Forex Market Explained

Introduction

1.1. Foreign Exchange as a Financial Market

1.2. Foreign Exchange in a Historical Perspective

1.3. Main Stages of Recent Foreign Exchange Development

The Bretton Woods Accord

The International Monetary Fund

Free-Floating of Currencies

The European Monetary Union

The European Monetary Cooperation FundThe Euro

1.4. Factors Caused Foreign Exchange Volume Growth

Interest Rate Volatility

Business Internationalization

Increasing of Corporate Interest

Increasing of Traders Sophistication

Developments in Telecommunications

Computer and Programming Development

Kinds Of Major Currencies and Exchange Systems

2.1. Major Currencies

The U.S. Dollar

The Euro

The Japanese Yen

The British Pound

The Swiss Franc

2.2. Kinds of Exchange Systems

Trading with Brokers

Direct Dealing

Dealing Systems

Matching Systems

2.3. The Federal Reserve System of the USA and

Central Banks of the Other G-7 Countries

The Federal Reserve System of the USA

The Central Banks of the Other G-7 Countries

Kinds of Foreign Exchange Market

3.1. Spot Market

3.2. Forward Market

3.3. Futures Market

3.4. Currency Options

Delta

Gamma

Vega

Theta

Fundamental Analysis

4.1. Economic Fundamentals

Theories of Exchange Rate Determination

Purchasing Power Parity

The PPP Relative Version

Theory of Elasticities

Modern Monetary Theories on Short-term Exchange

Rate Volatility

The Portfolio-Balance Approach

Synthesis of Traditional and Modern Monetary Views

4.2. Economic Indicators

The Gross National Product (GNP)

The Gross Domestic Product (GDP)

Consumption Spending

Investment Spending

Government Spending

Net Trade

Industrial Production

Capacity Utilization

Factory Orders

Durable Goods Orders

Business Inventories

Construction Indicators

Inflation Indicators

Producer Price Index (PPI)

Consumer Price Index (CPI)

Gross National Product Implicit Deflator

Gross Domestic Product Implicit Deflator

Commodity Research Bureau’s Futures Index (CRB Index)

The “Journal of Commerce” Industrial Price Index (Joc)

Merchandise Trade Balance

Employment Indicators

Employment Cost Index (ECI)

Consumer Spending Indicators

Auto Sales

Leading Indicators

Personal Income

4.3. Financial and Sociopolitical Factors

The Role of Financial Factors

Political Events and Crises

Technical Analysis

5.1. The Evolution and Fundamentals of Technical

Analysis Theory of Dow

Price

Volume and Open Interest

5.2. Types of Charts

Line Chart

Bar Chart

Candlestick Chart

5.3. Trends, Support and Resistance

Kinds of Trends

Percentage Retracement

The Trendline

Lines of Support and Resistance

5.4. Trend Reversal Patterns

Head-and-Shoulders

Signal Generated by the Head-and-shoulders Pattern

Inverse Head-and-Shoulders

Double Top

Signals Provided by the Double Top Formation

Double Bottom

Triple Top and Triple Bottom

The opposite is true for the triple bottom

Rounded Top and Bottom Formations

Diamond Formation

5.5. Trend Continuation Patterns

Flag Formation

Pennant Formation

Triangle Formation

Wedge Formation Rectangle Formation

5.6 Gaps

Common Gaps

Breakaway Gaps

Runaway Gaps

Trading Signals for Runaway Gaps

Exhaustion Gaps

5.7. Mathematical Trading Methods (Indicators)

Moving Averages

Trading Signals of Moving Averages

Oscillators

Stochastics

Moving Average Convergence-Divergence (MACD)

Momentum

The Relative Strength Index (RSI)

Rate of Change (ROC)

Larry Williams %R

Commodity Channel Index (CCI)

Bollinger Bands

The Parabolic System (SAR)

The directional movement index (DMI)

The Fibonacci Analysis and Elliott Wave Theory

6.1. The Fibonacci Analysis

6.2. The Elliott Wave

Basics of Wave Analysis

Impulse Waves—Variations

The Diagonal Triangles

Failures (Truncated Fifths)

Foreign Exchange Risks

7.1. Exchange Rate Risk

7.2. Interest Rate Risk

7.3. Credit Risk

7.4. Country Risk

Glossary And Foreign Exchange Terms

Introduction

1.1. Foreign Exchange as a Financial Market

Currency exchange is very attractive for both the corporate and individual

traders who make money on the Forex - a special financial market assigned for

the foreign exchange. The following features make this market different in

compare to all other sectors of the world financial system:

• heightened sensibility to a large and continuously changing number of

factors;

• accessibility to all traders in the major currencies;

• guaranteed quantity and liquidity of the major currencies;

• increased consideration for several currencies, round-the clock

business hours which enable traders to deal after normal hours or during

national holidays in their country finding markets abroad open and

• extremely high efficiency relative to other financial markets.

This goal of this manual is to introduce beginning traders to all the

essential aspects of foreign exchange in a practical manner and to be a source of

best answers on the typical questions as why are currencies being traded, who are

the traders, what currencies do they trade, what makes rates move, what

instruments are used for the trade, how a currency behavior can be forecasted and

where the pertinent information may be obtained from. Mastering the content of

an appropriate section the user will be able to make his/her own decisions, test

them, and ultimately use recommended tools and approaches for his/her own

benefit.

1.2. Foreign Exchange in a Historical Perspective

Currency trading has a long history and can be traced back to the ancient

Middle East and Middle Ages when foreign exchange started to take shape after

the international merchant bankers devised bills of exchange, which were

transferable third-party payments that allowed flexibility and growth in foreign

exchange dealings.

The modern foreign exchange market characterized by the consequent

periods of increased volatility and relative stability formed itself in the twentieth

century. By the mid-1930s London became to be the leading center for foreign

exchange and the British pound served as the currency to trade and to keep as a

reserve currency. Because in the old times foreign exchange was traded on the

telex machines, or cable, the pound has generally the nickname “cable”. In 1930,

the Bank for International Settlements was established in Basel, Switzerland, to

oversee the financial efforts of the newly independent countries, emerged after

the World War I, and to provide monetary relief to countries experiencing

temporary balance of payments difficulties.

After the World War II, where the British economy was destroyed and the

United States was the only country unscarred by war, U.S. dollar became the

prominent currency of the entire globe. Nowadays, currencies all over the world

are generally quoted against the U.S. dollar.

1.3. Main Stages of Recent Foreign Exchange

Development

The main phases of the further development of the Forex in modern

times were:

• signing of the Bretton Woods Accord;

• constitution of the international monetary fund (IMF);

• emergency of the free-floating foreign exchange markets;

• creation of currency reserves;

• constitution of the European Monetary Union and the European

Monetary Cooperation Fund;

• introduction of the Euro as a currency.

The Bretton Woods Accord

was signed in July 1944 by the United States,

Great Britain, and France which agreed to make the currency market stable,

particularly due to governmental controls on currency values. In order to

implement it, two major goals were: emphasized: to provide the pegging

(backing of prices) of currencies and to organize the International Monetary Fund

(IMF).

In accordance to the Bretton Woods Accord, the major trading currencies

were pegged to the U.S. dollar in the sense that they were allowed to fluctuate

only one percent on either side of that rate. When a currency exceeded this

range, marked by intervention points, the central bank in charge had to buy it or

sell it, and thus bring it back into range. In turn, the U.S. dollar was pegged to

gold at $35 per ounce. Thus, the U.S. dollar became the world’s reserve currency.

The purpose of IMF is to consult with one another to maintain a stable

system of buying and selling the currencies, so that payments in foreign

money can take place between countries smoothly and timely.

The IMF lends money to members who have trouble meeting financial

obligations to other members, on the condition that they undertake economic

reforms to eliminate these difficulties for their own good and the good of the

entire membership. In total the main tasks of the IMF are:

• to promote international cooperation by providing the means for

members to consult and collaborate on international monetary issues;

• to facilitate the growth of international trade and thus contribute to

high levels of employment and real income among member nations;

• to promote stability of exchange rates and orderly exchange

agreements, and [to] discourage competitive currency depreciation;

• to foster a multilateral system of international payments, and to seek

the elimination of exchange restrictions that hinder the growth of world trade;

• to make financial resources available to members, on a temporary

basis and with adequate safeguards, to permit them to correct payments

imbalances without resorting to measures destructive to national and international

prosperity.

To execute these goals the IMF uses such instruments as Reserve tranche

which allows a member to draw on its own reserve asset quota at the time of

payment, Credit tranche drawings and stand-by arrangements are the standard

form of IMF loans, the compensatory financing facility extends financial help to

countries with temporary problems generated by reductions in export revenues,

the buffer stock financing facility which is geared toward assisting the stocking

up on primary commodities in order to ensure price stability in a specific

commodity and the extended facility designed to assist members with financial

problems in amounts or for periods exceeding the scope of the other facilities.

Since 1978 free-floating of currencies were officially mandated by the

International Monetary Fund. That is the currency may be traded by anybody and

its value is a function of the current supply and demand forces in the market, and

there are no specific intervention points that have to be observed. Of course, the

Federal Reserve Bank irregularly intervenes to change the value of the U.S.

dollar, but no specific levels are ever imposed. Naturally, free-floating

currencies are in the heaviest trading demand. Free-floating is not the sine qua

non condition for trading. Liquidity is also an indispensable condition.

A tool for people and corporations to protect investments in times of

economic or political instability is currency reserves for international

transactions. Immediately after the World War II the reserve currency worldwide

was the U.S. dollar. Currently there are other reserve currencies: the euro and

the Japanese yen. The portfolio of reserve currencies may change depending on

specific international conditions, for instance it may include the Swiss franc.

The creation of the European Monetary Union was the result of a long and

continuous series of post-World War II efforts aimed at creating closer economic

cooperation among the capitalist European countries. The European Community

(EC) commission’s officially stated goals were to improve the inter-European

economic cooperation, create a regional area of monetary stability, and act as “a

pole of stability in world currency markets.”

The first steps in this rebuilding were taken in 1950, when the European

Payment Union was instituted to facilitate the inter-European settlements of

international trade transactions. The purpose of the community was to promote

inter-European trade in general, and to eliminate restrictions on the trade of coal

and raw steel in particular.

In 1957, the Treaty of Rome established the European Economic

Community, with the same signatories as the European Coal and Steel

Community. The stated goal of the European Economic Community was to

eliminate customs duties and any barriers against the transit of capital, services,

and people among the member nations. The EC also started to raise common

tariff barriers against outsiders.

The European Community consists of four executive and legislative bodies:

1. The European Commission. The executive body in charge of making

and observing the enforcement of the policies. Since it lacks an enforcement

arm, the commission must rely on individual governments to enforce the policies.

There are 23 departments, such as foreign affairs, competition policy, and

agriculture. Each country selects its own representatives for four-year terms. The

commission is based in Brussels and consists of 17 members.

2. The Council of Ministers. Makes the major policy decisions. It is

composed of ministers from the 12 member nations. The presidency is held for

six months by each of the members, in alphabetical order. The meetings take

place in Brussels or in the capital of the nation holding the presidency.

3. The European Parliament. Reviews and amends legislative proposals

and has the power to adopt or reject budget proposals. It consists of 518

elected members. It is based in Luxembourg, but the sessions take place in

Strasbourg or Brussels.

4. The European Court of Justice. Settles disputes between the EC and

the member nations. It consists of 13 members and is based in Luxembourg.

In 1963, the French-West German Treaty of Cooperation was signed. This

pact was designed not only to end centuries of bellicose rivalry, but also to

settle the postwar reconciliation between two major foes. The treat stipulated

that West Germany would lead economically through the cold war, and France,

the former diplomatic powerhouse, would provide the political leadership. The

premise of this treaty was obviously correct in an environment defined by a

foreseeable long-term continuing cold war and a divided Germany. Later in this

chapter, we discuss the implications for the modern era of this enormously

expensive pact.

A conference of national leaders in 1969 set the objective of establishing a

monetary union within the European Community. This goal was supposed to be

implemented by 1980, when a common currency was planned to be used in

Europe. The reasons for the proposed common currency unit were to stimulate

inter-European trade and to weld together the individual member economies in

order to compete successfully with the economies of the United States and

Japan.

In 1978, the nine members of the European Community ratified a new plan

for stability—the European Monetary System. The new system was practically

established in 1979. Seven countries were then full members—West

Germany, France, the Netherlands, Belgium, Luxembourg, Denmark, and

Ireland. Great Britain did not participate in all of the arrangements and Italy

joined under special conditions. Greece joined in 1981, Spain and Portugal in

1986. Great Britain joined the Exchange Rate Mechanism in 1990.

The European Monetary Cooperation Fund

was established to manage

the EMS’ credit arrangements. In order to increase the acceptance of the

ECU, countries that hold more ECU deposits, or accept as loan repayment more

than their share of ECU, receive interest on the excess ECU deposits, and vice

versa. The interest rate is the weighted average of all the EMS members’

discount rates.

In 1998 the Euro was introduced as an all-European currency. Here are

the official locking rates of the 11 participating European currencies in the

euro (EUR). The rates were proposed by the EU Commission and approved by

EU finance ministers on December 31, 1998, ahead of the launch of the euro

at midnight, January 1, 1999.

The real starting date was Monday, January 4, 1999. The conversion

rates are:

1 EUR = 40.3399 BEF 1 EUR = 1.95583 DEM

1 EUR = 166.386 ESP 1 EUR = 6.55957 FRF

1 EUR = 0.787564 IEP 1 EUR = 1936.27 ITL

1 EUR = 40.3399 LUF 1 EUR = 2.20371 NLG

1 EUR = 13.7603 ATS 1 EUR = 200.482 PTE

1 EUR = 5.94573 FIM

The euro bills are issued in denominations of 5, 10, 20, 50, 100, 200,

and 500 euros. Coins are issued in denominations of 1 and 2 euros, and 50,

20,10, 5, 2, and 1 cent.

1.4. Factors Caused Foreign Exchange Volume Growth

Foreign exchange trading is generally conducted in a decentralized manner,

with the exceptions of currency futures and options. Foreign exchange has

experienced spectacular growth in volume ever since currencies were allowed to

float freely against each other. While the daily turnover in 1977 was U.S. $5

billion, it increased to U.S. $600 billion in 1987, reached the U.S. $1 trillion mark

in September 1992, and stabilized at around $1,5 trillion by the year 2000.

Main factors influence on this spectacular growth in volume are indicated

below.

For foreign exchange, currency volatility is a prime factor in the growth

of volume. In fact, volatility is a sine qua non condition for trading. The only

instruments that may be profitable under conditions of low volatility are

currency options.

Interest Rate Volatility

Economic internationalization generated a significant impact on interest

rates as well. Economics became much more interrelated and that exacerbated the

need to change interest rates faster. Interest rates are generally changed in order

to adjust the growth in the economy, and interest rate differentials have a

substantial impact on exchange rates.

Business Internationalization

In recent decades the business world the competition has intensified,

triggering a worldwide hunt for more markets and cheaper raw materials and

labor. The pace of economic internationalization picked up even more in the

1990s, due to the fall of Communism in Europe and to up-and-down economic

and financial development in both Southeast Asia and South America. These

changes have been positive toward foreign exchange, since more transactional

layers were added.

Increasing of Corporate Interest

A successful performance of a product or service overseas may be pulled

down from the profit point of view by adverse foreign exchange conditions and

vice versa. An accurate handling of the foreign exchange may enhance the overall

international performance of a product or service. Proper handling of foreign

exchange generally adds substantially to the rate of return. Therefore, interest

in foreign exchange has increased in the past decade. Many corporations are

using currencies not only for hedging, but also for capitalizing on opportunities that

exist solely in the currency markets.

Increasing of Traders Sophistication

Advances in technology, computer software, and telecommunications and

increased experience have increased the level of traders’ sophistication. This

FOREX. On-line Manual For Successful Trading

14

enhanced traders’ confidence in their ability to both generate profits and

properly handle the exchange risks. Therefore, trading sophistication led toward

volume increase.

Developments in Telecommunications

The introduction of automated dealing systems in the 1980s, of matching

systems in the early 1990s, and of Internet trading in the late 1990s completely

altered the way foreign exchange was conducted. The dealing systems are online

computer systems that link banks on a one-to-one basis, while matching

systems are electronic brokers. They are reliable and much faster, allowing traders

to conduct more simultaneous trades. They are also safer, as traders are able to

see the deals that they execute. The dealing systems had a major role in

expanding the foreign exchange business due to their reliability, speed, and

safety.

Computer and Programming development

Computers play a significant role at many stages of conducting foreign

exchange. In addition to the dealing systems, matching systems simultaneously

connect all traders around the world, electronically duplicating the brokers’

market. The new office systems provide full accounting coverage, ticket writing,

back office processing, and risk management implementation at a fraction of their

previous cost. Advanced software makes it possible to generate all types of

charts, augment them with sophisticated technical studies, and put them at

traders’ fingertips on a continuous basis at a rather limited cost.

Kinds Of Major Currencies

And Exchange Systems

2.1. Major Currencies

The U.S. Dollar

The United States dollar is the world’s main currency. All currencies are

generally quoted in U.S. dollar terms. Under conditions of international economic

and political unrest, the U.S. dollar is the main safe-haven currency which was

proven particularly well during the Southeast Asian crisis of 1997-1998.

The U.S. dollar became the leading currency toward the end of the

Second World War and was at the center of the Bretton Woods Accord, as the

other currencies were virtually pegged against it. The introduction of the euro in

1999 reduced the dollar’s importance only marginally.

The major currencies traded against the U.S. dollar are the euro,

Japanese yen, British pound, and Swiss franc.

The Euro

The euro was designed to become the premier currency in trading by

simply being quoted in American terms. Like the U.S. dollar, the euro has a

strong international presence stemming from members of the European

Monetary Union. The currency remains plagued by unequal growth, high

unemployment, and government resistance to structural changes. The pair was

also weighed in 1999 and 2000 by outflows from foreign investors, particularly

Japanese, who were forced to liquidate their losing investments in eurodenominated

assets. Moreover, European money managers rebalanced their

portfolios and reduced their euro exposure as their needs for hedging currency

risk in Europe declined.

The Japanese Yen

The Japanese yen is the third most traded currency in the world; it has a

much smaller international presence than the U.S. dollar or the euro. The yen is

very liquid around the world, practically around the clock. The natural demand to

trade the yen concentrated mostly among the Japanese keiretsu, the economic

and financial conglomerates.

The yen is much more sensitive to the fortunes of the Nikkei index, the

Japanese stock market, and the real estate market. The attempt of the Bank of

Japan to deflate the double bubble in these two markets had a negative effect

on the Japanese yen, although the impact was short-lived

The British Pound

Until the end of World War II, the pound was the currency of reference. Its

nickname, cable, is derived from the telex machine, which was used to trade it

in its heyday. The currency is heavily traded against the euro and the U.S.

dollar, but has a spotty presence against other currencies. The two-year bout

with the Exchange Rate Mechanism, between 1990 and 1992, had a soothing

effect on the British pound, as it generally had to follow the deutsche mark’s

fluctuations, but the crisis conditions that precipitated the pound’s withdrawal from

the ERM had a psychological effect on the currency.

Prior to the introduction of the euro, both the pound benefited from any

doubts about the currency convergence. After the introduction of the euro, Bank

of England is attempting to bring the high U.K. rates closer to the lower rates in

the euro zone. The pound could join the euro in the early 2000s, provided that

the U.K. referendum is positive.

The Swiss Franc

The Swiss franc is the only currency of a major European country that

belongs neither to the European Monetary Union nor to the G-7 countries.

Although the Swiss economy is relatively small, the Swiss franc is one of the

four major currencies, closely resembling the strength and quality of the Swiss

economy and finance. Switzerland has a very close economic relationship with

Germany, and thus to the euro zone. Therefore, in terms of political uncertainty

in the East, the Swiss franc is favored generally over the euro.

Typically, it is believed that the Swiss franc is a stable currency.

Actually, from a foreign exchange point of view, the Swiss franc closely

resembles the patterns of the euro, but lacks its liquidity. As the demand for it

exceeds supply, the Swiss franc can be more volatile than the euro.

2.2. Kinds of Exchange Systems

Trading with Brokers

Foreign exchange brokers, unlike equity brokers, do not take positions for

themselves; they only service banks. Their roles are:

• bringing together buyers and sellers in the market;

• optimizing the price they show to their customers;

• quickly, accurately, and faithfully executing the traders’ orders.

The majority of the foreign exchange brokers execute business via phone.

The phone lines between brokers and banks are dedicated, or direct, and are

usually in-stalled free of charge by the broker. A foreign exchange brokerage

firm has direct lines to banks around the world. Most foreign exchange is

executed through an open box system—a microphone in front of the broker that

continuously transmits everything he or she says on the direct phone lines to the

speaker boxes in the banks. This way, all banks can hear all the deals being

executed. Because of the open box system used by brokers, a trader is able to

hear all prices quoted; whether the bid was hit or the offer taken; and the

following price. What the trader will not be able to hear is the amounts of

particular bids and offers and the names of the banks showing the prices. Prices

are anonymous the anonymity of the banks that are trading in the market ensures

the market’s efficiency, as all banks have a fair chance to trade.

Brokers charge a commission that is paid equally by the buyer and the

seller. The fees are negotiated on an individual basis by the bank and the

brokerage firm.

Brokers show their customers the prices made by other customers either

two-way (bid and offer) prices or one way (bid or offer) prices from his or her

customers. Traders show different prices because they “read” the market

differently; they have different expectations and different interests. A broker who

has more than one price on one or both sides will automatically optimize the

price. In other words, the broker will always show the highest bid and the

lowest offer. Therefore, the market has access to the narrowest spread possible.

Fundamental and technical analyses are used for forecasting the future direction

of the currency. A trader might test the market by hitting a bid for a small

amount to see if there is any reaction.

Brokers cannot be forced into taking a principal’s role if the name switch

takes longer than anticipated.

Another advantage of the brokers’ market is that brokers might provide a

broader selection of banks to their customers. Some European and Asian banks

have overnight desks so their orders are usually placed with brokers who can deal

with the American banks, adding to the liquidity of the market.

Direct Dealing

Direct dealing is based on trading reciprocity. A market maker—the bank

making or quoting a price—expects the bank that is calling to reciprocate with

respect to making a price when called upon. Direct dealing provides more trading

discretion, as compared to dealing in the brokers’ market. Sometimes traders take

advantage of this characteristic.

Direct dealing used to be conducted mostly on the phone. Dealing errors

were difficult to prove and even more difficult to settle. In order to increase

dealing safety, most banks tapped the phone lines on which trading was

conducted. This measure was helpful in recording all the transaction details and

enabling the dealers to allocate the responsibility for errors fairly. But tape

recorders were unable to prevent trading errors. Direct dealing was forever

changed in the mid - 1980s, by the introduction of dealing systems.

Dealing Systems

Dealing systems are on-line computers that link the contributing banks

around the world on a one-on-one basis. The performance of dealing systems is

characterized by speed, reliability, and safety. Accessing a bank through a dealing

system is much faster than making a phone call. Dealing systems are

continuously being improved in order to offer maximum support to the dealer’s

main function: trading. The software is very reliable in picking up the big figure of

the exchange rates and the standard value dates. In addition, it is extremely

precise and fast in contacting other parties, switching among conversations, and

accessing the database. The trader is in continuous visual contact with the

information exchanged on the monitor. It is easier to see than hear this

information, especially when switching among conversations.

Most banks use a combination of brokers and direct dealing systems. Both

approaches reach the same banks, but not the same parties, because

corporations, for instance, cannot deal in the brokers’ market. Traders develop

personal relationships with both brokers and traders in the markets, but select

their trading medium based on price quality, not on personal feelings. The market

share between dealing systems and brokers fluctuates based on market

conditions. Fast market conditions are beneficial to dealing systems, whereas

regular market conditions are more beneficial to brokers.

Matching Systems

Unlike dealing systems, on which trading is not anonymous and is

conducted on a one-on-one basis, matching systems are anonymous and

individual traders deal against the rest of the market, similar to dealing in the

brokers’ market. However, unlike the brokers’ market, there are no individuals

to bring the prices to the market, and liquidity may be limited at times. Matching

systems are well-suited for trading smaller amounts as well.

The dealing systems characteristics of speed, reliability, and safety are

replicated in the matching systems. In addition, credit lines are automatically

managed by the systems. Traders input the total credit line for each counter

party. When the credit line has been reached, the system automatically disallows

dealing with the particular party by displaying credit restrictions, or shows the

trader only the price made by banks that have open lines of credit. As soon as

the credit line is restored, the system allows the bank to deal again. In the

interbank market, traders deal directly with dealing systems, matching systems,

and brokers in a complementary fashion.

2.3. The Federal Reserve System of the USA and

Central Banks of the Other G-7 Countries

The Federal Reserve System of the USA

Like the other central banks, the Federal Reserve of the USA affects the

foreign exchange markets in three general areas:

• the discount rate;

• the money market instruments;

• foreign exchange operations.

For the foreign exchange operations most significant are repurchase

agreements to sell the same security back at the same price at a predetermined

date in the future (usually within 15 days), and at a specific rate of interest. This

arrangement amounts to a temporary injection of reserves into the banking

system. The impact on the foreign exchange market is that the dollar should

weaken. The repurchase agreements may be either customer repos or system

repos.

Matched sale-purchase agreements are just the opposite of repurchase

agreements. When executing a matched sale-purchase agreement, the Fed sells

a security for immediate delivery to a dealer or a foreign central bank, with the

agreement to buy back the same security at the same price at a predetermined

time in the future (generally within 7 days). This arrangement amounts to a

temporary drain of reserves. The impact on the foreign exchange market is that

the dollar should strengthen.

The major central banks are involved in foreign exchange operations in

more ways than intervening in the open market. Their operations include payments

among central banks or to international agencies. In addition, the Federal Reserve

has entered a series of currency swap arrangements with other central banks since

1962. For instance, to help the allied war effort against Iraq’s invasion of Kuwait in

1990-1991, payments were executed by the Bundesbank and Bank of Japan to the

Federal Reserve. Also, payments to the World bank or the United Nations are executed

through central banks.

Intervention in the United States foreign exchange markets by the U.S.

Treasury and the Federal Reserve is geared toward restoring orderly conditions

in the market or influencing the exchange rates. It is not geared toward

affecting the reserves.

There are two types of foreign exchange interventions: naked intervention

and sterilized intervention.

Naked intervention, or unsterilized intervention, refers to the sole foreign

exchange activity. All that takes place is the intervention itself, in which the

Federal Reserve either buys or sells U.S. dollars against a foreign currency. In

addition to the impact on the foreign exchange market, there is also a monetary

effect on the money supply. If the money supply is impacted, then consequent

adjustments must be made in interest rates, in prices, and at all levels of the

economy. Therefore, a naked foreign exchange intervention has a long-term

effect.

Sterilized intervention neutralizes its impact on the money supply. As there

are rather few central banks that want the impact of their intervention in the

foreign exchange markets to affect all corners of their economy, sterilized

interventions have been the tool of choice. This holds true for the Federal

Reserve as well.

The sterilized intervention involves an additional step to the original

currency transaction. This step consists of a sale of government securities that

offsets the reserve addition that occurs due to the intervention. It may be easier

to visualize it if you think that the central bank will finance the sale of a currency

through the sale of a number of government securities.

Because a sterilized intervention only generates an impact on the supply

and demand of a certain currency, its impact will tend to have a short-to

medium-term effect.

The Central Banks of the Other G-7 Countries

In the wake of World War II, both Germany and Japan were helped to

develop new financial systems. Both countries created central banks that were

fundamentally similar to the Federal Reserve. Along the line, their scope was

customized to their domestic needs and they diverged from their model.

The European Central Bank was set up on June 1, 1998 to oversee the

ascent of the euro. During the transition to the third stage of economic and

monetary union (introduction of the single currency on January 1, 1999), it was

responsible for carrying out the Community’s monetary policy. The ECB, which

is an independent entity, supervises the activity of individual member European

central banks, such as Deutsche Bundesbank, Banque de France, and Ufficio

Italiano dei Cambi. The ECB’s decision-making bodies run a European System of

Central Banks whose task is to manage the money in circulation, conduct

foreign exchange operations, hold and manage the Member States’ official foreign

reserves, and promote the smooth operation of payment systems. The ECB is

the successor to the European Monetary Institute (EMI).

The German central bank, widely known as the Bundesbank, was the

model for the ECB. The Bundesbank was a very independent entity, dedicated to

a stable currency, low inflation, and a controlled money supply. The

hyperinflation that developed in Germany after World War I created a fertile

economic and political scenario for the rise of an extremist political party and for

the start of World War II. The Bundesbank’s chapter obligated it to avoid any such

economic chaos.

The Bank of Japan has deviated from the Federal Reserve model in terms

of independence. Although its Policy Board is still fully in charge of monetary

policy, changes are still subject to the approval of the Ministry of Finance

(MOF). The BOJ targets the M2 aggregate. On a quarterly basis, the BOJ

releases its Tankan economic survey. Tankan is the Japanese equivalent of the

American tan book, which presents the state of the economy. The Tankan’s

findings are not automatic triggers of monetary policy changes. Generally, the

lack of independence of a central bank signals inflation. This is not the case in

Japan, and it is yet another example of how different fiscal or economic policies

can have opposite effects in separate environments.

The Bank of England may be characterized as a less independent central

bank, because the government may overrule its decision. The BOE has not had an

easy tenure. Despite the fact that British inflation was high through 1991, reaching

double-digit rates in the late 1980s, the Bank of England did a marvelous job of

proving to the world that it was able to maneuver the pound into mirroring the

Exchange Rate Mechanism.

After joining the ERM late in 1990, the BOE was instrumental in keeping

the pound within its 6 percent allowed range against the deutsche mark, but the

pound had a short stay in the Exchange Rate Mechanism. The divergence

between the artificially high interest rates linked to ERM commitments and

Britain’s weak domestic economy triggered a massive sell-off of the pound in

September 1992.

The Bank of France has joint responsibility, with the Ministry of Finance, to

conduct domestic monetary policy. Their main goals are non-inflationary growth

and external account equilibrium. France has become a major player in the

foreign exchange markets since the ravages of the ERM crisis of July 1993, when

the French franc fell victim to the foreign exchange markets.

The Bank of Italy is in charge of the monetary policy, financial

intermediaries, and foreign exchange. Like the other former European

Monetary System central banks, BOI’s responsibilities shifted domestically

following the ERM crisis. Along with the Bundesbank and Bank of France, the Bank

of Italy is now part of the European System of Central Banks (ESC.

The Bank of Canada is an independent central bank that has a tight rein on

its currency. Due to its complex economic relations with the United States, the

Canadian dollar has a strong connection to the U.S. dollar. The BOC intervenes

more frequently than the other G7 central banks to shore up the fluctuations of

its Canadian dollar. The central bank changed its intervention policy in 1999 after

admitting that its previous mechanical policy, of intervening in increments of

only $50 million at a set price based on the previous closing, was not working.

Kinds Of Foreign

Exchange Market

3.1. Spot Market

Currency spot trading is the most popular foreign currency instrument

around the world, making up 37 percent of the total activity.

The fast-paced spot market is not for the fainthearted, as it features

high volatility and quick profits (and losses). A spot deal consists of a bilateral

contract whereby a party delivers a specified amount of a given currency

against receipt of a specified amount of another currency from a

counterparty, based on an agreed exchange rate, within two business days of

the deal date. The exception is the Canadian dollar, in which the spot delivery

is executed next business day.

The name “spot” does not mean that the currency exchange occurs the

same business day the deal is executed. Currency transactions that require

same-day delivery are called cash transactions. The two-day spot delivery for

currencies was developed long before technological breakthroughs in

information processing.

This time period was necessary to check out all transactions’ details

among counterparties. Although technologically feasible, the contemporary

markets did not find it necessary to reduce the time to make payments.

Human errors still occur and they need to be fixed before delivery. When

currency deliveries are made to the wrong party, fines are imposed.

In terms of volume, currencies around the world are traded mostly

against the U.S. dollar, because the U.S. dollar is the currency of reference.

The other major currencies are the euro, followed by the Japanese yen, the

British pound, and the Swiss franc. Other currencies with significant spot

market shares are the Canadian dollar and the Australian dollar.

In addition, a significant share of trading takes place in the currencies

crosses, a non-dollar instrument whereby foreign currencies are quoted

against other foreign currencies, such as euro against Japanese yen.

There are several reasons for the popularity of currency spot trading.

Profits (or losses) are realized quickly in the spot market, due to market

volatility. In addition, since spot deals mature in only two business days, the

time exposure to credit risk is limited. Turnover in the spot market has been

increasing dramatically, thanks to the combination of inherent profitability and

reduced credit risk. The spot market is characterized by high liquidity and

high volatility. Volatility is the degree to which the price of currency tends to

fluctuate within a certain period of time. Free-floating currencies, such as the

euro or the Japanese yen, tend to be volatile against the U.S. dollar.

In an active global trading day (24 hours), the euro/dollar exchange

rate may change its value 18,000 times. An exchange rate may “fly” 200 pips

in a matter of seconds if the market gets wind of a significant event. On the

other hand, the exchange rate may remain quite static for extended periods

of time, even in excess of an hour, when one market is almost finished

trading and waiting for the next market to take over. This is a common

occurrence toward the end of the New York trading day. Since California

failed in the late 1980s to provide the link between the New York and Tokyo

markets, there is a technical trading gap between around 4:30 pm and 6 pm

EDT. In the United States spot market, the majority of deals are executed

between 8 am and noon, when the New York and European markets overlap. The activity drops sharply in the afternoon, over 50 percent

in fact, when New York loses the international trading support. Overnight

trading is limited, as very few banks have overnight desks. Most of the banks

send their overnight orders to branches or other banks that operate in the

active time zones.

The major traders in the spot market are the commercial banks and the

investment banks, followed by hedge funds and corporate customers. In the

interbank market, the majority of the deals are international, reflecting

worldwide exchange rate competition and advanced telecommunication

systems. However, corporate customers tend to focus their foreign exchange

activity domestically, or to trade through foreign banks operating in the same

time zone. Although the hedge funds’ and corporate customers’ business in

foreign exchange has been growing, banks remain the predominant trading

force.

The bottom line is important in all financial markets, but in currency

spot trading the antes always seem to be higher as a result of the demand

from all around the world.

The profit and loss can be either realized or unrealized. The realized

profit and loss is a certain amount of money netted when a position is closed.

The unrealized profit and loss consists of an uncertain amount of money that

an outstanding position would roughly generate if it were closed at the

current rate. The unrealized profit and loss changes continuously in tandem

with the exchange rate.

3.2. Forward Market

The forward currency market consists of two instruments: forward

outright deals and swaps. A swap deal is unusual among the rest of the

foreign exchange instruments in the fact that it consists of two deals, or legs.

All the other transactions consist of single deals. In its original form, a swap

deal is a combination of a spot deal and a forward outright deal.

Generally, this market includes only cash transactions. Therefore,

currency futures contracts, although a special breed of forward outright

transactions, are analyzed separately.

According to figures published by the Bank for International

Settlements, the percentage share of the forward market was 57 percent in

1998. Translated into U.S. dollars, out of an estimated daily

gross turnover of US$1.49 trillion, the total forward market represents

US$900 billion.

In the forward market there is no norm with regard to the settlement

dates, which range from 3 days to 3 years. Volume in currency swaps longer

than one year tends to be light but, technically, there is no impediment to

making these deals. Any date past the spot date and within the above range

may be a forward settlement, provided that it is a valid business day for both

currencies. The forward markets are decentralized markets, with players

around the world entering into a variety of deals either on a one-on-one basis

or through brokers. In contrast, the currency futures market is a centralized

market, in which all the deals are executed on trading floors provided by

different exchanges.

Whereas in the futures market only a handful of foreign currencies may

be traded in multiples of standardized amounts, the forward markets are

open to any currencies in any amount. The forward price consists of two

significant parts: the spot exchange rate and the forward spread. The spot

rate is the main building block. The forward price is derived from the spot

price by adjusting the spot price with the forward spread, so it follows that

both forward outright and swap deals are derivative instruments. The forward

spread is also known as the forward points or the forward pips. The forward

spread is necessary for adjusting the spot rate for specific settlement dates

different from the spot date. It holds, then, that the maturity date is another

determining factor of the forward price. Just as in the case of the spot

market, the left side of the quote is the bid side, and the right side is the offer

side.

3.3. Futures Market

Currency futures are specific types of forward outright deals which

occupy in general a small part of the Forex market (See Figure 3.1). Because

they are derived from the spot price, they are derivative instruments. They

are specific with regard to the expiration date and the size of the trade

amount. Whereas, generally, forward outright deals—those that mature past

the spot delivery date—will mature on any valid date in the two countries

whose currencies are being traded, standardized amounts of foreign currency

futures mature only on the third Wednesday of March, June, September, and

December.

There is a row of characteristics of currency futures, which make them

attractive. It is open to all market participants, individuals included. This is

different from the spot market, which is virtually closed to individuals - except

high net-worth individuals—because of the size of the currency amounts

traded. It is a central market, just as efficient as the cash market, and

whereas the cash market is a very decentralized market, futures trading takes

place under one roof. It eliminates the credit risk because the Chicago

Mercantile Exchange Clearinghouse acts as the buyer for every seller, and

vice versa. In turn, the Clearinghouse minimizes its own exposure by

requiring traders who maintain a non-profitable position to post margins equal

in size to their losses.

Moreover, currency futures provide several benefits for traders because

futures are special types of forward outright contracts, corporations can use

them for hedging purposes. Although the futures and spot markets trade

closely together, certain divergences between the two occur, generating

arbitraging opportunities. Gaps, volume, and open interest are significant

technical analysis tools solely available in the futures market. Yet their

significance extrapolates to the spot market as well.

Because of these benefits, currency futures trading volume has steadily

attracted a large variety of players.

For traders outside the exchange, the prices are available from on-line

monitors. The most popular pages are found on Bridge, Telerate, Reuters,

and Bloomberg. Telerate presents the currency futures on composite pages,

while Reuters and Bloomberg display currency futures on individual pages

shows the convergence between the futures and spot prices.

3.4. Currency Options

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. 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. 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 the

seller, 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.

Fundamental Analysis

Two types of analysis are used for the market movements forecasting:

fundamental, and technical (the chart study of past behavior of commodity

prices). The fundamental one focuses on the theoretical models of exchange

rate determination and on the major economic factors and their likelihood of

affecting the foreign exchange rates.

4.1. 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

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 capital