The most
valuable information I got is through interviewing Mr.Sanjay Podar, Forex
Department, Standard Chartered Bank. He provided me practical information in a
very awesome manner as discussed below.
What causes
currency values to fluctuate?
The simple
answer to this complex question is that supply and demand determines the
value of a currency. If demand is high, the value rises, and vice versa.
Factors that affect supply and demand include the following:
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Interest
rates
When a
country's interest rates are high relative to elsewhere, money tends to flow
into that country as investors and speculators seek to take advantage of the
higher interest rates. This "interest differential" boosts the
demand for the currency and can cause its value to rise.
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Inflation
The causes of
inflation are much debated – foreign debt and the increased taxation needed
to service it; using high interest rates to attract foreign currency deposits
and consequently inflating the cost of money; too much money in circulation
causing the currency’s value to decline. When inflation is high, a country
becomes less competitive in international markets, causing a drop in exports
and a rise in imports, which tends to push the currency downwards. All else
being equal, when a country’s central bank prints more money, inflation goes
up and the exchange rate (the price of the currency) goes down.
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Balance of
trade
If a country
runs a substantial trade surplus, the result of other countries wanting its
exports, a large demand for its currency usually follows and therefore the
currency’s value should appreciate. By contrast, if a country relies more on
imports and runs a large trade deficit, it must sell its currency to buy
someone else’s goods. This puts downward pressure on the currency and usually
causes it to lose value.
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Economic
growth
Countries
experiencing a deep recession often find that their exchange rate is
weakening. Traders in the currency markets may take the slow growth to be a
sign of general economic weakness and "mark down" the value of the
currency as a result. On the other hand, economies with strong
"export-led" growth may see their currency's rise in value.
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Market
speculators
When
speculators decide, based on special factors such as political events or
changing commodity prices, that a currency is going to fall in value, they
sell that currency and buy those that they anticipate will rise in
value. This can have a significant effect on a currency. Governments are
limited as to what they can do to offset the power of speculators because
they generally have limited reserves of foreign currencies compared to daily
turnovers in the FX market.
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Government
budget deficits/surpluses
If a
government runs a deficit, it has to borrow money, by selling bonds. If it
can’t borrow enough from its own citizens, it must sell to foreign investors.
That means selling more of its currency, driving the price down.
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Statistics on
all these items are reported on a regular basis. The precise date and time of
the data releases are well known to the market in advance and exchange rates
can move accordingly.
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What is the
difference between speculating and hedging in foreign exchange?
Hedging is
insurance, its purpose to minimize risk and protect against negative events.
In the forex market, hedging can be used to mitigate the effects of currency
fluctuations. Thus, a business importing from overseas could purchase a
forward contract in the amount of its payable for a future shipment, locking
in at the current rate of exchange between, say, the English pound and the US
dollar. This hedges the business from unfavorable changes in that exchange
rate between now and the date when payment is due. Speculating, on the other
hand, is not linked to an underlying business transaction. Speculators
deliberately incur risk in the hope of increasing their profit.
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What is economic
exposure?
There are
various types of exposure, all describing a kind of risk. If a company
imports from other countries, that company is exposed to the risk of
fluctuating exchange rates. Such fluctuations can affect a company's
earnings, cash flow and foreign investments.
How can one
protect himself from economic exposure?
The Forward
Contract is one of the most effective ways to protect against economic
exposure. A Forward Contract is a foreign exchange transaction in which a
client locks in a rate for settlement on a date more than five days in the
future. It is an agreement to purchase or sell a set amount of a foreign
currency at a specified price for settlement at a predetermined future date,
or within a predetermined window of time. Closed forwards must be settled on
a specified date. Open forwards set a window of time during which any portion
of the contract can be settled, as long as the entire contract is settled by
the end date.
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