What moves currency derivatives

T. S. NARAYANASAMI | Updated on February 26, 2011

Trading in currency futures is a comparatively new phenomenon in India, and the market is still in a growth phase, compared with global markets where it is one of the largest traded asset classes. The factors that affect exchange rates and hence impact trading in the segment can be divided into three categories: economic factors, political conditions and market psychology.

Economic factors

Economic policy is based on economic conditions that can be estimated on the basis of important indicators such as the GDP, inflation rates and so on. Economic policy can be either fiscal policy of the Government that is expressed in the Budget and spending documents or monetary policy decisions taken by the Central Bank of a country such as interest rates, reserve ratios and so on. Economic conditions can be broadly classified under:

Government budget deficits or surpluses: When the deficit broadens the real exchange rate of its currency decreases and its net exports increase. The reverse happens when the surplus broadens

Balance of trade levels and trends: The trade flow between countries reflects the demand for the services and goods, which reflects the demand for the currency of the country needed to participate in trading process

Inflation levels and trends: When inflation levels are high, the Government is forced to increase key rates such as the CRR and the interest rate to decrease the liquidity in the system. This might cause lower foreign investment and hence strengthening of the local currency. The reverse happens when the inflation levels are low

Economic growth and health: Reflected in data e.g. GDP, the level of employment, retail sales, capacity utilisation . Usually a healthy economy is accompanied by better currency and the demand for it, leading to an appreciation in its value

Political conditions: Political conditions of any scale can have an impact on the currency markets e.g. the instability in the political sector may affect the economy of the country negatively. The strengthening / weakening of the political group that is responsible for financial decisions can cause strengthening / weakening of the economy and hence the currency. Events in one country affects its neighbours and trade partners.

Market psychology

Market psychology and the way the trader perceives the events can impact forex market in various ways. There can be flight to quality as events at the international level (the current situation in West Asia for example) can make an investor sell riskier investments and buy safer ones.

Some trends can be seen from the business cycles e.g. in a country like India, where the equity markets depend to a significant extent on FII inflows, there is a positive correlation between the equity indexes and the exchange rates. These cycles are considered to provide long-term price trends that can be caused by economic and political directions.

Economic indicators that reflect the condition of the economy and influence economic policy also affect market psychology.

The changes of the currency pairs' prices can be aggregated into charts and tables for further consideration and use by traders. Technical trading considerations of traders who use these graphs also affect foreign exchange rates.

(The author is the MD & CEO, United Stock Exchange.)

Published on February 26, 2011

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