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Forex Currency Trading Online: 5 Steps To Avoid The Common Tragedy

Forex Currency Trading Online: 5 Steps To Avoid The Common Tragedy



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We saw in previous chapters that one way in which one can profit in the financial markets is by anticipating correctly changes in market rates. It is this anticipation that leads the funds manager to produce "mismatched" cash-flow positions and be exposed to undesirable fluctuations in rates. the rate risk.

Rate Risk in the Money Market

In the money market, the rate risk arises when the maturities of the placement and the borrowings are not matched. For example. when we lend funds for six months while borrowing with a one-month maturity, the interest rate on the six-month loan has been locked in from the beginning. However, at the end of the first month, additional borrowings are necessary to repay the initial debt or to roll over the debt. But, at the beginning of the transaction. we do not know with certainty what the interest rate will be at that time. Most likely. the funds manager in this situation is speculating that interest rates will decline after a month. If the assumption proves correct. the funds manager would have locked in a high interest rate on the loan for six months. while refinancing the operation at a lower interest rate after the initial first month. If the initial expectation proves to be wrong and interest rates actually increase and keep doing so for the remainder of the loan period. however. the funds manager will be forced to obtain financing (to borrow) at rates which might prove to be higher than the one at which the funds were placed or lent initially.

Rate Risk in the Foreign Exchange Market

In forex transactions the rate risk appears in two forms: (1) in net exchange positions. and (2) in swap positions or mismatched maturities. The most obvious case of rate risk is the maintenance of a net exchange position in a given currency. If the position is long or overbought and there is a depreciation of the currency, a loss is sure to occur. On the other hand, if an up valuation occurs while the funds manager is holding a long net exchange position. there will be a profit from such a change in exchange rates. The opposite results would occur if the net exchange position were short or oversold in that currency.

The other way in which rate risk appears when one operates in the foreign exchange market is through swap positions. As explained in previous chapters, a swap transaction does not affect the net exchange position. By definition, a swap involves a simultaneous buy and sale of currency for two different maturities. For example, the funds manager may buy German marks against U.S. dollars for three-month delivery and sell German marks against U.S. dollars for one-month delivery. Let's say that the forward mark is selling at a premium against the dollar. In this case, in order to make a profit. the funds manager must be expecting that, when the one-month transaction matures, it will be possible to square the two-month gap at a premium larger than the one that prevailed initially. If the mark had been selling at a discount. the funds manager, when entering into this specific swap, would have expected that the discount would decrease.

This expectation of an increase in the premium or a decrease in the discount of the mark against the dollar must be based on a change in relative interest rates. The interest differential must change in favor of the dollar. If the initial situation was one of a forward premium on the mark against the dollar. then, in this case, the interest differential was in favor of the dollar. In other words, the interest rate for dollars was higher than the one for marks, and the forecast implied that the interest differential would become even more strongly in favor of the dollar. If the initial situation was one of a discount on the mark against the dollar, then the interest differential must have been in favor of the mark. Therefore. the expectation behind the swap transaction described earlier must have been that the differential would narrow (become less favorable to the mark) either because the mark rate would decrease or the dollar rate would increase.

The previous paragraph clearly points out the connection between the forward exchange market and the money market. The rate risks in the forward exchange market. when one is dealing in swap transactions. are dependent on the same assumptions and outcomes as in the money market. A swap position. after all. is not really an exchange position. Profits and losses in a swap position depend exclusively on the development of interest rates for the two currencies involved. A swap position is a money market position disguised with exchange contracts.

One major distinction between the rate risk in money market operations and swap transactions is that. when operating in the money market, we are forecasting only the rates for one currency. When operating in the foreign exchange market through a swap, it becomes necessary to take into account the future interest rates for two currencies, a slightly more complicated task!

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