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
markets. 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.
4.2. Economic Indicators
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.
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. 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.
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.
Producer Price Index (PPI)
Producer price index is compiled from most sectors of the economy,
such as manufacturing, mining, and agriculture. The sample used to calculate
the index contains about 3400 commodities. The weights used for the
calculation of the index for some of the most important groups are: food - 24
percent; fuel - 7 percent; autos - 7 percent; and clothing - 6 percent. Unlike
the CPI, the PPI does not include imported goods, services, or taxes.
Consumer Price Index (CPI)
Consumer price index reflects the average change in retail prices for a
fixed market basket of goods and services. The CPI data is compiled from a
sample of prices for food, shelter, clothing, fuel, transportation, and medical
services that people purchase on daily basis. The weights attached for the
calculation of the index to the most important groups are: housing - 38
percent; food - 19 percent; fuel - 8 percent; and autos - 7 percent.
The two indexes, PPI and CPI, are instrumental in helping traders
measure inflationary activity, although the Federal Reserve takes the position
that the indexes overstate the strength of inflation.
Gross National Product Implicit Deflator
Gross national product implicit deflator is calculated by dividing the
current dollar GNP figure by the constant dollar GNP figure.
Gross Domestic Product Implicit
Gross domestic product implicit deflator is calculated by dividing the
current dollar GDP figure by the constant dollar GDP figure.
Both the GNP and GDP implicit deflators are released quarterly, along
with the respective GNP and GDP figures. The implicit deflators are generally
regarded as the most significant measure of inflation.
Commodity Research Bureau’s Futures Index (CRB index)
The Commodity Research Bureau’s Futures Index makes watching for
inflationary trends easier. The CRB Index consists of the equally weighted
futures prices of 21 commodities. The components of the CRB Index are:
• precious metals: gold, silver, platinum;
• industrials: crude oil, heating oil, unleaded gas, lumber, copper,
and cotton;
• grains: corn, wheat, soybeans, soy meal, soy oil;
• livestock and meat: cattle, hogs, and pork bellies;
• imports: coffee, cocoa, sugar;
• miscellaneous: orange juice.
The preponderance of food commodities makes the CRB Index less
reliable in terms of general inflation. Nevertheless, the index is a popular tool
that has proved quite reliable since the late 1980s.
The “Journal of commerce” Industrial Price Index (JoC)
The “Journal of commerce” industrial price index consists of the prices
of 18 industrial materials and supplies processed in the initial stages of
manufacturing, building, and energy production. It is more sensitive than
other indexes, as it was designed to signal changes in inflation prior to the
other price indexes.
Merchandise Trade Balance
is one of the most important economic indicators. Its value may trigger
long-lasting changes in monetary and foreign policies. The trade balance
consists of the net difference between the exports and imports of a certain
economy. The data includes six categories:
1. food;
2. raw materials and industrial supplies;
3. consumer goods;
4. autos;
5. capital goods;
6. other merchandise.
Employment Indicators
The employment rate is an economic indicator with significance in
multiple areas. The rate of employment, naturally, measures the soundness of
an economy. The unemployment rate is a lagging economic
indicator. It is an important feature to remember, especially in times of
economic recession. Whereas people focus on the health and recovery of the
job sector, employment is the last economic indicator to rebound. When
economic contraction causes jobs to be cut, it takes time to generate
psychological confidence in economic recovery at the managerial level before
new positions are added. At individual levels, the improvement of the job
outlook may be clouded when new positions are added in small companies
and thus not fully reflected in the data. The employment reports are
significant to the financial markets in general and to foreign exchange in
particular. In foreign exchange, the data is truly affective in periods of
economic transition—recovery and contraction. The reason for the indicators’
importance in extreme economic situations lies in the picture they paint of the
health of the economy and in the degree of maturity of a business cycle. A
decreasing unemployment figure signals a maturing cycle, whereas the
opposite is true for an increasing unemployment indicator.
Employment Cost Index (ECI)
Employment cost index measures wages and inflation and provides the
most comprehensive analysis of worker compensation, including wages,
salaries, and fringe benefits. The ECI is one of the Fed’s favorite quarterly
economic statistics.
Consumer Spending Indicators
Retail sales is a significant consumer spending indicator for foreign
exchange traders, as it shows the strength of consumer demand as well as
consumer confidence. component in the calculation of other economic
indicators, such as GNP and GDP.
Generally, the most commonly used employment figure is not the
monthly unemployment rate, which is released as a percentage, but the
nonfarm payroll rate. The rate figure is calculated as the ratio of the
difference between the total labor force and the employed labor force, divided
by the total labor force. The data is more complex, though, and it generates
more information. In foreign exchange, the standard indicators monitored by
traders are the unemployment rate, manufacturing payrolls, nonfarm payrolls,
average earnings, and average workweek. Generally, the most significant
employment data are manufacturing and nonfarm payrolls, followed by the
unemployment rate.
Auto Sales
Despite the importance of the auto industry in terms of both production
and sales, the level of auto sales is not an economic indicator widely followed
by foreign exchange traders. The American automakers experienced a long,
steady market share loss, only to start rebounding in the early 1990s. But car
manufacturing has become increasingly internationalized, with American cars
being assembled outside the United States and Japanese and German cars
assembled within the United States. Because of their confusing nature, auto
sales figures cannot easily be used in foreign exchange analysis.
Leading Indicators
The leading indicators consist of the following economic indicators:
• average workweek of production workers in manufacturing;
• average weekly claims for state unemployment;
• new orders for consumer goods and materials (adjusted for
inflation);
• vendor performance (companies receiving slower deliveries from
suppliers);
• contracts and orders for plant and equipment (adjusted for
inflation);
• new building permits issued;
• change in manufacturers’ unfilled orders, durable goods;
• change in sensitive materials prices.
Personal Income
is the income received by individuals, nonprofit institutions, and private
trust funds. Components of this indicator include wages and salaries, rental
income, dividends, interest earnings, and transfer payments (Social Security,
state unemployment insurance, and veterans’ benefits). The wages and
salaries reflect the underlying economic conditions.
This indicator is vital for the sales sector. Without an adequate personal
income and a propensity to purchase, consumer purchases of durable and
nondurable goods are limited.
For the Forex traders, personal income is not significant.
4.3. Financial and Sociopolitical Factors
The Role of Financial Factors
Financial factors are vital to fundamental analysis. Changes in a
government’s monetary or fiscal policies are bound to generate changes in
the economy, and these will be reflected in the exchange rates. Financial
factors should be triggered only by economic factors. When governments
focus on different aspects of the economy or have additional international
responsibilities, financial factors may have priority over economic factors. This
was painfully true in the case of the European Monetary System in the early
1990s. The realities of the marketplace revealed the underlying artificiality of
this approach. Using the interest rates independently from the real economic
environment translated into a very expensive strategy.
Because foreign exchange, by definition, consists of simultaneous
transactions in two currencies, then it follows that the market must focus on
two respective interest rates as well. This is the interest rate differential, a
basic factor in the markets. Traders react when the interest rate differential
changes, not simply when the interest rates themselves change. For example,
if all the G-5 countries decided to simultaneously lower their interest rates by
0.5 percent, the move would be neutral for foreign exchange, because the
interest rate differentials would also be neutral.
Of course, most of the time the discount rates are cut unilaterally, a
move that generates changes in both the interest differential and the
exchange rate. Traders approach the interest rates like any other factor,
trading on expectations and facts. For example, if rumor says that a discount
rate will be cut, the respective currency will be sold before the fact. Once the
cut occurs, it is quite possible that the currency will be bought back, or the
other way around. An unexpected change in interest rates is likely to trigger a
sharp currency move. “Buy on the rumor, sell on the fact…”.
Other factors affecting the trading decision are the time lag between
the rumor and the fact, the reasons behind the interest rate change, and the
perceived importance of the change. The market generally prices in a
discount rate change that was delayed. Since it is a fait accompli, it is neutral
to the market. If the discount rate was changed for political rather than
economic reasons, what is a common practice in the European Monetary
System, the markets are likely to go against the central banks, sticking to the
real fundamentals rather than the political ones. This happened in both
September 1992 and the summer of 1993, when the European central banks
lost unprecedented amounts of money trying to prop up their currencies,
despite having high interest rates. The market perceived those interest rates
as artificially high and, therefore, aggressively sold the respective currencies.
Finally, traders deal on the perceived importance of a change in the interest
rate differential.
Political Events and Crises
Political events generally take place over a period of time, but political
crises strike suddenly. They are almost always, by definition, unexpected.
Currency traders have a knack for responding to crises. Speed is essential;
shooting from the hip is the only fighting option. The traders’ reflexes take
over. Without fast action, traders can be left out in the cold. There is no time
for analysis, and only a split second, at best, to act. As volume drops
dramatically, trading is hindered by a crisis. Prices dry out quickly, and
sometimes the spreads between bid and offer jump from 5 pips to 100 pips.
Getting back to the market is difficult.
Technical Analysis
5.1. The Fundamentals Of Technical Analysis
Technical analysis is appointed to analyze market movement (the
movement of prices, volumes and open interests) using the information
obtained for a past time. Mainly, it is the chart study of past behavior of
currencies prices in order to forecast their future performance. It is one of the
most significant tools available for the forecasting of financial markets. Such
analysis has been an increasingly utilized forecasting tool over the last two
centuries.
The main strength of technical analysis is the flexibility with regard to
the underlying instrument, regarding the markets and regarding the time
frame. A trader who deals several currencies but specializes in one may easily
apply the same technical expertise to trading another currency. A trader who
specializes in spot trading can make a smooth transition to dealing currency
futures by using chart studies, because the same technical principles apply
over and over again, regardless of the market. Finally, different players have
different trading styles, objectives, and time frames.
Technical analysis is easy to compute what is important while the
technical services are becoming increasingly sophisticated and reasonably
priced.
Prior to this historic open market intervention, technical analysis
provided ample selling signals.
Price
The Fundamental Principles of Technical Analysis are based on the Dow
Theory with the following main thesis:
1. The price is a comprehensive reflection of all the market forces. At
any given time, all market information and forces are reflected in the currency
prices.
2. Price movements are historically repetitive.
3. Price movements are trend followers.
4. The market has three trends: primary, secondary, and minor. The
primary trend has three phases: accumulation, run-up/run-down, and
distribution. In the accumulation phase the shrewdest traders enter new
positions. In the run-up/run-down phase, the majority of the market finally
“sees” the move and jumps on the bandwagon. Finally, in the distribution
phase, the keenest traders take their profits and close their positions while
the general trading interest slows down in an overshooting market. The
secondary trend is a correction to the primary trend and may retrace onethird,
one-half or two-thirds from the primary trend.
5. Volume must confirm the trend.
6. Trends exist until their reversals are confirmed. Cycles of currency price change are the propensity for events to repeat
themselves at roughly the same time and are an important ground to justify
the Dow Theory.
Cycle identification is a powerful tool that can be used in both the long
and the short term. The longer the term, the more significance a cycle has.
Analysts measure cycles from trough to trough.
Cycles are gauged in terms of amplitude, period, and phase. The
amplitude shows the height of the cycle, the period shows the length of the
cycle, the phase shows the location of a wave trough.
Volume and Open Interest
Volume consists of the total amount of currency traded within a period
of time, usually one day. For example, by year 2000, the total foreign
currency daily trading volume was $1.4 trillion. But traders are naturally more
interested in the volume of specific instruments for specific trading periods,
because large trading volume suggests that there is interest and liquidity in a
certain market, and low volume warns the trader to veer away from that
market.
The risks of a low-volume market are usually very difficult to quantify or
hedge. In addition, certain chart formations require heavy trading volume for
successful development. An example is the head-and-shoulder formation.
Therefore, despite its obvious importance, volume is not easy to quantify in
all foreign exchange markets.
One method to estimate volume is to extrapolate the figures from the
futures market. Another is “feeling” the size of volume based on the number
of calls on the dealing systems or phones, and the “noise” from the brokers’
market.
Open interest is the total exposure, or outstanding position, in a certain
instrument. The same problems that affect volume are also present here. As
it was already mentioned, figures for volume and open interest are available
for currency futures. If you have access to printed or electronic charts on
futures, you will be able to see these numbers plotted at the bottom of the
futures charts.
Volume and open interest figures are available from different sources,
although one day late such as the newswires (Bridge Information Systems,
Reuters, Bloomberg), newspapers (the Wall Street Journal, the Journal of
Commerce), Weekly printed charts (Commodity Perspective, Commodity
Trend Service).
5.2. Types of charts
Line Chart
The line chart is the original type of chart. In order to plot it, a line
connects single prices for a selected time period. The most popular line chart
is the daily chart. Although any point in the day can be plotted, most traders
focus on the closing price, which they perceive as the most important. But an immediate problem with the daily line chart is the fact that
it is impossible to see the price activity for the balance of the day.
Line charts are considered for technical analysis because due to the
sophistication of current charting services, daily price activity does not need
to be lost.
Daily line charts are useful when looking for the big picture or the major
trend because, without line charts, intraday activity would be-come an
unimportant detail. When plotted over a long stretch of time, such as several
years, a line chart is easier to visualize. Also, technical analysis goes well
beyond chart formation; in order to execute certain models and techniques,
line charts are better suited than any of the other charts.
However the line chart is a continuous chart, and this is a disadvantage
because price gaps cannot be charted on a continuous chart.
Bar Chart
The bar chart is arguably the most popular type of chart currently in
use. It consists of four significant points the high and the low prices, which are united by a vertical bar;
the opening price, which is marked with a little horizontal line to the
left of the bar;
the closing price, which is marked with a little horizontal line to the
right of the bar.
The opening price is not always important for analysis.
Bar charts have the obvious advantage of displaying the currency range
for the period selected. The most popular period is daily, followed by weekly.
Other periods may be selected as well. An advantage of this chart is that,
unlike line charts, the bar chart is able to plot price gaps that are formed in
the currency futures market. Although the currency futures market trades
around the clock, physically it is open for only about a third of the trading
day. (Chicago IMM is open for business 7:20 am to 2 pm CDT.) Therefore,
price gaps may occur between two days’ price ranges. Incidentally, the bar
chart is the chart of choice among currency futures traders.
Candlestick Chart
The candlestick chart is closely related to the bar chart. It also consists
of four major prices: high, low, open, and close. (See Figure 5.6.) In addition
to the common readings, the candlestick chart has a set of particular
interpretations. It is also easier to view.
The opening and closing prices form the body (jittai) of the candlestick.
To indicate that the opening was lower than the closing, the body of the bar
is left blank. In its original form, the body was colored red. Current standard
electronic displays allow you to keep it blank or select a color of your choice.
If the currency closes below its opening, the body is filled. In its original form,
the body was colored black, but the electronic displays allow you to keep it
filled or to select a color of your choice.
The intraday (or weekly) direction on a candlestick chart can be traced
by means of two “shadows”: the upper shadow (uwakage) and the lower
shadow (shitakage).
Just as with a bar chart, the candlestick chart is unable to trace every
price movement during a day’s activity.
5.3. Trends, Support and Resistance
Kinds Of Trends
The trend shows a pending direction of the market movement.
A trend may be:
1. Upward
2. Downward
3. Sideways, also known as a “flat market” or “trendless”Because the markets do not move in a straight line in any direction, but
rather in zigzags, it is the direction of these peaks and troughs that creates
the market trend. In addition to direction, trends are also classified by time
frame: major or l