2010

Financial Management
Faiza Sajjad

Submitted To:

**************
Assignment #4
Madam

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

Shahid Muhammad Khan

Fa08-bba-043

Zaka ul Hassan
Fa08-bba-040

Uzair Ali Shah

Fa08-bba-053

[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

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• Introduction 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

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• 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.

On the spot market, according to the 2010 Triennial Survey, the most heavily traded
bilateral currency pairs were:

 EURUSD: 28%

 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

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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 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.

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.

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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 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.

• 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

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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 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.

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Central banks do not always 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. To deal with the issue, the
NFA and CFTC began (as of 2009) imposing stricter requirements,
particularly in relation to the amount of Net Capitalization required of its
members. As a result many of the smaller, and perhaps questionable
brokers are now gone.
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 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.

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• 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.
It is estimated that in the UK, 14% of currency
transfers/payments are made via Foreign Exchange Companies. These
companies' selling point is usually that they will offer better exchange
rates or cheaper payments than the customer's bank. These companies
differ from Money Transfer/Remittance Companies in that they generally
offer higher-value services.

• 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 Aite 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.

• 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.
The spot exchange rate refers to the current exchange rate. The forward exchange
rate refers to an exchange rate that is quoted and traded today but for delivery and
payment on a specific future date.

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a. 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.

(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.

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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.
With a current account surplus in recent years, Pakistan's hard currency reserves have
grown rapidly. Improved fiscal management, greater transparency and other governance
reforms have led to upgrades in Pakistan's credit rating. Together with lower global
interest rates, these factors have enabled Pakistan to prepay, refinance and reschedule its
debts to its advantage. Despite the country's current account surplus and increased
exports in recent years, Pakistan still has a large merchandise-trade deficit. The budget
deficit in fiscal year 1996-97 was 6.4% of GDP. The budget deficit in fiscal year 2003-04
is expected to be around 4% of GDP.
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.

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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.

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.

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