Foreign Exchange: The Complete Deal

A comprehensive guide to the theory and practice of the Forex market

James Sharpe

• Publisher: Harriman House
• Year: 2012
• Print ISBN: 9781906659653
• eBook ISBN: 9780857192066
• Edition: 1
• Topic: Business
• Subtopic: Stocks
• Index: Business

The foreign exchange market is the largest and most liquid financial market in the world. In recent years its volatility has been especially pronounced, which has posed problems for investors, companies and governments attempting to manage their economies. The management of exchange rates has become integral to economic performance and to the political landscape.'Foreign Exchange, The Complete Deal', part of Harriman House's Applied Essentials series, is a comprehensive guide to this broad and exciting market, and how it is traded. James Sharpe, a foreign exchange practitioner with more than 30 years' experience, unravels the important features of the Forex market to give a clear understanding of the issues and processes involved in foreign exchange transactions.This book begins with an exploration of the historical and theoretical background to the markets as they exist today. The transition from a fixed exchange rate system to a floating system is examined and insight is given on the processes that determine exchange rates and how the system employed impacts government policy. There is also a detailed section about the influence interventions by central banks have on the market.The focus then moves to foreign exchange in practice, the core of the book. Topics covered include:- The range of foreign exchange transactions available - including spot, forward, broken date, non-deliverable forwards (NDFs), swaps and options - and how they can be used, with clear worked examples- How foreign exchange prices are quoted; bid-offer spreads; pips- How foreign exposures are hedged- How banks and dealers cover their exposure in the market and make profits- A discussion of tools that are used to analyse the market, including technical analysis- Factors that influence foreign exchange prices on a daily basis including a detailed look at liquidity- How professional traders analyse markets and provide a blueprint for professional trading- How best to choose and manage the relationship with foreign exchange providersThis is an indispensable guide for those who need to understand more about the commercial realities of currency trading and hedging, providing a clear and thorough explanation of the complete world of foreign exchange.

1. Exchange Rate Systems: From Fixed to Floating, and Chaos

An exchange rate system is any system which determines the conditions under which one currency can be exchanged for another. Fixed, floating and adjustable peg systems (of which there are various) are the three main systems available. All systems are designed to facilitate trade and investment across national boundaries.

To understand the foreign exchange systems in the 21st century we need to see where we have come from and why. In this overview I will start from the end of the First World War, which allows us to look at all the main examples of exchange rate systems up to the present day. In essence, every generation has wrestled with the same problem: namely, how to set up an effective system to determine how exchange rates should be calculated and how deficits should be financed.

No system has been without its problems, hence the variety of approaches that have been developed, although these problems have as much to do with an extraordinary passage of events in this period as to specific defects in any particular system. These events include two World Wars, the Korean War, the Vietnam War, the Cold War, the Great Depression, oil shocks and rampant inflation. Over this period the social and political landscape has changed dramatically; political accountability is now widespread and, as mentioned in the preface, events that would have been viewed as inevitable or just economic misfortune in the past are now judged to be mismanagement. For this reason I have paid particular attention to the role of central banks, especially their intervention in the markets.

While the period is littered with crises I have only covered pivotal moments, or events that illustrate a key issue. It is not intended to be a complete history of foreign exchange but rather to provide a rich insight into what actually drives the foreign exchange markets. Each generation is inclined to view its circumstances as something unprecedented or unique, but, as we will see, this is rarely the case.

At the end of the chapter, the overview of the route from fixed exchange rates to a floating rate system is followed by a specific look at the UK foreign exchange experience since 1960.

This chapter will make some reference to countries’ current accounts and, therefore, before we move on to the historical overview of the transition from fixed exchange rates to floating exchange rates, it is important to introduce the idea of current accounts here.

National current accounts

The current account of a country is made up of the difference between the worth of exports and imports (visibles) and the difference in trade in services, e.g., insurance, shipping, banking and investment income (invisibles). Current account deficits (where imports are worth more than exports) are generally seen as a sign of economic weakness, with surpluses (where exports are worth more than imports) viewed as the opposite. This is rather simplistic but it provides a useful starting point.

A current account deficit may occur because of government spending, or spending by private firms and individuals. A deficit, whoever is generating it, will need to be financed. This is either through increased borrowing overseas or by a reduction in investments overseas. Debt in itself is not bad. Borrowings may increase the productive potential of the economy, particularly in a development context. Also, debt may be rising but actually falling as a percentage of Gross National Product (GNP). This normally will not create problems.

However, if the deficit is rising as a percentage of the economy there comes a point when lenders start to worry about the risk of default and refuse to lend more. During this process the cost of borrowing will inevitably rise. Examples of this were provided by Greece, Portugal and Ireland in 2010 and 2011. This can prompt an enforced adjustment where further funding, for example from the International Monetary Fund (IMF) or European Union (EU), is conditional upon cuts in spending, including pension and welfare provisions. Apart from the economic implications – such as a short-term negative impact on employment and growth – this has a political downside as it can lead to demonstrations and civil unrest.

The US experience is a special case in so far as the US dollar is the world’s reserve currency, meaning that it is the currency most other countries use to pay their debts. Spiralling deficits, however, have raised doubts about whether this can continue. More debt will tend to lead to higher costs for the issuer and overseas investors may lose their appetite for funding the deficit by buying dollars, at least at the current exchange rate. As C. Fred Bergsten rather succinctly put it:

It has long been known that large external deficits pose substantial risks to the US economy because foreign investors might at some point refuse to finance these deficits on terms compatible with US prosperity. Any sudden stop in lending to the United States would drive the dollar down, push inflation and interest rates up, and perhaps bring on a hard landing for the United States – and the world economy at large. ^[1]

This was very much the concern of the US Treasury and Federal Reserve in 2008 when a collapsing dollar was putting at risk the US bond and asset markets.

When the point at which overseas investors refuse to lend any more is reached, countries are forced to return the current account to balance, usually through cutting down on imports, expanding exports, depressing domestic consumption and depressing living standards. This adjustment process is usually relatively short. However, the readjustment forces on sub-Saharan economies in the early 1980s were to have a negative impact for decades.

Some countries (such as Japan and China) run large sustained current account surpluses via the trade balance. This has benefits of increased investment income. A number of oil-producing countries have created funds for future generations from the surpluses, e.g., Norway, Kuwait and Abu Dhabi. The problem with large prolonged surpluses is that they inevitably lead to friction between countries over jobs and exports. Surpluses invested in government bonds are not especially politically sensitive as they have little visibility to the electorate but this soon changes when iconic buildings and flagship companies are bought.

In the 2000s, China has regularly faced accusations of an undervalued currency, manipulated by the authorities, being used to generate enormous surpluses. This has been hotly disputed by the Chinese authorities who, nevertheless, most notably from 2003, have regularly sold the Chinese Renminbi and bought dollars. These imbalances are effectively a savings gap. The US consumes too much, and saves too little; China is saving too much and forgoing consumption. In this context Chinese savings are being used to plug the US deficit through US Treasury purchases.

These imbalances create volatility in the foreign exchange markets in times of crisis as investors repatriate funds (such as in 2008) and if it is felt the currency valuation is seriously at odds with fair value. Global imbalances require global solutions but to date political consensus has not been achieved. Policies that have a negative impact on domestic employment, even in the short term, are not easily embraced. In practice the situation early in the 21st century is not that different to the 1930s, when countries looked to devalue their currencies in order to gain competitive advantage.

A natural partner to protectionism is a global economic and financial crisis leading to a sharp drop in global trade volumes. The 1930s is an obvious example but trade tensions were very evident in 2002 (following the 2001 recession) and in 2009. An indicator in the last two cases is the number of complaints to the World Trade Organisation (WTO), which rose sharply. For example, Europe was increasingly vocal on China. European Central Bank (ECB) President Trichet said in March 2010: “the message is that progressive and orderly appreciation of the Chinese currency would be both in the interest of China and the interest of the global economy”.

There are no recent examples of a full trade war but the impact can be surmised. Protectionist policies will reduce the potential growth of an economy and in a global economic recession protectionism can lengthen the downturn and hinder any recovery. The leading industrialised nations (the members of the G7 and G20) have increasingly looked to the IMF to provide currency surveillance to prevent such circumstances, but not a great deal has come of this as yet.

With the concept of the current account and its importance introduced, I now move on to the overview of exchange rate systems since 1918. This begins with a look at fixed exchange rates.

Fixed exchange rates

A fixed exchange rate system is one where a currency has a fixed value against another currency or commodity. The implied purpose of fixed exchange rate systems is to unite the global economic performance and policies of nations. The best known example of a fixed system was the gold standard which operated in the 19th and early 20th centuries.

The gold standard

In 1914 a holder of a £1 note could go to the Bank of England and exchange the note for 0.257 ounces of gold. Similar practices existed in other European countries and the USA, which meant that there was a fixed exchange rate between the major trading currencies.

The key element in the adjustment mechanism was that domestic money supply in a country was directly related to the amount of gold held by the country’s central bank. If the UK was running a deficit there was a net outflow of pounds from the country. When these pounds in turn were exchanged for gold at the Bank of England there would be a net outflow of gold from the UK. With the reduction in gold, the Bank of England would have to make a corresponding reduction of notes in circulation. This led to a reduction in money supply as cash was withdrawn, a rise in interest rates, a reduction in loans, a weakening of prices, and cutbacks in output and employment. Meanwhile, the gold arriving in Paris or Berlin (for example) would prompt an opposite pattern: the expansion of loans activity and an associated rise in prices.

In this example, the fall in demand in the UK would reduce imports, and exports would become more competitive as prices fell. Employment would be restored, the current account would be returned to equilibrium and another cycle would begin. A deficit on the current account could not be corrected by a devaluation of the currency (as it might be in 2011) because under the gold standard mechanism the currency was fixed in value. Imbalances were corrected through deflation and reflation via interest rates and fiscal policy.

In effect the First World War marked the beginning of the end of the standard as the belligerent powers were forced to reduce their gold holdings to pay for US weaponry and wheat. US gold stocks at the end of 1914 stood at $1.5bn but by the end of 1917 they were valued at $2.9bn. In practice there was no longer a workable distribution of gold stocks because there was abundance in the US and paucity almost everywhere else.

Efforts to revive the gold standard were made in the 1920s but with little success. After the First World War no major country allowed the free export of gold. This meant that domestic policy was no longer constrained by the fear that gold would go offshore. The prospect of reduced note circulation, bank loans, and the depressing impact on prices, employment and production had been removed. As such, countries were now free to pursue their own policies with no immediate regard for what other countries were doing. The coordinating discipline imposed by the gold standard (reinforced by a balanced budget mantra) had gone.

This is similar to the dilemmas facing international exchange management in the early part of the 21st century as the demise of the gold standard coincided with growing nationalism and a growing tendency to hold governments accountable for economic performance. Under this new freedom the greatest inflations of modern history in Germany and Austria occurred, as well as the rise of fascism and communism, protectionism, and the Great Depression.

The arguments in favour of a fixed rate revolve around certainty and economic discipline. Extreme volatility under a floating exchange rate system is regularly cited as its principal weakness. This is simply because in international business there is usually an element of futurity: deals are struck now against future payment. When a currency changes in price from day to day this introduces instability or uncertainty into trade, which affects prices and in turn sales. In a similar way, importers are unsure how much it is going to cost them to import a given amount of foreign goods. Related arguments are also applied to foreign investment flows, which involve the purchase or sale of equities, bonds, commercial interests and fixed assets, e.g., land and property.

This uncertainty can be reduced by hedging foreign exchange risk, and banks have created a panoply of products to resolve this problem, many of which are discussed later. These products have certainly reduced the negative impact of volatility on trade and investment. As we have seen, trade flows and current account balances have historically been the drivers of foreign exchange markets. Of growing importance is real money portfolio flows (bonds and equities) and any hedging that may be applied to these investments. Fund managers may hedge all, part or none of their exposure.

Bretton Woods and adjustable pegs

Before long – in fact prior to the end of the Second World War – it was recognised that a new international monetary framework was required in order to determine how exchange rates would be valued and how deficits would be financed. With the aim of resolving this dilemma, at Bretton Woods in 1944 the International Monetary Fund (IMF) was established and the member countries of the fund assented to have their currencies expressed either in terms of a given amount of gold or an amount of US dollars. Each member country agreed to see that these values were maintained within a given range. At the same time the US agreed with the IMF that its currency would always be convertible into gold and that it in turn would always buy and sell gold at a fixed price of $35 per ounce. This became the basis of the US dollar reserve function. The dollar had become the predominant medium for the settlement of international transactions.

For instance, from 1949 to 1967 the pound was valued at $2.80. This was known as par value for the currency. The Bank of England agreed to maintain prices within a 1% range so the pound could fluctuate from $2.78 to $2.82. If the price drifted below or above these levels the Bank of England would intervene in the market, buying or selling pounds as appropriate.

The Bretton Woods System is the best example of an adjustable peg system. In the short term, currencies are fixed in value against one another. In the longer term, currencies could be devalued or revalued if dictated by economic fundament...

Table of contents

• Cover
• Publishing Details
• Acknowledgements
• About the author
• Preface
• 1. Exchange Rate Systems: From Fixed to Floating, and Chaos
• 2. Central Banks and Foreign Exchange Intervention
• 3. The Basics of Foreign Exchange
• 4. The Theory of Foreign Exchange: How Exchange Rates are Determined
• 5. Foreign Exchange in Practice
• 6. Types of Foreign Exchange Transactions
• 7. Predicting the Future: Technical Analysis and FX Forecasting
• 8. Psychology and Foreign Exchange
• 9. Influences on Foreign Exchange Markets
• 10. A Blueprint for Trading
• 11. Liquidity
• 12. Hedging Currency Exposure
• 13. The Management of Dealing
• 14. Dealing with Banks and Financial Institutions
• Afterword
• Appendices
• Glossary
• Bibliography