Forex Investment and Currency Trading

For USD, EUR, JPY, GBP, CAD, etc., the foreign exchange rate changes depend on the interaction of supply and demand. No restrictions on the transactions that you can conduct. But this is not the norm! Most currencies are “managed – either informally or formally. Most countries place restrictions on FX transactions.

Exchange Controls

Most developing countries impose some restrictions on the ability of residents to buy foreign exchange or retain foreign exchange. They will typically allow free flows with respect to the current account though this will necessitate documentation. But not with regard to capital flows.

Typical implications:

• You can buy the local currency without restriction
• Sales of the local currency must be handled locally – documentation will be required, approvals may be lengthy, trade transactions will take precedence over invisibles, with capital account transactions at the bottom of the list
• U.S. dollar accounts cannot be opened locally or foreign currency accounts in New York

Some of the more problematic countries:

• China: everything has to be done locally
• Korea: may not be able to agree on settlement until local office receives necessary documentation
• Venezuela: draconian controls

Key point:

• The FX transaction does not end when you’ve hung up the telephone with the bank salesperson!

Exchange Rate Intervention

• Purchase or sale of foreign exchange by a central bank (or other monetary authority) for a policy reason, in other words, to influence the exchange rate
• Does not include purchases or sales undertaken for normal business reasons, e.g., the government needs to purchase something or is servicing debt
• Result: rising or falling foreign exchange reserves

Why is this important?

• To trade a currency you need to understand the currency
• Trade against a base currency, e.g., USD/PLN is a cross-rate!
• Understand & forecast exposures
• Help evaluate risk
• Create an effective hedging policy

Saudi Arabian Riyal – it is effectively pegged to the U.S. dollar at 3.75, with central bank intervention to prevent significant deviations

Hong Kong Dollar – the narrowest of bands and a currency board arrangement

Interest rates in countries whose currencies are pegged to the dollar will follow those in the United States, which can be a problem if inflation trends are different to those in the United States, in other words, no monetary independence.

Russian Rouble: Basket value
It is managed against a basket, not against the U.S. dollar. It is based on 0.55*USD + 0.45* EUR

Brazilian Real: Foreign Exchange Reserves
No formal exchange rate regime – but a clear policy of “leaning against the wind”.

The Ultimate Solution

• USE Another Country’s currency – Ecuador, El Salvador, Panama all use the U.S. dollar
• Design a currency for use in multiple countries – the euro has already 15 currencies within the European union – and eventually 9 more currencies will be subsumed into the euro. In effect, it floats against the U.S. dollar, but within the 15 countries, the exchange rate is fixed.

In practice, very few currencies are truly floating – there are limits to how much any country will allow its currency to move.

What are U.S. foreign exchange reserves?

• It doesn’t matter because the United States does not intervene in the market (or very occasionally)
• Reserves are only important for countries that intervene regularly