There are two groups of participants in the Forex market: speculative and non-speculative participants.
Investment Banks also represent real fundamental flow because they deal for and on behalf of Businesses, Corporations, and Pension Funds. They also deal with Hedge Funds.
Hedge funds, Investment Banks and Retail Traders are speculative and make up 80% of daily Forex transactions.
Hedge Funds only use Forex as a hedging instrument to Equities, Commodities and Debt portfolio’s. Their portfolios are speculative.
Investment banks, when they are not dealing on behalf of their clients they are engaging in risk transactions or trading purely on a Proprietary basis.
Retail brokers are incentivized by size and volume, and to take the other side of losing trades. Therefore they require dumb money (retail traders) to exist in order to maintain the status quo. They promote dumb money strategies and provide leverage in order to increase retail trader participation, maximize commission and to take the other side.
Businesses & Corporations
Let’s say that a company X in US is selling some goods to a company Y in Europe. The company X is projecting a potential fall in Euro and the US Dollar may rise from EUR/USD = 1.30 to 1.20.
To hedge this exposure, the board of the company X in US proposes entering a one year forward contract to sell € 1,000,000 /and buy $ 1,300,000 USD close to the current spot rate at the beginning of the year.
The current rate is €1 = $1.30 USD, therefore if EUR/USD goes to 1.20 by the end of the financial year, they will have locked in a profit of $ 100,000 USD, which wipes out the local currency loss that the impact of the exchange rate move had on their USD reported sales.
Pension Funds & Hedge Funds
They are very active in the forex markets on a day to day basis. In order to buy a stock or a bond in another country, they must first purchase the currency of that country. The exchange rate matters over the lifetime of the investment.
If a pension fund sells USD to buy JPY in order to buy Japanese Equities, if they make 20% return on the Japanese Equities but when they sell the Equities and convert back into USD, the USD/JPY rate is 20% higher, they don’t make anything.
The currency conversion has cancelled out the profit on the day. The currency exposure can be hedged out by buying the same value of USD/JPY as the value of the Japanese Stocks at the time of purchase. If the fund is denominated in Yen, then this doesn’t matter as there is no currency conversion required.
Hedge Funds often trade correlation between asset classes and use liquid strategies to hedge the risk in their portfolios.
Classic risk on strategies in which global GDP is forecasted to go higher usually means that the world outside the US is set to grow faster than the US – Sell USD buy rest of the world’s currencies, buy rest of the world’s stocks market and debt (bonds).
Classic risk off strategies in which global GDP is forecast to go lower usually means that the world outside of the US is set to grow slower than the US – Buy USD Sell rest of the world’s currencies, Sell rest of the world’s stock market and debt.
Investment Banks & Retail Banks
The difference between investment banks and retail banks is the size of the client, the complexity of the trades and the price they pay.
Investment Banks offer hedging facilities in forex and retail banks do plain vanilla (spot) transactions for small and medium-sized enterprises (SME) importers and exporters for example, that do repeat business and require forex to pay for foreign inputs/goods, SME services to pay for foreign services and foreign purchases for retail clients that are travelling.
At Investment Banks client business is done on an Agency basis and on risk. So the bank will take the opposite trade to the client if they need to or even want to in order to provide over-the-counter (OTC) liquidity.
Retail Traders & Retail Brokers
Typically, forex is traded on 1% margin requirement. For example, if your initial margin deposit is $1,000 and your leverage is 100x, it means that if you lose 1% on the $100,000 position you will be wiped out. This is known as the margin call.
Retail brokers are incentivized to make you trade as frequently as possible, in the biggest size possible, to take the other side of your losing trades and to leverage their win ratio to maximize their revenues.
Brokers don’t like clients who make money, because they are low value to them. It means they get paid less spread and commissions. They also have to hedge out their exposure every time you trade and they make less profit on financing turn charges.
There are two types of money in the forex markets: smart money (professional traders) who know how to trade and dumb money (retail traders) that believe everything they are told and blindly rely on the infrastructure that is provided to them (free webinars, free resources online, etc.).
By Direct Intervention
The level of direct intervention from a Central Bank in manipulating the Exchange Rate for the benefit of an Economy is down to the Exchange Rate Regime they have chosen to follow: fixed or floating regimes.
When a domestic currency weakness and the central bank wants to intervene, they must use their Foreign Currency reserves to buy their own currency as a currency cannot be bought without selling another one.
When a domestic currency strengthens and the central bank wants to intervene, they must sell their own currency reserves to buy foreign currency as a currency cannot be bought without selling another one.
Also read about the Forex G10 Currencies and the different Exchange Regimes.
Controlling the Money Supply
Modern financial systems incorporate a Fractional Reserve Banking System which is the mechanism by which Money is created and flows to and from Banks, Institutions, Corporates, Businesses and Individuals.
Whenever a bank gives out a loan in a fractional-reserve banking system, a new sum of money is created. This new type of money is what makes up the non-M0 components in the M1-M3 statistics.
There are two types of money in a fractional-reserve banking system:
- Central bank money (obligations of a central bank, including currency and central bank depository accounts)
- Commercial bank money (obligations of commercial banks, including checking accounts and savings accounts)
Central bank money is defined as Monetary Base (MB) and Commercial Bank Money is defined as M0-M3.
In financial Banking System a Reserve Requirement Ratio is minimum fraction of customer deposits and notes that each Commercial Bank must hold as reserves (rather than lend out). These required reserves are normally in the form of cash stored physically in a bank vault or deposits made with a central bank.
Central Banks increase/decrease the Money Supply M2 by increasing or decreasing Banking Reserves.
Adding to Reserves is the money printing mechanism – this allows banks to multiply their deposits and increases the amount of Money M2 in circulation in an Economy at a supposed constant and predictable rate.
M2 is the broadest and most important measure of money supply and is used as an injection and withdrawal to control inflation.
A country’s Exchange Rate is therefore affected by the Central Banks policy/rate of growth of M2.
Quantitative Easing (QE)
Quantitative Easing (QE) – QE is a non-classic monetary policy used by Central Banks to stimulate an Economy when Classic Monetary policies like increasing loans through increasing M2 and Interest Rates have failed to stimulate the Economy.
Central Bank implements QE by buying specified amount of financial assets which raises the price of those financial assets and decreases the yield, while increasing the monetary base.
Expansionary monetary policy to stimulate an economy typically involves the Central Bank buying short-term government bonds in order to lower short-term market rates to encourage banks to increase loans.
However, when short-term interest rates reach or approach zero and this hasn’t stimulated loans there may be no other option to increase MB.
QE differs from the classic monetary policy of buying or selling short-term government bonds in order to keep interbank interest rates at a specified target value.
QE can be used to further stimulate the economy by buying assets of longer maturity than short-term government bonds, thereby lowering longer-term interest rates further out on the yield curve. Risks include the policy being more effective than intended in acting against deflation, leading to higher inflation in the longer term, or not being effective enough if banks don’t lend out on the additional reserves.
If loans are at capacity (zero excess reserves), the reserve ratio requirement is at the maximum it can possibly be and increasing reserves by lowering rates to zero does not work, then the implementation of QE is a desperate measure and is a last throw of the dice lever – no more levers exist unless.
Implementation of quantitative easing is an injection to the Money Supply and therefore has the risk of a lower Exchange Rate, longer term domestic inflation and possibly not having the effect of even increasing banks loans through increased reserves.
Expansionary monetary policy to stimulate an economy typically involves Central Banks buying short-term government bonds in order to lower short-term market interest rates to encourage banks/businesses/individuals to increase loans.
Contractionary monetary policy to deflate an economy typically involves Central Banks selling short-term government bonds in order to raise short-term market interest rates to discourage banks to decrease loans.
When a Central Bank is in the mode of lowering interest rates (Dovish), they are buyers of short-term government bonds.
When a Central Bank is in the mode of increasing interest rates (Hawkish), they are sellers of short-term government bonds.
When interest rates are falling this discourages capital from abroad flowing into a particular country for the purposes of risk free investment in favor of countries with relatively higher interest rates – therefore lower Exchange Rate (sell Currency).
When interest rates are rising this encourages capital from abroad flowing into a particular country for the purposes of risk free investment in away from countries with relatively lower interest rates – therefore higher Exchange Rate (buy Currency).
What matters for the relative exchange rate is the interest rate differential which forms the basis of what is termed as a Carry or the Carry Trade.
Understanding Carry and Interest Rate Differentials is crucial to understanding Forex trading.
Taxes on Imports
If a Government wants to make domestic goods relatively cheaper they can introduce Import Tariffs making foreign goods more expensive for domestic consumers. Foreign goods and therefore currency will be relatively less in demand on the international Forex markets and foreign currency will therefore fall in value seeing the domestic currency rise.
This policy intended to be Inflationary (stimulating measure) by reducing Imports and increasing Exports. All things being equal this policy is intended to increase a country’s surplus and decrease Deficit.
The reverse will happen if a Government decides to lower Import Tariffs i.e. Exchange rate of foreign trade partners rise due to higher demand for imports relative to domestic goods i.e. deflationary/ decrease surplus/ increase deficit.
Taxes on Exports
If a Government wants to make domestic goods relatively more expensive they can increase tariffs on exports to other countries making domestic goods more expensive for consumers abroad. Domestic goods and currency will therefore be less in demand in International Forex markets and Domestic Currency will therefore fall in value seeing foreign trading partner’s currency rise.
This policy is intended to be deflationary. This policy may not work at all if the domestic exchange rate falls by the same amount as the export tax has increased.
The reverse will happen if a Government decides to lower export tariffs i.e. exchange rate of foreign trade partners rises relative to domestic currency due to lower demand for foreign goods relative to domestic exports.
In most developed nations are duties (taxes) on both Imports and Exports, therefore the balance between Import and Export taxes is what matters for the Exchange Rate.
In order to win, retail traders must do everything in the opposite way to the way in which they are told to trade, by participants with inherent conflicts of interest.
- Decrease leverage,
- Implement smart money systematic approach utilizing predictive fundamentals,
- Overlaid with technical and price action indicators,
- More sophisticated risk management strategies,
We have to predict what businesses and corporations, pension funds, central banks and governments will do in the future and buy or sell currencies based on our future predictions.