Forex for Beginners Part 2: Currency, Hedge

International currency market and major world currencies

Suppose we formulate a definition that is as precise as possible. In that case, the international currency market FOREX (Foreign Exchange Market) is a set of operations for the purchase and sale of foreign currency and the provision of loans on specific conditions (amount, exchange rate, interest rate) with execution of a particular date. The main participants in the foreign exchange market are commercial banks, currency exchanges, central banks, firms engaged in foreign trade operations, investment funds, and brokerage companies; individuals’ direct participation in foreign exchange transactions is constantly growing.

FOREX is the largest market in the world; it accounts for up to 90% of the entire global financial market. Thousands of participants in this market – banks, brokerage firms, investment funds, financial and insurance companies – buy and sell currency within 24 hours a day, making transactions within a few seconds anywhere in the world. Combined into a single global network by satellite communication channels using the most advanced computer systems, they create a turnover of foreign exchange funds, which in total exceeds 10 times the total annual gross national product of all states of the world per year (moreover, the figure is taken from a 5-year-old textbook).

Why is it necessary to move such vast masses of money through electronic channels? Currency transactions provide economic links between participants in various markets located on different sides of state borders: interstate settlements, settlements between firms from other countries for goods and services supplied, foreign investment, international tourism, and business trips. Without foreign exchange transactions, these essential types of economic activity could not exist. But the money that serves here as an instrument becomes a commodity itself since the supply and demand for transactions with each currency in various business centers changes over time, and consequently, the price of each currency varies.

The international monetary device today is based on the regime of floating exchange rates: the price of the currency is determined, first of all, by the market. Therefore, the exchange rate either rises (the currency rises in price) or falls. This means that you can buy a currency cheaper and, after a while, sell it at a higher price while making a profit. The international monetary system has come a long way over the millennia of human history, but undoubtedly, today, the most exciting and previously unthinkable changes are taking place in it. Two significant changes define the new face of the global monetary system:

a) money is now completely separated from any material carrier;

b) robust information and telecommunication technologies have made it possible to unite the monetary systems of different countries into a single global financial system that does not recognize borders.

Previously, everything was quite simple: “People are dying for the metal.” And now money is not only not metal, but not even those green pieces of paper that warm the eyes. Real money drives the destinies of people, pushes countries and peoples together, destroys empires, and creates new ones; today, this money is just numbers on computer screens. Whether this is good or not is not the subject of fundamental analysis, but the financial market of the planet is such today, and we must learn to work on it.

The international currency market as we know it emerged after 1973, but its modern history began in the summer of 1944 in the American resort town of Bretton Woods. The outcome of the Second World War was no longer in doubt, and the Allies took up the post-war financial structure of the planet. While the economies of all leading states after the war were in ruins or the grip of military production, the US economy emerged from the war on the rise. And since the winners, the victims, and the vanquished needed food, fuel, raw materials, and equipment, and only the American economy could provide all this in sufficient quantities, the question arose of how other countries would pay for this. After the war, they had little of what could be of interest to the United States; The US gold reserve was already the largest, and many countries hardly had it at all. In any attempt to establish trade through currency exchange, the price of the dollar, due to the high demand for American goods, inevitably had to rise to such a level that all other currencies would depreciate, and the purchase of American goods became impossible.

On the other hand, this could be considered a problem for anyone but the United States, but a sufficient number of people understood that this approach led to the Second World War. After the First World War, America washed its hands, leaving international responsibility to other countries. The world experienced an intense dollar hunger; the gold reserves of countries flowed into the United States, and other currencies depreciated. Natural but short-sighted protectionist decisions isolated the economies from each other, and economic nationalism quickly turned into diplomatic relations and escalated into war.

To prevent the post-war collapse of currencies, the financial forum at Bretton Woods created a number of financial institutions, including the International Monetary Fund. initially represented by the combined currency resources, where all countries (but to the maximum extent the United States) contributed their share, and from where each country could take to maintain its currency. The US dollar had a fixed gold content ($35 per troy ounce), while other currencies were pegged to the dollar at a specific ratio (fixed exchange rates).

But the post-war demand for the dollar was above all expectations. Many countries sold their currencies to buy dollars to buy American goods. American exports far exceeded imports (the trade surplus was growing), and the world’s dollar deficit was increasing. IMF resources were not enough to borrow countries to support their currencies. The answer to these problems was the American Marshall Plan, according to which the European countries provided the United States with a list of material resources necessary for the recovery of their economies, and the United States transferred to them (not on loan) the number of dollars sufficient to purchase the specified. These dollars prevented the devaluation of other currencies and contributed to a new growth of American exports, opening up new markets for it.

The American presence in all parts of the world through the cost of maintaining military bases, American private investment in the business of Europe (acquisition of European firms or participation in them), and the activity of American tourists spending money around the world, gradually filled foreign banks with dollars in quantities greater than necessary. At the end of the 1950s, European businesses no longer needed the same amount of American goods, had more attractive investment opportunities than dollar deposits, and therefore did not want to hold excess dollars. At first, the US Treasury was ready to buy dollars, paying them with the established gold content, preventing the dollar from falling against other currencies. However, the flow of gold from the US led to a halving of the gold stock in the early 60s.

The system of fixed exchange rates lasted until the early 1970s. By this time, the US no longer had a favorable trade balance; other countries were selling more and more to America and buying less from it. Dollars that were disposed of abroad ended up in foreign central banks as hopeless unclaimed cargo. For several years, the United States resisted the inevitable devaluation of the dollar and did not agree to the establishment of free-floating exchange rates. Still, after a series of problems in the early 70s, they abandoned the gold content of the dollar, the rate of which has since been determined by market demand and supply (free floating- free-floating exchange rate). By 1980, the price of gold rose to almost $750 per troy ounce (since the beginning of 1975, Americans have been legally able to purchase gold as an investment). In the late 70s, the dollar fell to its post-war low, and its subsequent history is a series of ups and downs.

All major world currencies are now in such a free-floating mode when their price is determined by the market, depending on how much this currency is needed for the purchase of goods, investments, and interstate settlements. Of course, this swimming is not entirely free; each country has a central bank whose main task, in accordance with the law, is to ensure the stability of the national currency. The FOREX international currency market brings together many participants in currency exchange operations: individuals, firms, investment institutions, banks, and central banks.

The main currencies that account for the bulk of all transactions in the FOREX market today are the US dollar ( USD ), euro ( EUR ), Japanese yen ( JPY ), Swiss franc ( CHF ), and British pound sterling ( GBP ). Prior to the advent of the euro currency, the German mark ( DEM ) had a significant market share. Recently, the Canadian dollar ( CAD ), the Australian dollar ( AUD ), and the Swedish krona ( SEK ) are increasingly being included in the leading group of five currencies.

The US dollar (USD), as we have seen, became the world’s leading currency after World War II. Today, the dollar is a universal means of payment in international business, a safe-haven currency in various financial and political crises in other countries, as well as an object of global investment, thanks to a large volume of highly reliable securities – long-term US government bonds. Confidence in the stability of the American economic and financial system that all proceeds from government debt securities will be paid on time, not requisitioned, and not subject to unexpected taxes attracts both private foreign investors and foreign governments to this market.

In recent years, the US stock market has shown unprecedented growth, attracting huge capital from foreign and domestic investors, which serves as an additional source of strength for the dollar. Since the mid-1980s, American stocks have become a better investment option than gold: stocks have risen while the price of gold has fallen. In the period after 1993, American stocks have been increasing, and not only independent experts but also officials have repeatedly expressed fears that stock prices are too high and their fall could be too sharp and lead to a financial and economic crisis.

The dollar holds, according to various estimates, a share of 50 to 61 percent in the international reserves of central banks, amounting to up to $1 trillion. It is the generally accepted base currency when quoting other currencies. The dollar participates as one of the parties in 87% of all transactions in the FOREX market (as of October 1998). Of all Japanese yen exchanges, the US dollar accounted for 87%; for the German mark, this figure was 64%, and for the Canadian dollar – 98%.

The Japanese yen (JPY) went through a difficult path from the post-war level of 360 yen to the dollar, determined by the American occupation administration, to the rate of about 80 yen to the dollar in 1995, after which its level dropped again significantly and again strengthened in the second half of 1998.

The main feature of the financial situation in Japan today is meager short-term interest rates; practically, they are supported by the Bank of Japan at zero level. Therefore, vast volumes of savings and pension funds and other investments were invested in foreign securities, primarily in US government bonds and European assets. Significantly yielding to the dollar as a reserve currency and an instrument of international settlements, the yen is nevertheless one of the main currencies in the global financial market.

British pound (GBP). The British pound was the world’s leading currency until the First World War; having significantly weakened its position in the interwar period, it finally lost its leadership to the dollar after the Second World War, which was caused by natural problems in the economy affected by the war, as well as undermining confidence in the currency due to massive counterfeiting sabotage against it by Germany during the war.

Up to 50% of transactions involving the pound take place in the London market. In the global market, it occupies about 14%. Almost all of this volume accounted for the dollar and the German mark. New York banks practically stop quoting the GBP at noon. The pound is very sensitive to data on the labor market and inflation in England, as well as to oil prices (in textbooks on the foreign exchange market, it was even characterized as petrocurrency). In the comments on events on the FOREX market, the pound is referred to either as a cable or a pound. The first name has remained since the most operational data received in Europe from America were telegrams transmitted over the transatlantic submarine cable. Cable is used, as a rule, in the GBP quote to USD, and the pound was used in pound quotes to the German mark.

Swiss franc (CHF). The volume of transactions involving the Swiss franc is significantly less than that of other currencies. In relation to the German mark, he often played the role of a safe-haven currency (for example, in the event of crises in Russia). In previous years, the franc fluctuated more than the German mark, but lately, this has not been the case. The function of the franc as a safe-haven currency was significantly reduced in 1999 due to the military conflict in the Balkans.

With the advent of the euro, the volatility (volatility) of the franc against the euro became much less than the volatility of the franc against the German mark. The Swiss National Bank (SNB) is pursuing a policy aimed at coordinating financial conditions in Switzerland and the Euro-region; specifically, on the day the European Central Bank cut interest rates this spring, the SNB announced a cut in its interest rate 20 minutes later.

While the majority of exchanges involve the dollar, some non-dollar markets are also very active. About 98% of the total volume of the non-dollar market used to fall on the German mark. After the introduction of the euro, volumes in many markets declined and have not yet fully recovered.

The German mark (DEM) was second only to the dollar in terms of its share in the world’s foreign exchange reserves (about 25%). With regard to the stability of the exchange rate, the mark was strongly influenced by socio-political factors in Russia, with which economic and political relations most closely connect Germany, and this influence was transferred to the new euro currency since Germany represents a significant part of the economy of eleven states that have united their currency systems.

The new currency, the euro (EUR), which appeared on January 1, 1999, united 11 European nations into the most powerful economic bloc in the world, which accounts for almost a fifth of the global output of goods and services and world trade. The Euro-region (“Euro-area”) includes Austria, Belgium, Germany, Ireland, Spain, Italy, Luxembourg, the Netherlands, Portugal, Finland, and France, covering an area of ​​2,365,000 sq. km. with a population of 291 million people (for comparison – in the US 269 million, in Japan – 126).

The creation of a single European currency is, by far, the most significant financial experiment in the history of humanity. None of the previous attempts to create any substantial economic union was successful. The euro is now also viewed by many as an experiment, the outcome of which will not necessarily be a success. Throughout the first half of 1999, the exchange rate was steadily declining, which some see as signs of distrust in the new currency, while others see the monetary policy effectively pursued by a single European Central Bank since a low exchange rate plays into the hands of European exporters, significantly increasing the competitiveness of their goods on world markets. Markets.

The path of European states to the unification of monetary systems was long and not easy; not all countries could withstand the conditions formulated for unification, and the composition of the participants changed. But for several years, a synthetic ECU currency (ECU) made up of European currencies existed and was recognized in the world (its exchange rate on December 31, 1998, became the euro exchange rate); the persistent work of the leaders of a number of European states, primarily Germany, France, Italy, eventually led to the launch of a new currency.

Hedging

The most diverse companies in the field of activity, which are foreign trade operations (exporters and importers), in order to eliminate the danger of currency risks, often take part in operations on the international foreign exchange market FOREX.

The danger of currency risks for companies with operations in the foreign market lies in the constant change in world currencies. Exchange rates on the international market are constantly changing. As a result, the cost of goods that a particular company would like to buy or sell for foreign currency can vary significantly. As a result, the profit that the company planned to receive at the conclusion of any transaction may turn into a loss. Of course, the reverse situation is also possible when a change in the exchange rate can bring unplanned profits. Still, a trading company whose main activity is not trading on the FOREX market should first of all plan profit from its trading activities, for which it is essential to be able to calculate the actual cost of buying or selling goods.

For competent planning of the cost of goods with which export-import companies work with large firms, analytical departments that deal with forecasting exchange rates have been created. However, forecasting, although it allows you to buy or sell goods at more favorable prices, does not eliminate the possible losses of the company when the situation on the foreign exchange market does not develop in its favor. Unlike forecasting, hedging almost eliminates currency risks and the opportunity to receive both profit and loss as a result of the operation.

How hedging works

The fact is that the company’s accounting is kept in one currency. In the case of export-import operations, when buying and selling foreign currency, there is a possibility of making profits and losses that depend on the foreign exchange rate at the time of the transaction. In this case, the company uses hedging tactics. Hedging leads to the fact that the risk of changes in exchange rates disappears for the company, which makes it possible to plan activities and see the financial result not distorted by exchange rate fluctuations; it allows you to set product prices in advance, calculate profits, wages, etc.

Currency risk hedging is the protection of funds from unfavorable movements in exchange rates, which consists of fixing the current value of these funds by concluding transactions on the FOREX market.

Using the principle of margin trading when conducting operations on the FOREX market has a number of advantages that have made it especially popular for conducting currency risk insurance operations.

• Having a small insurance deposit on the trading account, the company can carry out transactions in the amount of tens and hundreds of times more than the value of this deposit. This is one of the advantages of margin trading (leverage – Leverage)
• When using leverage, trading occurs without the actual delivery of money, which reduces the overhead costs associated with transferring large amounts of money.
• One of the essential advantages of margin trading is that when opening a hedging position, significant funds will not be withdrawn from the company’s working capital, which is necessary for the purchase of raw materials or goods.

There are two main types of hedging – buyer’s hedging and seller’s hedging. Buyer hedging is used to reduce the risk associated with a possible increase in the price of a commodity. Seller hedging is used in the opposite situation – to limit the risk associated with a potential decrease in the price of goods.

The general principle of hedging in foreign trade operations is to open a currency position on a trading account in the direction of a future operation to convert funds. The importer needs to buy foreign currency, so he opens a position in advance by buying foreign currency on a trading account. When the time comes for an actual purchase of foreign currency in his bank, he closes this position. The exporter needs to sell foreign currency, so he opens a position in advance by the currency of sale on a trading account, and when the time comes for the actual sale of currency in his bank, he closes this position.

Thanks to hedging, a company can protect itself from currency risks, but this service is not free and contains several expense items.

• Any transaction concluded on the FOREX market is associated with expenses in the form of the difference in the prices of buying and selling currency (Spread). However, under current market practice, this difference is usually 0.05% – 0.1% of the transaction amount, which is not significant.
• The position has to be kept open for a long time, and every day, the position is rolled over to the following date (Rollover), taking into account the difference in interest rates for the currencies involved in the transaction. Under the prevailing market practice, this is approximately 0.01% per day, which is 0.3% of the transaction amount per month. However, depending on the direction of the transaction (buy or sell), the client will either pay this amount for the rollover of the position or receive this amount.
• A security deposit is required to open a position. The value of this deposit usually ranges from 1% to 5% of the amount of the transaction. After the position is closed, the deposit is withdrawn from the trading account (taking into account profit or loss).

Summing up all of the above, you can see all the benefits of hedging. Hedging costs are minimal compared to the amount of hedged contracts and possible losses in the event of unfavorable movements in the foreign exchange market for the company. A well-designed hedging program reduces not only risk but also costs by freeing up company resources and helping the company’s management to focus on the core aspects of the business.

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