Thursday, August 28, 2014

Philip Pilkington — Understanding the Current/Capital Account and the Value of the Currency

One thing that I notice on the blogs is that I don’t think I have ever seen anyone give a clear description of the external trade account of a country. Nor have I seen anyone give a clear explanation of what determines the value of a given currency….
Fixing the Economists
Understanding the Current/Capital Account and the Value of the Currency
Philip Pilkington


Ryan Harris said...
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Matt Franko said...

"Now, if the foreigners don’t want to hold these claims they may sell them and then convert the money they receive into money from their own country. This will drive down the price of the currency of the country with a trade deficit and drive up the price of the country with the trade surplus."

Why would the bank intermediary allow this to happen? If the exporting firms came in with an offer then I would think the bank would LOWER its bid in Euro but somehow the bank raises their bid? So when a bank raises its bid like this it is devaluing that nation's currency?

So in the current Euro devaluation, European exporters lower their prices to US buyers in USDs terms and then take some of those USDs to their bank and offer them to their banker and the banker has to raise its bid in Euro thus devaluing the Euro?

So it is actually the exporters who move the real terms of trade FIRST (by putting their real goods on sale) and then the banks 'ratify' these new real terms by setting the exchange rate lower?

Seems like this would not be in the banks best interests. . Rsp

Matt Franko said...

So its like a month ago, the firms came in and said "I'll offer you $1.37 for a Euro" and then their bank said "Nah that's too much just make it $1.36 ".... I don't see why a bank would ever do this...

Ryan Harris said...

The bank would front run the orders, then a 1000 speculators would hear the bank was on the bid and would jump in the market. Which would cause market makers to hedge those positions. And then everyone needing to buy or sell in the months ahead would get nervous about all the volatility and they would buy forwards and options to hedge their risk which would cause a trend to form.

NeilW said...

"Why would the bank intermediary allow this to happen?"

They wouldn't. That's why I commented that the PK people don't seem to understand foreign exchange that well - particularly the actual mechanism by which foreign exchange deals are settled.

The fallacy they fall across seems to me to be the assumption of infinite liquidity - as though there is some sort of buyer of last resort in the market. There most certainly isn't in the main FX market.

And if there isn't a buyer or holder, then the whole deal is off - including the real leg of the trade.

NeilW said...

"Which would cause market makers to hedge those positions."

With who? Where's the liquidity?

The 'market makers' in FX are making a market against their customers generally - because most of there retail speculation market is actually a bunch of leveraged derivatives that are really contracts for differences.

There is no overall market maker, unless you have a central bank daft enough to play patsy in the speculation market.

Mike himself has said that floor traders try and push each other around, but ultimately get nowhere because they are just pushing against themselves.

Unless there is a central bank playing patsy.

Matt Franko said...

Report this AM over here that US consumer spending hit the skids in July.... so did the Euro....

I think we'll see a corresponding reduction in the CAD/BOP in July...

in early 2008 we had another collapse in the CAD/BOP and the Euro collapsed likewise:

So imo somehow these FOREX rates are a function of the actual trade between the nations, and what price the deals are getting done at...

ie "its about price not quantity...."


mike norman said...

I've known a lot of bank FX traders and they're as clueless as everybody else, even more so. Be careful ascribing any "grand intelligence" to bank traders. And their market making function is designed pretty much to guarantee a nice "spread" in their favor, which they either cover instantly or "hedge out" in one way or another. (Buy/sell futures.)

There is no axiomatic fundamentals that determines the foreign exchange value of a currency. Lots of factors affect exchange rates and investor sentiment more than anything determines short term price movements. (And sentiment is usually based on a flawed understanding of fiscal and monetary policy effects.)

Ryan Harris said...

As an individual, most of the currency I buy is purchased to cover the costs of stocks or bonds bought in foreign currencies, so I don't have to pay interest on negative fx balances borrowed on margin.

I'm sure when I buy products at Walmart, those purchases set off a cascade of buying and selling and hedging forex on my behalf all along the supply chain.

So how does the bank hedge their market making activities when I place an order for a few Aussies at 10AM london time? Most trade confirmations for orders I place on the interbank market are reportedly filled by GS, HSBC, CITI, BAML, RABO, ANZ, RBS, SEB or a couple others I can't think of ATM. When I look at their balance sheets, I don't see trillions of dollars of foreign exchange assets, so it is probably fair to assume that they aren't sitting on the other side of my purchase without some sort of matching of customer orders or hedging using futures, forwards or ultimately some central bank that is accumulating the reserves if the country has a current account surplus problem. I don't know how all fx brokers work in the world, I know my broker does virtual fx contracts with actual positive and negative balances appearing on my brokerage account. When I read my brokerages annual report, they outline the basic parameters of how they provide access to interbank markets and how they hedge any of their own forex exposure using futures, swaps, and other derivatives.

NeilW said...

"So how does the bank hedge their market making activities when I place an order for a few Aussies at 10AM london time?"

In the retail market, the bank takes the opposite side of the deal if they are a market maker. You wouldn't be able to get an order otherwise.

Or you are part of an ECN broker network that clears at the next available order price. That is more 'pure' in market terms.

Retail access to the FX market is there for one reason - to provide loss absorption liquidity to the professionals. Retailers mostly get it wrong (because they haven't been on Mike's course :)

Quite a nice overview here

It's the same line that the spread betting firms use, who use standard bookie techniques to risk manage.

Just remember, for every trade that you do, there is rational person taking the other view. And for currencies there is actually a net settlement at T+2 requiring bank transfers.

I don't pretend to fully understand the dynamics yet of the whole structure, but I'm pretty sure that economists are assuming infinite liquidity and price moves to close out demand - rather than margin calls, stop knock outs and hitting daily settlement limits.

And somewhere there is the core of why they don't get floating FX.