forecasting techniques in foreign exchange markets

7/27/2019 Forecasting Techniques in Foreign Exchange Markets

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Executive Summary

Banks play a major role in maintaining confidence in the monetary system of a country.

This study investigates about different forecasting techniques of foreign exchange markets.

This includes different forecasting techniques which are followed by HSBC and also someother forecasting methods which I have suggested to do in stead of the current techniquesfollowed by the bank.

The foreign exchange market has played a vital role in the last decade or so in guiding thepurchase and sale of goods, services and raw materials globally. The market directly affectscountrys bond, equities, private property, manufacturing and all assets that are available toforeign investors. The market is a stabilizing factor in the world system of monetaryexchange and was created not by design but necessity.

Foreign exchange rates also play a major role in determining who finances government

deficits, which buys equities in companies and literally effects and influences the economicscenario of every nation to cope with the foreign exchange risk in an open market economy.The market has its own momentum and therefore it is crucial to follow a universal time tested

policy to tackle the forces behind the free market system with minimal risk involvement.

This study is based on both primary and secondary data, which are collected from manysources.

1.0.Introduction

Hong Kong Shanghai Banking Corporation (HSBC)

Headquartered in London, HSBC is one of the largest banking and financial servicesorganizations in the world. It began operations in Hong Kong more than 130 years ago. TheHSBC Groups international network comprises some 7,000 offices in 80 countries andterritories in Europe, the Asia-Pacific region, the Americas, the Middle East and Africa. Withlistings on the London, Hong Kong, New York and Paris stock exchanges, around 190,000shareholders in some 100 countries and territories hold shares in HSBC. Through a globalnetwork linked by advanced technology, including a rapidly growing e-commerce capability,HSBC provides a comprehensive range of financial services: personal, commercial,corporate, investment and private banking; trade services; cash management; treasury and

capital markets services; insurance; consumer and business finance;

HSBC group Vision & Values:

Become the worlds leading financial services company.

Long term, ethical client service. High productivity through teamwork. Confident and ambitious sense of excellence. Capable of creativity and strong marketing.

HSBCs Business Principal and value:


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The HSBC Group is committed to five Business Principles:

Outstanding customer service; Effective and efficient operations; Strong capital liquidity; Conservative lending policy; Strict expense discipline;

HSBC in Bangladesh

The HSBC Asia Pacific group represents HSBC in Bangladesh. HSBC opened its firstbranch in Dhaka in 17th December 1996 to provide personal banking services, trade andcorporate services, and custody services. The Bank was awarded ISO9002 accreditation forits personal and business banking services, which cover trade services, securities and safecustody, corporate banking, Hexagon and all personal banking. This ISO9002 designation isthe first of its kind for a bank in Bangladesh. The Hong Kong and Shanghai Banking

Corporation Bangladesh Ltd. primarily limited its operations to help garments industry and tocommercial banking. Latter, it is extended to pharmaceuticals, jute and consumer products.Other services include cash management, treasury, securities, and custodial service.

HSBC in Bangladesh also specializes in self-service banking through providing 24-hourATM services. In total the branch currently has 9 ATMs (5 on -site & 4 offsite) located atvarious geographical areas of Dhaka & Chittagong.

Operations of Global Markets:

HSBCs operations in Global Markets consist of treasury and capital markets services forsupranational, central banks, corporations, institutional and private investors, financialinstitutions and other market participants. Products include:

Foreign exchange;

Currency, interest rate, bond, credit, equity and otherspecialized derivatives;

Government and non-government fixed income and money market instruments;

Precious metals and exchange traded futures;

Equity services, including research, sales and trading for institutional, corporate and private

clients and asset management services, including global investment advisory and fundmanagement services; and

Distribution of capital markets instruments, including debt, equity and structured products,

utilizing links with HSBCs global networks. Corporate and Investment Banking

The main purpose of treasury is to:

Manage banks assets and liabilities. Promote and sell banks product. Manage the Banks excess/short foreign exchange products.


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Manage the banks excess/short interest rate products.Some Typical Treasury Products

Spot foreign exchange Forward foreign exchange Swaps : a) currency b) interest rate & c) structured Options : a) plain vanilla & b) complex Derivatives : a) plain vanilla & b) structured Securities : a) T-Bills and T-Bonds b) FRNs Repo & Reverse Repo : Repurchase / Sell-Buy transactions Money market : overnight and term deposits

2.0 Statement of the Problem

Now a days, competition between banks has really increased in Bangladesh as there are

quite a large numbers of banks has established in past few years. So it has really importantfor HSBC to hold up there current customers. So the management of HSBC is facing a lot ofcompetition and also thinking how they can attract new customers.

In this research I have tried to show different forecasting techniques of exchange rate,some forecasting problems in the forex markets due to technical problem or wrong predictionand also tried to recommend some solution to overcome these problems.

3.0 Purpose of the study

The purposes of this paper are to establish rational behind the activity and to enlighten acore area of operation- to forecast the exchange rate. Within the two major forecastingtechniques, more emphasis is given on the technical forecasting techniques which is followed

by HSBC and I have also tried to shown some alternative forecasting techniques and alsosuggested the best one I found based on my calculations. A detailed discussion of these is

presented in this paper.

The purpose of the study is to explore different forecasting techniques of foreign exchangemarkets, technical analysis basics of foreign exchange market, business utilization oftechnical analysis, use of technical analysis in HSBC, some risks involved in foreignexchange market and also the way to avoid mistakes in foreign exchange market

4.0 Research Time Line

2007-Sept Writing Research Proposal

2007-Sept Developing Literature Review

2007-Sept Collecting Data

2007-Oct Data Analysis and Interpretation of the Findings

2007-Nov Preparing Draft and Finalizing the Research Paper

2007-Dec Submission of the Research Paper

5.0 Limitation of the Study


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The major limitations of the technical analysis is, it may or may not produces theaccurate projections of the foreign currency rates as a large amount of dependency onthe dealers perspective. Also experience is the countable variables here, which cannot

be expressed, in any mathematical models. According to the technical forecasting techniques the market has it own destiny and

the major part of the analysis based on to determine the future. So major social oreconomical even political events can change it a lot. So dealers must be reactiverather than proactive.

Time frame for the research was very limited. Large-scale research was not possible due to constraints and restrictions posed by the

organization. Getting relevant papers and documents were strictly prohibited. The limitations that I already faced are to unable to collect local financial data, and

also direct interviewing to managers doesnt reveal many aspects of HSBC whichthey deny to answer or doesnt want to answer due to their own personal career

security at HSBC One of the main barriers in writing this report was the confidentiality of data. Though

I saw their internal procedure that is being used in processing and evaluating anydocumentary credit, but I was told strictly not to disclose that even in my internshipreport.

6.0 Literature Review

Financial markets could mean:

1. Organizations that facilitate the trade in financial products. i.e. Stock exchanges facilitatethe trade in stocks, bonds and warrants.

2. The coming together of buyers and sellers to trade financial products. i.e. stocks and sharesare traded between buyers and sellers in a number of ways including: the use of stockexchanges; directly between buyers and sellers etc.

In academia, students of finance will use both meanings but students of economics will onlyuse the second meaning.

Financial markets can be domestic or they can be international.

The foreign exchange (currency or forex or FX) market exists wherever one currency istraded for another. It is by far the largest financial market in the world, and includes tradingbetween large banks, central banks, currency speculators, multinational corporations,governments, and other financial markets and institutions. The average daily trade in theglobal forex and related markets currently is over US$ 3 trillion. Retail traders (individuals)are a small fraction of this market and may only participate indirectly through brokers or

banks, and are subject to forex scams

The term FOREX is derived from the words Foreign exchange and is the largest financialmarket in the world. Unlike many markets the FX market is open 24 hours per day and has anestimated $1.2 Trillion in turnover every day. This tremendous turnover is more than the

combined turnover of the main worlds stock markets on any given day. This trends to lead toa very liquid market and thus a desirable market to trade.


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Unlike many other securities (any financial instrument that can be traded) the FX marketdoes not have a fixed exchange. It is primarily traded through banks, brokers, dealers,financial institutions and private individuals.

The Foreign Exchange market is a worldwide network which connects the various

national exchange markets by telephone and telex etc, either directly or via brokers, totransact foreign exchange business.

The Foreign Exchange, also referred to as the Forex or Spot FX market, is the largest

financial market in the world. Money is traded in the FX market. Forex trading is where thecurrency of one nation is traded for that of another. Therefore, Forex trading is always tradedin pairs. The most commonly traded currency pairs are traded against the US Dollar (USD).They are called the Majors. The major currency pairs are the Euro Dollar (EUR/USD); the

British Pound (GBP/USD); the Japanese Yen (USD/JPY); and the Swiss Franc (USD/CHF).

The notable commodity currency pairs that trade are the Canadian Dollar (USD/CAD) and

the Australian Dollar AUD/USD. Because there is not a central exchange for the Forexmarket, these pairs and their crosses are traded over the telephone and online through a globalnetwork of banks, multinational corporations, importers and exporters, brokers and currencytraders.

Technical analysis is the study of market action, primarily through the use of charts, forthe purpose of forecasting future price trends. In its purest form, technical analysis considers

only the actual price behavior of the market or instrument, based on the premise that pricereflects all relevant factors before an investor becomes aware of them through other channels.

Technical analysis is widely used among traders and financial professionals, and somestudies say its use is more widespread than is fundamental analysis in the foreign exchange

market. Academics such as Eugene Fama say the evidence for technical analysis is sparse andis refuted by the efficient market hypothesis, yet some Federal Reserve and academic studiesinclude evidence that supports technical analysis. MIT finance professor Andrew Lo arguesthat several academic studies suggest thattechnical analysis may well be an effective

means for extracting useful information from market prices. Burton Malkiel argues,Technical analysis is anathema to the academic world. He further argues that under the

weak form of the efficient market hypothesis, you cannot predict future stock prices from

past stock prices.

7.0 Forecasting techniques in the foreign exchange markets:

Currently there are widely accepted two alternative techniques for forecasting, namely

1. Fundamental Analysis

2. Technical Analysis

7.1 Fundamental Analysis

A method of currency valuation which involves examining the countries financial figures

like import/exports, balance of trade, reserve on currency, political and economical news etc.


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Fundamental analysis takes into consideration only those variables that are directly related tothe country itself, rather than the overall state of the market or technical analysis data.

Fundamental analysis is the examination of the underlying forces that affect the well being ofthe economy, industry groups, and companies. As with most analysis, the goal is to derive a

forecast and profit from future price movements. At the company level, fundamental analysismay involve examination of financial data, management, business concept and competition.At the industry level, there might be an examination of supply and demand forces for the

products offered. For the national economy, fundamental analysis might focus on economicdata to assess the present and future growth of the economy. To forecast future stock prices,fundamental analysis combines economic, industry, and company analysis to derive a stockscurrent fair value and forecast future value. If fair value is not equal to the current stock price,fundamental analysts believe that the stock is either over or under valued and the market

price will ultimately gravitate towards fair value. Fundamentalists do not heed the advice ofthe random walkers and believe that markets are weak-form efficient. By believing that pricesdo not accurately reflect all available information, fundamental analysts look to capitalize on

perceived price discrepancies.

7.1. a General Steps to Fundamental Evaluation

Even though there is no one clear-cut method, a breakdown is presented below in theorder an investor might proceed. This method employs a top-down approach that starts withthe overall economy and then works down from industry groups to specific companies. As

part of the analysis process, it is important to remember that all information is relative.Industry groups are compared against other industry groups and companies against othercompanies. Usually, companies are compared with others in the same group. For example, atelecom operator (City cell) would be compared to another telecom operator (GremeenPhone), not to an Electronics company (Philips).

7.1. b Economic Forecast

First and foremost in a top-down approach would be an overall evaluation of the generaleconomy. The economy is like the tide and the various industry groups and individualcompanies are like boats. When the economy expands, most industry groups and companies

benefit and grow. When the economy declines, most sectors and companies usually suffer.Many economists link economic expansion and contraction to the level of interest rates.Interest rates are seen as a leading indicator for the stock market as well.

Below is a chart of the S&P 500 and the yield on the 10-year note over the last 30 years.Although not exact, a correlation between stock prices and interest rates can be seen. Once ascenario for the overall economy has been developed, an investor can break down theeconomy into its various industry groups.

7.2 Technical Analysis

In contrast to the efficient market hypothesis or fundamental analysis, technical analysisinvolves the examination of past data like prices and volume of trading, which leads to anestimation of future price trends and there of an investment decision. Technical analysis dont

require any analysis of the multitude of economic, industry and company variables to arrive


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at an estimate of future value because they believe that past price movements will signalfuture price movements.

7.2. a Underlying assumptions of technical analysis

1. The market value of any goods and service is determined solely by the interaction ofsupply and demand

2. Supply and demand is governed by numerous factors, both rational and irrational.

3. Disregarding minor fluctuations, the prices for individual securities and the overall valueof the market tend to move in trends, which persists for appreciable length of time

4. Prevailing trends change in reaction to shifts in supply and demand relationships. Theseshifts, no matter why they occur can be detected sooner or later in the action of the marketitself.

(Figure: 1- A chart of the S&P 500 and the yield on the 10-year note over the last 30 years)

7.2. The main considerations in Technical Analysis

Price: Changes in price reflect in investor attitudes and demand and supply of securities.

Time: The degree of movements in price is a function of time. The longer it takes for areversal in trend for instance, the greater the price changes that would follow.

Volume: The intensity of price changes is reflected in the volume transactions thataccompany the changes. An increase is not strong enough.

Breadth: Study of Breadth of market indicators, the extent to which the price changes have

taken place in the market in accordance with a certain overall limit.


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8.0 Research Methodology:

8.1 Research Design:

Source of Data

Both the primary as well as the secondary form of data was used to prepare the report. Thedetails of these sources are highlighted below:

8.1. a Primary Sources

Major sources of primary information were discussions with Mr. Wahiduzzaman and Md.Bahaudding Saad, Dealers of global markets.

8.1.b Secondary Sources

Secondary information was collected from relevant documents and literature, HSBCInternet web sites, ABC guide to foreign exchange, treasury.

Other secondary sources were books on foreign exchange and treasury back office stuffs.

8.2 Data Collection

For data collection I have interviewed dealers of global markets and also the treasurer ofglobal market. I have asked them many questions about my related topics. Some questionsare:

What are the operations of Global Markets? What are the main purposes of Treasury? What are the Treasury products HSBC is using right now? What are the forecasting techniques of foreign exchange market? What are the Basic for technical analysis?

8.3 Data Analysis

Here are some Forecasting Techniques followed by HSBC in their Foreign ExchangeMarkets:

8.3.1 Technical Analysis Basics

8.3.1. a Rationale

Examination of the past price movements to forecast future movements

Price Discounts Everything

Price Movements are not Totally Random

What is More Important than Why


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Disciplinedivorce yourself from emotions

Volume for Stock, Open Interest & volume for Futures

8.3.1. b Types of Charts

Line, Bar, Candle, Points & Figure Etc

(Figure: 2- Types of charts used in forecasting)

(Figure: 3- A price chart that displays the high, low, open, and close for a security each day over a

specified period of time)8.3.1. c Candle Chart

8.3.1. d Why Use Candle charts


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Make use of your opportunities. (Japanese proverb)

The candlestick techniques we use today originated in the style of technical charting used bythe Japanese for over 100 years before the West developed the bar and point-and-figureanalysis systems. In the 1700s a Japanese man named Homma, a trader in the futures market,

discovered that, although there was a link between price and the supply and demand of rice,the markets were strongly influenced by the emotions of the traders. He understood that whenemotions played into the equation a vast difference between the value and the price of riceoccurred. This difference between the value and the price is as applicable to stocks today as itwas to rice in Japan centuries ago. The principles established by Homma are the basis for thecandlestick chart analysis, which is used to measure market emotions towards a stock.

This charting technique has become very popular among traders. One reason is that thecharts reflect only short-term outlookssometimes lasting less than eight to 10 tradingsessions.

A big difference between the bar charts common in North America and the Japanesecandlestick line is the relationship between opening and closing prices. We place moreemphasis on the progression of todays closing price from yesterdays close. In Japan,

chartists are more interested in the relationship between the closing price and the openingprice of the same trading day.

8.3.2 Followings are some other Forecasting Techniques in which I have shown the

calculations of forecasting foreign exchange rates and also based on the result I made

recommendation for HSBC which they can be used instead of their current method:

Moving Average:

In the moving average method, we use the most recent n data values in the time series asthe forecast for the next period. Mathematically, the moving average calculation is made asfollows:

Moving Average= (most recent n data values)/n

The term moving is used because every time a new observation becomes available for the

time series, it replaces the oldest observations, and a new average is computed. The averagechanges, or moves, as new observations become available.

(See Appendix: 4- Calculation of moving average)

Exponential Smoothing Average:

Exponential smoothing uses a weighted average of past time values as the forecast, it isspecial case of the weighted moving averages method in which we select only one weight-theweight for the most recent observation. The weights for the other data values are computedautomatically and become smaller as the observations move farther into the past. The basicexponential smoothing model follows:

Exponential Smoothing Average, F (t+1)=Yt+(1-)Ft


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Where,

F (t+1) =forecast of the time series for period t+1

Yt =actual value of the time series in period t

Ft=forecast of the time series for period t

=smoothing constant (01)

Or we can use the simplified form,

F(t+1)=0.2Yt+0.8Ft

(See Appendix: 5- Calculation of exponential smoothing average)

Seasonal Variation:

Seasonal variation is the patterns of change in a time series within a year. These patternstend to repeat themselves each year.

The third component of a time series is the seasonal component. Many sales, production,and other series fluctuate with the seasons. The unit of time reported is either quarterly ormonthly.

Almost all businesses tend to have recurring seasonal patterns. Mens and boys clothing,

for example, have extremely high sales just prior to Christmas and relatively low sales justafter Christmas and during summer.

In the following Graph I will show you the comparison between different forecasting ratewith the actual market rate (See appendix: 7):

Among the three forecasting techniques, I think the moving average technique is the mostappropriate, because from the graph you can see that among the three techniques the moving


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average techniques has the least spread than the other techniques compared to the actualforecasting techniques.

And also from the mean calculation(See-Appendix: 7),we can see that the spread betweenMoving Average method and the Actual Market rate is the least, which is 0.116172778,and it

is the closest amongst the other methods. So, I can suggest HSBC to use the moving averagemethod if they wants to change their current Forecasting Method.

9.0 Discussion

9.1 Business utilization of technical analysis

9.1.1 Bangladesh inter-bank Foreign Exchange Market

9.1.1. a Inter-Bank Transaction in Foreign Exchange

The volume of inter-bank foreign exchange transaction maintained a downward trend till year2006 but started to move upward from the year 2006. In year 2006-2007, the inter-banktransactions in foreign exchange were totaled US$13,705,791.14, which has increased by6,709,141.064 compared with the preceding year total US$ 6,996,650.076 (See appendix 1).

Total transactions in the inter-bank foreign exchange market from the year 2002-2007 weregiven into a graph as under.

Monthly position of inter-bank transactions was uneven over the period due to unpredictabledemand and supply position in the inter-bank market.

Month-wise position of inter-bank transaction in foreign exchange for last twelve months isgiven below in a graphical form. It appears from the graph that the highest transaction took

place in June-July 2007, over the last 12 months period (see appendix 2).


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Inter-bank foreign exchange transactions have been going on smoothly despite declining thetrend of transaction volume from July 2007. The transactions equivalent in million U.S.

Dollar in the inter-bank foreign exchange market during July-Sept, 2007 were the followings-17914318.18, 16027368.42, and

10396500(equivalent in US Dollar), from which we can see very easily that the transactionvolume is declining month by month.

9.1.1. b Quarterly transactions of USD/BDT and Other FCY/BDT Transaction

FCY/BDT Market has experienced much unsteady condition over the period in current year.

The volume of other FCY/BDT transactions incredibly increased during second quarter, theamount equal to 1478914.474, and after that during third and forth quarter it again declinedand reach almost to its earlier position.

On the other hand, USD/BDT transactions decreased from 13738515.63 to 10706875 duringthe second quarter, but after that it again started moving upward and reached to15385873.02during the fourth quarter (see appendix 4).

This is happened mainly due to supply of U.S. Dollar in the inter-bank forex market and pricehike of importable products like petroleum & petroleum products and other essentialcommodities in the international market. A comparative position showing quarterlymovement of USD/BDT and other FCY/BDT transactions for the current year is given ingraph:


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The volume of BDT trades against USD decline during the second quarter due to the higher

demand of import payments as well as the official rate declared against the USD/BDT by thecentral bank. According to the official sources from Central Bank USD/BDT rates are 68.61taka (as of Nov 07) whereas the underlying rates of BDT against FCY reaches Tk69.50.Comparing average TT clean buying rates of the commercial banks operated into this marketstands at 68.80 on 15Nov06 and selling rates at 69.80 (refers appendix 6). The difference

between these 1..00 taka between the official and actual markets rates insist the volume ofFCY deals against BDT thus originating more cross currency trading.

9.2 The use of Technical analysis in Bangladesh

The use of forecasting techniques can play major role in the increasing amount of

transactions into the inter-bank foreign exchange markets in the third currency. The reasonsunderlying these transactions are mainly the Spot currency speculations as well as theobligations arise from the imports and governments payments.

In order to minimize the risk and to gain the opportunity over the global currency marketsthe introduction of the technical analysis help the speculators and give the importer orexporter the opportunity to hedge their currency positions.

9.2.1 Importers point of views

If major trends can be identified in advance the dealers can advise the importer in advance tocover the risk through forwards or even within the day transactions.

Suppose an importer opens a L/C of GBP1.00 million and the current market rate againstGBP= USD 2.0655 and USD= TK 68.6050. if the documents have to retire today theimporter have to pay Tk141.7036 million today.

But utilizing the technical analysis, if the major trends can be identified, the importer canhedge their obligations as per the trend, i.e. if the trend is upward in both GBP/USD andUSD/BDT, hedge it today through spot of forward or if the trend in downward use themaximum period before the payments due date.

9.2.2 Exporters point of views


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Similar to an importer, if an exporter due to receive currency like GBP or USD against theexport documents, can position accordingly to the major outlooks of the underlying currencyhe/she will receive.

In the current scenario in USD/BDT as the market is in favor of USD, the exporter should try

to lag his/her export proceeds in order to get deprecated rates over Taka.

10.0 Significance of the Study

The foreign exchange market has played a vital role in the last decade or so in guiding thepurchase and sale of goods, services and raw materials globally. The market directly affectscountrys bond, equities, private property, manufacturing and all assets that are available toforeign investors. The market is a stabilizing factor in the world system of monetaryexchange and was created not by design but by necessity.

Foreign exchange rates also play a major role in determining who finances government

deficits, which buys equities in companies and literally effects and influences the economicscenario of every nation to cope with the foreign exchange risk in an open market economy.The market has its own momentum and therefore it is crucial to follow a universal time tested

policy to tackle the forces behind the free market system with minimal risk involvement.

The research will draw various forecasting techniques in the foreign exchange market, basicsof the technical analysis, business utilization of the technical analysis and also the utilizationof the technical analysis in Bangladesh.

And finally the research has also described about some of the mistakes made in the forexmarkets and also some techniques to avoid the mistakes in the forex markets which thedealers apply while doing their works.

11.0 Risks Involved in foreign exchange

On the foreign exchange market one discerns the following kinds of the risks:

Exchange rate risk; Interest rate risk; Credit risk; Country risk.

11.1. Exchange Rate Risk

Exchange rate risk is a consequence of the continuous shift in the worldwide market supplyand demand balance on an outstanding foreign exchange position. A position will be asubject to all the price changes as long as it is outstanding. In order to cut losses short andride profitable positions that losses should be kept within manageable limits. The most

popular steps are the position limit and the loss limit. The limits are a function of the policyof the banks along with the skills of the traders and their specific areas of expertise. There aretwo types of position limits: daylight and overnight.

1. The daylight position limit establishes the maximum amount of a certain currency which atrader is allowed to carry at any single time during.


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The limit should reflect both the traders level of trading skills and the amount at which atrader peaks.

2. The overnight position limit which should be smaller than daylight limits refers to anyoutstanding position kept overnight by traders. Really, the majority of foreign exchange

traders do not hold overnight positions.

The loss limit is a measure to avoid unsustainable losses made by traders; which is enforcedby the senior officers in the dealing center. The loss limits are selected on a daily andmonthly basis by top management.

The position and loss limits can now be implemented more conveniently with the help ofcomputerized systems which enable the treasurer and the chief trader to have continuous,instantaneous, and comprehensive access to accurate figures for all the positions and the

profit and loss. This information may also be delivered from all the branches abroad into theheadquarters terminals.

Trading 106

11.2. Interest Rate Risk

Interest rate risk is pertinent to currency swaps, forward out rights, futures, and options. Itrefers to the profit and loss generated by both the fluctuations in the forward spreads and byforward amount mismatches and maturity gaps among transactions in the foreign exchange

book. An amount mismatch is the difference between the spot and the forward amounts. Foran active forward desk the complete elimination of maturity gaps is virtually impossible.However, this may not be a serious problem if the amounts involved in these mismatches aresmall. On a daily basis, traders balance the net payments and receipts for each currencythrough a special type of swap, called tomorrow/next or rollover.

To minimize interest rate risk, management sets limits on the total size of mismatches. Thepolicies differ among banks, but a common approach is to separate the mismatches, based ontheir maturity dates, into up to six months and past six months. All the transactions areentered in computerized systems in order to calculate the positions for all the delivery datesand the profit and loss. Continuous analysis of the interest rate environment is necessary toforecast any changes that may impact on the outstanding gaps.

11.3. Credit Risk

Credit risk is connected with the possibility that an outstanding currency position may not berepaid as agreed, due to a voluntary or involuntary action by a counter party. In these cases,trading occurs on regulated exchanges, where all trades are settled by the clearing house. Onsuch exchanges, traders of all sizes can deal without any credit concern.

The following forms of credit risk are known:

1. Replacement risk which occurs when counter parties of the failed bank find their booksunbalanced to the extent of their exposure to the insolvent party. To rebalance their books,

these banks enter new transactions.


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2. Settlement risk which occurs because of different time zones on different continents. Sucha way, currencies may be credited at different times during the day. Australian and NewZealand dollars are credited first, then Japanese yen, followed by the European currenciesand ending with the U.S. dollar. Therefore, payment may be made to a party that will declareinsolvency (or be declared insolvent) immediately after, but prior to executing its own

payments.

The credit risk for instruments traded off regulated exchanges is to be minimized through thecustomers creditworthiness. Commercial and investment banks, trading companies, and

banks customers must have credit lines with each other to be able to trade. Even after the

credit lines are extended, the counter parties financial soundness should be continuouslymonitored. Along with the market value of their currency portfolios, end users, in assessingthe credit risk, must consider also the potential portfolios exposure. The latter may bedetermined through probability analysis over the time to maturity of the outstanding position.For the same purposes netting is used. Netting is a process that enables institutions tosettle only their net positions with one another not trade by trade but at the end of the day, in

a single transaction. If signs of payment difficulty of a bank are shown, a group of largebanks may provide short-term backing from a common reserve pool.

Successful Trading 108

11.4. Country Risk

The failure to receive an expected payment due to government interference amounts to theinsolvency of an individual bank or institution, a situation described under credit risk.Country risk refers to the governments interference in the foreign exchange markets and falls

under the joint responsibility of the treasurer and the credit department. Outside the majoreconomies, controls on foreign exchange activities are still present and actively implemented.

For the traders it is important to know or be able to anticipate any restrictive changesconcerning the free flow of currencies. If this is possible, though trading in the affectedcurrency will dry up considerably, it is still a manageable situation

12.0 Recommendation

Followings are some methods of avoiding foreign exchange risks:

Dont read the news-analyze the news: Many times, seemingly straight forwardnews releases from government agencies are really public relation vehicles to advancea particular point of view or policy. Such news, in the forex markets more than anyother, is used as a tool to affect the investment psychology of the crowd. Such mediamanipulation is not inherently a negative. Governments and traders try to do that allthe time. The new forex trader must realize that it is important to read the news toassess the message behind the drums.

Dont trade surges: A price surge is a signature of panic or surprise. InReproduction or use of the text or pictorial content in any manner without written

permission is prohibited. Copyright 2002 by Futures Magazine Group, 250 S. Wacker

Dr., Suite 1150, Chicago, IL60606 these events, professional traders take cover andsee what happens. The retail trader also should let the market digest such shocks.


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Trading during an announcement or right before, or amid some turmoil, minimizes the oddsof predicting the probable direction. Technical indicators during surge periods will bedistorted. You should wait for a confirmation of the new direction and remember that priceaction will tend to revert to pre-surge ranges providing nothing fundamental has occurred.

Simple is better: The desire to achieve great gains in forex trading can drive us tokeep adding indicators in a never-ending quest for the impossible dream.

Similarly, trading with a dozen indicators is not necessary. Many indicators just addredundant information. Indicators should be used that give clues to:1) trend direction, 2)resistance, 3) support and 4) buying and selling pres sure.

13.0 Conclusion

Technical analysts consider the market to be 80% psychological and 20% logical.Fundamental analysts consider the market to be 20% psychological and 80% logical. It may

be open for debate, but there is no questioning on the current price. After all, it is availablefor all to see and nobody doubts its legitimacy. The price set by the market reflects the sumknowledge of all participants, and we are not dealing with lightweights here. These

participants have considered (discounted) everything under the sun and settled on a price tobuy or sell. These are the forces of supply and demand at work. By examining price action todetermine which force is prevailing, technical analysis focuses directly on the bottom line:What is the price? Where has it been? Where is it going?

Even though there are some universal principles and rules that can be applied, it must beremembered that technical analysis is more a practitioners things form than a science. As

over time form, it is subject to interpretation. However, it is also flexible in approach andeach trader should use only that which suits his/her style. Developing a style takes time,effort and dedication, but the rewards can be significant.

Todays markets are incredibly volatile. Plus, thousands competing against HSBC who are

constantly looking for an edge. The market risk is very real, and can be daunting if HSBCis not prepared. Thats why need a trading strategy that will help to reduce risk and ensure

reward.

Appendix

Appendix1: Inter-Bank Transaction in Foreign Exchange on Yearly Basis:

CalendarYear

Total transactions(Spot and Forward-equivalentin US Dollar)

02-03 11,574,579.4403-04 10,754,685.9204-05 8,590,738.17505-06 6,996,650.07606-07 13,705,791.14

Appendix 2: Month to Month Inter-Bank Transaction in Foreign Exchange:

Month Amount(Equivalent in US


19/22

Dollar)Sep-06 13,673,250Oct-06 9,867222.222

Nov-06 8,601,500Dec-06 13,885,833.33

Jan-07 12,730,526.32Feb-07 13,128,947.37Mar-07 14,814,868.42Apr-07 13,628,571.43

May-07 14,623,809.52Jun-07 17,905,238.1Jul-07 17,914,318.18

Aug-07 16,027,368.42Sep-07 10,396,500

Appendix3: Quarterly transactions of USD/BDT and Other FCY/BDT Transaction in the

inter-bank markets:

Quarters of yearJuly2006-Jun2007

USD/BDTTransaction FCY/BDT Transaction

1st Quarter 13738515.63 746,640.6252nd Quarter 10706875 1,478,914.4743rd Quarter 13558114.04 677,216.43884th Quarter 15385873.02 675,238.0952

Appendix 4: Summary of 23 months Moving Average Calculations:

Summary of the 12 months moving average calculation

MonthDaily marketRate Moving average forecast Forecast error

Squared forecasterror

January-06 68.65492February-06 70.23846

March-06 72.13497April-06 70.63066 70.34278333 0.287876667 0.082872975May-06 69.89733 71.00136333 -1.104033333 1.218889601June-06 70.2956 70.88765333 -0.592053333 0.35052715July-06 70.37398 70.27453 0.09945 0.009890303

August-06 70.18733 70.18897 -0.00164 2.6896E-06September-06 68.33639 70.28563667 -1.949246667 3.799562568October-06 67.58447 69.63256667 -2.048096667 4.194699956

November-06 71.76473 68.70273 3.062 9.375844December-06 70.11912 69.22853 0.89059 0.793150548

January-07 70.26637 69.82277333 0.443596667 0.196778003February-07 69.4276 70.71674 -1.28914 1.66188194

March-07 69.21849 69.93769667 -0.719206667 0.517258229April-07 69.28277 69.63748667 -0.354716667 0.125823914May-07 69.3557 69.30962 0.04608 0.002123366June-07 69.24568 69.28565333 -0.039973333 0.001597867

July-07 68.9061 69.29471667 -0.388616667 0.151022914August-07 69.00869 69.16916 -0.16047 0.025750621


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September-07 69.33975 69.05349 0.28626 0.081944788October-07 69.423 69.08484667 0.338153333 0.114347677

November-07 69.57957 69.25714667 0.322423333 0.103956806

5. Summary of the 15 months exponential smoothing average calculation:

Summary of the 15 months exponential smoothing average calculationMonth Rate (Yt) Exponential Smoothing Forecast (Ft) Forecast Error

Jan-06 68.65492Feb-06 70.23846 68.65492 1.58354Mar-06 72.13497 68.971628 3.163342Apr-06 70.63066 69.6042964 1.0263636

May-06 69.89733 69.8096 0.08773Jun-06 70.2956 69.82718 0.46842Jul-06 70.37398 69.9209 0.45308

Aug-06 70.18733 70.0115 0.17583

Sep-06 68.33639 70.0467 -1.71031Oct-06 67.58447 69.7047 -2.12023

Nov-06 71.76473 69.2807 2.48403Dec-06 70.11912 69.7775 0.34162Jan-07 70.26637 69.8458 0.42057Feb-07 69.4276 69.92994 -0.50234Mar-07 69.21849 69.8295 -0.61101Apr-07 69.28277 69.707298 -0.424528

May-07 69.3557 69.6223924 -0.2666924Jun-07 69.24568 69.56905392 -0.32337392

6. Summary of the 12 months Seasonal irregular values:Summary of the 12 months Seasonal irregular values

Year Quarter RateFour quartertotal

Four quarter movingaverage

Centered movingaverage

Seasonal-Irregular Value

2006 1 70.342782 70.274533 69.63257 280.0726533 70.01816333 69.9300013 1.0012607194 69.82277 279.3673567 69.84183917 69.7193625 1.00175671

2007 1 69.63749 278.3875433 69.59688583 69.5284208 1.0009847052 69.29472 277.8398233 69.459955833 69.08485

7. Comparison of Different forecasted rates with the Actual Market rate:

Comparison of Different forecasted rates with the Actual Market rate

MonthMoving averageforecast

Centered movingaverage

Exponential SmoothingForecast (Ft)

Actual MarketRate

Jan-06 68.65492Feb-06 68.65492 70.23846Mar-06 68.971628 72.13497Apr-06 70.34278333 69.6042964 70.63066

May-06 71.00136333 69.8096 69.89733

Jun-06 70.88765333 69.82718 70.2956Jul-06 70.27453 69.93000125 69.9209 70.37398


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Aug-06 70.18897 69.93000125 70.0115 70.18733Sep-06 70.28563667 69.93000125 70.0467 68.33639Oct-06 69.63256667 69.7193625 69.7047 67.58447

Nov-06 68.70273 69.7193625 69.2807 71.76473Dec-06 69.22853 69.7193625 69.7775 70.11912

Jan-07 69.82277333 69.52842083 69.8458 70.26637Feb-07 70.71674 69.52842083 69.92994 69.4276Mar-07 69.93769667 69.52842083 69.8295 69.21849Apr-07 69.63748667 69.707298 69.28277

May-07 69.30962 69.6223924 69.3557Jun-07 69.28565333 69.56905392 69.24568Mean- 69.9503155669.72592819 69.65374169 69.83414278

8. Exchange rates of Commercial Banks to public for Us Dollar

U. S. Dollar

SL. Spot Buying Spot SellingNo. Name of Bank T.T. O.D.Sight O.D. T.T. & B.C.

Clean Exp. Bills Transfer O.D.1 Agrani Bank 68.0200 68.0000 67.7500 68.9200 68.97002 Al-Arafah Islami Bank Limited 68.5500 68.4705 68.3900 69.6300 69.65003 Arab Bangladesh Bank Limited 69.0500 68.9500 68.5332 69.9400 69.99004 Bangladesh Krishi Bank 68.0700 68.0500 67.8300 68.9500 69.00005 Bangladesh Shilpa Bank 68.0200 68.0000 67.7400 68.9200 68.97006 BASIC Bank Limited 68.5500 68.4000 68.3000 69.5700 69.60007 Bank Asia Limited 68.9500 68.9069 68.4674 69.9000 69.95008 BRAC Bank Limited 68.7500 68.7264 68.7130 69.7000 69.74009 Citibank, N.A. 68.9000 68.8700 68.6656 69.9200 69.9500

10 Commercial Bank of Ceylon Ltd. 68.9000 68.8732 68.7641 69.9150 69.945011 Dhaka Bank Limited 68.8900 68.7369 68.4681 69.8200 69.880012 Dutch-Bangla Bank Limited 68.7200 68.6265 68.0786 69.7000 69.750013 Eastern Bank Limited 68.8500 68.7429 68.3910 69.8700 69.900014 EXIM Bank Limited 68.5500 68.4500 68.3539 69.4700 69.500015 First Security Bank Limited 68.0500 67.8650 67.5150 69.2000 69.250016 Habib Bank Limited 68.3000 68.4600 68.6200 69.4700 69.500017 HSBC Limited 68.8837 68.8795 68.6705 69.9206 69.944718 IFIC Bank Limited 68.6945 68.5075 68.1335 69.4775 69.5075

19 Islami Bank Bangladesh Limited 68.5000 68.4500 68.2500 69.4500 69.500020 Janata Bank 68.0200 68.0000 67.7400 68.9200 68.970021 Jamuna Bank Limited 68.6000 68.4105 68.1732 69.6750 69.700022 Mercantile Bank Limited 68.7000 68.5000 68.2592 69.6500 69.700023 Mutual Trust Bank Limited 68.7000 68.4023 68.1790 69.6700 69.700024 National Bank Limited 68.5000 68.4100 68.1600 69.4500 69.500025 NCC Bank Limited 68.9000 68.8000 68.7000 69.8500 69.900026 ONE Bank Limited 68.6340 68.6022 68.2147 69.5500 69.600027 Prime Bank Limited 68.9000 68.7124 68.4981 69.8500 69.900028 Pubali Bank Limited 68.4500 68.3500 68.3000 69.4500 69.500029 Rupali Bank Limited 68.2500 68.2000 68.0000 69.2300 69.2500

30 Shahjalal Islami Bank Limited 68.8500 68.6626 68.2074 69.8600 69.900031 Social Investment Bank Limited 68.9000 68.7401 68.1912 69.7500 69.8000


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32 Sonali Bank 68.0200 68.0000 67.7400 68.9200 68.970033 Southeast Bank Limited 68.7500 68.5500 68.1000 69.6500 69.750034 Standard Bank Limited 68.9000 68.8001 68.7003 69.8600 69.900035 Standard Chartered Bank 68.9000 68.8770 68.8311 69.9200 69.950036 State Bank of India 68.6500 68.6175 68.3700 69.6500 69.7000

37 The City Bank Limited 68.9000 68.8062 68.4558 69.7800 69.850038 The Oriental Bank Limited 67.8000 67.6995 67.5682 68.8500 68.900039 The Premier Bank Limited 68.0500 67.8912 67.7551 69.2000 69.250040 The Trust Bank Limited 68.9500 68.8500 68.5500 69.8000 69.850041 United Commercial Bank Limited 68.8500 68.7500 68.5900 69.8200 69.850042 Uttara Bank Limited 68.4400 68.3403 68.1350 69.4500 59.5000

Average 68.5908 68.4985 68.2631 69.5607 69.3664

forecasting techniques in foreign exchange markets

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