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Chapter 10

Determinants Of Currency Value

When we talk of currency value in the context of global currency trading, we are always talking about relative values. For example, the dollar is the most popular currency and it is also the benchmark to which most currencies are pegged. That is because most of the trade in the world is still denominated in US Dollars. Even in the case of India, the most popular exchange rate is the USDINR which is the amount of rupees you pay for 1 dollar. It is always expressed in terms of 1 dollar. For example USDINR = 69.90 means that you have to pay Rs.69.90 for a dollar. However, when you go to the bank you will never get to buy or sell at the spot price of Rs.69.90 to a dollar. You buy dollar at the ask price which will be above the spot price and you will sell dollars at the bid price which will be below the spot price. The gap between the bid price and the ask price is called the spread and that is the income that the bank / currency dealer earns on currencies.

WHAT DO WE UNDERSTAND BY CURRENCY VALUE?

When we talk of currency value, we always refer to the exchange rate of the domestic currency vis-à-vis a foreign currency. The benchmark for reference is normally the US dollar which is the most liquid and actively traded currency in the international market. Currency value shows how much one unit of a currency can be exchanged for another currency.

Typically, such currency exchange rates can be floating or they can be pegged. Countries like India follow the system of “Managed Float”, wherein the currency is largely free to move but in the event of extreme movements, the RBI intervenes to restore stability in the rupee market. Some of the world’s largest hard currencies like the Dollar, Pound, Euro and Yen are fully floating currencies.

CURRENCY DEPRECIATION AND CURRENCY APPRECIATION

Currency appreciation is an increase in the value of one currency in relation to another currency. Currencies appreciate against each other for a variety of reasons, including government policy, interest rates, trade balances and business cycles. Currency depreciation is the exact opposite and it refers to the weakening of the local currency versus the foreign currency. For example, if the INR goes from 68/$ to 70/$, it is a case of rupee depreciation. On the other hand if the INR goes from 68/$ to 66/$, it is a case of rupee appreciation. In a floating rate exchange system, the value of a currency constantly changes based on supply and demand in the forex market. The fluctuation in values allows traders and hedgers to take appropriate directional positions to make profit from such currency appreciation and depreciation.

When we refer to currency appreciation or currency depreciation, it is always in pairs. For example, if the rupee appreciates versus the dollar, it is not necessary that it should appreciate against the Pound and the Euro too. Each currency pair is driven by its own set of dynamics and its unique set of economics. When it comes to absolute value assets like stocks, an appreciation is an increase in value and depreciation is decrease in absolute value. That is where currency appreciation and depreciation differ from standard assets.

What are the effects of currency appreciation and depreciation?

An appreciation or depreciation of the local currency vis-à-vis a foreign currency has a number of side effects. Let us look at some of them.

  • An appreciating rupee versus the dollar is negative for exports. That is because with a stronger rupee, foreign buyers will find Indian goods more expensive and therefore less attractive. A weaker rupee actually benefits the exporter. The reverse is true for an importer. The depreciation of the rupee is negative for the importer and the appreciation of the rupee is positive for the importer.
  • Currency appreciation impacts your portfolio value. For example, if a US investor invests in India and earns 18% returns, it is important to know how the rupee has done. If the rupee has depreciated by 7% then his actual net return in dollar terms is just 11%. On the other hand, an appreciating rupee adds to the returns of foreign investors.

CURRENCY DEVALUATION AND CURRENCY REVALUATION

The difference between currency depreciation and devaluation is that while depreciation happens due to the operation of market forces, the devaluation is done by the government, in consultation with the central bank of the country, as a conscious measure if they find the local currency overpriced. For example, when India liberalized in 1991, the rupee was devalued from Rs.19.64/$ to Rs.31.23/$ in a span of 1 year and remains one of the sharpest devaluations done by any government in recent memory.

Devaluation of a currency is a deliberate lowering of the official exchange rate of a country and setting a new fixed rate with respect to a reference of foreign currency such as the USD. It should not be confused with depreciation which is the decrease in the currency value as compared to other major currency benchmarks due to market forces. The process of devaluation renders the foreign currency more expensive than the local currency. The most important reason for devaluation is to push exports, reduce the trade deficit and reduce the debt burden.

What are some of the key effects of devaluation? It is normally inflationary as it leads to an increase in the demand for goods from India. Normally, governments raise interest rates in response but this has the effect of slowing down the economy. Secondly, devaluation also discourages foreign investors as they see the dollar value of their returns going down sharply. Quite often such devaluation also leads to a run on currencies where traders gain at the cost of the economy.

Revaluation is the exact opposite of devaluation and refers to a deliberate strengthening of the currency. As a strategy, revaluation is rarely used by countries as it can have the effect of encouraging imports and import inflation from other countries and putting their exporters at a major disadvantage.

FACTORS DRIVING CURRENCIES IN THE SHORT TERM

Trading in the currency markets typically begins by capitalizing on the short term trends in the market. The focus is largely on short term currency moves. While this is not a wrong approach, most of the traders do not pay adequate attention to all the short-term influences in the Forex market, many of which can be multivariate in nature. Currency markets in the very short term consists primary of market noise that is extremely difficult to predict. You can at best use the technical charts to extrapolate post trends into the future and trade accordingly. Short term in the forex markets normally refers to a period of few days ranging up to few weeks. The following factors drive the exchange rate movements in the very short run.

Wisdom of crowds - Wisdom may often be a misnomer but the crowd reactions and actions make a big impact on currency markets in the short term. It is also called the herd mentality in markets and it happens because traders feel that they have missed a strong up move or down move. In such cases, the participation in the currency markets is purely an afterthought. While crowd dynamics add to the market volatility, they can be treacherously hard to predict.

Inter correlations in the currency market - Currencies exhibit differing degrees of correlations in the short-term, although the trend may be entirely different in the long run. Think about GBP/USD and EUR/USD, where the former pair usually works as a leader of the latter one, i.e. they are positively correlated. You can use these as lead indicators or lag indicators to take a short term trading view on currencies.

Sentiments in the market - There are positive or negative sentiments attached to certain currencies and they take time to change. What people think about a currency tends to have a large impact on that currency’s price in the short run? Market sentiment is influenced by news to a large extent, so make sure to follow an economic calendar to stay up-to-date on major events and announcements.

Overbought and oversold zones - We have seen overbought and oversold zones based on RSI indicators. They are broadly good indicators to help us take a view on markets for currency trading.

FACTORS DRIVING CURRENCIES IN THE MEDIUM TERM

The medium-term in the currency markets can be considered a period of a few weeks up to six months. In the medium run, fundamental factors start to play in increasingly important role in the move of exchange rates, and traders need to pay attention to them when learning online Forex trading. Here are common methodologies used to trading currencies in the medium term.

Playing on Interest differentials - Interest rates are the price of money and international capital tends to chase high-yielding currencies in times of a risk-on market environment. Risk-on refers to the willingness of traders and investors to take on the risk of investing in emerging markets. This in turn increases the price of currencies with higher interest rates relative to currencies with lower interest rates. Quite often you will find that interest rates provide a very lucid and unbiased picture of medium term currency trends.

Monetary policy / Fed announcements - The expected change in monetary policy is an important driver of medium-term currency movements. If the fundamentals of a country show that a tighter monetary policy is more appropriate, the exchange rate will move accordingly. That is one of the main reasons why traders across the world track the Fed policy announcements, ECB policy and BOJ policy quite closely.

Balance of payments - The balance of payments and the trend of its current and capital accounts can change the supply and demand for a currency. While current accounts are usually followed in this regard, note that with the fall of investment barriers between countries, capital account trends have started to have an increasingly important role in medium-term exchange rates.

FACTORS DRIVING CURRENCIES IN THE LONG TERM

Let us start off with a caveat. Is it really possible to take a long term view on trading currencies? That would largely depend on your perspective and the interests of the IBA and other lobbying bodies. Some of the key long term triggers are as under:

Purchasing power parity - You always heard of the Purchasing Power Module, which is now used by banks to report their MTM losses n a transparent manner. The PPP model suggests that the differential in inflation rates can be used to determine the equilibrium of long-term exchange rates. In essence, this model is based that the purchasing power of two currencies needs to be in parity in the long run. However, evidence suggests that exchange rates can stay overvalued or undervalued for a long period of time before reverting to their PPP-equilibrium rate. This cannot be a very reliable indicator in the Indian context.

Improving the terms-of-trade - This is more of a macro factor and impacts the roof under which the Terms-of-Trade of a country is heavily influenced by its main exporting/importing commodity. In other words, a rising oil price may be beneficial to the Terms-of-Trade of Canada, Russia, Saudi Arabia etc. But the same will be detrimental to countries like China, Japan and India. To assess the importance of a country’s Terms-of-Trade on the currency’s long-term exchange rate, you can follow the price-trend of its main exporting/importing commodity. That is a fairly reliable indicator for you to track.

Generally, there are no hard and fast rules here and traders follow a mix of different approaches to make the best of the markets.

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