2010

Financial Management
Faiza Sajjad

Submitted To:

**************
Assignment #2
Madam

**************
Submitted By:

Shahid Muhammad Khan

Fa08-bba-043

Zaka ul Hassan
Fa08-bba-040

Uzair Ali Shah

Fa08-bba-051

[TRADING & FOREIGN EXCHANGE]

Foreign Exchange Trading or FX Trading, clients are able to

hedge against, or speculate upon, changes in the exchange rate
of two currencies. The foreign exchange market (forex, FX, or
currency market) is a worldwide decentralized over-the-
counter financial market for the trading of currencies.
Trading & Foreign Exchange

Table of Contents

Introduction Foreign Exchange .......................................................3

Foreign exchange trading .............................................................3
Definition with example .......................................................3
Trading Characteristics ........................................................3

Defining Foreign exchange market........................................................................4

Purpose of Foreign exchange market ............................................4
Uniqueness of Foreign exchange market ..................................................5
Foreign exchange market Participants ........................................................6

Foreign Exchange Risk................................................................................6

Foreign Exchange rate................................................................................7

Determinants of Foreign Exchange rate..........................................7

Foreign Exchange trade of Pakistan............................................................8

Conclusion...................................................................................................8

• Introduction Foreign Exchange:

Page
2
Trading & Foreign Exchange

Definition
Instruments, such as paper currency, notes, and
checks, used to make payments between countries.
The exchange of one currency for another or the
conversion of one currency into another currency.

What Does Foreign Exchange Mean?

Foreign exchange also refers to the global market where currencies

are traded virtually around-the-clock. The term foreign exchange is
usually abbreviated as "forex" and occasionally as "FX."

Foreign exchange transactions encompass

everything from the conversion of currencies by a
traveler at an airport kiosk to billion-dollar payments
made by corporate giants and governments for goods
and services purchased overseas. Increasing
globalization has led to a massive increase in the
number of foreign exchange transactions in recent
decades. The global foreign exchange market is by far
the largest financial market, with average daily volumes
in the trillions of dollars.

Foreign exchange may refer to:

 Foreign exchange markets, where money in one
currency is exchanged for another
 Exchange rate, the price for which one currency is
exchanged for another
 Foreign exchange reserves, holdings of other countries'
currencies

Exchange-traded FX futures contracts were introduced in 1972 at

the Chicago Mercantile Exchange and are actively traded relative to
most other futures contracts. Several other developed countries also
permit the trading of FX derivative products (like currency futures
and options on currency futures) on their exchanges.
All these developed
countries already have fully convertible capital accounts. Most
emerging countries do not permit FX derivative products on their
exchanges in view of prevalent controls on the capital accounts.
However, a few select emerging countries (e.g., Korea, South Africa,
India—[1]; [2]) have already successfully experimented with the
currency futures exchanges, despite having some controls on the
capital account.
FX futures volume has grown rapidly in recent years, and accounts
for about 7% of the total foreign exchange market volume,
according to The Wall Street Journal Europe

Page
3
Trading & Foreign Exchange

• Foreign exchange trading:

Foreign Exchange Trading or FX Trading, clients are able to hedge
against, or speculate upon, changes in the exchange rate of two
currencies. For example, a speculator can long EUR/USD in foreign
exchange market in order to profit from capturing the appreciation
of Euro against the U.S. Dollar. Foreign exchange services provide
an opportunity for clients to trade FX. Foreign Exchange Trading is
done on the foreign exchange market.

Trading Characteristics:

There is no unified or centrally cleared market for the majority of FX

trades, and there is very little cross-border regulation. Due to
the over-the-counter (OTC) nature of currency markets, there are
rather a number of interconnected marketplaces, where different
currencies instruments are traded. This implies that there is not
a single exchange rate but rather a number of different rates
(prices), depending on what bank or market maker is trading, and
where it is.

The main trading center is London, but New York, Tokyo, Hong Kong
and Singapore are all important centers as well. Banks throughout
the world participate. Currency trading happens continuously
throughout the day; as the Asian trading session ends, the European
session begins, followed by the North American session and then
back to the Asian session, excluding weekends.

Currencies are traded against one another. Each

currency pair thus constitutes an individual
trading product and is traditionally noted XXXYYY
or XXX/YYY, where XXX and YYY are the ISO 4217
international three-letter code of the currencies
involved. The first currency (XXX) is the base
currency that is quoted relative to the second
currency (YYY), called the counter currency (or
quote currency).

The factors affecting XXX will affect both XXXYYY and XXXZZZ. This
causes positive currency correlation between XXXYYY and XXXZZZ.

On the spot market, according to the 2010 Triennial Survey, the

most heavily traded bilateral currency pairs were:

 EURUSD: 28%

Page
4
Trading & Foreign Exchange

 USDJPY: 14%

 GBPUSD (also called cable): 9%

And the US currency was involved in 84.9% of transactions, followed

by the euro (39.1%), the yen (19.0%), and sterling (12.9%) (see
table). Volume percentages for all individual currencies should add
up to 200%, as each transaction involves two currencies.

Trading in the euro has grown considerably since the currency's

creation in January 1999, and how long the foreign exchange market
will remain dollar-centered is open to debate. Until recently, trading
the euro versus a non-European currency ZZZ would have usually
involved two trades: EURUSD and USDZZZ. The exception to this is
EURJPY, which is an established traded currency pair in the
interbank spot market. As the dollar's value has eroded during 2008,
interest in using the euro as reference currency for prices in
commodities (such as oil), as well as a larger component of foreign
reserves by banks, has increased dramatically. Transactions in the
currencies of commodity-producing countries, such as AUD, NZD,
CAD, have also increased.

• Foreign exchange market:

The markets, in which participants are able to buy, sell

exchange and speculate on currencies. Foreign exchange
markets are made up of banks, commercial companies, central
banks, investment management firms, hedge funds, and retail forex
brokers and investors. The forex market is considered to be the
largest financial market in the world. The foreign exchange market
is the largest and most liquid financial market in the world. Traders
include large banks, central banks, currency speculators,
corporations, governments, and other financial institutions. The
average daily volume in the global foreign exchange and related
markets is continuously growing. Daily turnover was reported to be
over US$3.98 trillion in April 2010 by the Bank for International
Settlements.

Purpose of Foreign exchange market:

The primary purpose of the foreign exchange is to assist

international trade and investment, by allowing businesses to
convert one currency to another currency. For example, it permits a

Page
5
Trading & Foreign Exchange

US business to import British goods and pay Pound Sterling, even

though the business's income is in US dollars. It also supports
speculation, and facilitates the carry trade, in which investors
borrow low-yielding currencies and lend (invest in) high-yielding
currencies, and which (it has been claimed) may lead to loss of
competitiveness in some countries.

In a typical foreign exchange transaction, a party

purchases a quantity of one currency by paying a
quantity of another currency. The modern foreign
exchange market began forming during the 1970s when
countries gradually switched to floating exchange rates
from the previous exchange rate regime, which
remained fixed as per the Bretton Woods system.

Uniqueness of Foreign exchange market:

The foreign exchange market is unique because of:

 its huge trading volume, leading to high liquidity
 its geographical dispersion
 its continuous operation: 24 hours a day except
weekends
 the variety of factors that affect exchange rates
 the low margins of relative profit compared with other
markets of fixed income
 The use of leverage to enhance profit margins with
respect to account size.

As such, it has been referred to as the market closest to the ideal of

perfect competition, notwithstanding market manipulation by
central banks. According to the Bank for
International Settlements, as of April
2010, average daily turnover in global
foreign exchange markets is estimated
at $3.98 trillion, a growth of

Page
6
Trading & Foreign Exchange

approximately 20% over the $3.21 trillion daily volume as of April

2007.

The $3.98 trillion break-down is as follows:

 $1.490 trillion in spot transactions
 $475 billion in outright forwards
 $1.765 trillion in foreign exchange swaps
 $43 billion currency swaps
 $207 billion in options and other products

• Foreign Exchange Risk:

Currency risk is a form of risk that arises from the change in price of
one currency against another. Whenever investors or companies
have assets or business operations across national borders, they
face currency risk if their positions are not hedged.
 Transaction risk is the risk that exchange rates will change
unfavorably over time. It can be hedged against using forward
currency contracts;
 Translation risk is an accounting risk, proportional to the
amount of assets held in foreign currencies. Changes in the
exchange rate over time will render a report inaccurate, and so
assets are usually balanced by borrowings in that currency.
The exchange risk associated with a foreign denominated
instrument is a key element in foreign investment. This risk flows
from differential monetary policy and growth in real productivity,
which results in differential inflation rates.

Financial instruments

Spot
A spot transaction is a two-day delivery transaction (except in the
case of trades between the US Dollar, Canadian Dollar, Turkish Lira,
EURO and Russian Ruble, which settle the next business day), as
opposed to the futures contracts, which are usually three months.
This trade represents a “direct exchange” between two currencies,
has the shortest time frame, involves cash rather than a contract;
and interest is not included in the agreed-upon transaction.

Forward
One way to deal with the foreign exchange risk is to engage in a
forward transaction. In this transaction, money does not actually
change hands until some agreed upon future date. A buyer and
seller agree on an exchange rate for any date in the future, and the

Page
7
Trading & Foreign Exchange

transaction occurs on that date, regardless of what the market rates

are then. The duration of the trade can be one day, a few days,
months or years. Usually the date is decided by both parties. Then
the forward contract is negotiated and agreed upon by both parties.

Swap
The most common type of forward transaction is the FX swap. In an
FX swap, two parties exchange currencies for a certain length of
time and agree to reverse the transaction at a later date. These are
not standardized contracts and are not traded through an exchange.

Future
Foreign currency futures are exchange traded forward transactions
with standard contract sizes and maturity dates — for example,
$1000 for next November at an agreed rate. Futures are
standardized and are usually traded on an exchange created for this
purpose. The average contract length is roughly 3 months. Futures
contracts are usually inclusive of any interest amounts.

Option
A foreign exchange option (commonly shortened to just FX option) is
a derivative where the owner has the right but not the obligation to
exchange money denominated in one currency into another
currency at a pre-agreed exchange rate on a specified date. The FX
options market is the deepest, largest and most liquid market for
options of any kind in the world.
Global Currencies - Cross Rates Table... BUY, SELL, Pounds, Euros,
US Dollars, AED and many more
currencies
GBP EUR USD CAD AUD CHF
GBP 1 1.1825 1.55531 1.57625
1.57185 1.50426
EUR 0.84567 1 1.31527
1.33298 1.32926 1.2721
USD 0.64296 0.7603 1 1.01346
1.01063 0.96718
CAD 0.63442 0.7502 0.98672 1
0.99721 0.95433
AUD 0.63619 0.7523 0.98948 1.0028
1 0.957
CHF 0.66478 0.7861 1.03393
1.04785 1.04493 1

Page
8
Trading & Foreign Exchange

Speculation:
Controversy about currency speculators and their effect on currency
devaluations and national economies recurs regularly. Nevertheless,
economists including Milton Friedman have argued that speculators
ultimately are a stabilizing influence on the market and perform the
important function of providing a market for hedgers and
transferring risk from those people who don't wish to bear it, to
those who do.
In finance, speculation is a financial action that does not promise
safety of the initial investment along with the return on the principal
sum. Speculation typically involves the lending of money or the
purchase of assets, equity or debt but in a manner that has not
been given thorough analysis or is deemed to have low margin of
safety or a significant risk of the loss of the principal investment.
Large hedge funds and other well capitalized "position traders" are
the main professional speculators. According to some economists,
individual traders could act as "noise traders" and have a more
destabilizing role than larger and better informed actors
Currency speculation is considered a highly suspect activity in many
countries. While investment in traditional financial instruments like
bonds or stocks often is considered to contribute positively to
economic growth by providing capital, currency speculation does
not; according to this view, it is simply gambling that often
interferes with economic policy.

• Foreign exchange market Participants:

Unlike a stock market, the foreign exchange market is divided into
levels of access. At the top is the inter-bank market, which is made
up of the largest commercial banks and securities dealers. Within
the inter-bank market, spreads, which are the difference between
the bids and ask prices, are razor sharp and usually unavailable, and
not known to players outside the inner circle. The difference
between the bid and ask prices widens (from 0-1 pip to 1-2 pips for
some currencies such as the EUR). This is due to volume. If a trader
can guarantee large numbers of transactions for large amounts,
they can demand a smaller difference between the bid and ask
price, which is referred to as a better spread.

• Banks
The interbank market caters for both the majority of
commercial turnover and large amounts of speculative
trading every day. A large bank may trade billions of
dollars daily. Some of this trading is undertaken on
behalf of customers, but much is conducted by

Page
9
Trading & Foreign Exchange

proprietary desks, trading for the bank's own account.

Until recently, foreign exchange brokers did large
amounts of business, facilitating interbank trading and
matching anonymous counterparts for large fees. Today,
however, much of this business has moved on to more
efficient electronic systems. The broker squawk box lets
traders listen in on ongoing interbank trading.
• Commercial companies
An important part of this market comes from the
financial activities of companies seeking foreign
exchange to pay for goods or services. Commercial
companies often trade fairly small amounts compared to
those of banks or speculators, and their trades often
have little short term impact on market rates.
Nevertheless, trade flows are an important factor in the
long-term direction of a currency's exchange rate. Some
multinational companies can have an unpredictable
impact when very large positions are covered due to
exposures that are not widely known by other market
participants.
• Central banks
National central banks play an important role in the
foreign exchange markets. They try to control
the money supply, inflation, and/or interest rates and
often have official or unofficial target rates for their
currencies. They can use their often substantial foreign
exchange reserves to stabilize the market.
Nevertheless, the effectiveness of central bank
"stabilizing speculation" is doubtful because central
banks do not go bankrupt if they make large losses, like
other traders would, and there is no convincing
evidence that they do make a profit trading.

• Forex Fixing
Forex fixing is the daily monetary exchange rate fixed
by the national bank of each country. The idea is that
central banks use the fixing time and exchange rate to
evaluate behavior of their currency. Fixing exchange
rates reflects the real value of equilibrium in the forex
market. Banks, dealers and online foreign exchange
traders use fixing rates as a trend indicator.
The mere expectation or rumor of central
bank intervention might be enough to stabilize a
currency, but aggressive intervention might be used
several times each year in countries with a dirty
float currency regime. Central banks do not always

Page
10
Trading & Foreign Exchange

achieve their objectives. The combined resources of the

market can easily overwhelm any central bank. Several
scenarios of this nature were seen in the 1992–
93 ERM collapse and in more recent times in Southeast
Asia.
• Hedge funds as speculators
About 70% to 90% of the foreign exchange transactions
are speculative. In other words, the person or institution
that bought or sold the currency has no plan to actually
take delivery of the currency in the end; rather, they
were solely speculating on the movement of that
particular currency. Hedge funds have gained a
reputation for aggressive currency speculation since
1996. They control billions of dollars of equity and may
borrow billions more, and thus may overwhelm
intervention by central banks to support almost any
currency, if the economic fundamentals are in the hedge
funds' favor.
• Investment management firms
Investment management firms (who typically manage
large accounts on behalf of customers such as pension
funds and endowments) use the foreign exchange
market to facilitate transactions in foreign securities. For
example, an investment manager bearing an
international equity portfolio needs to purchase and sell
several pairs of foreign currencies to pay for foreign
securities purchases.
Some investment management firms also have more
speculative specialist currency overlay operations,
which manage clients' currency exposures with the aim
of generating profits as well as limiting risk.
• Retail foreign exchange brokers
Retail traders (individuals) constitute a growing segment
of this market, both in size and importance. Currently,
they participate indirectly through brokers or banks.
Retail brokers, while largely controlled and regulated in
the USA by the CFTC and NFA have in the past been
subjected to periodic foreign exchange scams. There are
two main types of retail FX brokers offering the
opportunity for speculative currency
trading: brokers and dealers or market makers.
Brokers serve as an agent of the customer in the
broader FX market, by seeking the best price in the
market for a retail order and dealing on behalf of the
retail customer. They charge a commission or mark-up
in addition to the price obtained in the

Page
11
Trading & Foreign Exchange

market. Dealers or market makers, by contrast, typically

act as principal in the transaction versus the retail
customer, and quote a price they are willing to deal at—
the customer has the choice whether or not to trade at
that price.

• Non-bank foreign exchange companies

Non-bank foreign exchange companies offer currency
exchange and international payments to private
individuals and companies. These are also known as
foreign exchange brokers but are distinct in that they do
not offer speculative trading but currency exchange with
payments. I.e., there is usually a physical delivery of
currency to a bank account. Send Money Home offers an
in-depth comparison into the services offered by all the
major non-bank foreign exchange companies.

• Money transfer/remittance companies

Money transfer companies/remittance companies

perform high-volume low-value transfers generally by
economic migrants back to their home country. In 2007,
the Aide Group estimated that there were $369 billion of
remittances (an increase of 8% on the previous year).
The four largest markets (India, China, Mexico and
the Philippines) receive $95 billion. The largest and best
known provider is Western Union with 345,000 agents
globally followed by UAE Exchange & Financial Services
Ltd.

Page
12
Trading & Foreign Exchange

• Foreign Exchange rate:

In finance, the exchange rates (also known as the foreign-exchange
rate, forex rate or FX rate) between two currencies specify how
much one currency is worth in terms of the other. It is the value of a
foreign nation’s currency in terms of the home nation’s currency.
For example an exchange rate of 91Japanese yen (JPY, ¥) to
the United States dollar (USD, $) means that JPY 91 is worth the
same as USD 1. The foreign exchange market is one of the largest
markets in the world. By some estimates, about 3.2 trillion USD
worth of currency changes hands every day.
Determinants of Foreign Exchange rate

The following theories explain the fluctuations in FX rates in a

floating exchange rate regime (In a fixed exchange rate regime, FX
rates are decided by its government):
• Market psychology
• Political conditions
• Economic factors

(a) International parity conditions: Relative Purchasing Power Parity,

interest rate parity, Domestic Fisher effect, International Fisher
effect. Though to some extent the above theories provide logical
explanation for the fluctuations in exchange rates, yet these
theories falter as they are based on challengeable assumptions
[e.g., free flow of goods, services and capital] which seldom hold
true in the real world.

(b) Balance of payments model (see exchange rate): This model,

however, focuses largely on tradable goods and services, ignoring
the increasing role of global capital flows. It failed to provide any
explanation for continuous appreciation of dollar during 1980s and
most part of 1990s in face of soaring US current account deficit.

Page
13
Trading & Foreign Exchange

(c) Asset market model (see exchange rate): views currencies as an

important asset class for constructing investment portfolios. Assets
prices are influenced mostly by people’s willingness to hold the
existing quantities of assets, which in turn depends on their
expectations on the future worth of these assets. The asset market
model of exchange rate determination states that “the exchange
rate between two currencies represents the price that just balances
the relative supplies of, and demand for, assets denominated in
those currencies.”
Supply and demand for any given currency, and thus its value, are
not influenced by any single element, but rather by several. These
elements generally fall into three categories: economic factors,
political conditions and market psychology.

• Foreign Exchange trade of Pakistan

The economy of Pakistan is the 25th largest economy in the world in
terms of purchasing, and the 45th largest in absolute dollar terms.
Pakistan has a semi-industrialized economy. Which mainly
encompasses textiles, chemicals, food processing, agriculture and
other industries. Growth poles of Pakistan's economy are situated
along the Indus River, diversified economies of Karachi and Punjab's
urban centers, coexist with lesser developed areas in other parts of
the country. The economy has suffered in the past from decades
of internal political disputes, a fast growing population, mixed levels
of foreign investment, and a costly, ongoing confrontation
with neighboring India.

Foreign trade of Pakistan

Pakistan is a member of the World Trade Organization, and
has bilateral and multilateral trade agreements with many nations
and international organizations.
Fluctuating world demand for its exports, domestic political
uncertainty, and the impact of occasional droughts on its
agricultural production have all contributed to variability in
Pakistan's trade deficit.
In the six months to December 2003, Pakistan recorded a current
account surplus of $1.761 billion, roughly 5% of GDP. Pakistan's
exports continue to be dominated by cotton textiles and apparel,
despite government diversification efforts. Exports grew by 19.1% in
FY 2002-03. Major imports include petroleum and petroleum
products, edible oil, chemicals, fertilizer, capital goods, industrial
raw materials, and consumer products.

Page
14
Trading & Foreign Exchange

While the country has a current account surplus and both imports
and exports have grown rapidly in recent years, it still has a large
merchandise-trade deficit. The budget deficit in fiscal year 2004-
2005 was 3.4% of GDP. The budget deficit in fiscal year 2005-06 is
expected to be over 4% of GDP. Economists believe that the soaring
trade deficit would have an adverse impact on Pakistani rupee by
depreciating its value against dollar (1 US $ = 60 Rupees (March
2006) ) and other currencies.

• Foreign exchange rate of Pakistan

1 Pakistani Rupee (PKR) = 100 Paisa
The Pakistani rupee depreciated against the US dollar until the turn
of the century, when Pakistan's large current-account surplus
pushed the value of the rupee up versus the dollar. Pakistan's
central bank then stabilized by lowering interest rates and buying
dollars, in order to preserve the country's export competitiveness
Exchange rates: Pakistani rupee (PKR) per US$1

• Foreign exchange reserves of Pakistan

By October 2007, at the end of Prime Minister
Shaukat Aziz’s tenure, Pakistan raised back its
Foreign Reserves to $16.4 billion. Pakistan's trade
deficit was at $13 billion, exports grew to $18
billion, revenue generation increased to become
$13 billion and the country attracted foreign
investment of $8.4 billion.
On October 11, 2008 State Bank of
Pakistan reported that country's foreign exchange
reserves had gone down by $571.9 Million to
$7749.7 Million. The foreign exchange reserves
had declined more by $10 billion to an alarming
rate of $6.59 billion. In September 2010 According
the State Bank Of Pakistan Pakistan's Foreign
Reserves Stood at $16.99 Billion.

Page
15
Trading & Foreign Exchange

Conclude:
Foreign Exchange Trading or FX Trading, clients are able to
hedge against, or speculate upon, changes in the exchange rate
of two currencies. The foreign exchange market determines the
relative values of different currencies.
The purpose of the foreign exchange is to assist international
trade and investment, by allowing businesses to convert one
currency to another currency. In a typical foreign exchange
transaction, a party purchases a quantity of one currency by
paying a quantity of another currency.

Page
16