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Currency Risk In this short video, we will discuss currency
risk. Our discussion will touch on the currency market and its history, types of currency
instruments, how risk is generated, and why currencies fluctuate.
Currency risk can be thought of as the exposure a portfolio manager has to one currency relative
to another. This risk can be created by speculation in this market known as the foreign exchange
market, or by receiving profits or capital in a currency that is not your home currency.
The currency markets is the largest and most liquid of the capital markets with over 4
trillion dollars per day changing hands. The market is active 6 days a week, nearly 24
hours per day. Trade flow is dominated by money center banks, large financial institutions,
and funds. History
The Modern Foreign Exchange market began in the early 1970’s when countries began to
switch to a floating exchange rate regime from a fixed rate regime. Prior to this period,
countries fixed their currencies to other countries currencies and did not let them
float per market sentiment. The Bretton Woods agreement established the
financial and commercial relations between major industrial countries. The countries
that participated agreed they would allow their currencies to float in a market place.
Instruments The currency markets are vast, but the majority
of the capital flows come through the major currency pairs which trade against the US
dollar. These pairs include currencies from the UK, the EU, Japan, Switzerland, Australia
and Canada. In addition to major currency pairs, there are also cross transactions,
which do not include the US dollar as a counter currency, as well as, emerging market currency
pairs. Currency instruments are traded on an institutional
as well as retail level. Large currency transactions usually take place in the interbank market,
in which large money center and investment banks, dominate capital flows. Many hedge
funds use banks as their market makers for currency transaction as the bid offer spread
is relatively tight. In addition to the over the counter interbank
market, investors can access the currency markets through the regulated futures exchange.
These exchanges offer futures on currency pairs, but are limited on the number of cross
currencies that are available. There are also a number of retail currency brokers, who offer
a plethora of currency pairs to their clients, with relatively solid market making capabilities.
The majority of the transaction that take place in the forex market are spot transaction,
which settle two days from the date of the transaction. Other types of transactions that
take place in the currency market include forward transactions and options transactions.
A forward transaction occurs when the settlement data is beyond the normal 2 day settlement
period. In this case, the short term interest rate differential between the two countries
are used to determine the forward points which are either added or subtracted from the spot
rate to create the forward rate. The options market is liquid and sophisticated
and offers a range of products from standard European settlement to exotic complex structures.
Risks Risk in the currency market are usually initiated
by speculation on the relative direction of one currency versus another or generated from
profits in a foreign currency that need to be exchange for a home currency. Profits can
come in the form of investment income or capital gains form a portfolio that is invested in
instruments that are not denominated in a portfolio managers home currency. Profits
can also be operating income that is generated overseas, which need to be converted to the
home currency. When an investor speculates in the currency
markets, he is speculating on the relative value of one currency toward another. This
is accomplished by purchasing or selling a currency pair.
Doodle For Example, if an investor purchases the
currency pair EUR/USD, they are speculating on the relative value of the Euro vs. the
dollar. If the EUR/USD currency pair rises, the investor will benefit as number of dollars
it will take to purchase 1 Euro will increase. If the EUR/USD falls, the investor will lose
income, as the number of dollars it take to purchase 1 Euro will fall.
The currency markets are one of the most highly leveraged of the capital markets. Leverage
on both the retail and institutional level can reach levels near 100 to 1. This means
for every dollar risked by an investor, $99 dollars can be borrowed for investing in a
currency pair. With leverage this high, an investor's capital can be wiped out with just
a 1% move in the current pair. Risks in the currency market stem from a change
in the underlying exchange rate, to changes in the forward rate. As mentioned early, the
forward rate is the interest rate differential between the home currency and the counter
currency. A change in the interest rate differential between these two countries will have an effect
on the currency pairs exchange rate. Currency Rate Changes
Currencies move based on the supply and demand for an individual currency similar to other
capital market products. Most market pundits monitor the economic data points globally,
to determine if capital flows with move into or out of a specific currency. This type of
reasoning is called fundamental analysis, and can be absorbed by monitoring global events
on a daily basis. Additionally, following the specifics of monetary policy is vital
to a currencies movements, which can be altered when central banks change their stance on
interest rates. The currency markets are the most liquid in
the world and generally the risks associated with these markets are systematic risks. For
many of the emerging market currencies, investors can face liquidities risk. The leverage associated
with this market also creates substantial risks to investors that are not aware of the
pitfalls of gearing.