Sunday, April 26, 2015

Exchange Rates and Supply and Demand

Supply and Demand

Prices of goods, commodities and exchange rates are determined on open markets under the control of two forces, supply and demand.
The laws of supply and demand show that:
  • High supply causes low prices, and high demand causes high prices.
  • When there is an abundant supply of a given commodity then the price should fall.
  • When there is a scarce supply of a given commodity then the price should increase.
  • Therefore, an increase in the demand for a commodity would cause it to appreciate in value, whereas an increase in supply would cause it to depreciate.
The value of a nation’s currency, under a floating exchange rate, is determined by the interaction of supply and demand. We will work through some charts and an example to show how these forces work, from a theoretical point of view.
Demand Curve Figure 1 shows the demand for British pounds in the United States. The curve is a normal downward sloping demand curve, indicating that as the pound depreciates relative to the dollar, the quantity of pounds demanded by Americans increases. Note that we are measuring the price of the pound-the exchange rate-on the vertical axis. Since it is dollars per pound ($/£), it is the price of a pound in terms of dollars and an increase in the exchange rate, R, is a decline in the value of the dollar. In other words, movements up the vertical axis represent an increase in price of the pound, which is equivalent to a fall in the price of the dollar. Similarly, movements down the vertical axis represent a decrease in the price of the pound.
For Americans, British goods are less expensive when the pound is cheaper and the dollar is stronger. At depreciated values for the pound, Americans will switch from American-made or third-party suppliers of goods and services to British suppliers. Before they can purchase goods made in Britain, they must exchange dollars for British pounds. Consequently, the increased demand for British goods is simultaneously an increase in the quantity of British pounds demanded.
Supply Curve Figure 2 shows the supply side of the picture. The supply curve slopes up because British firms and consumers are willing to buy a greater quantity of American goods as the dollar becomes cheaper (i.e. they receive more dollars per pound). Before British customers can buy American goods, however, they must first convert pounds into dollars, so the increase in the quantity of American goods demanded is simultaneously an increase in the quantity of foreign currency supplied to the United States.
Equilibrium Price Suppliers and consumers meet at a particular quantity and price at which they are both satisfied. Figure 3 combines the supply and demand curves. The intersection determines the market exchange rate and the quantity of dollars supplied to United States. At the exchange rate R, the demand and supply of British pounds to the United States is Q.
This is known as the equilibrium or the market’s clearing point.
Changes in Demand and Supply
www.cmsfx.comIn figure 4, an increase in the US demand for the pound (rightward shift of the demand curve) causes a rise in the exchange rate, an appreciation in the pound, and a depreciation in the dollar. Conversely, a fall in demand would shift the demand curve left and lead to a falling pound and rising dollar. On the supply side, an increase in the supply of pounds to the US market (supply curve shifts right) is illustrated in Figure 5, where a new intersection for supply and demand occurs at a lower exchange rate and an appreciated dollar. A decrease in the supply of pounds shifts the curve leftward, causing the exchange rate to rise and the dollar to depreciate.
Increase in Demand Increase in Supply
www.cmsfx.comWhen the forces between supply and demand change, the market moves in ways to clear itself through a change in price.
In international finance markets, if many investors are selling a particular currency, they are making it more readily available and increasing its supply. If there is not an equal amount of buyers, or demand, for that currency, its price will go down in order to strike a new balance between supply and demand.
The direction in which the value of a currency is heading can cause cash to flow into or out of that currency. A currency that is appreciating can cause money to flow into its country’s assets as investors and Forex traders want to benefit from buying or taking “long” positions on the currency as the currency’s price rises. 

Factors that Affect Supply and Demand

A variety of actors cause currencies to experience changes in supply and demand:
  • companies that export and import,
  • foreign investors and banks,
  • speculators who wish to engage in market activity,
  • and central banks that control the movement of interest rates.
Who Comprises the Forex market?
Due to its vast volume and large number of participants, no individual or single company has complete control over which way the market will sway. Historically, Forex has been dominated by commercial banks, money portfolio managers, money brokers, large corporations, and very few private traders.
Lately this trend has changed. While there are many reasons for participating in foreign exchange including facilitating commercial transactions, corporations converting its profits, or hedging against future price drops, more and more people are getting involved in the market for the purposes of speculation.
Exporting and Importing Companies
Large multinational corporations influence the foreign exchange market as they purchase and sell goods and materials between different countries.

The first group that has influence in the foreign exchange markets is typified by large, multinational corporations. Imagine a New York City firm exports its products to a German company. The business transaction will be settled in dollars so the American firm obtains revenue in its own currency and can pay its employees’ salaries in dollars.
To facilitate the transaction, the German firm needs to convert some of its capital from euros to dollars on the foreign exchange market. The supply of euros increases leading to an appreciation of the dollar and depreciation of the euro. It can also be said that the German firm increases the demand for dollars, again causing the dollar to appreciate in comparison to the euro. This transaction would have to be for a very large contract in order for the exchange rate to actually move a pip up or down.
If the payment by the German company is coming 6 months later, it introduces the risk that the amount of dollars they would receive for a certain amount of euros today will not be the same in 6 months time. A company may want to limit, or hedge, this exchange rate risk by immediately converting their euro into dollars, or by purchasing forward contracts in the foreign exchange market. A forward contract is a contract to convert euros into dollars at a future date at a set price.
Importing companies affect the demand of a currency as well. For example, an American retailer features Japanese furnishings and pays its suppliers in Japanese yen. If consumers like these products then they will indirectly contribute to an increase in demand for the yen as the American retailer will have to buy more merchandise from Japan. As the retailer purchases the yen and sells the dollar on the exchange market, the yen appreciates.
Foreign Investment Flows
Foreign investment has many aspects, having to do with goods, services, stocks, bonds, or property. Suppose a Canadian company wants to open a factory in America. In order to cover the costs of the land, labor and capital the firm will need dollars. Suppose the company holds most of its reserves in Canadian dollars. It must sell some of its Canadian dollars to buy US dollars.
The supply of Canadian dollars on the foreign exchange market will increase and the supply of US dollars will decrease, which causes the US dollar to appreciate against the Canadian dollar. On the flip side, foreign investors are also increasing or decreasing the demand for the currency of the country in which they are interested in investing.
  The Federal Reserve For a long time the foreign exchange market has been associated with the term “interbank” market. This term was employed to capture the nature of the foreign exchange market when it predominantly dealt with banks. Banks included central banks, investment banks and commercial banks.
  • Examples of central banks include the Federal Reserve Bank of the United States or the European Central Bank.
  • Investment banks include those of Goldman Sachs, JP Morgan, and Bank of America.
  • Today, banks are not the only participants within the foreign exchange market. With the onset of technology and the growing ease of accessibility to market activity, there has been an increase in many non bank participants such as individuals.
Speculators - Investment Management Firms, Hedge funds, and Retail Traders
Many financial institutions use currency exchange as a method to generate income. There are also many individuals who try to do the same thing. The currency markets move in one direction only when many investors act together. An individual investor cannot move the exchange rate of a currency but many traders, investment funds, and banks may collectively move it.
If speculating traders think the Japanese Yen is going to weaken in the near future due to poor economic data or a change in interest rate policy, then they sell the yen on the foreign exchange market relative to another stronger currency. The supply of yen will increase and cause the currency to depreciate. If many investors feel that a particular currency will depreciate in the near future, their collective selling of that currency will move its price down. Similarly, if speculators feel that a currency is going to appreciate in the near future then they will buy that currency today and cause it to experience a higher demand which causes its price to go up. Investors help materialize their predictions by acting in a herd mentality, and in some peoples eyes bring about a self fulfilling prophecy.

Central Banks

Floating vs. Fixed Exchange Rates
There are two types of exchange rate systems: floating or fixed. A floating exchange rate is one in which a currency’s value is determined by market forces. A fixed exchange rate matches, “pegs”, the value of the currency to: one currency, several currencies or even to a fixed amount of a commodity.
Floating Exchange Rates Prior to 1971’s breakdown of the Bretton Woods Agreement (a fixed exchange rate system revolving around the US Dollar and gold), most currencies were pegged. Today, the current international financial system squares most of the currencies of the world against one another in a free market. Floating exchange rates are preferable to fixed ones since floating rates are reflective of market movement and the principles of supply and demand and limit imbalances in the international financial system. Fixed exchange rates grant more control to central banks (who may or may not be independent of the government) to set a currency’s value, and during times of volatility are preferred for their greater stability. Many developing countries use fixed exchange rates in order to evade market abuse.
In extreme situations such as political unrest, terrorist attacks or natural disasters a country’s currency may experience a period of heavy selling that causes it to depreciate in value. The country’s central bank may intervene in order to restore the value of the currency. A central bank regime that routinely intervenes would use the term "managed float". Sometimes, the central bank may set upper and lower bounds known as price ceilings and floors, respectively, and intervene whenever those bounds are reached.
Central Banks, Interventions, and Interest Rates
Central banks influence the supply and demand of their country’s currency through control of interest rates or though intervention actions.
For many large economies, central banks can influence their currency’s value by changing interest rates. The US central bank, the Federal Reserve, is not necessarily trying to achieve a weak or strong dollar policy, but acts in a manner that curbs inflationary pressure while maintaining steady growth within the economy. It uses interest rates as a mechanism to achieve this type of economic state. Our next lesson explains more about interest rates and central banks.
www.cmsfx.comThe other method used by banks to influence supply and demand of its currency deals with directly buying or selling currencies through its reserves (as was explained above). An example of such operation can be seen by the Reserve Bank of China. Suppose the Reserve Bank of China thinks that the Chinese Yuan had appreciated too much and wanted to lower its value. Then, the Reserve Bank of China will sell its yuan and buy another currency such as the Japanese Yen into its reserves. The increased supply of yuan should work to lower the yuan’s exchange rate.
Although this provides a convenient way for the central banks to control the value of their currency, the banks must be careful. There is only a limited amount of currencies that each country has within its reserves and a prolonged attempt to fight market forces can deplete it causing a financial crisis.
A central bank can affect the demand for other countries currency as well. If the bank (Russian Central Bank) feels that its reserve amount of a particular country’s currency (Euro) is too low then it will engage in the foreign exchange market and buy that currency. This change in the composition of the Russian central banks reserves, will lead to an increase in demand of the Euro since it is being bought, and the Euro’s appreciation.

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