3.1 - The event extraordinaire, Brexit!

I had originally intended to dedicate the entire chapter to USD INR, which is the most traded currency contract in India. Then, I was distracted by the BREXIT issue, which is the largest currency pair in India.

Here's a glimpse at the Great Britain Pound's reaction to the events. It fell by 8.64% which is quite significant in currency terms.

The Guardian UK had this to say about the event –

This is my goal: to simplify Brexit as best I can and to help you understand why it behaved the way that it did. The bigger goal is to help you understand how such events could impact currencies. This will help you to understand how to summarise global events like Brexit and what impact they might have on currencies.

Let me briefly mention Brexit in order to keep it simple and concise. Let's start with some history.

1. France and Germany debated the possibility of forming a sort of union after World War 2. It was thought that countries could trade and do business together to make war less likely.
2. This was the basis for the formation of a larger union, the "European Union" (EU), with more European countries joining the EU.
3. The EU created a single market where goods, services, and people could move easily between countries. The EU even created its own currency, the 'Euro'.
4. Although the UK was an EU member, it never accepted the Euro for their currency. You should also know that there are many countries within the EU that still have their own currencies, such as Denmark, Chez Republic and Switzerland.
5. In recent years, there was a lot of debate in the UK about whether the UK should stay in the EU. Many UK citizens believe that the UK is better off being outside the EU, as the EU commission's rules are more taxing than beneficial for them. They believe that they would be able to progress more economically and socially if they were not part of the EU.
6. BrItain optionExitThe EU was called "Brexit"
7. On 23 June 2016, the UK officially sought its citizens' votes. The citizen would then vote to be in or leave the EU. This is known as a "referendum."
8. Surprise! The UK opted out of the EU in the referendum. Many people in the UK and around the world believed that the UK would opt-out of the EU.

The result of the referendum sent investors and traders around the world shivering. GBP fell to a 31-year low while major European indices dropped to 8-10%.

Now, how did this happen? What caused the market to fall? What's the relationship between Brexit, the currency markets, and the work market?

Here's where I hope the previous chapter will help us.

Remember, we talked about how strong economies can be defied by interest rates, inflation, and trade deficits in the previous chapter. A strong currency is the result.

This is why you should think about the UK. The UK is clearly one of the most powerful economies in the world, and it contributes significantly to EU. Things are about to change economically and politically with the UK leaving the EU.

The UK trades with the EU in surplus, despite having a trade deficit with other countries. This should give an idea of the strength of the UK's economic relationship with the EU. The UK's finances will be affected if it leaves the EU.

The problem lies in clarity. While everyone knows the economic situation will change, no one knows how much. What will the Bank of England do? They will likely reduce rates to near zero.

The market hates uncertainty, and Brexit is no exception. The markets collapsed as a result.

As a currency trader you should be able to understand the basics and study the event. My experience has shown that sometimes the best trades can be set up with basic knowledge and common sense.

If you'd studied the event and decided not to trade, that would be a good trade in itself. The rule of thumb is "when in confusion, don't do anything".

It is imperative that you know the details of events when they are happening. It is like taking on a blind speculative trade without having the necessary knowledge.

This is all about Brexit and how it can affect currencies.

Let's move on to learn more about other currencies.

3.2 - Fairy Trade

Imagine a world where you can borrow money at a fixed interest rate and then invest it at a higher rate to earn the differential. Are you confused? This is confusing?Let me simplify it.

The US interest rate is 0.5%. This is the lowest rate in the world. Let's say you take $10,000 from the United States bank at 0.5%. You then invest the borrowed money in India, where the interest rate averages 6-7%.

You will need to convert the USD-currency to INR. A US dollar is equivalent to 67 INR at today's exchange rate. Thus, $10,000 is equivalent to Rs.670,000/-. The converted money is invested in India at 7%, say.

We get back 7% plus the initial capital at the end of each invested year. This would be:

670000 + 67000* (7%)

= 670000 + 469900

= Rs.716,900/

This money is converted to USD and assumed that the conversion rate of 67. We get back $10,700. Now we have to repay the principal plus 0.5% interest. This would amount to $10000 plus $50

After paying $10,050, we retain $650. This is, if you consider it, a risk-free win!

Realize that $650 is the difference in interest rates multiplied by the amount of borrowed money.

10000* (7%-0.5%)

10000* (6.5%)

650

This is an easy case of arbitrage.

This is how you can imagine an investment in India where you can borrow huge amounts of money from the US, and then make a lot of money every year.

Sorry to burst the bubble. Such trades are only possible in fairy tales J. These easy, risk-free profits are not possible in the world we live. It would disappear before you even realize it existed, even if it did exist.

The bigger question is: Why is fair trade not possible?

3.3 - The Forward Premia & Interest Rate parity

The problem with the trade above is that we made too many assumptions.

1. The US could lend us unlimited amounts of money
2. You could make unlimited deposits in India
3. The transaction is free of cost and there are no taxes
4. Transferring currency between countries is easy
5. We assumed that the conversion rate would remain flat at 67 for 1 year.

Because such arbitrage is unlikely to continue, the currency rate one year later should be so that it would stop arbitrage from ever happening. This is also known as:

The money we get from India one year later = Money that we repay to the banks in the USA one year later

As you can see, we borrowed $10,000 in the US and invested it in India. A year later, we received Rs.716,900/.

To ensure that arbitrage does not exist, the amount of Rs.716,900/ at the end 1 year should equal $10,050.

This means that the conversion rate should be at -

716900/10050

=71.33

This is known as the "Forward PremiaIn the currency world,'is '. The formula for calculating Forward Premia is:

F = S * (1+ Roc * * N)/ (1 + Rbc* N)

Where?

F = Future Rate

S = Spot rate today

N = Period in Years

Roc = Interest rate in quotation currency

R bc= Base currency interest rate

Let's use this formula to see if the forward rate is correct for the above scenario. The spot rate is 67.

F = 67* (1+7%*1) / (1+0.5%*1)

=71.33

Also, the forward premia is roughly equal to spot plus spot times the difference of interest rate. -

F = S* (1+differences in interest rates).

= 67* (1+ 7% - 0.5%)

= 67* (1+6.5%)

= 71.35

This is known as the "Parity of interest rates".

This is what you should think about: Indian Rupees trade at 67 today, whereas they will trade at 71.35 tomorrow. The Rupee is therefore considered to be discountedNowIn general, a currency with a higher interest rates will have a discount on its future value relative to one that has a lower rate.

Why are we talking about this? And what does it have to do with currency trading? The futures price is determined by the forward premia.

This will be discussed further.

To Summarize

1. Brexit and other events can have a profound effect on currencies.
2. A weaker currency is a sign that a country's economy is likely to be hurt.
3. Forward premia refer to the spot rate expected for a period.
4. Forward premia = 1+ Roc *N / 1 + Rbc* N
5. The Interest Rate Parity indicates that forward premia are roughly equal to spot rates plus spot times any difference in interest rates.
6. The future value of any currency with higher interest rates is discounted to one that has a lower rate