The Changing Role Of Currency
Jul0
In modern times, currency has come to denote money. It has become the most important means of transactions. But in earlier times, coins made of gold and silver were the means of transactions. Because these were made from precious metals, the coins had a natural value. While the silver coins were used to purchase smaller goods, the larger goods were purchased with gold coins. Very soon banknotes came to replace coins as the medium of transactions. Though the banknotes by themselves did not have any natural value as the coins, it was the legal tender by virtue of government order.
Different countries have different currency. The exchange of these currencies acted as the means of trade in goods and services between any two countries. The exchange of the currencies between the two countries becomes possible with its exchange rates. It is normally the central bank or the Ministry of Finance who is the authority to produces and distributes the currency of that country that also influences what value the currency holds. The Federal Reserve System for instance is responsible in the United States.
The name of the currency is the same in some countries. Countries such as United States, Malaysia, Canada, Zimbabwe, Singapore and Australia have named their currency as dollar. There are other similar currencies common to a number of countries such as Dinar, Franc, Escudo, Gulden, Frank, Krone, Lira, Mark, Livre, Pound, Peso, Rial, Real, Rupee, Ruble, Shilling and Scudo. Sometimes the same currency becomes the common currency used in a number of countries such in European Union where Euro is used as the common currency. A foreign currency is sometimes accepted as the legal tender as, for instance, the US Dollar in Panama and El Salvador. Trading in currencies takes place in the foreign exchange market, both for the purpose of international trade as well as for speculation. Forex trading is explained, amongst others, by a number of websites and books such as Forex Made EZ, Forex Trading Explained and Tax Lien Investing.
The demand of a currency will determine its exchange rate with reference to another currency. The value of the currency increases when the supply is limited but demand increases. The value of the currency declines when the demand is low as compared to the extent of supply.
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Interest Rate
May0
Interest Rate
Getting something extra without the added cost can be a nice change sometimes. The ultimate traders dream is to enter a trade and turn a profit even though the currency pair does not budge. There are others who desire to make money off their trades, even though the market is seemingly uncooperative. This would surely make trading a lot easier. Although it may seem farfetched to those who are unfamiliar with the methods of forex market, that is exactly how the hedge funds, banks and other institutional traders play the forex game.
The Interest Rate Differentials
The heart of this technique lies on the interest rate arbitrage and in the reality that every currency has a matching rate of interest. The rate is determined by the nations central bank or the nations that use the currency. For instance, the Federal Reserve sets the U.S. interest rates, while the interest rate for France, Germany and other nations of the European Monetary Union are determined by the European Central Bank.
In the forex market, currencies trade in pairs and each currency has an equivalent interest rate. For these reasons, there are two different rates on interest for every pair involved. Generally, a disparity exists between the rates, and so in most cases, one currency yields higher than the other.
Large institutional traders seek to exploit this kind of edge. Additionally, the trader can be long one currency and short one currency in every foreign exchange market. The trader who is long, the higher yielding of the pair collects interest on the trade.
In contrast, the trader who is short, the higher yielding of the pair is required to pay the interest. The amount of the interest that the trader either pays or collects is based on the interest rate differential. This factor is described as the difference in the interest rates between the two currencies.
How Does the Interest Rate Differential Works
Suppose that a certain trade is placed in the imaginary currency pair, say ABC/XYZ. The rate of interest for the ABC currency is 4.0 percent, while 1.0 percent for the XYZ currency.
Hence, the ABC yields higher than the other. Traders who are long ABC and short XYZ will collect 3.0 percent in interest, which is the differential between ABC and XYZ. Note that the trader must be long the higher-yielding currency in order to collect the interest.
However, traders who are long XYZ and short ABC must therefore pay the same 3.0 percent in interest rate differential. Arbitrage traders who are long the higher-yielding currency seek to collect interest every day, given that they hold the currency pair.
For starters, this might seem at bit simple. However, there is more to this strategy than merely matching up a currency that is yielding high against a currency that is yielding low. Traders utilize this strategy when they are able to identify a situation where the interest rate differential is likely to expand over time.
Such event would result in an even greater payoff for the trader who is long the higher-yielding currency. Normally, traders would leave the strategy when it becomes evident that the interest rate differential will stop growing or become smaller in the future.
Changing the Differentials
By using the previous example provided, assume that the traders are trading currency pair ABC/XYZ, and they are collecting interest since they are long currency ABC and short currency XYZ.
If there is a strong economy for ABC, the central bank handling the currency is likely to raise the interest rates to control inflation and contain growth. When the bank takes a course of action, the interest rate of ABC rises from 4.0 percent to 4.25 percent, thus causing the differential from 3.0 percent to 3.25 percent.
Similarly, if there is an apparent weakness in the economy of XYZ, its central bank is likely to lower the interest rates in order to encourage demand and promote growth. The interest rate for the currency will be lowered from 1.0 percent to 0.75 percent, thus the differential would have grown to 3.5 percent.
The traders, who are encouraged by the growing interest rate differential, go long ABC and sell short XYZ to collect the extra interest. If there are enough traders tempted to go long ABC and sell short XYZ, this event will create a positive pressure on ABC and negative on XYZ. Thus, the currency pair will begin to rise.
Collecting the Interest
There is an advantage to this technique, which is the ability to turn a profit in spite of whether the trade moves in the preferred direction. For instance, if the trade maintains its flatness for several months, the trader can still come out ahead given that he or she collects interest. Moreover, this will provide the trader an exceptional edge.
When comparing this kind of situation to the trader who is on the other side of the trade, he or she must pay the interest day by day, even if the trade moves in the preferred direction or not. The trader who is short the higher-yielding currency is required to regain the interest lost to break even.
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