Risk Aversion in the Forex is a kind of trading behavior exhibited by the foreign exchange market when a potentially adverse event happens which may affect market conditions.
This behavior is caused when risk averse traders liquidate their positions in hazardous assets and shift the funds to less hazardous assets due to uncertainty.
In the context of the forex market, traders liquidate their positions in various currencies to take up positions in safe refuge currencies, such as the US Dollar.
Sometimes the choice of a safe refuge money is more of a choice based on prevailing sentiments than one of economic statistics.
An example would be the Financial Crisis of 2008. The value of equities across world fell while the US Dollar strengthened.( See Fig.1 ) This happened despite the strong focus of the crisis in the USA.
Saturday, February 27, 2010
Lesson 8 : Political Standings
All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation's economy. For example, destabilization of coalition governments in Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive/negative interest in a neighboring country and, in the method, affect its funds.
Internal, regional, and international political conditions and events can have a profound effect on funds markets.
Internal, regional, and international political conditions and events can have a profound effect on funds markets.
Lesson 7 : Economic Factors
* Economic policyowner comprises government fiscal policyowner (budget/spending practices) and monetary policyowner (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).
* Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's money.
* Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's money to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's money.
* Inflation levels and trends: Typically a money will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular money. However, a money may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.
* Economic growth and health: Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its money will perform, and the more demand for it there will be.
* Productivity of an economy: Increasing productivity in an economy should positively influence the value of its money. Its effects are more prominent if the increase is in the traded sector [3].
These include: (a)economic policyowner, disseminated by government agencies and central banks, (b)economic conditions, generally revealed through economic reports, and other economic indicators.
* Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's money.
* Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's money to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's money.
* Inflation levels and trends: Typically a money will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular money. However, a money may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.
* Economic growth and health: Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its money will perform, and the more demand for it there will be.
* Productivity of an economy: Increasing productivity in an economy should positively influence the value of its money. Its effects are more prominent if the increase is in the traded sector [3].
These include: (a)economic policyowner, disseminated by government agencies and central banks, (b)economic conditions, generally revealed through economic reports, and other economic indicators.
Lesson 5 : Central Banks
The mere expectation or rumor of central bank intervention might be to stabilize a funds, but aggressive intervention might be used several times each year in countries with a dirty float funds regime. Central banks do not always accomplish their objectives. The combined resources of the market can easily overwhelm any central bank.[7] Several scenarios of this nature were seen in the 1992–93 ERM collapse, & in more recent times in Southeast Asia.
National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates & often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Milton Friedman argued that the best stabilization strategy would be for central banks to buy when the exchange rate is low, & to sell when the rate is high—that is, to trade for a profit based on their more precise information. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make huge losses, like other traders would, & there is no convincing evidence that they do make a profit trading.
National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates & often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Milton Friedman argued that the best stabilization strategy would be for central banks to buy when the exchange rate is low, & to sell when the rate is high—that is, to trade for a profit based on their more precise information. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make huge losses, like other traders would, & there is no convincing evidence that they do make a profit trading.
Lesson 6 : Retail Forex Brokers
There's one main types of retail FX brokers offering the chance for speculative money trading: brokers & 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 & dealing on behalf of the retail customer. They charge a commission or mark-up in addition to the price obtained in the market. Dealers or market makers, by contrast, typically act as principal in the transaction versus the retail customer, & quote a price they are willing to deal at—the customer has the choice whether or not to trade at that price.
Retail traders (individuals) constitute a growing segment of this market, both in size & importance. Currently, they participate indirectly through brokers or banks. Retail brokers, while largely controlled & regulated in the USA by the CFTC & NFA have historicallyin the past been subjected to periodic foreign exchange scams.[8][9] To deal with the issue, the NFA & CFTC began (as of 2009) imposing stricter requirements, in relation to the amount of Net Capitalization necessary of its members. As a result plenty of of the smaller, & perhaps open to doubt brokers are now gone.
In assessing the suitability of a FX trading services, the customer should think about the ramifications of whether the service provider is acting as principal or agent. When the service provider acts as agent, the customer is generally assured of a known cost above the best inter-dealer FX rate. When the service provider acts as principal, no commission is paid, but the price offered may not be the best obtainable in the market—since the service provider is taking the other side of the transaction, a conflict of interest may occur.
Retail traders (individuals) constitute a growing segment of this market, both in size & importance. Currently, they participate indirectly through brokers or banks. Retail brokers, while largely controlled & regulated in the USA by the CFTC & NFA have historicallyin the past been subjected to periodic foreign exchange scams.[8][9] To deal with the issue, the NFA & CFTC began (as of 2009) imposing stricter requirements, in relation to the amount of Net Capitalization necessary of its members. As a result plenty of of the smaller, & perhaps open to doubt brokers are now gone.
In assessing the suitability of a FX trading services, the customer should think about the ramifications of whether the service provider is acting as principal or agent. When the service provider acts as agent, the customer is generally assured of a known cost above the best inter-dealer FX rate. When the service provider acts as principal, no commission is paid, but the price offered may not be the best obtainable in the market—since the service provider is taking the other side of the transaction, a conflict of interest may occur.
Lesson 4 : Companies (Commercial)
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 small amounts compared to those of banks or speculators, & their trades often have small 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 gigantic positions are covered due to exposures that are not widely known by other market participants.
Lesson 3 : Banks
The interbank market caters for both the majority of commercial turnover & giant amounts of speculative trading every day. A giant bank may trade billions of dollars every day. A number of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account. Until recently, foreign exchange brokers did giant amounts of business, facilitating interbank trading & matching anonymous counterparts for little 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 & is heard in most trading rooms, but turnover is noticeably smaller than a few years ago.
Lesson 2 : Market Participants
Unlike a stock market, the foreign exchange market is divided in to levels of access. At the top is the inter-bank market, which is made up of the largest commercial banks & securities dealers. Within the inter-bank market, spreads, which are the difference between the bid & ask prices, are razor sharp & usually unavailable, & not known to players outside the inner circle. The difference between the bid & 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 massive numbers of transactions for massive amounts, they can demand a smaller difference between the bid & ask price, which is called a better spread. The levels of access that make up the foreign exchange market are determined by the size of the "line" (the amount of money with which they are trading). The top-tier inter-bank market accounts for 53% of all transactions. After that there's usually smaller banks, followed by massive multi-national corporations (which need to hedge risk & pay employees in different countries), massive hedge money, & even a number of the retail FX-metal market makers. According to Galati & Melvin, “Pension money, insurance companies, mutual money, & other institutional investors have played an increasingly important role in financial markets in general, & in FX markets in particular, since the early 2000s.” (2004) In addition, they notes, “Hedge money have grown markedly over the 2001–2004 period in terms of both number & overall size” Central banks also participate in the foreign exchange market to align currencies to their economic needs.
Lesson 1 : Market Size & Liquidity
The foreign exchange market is the largest & most liquid financial market in the world. Traders include giant banks, central banks, funds speculators, corporations, governments, & other financial institutions. The average every day volume in the global foreign exchange & related markets is continuously growing. Every day turnover was reported to be over US$3.2 trillion in April 2007 by the Bank for International Settlements. [2] Since then, the market has continued to grow. According to Euromoney's annual FX Poll, volumes grew a further 41% between 2007 & 2008.[3]
Of the $3.98 trillion every day global turnover, trading in London accounted for around $1.36 trillion, or 34.1% of the total, making London by far the global center for foreign exchange. In second & third places respectively, trading in New York accounted for 16.6%, & Tokyo accounted for 6.0%.[4] In addition to "traditional" turnover, $2.1 trillion was traded in derivatives.
Exchange-traded FX futures contracts were introduced in 1972 at the Chicago Mercantile Exchange & are actively traded relative to most other futures contracts.
Several other developed countries also permit the trading of FX derivative products (like funds futures & options on funds 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 funds futures exchanges, despite having some controls on the capital account.
Of the $3.98 trillion every day global turnover, trading in London accounted for around $1.36 trillion, or 34.1% of the total, making London by far the global center for foreign exchange. In second & third places respectively, trading in New York accounted for 16.6%, & Tokyo accounted for 6.0%.[4] In addition to "traditional" turnover, $2.1 trillion was traded in derivatives.
Exchange-traded FX futures contracts were introduced in 1972 at the Chicago Mercantile Exchange & are actively traded relative to most other futures contracts.
Several other developed countries also permit the trading of FX derivative products (like funds futures & options on funds 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 funds futures exchanges, despite having some controls on the capital account.
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