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Read Forex Concept Online
The Fallacious "Hot Forex Money" Theory
There is no doubt that interest rates and exchange rates have a profound effect upon each other; however, the relationship is not well understood. A Popular misconception has to do with "hot money."
Many believe that a huge source of funds overhangs the forex markets worldwide. Whenever interest rates rise in one country, especially a major industrial country with an unrestricted currency, the fund managers rush in to take advantage of the increased yield.
Funds remain parked in that currency only until the rate of interest moves back down, or interest rates for other simply stated, the difference between the spot and futures or forward rates is approximately equivalent to the difference between the interest rates. For both sides to be precisely equal, both denominators would have to equal 1.00, which would only occur if the foreign currency interest rate were O%-which never happens. The higher the foreign currency interest rate, the greater the error factor. Currencies move higher, at which time they again flow into the currency paying the highest yield.
Proponents of the "hot money" theory contend that the sudden shifts in demand have a dramatic effect on exchange rates, the highest yielding currency rising quickly in price as buyers pour m.
With the very deep pockets of today’s global fund managers, and with today's instant telecommunication and transfer capabilities, the "hot money" theory appears quite plausible; however, it is a false perception. There is no tremendous flow of funds chasing interest rates. Some money does, but not much, and "hot money" does not move exchange rates. |
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Base Currency
 Base currency is the currency in which an investor or issuer maintains its book of accounts. In the FX markets, the US Dollar is normally considered the 'base' currency for quotes.
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Technical Analysis
 An effort to forecast prices by analyzing market data, i.e. historical price trends and averages, volumes, open interest, etc. |
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It's normally condensed as the dollar sign, $. The U.S. dollar is divided into 100 cents.
The euro is the currency of 13 European Union countries.
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This is because the implied automatic gains simply do not exist. The implication of automatic losses is just as valid.
A look at the treasurer's options reveals the problem. Remember that the higher interest-yielding currency trades at a discount. It has less value in the future. An investor who buys a currency at spot to capture an interest rate premium simply gives back the premium when he later sells the currency at a lower price.
Of course, there is a way to avoid selling at a discount. The investor can simply hold the currency unheeded, hoping that the forward price rises to the current spot level, but then it is no longer an interest rate game. The "hot money" investor chasing interest rate yield ends up speculating in foreign exchange, just like any other currency trader.
Why Interest Rate Parity?
Conventional wisdom has it that forward rates are determined by interest rate parity because of arbitrage. In other words, interest rate differentials translate into forward pricing, so any mis-price between the cash and forward markets is instantly traded away. Interest rate parity works, according to this line of reasoning, because arbitrage makes it work. But does it really? It is just as easy to argue that arbitrage is simply an effect of interest rate parity, rather than the cause. Perhaps arbitrageurs act quickly when noticing a price disparity only because they realize that parity will occur regardless of what they do. It can be shown that this is what actually happens, and that interest rate parity is much more fundamental than the results produced by arbitrage.
Imagine the following scenario: you are approached by a benefactor who proposes to enhance your well-being. He offers you $1,000 with no strings attached. You are given two choices. Either you can receive the cash immediately, or you can receive the cash after an interval of one year. Which option would you choose?
Reasons
There is a high probability that you would take the cash immediately in online trade Why? For the following reasons:
1. The delay of one year represents 365 days of lost opportunity. You can purchase a lot of things with $1,000 during a year's time (this is the time value of money).
2. The money will be less valuable in one year because of the effects of inflation.
3. The future is uncertain. The benefactor may change his mind or lose the money during the year.
In short, there are three factors which affect the value of money to be received in the future: the time value of money, the inflation rate, and the borrowers (or benefactor's) credit risk.
Although we cannot determine the future value of $1,000 today, we can measure precisely the expected future value. It is equal to the current inducement that must be paid to turn money in hand into money promised. Stated another way, the current value of a future sum of money is determined by the current rate of interest.
Viewed in this manner, we can neglect for the moment the differences between nominal and real market interest rates. It is the nominal rate of interest, after all, that determines the price differential between spot and forward prices of nominal exchange rates. In fact, the two rates are simply different expressions of the same thing, as we illustrated in the foregoing Interest Rate Parity equation. |
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