Currency Market, Commodity Market, and Government Securities

Lesson -> The Reference Rate and impact of events

2.1 - Dual view

You can think of Infosys as a stock. When you buy or trade Infosys, your outlook on the stock will be clear. You are either bullish (or bearish) on Infosys. You can either buy or sell Infosys. Think about a currency pair, USD INR. When you buy or trade USD INR you have a dual perspective on the currency pair. If you buy USD INR, it means you are bullish about the US Dollar but bearish on Indian currency.

You may be wondering why it is this way.

The currency's value is always quoted against the other. As you recall from the previous chapter, the currency pair is listed as -

Base Currency/Quotation Currency = Value

This format, in other words, tells us how many units one can purchase for 1 unit base currency.

You expect the currency pair's value to rise if you buy it. Take this as an example: USD = 65. One would purchase the pair and hope for the pair's price to reach 68.

If the price of the pair rises, it means that 1 unit of base currency will be able to buy more units in the future. To buy more INR, 1 USD.

This means that if the pair's value increases, the power of Base currency will also rise while the quotation currency will fall. This means that you can be bullish on both the Base currency as well as the quotation currency simultaneously.

Similar to the USD INR pair being sold, it means that you expect the Base Currency will buy less quotation currency. This means that you are bullish on the base currency but bearish on it.

 The strengthening or the weakening of a currency" refers to the these following situations -

  1. When base currency can, it strengthensBuy more units of the quotation currency. USD INR, for example, moves from 67 a 68. This means that the base currency (USD), strengthens and the quotation currency(INR) weakens.
  2. Strengthening the quotation currency when the base currency isPurchases less units of the quotation currencyUSD INR, for example, moves from 66 a 65; this means that the base currency (USD), weakens, and the quotation currency(INR) increases.

It is important to note that currency strengthening and weakness are the same as currency appreciation and depreciation. These terms are often interchangeable.

Here's something you should know before we move on. The currency and the currency pair have a "two-way quote", just like stocks. You can identify the rate at the which you can buy or sell currency (or currency pair) using the two-way quote.

Do not get confused about the "two-way quotation". It simply refers to the "Bid and Ask" rates J. However, we must touch on this because it is vital to understand how the two-way price works.

Take a look at this image -

Here is a snapshot showing the currency spot rates as they appear on a Forex trading website. The two-way quote is EUR USD and GBPUSD. This will be discussed later. This quote shows you the exchange rate at which the currency pair can be bought and sold.

If you wish to purchase the EUR/USD, you will need to buy it at the "Ask" price. 1.12270 Technically, you are short USD and long EUR when you buy the pair. You can also sell EUR/USD at 1.1269 (Bid Price), but you will be short EUR (remember dual view concept).

Sometimes, the pairs are quoted in a shorter form. This is a very popular way to internationalize currencies. For the EUR/USD pair, you can get a shorter two-way quote like this.

EUR/USD - 1.1269/70.

You will notice that the 'bid price' is not stated in its entirety in the shorter version. However, it is only the last two digits for 'ask.

In Forex terminology, digits are also called "Analog" or "Numerics."Pips". If the EURUSD moves between 1.1270 and 1.1272, it indicates that the pair has moved by 2 pip.

2.2 - Rate fixing, conversion path

Today's USD/INR rate is 67.0737. This rate is known as RBI's daily fix and is maintained by the RBI.Refer to the 'Reference rate'These rates are published by RBI on their website daily. Because all settlements are made on the Reference rate, it is a critical input to currency futures trading, it acts as an important input.

Take a look at these -

Above is an image from RBI's website showing the reference rate of 14Th June 2016. These are not to be taken as legal advice.Spot ratesFuture rates are not included in this rate. Future rates can be found on NSE's website.

The obvious question is: How does the RBI arrive to this rate?

This isn't hi-tech, RBI uses the traditional polling method to determine the spot rate. However, if you don't have the time or desire to read it, the following points will summarize the procedure.

  1. The RBI has identified a number of banks based upon their foreign exchange market share. They are called the "contributing banks" by RBI.
  2. Between 11:30 AM to 12:30 PM, RBI calls random banks and requests a quote on USD INR.
  3. These rates are averaged by RBI and based on the ask and bid, RBI compiles them.
  4. The USD INR rate for the day is the average rate.
  5. Except for bank holidays and weekends, the same process is used every day.

It's that simple!

It is very simple, but RBI only polls for USD INR rates. The other major rates, i.e.Crossing also known as the cross rate mechanism is a technique used by EUR GBP INR JPYINR RBI

Crossing currencies is impossible because the rate of one currency does not apply to another. The direct rate of Euro relative to INR, for example, is not available. To get the rates one must cross the rates using a common denominator.

Let's take an example: Deriving the EUR-INR rate by crossing USD, while keeping USD as the common numerator. This will hopefully clarify the crossing procedure.

Let's start by getting the spot rate USD INR. As you can see in the above snapshot, the USD spot is -

USD INR - 67.0737

This is the spot rate. The two-way quote would look something like the following -

USD INR - 66.730 / 66.70740

If I want to purchase 1 USD, I'll need to pay INR67.0740. If I need to sell 1 USD I will get INR67.0730.

Let's not forget this important information. Now, we will be focusing on EUR USD spot rates from international markets.

Bloomberg's two-way quote suggests that -

EUR USD - 1.1334/40

To buy 1 euro, I will need USD 1.1140 (Ask Price). The cost of 1 Euro is equivalent to USD 1.1140. If I convert the USD price to INR, I will have enough INR for 1 Euro. I can also convert the EUR/INR rate to INR.

We will now return to the USD INR Rate -

1 USD = Rs.67.0740

1.1140 USD = How Many Rupees

= 67.0740 * 1.1314

= 74.72044

To buy 1 Euro, I need 74.72400 INR.EUR INR = 74.722400

You can see how the USD acts like a pivot in this crossing technique.

Here's a simple task: Using the crossing technique, have we calculated the ASK Price of the EUR-INR pair? Can you then extend this logic to calculate a Bid price for that EUR-INR pair?Feel free to comment below.

This makes it clear that cross and reference rates are affected by the sentiments of contributing banks. We can now ask a larger question: What influences the sentiments of the contributing banks?

It is simple: domestic and international events.


2.3 - Events that matter

Consider an event that could potentially affect the stock's sentiment. One example of such an event is the quarterly results. It is easy to estimate the sentiment change based on this event. The stock price should rise if the quarterly results are positive. If the quarterly results are not good, the sentiment is low, and the stock price will likely fall. This is because there is some linearity between what happened and what is expected to happen.

But, currency pairs are not linear. It is difficult to evaluate the impact of events. Fundamentals about currencies. This complexity is mainly due to the fact that currencies can be quoted in pairs. Some factors can lead to strengthening a pair. However, there are other events that could cause a weakening of the pair.

Let me show you an example. Imagine two economic events happening simultaneously.Event 1- India is receiving a steady inflow of Foreign Direct Investments, FDI, geared toward long-term investments. This is clearly a positive for the economy and tends to strengthen India's currency.Event 2- The US economy is experiencing an increase or a fear of a commodity crash, which leads to an appreciation of the US Dollar.

These two events are occurring simultaneously. In which direction will the USD/INR currency pair move? The answer is complicated. The currency pair will eventually take cues form the dominant factor and move in that direction. However, until then, volatile behavior is a constant. To trade currencies successfully, it is important to keep track of world events and evaluate their impact on the currency pair.

These are a few of the data and events that you should be following -

Export/import dataThese numbers are significant, especially for India, which is vulnerable to trade deficits. India imports commodities like crude oil and bullion, while it exports software and goods such as rice. An increase in exports tends towards strengthening the domestic currency. Conversely, an increase of imports tends toward weakening the domestic currency. You may be wondering why?

Imports (for example, crude oil) must be purchased on the International Market, which means that one must pay USD. To facilitate the purchase one must sell INR to buy USD. This creates a demand for USD, and thus USD strength.

The same logic can be applied to exports. Export goods are a way to receive USD. We then convert the USD into INR by selling the goods. This makes the INR stronger.

Trade DeficitThe excess imports over exports is an important factor to monitor as it can influence the direction of currency trades. The domestic currency will benefit from a smaller trade deficit. Also known as the "Current account deficit", the trade deficit can also be referred to. This is a good place to pieceThis will help you to understand the topic better.

Rates of Interest-Investors typically borrow money from low-interest countries and then invest in high-interest countries to make a profit. This is known as the "The 'Carry trade. It is clear that countries offering higher interest rates attract more foreign investment. This naturally leads to the strengthening the domestic currency. This is why currency traders are always on the lookout for the 'Interest Rate'.

The central banks review the interest rates in the country through a monetary policy review (RBI in India and the US Federal Reserves). The policy review is therefore very important. Market participants also monitor the change in numbers during the ongoing review. They look for clues about the policy stance. Participants can use the monetary stance to help them understand the future direction of the interest rate.

Dovish-Dovish refers to the central bank's position that they will likely lower the interest rate in future. Lower interest rates weaken the domestic currency. This headline focuses on the relationship between a dovish position and the currency.

Hawkish-Hawkish refers to the central bank's position that they will likely increase the interest rate in future. Higher interest rates are good for foreign investment and strengthen the currency.

Here's another headline that talks about the hawkish stance.

Inflation-As you might know, inflation is the increase in the price of basic goods or services over time. Inflation is an increase in the price of basic goods and services. This affects our daily lives. The central bank works hard to control inflation. It is not easy to see the link between currency movements and inflation.

The interest rates can be adjusted to reduce inflation. If inflation is perceived to be high, the central bank will likely take a hawkish position and raise the interest rates.

What do you think the logic is?

Easy money for consumers and corporations increases spending. When spending increases merchants see an opportunity to make greater margins and this leads to rapid increases in prices and so, inflation. The central banks will reduce easy money access in order to curtail inflation. How do they do this? They increase interest rates.

When inflation is high, expect the central bank to adopt a hawkish stance, increasing interest rates as domestic currency strength increases.

As I said, the relationship between currencies and interest rates is complicated. Therefore, traders closely monitor inflation data in order to determine what central banks will do next and take positions on the currency pair.

Keep in mind that if inflation is high, the central government will adopt a hawkish stance and the domestic currency will strengthen. The central bankers will encourage spending, so expect a dovish stance if inflation is low. Thus, interest rates will likely fall. This will lead to a weakening of the domestic currency.

Consumer Price Index (CPI).- The CPI is time-series data that averages out the prices for basic goods and services. The CPI is an indicator of inflation. Inflation is rising if the CPI is higher, and vice versa.

Gross Domestic Product (GDP).The country's GDP is the total Rupee value, for Indian GDP, of all goods and services that were produced within the country in a given year.The GDP is a huge number. It's not logical to use the same number in estimates or conversations. The GDP is a measure of the country's growth rate. If a country's GDP is 7.1%, then the GPD number indicates that it is growing at 7.1%.

The GDP growth rate is a measure of investor confidence and the country's currency strength.

There are many events that can impact currency trading. You will eventually realize that all data you look at is connected. It would be helpful if you didn't know the unknowns about each event like an economist. It is enough to understand the cause-effect relationship. Here are some key data points and events that can be important when trading currencies. This would be a good place to start, if not more.

To Summarize

  1. The base currency is said to strengthen/appreciate against the quotation currency when it can buy more units of quotation currency.
  2. When it purchases less units of the quotation, the base currency will be said to depreciate or weaken against the quotation currency.
  3. If you take a long position on a currency pair you are basically taking a long position on the base currency but short on the quotation currency.
  4. If you sell short on a currency pair you are actually selling short on the base currency but long on the quotation currency.
  5. The RBI determines the USD INR reference rate each day by conducting a poll.
  6. Crossing technique is used to calculate the reference rates for currency pairs.
  7. Understanding events and their impact on currencies is difficult because the currency is quoted in pairs. The impact on each pair can be similar.
  8. The pair will eventually follow the lead of the dominant event.
  9. Countries with higher interest rates tend have more stringent currencies, and vice versa.
  10. The country's trade deficit is lower, and the currency is stronger.
  11. Inflation increases, which leads to currency strengthening and vice-versa.
  12. While trading currencies.