Ultimate Stocks & Forex Trading Course: [Lesson 2] Exchange Rate Regimes

In the last video when we were talking about  central banks being participants in the foreign   exchange market we mentioned regimes and we're  going to look specifically at what exchange rate   regimes are in this module so as we know exchange  rates represents the price of one currency in   relation to the price of another currency  so exchange rates regimes are the mechanism   by which the price of currencies are managed in  order to facilitate global trade and investment   this is often done using monetary and fiscal  policies to achieve economic objectives such   as full employment and price stability  so that's controlling inflation now price   stability we will look further on in the course  at full employment and what that actually means   price stability if you take for example just as  a side note the European union and the euro area   price stability there is defined as a year-on-year  increase of below two percent and full employment   and price stability don't forget are the dual  mandate of central banks around the world   so the central drivers of currency  prices are as follows and these are   very important because these are the  factors which move the currency markets   first of all the overall economic health so you're  looking at the businesses and the consumers within   any given economy second we have monetary policy  which is very significant and monetary policy is   what comes from central banks it's the managing  of the currency in a given exchange rates regime   we then have fiscal policy these are policies  conducted by the government so instead of the   central bank is conducted by the government  such as for example the raising of taxes or   perhaps the reducing of taxes and last but not  least we have politics so what political decisions   are being made this will also have an effect on  not just GDP and the overall health of the economy   but also the currencies of any countries where  these political decisions are being made. So what you'll find is that money managers will  actually look to preempt some of the central   drivers of currency prices so they will look  to predict the economic health they will look   to predict future monetary policy future fiscal  policy and also future political decisions or the   impacts of political decisions so future impacts  of current political decisions and they will look   to place bets on the markets before these central  drivers move currency prices one way or another   so this speculation from investors based on the  outcomes or even just the perceived outcomes   of these four drivers is a significant factor  behind currency pricing and fluctuations in the   forex markets as we go through the course  you will start to realize that if we can   understand what the underlying economic health of  a country is if we can understand what monetary   policies are likely to be enacted what fiscal  policies are likely to be enacted and what   ramifications political decisions are going to  have we will actually have a very good handle on   the direction and the fundamental future movements  in the currency pairs and the markets themselves   so we're now going to look at the different types  of exchange rates regimes and the two different   types of exchange rates regimes that we're going  to look at are fixed exchange rates regimes and   floating exchange rate regimes so first of  all we're going to take a look at floating   exchange rate to regimes floating exchange rates  regimes are regimes in which prices are determined   so the price of the currency is determined by  the global supply and demand of that currency   this means that they are determined by the market  and not controlled by monetary authorities such   as governments and central banks so the two  main types of floating regimes are as follows   first of all we have what's called a free  float so a free floating exchange rate regime   a free floating exchange rate regime is a  flexible exchange rate system which is exclusively   determined by market forces so the supply  and demand of foreign and domestic currencies   so free floats operate without government  and without any central bank intervention   they are left to freely float as  the name suggests in the open market   free floating exchange rate regimes  retain monetary independence but   due to external shocks such as capital  flight or fluctuations in oil prices   free floating regimes are almost impossible to  maintain so at some point the central bank or   a government will have to step in if something  happens in an economy which destabilizes it or   could be a destabilizing force they will actually  come in to mitigate that so because of this some   level of government or central bank intervention  is usually necessary as a result of this there are   pretty much no free floating regimes in the global  economy there's some which are very close to it   however there are none which are actually  truly free floating regimes so the other type   of floating regime is a managed float and this  is by far the most common out of the two regimes   so a managed float is a flexible exchange rate  system in which governments and central banks   intervene from time to time in order to guide a  country's domestic currency value down a desired   path so this is very common this is what you'll  see in america in the UK and in the European   Union etc pretty much all of the exchange rates  regimes which are not fixed are managed floats   one of the prime objectives behind government  or central bank intervention is price stability   so this is going back to the dual mandate of the  central bank full employment price stability and   we're talking about managing inflation here and  this is primarily carried out to counter external   economic shocks as we've previously mentioned so  maybe you get an oil shock or perhaps at the time   of writing this we have an external economic shock  in the form of covid19 virus we have external   economic shock the value of the dollar let's  say explodes to the upside federal reserve steps   in to devalue the dollar makes sense so managed  floats are considered flexible exchange rates but   with the added ability to suppress currency  volatility and another way of actually looking   at price stability the managing of inflation  is also the suppression of currency volatility   the reduction of volatility in currency prices  via central bank and government intervention   so now we're going to have a look at fixed  exchange rates or pegged exchange rates you   may have heard the term before currency peg that's  what we're going to be looking at in this video   so a fixed exchange rate or a pegged exchange  rate is a regime where a country's monetary   authority so the government or the central  bank sets and maintains its exchange rate   using the price of another currency a basket  of currencies or a commodity such as gold   so fixed exchange rates are designed to limit  exchange rate volatility remember going back   to the main participants in the foreign exchange  market you have the large multinationals importers   and exporters and they have problems when  they have fluctuations large fluctuations   in the exchange rate because this causes large  fluctuations in their gross profit margins so   one reason for a fixed exchange rate is to  reduce the volatility so this actually helps   facilitate trade and actually helps importers and  exporters removing this problem of volatility in   their gross profit margins now when fixed  exchange rates fail so when pegs are broken   or they're removed enormous amounts of volatility  can actually take place making pegged currencies   potentially very risky to trade this is something  you have to understand if you are trading the   markets because we've seen historically very very  large moves and moves which have wiped people out   in the past when pegs have either been removed  or broken so some recent examples of this are   when the British pound peg was broken and the UK  crashed out of the rm in 1992 you remember that   George Soros trade which broke the bank of England  quote unquote and this was because rather than the   currency peg actually being removed by the central  bank George Soros had effectively worked out how   much foreign reserves the UK central bank had  and he placed a bet which was large enough that   he knew the central bank would not be able to  defend the peg once it came under the pressure   from the trade he was placing and also subsequent  follow-through trades from other investors   so quite famously from that trade he actually  made a billion dollars in one afternoon and also   sent interest rates through the roof in the UK and  actually puts a number of people out of business   so make up that what you will but it's certainly  a very famous trade in the financial world   a more recent example of this was in 2015 when the  swiss national bank removed the swiss franc peg   from the euro and you will remember for those  of you who are trading during that period the   SNB governor Jordan telling everybody that they  would maintain the peg and then they removed the   peg pretty unexpectedly so there's also a lesson  in there somewhere about trusting central banks   having said that traders should not really  have been wiped out during either of these   recent examples of pegs being broken or removed  and that is just by one simple understanding   which is that huge market volatility can come  from fixed exchange rates and as a result   especially if you're a new trader and generally  speaking even if you've been trading for a while   you should really filter out pegged exchange  rates and you should really be focusing on   trading floating exchange rate regimes as a rule  anybody who had done that or who understood the   risks associated with fixed exchange rates  would not have lost their shirt in those   events and this is certainly something you have  to consider when you're trading in the future   the us dollar was previously pegged to the value  of gold and this was known as the gold standard. So to maintain a fixed exchange rate a country's  monetary authority will intervene directly   by buying and selling the domestic currency   and they will use the foreign currency  that it is pegged to in order to do so. So if as an example country a fixes its exchange  rate to that of country b the monetary authorities   of country a must hold a large amount of  foreign reserves in the currency of country b   and this is because in order for a central  bank of country a to maintain a peg it   must buy and sell its own currency using or  amassing the foreign reserves of country b   so if it is buying its own currency it must use  the foreign reserves of country b so it needs to   use the currency of country b in order to buy its  own currency and if it is selling its own currency   converting out of its own currency to increase the  supply and devalue the domestic currency then it   will at the same time be amassing the currency  of country b in the form of foreign reserves. So remember in order to buy or sell one currency  another currency must be bought or sold so here   is what currency peg looks like on a chart this is  the weekly euro swiss franc chart and this was the   removal of the EurChf peg that we discussed and as  you can see the peg was actually set at 1.2000 so   the 120 peg in EurChf simply meant every time  the euro declined against the swiss franc   and approached the level of the 1.200 the Swiss  National Bank would step in and it would buy euros  

and it would be exchanging those for swiss franc  so it would be selling swiss francs and it would   be buying euros so taking those swiss francs  and buying euros with them this would actually   appreciate the value of the euro and at the same  time depreciate the value of the swiss franc   now when the swiss national bank came out  unexpectedly and announced that it would no   longer defend the peg of 1.20 this meant that  of course when the price got to the 1.20 handle   there was nobody to step in and to buy euros  converting out of swiss francs and this is   what caused a huge devaluation of the euro  against the swiss franc and this was the major   revaluation in the swiss franc about 30% to the  upside many people actually believed that this was   easy money and that they just simply placed the  stop loss at below the 1.20 and they could just   keep buying the swiss franc on every dip and they  would never get stopped out because the central   bank would step in and this was what caused a  lot of people to get wiped out when the swiss   national bank said it would no longer step in to  do that and very simply i mean this is a currency   pair you can see when the peg was in place it  really did not move a huge amount so there was   no reason there was very little reward compared  to the risk in terms of buying this to the upside   and this is why we would actually always  look to filter out pegged currency pairs   so the two main types of fixed exchange rates  regimes are Target Zones and Crawling Pegs. So first of all we're going to look at target  zones now a target zone is a fixed exchange rate   system where currency fluctuations are maintained  within a target range or with an upper bound and a   lower bound in relation to another currency or  a basket of currencies target zones themselves   can be separated into two categories the first is  known as a strong target zone and this is where   the exchange rate is maintained within a range  of plus or minus one percent around the fixed   central rate and second we have what's known as  a weak target zone and this is where the exchange   rate is allowed to fluctuate by more than plus or  minus one percent around the fixed central rate. So target zone rate systems are fixed exchanges   however they still allow for some degree of  fluctuation as would take place in a floating   exchange rate so volatility is permitted but  it is limited and remember prices will be kept   within their range within their peg by central  banks using foreign exchange reserves to do so   so the second fixed exchange rate system we're  going to look at is called a crawling peg.

Now a crawling peg is a fixed exchange rate  system where currency fluctuations are maintained   within a target range so the target zone that we  just looked at in relation to another currency. However the range is frequently adjusted by small  amounts so up or down to allow for changes in   economic data such as inflation so these small  adjustments to the target range up and down   are what gives it the name crawling peg so it is  essentially a target zone so you may for example   have a strong target zone with an upper bound  of one percent and a lower bound of one percent   but the difference between a crawling peg and a  target zone is just the target zone is in and of   itself static it doesn't move whereas the crawling  peg is a moving target zone so if you just imagine   for a moment that you have your target zone which  looks like this let's say you have your mid-range   right here this could be let's say 1.20  on any given pair and you have your plus   one percent upper bound and  below you have your minus   one percent lower bound and what will  happen is if the currency actually goes up   by one percent if it appreciates by one percent  monetary authorities will start to sell the   currency to push it back into this range and if it  starts to devalue towards the lower bound of minus   one percent below 1.20 they will start to buy the  currency to appreciate the value back in the range   so we have a range between here and here and that  becomes your target zone now imagine taking the   whole thing so you have just a rectangle like this  for example okay this is your entire target zone   and now imagine moving the whole of this zone up  and down so you keep the structures in place here   you have your plus one percent to the upside  and your minus one percent to the downside   but the one point twenty so the mid level goes up  and down and of course as the mid level goes up   so too will the lower bound and so too will the  upper bound and as the mid-level price goes down   so too will be dragged down the upper bound and  also the lower bound that is your target zone here   and the movement up and down so the changing  of the mid price becomes the crawling peg. Okay? Now this system actually allows for gradual  currency devaluation if the monetary authorities   wish to do that and it reduces the volatility  of the currency as a pegged exchange rate system   and this actually deters currency speculation  so just as we were discussing previously many   people will avoid trading pegged currency pairs  and because of this they tend to lack volatility   unless or until of course the peg breaks  or is removed by the monetary authorities. Crawling pegs are commonly used by countries with  weak currencies and as with any pegged or fixed   system this type of regime limits the ability to  operate monetary policy peg rate systems are fixed   exchanges and they're essentially target zone  systems as we discussed however the difference   is that they are frequently adjusted up and  down to allow for incoming economic data.

Just like target zone systems they do  still allow for some degree of fluctuation   as would take place in a floating exchange rate  however volatility is permitted but it is limited. So please download the attach spreadsheet  for global currencies overview and we're   going to jump over to this spreadsheet  now and have a look inside so in the   world currency overview spreadsheets that we  put together for you you can see first of all   in the a column we have the currencies by name in  the b column we have the iso 4217 code and this   is the code that you will see in your brokerage  accounts so if for example you see GBPHUF   you know that is the Great British pound against  the Hungarian Forint we have in the c column the   exchange rate regimes so if you look at the key  down here you can see that floating exchange   rates are represented with a zero and most of  these are actually represented with a zero and   fixed exchange rates or the pegged systems are  highlighted in gray and they are represented   by the number one so any currency with a one  next to it here you know is a pegged currency   and we actually have the pegs down here so for  example the danish chrono is pegged to the euro   and we have the exact peg over here so you can  see plus or minus 2.25 percent so this is what   would be a weak target zone based on  what we discussed in previous slides   you can see the Hong Kong dollar over here  is pegged to the us dollar in a range and you   can see the Singapore dollar and the Chinese yuan  are pegged to a basket of currencies and they are   undisclosed because they want to deter speculators  from placing bets on pegs breaking uh just like we   talked about with the George Soros trade and the  Bank of England previously in the f column we have   the commodity currencies so these are currencies  which are exposed to commodity prices and they   are linked to the price of commodities so if the  commodity the relevant commodity for example let's   say crude oil and the Canadian dollar if crude  oil is rising this is actually beneficial for   the Canadian dollar and these currencies which are  highlighted and labeled with one are the commodity   currencies any currency down here which has a  zero which isn't highlighted isn't a non-commodity   currency so this means that all of these  currencies here all the way down to the Singapore   dollar are not majorly influenced by commodity  prices in the way that these currencies are   in the g column we have the designation so this is  the geographical designation you can see down here   we have developed economies we have the Europe,  Middle East and African economies we have the   Asian and we have the Latin American and they're  also color coded with green blue red and yellow   and in the h column we actually have the  different central banks of the countries   which are represented by each of these currencies  and we have the links through to the central bank   websites so you can click on any of these go  straight through to the central bank and you can   view for example some of the latest releases or if  there is an interest rate decision this is where   you will find these interest rate decisions on  the actual central bank websites so as an example   you may wish to click on the federal reserve link  and this will take you through to the central bank   of the us so the federal reserve website and you  will see this will be pretty much the same format   across all of the central banks they will differ  slightly of course but generally speaking you'll   be able to click on see the latest news and  events the press releases from that central bank. And you will see you can actually access  all of the central bank statements as they   are released and as i said before this will  also include statements rate statements and   also minutes from FOMC meetings and if you  click on for example if we go back and look. At the federal reserve issues FOMC statement  on the 10th of the 6th you can see we can   click on this and this will bring up  the exact statement which is released   and this will be released straight away onto this  website this will be the first place that this   statement is actually released and as you can see  in fact talking about straight off the bat here   the promotion of its dual mandate  which we discussed in previous slides   being maximum employment full employment  and its price stability goals.

So if we just jump back to the spreadsheet  quickly uh you can see also just by applying   the filter here you can actually order  these in any which way you like you can   quite quickly just sort by smallest  largest or largest smallest to see   which currencies are in which exchange  rates regime you can see by doing the same   quite quickly which currencies are exposed to  commodity prices and which countries are not   and if you so wish as well you can actually see  which designation geographically these currencies   are by filtering these as well so finally if  you were just to click through to the second tab   here the free economic data you can see we have a  resource here which actually takes you through to   a website called trading economics we do not have  any involvement with this website we do not have   any agreements this is not a promotion or a cross  promotion or anything like that we are simply   providing you with this resource because the data  they provide is free and it is in line with the   free course that we are also providing so it is a  very good free resource if we click on for example   the top link up here which is for Australia  you will see it takes you straight through   to the website and it takes you directly to the  Australian economic data so all of this data is   actually released by the country for free so it's  free data anyway however this website compiles it   all into one place so you can very easily click  through without any cost at all and just see   what the latest economic releases are and we  will be showing you as we go through the course   what pieces of data are the most important  how to put them together to form an overall   picture of the underlying health of  the economy and how this will affect   the relevant currencies of the economy which  you're looking at so for example you can just   click on GDP annual growth rate and it will show  you the latest releases for Australian GDP etc. So that brings us to the end of this video  and you can put this spreadsheet away   and you can reference this back at any point and  hopefully you will find this useful and it'll be   a good resource to keep reference into as we  go through the course and you start to learn   more and more about the economic data and how  you can use it to form a macro economic analysis.

2021-12-11 21:07

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