Kinds of prices and time units. Charts for technical analysis are being constructed in coordinates,“price (the vertical axis) – time (the horizontal axis)”. The following kinds of currency prices represented on charts are being distinguished on Forex:
• open – a price at the beginning of a trade period (year, month, day, week, hour,
minute or a certain amount of one from these units);
• close - a price at the end of a trade period;
• high – the highest from prices observed during a trade period;
• low – the lowest from prices observed during a trade period.
Providing the technical analysis one uses charts for different time units – from 1 year or more until 1 minute. For instance, the computer program Trading Intl. uses allows you to analyze price movement charts for 1 day, 4 hours, 30 minutes, 15 minutes, 5 minutes and 1 minute. The longer the time unit applied to plotting the chart, the longer the time span used to analyze price movements and to determine the major trend by means of the chart. For short trading, charts for smaller time units are more suitable.
Line chart. The line chart is plotted connecting 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 period as well as gaps (See chapter 4.6) – breakups in prices at joints of trade periods.
Nevertheless, line charts are 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.
Bar chart. The bar chart consists from separate histograms (See figure 4.7). To plot a histogram in coordinates price – time the points responding to high, low, open and close prices for a time period analyzed should be marked on the one vertical bar. The opening price usually is marked with a little horizontal line to the left of the bar; and the closing price is marked with a little horizontal line to the right of the bar. Bar charts have the obvious advantage of displaying the currency range for the period selected. An advantage of this chart is that, unlike line charts, the bar chart is able to plot price gaps. Hence, it is impossible to see on a bar chart absolutely all price movements during the period.
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 4.8). In addition to the common readings, the candlestick chart has a set of particular interpretations. The latter is possible thanks to the convenient visual observation of that chart.
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. 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 period's activity.
Read More...
Charts for the technical analysis
The destination and fundamentals of technical analysis
Technical analysis is used for the prediction of market movements (that is alterations in currencies prices, volumes and open interests) outgoing from the information obtained for the past. The main instruments of technical analysis are different kinds of charts, which represent currencies price change during a certain time preceding exchange deals, as well as technical indicators. The latter are obtained as a result of the mathematical processing of averaging and other characteristics of price movements. The instruments of technical analysis are universal and applicable to any Forex sector, any currency and any time span.
Technical analysis is easy to compute what is important while the technical services are becoming increasingly sophisticated and reasonably priced. They are available to all Forex participants independent of their trade plans, strategies applied and the time of position continuance.
DOW Theory
The fundamental principles of technical analysis are based on the Dow Theory with the following main thesis:
- 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 (“The market knows everything”).
- Price movements are trend followers (“Trend is your friend”); trends are classified as up trends (bullish), downtrends (bearish) and flat (sideways).
- Price movements are historically repetitive (“The history repeats”) which results in the same patterns periodically emerging on the charts.
- The market has three trends: the longest (about 1 year) major, or primary, less enduring (1 month and more) intermediate, or secondary, and rather short (several days or weeks) minor. The primary trend has three phases: accumulation, run-up/run-down, and distribution. In this way, in the accumulation phase of a bullish market 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 one-third, one-half or two-thirds from the primary trend. In frame of a major trend may be any amount of secondary or minor trends.
- Trends exist until they are broken and their reversals are confirmed. It shows examples of reversals in a bearish currency market. The buying signals occur at points A and В when the currency exceeds the previous highs.
Forex dependence on financial and sociopolitical 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 (EMS) in the early 1990s. The realities of the marketplace revealed the underlying artificiality of this approach.
The role of interest rates. 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.
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, 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 crises influence. A political crisis is commonly dangerous for the Forex because it may trigger a sharp decrease in trade volumes. Prices under critical conditions dry out quickly, and sometimes the spreads between bid and offer jump from 5 pips to 100 pips. Unlike predictable political events (parliament elections, interstate agreements conclusion etc), which generally take place in an exact time and give market the opportunity to adopt, political crises come and strike suddenly. Currency traders have a knack for responding to crises. The traders should react as fast as possible to avoid big losses. They may not have much time to make decisions, often they have only seconds. Return on the market after a crisis is often problematic.
Read More...
Economics for fundamental analysis
For fundamental analysis on Forex, just as on any goods market, traders use the information from analytical reviews of specialists published in newspapers as well as charts and tables of many numerical indicators serving this purpose. All fundamental indicators are generally released on a monthly basis, except for the Gross Domestic Product and the Employment Cost Index, which are released quarterly (See below). All economic indicators are released in pairs. The first number eflects 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 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% for the past month, but the previous month's number is revised lower by 0.4%, then traders can draw a justified conclusion about the economy’s situation.
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. Sources of information. 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. Separate groups of fundamental indicators are considered below in accordance with a generally accepted classification.
Economic indicators
The Gross National Product (GNP) 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) refers to the sum of all goods and services produced in the United States, either by domestic or foreign companies. The differences 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 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 (or gross private domestic) Spending consists of fixed investment and inventories. 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 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 sector indicators
Industrial Production indicator 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 indicator 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 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 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 non-defense. This data is fairly important to foreign exchange markets because it gives a good indication of consumer confidence. Because durable goods cost more than nondurable, a high number in this indicator shows consumers' propensity to spend.
Therefore, a good figure is generally bullish for the domestic currency. 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. 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 Data
Construction indicators constitute a significant group that is 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 as it did 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.
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. For example, in spite of the 2000 – 2001 recession, the cost of houses in California hardly decreased. 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.
Read More...
Theories of exchange rate determination
Two types of analysis are used for market movements forecasting: fundamental, and technical (the chart study of past behavior of currencies prices). The fundamental one focuses on theoretical models of exchange rate determination and on major economic factors and their likelihood of affecting foreign exchange rates.
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").
Under the PPP 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 holds that the exchange rate is simply the price of foreign exchange that maintains the balance of payments in equilibrium. In other words, the degree to which the exchange rate responds to a change in the trade balance depends entirely on the elasticity of demand to a change in price. For instance, if the imports of country A are strong, then the trade balance is weak. Consequently, the exchange rate rises, leading to the growth of country A's exports, and triggers in turn a rise in its domestic income, along with a decrease in its foreign income. Whereas a rise in the domestic income (in country A) will trigger an increase in the
domestic consumption of both domestic and foreign goods and, therefore, more demand for foreign currencies, a decrease in the foreign income (in country B) will trigger a decrease in the domestic consumption of both country B's domestic and foreign goods, and therefore less demand for its own currency. The elasticities approach is not problem-free because in the short term the exchange rate is more inelastic than it is in the long term and additional exchange rate variables arise continuously, changing the rules of the game.
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 onetime 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.
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 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.
Read More...
Trade systems on Forex
Trading with brokers. Foreign exchange brokers, unlike equity brokers, do not take positions for themselves; they only service banks. Their roles are to bring together buyers and sellers in the market, to optimize the price they show to their customers and quickly, accurately, and faithfully executing the traders' orders. The majority of the foreign exchange brokers execute business via phone using 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.
Sometimes 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 an optimal 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. 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. Phone dealing was error-prone and slow. Dealing errors were difficult to prove and even more difficult to settle. Direct dealing was forever changed in the mid- 1980s, by the introduction of 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. Dealing systems are continuously being improved in order to offer maximum support to the dealer's main function: trading.
The software is rather 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 aystems. 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 counterparty. 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 inter-bank market, traders deal directly with dealing systems, matching systems, and brokers in a complementary fashion.
Read More...
Major currencies
The U.S. Dollar. The United States dollar is the world's main currency – a universal measure to evaluate any other currency traded on Forex. 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. As it was indicated, the U.S. dollar became the leading currency toward the end of the Second World War along the Breton 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 other 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 euro-denominated 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 is 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 British Pound. Until the end of World War II, the pound was the currency of reference. The currency is heavily traded against the euro and the U.S. dollar, but has a spotty presence against other currencies. 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.
Read More...
Kinds of the Forex
Spot Market. Currency spot trading is the most popular foreign currency instrument around the world, making up 37 percent of the total activity (See Figure 1.2). The features of the fast-paced spot market are high volatility and quick profits (as well 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 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 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. By the entering into a contract on the spot market a bank serving a trader tells the latter the quota – an evaluation of the currency traded against the U.S. dollar or another currency.
A quota consists of two figures (for example, USD/JPY = 133.27/133.32 or USD/JPY = 133.27/32 which means the same). The first of these figures (the left part) is called the bid – price (that is a price at which the trader sells), the second (the right part) is called the ask - price (the price at which the trader buys the currency). The difference between asks and bid is called the spread. The spread, as any currency price alteration, is being measured in points (pips).
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.
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. For instance, in an active global trading day (24 hours), the euro/dollar exchange rate may change its value 18,000 times "flying" 100-200 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. For example, there is a technical trading gap between around 4:30 PM and 6 PM EDT. In the New York market, the majority of transactions occur between 8 AM and 12 PM, 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. Reasons for the popularity of the spot-market include the rapid liquidity, thanks to the market volatility, and short term contract execution. Therefore, the credit risk is restricted. The profit and loss can be either realized or unrealized. The realized P&L is a certain amount of money netted when a
position is closed. The unrealized P&L consists of an uncertain amount of money that an outstanding position would roughly generate if it were closed at the current rate. The unrealized P&L changes continuously in tandem with the exchange rate. Forward Market. Two tools are used on the forward Forex: forward outright deals and exchange deals or swaps. A swap deal is a combination of a spot deal and a forward outright deal.
According to figures published by the Bank for International Settlements, the percentage share of the forward market was 57 percent in 1998. (See Figure 1.2). 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. 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 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.
Futures Market. Currency futures are specific types of forward outright deals. Because they are derived from the spot price, they are derivative instruments. (See Figure 1.2). 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.
The following are characteristics of currency futures that make them attractive. They are open to all market participants, individuals included. It is a central market, just as efficient as the cash market, and whereas the cash market is a much 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 nonprofitable position to post
margins equal in size to their losses. 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 (See Chapter 4) solely available in the futures market. Because of these benefits, currency futures trading volume has steadily attracted a large variety of players. Because futures are forward outright contracts and the forward prices are generally slow movers, the elimination of the forward spreads will transform the futures contracts into spot contracts.
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 that show the convergence between the futures and spot prices.
Read More...
Risks by the foreign exchange on Forex
As it was mentioned above trading on the Forex is essentially risk-bearing. By the evaluation of the grade of a possible risk accounted should be the following kinds of it: exchange rate risk, interest rate risk, and credit risk, country risk. Exchange rate risk is the effect of the continuous shift in the worldwide market supply and demand balance on an outstanding foreign exchange position. For the period it is outstanding, the position will be subject to all the price changes. The most popular measures to cut losses short and ride profitable positions that losses should be kept within manageable limits are the position limit and the loss limit. By the position limitation a maximum amount of a certain currency a trader is allowed to carry at any single time during the regular trading hours is to be established. The loss limit is a measure designed to avoid unsustainable losses made by traders by means of stop-loss levels setting.
Interest rate risk refers to the profit and loss generated by fluctuations in the forward spreads, along with forward amount mismatches and maturity gaps among transactions in the foreign exchange book. This risk is pertinent to currency swaps; forward outright, futures, and options (See below). To minimize interest rate risk, one sets limits on the total size of mismatches. A common approach is to separate the mismatches, based on their maturity dates, into up to six months and past six months. All the transactions are entered in computerized systems in order o calculate the positions for all the dates of the delivery, gains and losses. Continuous analysis of the interest rate environment is necessary to forecast any changes that may impact on the outstanding gaps.
Credit risk refers to the possibility that an outstanding currency position may not be repaid as agreed, due to a voluntary or involuntary action by a counter party. In these cases, trading occurs on regulated exchanges, such as the clearinghouse of Chicago. The following forms of credit risk are known:
1. Replacement risk occurs when counterparties of the failed bank find their books are subjected to the danger not to get refunds from the bank, where appropriate accounts became unbalanced. Settlement risk occurs because of the time zones on different continents. Consequently, currencies may be traded at the different price at different times during the trading day. Australian and New Zealand dollars are credited first, then Japanese yen, followed by the European currencies and ending with the U.S. dollar. Therefore, payment may be made to a party that will declare insolvency (or be declared insolvent) immediately after, but prior to executing its own payments.
Therefore, in assessing the credit risk, end users must consider not only the market value of their currency portfolios, but also the potential exposure of these portfolios. The potential exposure may be determined through probability analysis over the time to maturity of the outstanding position. The computerized systems currently available are very useful in implementing credit risk policies. Credit lines are easily monitored. In addition, the matching systems introduced in foreign exchange since April 1993 are used by traders for credit policy implementation as well.
Traders input the total line of credit for a specific counterparty. During the trading session, the line of credit is automatically adjusted. If the line is fully used, the system will prevent the trader
from further dealing with that counterparty. After maturity, the credit line reverts to its original
level.
Read More...
Foreign exchange as a part of the world financial market
Forex – What is it? The international currency market Forex is a special kind of the worldfinancial market. Trader’s purpose on the Forex to get profit as the result of foreign currencies purchase and sale. The exchange rates of all currencies being in the market turnover are permanently changing under the action of the demand and supply alteration. The latter is a strong subject to the influence of any important for the human society event in the sphere of economy, politics and nature. Consequently current prices of foreign currencies, evaluated for instance in US dollars, fluctuate towards its higher and lower meanings.
Using these fluctuations in accordance with a known principle “buy cheaper – sell higher” traders obtain gains. Forex is different in compare to all other sectors of the world financial system thanks to his heightened sensibility to a large and continuously changing number of factors, accessibility to all individual and corporative traders, exclusively high trade turnover which creates an ensured liquidity of traded currencies and the round – the clock business hours which enable traders to deal after normal hours or during national holidays in their country finding markets abroad open. Just as on any other market the trading on Forex, along with an exclusively high potential profitability, is essentially risk - bearing one. It is possible to gain a success on it only after a certain training including a familiarization with the structure and kinds of Forex, the principles of currencies price formation, the factors affecting prices alterations and trading risks levels, sources of the information necessary to account all those factors, techniques of the analysis and prediction of the market movements as well as with the trading tools and rules.
An important role in the process of the preparation for trading Forex belongs to the demo-trading (that is to trade using a demo-account with some virtual money), which allows to testify all the theoretical knowledge and to obtain a required minimum of the trade experience not being subjected to a material damage. A short history about the origin and development of the currency exchange market. 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 periods of high volatility (that is afrequency and amplitude of price alteration) and relative stability formed itself in the twentieth
century. By the mid-1930s London became 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”. 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, in accordance with the Breton Woods Accord between the USA, Great Britain and France (1944) became the reserve currency
for all the capitalist countries and all currencies were pegged to the American dollar (through the
constitution of currency ranges maintained by central banks of relevant countries by means of interventions or currency purchases).
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. In accordance with the same agreement was organized the International Monetary Fund (IMF) rendering now a significant financial support to the developing and former socialist countries effecting economical transformation. To execute these goals the IMF uses such instruments as Reserve trenches, which allows a member to draw on its own reserve asset quota at the time of payment, Credit trenches drawings and stand-by arrangements. The letters are the standard form of IMF loans unlike of those as 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.
At the end of the 70-s the free-floating of currencies was officially mandated that became the most important landmark in the history of financial markets in the XX century lead to the formation of Forex in the contemporary understanding. 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. 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 influences on this spectacular growth in volume are mentioned below. A significant role belonged to the increased volatility of currencies rates, growing mutual influence of different economies on bank-rates established by central banks, which affect essentially currencies exchange rates, more intense competition on goods markets and, at the same time, amalgamation of the corporations of different countries, technological revolution in the sphere of the currencies trading. The latter exposed in the development of automated dealing systems and the transition to the currency trading by means of the Internet. In addition to the dealing systems, matching systems simultaneously connect all traders around the world, electronically duplicating the brokers' market. Advances in technology, computer software, and telecommunications and increased experience have increased the level of traders' sophistication, their ability to both generate profits and properly handle the exchange risks. Therefore, trading sophistication led toward volume increase.
Regional reserve countries. Along with the global reserve currency – U.S. dollar, there are also other regional and international reserve countries. In 1978, the nine members of the European Community ratified a plan for the creation of the European Monetary System managed by the European Fund of the Monetary Cooperation. By 1999 these countries, which constituted socalled Euro zone, have implemented the transition to the common European currency - the euro (see Figure 1.1). 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.
The euro is a regional reserve currency for the euro zone countries and the Japanese yen – for the countries of Southeast Asia. The portfolio of reserve currencies may change depending on specific international conditions, to include the Swiss franc. The role of the U.S. Federal Reserve System and Central banks of other G-7 countries on Forex. All central banks and the U.S. Federal Reserve System (FRS) as well, affect the foreign exchange markets changing discount rates and performing the monetary operations (as interventions and currency purchases). 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 national currency should weaken.
The repurchase agreements may be either customer repos or system repos. Matched salepurchase agreements are just the opposite of repurchase agreements. When executing a matched sale-purchase agreement, a bank or the FRS 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 national currency should strengthen. Monetary operations include payments among central banks or to international agencies. In addition, the FRS 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. States foreign exchange markets by the U.S. Treasury and the FRS 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.
Read More...
