Foreign Exchange Risk Mitigation Techniques/Market Drivers
Political, economic and technical events are the drivers of change in the foreign exchange markets. Having a broad understanding of these factors provides a practical means of forecasting foreign exchange rates. A forecast is static and not constant and therefore must be monitored and adjusted based on market conditions. Some key factors to consider are balance of payment, inflation rates, investor confidence and intervention in the foreign exchange market. Historically businesses purchased foreign currencies to settle trade-related transactions. Today there are many reasons to purchase foreign currencies. Investing in stock markets, the purchase of manufacturing facilities, holding the currency for interest income or speculation and the purchase of bonds are some of the ways investors utilize foreign currency. Markets are now impacted by market makers as they assume a high level of risk by buying and selling in sufficient quantities to affect market prices.
Balance of Payments
Payments that flow between one country and all other countries determine its balance of payments. It is defined as the sum of the current account, the capital account and the change in official reserves. A current account is considered more short-term in nature while the other two are more long-term.
Balance of Payments = Current Account + Capital Account + Change in Official Reserves
- The current account is the net of all goods and services between the United States and all other countries. The current account is generally the most volatile. The balance of trade between the United States and all other countries determines whether we are a net exporter or importer. Our need for inexpensive goods over what we could buy locally has caused us to become a net importer with a growing trade deficit. The deficit could be a severe problem if dollars were sold in mass quantities to the extent of lowering the value of the dollar itself.
- The capital account is the purchase of our currency or the repatriation of our currency for direct foreign investment in stocks, capital goods, land, etc. Capital goods are holdings other than cash and have to be converted back to cash in order to remove them from the country. This conversion process takes more time and is less volatile than having a current account.
- Official reserves are the holdings by foreign governments in the US dollar. These reserves can be used to stabilize their currency by selling off the dollars and purchasing their local currency, creating an artificial demand and driving the price of their currency up. The impact of this type of selling, which is generally short-term in nature, is done to prevent wide swings in the value of the local currency.
The balance of payments has a significant impact on the value of a currency. While movements in a current account have the biggest impact, they are often balanced by the other two. The United States tries to entice foreign investors to invest in capital goods; in doing so we repatriate some of the dollars back into our country. We also encourage governments to increase their reserves in the United States. The impact of making similar investments in dollars can offset the fluctuations in the current account. It is only when confidence in all three areas is lacking that the United States dollar will decline significantly.
Inflation causes the value of local goods to become more expensive, impacting the ability of other countries to buy local goods and services. It makes products less competitive in a free-market economy. Time combined with market conditions will cause the re-establishment of purchasing power parity between two countries.
Purchasing power parity (PPP), as defined by the Swedish economist G. Cassel in 1918, is that natural market conditions will adjust the exchange rates between the domestic currency and any foreign currency to reflect differences in the inflation rates between them, which means there is a direct correlation between the movement of inflation rates between two counties and their respective foreign exchange rates.
The typical foreign business model starts with the export of goods. The eventual success will lead to the establishment of a manufacturing plant with local production. Eventually competition, if unchecked, will force the manufacturing costs to go down so that the once- exporter starts importing goods he exported. The ability to follow this model is heavily dependent upon investor confidence. Foreign direct investment is dependent upon political stability, GDP (economic performance) and government deficits. Investors’ expectations are for higher returns with managed risk. Political stability is a key determinant of investor confidence. Civil strife in the form of strikes, riots or civil commotion and expropriations by governments discourage investor confidence and lower the value of a currency. High tax rates, high deficits and poor overall economic performance by a country contribute to poor investor confidence. Investment will return should investors believe that the country is in a recovery mode and these factors will change to their benefit.
Trading in foreign exchange can be very risky. There are arbitrageurs that benefit from price differences based on time and place. Their ability to enter and exit the market quickly can create a temporary price differential. Their objective is to make quick profits; this form of derivative trading is considered the most risky. Governments use their ability to intervene in the market to prevent wide swings in their currency. Their ability to utilize their reserves to buy and sell their currency can stabilize the market temporarily providing time to adjust any other market conditions that impact the value of their currency. Governments also determine interest rates, thus creating an investment option that entices capital into the country. These tools are temporary in nature: in order to keep long-term capital in a country, there must be stability without political turmoil.