Japan, and the rest of the world it seems, know this and therefore they are selling the AUD. Dream for Exporters and Tourists. Sucks for Importers and Holiday Makers.

So how to get through ?

1) In my opinion, the first way to get through is to start liquefying any relevant risky financial positions and cease entering ‘quick money’ arrangements which carry high risk. At the very least, a substantial reduction in these types of instruments will ensure that you are not hammered by adverse market movements. For the average portfolio holder – it’s all about reducing the risk and exposure. This may also mean closing down any positions where you have the thought that the stock ‘may go up, but will more than likely go down’. If the probability of ‘down’ is greater, in your opinion, than the probability of ‘up’ and the financial loss is not enormous – then it makes no sense to hold these so called ‘fence sitter’ positions in the current market. You are either going to lose massively, or gain a little – think sensibly and not greedily. A small loss is much better than a huge one.

2) Avoid any relevant exposure to the counter party risk that is reeking havoc to basically every major investment bank at the moment. You see this is where the biggest problem has been for all the US financials. Basically, all the major investment banks have engaged in credit default swaps which allow a buyer or ‘fixed rate’ party to make periodic payments to a ‘floating rate’ party in exchange for the ‘right’ to a payoff if there is a default or credit event in respect to a third party – called the reference entity. Simplistically, the lower the credit rating of a contracting party the greater the risk that the third party reference entity will default on its payments and this increases the cost of the credit swap.

Of course, because of the huge mortgage problem in the US at the moment – this has meant that the counterparty risk associated with these instruments has gone through the roof as contracting parties are defaulting on their obligations which has basically engulfed a lot of companies - American International Group (AIG) most prominently. The reason they have taken such a massive hit is because they offer insurance to the financial markets on so called ‘non-risky financial instruments’ such as ‘credit defaults swaps’. Of course, traditionally these instruments have never really been in the ‘high risk’ category – hence the reason AIG insured them – but in the current United States financial market where the securitisation industry is getting pummelled in every direction and the underlying price of houses are next to nothing – these instruments are now obviously, high risk. Do some research, don’t invest in companies who haven’t stated their entire position to the market yet or who ‘may be’ even the slightest bit exposed to credit swaps with contracting parties who are considered high risk.

3) Diversification should always be a part of any good portfolio position and if you portfolio isn’t diversified chances are you are either holidaying in Hawaii off your recent profits, or needing to buy another case of wine to calm the nerves from the losses you have sustained. In a market like this, it’s the turbulence that makes it very difficult to try and find good investments. I tend to argue that good performers over the last 2 years, will be good performers in the next 2 years assuming they can weather the financial storm. Most recent stock losses primarily relate to two things – the first being plan old market panic, and the second being a big sell off of any company remotely connected to ‘mortgages’ or ‘securities’. Does this make sense? Yes and no (I’m not going to go off down this road for this post). Most importantly, think sensibly and rationally – all the major financials in Australia will recover because regulators don’t give them a choice. More so, interest rates will fall – this is really inevitable otherwise the economy will come to a roaring halt which the RBA won’t let happen – so once again banks etc will be able to lock in profits from a reduction in funding costs and their share prices will rise in correlation with these interest rate reductions. Remember to look at any relevant dividend payments and focus on the underlying growth of businesses which you are analysing and/or looking to invest in.

4) For traders, please ensure that you ALWAYS use stop losses. No matter how ‘good’ you are – you are never better than a good stop loss. If you trade a lot you will already know this, if you are starting to trade – don’t bother in this market – and if you have never traded, don’t start yet. By all means practice with a Excel spreadsheet and “fake” money, but trying to pinpoint good investments in this market and trade them well with little experience is really something that I wouldn’t recommended to anyone at this current point in time. It’s best to learn in this market, but not best to use your own money. Practice, practice, practice using a real live trading program so you get a ‘realistic’ exposure to how difficult it is to trade in turbulent markets. If you find yourself ‘more up than down’ – let it stay that way until the market settles.

5) Keep rational, stay focused. This is probably the most important thing to do in a market such as this one. Don’t take risky CFD positions or Index options or even attempt to create complex trading systems which can ‘beat the market’. There’s a ‘high risk’ chance you will end up down and I recommend you re-read point 1 above if you are even thinking this. You can bet your bottom dollar that billions of dollars was lost in call options alone in the United States because many financial experts had suggested ‘the worst was over’. The worst is never over until the Regulators start shaking down the biggest companies and demanding they account for their risk and balance sheet exposure. Once you see this start happening publicly as it is slowly starting to happen in the US – then you will start to see the ‘true state of affairs’. This hasn’t happened to a great extent yet, and I think in the next few months there will be a few more issues in the pipe particularly around investor sentiment leading up to the next US president and their respective economic policy.

These are just a few tips in order to “weather the financial storm”. Feel free to contact me via the Contact Page above if you have any comment.

Inflation is represented by a percentage, and in most cases a countries central bank tries to maintain the rate at around 2-3% per year. The central bank which does this in Australia is the Reserve Bank of Australia. The simplest example to highlight the affects of inflation is to say for example in Australia this year inflation is expected to rise by 2%. Because of this rise, say a bottle of milk that last year cost $1.00 is now priced at $1.02 because of the inflation rate rise.

Like interest rates, inflation also plays a big part in the way exchange rates are determined. Because each country will have a different inflation rate, the exchange rate between the 2 over time, will automatically adjust to compensate for the difference.

Example

Say the current spot rate is:

USD 0.7500 AUD

Meaning $1 Australian Dollar equals 75 US cents. Now say that the inflation in the US is greater than that in Australia. For example inflation is 5% in the US and 3% in Australia. This would mean that in Australia you would be getting more value for your money, as goods and services are only 3% more than what you would be expecting to pay from last year, whereas in America they have increased 5% – a 2% difference in inflation rates.

Because of this inequality, the exchange rate will adjust to compensate for the inflation rates not being equal. Because American goods are relatively more expensive, American will converting their USD to get AUD so that they can buy goods in Australia. The increases in the supply of USD and the demand for AUD will drive up the price of AUD.  USD will continue to depreciate until an equilibrium point is reached. Or put simply, if the above example of inflation rates holds true, then $1 Australian dollar would now be able to purchase more US dollars than before. This means that the Australian dollar has increased in value, while the US dollar has fallen.

The mechanics behind this theory have been developed from something called Purchasing Power Parity or PPP in short hand. Purchasing Power Parity simply means that no matter which country you are in, it would cost the same to buy an item in that country as it would in any other country you are in. However as we all know this is not true. The easiest example is when Australians or tourists from more developed countries go to Asian countries and find many bargains. Goods in Asia are so much cheaper than that of their own country generally speaking. PPP simply states that the exchange rate between two currencies will adjust to reflect the relative inflation rates in the two countries.  It is assumed that the law of one price is valid.

As discussed previously, forward exchange rates are expressed as a forward discount or a forward premium. The most common reason as to why they are higher or lower than the current spot rate is due to the interest rates of the 2 countries involved in the currency exchange.

Indirect Quote Example

Say the current spot rate is:

USD 0.7500 AUD

Meaning $1 Australian Dollar equals 75 US cents. If the forward rate was then quoted as:

USD 0.7450 AUD

Then it would mean that $1 Australian Dollar equals 74.5 US cents or in other words the forward rate is lower than the spot – i.e. forward discount. This would be the case if Australian interest rates are higher than that of the U.S. and that the Australian dollar is expected to depreciate against the US dollar. As in the future 1 Australian Dollar will buy you less US currency. Put simply the Australian Dollar is now worth less than what it was before. Or the US dollar is now worth more than what it was before. Remember that the above exchange rate has been represented in an indirect quote.

Direct Quote Example

To represent the same example above in a director quote would be the following. Say the current spot rate is:

AUD 1.3333 USD

Meaning $1 US Dollar equals $1.33 Australian.  If the forward rate was then quoted as:

AUD 1.3500 USD

The forward margin is now represented as a forward premium to have the same affect as the first example. This is because to change from indirect to the director form of exchange rate quotes, you must divide 1 over the previous quote – 1/0.75 = 1.3333. Or in other words to find the inverse of the quote. By finding the inverse, all of the things from the following example must be reversed, to maintain the overall picture that the AUD $ is now worth less and that the USD is now worth more. Or, in terms of interest rates, Australian interest rates are higher than that of the U.S. and that the Australian dollar is expected to depreciate against the US dollar.

However, if the story was that Australian interest rates are lower than that of the U.S., then the reverse of the outcomes would occur. In this example the US dollar would now be worth less, and the AUD dollar would now be worth more.

The theory behind this form of exchange rate adjustment according to interest rates is called Interest Rate Parity (PPP). This theory basically acknowledges the fact that most countries will have different interest rates, in comparison to other countries. Due to this difference and the floating exchange rate system (exchange rates are freely moving and determined by market forces) then the exchange rates will depreciate or appreciate according to the difference in the interest rates between each country.

They are usually quoted in terms of the difference between the spot rate and the forward rate.  This difference is known as forward margin.  It is either forward premium (+) or forward discount (-). The spot rate refers to the current exchange rate, where the delivery of the exchange takes place immediately.

The forward rate spread will always be greater than the spot rate. This means that the gap between the 2 quoted prices is larger. This is due to the fact that delivery happens in the future and therefore uncertainness and risk are present. The larger this spread is the more volatile or risky the market is, and as such the exchange rate dealer will pocket a greater profit. The higher the forward rate premium or discount the more uncertain or risky the relative exchange rate is in terms of the local or domestic currency.

Example

Say the current or spot exchange rate is the following:

USD 0.7455 / 0.7500 AUD

And the 6 month forward rate given is 10/15. Now to work out the forward rate in terms of the bid and ask exchange, we would need to incorporate the forward rate into the current spot rate (remembering that the spread in the forward rate must be greater than that in the spot rate). The current spread in the spot rate is 45 points. Therefore if we use the forward rate as a premium (i.e. adding the forward rate) then it would appear as the following:

Therefore the forward rate is:

USD 0.7465 / 0.7515 AUD

And the spread for the forward rate is: 50 points

(0.7515 – 0.7565)

Which would be correct as the forward rate spread is greater than the spot rate spread Or in other words 50 is greater than 45. And because we have added the forward margin onto the spot rates, this means that the forward rate which we have been given is quoted at a forward premium. The following is INCORRECT and is an example of what NOT TO DO!!!

A WRONG Example

Using the same information as the correct example above, the current or spot exchange rate is the following:

USD 0.7455 / 0.7500 AUD

And the 6 month forward rate given is 10/15. Therefore the spot spread = 45 points

By expressing the forward margin as a forward discount (subtracting the forward margin from the spot rate) we can see that the forward rate spread is not less than the spot.

0.7485 – 0.7445 = 40 points

Therefore this would be incorrect!!! The most important thing to realize when calculating forward rates is that the forward rate spread must be bigger than the current spot rate spread.

Direct Quote:

The most common way in which they are expressed is called a direct quote. Generally speaking, most international countries deal with the direct quote in all their transactions and the quotes that they give are in accordance with international convention. Australia on the other hand uses an indirect quote.

The direct quote is expressed in terms of 1 unit of the foreign quoted currency will equal the quoted amount of the local or domestic currency.

AUD 1.35 USD

The above example would correspond to 1 US Dollar equating to $1.35 Australian. Meaning that 1 unit of the right sided currency (ie USD or US Dollars) will buy the quoted amount (in this case $1.25 of Australian Dollars) of the left sided currency.

Indirect Quote:

However in Australia the system which we use is called an in-direct quote. This can be seen on most Australian financial sites where they will say 1 Australian Dollar is buying 75 US cents.

This form is usually expressed as the following:

USD 0.75 AUD

Meaning that 1 unit of the right sided currency (ie AUD or Australian Dollars) will buy the quoted amount (in this case 75 cents of the left US Dollars) of the left sided currency.

The technical terms for the currency are:

AUD = The commodity currency

USD = The term currency

When expressed as a direct quote:

AUD 1.33 USD

Then the terms will be reversed:

USD = The commodity currency

AUD = The term currency

The same applies when expressing or interpreting the given quote. It will still be the case that 1 unit of the right side of the currency will buy the quoted amount of the left sided currency.Iin other words for this example, 1 US Dollar will equal to $1.33 Australian Dollars.

For simplicity however, the above examples have been quoted to 2 decimal places although they are usually quoted to the 4th decimal place.  Which is also called One basic point = 0.0001

If the quoted amount ends in a zero like the indirect quote above:

USD 0.75 AUD

Then it is still expressed as 4 decimal places, by adding an additional two 0’s to the end:

USD 0.7500 AUD

BID / ASK Rates

When being quoted foreign currency rates, they will also be in the form of 2 different figures, which are called bid/ask rates.

USD 0.7455 / 0.7500 AUD

The left sided figure is called the bid rate. This refers to the amount at which people are willing to purchase USD. However in some cases, quotes may be given as the following:

USD 0.7500 / 0.7455 AUD

The figure of 0.7455 is still the bid rate. This is because it is the lower of the 2 rates.To explain this, you need to picture what you would do in the situation. As a buyer you will always have to pay the higher rate. This is because you want to purchase the currency, not sell it.This implies that you will be buying at whatever the selling price is.

An easy way to remember it is the bid rate is always the lower of the 2 prices.

ASK Rate

Following on from the previous example of the Bid Rate, the Ask Rate is always the higher of the 2 prices, this is because the Ask Rate represents the price at which someone is willing to sell 1 unit of the relative foreign exchange currency.

USD 0.7455 / 0.7500 AUD

The right sided figure is called the ask rate. The quoted figure which is the greater of the 2 rates will always be the ask rate. Another way to remember which rate is the bid or ask; is to relate the quoted figure in terms of share trading.Like foreign exchange, shares are also a 2 party transaction. When buying or selling shares, the actual transaction is completed in reference to 2 different prices – whether the trade is a selling order or a buying order.

If you have an online brokerage service, then the following would represent a similar view of the information you would have available when you are executing a trade.

Stock: TLS – Telstra

When relating the following back to foreign currency exchange transactions, the BUY price for share trading represents the bid rate – which is lower than the sell price while the SELL price would represent the ask rate – which is higher than the buy price.

Shortened Quotes

In some situations the quoted exchange rate may also be presented in a shortened form:

USD 0.7455 / 70 AUD

The noticeable change here is the 2nd part of the quoted rate or the ask rate. Here the ask rate has been quoted as “ / 70”. This refers to the exchange rate as been quoted as:

USD 0.7455 / 0.7470 AUD

Therefore you simply work use the / 70 and swap it for the last 2 numbers from the bid rate. In other words the ask rate will equal 0.7470. We replace the 55 with 70.

International Finance has introduced a new economic environment that is unlimited in its boundaries. Companies are now able to transfer huge quantities of money across the globe to an infinite number of clients with unprecedented security – something that was once thought to be impossible. Our acceptance of this technology has occurred so quickly that we have become not only used to this type of interaction across our borders, but begun to rely heavily on its presence in our daily lives.

Thus, welcome to the world of International Finance where global financial interactions occur in the millions each day. This tutorial seeks to improve your knowledge on the global market place by explaining everything from how to calculate exchanges rates through to inflation and purchasing power parity. Once you are finished reading through it all, we hope that you will begin to appreciate some of the fundamental theory behind what makes our global network tick.