Forex
Domestic rate definition
Domestic rates are defined as the interest rate of currencies in their own countries expressed in real terms. By comparing the interest rates of domestic currency against the rates of foreign currencies, it may be possible for investors to identify opportunities for arbitrage transactions; these allow investors to offset lower interest rates for one currency against higher rates paid by another and derive a profit without significant risk.
Interest rate parity
The concept of interest rate parity deals with the exchange rate for currencies that have different interest rates, and presumes that no guaranteed risk-free profit can be derived through leveraging interest rates against each other on the FOREX market. For instance, if interest rate parity applies, then the returns achieved by borrowing in domestic currency at the domestic rate, then exchanging the domestic currency for foreign currency and purchasing interest-bearing securities at the foreign currency’s prevailing rate should not produce profit or loss for the investor. In reality, this is rarely exactly the case; by researching the current market conditions and offsetting the varying interest rates and exchange rates available, arbitrageurs can often achieve virtually riskless profits in the FOREX market for short periods of time. These profits typically are very small and require large investments in order to make them worthwhile, however.
Effects of domestic rates
Typically, domestic rates are determined by a combination of market factors and governmental oversight. When domestic rates are higher, international investment in bonds and government-backed securities tends to increase, drawn by the higher return on initial investment. However, money becomes tighter within the country, since there is greater demand for a limited supply of circulating currency. This can lead to negative economic effects like layoffs and unemployment, and can hinder companies from obtaining necessary funds, leading to a recession. Lower interest rates tend to discourage international investment, but can allow freer access to funds for companies looking to expand; additionally, these rates can sometimes offer opportunities for arbitrage, allowing companies to profit by international FOREX trades. The FOREX market is the largest and most liquid financial market in the world; because it is so volatile, the value of any currency is usually closely tied to an amount that yields interest rate parity with other currencies traded on the market. While arbitrage opportunities do exist, they are usually of short duration and quickly assimilated into the exchange value of currencies on the overall FOREX market.
Dollar drain definition
The accepted dollar drain definition applies to economies throughout the world, not only those using the dollar as a unit of currency. Dollar drains are trade deficits that result when imports exceed exports in monetary terms. For instance, a country that imports more goods from overseas than it exports to foreign countries is, in effect, sending its currency overseas in return for those goods. This can lead to a shortage of currency in circulation at home, creating a tight money situation in which companies have difficulty obtaining the loans and funds they need to grow or to continue operations. Consumers feel the effects of dollar drains as well, since they cannot obtain loans for the purchase of property or for other immediate needs; a shortage of currency in the home economy affects every aspect of that economy.
Major risks of dollar drains
A ready supply of circulating money is necessary for economies to engage in setting monetary policies; loosening or tightening the supply of money in the market is one of the most important tools government has in determining fiscal policy. When there is a shortage of currency in the economy, the government cannot exercise this control over the economic situation. If the dollar drain continues for a significant length of time, the government may be forced to curtail foreign purchases or to borrow heavily from other countries in order to meet its obligations. This can lead to inflation and devaluation of the currency on the international FOREX market.
Methods for addressing dollar drain
Governments experiencing dollar drains are left with limited options. They can attempt to control imports through tariffs or barriers to foreign trade; existing agreements may make this option impractical, however. The government may choose to encourage foreign investment in the country, in effect offsetting the drain on its own currency by exercising a drain on the currencies of other nations. This may not be possible in countries with significantly higher costs of living, however, since the operating costs may be too high for companies in less developed nations. Most analysts believe the long-term solution to dollar drain is to promote and encourage consumers to purchase goods manufactured in their own country where possible; this can stem the flow of currency out of the country and lessen the trade differential over time.
Denominated definition
As its name suggests, denominated securities and currencies are expressed in terms of a specific unit of currency. U.S. dollar-denominated financial instruments are issued with face values that refer to a specific amount in dollars; Chinese yuan-denominated bonds are considered in terms of yuan. Some members of the European Economic Union offer Euro-denominated securities as well; any country or organization that issues circulating currency can potentially issue financial instruments that are denominated in that currency.
Currency denomination
Currency denomination is perhaps the easiest type to recognize, since it typically is indicated on the currency itself. For instance, dollar-denominated currency has its value expressed in dollars written on the face. Currency can be converted from one denomination to another or traded in its original denomination, depending on the desired result. Denominated currency can be held in a country other than the one in which it was issued. When U.S. dollars are held in foreign banks, for example, they are called Eurodollars. This is true whether the dollar-denominated currency is deposited in a European bank or anywhere else in the world. The term Eurodollars was coined during a time when most such deposit arrangements were conducted with European banking houses, but its usage has expanded over time to include other countries as well.
Denominated bonds
Like currencies, bonds and other financial securities can be denominated as well. A denominated bond can be traded internationally, but is expressed in terms of its denominating currency. For instance, the Chinese Ministry of Finance recently announced that it would issue yuan-denominated bonds in Hong Kong in an effort to establish a foothold for the yuan in the larger international economic market and to show FOREX investors that the yuan is a viable and reliable medium for trade and investment.
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