Economic Indicators part one

tags: The Gross Domestic Product (GDP),Factory Orders,Inflation Indicators,Construction Indicators,Business Inventories,Durable Goods Orders,Consumption Spending,Investment Spending,Government Spending,Net Trade,Industrial Production,Capacity Utilization
Economic indicators occur in a steady stream, at certain times, and a little more often than changes in interest rates, governments, or natural activity such as earthquakes etc. Economic data is generally (except of the Gross Domestic Product and the Employment Cost Index, which are released quarterly) released on a monthly basis.

Economic Indicators part one

All economic indicators are released in pairs. The first number reflects the latest period. The second number is the revised figure for the month prior to the latest period. For instance, in July, economic data is released for the month of June, the latest period. In addition, the release includes the revision of the same economic indicator figure for the month of May. The reason for the revision is that the department in charge of the economic statistics compilation is in a better position to gather more information in a month's time. This feature is important for traders. If the figure for an economic indicator is better than expected by 0.4 percent for the past month, but the previous month's number is revised lower by 0.4 percent, then traders are likely to ignore the overall release of that specific economic data.

Economic indicators are released at different times. In the United States, economic data is generally released at 8:30 and 10 am ET. It is important to remember that the most significant data for foreign exchange is released at 8:30 am ET. In order to allow time for last-minute adjustments, the United States currency futures markets open at 8:20 am ET.

Information on upcoming economic indicators is published in all leading newspapers, such as the Wall Street Journal, the Financial Times, and the New York Times; and business magazines, such as Business Week. More often than not, traders use the monitor sources—Bridge Information Systems, Reuters, or Bloomberg—to gather information both from news publications and from the sources' own up-to-date information.

The Gross National Product (GNP)

The Gross National Product measures the economic performance of the whole economy.

This indicator consists, at macro scale, of the sum of consumption spending, investment spending, government spending, and net trade. The gross national product refers to the sum of all goods and services produced by United States residents, either in the United States or abroad.

The Gross Domestic Product (GDP)

The Gross Domestic Product (GDP) refers to the sum of all goods and services produced in the United States, either by domestic or foreign companies. The differences between the two are nominal in the case of the economy of the United States. GDP figures are more popular outside the United States. In order to make it easier to compare the performances of different economies, the United States also releases GDP figures.

Consumption Spending

Consumption is made possible by personal income and discretionary income. The decision by consumers to spend or to save is psychological in nature. Consumer confidence is also measured as an important indicator of the propensity of consumers who have discretionary income to switch from saving to buying.

Investment Spending

Investment—or gross private domestic spending - consists of fixed investment and inventories.

Government Spending

Government spending is very influential in terms of both sheer size and its impact on other economic indicators, due to special expenditures. For instance, United States military expenditures had a significant role in total U.S. employment until 1990. The defense cuts that occurred at the time increased unemployment figures in the short run.

Net Trade

Net trade is another major component of the GNP. Worldwide internationalization and the economic and political developments since 1980 have had a sharp impact on the United States' ability to compete overseas. The U.S. trade deficit of the past decades has slowed down the overall GNP. GNP can be approached in two ways: flow of product and flow of cost.

Industrial Production

Industrial production consists of the total output of a nation's plants, utilities, and mines. From a fundamental point of view, it is an important economic indicator that reflects the strength of the economy, and by extrapolation, the strength of a specific currency. Therefore, foreign exchange traders use this economic indicator as a potential trading signal.

Capacity Utilization

Capacity utilization consists of total industrial output divided by total production capability. The term refers to the maximum level of output a plant can generate under normal business conditions. In general, capacity utilization is not a major economic indicator for the foreign exchange market.

However, there are instances when its economic implications are useful for fundamental analysis. A "normal" figure for a steady economy is 81.5 percent. If the figure reads 85 percent or more, the data suggests that the industrial production is overheating, that the economy is close to full capacity. High capacity utilization rates precede inflation, and expectation in the foreign exchange market is that the central bank will raise interest rates in order to avoid or fight inflation.

Factory Orders

Factory orders refer to the total of durable and nondurable goods orders. Nondurable goods consist of food, clothing, light industrial products, and products designed for the maintenance of durable goods. Durable goods orders are discussed separately. The factory orders indicator has limited significance for foreign exchange traders.

Durable Goods Orders

Durable goods orders consist of products with a life span of more than three years. Examples of durable goods are autos, appliances, furniture, jewelry, and toys. They are divided into four major categories: primary metals, machinery, electrical machinery, and transportation.

In order to eliminate the volatility pertinent to large military orders, the indicator includes a breakdown of the orders between defense and nondefense.

This data is fairly important to foreign exchange markets because it gives a good indication of consumer confidence. Because durable goods cost more than nondurables, a high number in this indicator shows consumers' propensity to spend. Therefore, a good figure is generally bullish for the domestic currency.

Business Inventories

Business inventories consist of items produced and held for future sale. The compilation of this information is facile and holds little surprise for the market. Moreover, financial management and computerization help control business inventories in unprecedented ways. Therefore, the importance of this indicator for foreign exchange traders is limited.

Construction Indicators

Construction indicators constitute significant economic indicators that are included in the calculation of the GDP of the United States. Moreover, housing has traditionally been the engine that pulled the U.S. economy out of recessions after World War II. These indicators are classified into three major
categories:

1. housing starts and permits;
2. new and existing one-family home sales and
3. construction spending.

Private housing is monitored closely at all the major stages. (See Figure 4.1.) Private housing is classified based on the number of units (one, two, three, four, five, or more); region (Northeast, West, Midwest, and South); and inside or outside metropolitan statistical areas.

Figure 4.1. Diagram of construction of private housing

Construction indicators are cyclical and very sensitive to the level of interest rates (and consequently mortgage rates) and the level of disposable income. Low interest rates alone may not be able to generate a high demand for housing, though. As the situation in the early 1990s demonstrated, despite historically low mortgage rates in the United States, housing increased only marginally, as a result of the lack of job security in a weak economy. Housing starts between one and a half and two million units reflect a strong economy, whereas a figure of approximately one million units suggests that the economy is in recession.

Inflation Indicators

The rate of inflation is the widespread rise in prices. Therefore, gauging inflation is a vital macroeconomic task. Traders watch the development of inflation closely, because the method of choice for fighting inflation is raising the interest rates, and higher interest rates tend to support the local currency. Moreover, the inflation rate is used to "deflate" nominal interest rates and the GNP or GDP to their real values in order to achieve a more accurate measure of the data.

The values of the real interest rates or real GNP and GDP are of the utmost importance to the money managers and traders of international financial instruments, allowing them to accurately compare opportunities worldwide.

To measure inflation traders use following economic tools:

• Producer Price Index (PPI);
• Consumer Price Index (CPI);
• GNP Deflator;
• GDP Deflator;
• Employment Cost Index (ECI);
• Commodity Research Bureau's Index (CRB Index);
• Journal of Commerce Industrial Price Index (JoC).

The first four are strictly economic indicators; they are released at specific intervals. The commodity indexes provide information on inflation quickly and continuously. Other economic data that measure inflation are unemployment, consumer prices, and capacity utilization.

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Economic Fundamentals

Theories of Exchange Rate Determination

Fundamentals may be classified into economic factors, financial factors, political factors, and crises. Economic factors differ from the other three factors in terms of the certainty of their release. The dates and times of economic data release are known well in advance, at least among the industrialized nations. Below are given briefly several known theories of exchange rate determination.

Purchasing Power Parity

Purchasing power parity states that the price of a good in one country should equal the price of the same good in another country, exchanged at the current rate—the law of one price. There are two versions of the purchasing power parity theory: the absolute version and the relative version. Under the absolute version, the exchange rate simply equals the ratio of the two countries' general price levels, which is the weighted average of all goods produced in a country. However, this version works only if it is possible to find two countries, which produce or consume the same goods. Moreover, the absolute version assumes that transportation costs and trade barriers are insignificant. In reality, transportation costs are significant and dissimilar around the world.

Trade barriers are still alive and well, sometimes obvious and sometimes hidden, and they influence costs and goods distribution.

Finally, this version disregards the importance of brand names. For example, cars are chosen not only based on the best price for the same type of car, but also on the basis of the name ("You are what you drive").

The PPP Relative Version

Under the relative version, the percentage change in the exchange rate from a given base period must equal the difference between the percentage change in the domestic price level and the percentage change in the foreign price level. The relative version of the PPP is also not free of problems: it is difficult or arbitrary to define the base period, trade restrictions remain a real and thorny issue, just as with the absolute version, different price index weighting and the inclusion of different products in the indexes make the comparison difficult and in the long term, countries' internal price ratios may change, causing the exchange rate to move away from the relative PPP.

In conclusion, the spot exchange rate moves independently of relative domestic and foreign prices. In the short run, the exchange rate is influenced by financial and not by commodity market conditions.

Theory of Elasticities

The theory of elasticities holds that the exchange rate is simply the price of foreign exchange that maintains the balance of payments in equilibrium. For instance, if the imports of country A are strong, then the trade balance is weak. Consequently, the exchange rate rises, leading to the growth of country A's exports, and triggers in turn a rise in its domestic income, along with a decrease in its foreign income. Whereas a rise in the domestic income (in country A) will trigger an increase in the domestic consumption of both domestic and foreign goods and, therefore, more demand for foreign currencies, a decrease in the foreign income (in country B) will trigger a decrease in the domestic consumption of both country B's domestic and foreign goods, and therefore less demand for its own currency.

The elasticities approach is not problem-free because in the short term the exchange rate is more inelastic than it is in the long term and the additional exchange rate variables arise continuously, changing the rules of the game.

Modern Monetary Theories on Short-Term Exchange Rate Volatility

The modern monetary theories on short-term exchange rate volatility take into consideration the short-term capital markets' role and the long-term impact of the commodity markets on foreign exchange. These theories hold that the divergence between the exchange rate and the purchasing power parity is due to the supply and demand for financial assets and the international capability.

One of the modern monetary theories states that exchange rate volatility is triggered by a one-time domestic money supply increase, because this is assumed to raise expectations of higher future monetary growth.

The purchasing power parity theory is extended to include the capitalmarkets. If, in both countries whose currencies are exchanged, the demand for money is determined by the level of domestic income and domestic interest rates, then a higher income increases demand for transactions balances while a higher interest rate increases the opportunity cost of holding money, reducing the demand for money.

Under a second approach, the exchange rate adjusts instantaneously to maintain continuous interest rate parity, but only in the long run to maintain PPP.

Volatility occurs because the commodity markets adjust more slowly than the financial markets. This version is known as the dynamic monetary approach.

The Portfolio-Balance Approach

The portfolio-balance approach holds that currency demand is triggered by the demand for financial assets, rather than the demand for the currency per se.

Synthesis of Traditional and Modern Monetary Views

In order to better suit the previous theories to the realities of the market, some of the more stringent conditions were adjusted into a synthesis of the traditional and modern monetary theories.

A short-term capital outflow induced by a monetary shock creates a payments imbalance that requires an exchange rate change to maintain balance of payments equilibrium. Speculative forces, commodity markets disturbances, and the existence of short-term capital mobility trigger the exchange rate volatility. The degree of change in the exchange rate is a function of consumers' elasticity of demand.

Because the financial markets adjust faster than the commodities markets, the exchange rate tends to be affected in the short term by capital market changes, and in the long term by commodities changes.

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Currency Options Theta,Vega,Gamma,Delta

A currency option is a contract between a buyer and a seller that gives the buyer the right, but not the obligation, to trade a specific amount of currency at a predetermined price and within a predetermined period of time, regardless of the market price of the currency; and gives the seller, or writer, the obligation to deliver the currency under the predetermined terms, if and when the buyer wants to exercise the option.

Currency options are unique trading instruments, equally fit for speculation and hedging. Options allow for a comprehensive customization of each individual strategy, a quality of vital importance for the sophisticated investor. More factors affect the option price relative to the prices of other foreign currency instruments. Unlike spot or forwards, both high and low volatility may generate a profit in the options market. For some, options are a cheaper vehicle for currency trading. For others, options mean added security and exact stop-loss order execution.

Currency options constitute the fastest-growing segment of the foreign exchange market. As of April 1998, options represented 5 percent of the foreign exchange market. (See Figure 3.1) The biggest options trading center is the United States, followed by the United Kingdom and Japan. Options prices are based on, or derived from, the cash instruments. Therefore, an option is a derivative instrument. Options are usually mentioned vis-a-vis insurance and hedging strategies. Often, however, traders have misconceptions regarding both the difficulty and simplicity of using options.

There are also misconceptions regarding the capabilities of options. In the currency markets, options are available on either cash or futures. It follows, then, that they are traded either over-the-counter (OTC) or on the centralized futures markets.

The majority of currency options, around 81 percent, are traded overthe- counter. (See Figure 3.3) The over-the-counter market is similar to the spot or swap market.

Corporations may call banks and banks will trade with each other either directly or in the brokers' market. This type of dealing allows for maximum flexibility: any amount, any currency, any odd expiration date, any time. The currency amounts may be even or odd. The amounts may be quoted in either U.S. dollars or foreign currencies.

Any currency may be traded as an option, not only the ones available as futures contracts. Therefore, traders may quote on any exotic currency, as required, including any cross currencies.

The expiration date may be quoted anywhere from several hours to several years, although the bulk of dates are concentrated around the even dates—one week, one month, two months, and so on. The cash market never closes, so options may be traded literally around the clock. 

Trading an option on currency futures will entitle the buyer to the right, but not the obligation, to take physical possession of the currency future. Unlike the currency futures, buying currency options does not require an initiation margin. The option premium, or price, paid by the buyer to theseller, or writer, reflects the buyer's total risk.

However, upon taking physical possession of the currency future by exercising the option, a trader will have to deposit a margin.

Seven major factors have an impact on the option price:

1. Price of the currency.
2. Strike (exercise) price.
3. Volatility of the currency.
4. Expiration date.
5. Interest rate differential.
6. Call or put.
7. American or European option style.

The currency price is the central building block, as all the other factors are compared and analyzed against it. It is the currency price behavior that both generates the need for options and impacts on the profitability of options.

The impact of the currency price on the option premium is measured by delta, the first of the Greek letters used to describe aspects of the theoretical pricing models in this discussion of factors determining the option price.

Delta

Delta, or commonly A, is the first derivative of the option-pricing model
Delta may be viewed in three respects:

• as the change of the currency option price relative to a change in the currency price. For instance, an option with a delta of 0.5 is expected to move at one half the rate of change of the currency price. Therefore, if the price of a currency goes up 10 percent, then the price of an option on that particular currency is expected to rise by 5 percent.
• as the hedge ratio between the option contracts and the currency futures contracts necessary to establish a neutral hedge. Therefore, an option with a delta of 0.5 will need two option contracts for each of the currency futures contracts.
• as the theoretical or equivalent share position. In this case, delta is the number of currency futures contracts by which a call buyer is long or a put buyer is short. If we use the same example of the delta of 5, then the buyer of the put option is short half a currency futures contract.

Traders may be unable to secure prices in the spot, forward outright, or
futures market, temporarily leaving the position delta unhedged. In order to
avoid the high cost of hedging and the risk of unusually high volatility, traders
may hedge their original options positions with other options. This method of
risk neutralization is called gamma or vega hedging.

Gamma

Gamma (Г) is also known as the curvature of the option. It is the second derivative of the option-pricing model and is the rate of change of an option's delta, or the sensitivity of the delta. For instance, an option with delta = 0.5 and gamma = 0.05 is expected to have a delta = 0.55 if the currency rises by 1 point, or a delta = 0.45 if the currency decreases by 1 point.
Gamma ranges between 0 percent and 100 percent. The higher the gamma, the higher the sensitivity of the delta. It may therefore be useful to think of gamma as the acceleration of the option relative to the movement of the
currency.

Vega

Vega gauges volatility impact on the option premium. Vega (<;) is the sensitivity of the theoretical value of an option to a change in volatility. For instance, a vega of 0.2 will generate a 0.2 percent increase in the premium for each percentage increase in the volatility estimate, and a 0.2 percent decrease in the premium for each percentage decrease in the volatility estimate.

The option is traded for a predetermined period of time, and when this time expires, there is a delivery date known as the expiration date. A buyer who intends to exercise the option must inform the writer on or before expiration. The buyer's failure to inform the writer about exercising the option frees the writer of any legal obligation. An option cannot be exercised past the expiration date.

Theta

Theta (T), also known as time decay, occurs as the very slow or nonexistent movement of the currency triggers losses in the option's theoretical value.

For instance, a theta of 0.02 will generate a loss of 0.02 in the premium for each day that the currency price is flat. Intrinsic value is not affected by time, but extrinsic value is. Time decay accelerates as the option approaches expiration, since the number of possible outcomes is continuously reduced as the time passes.

Time has its maximum impact on at-the-money options and its minimum effect on in-the-money options. Time's effect on out-of-the-money options occurs somewhere within that range. Bid-offer spreads in the market may make it too expensive to sell the option and trade forward out rights.

If the option shifts deeply into the money, the interest rate differential gained by early exercise may exceed the value of the option. If the option amount is small or the expiration is close and the option value only consists of the intrinsic value, it may be better to use the early exercise.

Due to the complexity of its determining factors, option pricing is difficult. In the absence of option pricing models, option trading is nothing but inefficient gambling.

The one idea to make option pricing is that the option of buying the domestic currency with a foreign currency at a certain price x is equivalent to the option of selling the foreign currency with the domestic currency at the same price x. Therefore, the call option in the domestic currency becomes the put option in the other, and vice versa.

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