Through out this forum, I have seen many posters engage in pissing contests about which system, method, M.O, Way of trading....etc. For how we trade vary up to the the names triggers we use to get into the markets. I'm still hungry after what will probably be my second year trading the markets for a more empirically based, more scientific approach. This Thread will be for people who want to enter discussions on the matter. This will not be a place to demonstrate your set ups....because IF you do I will expect strong, statistical, mathematical, falsifiable, replicable, and testable data with a well thought out rationale behind it.

I'm not a guru and don't purport to become a single, Cult mindset, superstitious and irrational thinking should just belong in RELIGION, not investing.

Before we get to statisticscharts
probabilities
risk models
and the rest of the good things myself along with other traders want to jump to...I want to be certain that we know the idea behind what we do daily in the markets.

I'm not claiming to instruct you how to trade but I really do want to dispel a lot of the B/S in this forum or corroborate that b/s with good rational thinking behind why certain things work.


To launch of the thread Here's a piece composed by Showbik Karla in Harvard Business School, seeing exchange rate determinants.

Http://people.hbs.edu/mdesai/IFM05/Kalra.pdf



December 13, 2005

SHOWBHIK KALRA

Notice on Determinants of Foreign Exchange Rates

Exchange rates are relative prices of domestic currencies, and beneath a floating rate regime
they may be seen as being dependent upon the interplay of demand and supply in
foreign exchange markets. The exchange rate simply expresses a national currency's
quotation with regard to foreign ones. By way of instance, if a single US dollar is worth 100 Japanese
yen, then the exchange rate of dollar is 100 yen. Therefore, the exchange rate is a
conversion factor, a multiplier or a ratio, depending upon the path of conversion. Therefore,
the exchange rate can also be thought of as a price of one currency in terms of the other.
Exchange rate regimes (fixed or floating) are preferred by central banks (or authorities ).
It is important to distinguish nominal exchange rates in actual exchange rates. Nominal
exchange rates are established on currency monetary markets. Rates are often
established in constant quotation (they possibly fixed). Real exchange rates are nominal
rates fixed by inflation measures.

The following part presents some determinants of the nominal exchange rate. These
determinants can lead to fluctuations of a floating exchange rate or put pressure on a predetermined
exchange rate. The objective of the note is not to determine how to forecast changes in
exchanges rates but is an effort to discuss exchange rates change.
Determinants of the Nominal Exchange Rate

1. Trade Balance

Exports, imports and the trade balance can influence the need of currency aimed at
actual trades. An increasing trade surplus will increase the requirement for nation's
currency by foreigners (e.g. when the USA is running a trade surplus, there'll be
need from abroad for the USD to cover these goods), so that there should be a
strain for appreciation. A trade deficit should lead to the currency .
If imports and exports mainly dependent on price competitiveness as well as the exchange rate
truly sensitive to exchange imbalances, then some shortage would imply a depreciation followed
by booming exports and decreasing imports. Therefore, the first deficit will be quickly
reversed. Trade accounts would always be zero.
But imports and exports aren't just dependent on price competitiveness (along with also the
exchange rate is not truly sensitive to exchange imbalances), so trade imbalances may
be quite persistent (as is the case with the current trade deficit in the United States).

One reason is tariffs and quotas that exist to protect a country#8217;s foreign exchange by decreasing
demand. For e.g. till before liberalization, India followed a policy of tariffs and
limitations on imports. Not many items were permitted to be imported.
Additionally, high customs duties were levied to discourage imports and also to protect the
domestic sector. Tariffs and quotas aren't popular internationally as they tend to close
markets. Quotas aren't limited to developing nations. The United States imposes
quotas on clothing garments and Japan has quotas on certain non-Japanese goods.
Capital moves of foreign currency exchange are usually connected with global trade.
When India started its economic liberalization and invited Foreign Institutional Investors
(FIIs) to purchase equity shares in Indian companies, billions of US dollars came into the
nation strengthening the currency. In 1996 and 1997, as a result of political scenario, FIIs
took several billion US dollars (capital outflows) from the nation worsening the
currency.


2. Relative Purchasing Power Parity

The other kind of real determination of exchange rate is offered by the 1 price law or
the #8220;purchasing power parity#8221;, based on which any freely service or good gets the
same price worldwide, after taking into account nominal exchange rates. But in order to
equalize the price of several goods, greater than 1 exchange rate may turn out to become
required, or an exchange rate which represents a tradable basket of products and services.
The purchasing power parity exchange rate (PPP) involving a foreign currency and the
U.S. dollar can be described as:
PPP = (Price of a Market Basket of Goods and Services in Foreign Prices) / (Price of the exact same Market Basket of Goods
and Services in U.S. Prices)

This gives us the exchange rate in terms of the components of foreign currency per dollar. The
dollars per unit of foreign currency is just the reciprocal.
The exchange rate between nations, therefore, ought to be such that the currencies have
equivalent purchasing power. For e.g. when a hamburger costs 3 US dollars in the United
States and 100 yen in Japan, then the exchange rate has to be 100 yen per dollar. The
foreign exchange market would adjust, over the long term, allowing the functioning of
the 1 price law, since the purchasing power of a single currency increases (or
decreases) relative to another currency.

3. Relative Interest Rates

Interest rates on treasury bonds will influence the decision of foreigners to purchase
domestic currency in order to buy these treasury bonds. Higher interest rates will attract
capital from abroad, thus increasing demand for the currency, and so the
currency will appreciate. Notice, what's important is difference between domestic and
foreign interest rates, thus a decrease in foreign interest rates would have a similar impact.
Accordingly, an increase of domestic interest rates from the central bank could be
considered a way to defend the currency.
However, it may be the situation that thieves rather buy shares rather than treasury bonds. Whether this
were the most powerful component of currency requirement, then an increase of interest rate may
even lead to the contrary results, because an increase of interest rate quite often depresses
the stock market, resulting in discuss earnings by foreigners. A restrictive monetary policy
(increasing interest rates) usually also depresses the expansion perspective of the economy.
If foreign direct investment are primarily brought on by future growth prospects and they
constitute a sizable component of capital flows, then that FDI inflow might stop along with the
currency could weaken. Therefore, interest rates have an important impact on
exchange rate however, one must be careful to check extra conditions.
Capital from abroad #8593;; Demand for currency #8593;;
Currency appreciates
Stock market #8595;; Capital from abroad #8595;;
Currency depreciates
Economic growth prospects #8595;; FDI #8595;; Currency
depreciates
influence on the exchange rate when interest rates are increased
Interest Rates #8593;

4. Relative Price Changes

The inflation rate can be regarded as a determinant of the exchange rate. A high
inflation rate ought to come with depreciation of the exchange rate. The more so if
other nations like lower inflation rates, because it ought to be the difference between
domestic and foreign inflation rates to determine the management and the scale of trade
rate moves.
Therefore, in case a hamburger costs 5 percent more in Japan compared to one year ago, while at USA it costs
8% greater, then the dollar should have been depreciated this year by about 8%-5%=3%.
Here we have used the burger as a general example. The relationship between actual,
nominal exchange rates and inflation can be expressed as the next approximation
(that can be applied to any two nations, not just the USA and Japan):
percent 916;Real Exchange Rate (Â¥/$) #8776; percent #916;Nominal Exchange Rate (Â¥/$) #8211; (Japanese Inflation% - U.S. Inflation%)
With regard to the overall price level of the economy, if exchange rates would move
precisely counterbalancing inflation dynamics, then actual exchange rates should be steady.

5. Speculators, Traders and Fiscal Instruments

George Soros is famous for His single-day profit of US$1 billion on Sept 6, 1992, which he
produced by short selling the British pound. At that time, England was a part of the European Exchange
Rate Mechanism, a fixed exchange-rate system which included other European nations. The
other nations were pressuring England to devalue its currency in connection to the other nations in
the system or to leave the system. England resisted the devaluation, but with continuing pressure
from the system and speculators in the currency market, England floated its currency and the
value of the pound suffered. By leveraging the value of his fund, Soros was able to take a $10
billion short position on the pound which forced him US$1 billion. This trade is considered one of
the greatest trades of all time.
Past and expected values of the exchange rate itself may impact on current values of this.
The actions of foreign exchange traders, speculators and investors may turn out to become
extremely related to the conclusion of the market exchange rate. Financial
instruments like futures and forward could also play an essential function in the
determination of exchange rates.
A currency speculator who expects the spot rate of a foreign currency to become
higher in three months can purchase the currency in the spot market today at today's spot
rate, hold it for three months, and then resell it for the national currency in the spot
market after three months. When he is correct, he'll earn a profit; otherwise, he'll break
even or incur a loss. On the flip side, a currency speculator who expects the
spot rate of a foreign currency to be lower in three months can borrow the foreign
currency and swap it for the national currency at today's spot rate. Following three
months, even if the spot rate on the foreign currency is satisfactorily reduced, he can make a profit
by being in a position to repurchase the foreign currency (to repay the currency loan) at
the lower spot rate. (NOTE: To earn a profit, the new spot rate has to be satisfactorily
lower to overcome the extra interest paid on the foreign currency borrowed for 3
months, over the interest received on an equal amount of the federal currency deposited
at a bank for three months.)
It is essential to be aware that foreign exchange speculation usually occurs from the
ahead market because it is simpler and, at precisely the same time, involves no borrowing of their
foreign currency or joining up of the speculator's funds. Actions in foreign exchange
options markets can also affect exchange rates, especially in the short-term. To
know the dynamics between spot rates, interest rates and forward rates it is
interesting to comprehend the mechanisms behind covered interest arbitrage.

5.1. Covered Interest Arbitrage
Covered interest arbitrage is the transport of liquid capital from 1 currency to another to
make the most of higher rates of interest or return, while covering the trade with a
forward currency market. Since the foreign currency is very likely to be in a forward discount,
the investor loses the foreign transfer currency trade per se. However, if the positive
interest differential in favor of the foreign money center exceeds the forward discount on
the foreign currency (when both are expressed in percent each year), it pays to make
the foreign investment.
For e.g., when interest rates in the United States are greater than in Brazil (or elsewhere),
a Brazilian investor could swap reals for dollars today and use these dollars to buy a 3-
month T-bill at New York in 12%. She earns 4% more annually (or 1 percent more per 3
weeks ) than if he had utilized his reals to buy a 3-month T-bill at Brazil at 8 percent. If the spot
rate today is 3.0 actual /$ and the area rate in 3 weeks is 2.97 actual /$, she'll lose .03
reals or 1 percent on the currency conversion. The annualized 4% profit from the U.S.
T-bill is only offset from the annualized 4% currency loss. She breaks even.
If, on the other hand, the 3-month forward rate is between 3.0 and 2.97, the investor can
cover her foreign exchange rate risk by buying a forward contract to sell dollars in 3
months in exchange for reals. E.g. if the forward rate us 2.985:

Foreign currency loss = (3-month forward rate - spot rate)/spot rate
= (2.985 real - 3.0 actual )/3.0real = -.015/3.0 = -0.5percent

When the 3-month interest differential is 1 percent and the foreign exchange differential is just
0.5 percent, the investor nets 0.5percent and ought to undertake the investment. This yield (0.5percent )
annualized is just 2% each year. Provided that the interest rate differential is greater than the
ahead exchange rate payable, the Brazilian investor profits from buying U.S. T-bills
and selling ahead dollars. In the procedure, she raises his return from 8 percent over the Brazilian
T-bill to 10.30percent over the U.S. T-bill plus the foreign currency translation.
As funds are moved from Brazil to the U.S., the source of capital is decreased in Brazil
and increased in the US.
This will put upward pressure on interest rates in Brazil and
downward pressure on interest rates in america, so the positive interest differential of
4% annually will have a tendency to fall toward 2% each year.
At precisely the same time, the greater demand for dollars at the spot market will raise the
spot rate for dollars along with the increased forward supply of dollars will push the
forward rate. For both reasons, the forward discount on the dollar will have a tendency to increase,
pushing it up to the interest rate differential.
Under normal conditions, the relationship between forward and spot rates is determined
largely by covered interest arbitrage (this connection is known as the interest rate parity).
If interest rates are higher overseas, covered interest arbitrage tends to maintain the foreign
currency at a forward discount (along with the national currency at a forward premium) equal
to the positive interest differential in favor of their foreign monetary center. If domestic
interest rates are higher, covered interest arbitrage will maintain the foreign currency at a
forward premium relative to the spot rate (along with the national currency in a forward
reduction ) equal to the national positive interest differential. Nevertheless, this might not hold
even about when covered interest arbitrage is forbidden or using big
destabilizing speculation happening.

5.2. Interest Rate Parity

Interest rate parity is a relationship that has to hold between the spot interest rates of two
currencies if you're still no arbitrage opportunities. The connection depends upon
area and forward exchange rates between the currencies. It is:
#8226; s is the spot exchange rate, expressed as the price in currency a of a component of currency b
#8226; f is the corresponding forward exchange rate
#8226; ra and rb are the interest rates for the respective currencies
#8226; m is the frequent maturity in years for the forward rate and both interest rates.
The interest rate parity (covered interest arbitrage) plays a fundamental role in foreign
exchange markets, enforcing a vital link between short-term interest rates, spot
exchange rates and forward exchange rates.

5.3. Influence of the FX Options Market on Short-Term Exchange Expectations

Implied volatility is one of the key variables used to calculate the price of an FX option.
It is often translated as the market#8217;s measure about possible future movements in spot
(related to the standard deviation of returns over a sample interval ). In the FX choices
market, the preference of calls (right to buy a currency) over places (right to sell a
currency) is measured by means of an asset category called risk reversal skew (RR) which can be
mathematically defined as:

D delta Risk Reversal Skew = Implied Volatility of a D Delta Call #8211; Implied Volatility of a D Delta Put

The FX market closely watches these risk
reversals. A favorable RR, by way of example,
indies preference for calls over places, a
signal frequently perceived as bullish from the
market, resulting in overbought positions in
the underlying currency, which further
exacerbate the RR. This is a par excellence
example of a self-fulfilling prophecy. A
defining example of this phenomenon was
the trend up in EUR from the lows in 2002
which saw the risk reversal continually
favoring EUR calls (see figure on left).

FX Choice positions also contribute to a
occurrence known as strike gravity. Since the FX option trader deals at the spot market
to market a substantial FX alternative position contrary to a counterparty that is not an energetic
market participant, the spot gravitates towards the attack of the option as the trade
approaches maturity. This effect is more pronounced when the stated place is an exotic
alternative with an electronic payout and the participants have access to liquidity at the cash
market to actively handle the exotic option. These FX flows arising from aggressive
hedging by the FX Option market players frequently dictate short-term currency moves.


6. Political and Plogical Factors

Political or plogical variables are also believed to have an influence on exchange
rates. Many currencies have a custom of acting in a particular manner like Swiss
francs That Are known as a refuge or safe haven currency whereas the dollar moves (either
down or up ) whenever There's a catastrophe anywhere in the world. Exchange rates
may also fluctuate if there's a change in government. A few years ago, India#8217;s overseas
exchange rating was downgraded due to political instability and thus, the
external value of the rupee fell. Wars and other external factors also impact the exchange
rate. For instance, when Bill Clinton had been impeached, the US dollar dropped. Throughout the
Indo-Pak warfare that the rupee weakened. Following the 1999 coup in Pakistan (October/November
1999), the Pakistani rupee weakened.

Resources

Historical chart of USD PKR exchange rate (01/01/1998 #8211; 01/01/2002)
References
[1] Economics Web Institute (2001)
[two ] Explaining Exchange Rate Behavior, Menzie D. Chinn, National Bureau of Economic
Research, Spring 2003
[3] The Determinants of Exchange Rate Movements, OECD, Economics and Statistics
Department, Graham Hoche, June 1983
[4] Macro for Managers, Harvard Business School, David Moss, January 2005
[5] Foreign Exchange Markets and Transactions, Harvard Business School Case, Mihir
Desai, October 2004
[6] Exchange Rate Policy at the Monetary Authority of Singapore, Harvard Business
School Case, Mihir Desai and Mark Veblen, January 2004
[7] Foreign Exchange Markets, San Jose State University, Economics Department,
Thayer Watkins
[8] Interviews with FX Options structuring team at Citigroup
Military coup in Pakistan


I trust with this thread to proceed past simple lines on a chart to make better sound, and smart decisions on our insecure activities.