Page 290 - DCOM507_STOCK_MARKET_OPERATIONS

Unit 14: Currency/Forex Market

Notes
Did u know? The most famous of all currency speculators is probably George Soros. The
billionaire hedge fund manager is most famous for speculating on the decline of the
British pound, a move that earned $1.1 billion in less than a month. On the other hand,
Nick Leeson, a derivatives trader with England’s Barings Bank, took speculative positions
on futures contracts in yen that resulted in losses amounting to more than $1.4 billion,
which led to the collapse of the company.
Some of the largest and most controversial speculators on the forex market are hedge funds,
which are essentially unregulated funds that employ unconventional investment strategies in
order to reap large returns. Think of them as mutual funds on steroids. Hedge funds are the
favourite whipping boys of many a central banker. Given that they can place such massive bets,
they can have a major effect on a country’s currency and economy. Some critics blamed hedge
funds for the Asian currency crisis of the late 1990s, but others have pointed out that the real
problem was the ineptness of Asian central bankers.

Self Assessment

Fill in the blanks:
10. ……………………..... occurs when one country directly fixes its exchange rate to a foreign
currency so that the country will have somewhat more stability than a normal float.
11. ……………………..... occurs when a country decides not to issue its own currency and
adopts a foreign currency as its national currency.

14.4 Economic Theories and Data

There is a great deal of academic theory revolving around currencies. While often not applicable
directly to day-to-day trading, it is helpful to understand the overarching ideas behind the
academic research.
The main economic theories found in the foreign exchange deal with parity conditions. A parity
condition is an economic explanation of the price at which two currencies should be exchanged,
based on factors such as inflation and interest rates. The economic theories suggest that when the
parity condition does not hold, an arbitrage opportunity exists for market participants. However,
arbitrage opportunities, as in many other markets, are quickly discovered and eliminated before
even giving the individual investor an opportunity to capitalize on them. Other theories are
based on economic factors such as trade, capital flows and the way a country runs its operations.
We review each of them briefly below.

14.4.1 Major Theories

Purchasing Power Parity
Purchasing Power Parity (PPP) is the economic theory that price levels between two countries
should be equivalent to one another after exchange-rate adjustment. The basis of this theory is
the law of one price, where the cost of an identical good should be the same around the world.
Based on the theory, if there is a large difference in price between two countries for the same
product after exchange rate adjustment, an arbitrage opportunity is created, because the product
can be obtained from the country that sells it for the lowest price.
The relative version of PPP is as follows:

∏−∏
e = 1 2
1 +∏ 2

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