What are currency rates and why do they exist
When an American owned
cars from the manufacturer –
The American dealership checks the current exchange rate of U.S. dollars
for Japanese Yen and figures out how many U.S. dollars each car will
cost. If the dealer chooses to do so he can call a Bank and enter into a
foreign exchange contract. The Bank will give him the Japanese Yen he
needs to buy the cars and in exchange the dealer will give the Bank the
U.S. dollars. The number of Yen the dealer receives for those U.S. dollars
is the exchange rate. For example, if the dealer received 112,000,000 yen
for $1,000,000; the exchange rate would be 112.00 (112,000,000 Yen/
$1,000,000).
To do this identical transaction on the FXCM platform, the dealer would
wait until the quoted price was 112 00-04. The dealer would sell 100 lots
at 112.00; thereby selling U.S. dollars and buying Japanese Yen. We
refer to this as selling USDJPY.
Without a reference exchange rate that the dealer could rely on and be
able to transact at, he could not do business with
exchange rates therefore exist to facilitate trade between different
countries that use different monies.
History and evolution of foreign exchange rates
From 1944 to 1971 the world operated under a system of fixed exchange
rates. The U.S. dollar was convertible into gold at a set rate and all the
countries fixed their currencies to the U.S. dollar at a set rate. There was
no need for a foreign exchange market.
On
U.S. dollar could no longer be cashed in for gold. In 1973 the
formally announced the permanent floating of the U.S. dollar thereby
officially ending the system of fixed exchange rates.
Exchanges rates between different countries began to fluctuate widely;
creating the need for a foreign exchange market where exporters and
importers could lock in rates; clearly a prerequisite for doing business.
Simply put, an American Hondo dealer is quoted a price per car in
Japanese Yen from
a current dealable price for USDJPY, then the dealer would know for
sure how much those cars were costing him and whether or not he could
sell them profitably in his dealership.
And this is exactly what began happening.
Yen when they signed a contract to buy Hondos; then they left the Yen in
the Bank earning interest until contract payment date. It didn’t take long
for the Banks to figure out they could provide value added service by
quoting the importer a price for the contract date. The Bank did this by
simply starting with the current rate and adjusting the current rate to
account for the net interest earned or paid from trade date to contract
date. This became known as the forward rate.
History and evolution of the foreign exchange market
Because there was no central marketplace for transacting foreign
exchange in the early 1970s, exporters and importers could not accurately
track daily movements in the currencies. In fact, they had no prior
experience with floating exchange rates and therefore no in-house
expertise. They were at the mercy of the moneychangers, the Banks.
Overnight foreign exchange became a huge source of bottom revenue to
the banking industry.
To offset the risks of holding currency positions taken as a result of
customer transactions, the major banks entered into informal reciprocal
agreements to quote each other throughout the day on preset amounts. It
was understood that a certain maximum spread would be upheld, except
under extreme conditions. It was further agreed that the rate would be
supplied in a reasonable amount of time. Generally this meant the FX
dealer made the price within seconds, and therefore without calling
another bank for a second opinion. This was called direct dealing and all
the major banks participated.
In the beginning, banks were quoting customers one-way prices. The
customer would say where could I sell $10M USDJPY and the bank set a
rate. The bank left itself plenty of room for error, oftentimes quoting as
much as 50 points below the current market. This was a bonanza for the
banks. However, a lot of money was lost when other banks called for a
rate.
Description and evolution of the FX brokers
The first foreign exchange brokers came on the scene in the mid 1970s to
satisfy the demand for continuous price quotes in the major currencies
from the thousands of medium and small banks with significant customer
foreign exchange business to offset. These banks were unwilling to be in
the direct market because providing competitive rates to the large banks
was costing them more money then they were making from their
customers.
Initially the foreign exchange brokers installed direct lines to all the
banks willing to participate. Generally a major bank made a rate and the
brokers showed the rate to all the banks at about the same time. The first
bank to deal on the rate completed a transaction. The others waited for
the next rate. Any bank could make a rate; show a bid or an offer. Soon
the brokers became quite efficient at putting together a continuous twoway
price.
Reuters introduced a web based dealing system for banks 1992, followed
by a similar web based system introduced by EBS (Electronic Brokerage
System) for banks in 1993; although it took some time, by 1996 it was
clear the voice broker was being replaced by the electronic broker.
Around the same time web based dealing systems that corporations could
use in lieu of calling banks on the phone began to appear. Followed by
the first web based dealing systems for individuals. Today there are
hundreds of online FX brokers fighting for the business of the small
trader or investor. Some are good; some are not (more on this later).
The movers and the shakers in the FX market
It is widely understood that day traders in the aggregate do not move the
currency market much. They buy and sell and at the end of the day they
have no net long or short position. Therefore they have not changed the
demand/supply equilibrium and accordingly have not in the aggregate
had a lasting effect on the price of a currency.
What moves the currency market is the other time frame; central banks,
hedge funds, financial institutions, and corporations. These guys buy or
sell huge amounts and their time frame is generally weeks to months,
possibly years. Their transactions unbalance the market, requiring price
adjustment to rebalance demand and supply.
Furthermore, changing fundamentals or longer-term technicals generally
triggers the actions of the other time frame. Their affect on the price is
therefore two -fold; in addition to causing a demand/supply imbalance,
their actions generally reflect a price change that may have needed to
occur even if they did not get the ball rolling through large transactions.
Evidence that this is so can be found in the unusually large price moves
that often occur after significant scheduled economic news releases.
Oftentimes the move is much greater than what would appear necessary
given the deviation of the expected versus actual number (more on this
later).
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