Currency Future Strategies-I (Spreads)

In the previous article, we explored the basics of currency futures. In this one, we will take a closer look at various futures trading strategies and how to employ them.

Futures strategies in FX are also called spreads. The reason is because we are employing two or more different contracts by utilizing the difference (or spread) of one of the aspects of the contract. This can be a function of time, price or location.

Why Use Spreads?

Using spreads is the most common method of reducing your margin requirement and to hedge the outright positional futures position that you might have entered into. As a risk management system, future spreads are used and recommended by professional FX traders worldwide. Let us see why using spread strategies are beneficial for you:

1.Increasing avenues of profit

2. Risk Management

Imagine you have bought the USDINR DEC futures at 73. You have done this because your view on the USD is bearish. But what if something unexpected (an announcement by Mr. Trump maybe) happens and the USD shoots up the roof? You stand to make a huge loss. So as to hedge this risk of the market turning against your view, you can employ a future spread. Let us see how we can do that.

Spreads can be broadly classified into three: Intracurrency spreads, Intercurrency spreads and Interexchange spreads.

Intracurrency Spreads

This kind of spreads make use of the same currency futures contract with different expiry dates. Hence as explained above, this is a function of time. This is mainly used to capture a narrowing or widening spread between two contracts with different maturities. Since the spread you are trying to capture is based on contracts expiring in different calendar months, these popularly called calendar spreads. This is based on the fact that nearer term contracts tend to be cheaper than farther term contracts, mainly due to interest rate differences and cost of carry. There are two ways you can employ calendar spreads: Future Bull Spread and Future Bear Spread.

Future Bull Spread?

When you are bullish on an asset over time, you would go long on the futures of that asset, so you tend to gain when the underlying appreciates. A future bull spread is created when you are long on the nearer term contract of that asset and short on the farther term contract of the same asset.

Example: Your view on the USDINR is bullish so you buy the USDINR NOV FUT at 73.85 and simultaneously short the USDINR DEC FUT at 74.10.

Why do we do this? Unlike taking an outright long position in the USDINR NOV FUT which can only make you money if the USD appreciates, now you have a back up option that will make you money even if the trade goes the other way! As there are two ?legs? to this trade, let us see how our pay off will be:

1. USDINR NOV FUT appreciates; USDINR DEC FUT appreciates by the same amount. Slight loss (as DEC FUT are priced higher).

2. USDINR NOV FUT appreciates; USDINR DEC FUT appreciates but lower- Slight profit

3. USDINR NOV FUT appreciates; USDINR DEC FUT depreciates Maximum profit

4. USDINR NOV FUT depreciates; USDINR DEC FUT depreciates by the same amount Slight profit (as DEC FUT are priced higher)

5. USDINR NOV FUT depreciates but not as much as DEC FUT USDINR DEC FUT depreciates Slight profit

6. USDINR NOV FUT depreciates; USDINR DEC FUT appreciates Maximum loss.

As you can see above, there are 4 times you will end up making profit out of 6 times giving you a risk-reward ratio (RRR) of 2:3 (66.6%) which is much better than the RRR of an outright long futures position which is 1:2 (50%).

The second reason we do this is due to the way it helps us manage risk. I cannot say this enough, but as an investor your aim should always be to manage risk first before making profits. You will see that, amazingly, when your risk is minimised the profits start to come automatically. Bull spreads are just really trading the price difference (spread) between the two contracts, and you can see that such spreads do not move abruptly and are predictable to a large extent. Due to this in the global FX markets, a spread is usually considered as a single position by the brokers and require much lower margin requirements. Of course, this is because of better risk management.

When to Use the Future Bull Spread

We can use this strategy when you expect the spreads to narrow down between two different months. If you are planning to use an arbitrage opportunity, then you would want the spreads to widen.

The main opportunity to use the spread is when you think the near-term contract is going to appreciate in value much more than the farther month contract. This can be when you think an important announcement will boost the USDINR for a short while and then cool it down again in the medium to long term (like a temporary price hike on crude, which happened in the first week of October).

Conclusion

From the above discussion, it is clear that entering into a futures spread is much more logical and efficient than a single outright position due to the avenues of profit, management of risk and the capability to remain profitable even if the underlying remains stagnant even if the USDINR remains at 73 till December you still make a profit as you shorted the DEC FUT at 74.10 and the lower margin requirements due to the lower risk position.

In the next article, we will discuss Future Bear Spread and Intercurrency Spreads.

Currency Future

Introduction

For those who have trading experience in the equity market, the concept of futures would be easy to understand. But if you are true beginner, then let me make it simpler for you. In a futures contract, either of the parties agree to buy/sell an underlying in the future at a price that is decided in the present day.

For e.g., if you buy USDINR futures for December at 70 and the spot price of USDINR in December at expiry is 72, then you make a profit of Rs. 2/- on that contract. This happens when you have a bullish view on the USDINR. If your view was incorrect, USDINR might depreciate in the future and your long position will be in a loss.

This works very similar to buying and shorting of equities and is easy to understand. And since spot trading is not allowed on exchanges in India, currency futures are the closest instrument you have for straightforward trading in FX.

Types of participants in futures market

Before jumping into the intricacies of futures trading, let us take a moment to understand the various players in the FX futures market. This is necessary because you need to know who you will be playing against!

1. Hedgers:These types of participants have a real exposure to foreign currency risk on account of their underlying business and their objective is to remove the FX risk using currency futures. They are usually exporters/importers who try to lock in the future currency rates in the face of uncertainty. They are also the big boys at the table.

2.Speculators: This set of market participants does not have a real exposure to foreign currency risk. These participants assume FX risk by taking a view on the market direction and hope to make returns by taking the price risk. Most FX traders come under this category. In fact, it is estimated that almost 80% of the global FX transactions are speculative.

3.Arbitrageurs: They check for any opportunities of arbitrage in the market and try to make a profit out of it. For e.g., if they see USDINR is trading in the forward market (OTC market) at 72.085 and the future market (exchanges) at 72.285, arbitrageurs will buy forwards and sell futures thereby making a profit of 20 paise per dollar (200/- per lot). They also influence FX prices by buying dollars in the Indian markets and selling them at a higher price in the off-shore markets or vice-versa (NDF markets especially, we will come to this later).

Spreads trading

As we discussed in the previous article, the spot currency market in India is inaccessible to the retail traders. In global markets, spread trading is a very common and winnable strategy. In classic spread trading, you buy the spot and short the future of the same underlying. This is because in FX, the futures price is almost always higher than the spot (due to interest rate parity which will be covered subsequently).

For e.g., take the case of the USDINR the future price of the pair has been higher than the spot 90% of the time. There are times when the spread (difference between the buy and sell prices) is higher than it normally is. If you are able to figure this out, then this provides the trader with an arbitrage opportunity. If he thinks the future price is higher/lower than it should be, then he can go long/short on the spot and short/go long on the futures thereby taking the spread as profit. Wonder what kind of market player does this? You’re right, arbitrageurs!

However, since the currency spot market is inaccessible to the retail traders in India, we cannot really do this.

So, we do the next best thing ,spread trading the futures! This is easy to understand. Instead of buying the spot and shorting the futures at 3 months (for e.g.), we buy the 1-month futures and short the 4-month futures. This essentially gives us the same calendar period ? 3 months in this case ? and hence, are called Calendar spreads.

In calendar spreads, the trader has to decide if the spread between two future contracts (same underlying but different maturities) is ideal or otherwise. The farther month futures contract will always be at a premium to the nearer month futures contract, if all other variables are equal. For example,

USDINR OCT FUT – 73.085

USDINR NOV FUT – 74.110

When you look at the prices above, you can see the spread is 1.025. But from your observations in the past, the spread between two consecutive months should be around 0.800. So here, you have an arbitrage opportunity of 0.225. In that case, would it not be profitable to buy October futures and sell November futures? Yes sir! If you square off your trades before expiry (at which time spot becomes equal to future price), you get to keep this spread profit! Just like how you would trade premiums and not wait for an option to expire ? is it getting clearer now?

The difficult part is, to recognise whether a spread trading opportunity exists or not. Due to this, only experienced traders and arbitrageurs are able to make consistent profits through this method.

Regardless, let us explore the two major futures strategies in FX:

Intra currency spreads (or Calendar spreads) and Inter currency spreads (buying and selling different currencies with same maturities).

Before we dive in to them, let us understand the rationale behind the changing spreads between currency pairs. Spreads are influenced by mainly three factors:

i) Interest rate differential between the two countries (currencies)

ii) Liquidity in the FX market and the banking system

iii) Monetary policy decisions (Repo rates, Reverse repo rates, Cash Reserve Ratio etc)

Due to the various fundamental factors involved in FX futures, it is prudent to keep abreast of the latest news and developments around the world as all these contribute to the strength or weakness of the US Dollar. And since we will be focusing on USDINR pair for the most part in this series, the same becomes mandatory to make consistently profitable trades. In the next article, we will cover the Intra currency spreads, also popularly called the Calendar spread.

Forex Jargon- Spreads, Margin And Leverage

It is next to impossible to trade in Forex market without knowing the right terms and definitions that make up the market jargon. You must have heard experts talking on business news channels about things like, The spread looks tight on this pair or How much leverage does that brokerage offer you for currency options etc. It may look all fancy, but without knowing these concepts you cannot understand the market well and consequently won’t be able to make profitable trades. By the end of this chapter you would be able to understand and use some of the most important definitions in Forex trading. Let’s get to it.

What is a spread?

As you have learned, an FX quote consists of a buy (offer) and a sell (bid) price.

The difference between these prices is called the spread.

For highly traded currency pairs like EUR/USD or GBP/USD the spread will be very tight. Let’s take an example:

EUR/USD? Buy : 1.14977 Sell : 1.14982

The spread in the case of the above pair is 0.00005.

Now consider a lesser traded pair like the USD/INR:

USD/INR – Buy : 74.0962 Sell : 74.2962

The spread is now 0.2000, which is huge in the international Forex market and shows the weakness of the INR.

You must have seen this on currency exchange counters at airports or hotels. The buy price is always higher than the sell price, because of the charges and commissions availed by the bank or exchange. Hence, the spread is also called the cost of entry for a currency trade.

Spreads can vary with the Buy and Sell prices of the currency pairs offered by different entities – Banks, Brokers, Governments etc. They are also very sensitive to economic news breaks. But since we cannot yet trade in the spot currency market in India, spreads are of lesser concern to us.

Margin

This can be a confusing concept if you are just starting out in the markets, but if you already trade equities then you would be familiar with margins.

A margin is a deposit that the trader puts in his trading account to hold a position (long or short) open. For example, if you want to short a stock, you need to have a certain amount of money in our trading account as margin before you can enter the trade. This amount can be found through the margin calculators offered by your broker. In Forex, it works the exact same way as equities – to be considered along with the amount of leverage your broker offers you. We will see this in the next paragraph.

Leverage

Leverage can be seen as a partner or by-product to margins and enables a trader to place larger trade sizes on borrowed money. Traders can use this as a force multiplier to magnify their returns. Essentially, you are borrowing money from your broker to place a trade for which you don’t have the funds for with the margin as collateral. This money is returned when you make a larger profit, or from your own pocket if you make a loss. Once the margin is eaten up by your losses, your broker will initiate a margin call (which used to be an actual phone call back in the day) and ask you to bring in more money into your trading account if you want to keep your positions open. If you are unable to do that, then the broker will square off your positions at a loss and enter the amount you owe to them in a ledger. When you add funds to your trading account next time, this money will first be deducted by the broker and the rest will be available to you for placing trades.

Most Indian discount brokerages offer 10-100 times the leverage for currencies as the danger of abrupt movements (and thereby clients losing money) in FX markets is small.

You might have heard this enough, but it behaves me to repeat it: Leverage is a double-edged sword. It can bring you larger profits but also larger losses. Make sure you do not take extra leverage and ask your broker if a certain leverage level is ideal for you, if you are not sure. EZ Wealth Brokerage? helps you in this regard by advising you on your trade positions with respect to margins and leverages.

Now that we have learned the three most important definitions of Forex trading, let us see how to use them to our advantage:

1. If you trade in the spot FX markets, ensure the spread for a currency pair is on the lower side. Your cost of entering the trade is dictated by the spread. Never try to hedge your long position by a short position in the same currency pair which has a higher spread. You will lose out on both ends if the spread widens.
2. Do not enter trades that you cannot cover with enough margins. Keep sufficient margin in your trading account so when you suddenly spot an opportunity (they come and go really quickly in the FX market), you have the ability to place a trade immediately.
3. Never take extra leverage even if you are sure about the performance of a certain FX pair. It is easy to lose your entire corpus on a losing bet by taking added leverage.

That finishes the basic module of this Primer to Forex trading series! In the next module, I will introduce you to Currency Futures and Options in Indian markets and combining Fundamental and Technical Analysis (with charting techniques). Lots of interesting stuff! Stay tuned!

Introduction To Indian Currency Markets

In the previous module, we learned about the basics of the FX market and how it operates. Most information in that module were general in nature, to prime you up for the specifics of Indian currency markets. Though currency trading in India has existed for decades, the non-convertibility of the Indian Rupee (you could not take INR abroad or bring in foreign currency to India till 1991) made it very difficult for an active FX market to operate in India. Most foreign exchange transactions were limited to business houses (who had a license for it) or NRI businessmen. Draconian economic policies of a bygone centralized, socialist economy always restrained the potential for a vibrant and thriving FX market in India until the reforms of July 1991. Even after liberalization, the FX market remained the stronghold of an elite few major banks, businesses and the government. Since it was a comparatively more complex trading environment to understand, and the lack of interest of the general public led FX markets to remain in its infancy till the early 2000s.

The Indian foreign exchange market is a decentralized multiple dealership market comprising two segments the spot and the derivatives market. The FX spot market operates same as the equity spot market on a T+2 deliver basis. The derivatives market encompasses forwards, swaps, and options. As in case of other Emerging Market Economies (EMEs), the spot market remains an important segment of the Indian foreign exchange market. With the Indian economy getting exposed to risks arising out of changes in exchange rates, the derivative segment of the foreign exchange market has also strengthened and the activity in this segment is gradually rising.

Until 2008, FX market was restricted to the OTC (Over the Counter) market, which is very different from an exchange. This market mainly exists between select entities like banks, businesses and government bodies. Most of the trades are initiated and settled by phone or meetings, prices are not publicized and display a general lack of transparency. Also, there are no standardized financial products or contracts market players design them according to their own convenience and requirements. These trades in the OTC markets could be spot-price based or future-price based. When they are based on a future-price, they are called forwards. In 2008, finally RBI felt the need to let the general public and smaller traders get involved in FX transactions and it was decided to introduce Currency Futures in select exchanges across the country. The reasons for this were mainly to increase the size and liquidity of the FX market and to help businesses ?hedge? their currency risk arising from export/import payments.

Later in 2010, RBI decided to introduce Currency Options in select exchanges in India thereby giving the Indian FX market a much-needed shot in the arm. Equity options were introduced four years prior in 2006 and by then the traders were beginning to fully understand the advantages and risk management potential of option contracts. The currency F&O segment is also called the Currency Derivative Segment (CDS). With the arrival of currency options, the FX market became more affordable to the retail trader with smaller lot sizes (unlike futures) and lesser cost of entry, while providing the opportunity to hedge risk effectively through premiums.

It is important to note that unlike the global currency markets, spot trading is not available in India through exchanges. Spot trading is done in the OTC market mainly by authorized dealers, RBI and select public sector units.

Fig 1. USDINR rates since Independence. Until 1991, Indian FX market was highly regulated.

Difference between Forwards and Futures

Any contract that is signed between two parties for a settlement date in the future is called a forward contract. A forward contract can be of any lot size with a maturity date decided arbitrarily by the parties. These types of contracts are usually seen in OTC markets.

A forward contract that is traded on a recognised exchange is called a futures contract. Though it achieves the same economic functions of allocating risk in the probability of future price uncertainty, a futures contract is distinct from a forward in the following ways:

1. They reduce counter party risk (credit default is prevented by the exchange);
2. They are standardised products with fixed lot sizes and maturity dates;
3. They are accessible to retail traders;
4. Lower cost of trading than the OTC market.

Major characteristics of Indian FX markets

In India, the FX markets (both OTC and exchanges) are open for business Mon – Fri from 9.00 AM to 5.00 PM. The spot price published by the RBI (called the RBI reference rate) is considered the underlying price for the CDS and the value of futures and option premiums will move according to this. RBI updates this reference rate numerous times daily by averaging the different FX rates provided by the biggest banks in the country on a real-time basis.

In terms of value, the exchange traded derivatives still lag way behind the OTC market where the deals are much bigger in nature. The spot market in the OTC sector accounts for almost 50% of the total turnover, out of which Mumbai alone brings in 80%. Indian FX market had a 5-fold jump in turnover from $7 billion in 2004 to $34 billion in 2007. This clearly shows that Indian FX market is set to grow to be one of the largest in Asia soon. Hence, it is important that you get in the game early and stay in it while more and more traders will slowly flock to this market. The price transparency and lack of insider trading (no single entity, not even the RBI, can manipulate the currency markets over a short period of time) make the FX market very lucrative to the small, retail trader who has limited capital and time.

Fig 2. Chart showing RBI intervention in the USDINR market

The futures contracts are available for a 12-month trade cycle with the final settlement date (F) as the last business day of the month. The last trading day for a contract ending that month would be F-2 or two days prior to the settlement date. The expiry price would be the price at 12 noon on F-2. Similarly, option contracts are available as European options with a 3-month trade cycle. Expiry and settlement remain the same as futures.

Happy trading!

Impact Of Interest Rates On Currency

We discussed two of the most important factors that affect currency prices in the last article. To complete the equation, we need to discuss the final and major fundamental factor that moves FX prices Interest rates.

Every country that follows the central banking system, has a certain interest rate associated with its currency. This is not fixed value and keeps changing over time, up and down. It is one of the most potent tools that a central bank has, to control and ascertain the economic conditions prevailing in the country.

Let’s take an example of two commercial banks:

Bank A provides an interest rate on deposits/borrowings at 5% and Bank B does it at 10%. Which of these banks will you deposit your savings in?

Bank B of course. Why? They give you a much higher return on investment, that’s why!

Simple, right? Now imagine Bank A was Reserve Bank of India and Bank B the Bank of England (central bank of UK) and you are a millionaire US citizen with tons of money.

RBI is our central bank and all the commercial banks lend/borrow money to individuals and businesses with reference to its interest rate, which means interest rate of RBI can be taken as a yardstick of the return on capital made in the Indian economy.

Where would you? The US millionaire with US dollars ? invest your money in? In India or the UK? Or in other words, the Indian Rupee or the Sterling Pound?

I believe the answer is simple – you will invest in UK because the Bank of England gives you a much higher interest rate on your capital.

Fig 1. Central Bank Interest Rates of different countries

What happens when more people from other countries invest in your economy? Your economy starts doing better, and your currency starts to increase in value! Didn’t we discuss in the previous article? Of course, we did, and it is now easier to understand why.

Fig 2. Countries with the highest interest rates

In that case, why can’t the RBI just keep the interest rates high and make India rich?

Good question. Well, if we kept the interest rates too high then you won’t be able to afford that home loan (or a car loan) from your bank and your friend won’t be able to afford that business loan he has been hoping to get for his start up. Also, if you have observed how businesses work, most of the operating costs and other expenses are financed through debt (a fancier word for loans) and credit. So, if the interest rates remain high, private enterprises will find it very difficult to borrow money to sustain their operations. And as we all know, slowdown or shutdown of businesses is never a good thing for the economy.

Not to mention that we may not be able to pay back the foreign investors such huge amounts of interests earned, if our economy does not perform according to expectations. These are all factors that prevent RBI from raising interest rates too high.

Another complex variable now gets added to all this: Inflation.

As a nation’s economy strengthens over time, prices tend to rise as the consumers are able to spend more of their income. The more we make, the better our vacations can be, and the greater amount of goods and services we are able to consume. This creates a loop where more money chases roughly the same amount of goods which can lead to higher prices for those goods. This rise in prices is called inflation. High inflation leads to a loss of value in your currency as now you get less for the same amount of money. It affects everyone, for worse.

Fig 3. India’s inflation rate between 2000-2016

So, to get a grip on inflation RBI will increase (or tighten) interest rates which now makes it more expensive for you to buy homes, cars, spend on credit cards and in general take on any additional debts. Less spending means lower inflation.

But while this reduces inflation, it again works against businesses like we discussed above, as it becomes more expensive for them to borrow money to conduct operations. This will eventually lead to a slowdown in the economy. So, once the RBI is convinced that inflation is under control, they will slowly start reducing (or easing) interest rates. This cycle continues forever.

Due to this cycle, you will see that currency prices will also follow a cyclical trend in the short to mid-term periods. But in the long term (especially for INR), it finally comes down to the first two fundamental factors we discussed in the previous post, Current Account Deficit and Exposure to Commodities.

Now you know why RBI’s interest rate policy is watched so closely by investors both domestic and foreign alike. You will also see considerable fluctuations in currency prices around the time of the monthly and quarterly RBI council meetings mostly in anticipation of a rate hike or a rate easing.

That covers Forex fundamentals for you! Before we get into technical factors, we will learn the various terms used in the Forex market.

How do we make money by trading money?

We all understand how the stock market works. A company goes public to raise more money for their operations, you buy a share (or a bunch of them), the company does well, its share prices go up and you make a profit. It’s simple, right? Forex markets works on a similar principle. Let’s see how:

You read in the news that the US economy is doing well, higher GDP growth, less unemployment and better trade balances. You also read that Indian economy is slowing down a little- higher current account deficit, lower trade balances and higher unemployment. If you read my last blog post, you know that this means the US Dollar is going to be stronger in the near term vis-a-vis the Rupee. The current FX quote for the USD/INR pair looks like this:

USD/INR = 70.1458

Just like the stock market, you follow the same basic guidelines for a profitable trade: you buy lower and sell higher. So, you go ahead and buy the USD (say 1000). Why? Because your view on the USD is bullish. Two days later, you see that the quote looks like this:

USD/INR = 71.2300

Bingo! Your view was right! The USD has actually appreciated against the INR bringing you a profit. How did this happen? Simple, the economic indicators (more on this in detail later) that you evaluated for the US economy were positive and hence the same reflected on the US Dollar. So, instead of buying a stock at its CMP, you just bought the USD at its quote price. And when it appreciated (against the INR), you sold it at the higher quote price and made a handsome profit.

But in the forex market, we can trade the other direction as well. So, we could sell the USD/INR, effectively selling dollars and buying rupees. With that trade, we would want the USD/INR exchange rate to fall so we can buy back the dollars for less rupees than we originally sold them for and lock in a profit.

This is all FX trading is, in its most basic form. Instead of buying a part of a company (shares), you are buying a part of that country’s economy (currencies).

So, what is the catch? Is it that easy to make money in the FX market? Absolutely not. One needs to be careful about volatility (which will be explained in detail in the next chapter), which is the sudden fluctuations in price that happens in FX trading along with keeping a tab on economic indicators. Concurrently, you need to have a sound trading strategy that enables you to work the price action in your favor. These are very important concepts that we will learn soon in this series.

From this discussion, we can come to the following conclusions:

i) Just like a stock appreciates/depreciates in value, a currency does the same.

ii) Just like a stock, a currency can be bought at a lower value and sold at a higher value to make a profit. The same applies when you are shorting a currency when you think its value will fall, and then buying it back for a profit.

iii) Instead of earnings numbers, ROE, ROI and production growth etc. that gives value to a stock, a currency derives its value from its economy and its relationship with other economies.

iv) Just like stocks, currencies are traded in exchanges using the same BUY/SELL mechanism.

Do these conclusions ring a bell? Of course, they are the same principles/mechanisms used in equities and commodities! I hope you now understand that a currency can be traded just like anything else, even be used as an underlying asset when it comes to derivatives (more on that later). Now that you have understood how to make a profit (or a loss!) by trading currencies, let us learn the most important factors by which currencies are valued and priced.

Pricing And Valuation of Currency- Impact of CAD and Commodities

You know that the price of a stock goes up when the company creates value and goes down when it doesn’t. But what about the actual price of the share? I’m sure if you have been following the equity market, you know that share prices are determined by a variety of factors like supply and demand, market capitalization, earnings reports, earnings per share, a valuation multiple (like the P/E ratio) etc. In an IPO, the shares are valued and priced according to the shares outstanding (shares available to the general public) and market capitalization by an underwriter (an investment bank usually). Once it is in the secondary market, all the previous factors that I mentioned comes into play. The stock prices move up or down depending on these factors as well as news announcements, political developments and global cues (for large caps especially).

 Fig 1. Movement in stock price of RIL with a higher forward P/E

How about currencies?

Of course, there are no IPOs for currencies and no P/E ratios or EPS to go by to value them. The price movements of currencies are also not dependent on factors that are attributable to one single entity, like a stock company. So how do we value them and factor in their prices? Let’s study two of the most important factors responsible for this.

Current Account Deficit and Exposure to Commodities

We learned that the currency of a country is linked to the strength of its economy. Better the economic indicators, better the value of the currency. But the major catalyst for this is the position of a country’s current account deficit (CAD) which is how much money it owes to other countries.

Fig 2. Trade balances of major economical regions

CAD is easy to understand. If you import more goods and services than you export, then you have a trade deficit. If you export more than your import bill, then you have a trade surplus. Put into other words, if more people want to buy stuff from you then their money is coming into your account and you are getting richer. Similarly, when you have to buy stuff from others your money goes into their accounts and you get poorer. In the latter, at a certain point your account goes into a loss and that is when you have a current account deficit (CAD). And if you do, then your economy’s value comes down along with your currency. Higher the deficit, lower your currency goes. Similarly, when you have a current account surplus, your currency tends to do better. This seems like common sense, right?

This is the simplest way to understand CAD.

As you may have guessed, India doesn’t really stand tall when it comes to handling its CAD. We have had a considerable deficit for all the years after liberalization except for two years with a tiny surplus.

Fig 3. Chart showing the relationship between INR and India’s Current Account Deficit

Hence, we see that current account deficit of a country is a major factor in determining a currency’s price (value).

The second important reason that affect currency prices is exposure to commodities.

A considerable amount of world trade is concentrated on commodities (or goods) like crude oil, copper, wheat, rubber, steel, silicone etc. So, the more exposed (or dependent on) a currency is to certain commodities, the more its currency is influenced by changes in the value of those commodities. For example, since Japan is heavily dependent on its electronics exports, any rise in value of silicone (for making computer chips) will affect them badly ? thus hitting its economy and its currency, the Japanese Yen.

Now out of all the commodities traded globally, crude oil takes up a staggering 68.8% of global consumption. One the major economies that is heavily dependent on crude oil imports is India. This is the reason why INR’s value tends to fall when there is a surge in crude oil prices, because India is so exposed to that commodity – 70% of our total imports consist of crude oil. Similarly, it tends to perform better when crude oil prices are lower. This is shown below:

Fig 4. Graph showing the relation between crude oil prices and INR exchange rate

Now that we have understood two of the most fundamental factors affecting currency prices, we are now ready to explore the third factor that influences a country’s currency: Central Bank Interest rates. Once we are thorough with these, we can explore trading signals and strategies.

?Next: Interest Rate Expectations and Currency Prices