User blog: Karim Mansour
Inflation, Interest Rates & Forex
Relevant to the following CISI qualifications: IISI, Securities, Global Securities, ICWIM, ICAWM.
The inter-relationship between inflation, interest rates and foreign exchange rates has always been a popular area in CISI exams – with varying difficulty across different levels.
The recent turmoil in the Turkish Lira provides an excellent case study that would help students understand how the three pillars of monetary policy influence each other.
Before we begin, it is important to seperate the factors that caused the crisis between economical factors (inflation, interest, fx) and non-economical factors (psychological and religious).
Exports and GDP
Since July last year, the Turkish Lira has lost 35% of its value against the US dollar. This was mainly attributed to Trump’s tariffs on aluminium and steel which were imposed as a political retaliation for the imprisonment of an American pastor.
Tariffs on Turkish products will cause American importers to import less from Turkey and source their aluminium and steel from somewhere else. This means lesser exports from Turkey to the USA. If you’ve taken any CISI securities qualification, you’ll know that any adverse changes in exports have a direct effect on a country’s economy (remember: GDP = consumer spending + government spending + investments + exports – imports).
CISI exam point: negative movements in exports = negative effects on GDP = negative effects on currency
Interest rates and Inflation
Turkey’s inflation rates currently stand at an astonishing 15%. For comparison, in the USA, UK and the UAE inflation rates hover around 2%. Turkey has continuously used credit and its budget to stimulate its economy. This meant deficits in its current account and public-sector budget. These deficits were covered through foreign direct investments (FDI) and external borrowing (bond issuance). The yields on Turkish 1-year to 10-year government bonds range between 20% and 25%. Recent growth in income and GDP however was not adequate enough to cover the debt burden.
CISI exam points: Deficit in current account means imports are higher than exports. Governments cover deficits by borrowing – usually through the issuance of bonds.
With inflation at such high levels, investors and creditors expected the Turkish central bank to increase interest rates which are already high at 17.75%. Contrary to expectations, the central bank held interest rates at that level. This raised concern among investors who started to believe that the central bank is not serious about controlling inflation and stabilising the currency. These concerns grew when Erdogan appointed his son-in-law to run the Treasury and Finance Ministry.
CISI exam points: When inflation is high, central banks are expected to interfere and raise interest rates. This will cause borrowing to drop. Consequently, inflation will drop too.
As a conservative Muslim, Erdogan has continuously expressed his loathing for interest rates. On multiple occasions, he’s been quoted saying:
“If my people say continue on this path in the elections, I say I will emerge with victory in the fight against this curse of interest rates.”
“Because my belief is: interest rates are the mother and father of all evil.”
Islam considers charging interest on debts as usury, or “riba”, which is therefore prohibited. Therefore, Erdogan’s description of interest rates is literal and not figurative. Investors believe that Erdogan’s lack of understanding of how interest rates influence currency levels stems from his deep hatred for interest – which is not expected to change any time soon.
This article was originally published on Tadawul Academy’s website https://www.tadawul.academy/2018/08/16/cisi-exam-articles-inflation-interest-rates-forex/
The Structure and Function of the Foreign Exchange Market
Relevant to the following CISI qualifications: IISI, Securities, Global Securities, ICWIM and ICAWM
The foreign exchange market, also known as the forex, FX, or currency market, involves the trading of one currency for another. Prior to 1996 the market was confined to large corporate banks and international corporations. However it has since opened up to include all traders and speculators. Today, the average daily turnover in forex markets is US$1.9 trillion, according to the Bank of International Settlement’s Triennial Survey. The market is growing rapidly as investors gain more information and develop more interest.
In trading foreign exchange, investors bet that one currency will appreciate over another; they profit when they bet correctly and collect the profit in the form of an interest rate spread when they return to the original currency. The profit margins are low compared with other fixed-income markets. Large trading volumes can, however result, in very high profits. Most forex trading takes place in London, New York, and Tokyo, with most trading activity in London, which dominates the market at 30% of all transactions. New York’s market share is 16%, and Tokyo’s has fallen to 10% due to the growing prominence of Singapore and Hong Kong. Singapore has become the fourth largest exchange market globally, and Hong Kong is the fifth, having overtaken Switzerland. The various players in the foreign exchange market include bank dealers, 16% of which are international investors and speculators. Banks account for almost two-thirds of forex transactions; of the rest, about 20% is mainly attributable to securities firms that operate in the international debt and equity markets.
One type of very short-term transaction is the spot transaction between two currencies, delivering over two days and using cash as opposed to a contract.
In a forward transaction, the money is not exchanged until an arranged date and an exchange rate is agreed in advance. The time period ranges from days to years. Currency swaps are a popular type of forward transaction; these involve the exchange of currency by two parties for an agreed length of time and an arrangement to swap currencies at an agreed later date. Another type is a foreign currency future, which is inclusive of interest. A standard contract is drawn up and a maturity date arranged. The time schedule is about three months.
In a foreign exchange option (FX option), the most liquid and biggest options market in the world, the owner may elect to exchange money in a designated currency for another currency at an agreed date in the future. This type of transaction depends on the availability of option contracts on an organized exchange. Otherwise, such forex deals may be carried out using an over-the-counter (OTC) contract.
- The forex market is extremely liquid, hence its rapidly growing popularity. Currencies may be converted when bought or sold without causing too much movement in the price and keeping losses to a minimum.
- As there is no central bank, trading can take place anywhere in the world and operates on a 24-hour basis part from weekends.
- An investor needs only small amounts of capital compared with other investments. Forex trading is outstanding in this regard.
- It is an unregulated market, meaning that there is no trade commission overseeing transactions and there are no restrictions on trade.
- In common with futures, forex is traded using a “good faith deposit” rather than a loan. The interest rate spread is an attractive advantage.
- The major risk is that one counterparty fails to deliver the currency involved in a very large transaction. In theory at least, such a failure could bring ruin to the forex market as a whole.
- Investors need a lot of capital to make good profits because the profit marginson small-scale trades are very low.
This article was originally published on Tadawul Academy’s website: