchasing domestic assets such as stocks or real estate, will generally have a capital flow surplus. 

Balance of payments data is the combined total of a country's trade and capital flow over a period of time. The balance of payments is split into three categories: the current account, the capital account and the financial account. The current account looks at the flow of goods and services between countries. The capital account looks at the exchange of money between countries for the purpose of purchasing capital assets. The financial account looks at the monetary flow between countries for investment purposes. 

Macroeconomic and Geopolitical Events 

The biggest changes in the forex often come from macroeconomic and geopolitical events such as wars, elections, monetary policy changes and financial crises. These events have the ability to change or reshape the country, including its fundamentals. For example, wars can put a huge economic strain on a country and greatly increase the volatility in a region, which could impact the value of its currency. It is important to keep up to date on these macroeconomic and geopolitical events. 

There is so much data that is released in the forex market that it can be very difficult for the average individual to know which data to follow. Despite this, it is important to know what news releases will affect the currencies you trade. (For more insight, check out Trading On News Releases and Economic Indicators To Know.) 

Now that you know a little more about what drives the market, we will look next at the two main trading strategies used by traders in the forex market – fundamental and technical analysis.