FX Power Trading Course PDF

FX! OWER TRADING COURSE SUPPLEMENTARY MANUAL FOR POWER TRADING COURSE ee Copyright 2003, Forex Capital Markets LLCPOWER TRADING COURSE MANUAL Part 1: The FX Market What Makes a Good Trading Market? Superior Liquidity ‘Transparency of Market Information Perfect Market for Technical Analysis Unrivalled Leverage Capabiitios Review Forex vs. Equities Review: Forex vs. Futures Hierarchy of Participants Market Participants ‘A Closer Look at the Key Paricipants A Brie! History of Electronic Trading in Foreign Exchange ‘Overview of the Major Central Banks Market Hours . satis Review: FX A Brief History Part 2: Currency Trading Basics 180 Codes: How and FX Trade Works Caleulating Proft and Loss (Other Key Concapts in Currency Trading CCaloulating and Approximation of Interest Rollover Types of Orders. Phone Etiquette Part 3: What Moves the Market \Whet Moves the Market Key Factors in Fundamentals Analysis Other Fundamental Factors that impact Currency Movements How to Use Fundamental Analysis in Trading Candlesticks Fibonacci Retracement Levols Moving Average Bollinger Bands Osctlators Stochastics. oer Moving Average Convergence / Divergence (MACD) 12 13 16 8 19 20 2 24 32 35 38 39 42 a 45 49 5 89 n 73 ™ 75 7Table of Contents BE EERE Part 4: Currency Profiles and Outlook ‘What Makes 2 Good Trading Market? 78 Important Economic Indicators for the US s.iesiennsnnnsnsnsnnnsnnonn 83 ‘CANADA (CAD) sisoia 85 Impottant Characteristic of the Canadian Dollar e Important Economie Indicators for Canada 80 UNITED KINGDOM (GBP) “0 Monetary & Fiscal Policy Makers 2 Important Characteristics ofthe British Pound 8 Important Economic Indicators for the UK 99 European Monetary Union (EUR)... 96 SAPAN (APY) sons srciersncennsrcses: 0H SWITZERLAND (CHF) 107 AUSTRALIA (AUD) 3 vo . soon W2 NEW ZEALAND (NZD)... “ 116 Irnportant Charactoristc ofthe New Zoaland DOL nen 118 Part 5: Trading Rules to Live By Trading Rules to Live By 421 Money Managemant and Psychology 121 Appendix Appendix co 17 Purchasing Power PartyURL Image 135 ‘The FX POWER™ Trading Course contains propriatary subject matter developed and ‘owned by Forex Capital Markets LLC. This material, and all proprietary ‘aspects thereof, shall at al imes remain the property of Forex Capital Markets LLC. Reproduction oy other use of this material without the express written consent of Forex Capital Markets LLC is prohibited © Forex Capital Markots LLC 2003 ALL RIGHTS RESERVED,What Makes A Good Trading Market? Regardless of which instrument you are trading - be it stocks, municipal bonds, U-S. treasuries, agricul tural futures, foreign exchange, or any of the count lose othors - the attributes that determine the viabil ity of a market as an investment opportunity remain the same. Namaly, good investment markets all pos. sess the following characteristics: liquidity, market transparency, low transaction costs. and trending markets, Liguidity Liquidity, the term used to qualitatively assess how ‘sesily trades can be ontored and oxited, is of prime importance te all traders. Trading essentially involves two transactions: the opening of a position, followed by the subsequent closing of that position Liquidity, which is highly correlated to volume, assesses how easily traders can enter and exit posi tions. A liquid market is a market where participants can rapidly execute large volume transactions with little Impact on prices. Markets that have high daily, lurnover generally offer the most competitive prices and the best execution, Treders participating in ilig uid markets will experience delays and market order fills could potentially be ats very differont price from the market rato when the order was initially placed (slippage). Furthermore traders may have difficulty in exiting positions, therefore affecting the true cost of the trade, Ultimately this will create substantial barriers to clearing profitable trades, Market Transparency Market transparency is usually defined ax the ability of market participants to observe the information in the Wading process. Informed traders are better off while uninformod tradors become worse off, because markots can be expioited by those with private infor mation. Today's financial markets rely heavily on information transparency: traders need the ability to PART |: The FX Market ‘see @ transparent spread in order to omploy a strat ogy that is both pre-meditated and disciplined, while still flexible enough to accommodate an ever changing marketplace. Such transparency of information provides traders with the ability to craft a fine-tuned tisk management strategy. and apply it to the market in accordance with the fundamental and technical tools used to assess market opportunities Ultimately, greater market transparency leads to market efficiency. In the case of Worldcom, for example, inaccurate reporting by company principals. have resulted in the downfall of the company and losses for many shareholders. Markets where this, ean occur may not be considered a good trading market, Another key concept in market transparency i the ability to trade from live, executable prices Markets that do not offer prices that are executable are frustrating for traders. There is typically delayed fill and the fil price may not always be at the same rate as the market rate when the order was initially placec. Low Transaction Costs Transaction costs include all factors that may affect the ease of executing a trade. Transaction costs lower profits andior extond losses. The lower the transaction costs for trading, the more attractive the market is for active traders, Explicit transaction costs include commissions for trade. Trading on $0 commissions per trade Is always better than being charged $20 in commissions per trade. Implicit rans action costs can take several different forms that traders may or may not be aware of, but which can affect profitability nonetheless. For example, markets that have centralized exchanges tend to have higher transaction costs, due to exchange and clearing fooe associated with trading. Transaction costs can also be increased by faulty execution, if the actual price of execution diverges from the market-clearing pricesWhat Makes A Good Trading Market? Trending Markets Technical analyeie statistically works better in mar kote characterized by cycles that repeat themselves. The reason for this is because the whole premise of echnical analysis is based on the study of price movements. Historical price cata is used to foracast the direction of future prices, in addition, technical analysis works better In liquid markets. Through technical analysis traders can identity general trends and capture key enlry and exit points. Markets that are less liquid makes it more difficult to accurately gauge entry and exit points, PART I: The FX MarketSuperior Liquidity Spol currency trading is the most popular FX instrument ‘around the world, comprising more than 1/3 of the total activity. tis estimated that spat FX trading generates about $1.5 tillon a day in volume, making it the largest and most liquid market in the world. Compare that to futures ‘8437 bn and equities $194bn and you will see that foreign exchange liquidity towers aver any other market. Even though there are many currencies al over the world, 807% of al dally transactions involve trading the G-7 currencies Le. the "majors." When compared 10 the fulures market, whieh is fragmented between hundreds of types of com: modities, and multiple exchanges and the equities market, With 60,000 listed stocks (the S&P 600 being the majority), it becomes clear that the futures ané equities provide only limited liquidity when compared to currencies. Liquidity has ite advantages, the primary one being no manipulation of the market, Thin stock and futures markets can easily be pushed up or down by specialists, market makers, com- mercials, and locals. i takes real buyingisellng by banks and institutions to move the spot FX market. Any attempted manipulation of the spot FX market usually becomes an exercise i futity Traditional measures of fiquiity include dally volumes trad ed and number of transactions; however, itis also important Average Daily Derivatives, Equity Year in Billions PART I: The FX Market to consider volatility. Velatilty measures fuictuations in the ‘market price, Although many traders perceive volatity to be good thing for markets, in actualty low volaiity is a'sign ‘of a smoothly functioning liquid market, whereas markets ‘characterized by high volatlily tend to be ifiquid and less, suitable for small, active, shortterm taders. In highly volatile markets, large volume transactions can iteraly move the market and create “gapping.” In the foreign exchenge market studies Indicate that prices tend to move in relatively stall increments, despite very large vansac~ tion, Evidence exists fo suppor the notion that the foreign exchange market's volume provides it with protection against excess volatility, In addition, spot foreign exchange trading is the perfect market for active event driven traders, asitcan be traded 24 hours a day, Unlike stock and futures trading, currencies do ot get halted, ensuring the abiity to trade during virtvally any important event. Given its inherent intematonality, FX tradng serves @ purpose in ail geographic regions; as a result, trading must ovour during all hours. The round-the- clock nature of the foreign exchange market ensures that there will be minimal gaps in the market: in other words, there is no potential for the market to close one day and reopen the next dey at a drastically diferent price. In equi ties and futures markets, centralized exchangae end oper. ations when the businass day concludes. Aterchours market liquidity is quite thin, thus making trading unfeasibie More importantly, traders who leave positions open after the market closes expose themselves to greater risk’ should news be released after the markel closes thal affects positions, traders will nat have the opportunity to iromediately liquidate; as @ result. they will be forced to cope with market conditions upon opening the following day, when the market may epen at a very diferent rate than when it closed. As 6 result, tradors become vicime of lig: tid markets: they were unable to react to naws and world events when the market closed, and hence were unable tenteriaxit positions. The seamless continuity ofthe foraign exchange market ensures thal the markat is liquid at all times, thus alleviating traders of potantial risks associated= ao 2 2 3 FX: the Perfect Market for Active Traders Transparency of Market Information with market gaps and illiquidity, The apt EX market is onthe cuting edge of he tachnalo- ay revliton making Wading much mote ein, and sin- bY a beter choice for active rads. Price Wansparency i very high in the FX market and the evolution of online for- ‘eign exchange tracing continues to improve this to the benef of vaders. One of te Dagest advantages of trading fore exchange online I the ably to ade rectly wth the rake maker, A repulble forex broker wil provide treders with streaming, executable prices. It is important to. mreko 8 dsincton botwoon india pone and x0- tutablo prices. Indative quote ore thoeo that offer an Calin ofthe prices inthe markt, and the fale at which they ate chenging. Executable prices are actual pices where the market maker is willing to buy/sell, Although: online trading has reached equities and futures, prices represent te LAST Duyisel and terior represent naleatve prcas rater tran executable pices. Furtermore, rang nine rely wit the rarket mater means adr reco a fir price onal trensacions. When iadng equlles or ues through a broker, traders must request price before dealing. alowing for brokers to check # trader's onetng poston and chade’ he price (ntl favon a few pipe depending on tha ‘rade. poston. Online trading capabiiee In EX alee croate more aficiarey and market transparency by providing real time portfolio and account tracking capabilty. Traders have access to real time profitfioss on open positions and can generate reports on demand, which provide detailed information regarding ‘every open position, open order, margn position and: generated profivoss per trade. A Sample FX Trade Bae) lon log ante the online fading platform ant places pe) ced Pouch dabeeas eee, vy) ) 13 ) 3339°5 5 O°9 > Transparency of Market Information A Sample Futures Trade STEP 1 eee) STEP Z Te ge eee en ME ite] De ee Se ee ee a aie eee ea eee nes areata Se ee X: the Perfect Market for Active Traders Lower Transaction Costs than Equities and Futures: ‘As mentioned earlier, transaction costs Gan serve to lower profits or extend losees, Dus to the decentralized nature of tho FX markot, transactions costs in the FX market are sither z0r0 or close to z0ro, Tho FX market is able to offor lower transaction costs because there is no centralized exchange for trading such as the NYSE or the CBOT ‘Therefore, clants do not have to pay any exchange or clearing fees. Costs are further reduced by the eficiencies ‘ereated by @ purely etecttonic marketplace tet allows llents 10 deal direciy with the market maker, efminating both ticket costs and middlemen. Because the currency market ofles round-the-clock iquidy, keaders receive tight, Competitive spreads both inte-day and night. Online foreign ‘exchange 6 far and away the bost market choice for aggressive sherttorm oriented traders. Online FX allows active traders to trado without the huge costs associated with doing so in futures and equities trading. Equity and futures markets are structurally very antiquated and need to take small pienes of each transaction to keep their sys tems afloat. Active stock and futures traders often see sub> stantial porions of their gross profits go to brokers in the form of commissions, and exchanges in the form of exchange and data fees. Also with the growing trend of exchanges going public, it is reasonable to assume thet these “hidden” costs wil only ise, a8 these newly public entities will have shercholders to answer to.FX: the Perfect Market for Active Traders Lower Transaction Costs than Equities and Futures Average Roundtrip Commission Charge On $100K Position Average Roundtrip Commission ‘Charge On 100K PositionFX: the Perfect Market for Active Traders Pertect Market for Technical Analysis “The FX market is the perfect market for technical analysis, Long-torm movements in the currency market generally correlate with economic cycles. Economic cycles tend to repeat themselves and therefore can be predicted with 2 fair degree of accuracy. Repettion is the key to technical analysis, since the entre premise of techrical analysis lies in using historical price movement to forecast future price movement. in the stock market, the fundamertals ofa particular company can change radically in a short period of time, making historical pries irrelevant in the prediction of future movement. Technical analysis, which relies strongly on statistical assessments of market conditions, benefts ‘greatly for the fact that the FX market is more normalized, ‘meaning i is lags skawed - than other financial markets. “The equities and futures markets. which are more skewed than the FX market, offer less statistical reliability: their dis- ‘tribution is less normalized, and hence the market is not as Ikely to retrace back when a statistical indicator suggests that 2 partcular asset is overbough! or oversold. AS a result, other markets are not as conducive to technical analysis, Currencies rarely spend much time in tight trading ranges and have the tendency to develop strong trends. Over 80% of volume is speculative in natura; as a resul, the market frequently overshoots and then corrects teal. A techricaly trained trader can easily identity new trends and breakouts, Which provide multiple opportunites to enter and exit post tions. Charts and indicators are used by all professional FX market traders and cande charts are avaiable on most chatting packages. In addition, the most commonly usec Indicators suct as Fioonacel Retracernents, Stochestics, MAGD, Moving Averages, RSI and supportiresistance lev- ‘els have proven valid in many instances. In the NZD/USD chat below, itis clear that Fibonacci Retracements, Moving Averages and Stochastics have at one point or ancthar ‘given successful trading signals. For example, the 62% rotracement level has served as support for the NZD/USD from the beginning of September 2002 to the end of Sepiember 2002, Equity anc Futures traders. who focus on technical analysis. can implement the same technical strategies that they use in the futures market in the FX marketFX: the Perfect Market for Active Traders Not Convinced? Two More Reasons Why Traders Choos¢ Forex Ability to Go Long or Short with Equ Ease ‘Tho FX markot is considored by most traders to be the only {rue free market as its vast size and international presence allow itto be lbosaly regulated. This makas FX a very “tad- er fiendly" environment with litle restrictions impeding the average trader. A Key aspect of tgnt government intervention is the abilty to short on a dovmtick: currency traders, unlike their equity counterparss do not need to waste valuable time waiting for conditions to change before executing a trade, As the chart shows, a trader looking to short OSIP- Would have had to wait 3 minutes and over 2 $1 in potential profit before getting a short off, A currency trader facing @ similar situation would most likely have been able to get 3 short off almost immediately trading in the spot FX market Potential Lucrative Trade Missed because of Archaic Exchange Rules 4 stock id mot up tick Sor 3 minutes atone pi i hte 1 grib46 As ot son PM ESTFX: the Perfect Market for Active Traders Unrivalled Leverage Capabilities Anolher key altrbute in determining the worthiness of an Invostmant market is the leverage it affords, Because the FX market actually lacks volatility, traders have the poworto customize their risk exposure through the usage of lever: age. Leverage essentially allows traders to participate in the market with borrowed funds. The FX market is one of the most popular markets for speculation cue to its enormous size, Iquidity, and tie tendency for currencies to move in Strong trends, Most market makers allow posivons to be leveraged 100:1, This high leverage enables traders to access @ market that was previously not accessible to traders with 2 limited amourt of capital. Traditional ot sizes are 100,000 units, This meas that without leverage, traders would have to put up $100,000 pr lot that they buy or sell, With 100:1 leverage, traders who want to partici. pate in the FX market would only need to put up $1,000 per lot that thay buy or sell ‘This represents 100 times capital ‘versus the 10 times capital tat is characteristc of eauty and future markets, This addtional leverage provides to active Waders the abiity to maxmize profits based upon tally market fluctuations. To understand how leverage works, consider the (olowing exemple Trades A deposits $10,000 into a trading account to specu: late on the USDPY exchange rate, one of the most heav: Mergin Required to Put on a Position ly traded currency pas in the world. Instead of trading just $10,000, though, Trader A opts to use the leverage avail able. Trader A decides to trade $100,000 with his intial Investment, thus creating a leverage ratio of approximately 10:4 (since ha is trading circa 10 times what ne deposited) Now ‘ets say the USDJPY makes a 0.5% movement in favor of Trader A - a typical percentage move for the USDNPY in a single day. On a $100,000 investment, a 0.5% move results in a proft of $500. On an investment of $10,000, though, « $600 profit equates to a 5% return, ‘Alternatively, © more eggressive trader may decide to trade $200,000 with his initial $10,000 investment. In such @ case, a favorable move of 0.5% would result in reatzed profits of $1,000 - or 2 10% return on the initial investment. The aforementioned examples ilustrate how leverage can be used as a tool to precsely customize a traders risk exposure to market volatily. Instead of relying on volatile assets to generate profis oF losses, as other fhiancial mar kets do, leveraged currency trading takes a diferent ‘approach: the market is not very volatile, relatively speak- ing, and thus clients can use leverage to customize the level of risk they assume in the market. Margin Required to Put ‘ona PositionIII ) 24-Hour Market The FX markot isthe ideal market for active tradors, Itis a 24-hour market that grants instant accoss to trading for Inynediate response to glotial developments. It also gives traders the added flexibility of datermining thair trading day. Eaquitias on the other hand, open at 9:30am EST and close at 4:00pm EST, If there is a sionticant preakthrough between 4:00pm EST and 9:30am EST, most traders wil have to watt uri the open at 9:30am to place traces. Most likely by that time, unless youhave access to ECNs such as Instinet for pre-market vading, the market would have ‘gapped up or down against your favor. {n addition, if you have a fulltime job during the day anc ‘can only trade ator hours, equities would be a very incon veniant market for you to rade. You would basically be placing orders based upon past prices and rot current market prices. This lack of transparency makas trading very cumbersome. With the FX market, f you choose to trade alter hours, you can be assured that you would receive the same liquicty and spread as any otner time of day. In adi- tion, you would be able to access and trade on real time executable prices Low Transaction Costs In the oquity market, traders must pay @ spread and a commission. With onfne equily brokers, commissions can run upwares of $20 per trade. With positions of $100,000, average roundtrip commissions could be as high as $120. The over-the-counter structure of the FX market eliminates exchange and clearing fees, which in turn lowers transao- tion costs. Gosis are futher reduced by the elficiencies created by a purely electronic market place that allows clients to dea drectly with the market maker, eliminating both licket costs and middlemen. Because the currency market offers round-the-clock lquity, traders receive tight, competitive spreads both intra-day and night. Equiy traders are more vulnerable to liquidity risk and typically recol wider dealing spreads, especialy during after hours trading, REVIEW: FX vs. Equities Low to zero transaction costs makes online FX trading the best market to trade for shortcierm iradors. if you are an ‘equity trader who typically places 30 trades a day, at $20 commission per trade, you would have to pay S600 in dally transaction costs in this example. This is a significant amcunt of money that would serve to reduce profits or deepen losses, The simplest way to look at this sin an equities ade: there is broker, the exchange and the spe ciallst All of these parties need to be paid, and their pay ment comes from your commission and clearing foes. In tho FX market, these feos are net applicabl High Leverage The FX markel provides traders access to a much higher leverage than the equities market. FX traders can benef from leverage in excess of 100 times ther capital, versus ‘he 10 times capital that typically offered to professional equity day traders. The margin deposit for leverage is not ‘a down payment on a purchase of equily, as many perosive margins to be in the stock markets. Rather, the maigin is @ performance bond, or good faith deposit, to onsure against ‘trading losses, This ie very useful to short-term day traders who need the enhancement in capital to gonarato quick telus. However, laverage is a double-edged sword Without propar risk management, this high degree of leverage can lead to large losses as well as gains. Profit in Both Bull and Bear Markets Inthe FX market, prof potenta’s exist in bot) bull and bear markets. Since currency trading always Involves buying one currency and seling another, there is no structural bias tothe markot. Therefore, if you are long one currency, you are algo short ancthar. Ase result, proft potentials exist ‘equally in both upward trending and downward trending markets, This is diferent from the equities market, where ‘most traders go long instead of short stocks. so the gener al equity investment community tends to suffer in 2 bear market. 43No Trading Curbs / No Up Tick Ru The FX market has 2 dally volume in excose of $1.6 tilion, ‘making it the largest and most liquid market in tho word This is close to three times the size of the equitias market This additional volume and liquidity ensures traders that they will have access to the most competitive market in the world with the best executions. Unlike the equities market, there is never a time when vading curbs would take into effect and trading would be halted, only to gap when reopened. This eliminates missed profits due to archaic exchange reguations. In the FX market, traders would be able to place trades 24 hours # day, Also, in the equitias market, traders are prohibited from shorting 2 stock in a downtrond unloss there is an up tick. This can be voty frustrating as traders may want to join short sellers, but continually watch the stock trend down bfere an up tick occurs. In the FX market, there is na such rule. If you want to short a currancy pair, you can do so Immediately and not nave to wait for any requirement such a8 an up tick rule, This alls for instant and e_ficlent exe ution, Low Error Rates Online FX trading is typically @ 3.stop process. A trader would place an erder on the platform, the FX deating desk would automateally execute it electronically and the order confirmation would be logged on the trader's trading sta tion. An equities trade, on the other hand, would have a 5- step process: the client calls his broker to place an order, the broke: sends the order to the exchange floor: the spe Cialist on the floor tries to match up orders (the broker com- petes with other brokers to get the best il forthe client), the specialist executes the trade, and the client receives a con firmation from the broker, ‘The elimination of a middleman eliminates the orror rates on placing FX tradoe and Incroases the efficiency of each transaction REVIEW: FX vs. Equities Limited Slippage Unlike the equity markets, the most advanced online FX ‘market makers provide instantaneous execution from real time, twoay quotes. Thase quotes are the prices where the firms are willing to buy /sell the quoted currency, rather than vague indications of whare the market is trading ‘hich arent honored [indicative quotes J. Orders are exe cuted and confirmed within seconds, Robust systems ‘would never request the size of a travers potental order, or which side of the market he's trading, before giving him @ bid/offer quote. Inefficient dealers determine whether the investor is @ buyer or a soles, and ‘shade’ the price to increase their own proton the transaction. The equity markot typically operates under a “next best order’ systom, under which you may not get executed at the price you wish, but rather at the naxt best price available. For example, let's say Microsoft tracing at $52.50. If you enter 2 ‘buy order at this rate, by the time it reaches the specialist ‘on the exchange floor, the price may have risen to $53.25, In this case, you wil not get executed at $52.50; you wil get executed at $53.25, which is essentially a loss of % of @ point. The price transparency provided by the leading online foreign market makers assures that traders always, receive @ fair price, Every order you place, along with all ‘stops and limits, will be exocuted at EXACTLY that price without sippage: Liquidity Spot FX is @ market wth $1.5 Triton in dally turnover. ngar- y S tines that of the futures market. It is also a 24-hour market, granting instant access to trading for immediate response to global developments, This also gives traders the added flexibility of determining their trading day Futures on the other hand, have varying hours for open and loses. Fer example, if you traded gold futures it i only ‘open for trading between 7:20am: 30pm on the COMEX. (On the othor hand, if you traded crudo ll futures on the NYME, trading would only be open batwoen 8:30am.2 10pm. These varying hours create confusion and make i dificult to act on breakthrough announcements throughout 14the temainder of the day. In addition, if you have a fullime Job during the day and can only trade after hours, futures Would be a very inconvenient market for you to trade. You would basically be placing orders based upon past prices ‘and not current market prices. This lack of transparency makes trading very cumbersome. With the FX market, it you choose to trace after hours, you can be assuted that you Would receive the same liquidity and spread as any other time of day, In addition, you would be able 1o access and trade on real time executable prices, Low Transaction Costs ln the Futures market, traders must pay a spread andlor a commigsion, With future brokers, average comm can tun close to $180 per trade on positions of $100,000 or oreater. The over-the-counter structure of the FX market eliminates exchange and clearing fees, which in turn towers transaction costs. Costs ate further reduced by the etti- ciencles created by a purely electronic market place that allows cents to deal directly with the market maker, elmmi- nating both ticket costs and midvlemen, Because the our rency market offers roundsthe-clock liquidity, traders receive tight, competitive spreads both intraday and night Equity traders are more vulnerable to liquidity risk end typically toceive wider dealing epreads, espocially during aftor hours trading Low to 2e0 transaction costs makes online FX trading the best marke! to trade for snor+term traders. you are an active futures trader who typically places 20 trades a day, at $100 commission per trade, you would have to pay $2000 in daily transaction osts inthis example. This isa signi ‘cant amount of money that would serve to reduce profits oF deepen losses. The simplest way to look at this is in 2 futures trede; there is a broker, an FCM order desk, a dork fon the exchange floor, a runner, and a pit trader. All of those parties need to be paid, and their payment comes from your commission and clearing fees. In the FX market, these feas are not applicable REVIEW: FX vs. Equities 15 Execution Quality and Speed / Error Rate: Low “The futuroe markat ie known for inconsistont execution, both in terms of pricing and execution time. Evary futures trader has experienced a half hour wat for a market ordar to be filed and has been executed at a price far anay from where the market was trading when the intial order was placed. Even with electronic trading and imitad quarantees cof execution speed, the price for fils on market orders Is far from certain, In the fulures market, execution is uncertain because all orders must be done on the exchange. This creates @ situation where liquidity is imited by the number of participants, which in tum limits quantities that ean be traded at a given price, In ailition, the futures market typically operates under a ext best ord" system, under which traders frequently do ot get executed al the ritial market order price, but rather al the next best price available, For example, let's say 2 Client is long 5 March Dow Jones futures contracts at 8800. If the client enters a stop order at 8700, when the rate reaches this level, the client will most tkely be executed at £8690, This 10-point difference would be attributed to sti page, which is very common in the futures market. In the FX market, the price transparency provided by the leading online foreign exchange market makers assures that traders always receive 2 fair price. Every order you place, along with all sions and links will be executed at EXACT. LY that price without sippage. Now online foreign exchange platform allows for instants. ‘neous execution ‘rom lve streaming prices. There sno dis- ‘crepancy between the displayed price and the execution price, This holds tue even during volatile mes and fast moving markets, In the fulures market, executon is uncertain because all orders must be done on the exchange. This ‘creates @ stuation whore lquidty is imitod by the numbor Cf participants, which in tum limits quantties thst can be traded at a given price. Resl time streaming prises ensure that markat orders, stops, and limits are executed without929 DD ) ) 1373 3999399 ) YD) Which Do You Prefer? Pee 2 Large Market Liquidity Little Sc enc ar Limited ee REVIEW: c=) pr UCC eLe ly Rey Se) emic tia] Cay easy PS el 16 FX vs. Futures FUTURES Sey rey ons eR EA onl emi re eee Se a eu cd‘The foreign exchange market is the generié term for the werldwide institutions that exist to exchange or trade cur- {encies. Foreign exchange is often referred to as Torey" of "FX" The foreign exchange marke is an ‘over the counter (OTC) market, This means that here isa cena exchange and clearing house where orters are matched. FX dealers and market makers around the world are linked fo each other around: the-cock via telephone, computer, and fax, creating one cohesive market. Since there is no centralized exchange, compettion between market makers prohibits monopolist pricing strategies. If one market maker attompts 10 dresticaly skew the price, then traders simply hhave the option to find anether market maker. Moreover, spreads are closely watched to ensure market makors are ‘ot whimsicaly ltring the cost ofthe trade. Many equity rey ee ea Son By their very nature, centralized markets tend to be monop- olistic with a single specialist controling the market, pricas ‘can easily be skowed to accommodate the interesis of the ‘spocialis, not those of the traders, If for example, the market is filed with sellers from whom the specalisis must buy {from but there are no prospective buyers on the other side, the specials wil be forced to buy from the sellers in be in situation where they cannot sal a commodity that is being ‘sold off and hence faling in valve, In such a station, the ‘specialist may simply wen the spread, thereby increasing the cost of the trade end preventing aditional participants from entering the market. Or, specialists can simaly drasti cally alter the quotes they are offering, thus manipulating THE FX Market Structure ‘markets, on the other hand, operats in @ completely difer- ‘ent fashion; the New York Stock Exchange, for instance, ie the sole place where companies Fstod on the NYSE can hhave their stocks traded. Centralized markets are operated bby what are veferred to as specialis's: market makers. on the other hand. is the term used in reference to decentral zed marketplaces. Since the NYSE is a centralized market 4 Stock traded on the NYSE can only have 1 bid-ask quote at all times, Decentralized markets, such as foreign exchange, can have multiple market makers - all of whom hhave the right to quate different prices. Below is an ilusiration of how beth centralized and decentralized markets operate: the price to accommodate their ewn needs. 17Hierarchy of Participants While the foreign exchange market is decentralized, and hence employs muitiolo market makers rather than a single socialist, participants in the FX market are organized into 2 hiorarchy; those with superior credit access, volume transacted, and sophistication receives priority in the markot. At the top of the hierarchy is the intersank market Which trades the highest volume per day in relatively few. mostly G7 currenices. In the interbank market, the largest banks can dea! with each other ditectly, via interbank bro- ers or through electronic brokering systems Ike EBS oF Reulers, The interbank market is a credit-approved system where banks trade based solely on the credit relationships they have established with one another, Allthe banks can 02 the rates everyone is dealing at, however, each bank must have a specific credit felaionship with the other bank in order to trade at the rates being offered. Other instits- tions such as online FX market makers, hedge funds and corporations must trade FX through commercial banks Many banks (small community banks, banks in emerging markets), corporations, and insttutional investors co not have access to these rates because they have no estaby Retail Clients [J Online Trading CTT 4 Deed PCr 18 The FX Structure lished credit tines with big banks. This forces small partic. ‘pants to deal through just one bank for their foreign ‘exchange needs, and ofton times this means much less competitive rates for the participants further down the participant hierarchy, Those receiving the least competitive tales ate customers by banks and exchange agencies. Recently, technology has broken down the barriers that used fo Stand between the end-users of foreign exchange servicas and the Interbank market. The online trading rev ‘olution opened its doors to retail clientele by connecting ‘market makers and market participants in an efficient, low cost manner. In essence, the online trading platform serves {88 gateway to the liquid FX market. Average traders can now trade alongside the biggest banks in the world, with virtually similar pricing and execution. What used to be a ‘game dominated and controlled by the "big boys" is slowly becoming a level playing field where individuals can profit and take advantage of the same opportunities 2s big banks. FX is no longer an old boys cud, which means ‘opportunity is abound for aspiring online currency traders oud Markets EBS eo) ReutersMarket Participants In the last 25 years, increasing globalization has had a profound impact on the forsign exchange market, resulting in stoggoring growth as well a¢ an impressive riso in the number and diversity of players. The market has expandad from ‘one of banks trading predominantly amongst each otner to fone in which mary diferent kinds financial nsthutions all partcipate for a variety of reson, ‘There have been many contriouting factors to the growth of ‘he foreign exchange market bu the major developments that are worth noting are advancement in technology and the continuing growth of intematonal and cross-border capital movement, Le. foreign investment. Only ten years age most foreign exchange activity in the US was focused in international trade in goods and services. i.e. for Imporexport purposes. Now foreign exchange activity roflecte the changing financial arvironmont. Investment to and from overseas (Le. capital flows) has expanded tar more rapidly than trade. Institutional investors, insurance comparies, and mutual funds have become major partir pants in tne FX markets in addition to the more traditional financial and non- The FX Structure players such as contial banks, commersialinvestment banks, and commercial participants. The size and diversity ‘of players involved in the foreign exchange market contribute to the overall liquidity and price stability of the mar. ket. Simply pul, in the foreign exchange market there are always buyers and sellers, which creates an orderly market, The equities market is a speculators market, meaning, the majority of market participants waich the market to buy low and sell high for prof, When any kind of market news is released, which affects the intrinsic value of the stock, the market will immediately correct itself and trade ot that lovel For example, if Goze Cole releases corporate carnings that are substantially lower than market expectations, the stock wil immediately begin trading at a level that reflects its new Intrinsic value. The stock would have to reach a lower level then itis perceived to be worth before buyers will come back ino the market looking to pick up the stock on the cheap, FX Growth Continues to Impress Turnover in US$ Bin (Daily) FX Growth Continues to Impress Turnover in USS Bin (Daily) 19A Closer Look at the Key Participants “The foreign exchange market has become far more democ- ratzod in rocent years duo to advances in technology, ‘oxpanding beyond simply banks executing transactions ‘amongst themselves, to include a wide variety of market participants with many different reasons for participating in the market including: To eam short-term profits from fluctu ations in axchange rates, to protect themselves irom joss due to changes in exchange rates, o acquire the foreign currency necessary to buy goods and services trom other ‘countries, oF seeking to influence the exchange rate Regardless of the motivation, the key merket participants affect the supply end demand of the currencies involved, land subsequently play @ role in determining the exchange: rate at that moment; therefore itis important to know who. fare the key market participants, Thay include commer- cialinvestment banks, contral banks, corporations, funds, and individuals. Commercial/investment Banks Commercial banks account for the largest proportion ot total FX trading volume. The interbank market caters (0 both the majority of commercial lumnover as well as enor mous amounts of speculative trading every day. These banks will trade currencies among themselves as part of the eystam of balancing accounts. The interbank market is 2 credit-approved systam whore banks trade selely on the ‘rect relationships they have astablished with one another ‘About three quarters of all foreign exchange trading is ‘between banks: in fac! billions of dollars worth of currency is traded between banks each day. Essentially ‘Commercavinvestment Banks are the sell side of the FX ‘market, as a other participants must trade through them, ‘Commercial and investment banks are in the FX merkel on, behalf of both their customers and themselves. Authorized foreign exchange banks deal through electronic brokering systems, which automaticelly match sellers ond buyors using orders for spot deals through terminals established at banks, Reuters was set up in 1992, followed by Electronic 20 The FX Structure Brokering Services Limited (EBS) in 1999, which primarily replaced the voice broker system. Electronic brokering has. dramatically changad intarbank trading, As a result spreads hhave tightened dramatically, making trading within the spread (a favorite strategy in the 1980"s) virtually non-exis- tent, The advance of electronic brokering owes much to its lower cosis, higher efficiency and, most importantly. greater ‘wensparency compared to traditional means of dealing, All the banks can see the rates everyone is dealing al, howev- ef, each bank must have a specific crecitrelationsiip with that bank in order te trade et the rates being offered Although most trading activity is undertaken on behaif of customers, proprietary desks also conduct a large amount of trading, where daclers ara trading to make the bank prof. lis. Banks are very much in the know, as they can see ordar fiow and when other important participants, such as cantral banks and large hedge funds, are entering the marketA Brief History of Electronic Trading in “Traditionally reign exchange transactions took pave over the phone, and to @ much lesser extent on the telex machine, The ol system of voice brokering was a con- lomeration of two-way phone conversations. betwaen Interbank dealers, Not only wore thoso eystame slow, and ‘error prone, but thoy alse allowed for a true market pric that was fuzzy! as prices could difer from dealer to dealer In order to stay current about the marke! prise, dass would execute smelor trades regulary throughout the trading session, not only fr profit, but to get an idea ofthe current price. Now, his oid system of teephones and brokers has been replaced by electronic sysiems, and most voice trokers have been forced out ofthe markel cue o cost sav~ ings and benetis provided by these systems, The fist ven= ture into electronic trading in foreign exchange mavkets was the launch of Reuters "Moritor Dealing Service" In the arly 1980s, which was loter replaced by Routers Desling 2000-1 in 1989, Tho oarlost systems allowed for communi- Example of the EBS Dealing Seri The FX Structure Foreign Exchange cation between foreign exchange dealers with 2 single counterparty, but dd not serve as a matching sysiem bebween numbers of potential counterparties. In 1982 however, this changed when Reuters launched Dealing 2000-2, a trus electronic brokering sysiom that automat cally matchod buy and sell quotes from doslers. Noxt, tho Minex Corporation, # Japanese group of brokers and bankers. set up its own system in April 1963, In September 1993. EBS (Electronic Brokering Service) was formed by a ‘group of large dealing banks launched ts trading system, ‘Once Minex Corporation transtarred its business nights to [EBS in 1996; the foreign exchange market was fot with two major inter-dealer electronic brokering sysiems, Order matching systems are much more relable, and faster. allowing traders to conduct many simuitanecus trades, rather than one or two over the phone. Those systems have become the predominant vehicle for inter-dealer transactions. Because of the decentralized overthe ccountar- nature of foreign exchange markets, the exac! share of global foreign exchange tracing volume conducted trough lectronic broking services cannet be determined precisely but comprises approximately 85% if no! higher. aThe FX Structure A Brief History of Electronic Trading in Foreign Exchange Electronic Trading Dominates Marketshare 5% Central Banks Ceniral banks are large players in the currency markets ‘and can play an impertant role in spot price fluctuations. Ceniral banks are not speculators and antor the FX mar kets primarly for: 1). Markot supervision and 2), To control money supply and interest rates. Government and contral ‘banks closely monitor economic activity to keep money supply at a level appropriate to achieve thai economic ‘goals. Central banks influence money supply and interest rales through open market operations or the active trading of government securities. For example, 100 much money can lead {0 Inflation whereby the value of money dectines and real prices rise, Central barks also often attempt to restore order to volatile markets through interventions. Tho reasons for contral bank intervontion may bo a result of a variety of factors: to rastora stability, protect a certain price level, slow down curtency mavements, or fo reverse a trend. Interventions may ba coordinated with other central barks or undertaken by a single central bank. The operations may be announced of unannounced. They may operata openly and dreciy, or trough brokers or agents. Unimately different objectives 22 will require cifferent approaches. To restore stability, the central banks often work together. However, a country tak Ing a conservative view on intervention would act only in response to unusual circumstances that require immediate action, tke polical unvest or natural disesiers. Most mone tary authorities would be less likely to Intervene to counter ‘ac the fundamental forces that dive FX markels, such as trade patioms, interest rate differentials, and capital flows. Thowe are some noteworthy exceptions however, such ae the Bank of Japan, which has been known to intervene on ‘behalf of the yen on numerous occasions, One reason is a result of Japan's major exporters influencing the banks to protect their interests, In protecting certain price levels a central bank may intervene from tme to time to resist ‘moves that seem excessive in ether direction. For exampe, the United States has on occasion sold dollars when the currency was deemed to be getting “too strong’ reiative to economic fundamentals and bought back dollars wien i was regarded as becoming “to weak" (t should be noted that U.S Interventions are infrequent). Tho trancactions in tho intervontion aro small compared to the total volume of trading in the FX market and thase actions do not shif the balance of supply and demand immediately. Instead. intervention is used as a device to signal a desirad exchangeThe FX Structure A Brief History of Electronic Trading in Foreign Exchange rate movement and affect the behavior of participants in ‘the FX market, Often the mare mention of intervention will violently move a market It is also important to note that @ significant side effect of the increase of interrational economic activity over the past few dacades has been the creation and growth of the Eurocurrency market (oank deposits in any country held in a diferent countrys currency tke U.S. dollars in & British bank). A great deal of foreign exchange market actvty Involves the transfer of Eurocurrency deposits. Since cen ‘ral banks have such large amounts of reserves to juggle, it Is easy for them to have “unintentional” influence on the eurrency markets whan they make re-positoning decisions. 23Overview of the Major Central Banks The Federal Reserve (Fed) “Tho Fadoral Resorve Board (Fod) ie the central bank of the Uritod States. They are responsibi for setting and impla- ‘menting monetary policy. The board consists ofa 12-mam- bor commites, which comprise the Federal Open Market Committee (FOMC). The voting members of the FOMG are the seven Governors of the Federal Reserve Board plus five presidents of the twelve cistct reserve banks, ‘The FOMC holds 8 meatings per year, which are widely Welched for interest rate ennouncements or changes in growth expectations, The Fed has a high degree of independence to set monetary authority. They are less subject to paliical influences. as most members are accorded long terms that allow them fo remain in ofce through periods of alternate party dominance in boty the Presidency and Congress. The US Treasury is responsible fr issuing gov- femment debt and for makng fiscal policy deisions. Fiscal policy decisions include determining the appropriate level of taxes anc government spending, The US Treasurys the aciual governement body that determines dolar policy. That is, f they fee! at the USD rate on the foreign exchange market is under or overvalued, they ee the ones giving the NY Federal Reserve Board the insructions to intervene in the foreign exchange merket by physically seling or buying USD. Tharelore, the Treasury’ viow on dolar patcy and. changes to that view is very important tothe currency mar- wet. The European Central Bank (ECB): “The European Central Bank (ECB) is the governing body responsibie for determining the monelaty policy of the ‘countries participating in the EMU. The Executive Board of the EMU consists of the President of the ECB, the Vice President of the ECB and four other members. These individuals along with the governors of the natonal central bbanke comprise the Govorning Council, The ECB is set up ‘such that the Executive Board imialements the policies dic. tated by the Governing Council. New monetary policies decisions are typically made by majority vote, with the 24 The FX Structure President having the casting vote in the event of a tie, in biweekly meetings. Primary objective of European Central Bank is price stability ECB is considered “inflation para. noid’ as It has strong German influence. ECB and the ESCB are independent institutions trom both national gov ‘ernmenis and other EU institutions giving them fotal control over monetary and currency policy. The European central bank is a strict monetarist and much more likely 10 keep interest rates high. Two edicts of monetary poloy are keap Harmonized CP! below 2% and M3 annual growth (Money supply) around 4.5%. Refinance rate is the main weapon used by the ECB to implement EU monetary pol ‘¢y. ECB watches the fiscal discipline of its members close- 1y. Mf countries are undisciplined, the ECB is less likely to remain hawkish. ECE is considered an untested central bank and doubts inger as to how they wil react to any future crisis. The ECB keeps close tabs on budget deficits of the individual counties as the Stabiity and Growth Pact slates thal they must be kept below 3% of GDP. The ECB, does intervene in the FX markets, especially when inflation {is @ concen, Comments by members of the Governing Council are widely watched by FX market participants and frequently move the EUR, to Bank of England (BoE} ‘The Bank of England (BoE) is the central hank of United ‘Kingdom. Bank was founded in 1894, nationalized in 1946, and gained operational independence in 1997. The BoE is committed fo promoting and maintaining a stable and eft, clent monetary and financial framework as ts contribution to. healthy economy, in 1997 perllament passed the Bank ‘of England act giving the BoE total independence in setting monetary policy. Prior to 1997, the BoE was essentially 2 governmertal organization with very Iittle freedom Troasury’s role in sotting monetary policy diminishod markedly since 1997. Howaver, the Treasury etil ste inflation targots for the BoE, currently defined as 2.5% annual ‘rows in Retail Prices Index excluding mortgauges (RPIX), The treasury is also responsible for making key appoint. ments at the Central Bank The BoE’s nine memberOverview of the Major Central Banks Monatary Policy Committee (MPC) is responsible for mak ing decisions on interast rates. Alhough MPC has independence in setting interest rates, the legislation provides that in extreme circumstances the goverrmant may intervene, The Bank of England's main policy too! is the mini- ‘mum lending rate or base rate. Changes to the base raie are usually seen as a clear change in monetary policy. BOE ‘most frequently affects monetary policy through dally markel operations (the buying/seling of government bonds). “The BoE |s infamous for attempting to influence exchange rates through unsteriized market interventions, Swiss National Bank (SN. ‘The Swiss National Bank is the central Bank of ‘Switzerland. The Swiss National Bank enjoys 100% auton. ‘omy in determining the nation’s monetary and exchange rale poles. In December 1999, the SNB shifted from 2 ‘monetarist approach to an inflation-targeting one (2% ‘annwal infation target), Discount rate is official too! used 10 announce changes in monetery policy however, its rarely ‘used as the bank relies mare on the S-month LIBOR 10 ‘maripulate monetary policy. SNB officials often afiect the Franc spot movernents by making remarks on liquidity, ‘money supply and the currency itself. Intervention is fro- quont, however, most often intervention is used to enforce ‘economic potcy and uses open marke! oparations such as raising oF lowering interest rates to affect the value of its currency, As a country where internétional trade has been the primary source of the country’s economic development, Its preference is for a weaker franc (in order for its exports to remain competitive), SNB is highly regarded end the franc Is considered by most market participants to be the: "world’s best managed currency.” The Bank of J. an (BOJ): “The Bank of Japan (Bod) isthe key monetary policymaking body in Japan. In 1998, the Japanese goverment passed laws giving the BoJ operational independence from the: Ministry of Finance (MoF) and complete control over rran- 25 The FX Structure ‘tary policy. However, despite the governments attempis fo decentralze decision-making, the MoF sill remaine in charge of foreign exchange policy. MoF is considered the single most important poitical and monetary institution in Japan. MoF officials frequently make statements regarding the economy, which have notable impacts on the Yen. The Bod is responsitie for executing all oficial Japanese foreign exchange Uansaclons at the ditection of the MoF. Benk of Japan does possess total aulonomy over monetary policy and can have significant indirect mpacts on foreign exchange rales. The Boy's main economic tool is the ‘avemight call rato, The call rate is controlled by the open ‘market operations and any changes to it often signify major changes in monetary policy. Since the introduction of 2 floating exchange rate system in February 1973, the Japanese economy has experienced large fluctuations in foreign exchange rates, with the yen on a long fsing trend, ‘The reason for yen strenath (despite the plethora of prob- Jems that have plagued the Japanese economy) is the fact, ‘mat Japan his a trade surplus accounting for 3% of GOP. ‘This is the highest of the G-7 countries and therefore cre ates @ strong Inherent demand for the curtency for trade purposes, regardless of their economic conditions, The Japanese government is notorious for directly intervening ‘on behalf of yen through market interventions, BOY inter ventions are frequent and violent. As an sxpor-drven country, there are strong political interests in Japan for maintaining 2 weak yen in order to keap exports competi tive, Accordingly. the 80, has been known to go inio the ‘market and sel off yen when the yen rate is percewed to be too strong, Bank of Canada (BOC “The Bank of Canade (B00) is the central benk of Canada. “The Governing Council of the Bank of Canads is the board that ie responsible for setting monetary policy and ie an independent Central bank that has a tight reign on its currency. This counci consists of seven members: the Govemor and six Deputy Govemors. The Bank of Canada dos not have regular periodic policy setting meetings.Overview of the Major Central Banks Instead, the council meets on a daily basis and changes in policy can be made at any time, Dus to its tight economic relations wth the United States, the Canadian dollar has 3 strong connection to the US. dollar. Commercial Participants \With the rapid increase in globalization, corporations have: been forced more and more to focus on foreign exchange and in the process frave become very important players. Corporations comprise @ diverse group and include small and large corporations, importiexporters, financial service firms, and consumer service firms amongst others, Corporations’ intarests in foreign exchange are derived ‘rom several sources. For example, multinational corporations may need to make payments to foreign entties for materials, labor, marketing/advetising costs andlor disti- butions, which would require the exchange of currencies. Generally, exporters prefer to be paid in thelr country’s currency oF n U.S. dotars, which are accepted all over the ‘world, The primary use of multinational corporations in the marketplace is to offset risk by hedging against currency depreciation, which would affect future payments. The deck sion fora corporation to hedge depends on a varity of fac tors. For example, ifthe corporation believes that the home eurrency is oxpocted to depreciate, and as a result the out standing poston is al isk, it would most fkely enter the market via a hedging strategy. Some currancias are more volatile than others. For example, a EU member may be less indined to hedge its currency risk against the Swiss Franc (as these currencies tend to move in tandem due to their economic links); However, 2 company would surely consider edging against the Japenese yen, The correla tion between the Swiss Franc and Japanese yen is ruch lower for the Swiss Franc and Japanese yen, which would certainly allow for more fluctuations in the EURIPY pair. Now, however, a minority has begun to use the markotpiace 8S @ speculative teol, meaning, they entor the foreign exchange merkat purely to take advantage of expected curtency fluctuation, This group of corporations using the FX market for speculative purposes is growing. and as very 26 The FX Structure active participants they have a great impact on spot market prices. Corporations’ approach to trading tends to de longer-term since they use the market for covering commercial needs, hedging, and speculations, Generally corporations do not ike volatility: they have a natural demand, ‘which is derived form the nature of their business and are therefore required to be actively Invowved in order to hedge their exposure, Accorcingly the directions of the market ang price levels are extremely important Fund Managers Global fund managers. large mutual, pension, and arbi trage funds that invest in foreign securities and other for- ign Fnancial instruments can have substantial impacts on spot price movements 2s they are. constantly re-balancing and adjusting their international equity and fixed income portolios. These portfolio decisions can be influential because they often involve sizable capital transactions, During periods were local stocks and bonds are attracive, @ national economy can get substantial allocations of clot al capital driving that national currency up. Portfolio hedging activites are also beginning to affect the FX markets as ‘mors and more international funds have begun to impie- ‘ment currency hedging strategies. When this group wich- 5 to hedge ex:sting investments, they can gonerate selling flows, FX Funds Funds that invest in FX are commonly called Global Macro funcs, These funds depending, on size. tend to take ditfer- ent positions in the FX market, Many large funds tend to take large cary trade positions exploiting global interest rate differentials (a detailed explanation of carry trades can bbe found in the "what moves the market” section of the manual). Others tand cook to take advantogo of misguid- ed economic pales er currencies that overshoot their "real value." by entering large positions and betting on a return to equilibrium. Others simply gauge global events and take @ longer-term view on which currencies. willOverview of the Major Central Banks strergihen/weaken in the nest six to sight months. Fund participation in the FX market has risen shamply in the rocont years and its total trading share is now around 20% “There is no doubt that with the increasing amount of money ‘some of these investment vehicles have under manage nent, the size and liquidity of foreign exchange markets is very anpeaiing. While relatively small compared to other marke! participants, when acting together, hey can have a profound effect on the currency spot movements. Individuals Retail spot currency trading is the new frontier of the trate ing world. Up unt 1998 foreign exchange trading was only available to banks, institutions ard extremely high net- worth individuals, The only access individual investors had to currencies prior to 1895 was through the highly liquid futures and option markets and the un-tradable cash bank marke, Prior to online retat FX dealers, individuals could rot realistealy participate in the foreign exchange market from a speculative stancpoint, The interbank market oper~ ated as a light crcl; it acted somewhat like a specialist. 25 it manipulated the fates oftiers 2 and 3 to sccommodate its ‘own needs. Accordingly, incividual traders locking to trade FX could not find 2 market maker capable of providing competiive spreads, fair quotes, and equitable customer service, With the advent of online foreign exchange trading, ‘tail clients are provided with access to trading functonak ity that is highly comparable to the offerings of the inter~ bank market. Spreacs are slightly wider - 5 pips on most currency pairs as opposed to the interbank standard of 3 - ‘bul execution is unsurpassed: competiive firms will honor all quotes and entry orders, and execute ther at exactly the rate specified. Now retail clients ané multinational insitu- tions can participate in the FX market on a highly oquitable playing fold. a7 The FX Structure Investor protections Reaches Retail Lovet For many years the retal orline foraign exchange industry languished for years cue to the lack of a regulatory env Fonment to uphold Investor protection, In December 2000, however, Congress passed and the Presitent signed the ‘Commodities Modernization Act n December of 2000. The ‘Act finally tegulated the foreign exchange industry and placed its oversight under he auspices of the Commodities, Futures Trading Commission (yy he CFTC Government Regulation Enters The FX Market “The Commodity Futures Trading Commission (CFTC) was created by Congress in 1974 as an independent agency witn the mancate to requlate commodity futures and option rmarkeis in the United States. The agency protects market participants against manipulation, abusive ade practices fend fraud, Through effective oversight and regulation, the CFTC enables the markets to better serve their Important functions in the nation's economy-providing a mechanism for price discovery and a means of offsetting price risk ‘The CFTC sets forth mary of the guidelines the National Futures Association is raquited to fellow. NFA: Maintaining Integrity ‘The National Futures Association (NFA) officially began operations on October 1, 1982, withthe goal of maintaining the integrty of the futures marketplace, All companies tnading in futures must become NFA members. Those companies that are not rogistered with the NFA are subject to losure by the CFTC. The passage of the Commodities Modemization Act requirgs that any company trading online forex be registered with the NFA, The NFA has many capital requirements and makes sure companies maintain high ‘book- keeping and ethical standards in order to be registered. With the passage of the Modemization Act. the NFA required forex market makers to regisier as Futures Commission Merchants (CMSs).Overview of the Major Central Banks Market Hours TimeZone Poe rr no Prraered ene) Pred NY Close Er ‘Tho spot FX market is unique to any othor market in the ‘world, as tracing is available 24-hours a day. Somewhere ‘around the world, a financial center is open for business, ‘and banks and other institutions exchange currencies, every hour of the day and night with only minor gaps on the: ‘weekend, The major financial centers around the world overlap: while some markets are winding up their business ‘ay, other markeis around the word are Just beginning 10 ‘rade, Essentially foreign exchange markets follow the sun round the world ‘The International Date Line i located in the westom Pacific, and each business day arrives frst in the Asian financial canter. first in Wellington, New Zealand, then ‘Sydney, Australia, followed by Tokyo, Hong Kong, and ‘Singapore. Only a few hours tater markets open in the Middle East (beginning in Bahrain). When the markets in Tokyo ate beginning to wind down, Europe opens for bust- ess. Frally, New York and oer U.S. centers begin Towards the late aftemcon in the United States, the nest ay has artived in the Asia areas, and the first markets there have opened and the process begins again. While spot trades just about everywhers, the three main markets cf Tokyo, London, and Naw York are the most influential since they reprasant almost 70% of the wonlets FX volume. Foreign exchange activity dees not flow even 28 ‘The FX Structure ey ly, and throughout the course of the intemational tracing ‘ay, there cortain markets are characterized by very hoavy trading activity in some (or all) currancy pairs, and other periods are characterized by light activity in some (or al) ‘currency pairs. Foreign exchange activity tends to be the most active when markets overlap, particularly the U.S. markets and the major European markets, Le. when t's the morning in New York and the afternoon in London. On the: ext page, are the major characteristics of the three main markets are outlined:Overview of the Major Centra! Banks TOKYO: 7:00pm EDT - 3:00am EDT/ Avg. Daily Volume $150bn ‘As Japan's economy has dwindled over the past decade, Japanese banks have been unable to commit to FX the large amounts of capital they once did in the 1980. Despite this, Tokyo is the fist major market lo open, and many large participants use it to get a read on dynamics oF to begin scaling into positions. Approximately 10% of all FX trading volume takes place during the Tokyo session, Traving can be relatively thin and hedge funds and banks have been known to use the Tokyo lunch hour to run impor tant stop and option barrier favels. Yen, Kiwi, and Aussie pairs tand to 69 the biggost movers during Tokyo hours as: other curroncios are quite thin and usualy do nt move, 29 The FX Structure LONDON: 3:00am EDT to 44:00amEDT/Avg. Daily Volume $570bn London is by far the most important and influential FX market on the planet, with approximately 30% of all transac~ ions. Most big bank's dealing desks are run out of London, and the market is responsitie for roughly 28% of total spot volume. Loncon tends to be the most orderly market due to the large liquidity and ease of completing transactions. Most laige market participants use London hours to com= plete serious FX deals, NEW YORK: 8:00am EDT - 5:00pm EDT /Avg. Daily Volume $330bIn New York is the second most important market in FX, with approximately 16 % of market volume. In the United States spot market, the majaity of deals are executed between & ‘AM and 12.00 PM, when European traders are sill ive, Trading often becomes quite choppy after meiday however, a liquidity dries up. In fact, there is a drop of over 50% in trading activity since California never served to bridge the gap botwoen U.S and Asia. As a result, traders tend to pay Joss attention to market development in the afternoon, NY '5 very much influenced by the US equity and bond markets ‘and pairs will often move closely in tandam with the capital markets STs) (yaReview: FX A Brief History Bretton Woods Determined to re-establish tho gold standard and provide for the economic neods and stability of tho postwar inter: national system, 44 countries met in Bretton Woods, New Hampshire on July 1944 to estabish a fied exchange rate system, Goals included financial stability, convertible cur- fencies, tree trade, full employment, and economic growih, The systern was centered on the US colar. Major curren- ies were pegged to the dolar, which was in tum tled to gold at a value of $35 per ounce. The dollar was the pri mary reserve currency and member counties were able to soll currency to the Federal Reserve in exchange for gold at the progent rato. In addition to these parameters, Bratton Woods estabiichod the Intemational Monetary Fund (IMF). and tho Intemational Bank for Reconstruction and Development (World Bank). These muttiateral orgariza- tions were designed to ensure thatthe Bretton Woods systom operated effectively ‘Trading under the Bretton Woods system had unique characteristics. Since exchange rates were fixed, intense trad- Ing occured surrounding devaiuations oF revaluations, known as "oreeping pegs”. Speculation agsinst the British pound in 1967 demonstrated creeping pegs trading pat tems, Following intense speculation the Bank of England, along with other central banks, took action to support the pound, Howovor, despite their atiompts they fied and the ‘pound was devalued that November. The fallure was mon- ‘umental because it was the frst time that central bank inter- ‘vention failed under the Bretton Woods system. Falure of central bank intervention continued in the follow= ing years in the case of the daliar. The Bretton Woods sys- Jem was dependent on a strong US dollar. Therefore, when the dallar began to experience pressure in 1968, there were implications for the future of the system. Speculation ‘against the dollar incrossod as investors suspected that it was overvalued and confidence plummeted. By 1971, the dollar was in crisis and devaluation beceme imperative 30 The FX Structure Smithsonian Agi ment ‘A mutilatoral effort 1o improve the exchange rate mocha: nigm was finally accomplished in Docamber 1971 when the ‘Smithsonian Agreement was signed. The agreement devalued the dolar against major European currencies by around eight percent. Currency was allowed to fuctuate within a wiger band, 2.25% instead of 1%, and the price of gold rose to $38 an ounce, Despite the provisions of the Smithsonian Agreement, the US current account drastically deteriorated in 1872 and speculation against the dollar continued. In February 1973, intense. speculation forced forsign exchange markets to loss and a 10 percent devaluation of the dollar ensued. Following continued speculation, FX markets were once again forced to close. Birth of the Current Market The currencies of Japan and most European countries, were eating against the dollar when tre market reopened in March of 1973, As the result. the US dollar was devat ued at @ ful 10% and floating rates. The arrangement was considered temporary but continues to operate to this day, The naw method of placing value upon currency influenced the way that currency was traded and opened up new avenues for speculation. The majority of currency trading ‘today is no! for the purpose of buying or selling goods, but rather. is intended for profit. During ine 1970s, the FX market was dominated by bank brokers, However, deregulation and electronic trading has made the FX market the most liquie market in the word and more easily accessible to smaller investors. Central banks remain powedul inthis systern; however, their influence has. fallon from provous lovels. Furthormore, Tho National Futures Association (NFA) and the Commodty Futures: Trading Commission (CFTC) wore estabished in the 1970s ‘and 1980s to protect individual market participants.Review: FX A Brief History ‘As technology increased in the 1980s, cross-border capital movement followed, In the 1980s, FX daily racing volume wes $70 billion a day whereas today it is 1.5 tilicn, Furthermore, electronic brokers in London currently ‘account for about 70% of the brokor markot in hat area and the majority of speculation is electronic. European Monetary System {In March of 1979 nine of the European Community's members launched the European Monetary System. The goals of the EMS included @ common currency (European (Currency Unt), regulation in the fluctuations between cur rencies (Exchange Rate Mechanism), and the creation of a central reserve fund (European Monetary Cooperation Fund), Following the implementation guidelines set forth by the Maastricht Tresty (implemented in 1993), the European Central Bank (ECB) was created in 1998, the Euro was introduoad in 1999 for purposes of foreign exchange and electronic payments, and Euro banknotes were introduced in January 2002. The European Monetary System was. cconsicered a revolutionary step toward achieving increased Integration and liberalization, the conceptual bedrock upon Which the EC was fist founded post WWW 31 The FX StructurePART 2: Currency Trading Basics Jn the foreign exchange market currencies are rot referred to by theirfull name, Rather, standardized codes, developed by the Intemational Organization for Standardization, mown 6 ISO codes, are used. Accordingly, throughout this, ‘manual al currencies willbe referred to by their codes. ISO abbreviations, however, are not used in corwersation: rather traders generally refer to currencies by theit nicknames. ‘The USS. dollar, for example is tnown 2s the buck or green back; the Brits pound stering is commonly referred to as the cable, the Swiss franc, the swissy; the Australian dolar, aussie, and the New Zealand dollar, the kimi Corre eer eer oar New Zeatare! dolar ey Buying and Selling Inthe forex market currency trading always done in currency pairs, such as EURIUSD or USD/JPY, reflecting the ‘exchange rate between two currencies. An exchange rate {is simply the ratio of one currency valued against another ‘currency. For example, the USDIJFY exchange rate specl- fies how many U.S, dollars can purchase one Japanese yen, or conversely how many Japanese yen you need 10 buy one US dalle, ‘The fit currency in tho pair is roferrad to as the base curroncy, and the second currency is the counter or quote currency. For example for USDUPY, the U.S dellar isthe base currency and the Japanese yen is the counter currency, When buying, the exchange rate specifias how much you 32 have to pay in units ofthe counter currency to buy one unit of the base currency; in the above example, you have to ‘pay 117.10 yen to buy 1 US dolla. When selling, the foreign curroncy exchange rate specifies how much units of the quote curtency you get for seing one unit of the base curency; in the above example, you wil receive 117.10 Japanese Yen when you sel 1 US dollar. ‘The order in which currencies are quoted IS fixed, For ‘example, when entering @ spot transaction between the US dollar and Japanese Yen, the U.S dolir will always be quot 4 fest in the pair. The U.S dallaris placed first in most eur tency pairs because of its role as the world's main currency (ie, USDIIPY. USD/CAD, USDICHF), This moans that quotes are expressed as a unit of $1 USD per the other currency quoted in the pair. The exceptions are the Euro, Great Britain pound, and Australian doar. These curten- ies are quoted 28 dolar per foreign currency, Keeping in Straight: Trading in Pairs For practical purposes itis useful to consider the currency pair as an instrument, which can be bough! oF sold and itis Lsoful to think of the bese currency as the "basis" for the ‘buy and sell. Simply put, whon you BUY a currency pair implies that you are buying the first (base) eurrancy and selling the second (quote or counter) currency. A tradlar buys the pair if he beliaves the base currency will appreck ate relative to the quote curency. Selling the currency pair ‘moles selling the first (base) currency and buying the se>~ ‘ond (quote or counter) currency. A trader sells the pair, he believes the base currency will depreciate relative to the quote currency, ‘Thisis @ key example to grasp, therefore, fet go through @ fow oxamploe EUR/USD: When trading the EUR/USD the euro is the base curency and the U.S dolar § the counter currency: therefore thePART 2: Currency Trading Basics ‘eure is the basis for the buy and sell. you think the US. stock markot will fall and that wil hurt the USD, then you ould BLY the currency pair. By buying the pair, you are buying euros expecting tham to appreciate against the USD. If you SELL the pair then the opposite is true: you buy US Dollars expecting them to climb agaist the Euro uUSD/JPY: When trading the USD/JPY the U.S dollar fs the base curtency and the yen i the counter currency, therefore the dollar is the basis for the buy and soll. f you think that the Japanese government is going to weaken the Yen in order 10 holp thoir oxport industry, you would BUY the currency pai. By buying the pair, you are buying dollars with the expectation that it will Increase in value against the Yen ‘You would SELL the pair if you think that Japanese investors are pulling money out of US financial markets anc repetriating funds back to Japan . By selling the pair, you expect the Yen to svengthen against the US Dolar as Japanese investors sell thelr assets and convert thelr dollars to Yen GBP/USD: When trading the GBP/USD, tho pound is the base curren ey and the US dolar is the counter currency: therefore the pound is the basis for the buy and sell. IFfor example you think the British Economy will continue to be the leading economy amongst the G7 nations in terms of growth thus bbuoving the Pound, you would BUY the curenoy pair. By buying the pair, you are expecting the British Pound to strengthen against the US Dollar. If you beleve the British are about to commit themselves to adopting the Euro anc this wil weaken the pound, you would SELL the pair. By Soling the pair, you expect the Pound to weaken agsinst the Dollar as the British devalue their currency in anticipation of merging with the Euro 33 USD/CHF: When trading tho USD/CHF the U.S dollar ie the base currancy and the Swiss francis the counter currancy; therefore the dollar is the basis for the buy and sell. f for example you think the Swiss Francis overvalued you would BUY the ‘currency pair By buying the pair, you are expecting the US Dollar to strengthen against the Swiss Franc. f you bekeve ‘hat due to instabilty in the tiddle East and in US Financia Markets the Dollar will continue to weaken, you would SELL the currency pai. By selling the pa, you are expecting the ‘Swiss Franc to strengthen against the Dollar.PART 2: Currency Trading Basics How an FX Trade Works The objective of currency tiading is to exchange one cur tency fer ancthor in the expectation that the market rate or price wil chango 60 that the currancy you bought increas. ‘28 In value relative to the one you sold. In trading idiom, 2 long position is one In which a trader buys a currency at one price and aims to sell it later at a higher price. In this ‘scanavio, the investor benelis trom a rising market. When a vader buysa currency and the price appreciates in value, ‘he trader must sell the currency back in order to lock in the, profi. A snon position is one in which the trader sells a cur rency in anticipation that it wil depreciate. fa trace solls 2 curtency and the price depreciates in value, the trader must buy the currency back in order to lock in the profit, An ‘pon trade or pesition is one in which a trader has elthor bought/sold one curreney pair and has rat scld/bought back the equivalent amount to effectively close the position, AIIFX quotes include a two-way price, the bis and ask. The bid price is always lower than the ask price. The bid is the nice at which a market maker Is wiling to buy (and traders ‘can sell) he base currency in exchange for te counter currency. The asks the price at which a market maker will sel (and traders can buy) the base currency in exchange for the counter currency, The difference between the bid and the ask price is raferred to as the spread, which can be recov ‘red with a favorable curroncy movement, Givers a) Inthe above example, the bid prive for GBPIUSD Is 1.4240 USD, which indicates the price at which traders can SELL the currency pair, and the ask price is 1.4245 USD, indicat. ing the price where traders ean BUY the currenoy pair. In 34 this example, there is a 5-pip spread that represents the ‘cost of the transaction. itis impoitant to note that since the FX matkat i¢ a decentralized markel the spreads that a trader recowves for a given currency pair will vary according to the market maker one trades with. Typicaly spreads in the retal FX market are 4-5 pins in the major currency pairs and slightly wider on the cross currency pairs,PART 2: Currency Trading Basics Calculating Profits and Losses ‘A pip isthe smallest increment a price moves and wil deter- imino the profitioss of the trade. A pip in most curencles {is 0.0001 o .01%% but depends on cutrency pair. When 2 ‘currency moves from 1.0650 to 1.0685 it has moved 5 pips, When you have an open position. each upward or down- \ward pip movement in the market price can be either @ prof It oF a loss depending on which currency you bought and \which currency you Sold. The value of a pip is determined by the pair of currencies being traded and the rate et which the currency pair is wading. For currency pais where the: dollar Is not the base currency (EURIUSD, AUD/USD, NZDIUSD, GBP/USD), each pip has a fixed value of $10. For example, if you are trading EUR/USD and the market ‘moves § pips in your favor, than your profit would be exact- |y $60. On the other hand, when 2 currency other the dollar fs the counter currency (USD/JPY, USD/CHF, USD/CAD) the pip value in dolar terms fluctuates based on prevaling market rates, or SSD/CHE eg ene Vaties-about $7 et et Sort ere) eres) er ented eet ts ed 35 calcu! ting the Value of a Pip ‘Although most online trading platforms with reputable bro- hors feature live P/L tracking whareby profits and losses are calculated and re-calculated avary tima the exchange rate ‘movas, it is important to have an intuitwe understanding of the value of a pip. Calculating pip values when the dollar is the counter currence IF the current exchange rate for EUR/USD fs 1.0700, then fone euro is worth 1.0700 US dollars. Consequently, 100,000 euros are worth 107,000 US dolare [ Keep in mind that tho standard Intorbank let sizo is 100,000 units of the base currency or 100,000 euros |. If the market price moves one pip to 1.0701, then one euro is now worth 4.0701 US dolars. This is a pretty small change in the Value of the euro (one ten thousandth of @ dollar to be exact) but this can be substantial when we are talking about 2 Jot of euros...100,000 Euros are now worth 107,070 dot lars, IF a trader had bought 100,000 eurds by selling 107,000 dollars when the market price was 1.0700, then those 100,000 Euros would be worth 107,010 dollars (10 US dot {ars more) when tho market price movos to 1,0701. Tho trader could choose to close the position out and take this $10 prott Conversely, let's say the trader initialy sold 100,000 euros, by buying 107.000 dollars when EUR/USD was trading at 1.7000. If the market price moves to 1.0701 and tne traders chooses to close the postion, heishe would nave to buy back the 100,000 Euros with 107,010 dollars. The loss on the tiade would be $10. Calculating pip values when the doll is the base currency: If the current exchange rate for USDLIPY is 120.00, then,PART 2: Currency Trading Basics Calculating Profits and Losses ‘one dolla is worth 120.00 yer. With this market rate in miné, then 100,000 doliars are worth 12,000,000 yen. If the market price of USDIJPY moves up one pip to 120.01 then 1 dollar will be worth 120.01 yen, so a lot of 100,000 dollars equal 12,001,000 yen. In this particular case, a one pip Ructuation is valued at 1000 Japanese Yen for a standard fot of 100,000 units. A pip value of 1000 yen is hence ‘valued at $8.33 when the USDIUPY pice fs 120.01. The calculation s simple, since at ths time 1 USD=120.01 YEN, then 1000 YEN= 8.33 USD. Simply divide 1000 by 120.01 I¥@ trader closes out a position ata one pip profit when the USONPY market price 1 120.01, he/she automatically locks in @ 1000 yen profit which is equivalent to $8.23 at that time. At a diferent market price, however, such as 117.00, these 1000 yen will have a different dollar value ($8.54 to be exact) 36 Profiting When the Exchange Rate Moves Up- A Sample Trade Suppose Trader A wichos to spocuiate on the exchange rate between the GBP/USD. Believing that the GBP will rise against the USD - or that the exchange rate will move upwards - the trader places an order to buy GBPIUSD at a market rate ot 1.5758. Interms of volume, lets assume that Tracer A is speculat- ing on 100,000 units of the base currency ~ which is the standard Jot size, oF trading increment, used in the retail foreign exchange market, Since the base currency is the first curroney of the pair, wo know that Trader A is specu: lating on the value cf 100,000 British pounds with respect to the US dolar For Trader A. the value of the amount borrowed is a func tion of the exchange tate. Since the exchange rate at the ‘ume of the transaction was 1.5755, we know that the mar- et cost for 1 British pound was 1.5755 US dolias. ‘Accordingly, 100,000 pounds costs $157,550 (1.5755 * 100,000), This borrowed amount of 187,550 US dollars must be paid back when the transaction is closed, Lot's assume thet Trader A is correct in ascuming that the British pound would rise in value with respect to the US dob lar, and that the exchange rate moved to 1.8885 - 100 pips: above the rate that Trader A entered. If Trader A were to ‘close his position now, the 100,000 pounds he purchased at the onset ofthe transaction would be sold, and his debt ‘of 197.550 dollars could be paid of. ‘Avan exchange rate of 1.5855, Trader A's 100,000 pounds ‘are now worth 158,550 US dollars (100,000 * 1.5855), The ‘amount he borrowed - 157,550 - can now be repaid, leaving him with $1,000 extra. This is Trader A's profit from the ‘redo.PART 2: Currency Trading Basics Calculating Profits and Losses Sa een a pe ee ee ead Peet er sts) or ern realizing 8 proft of 100 pips. The value of a pip for GBP/L tis Raat Peet ene $10 per pip constitutes @ profit of Profiting When the Rate Moves Down- A Sample Trade Since each FX trade involves the buying and selling of currency, clients can profit in eitver ditection of the exchange rate's movement: they simply need to buy and sell the right currencies at the ght time. If, for exampie, Trader A believes the pound willfall agains! the value of the US dollar - meaning 1 pound wil buy fener US dolls - than he can simply place an order to sell GBPIUSD. The: trade works in essentially the same manner: Lote assume Trador A beliovos the exchange rate for the GBPIUSD wil fal from the 1.5755 level, ie. as the pound Wil fallin value against the US dollar. Accordingly, he places an order to sell GBP/USD - or in other words, bor- ‘owing pounds and buying US dolar. Trader A pleces an order to sell 1 let - oF 100,000 units of currency - of the (GBP/USD, Since FX transactons ate intially denominated tn terms of the base currency. or the fst currency in the pair, we know that Trader A fs borrowing 100,000 pounds, and buying US dollars with the proceeds, Since 1 pound can purchese 1.5755 US dollars at the time “Trador A placos his trade, he can purchase 187,550 US dol- fare with the 100,000 pounds he borrowed. Just as in the: previous example, the borewed amount will be repaid when the transaction is closed Let's assume that Trader A is correct in his belie! that the: pound wil fall in value against the USD, and that the GBP/USD reaches 1.5655 -a crop of 100 pips trom where “Trader A entered the market. Atthis point, Trader A decides 37 to take his profit and close out the trade, Accordingly, he ‘must repay the 100,000 pounds that were borrowed. Since the cost of | pound has now dropped to 1.5655, this moans that the cost of 100,000 pounds is 156.580 (100,000 * 41,5655), This amount is then subtracted from 157.550, Which was the number of dollars that Trader A received \when he intially placed the trade. The result is-a profit of $1,000 (157,880 - 156,550), Se ee ed falling market. The tracer sold one lot (100,0 tion) of GBP/USD at 1.5755, and oc eae ny Pee ee) eat) td a Oe oe et SeePART 2: Currency Trading Basics Other Key Concepts in Currency Trading Interest Rollover ‘Sineo every FX traneaction involves buying and selling ‘ono currency is borrowod or soki and used to finance the purchase of another currency =the interest rates associat. ‘ed with those currencies come into play. Traders that hoid a position overnight pay interest on the currency they borrow. ‘and earn interest on the utrency they purchase. Typically interest rollover charges are appled at 5 PM (17:00) New ‘York time (9 PM GMT; 10 PIM GMT when New York's oper- ating on daylight savings time from late October to late Merch) in coordination with the international tracing day. Interest rollover foes are a function of the intorost rates fsiablished by the various contral banks and federal authorities used to regulate the official policy of the curren- ‘y. Sinos interest rates raise the cost of the currency - itis more expensive to borrow currencies with a high interest rate - a central bank's interest rate poliey can be used 10 adjust the economy to is respective needs. For example ‘economies that are growing at an extremely rapid rate~ and ‘hus encountering inflation, where prices of all goods and seivices are rising rapidly ~ may often raise interest rates this works to increase the cost of the currency, and hence can be used to decrease overall demand for consumption ‘The decrease in conaumption will prevent pricos frem con- ‘ining to rise at an excessively rapid rate, and thus can be Lusod to combat inflation, Allematively, economies facing recessionary times may ‘need economic stimuli to restart businesses and consumer spending. A cut in mterest rates can make money more ‘accessible and cheaper to borrow, and hence decreases ‘he risk entrepreneurs face in borrowing capita to start ven tures. Ideally, such a scenario would allow for a cut in inter- 291 rales to revitalize the esenomy and thereby ward off any depression or serious economic drought “The rate established by the central banks essentially deter- ‘mines at what rate private banks can borrow fram the gov- ‘ernment. Private barks then can lend amongst themselves 38 and to individual and institutional clients at whatever rate they esiablish via the free market, Ultimately, though, the ‘alo established by the central banks serves as a founda: tion of the currency’s value, and hence is of prime importance from both economic and speculative perspectives: For he FX trader, interest rollover charges can have a small moact on their overall prof and loss from exchange rate speculation. On a dally bass, tie trader is paying interest fon the currency that is torrowed, while earring interest on the ore that has been purchased. To ilustrate how interest rollover charges work, consider the example: Rollover Example Trader A buying GBP/USD at 1.5755. In this case, Trader A Js borrowing US dollars, and hence will pay interes! on the borrowed funds. Trader A is, however, earming interest on the Bntish pounds that have been purchased. ifthe Bark of England - which regulates the pound - offers a higher inter- lest rale than the Federal Reserve - which regulates the US dollar - the clent has an opportunity to eam Interest Altemativaly, ifthe Federal Reserve issues ahigher interest ‘ale on the US dollar than the Bank of England offers on tho British pound, then the client will experionco a netiinter- (ost payment.PART 2: Currency Trading Basics Calculating an Approximation of Interest Rollover ‘The interest rcllover charge is generally quite small, and honce should rot serve as the core of a trading strategy. A sample calculation is 0s follows: ‘Suppose the Bank of England has an official interest rate of 4.0%, while the Federal Reserve has an official interest rate of 1.25%. A client who s buying GEP/USD wil thus ea Interest, since he is only paying 1.25% but earning 4%. Since interes rates ere quoted on @ yearly basis - meaning the cost ofthe currency wil be, for instance, 1.25% ofthe principal amount for the entire year - this must be divided doa te a daily bass, since rollover charges. aro appliod dally Soe financial Yansactons round off a yoar to 360 days, as opposed 0 385, the rate fs divided by 360 The following is @ simple formulaic example of how interest rollover is calculated No: of Lots x No. of Units fy terest Rate oe! Peer g teh aa See Pern hm aged Opening Price: 1 ne) 38 Because barks can fond to each otbor at rates different from what the central bank lends to them, the rollover cat cuiations can never be reduced to an exact science, Like the currency exchange rate, the rollover itarest rates are ‘subject to market conditions, and hence can fluctuate as well Triple Rollover on Wednesday Since there Is a two-day seltloment period in foreign exchange, the transactions that are open on Wednesday at 5 PM- which is the Thursday trading day - should nat get sottlod until Saturday. Of cource, banks are closad during the wockend, so the transaction cannot effectively bo set. tied until Monday (which begins on Sunday at § PM New York time). AS a result, rollover fees are tripled in the FX market on Wednesday,PART 2: Currency Trading Basics Types of Orders Market Order ‘A market ordor ie an order to buy or soll 2 cutroncy pair at tho curront market prico. One of the koy advantagos of trading in spot market is that market orders are guarantaed when dealing with a reputable broke . 2s the vast liquidity of the markel ensures that there are always buyers and sellers Limit Orders (or take profit order) A limit order allows a client to spect the rate at whi will take profits and exit the market, Essentially, it defnes the amount of proft thatthe trador is looking to capture on this particular trad. Lot's assume 9 trador has an open position where he is long (meaning he has bought) GBP/USD at 1.5800. In such a scenario, a trader can place: a limit order to determine at what rate he will close his position and take his profits. So. for Instance. if the aforementioned trader were looking 10 capture 100 pps on the GBP/USD, he woule place @ Imit order at 1.5900; f the market reached that rate, he would be taken out of te markel, and his: proft from the trade would immediately be reflected in his balance. they Altematively, a trader could place limit order to an existing soll postion. Example: ‘Suppose a tradar sold GBPIUSD at 1.58 short (sel) order; the trader profits from a downward move: ‘ment in the exchange rate ~ and ence must place their mit order, which Is only used to determine the desired prot kc from the vade, below the market rate, Accordingly, @ vad D. Since this is a fe looking to capture 100 pips on the GBP/USD would plece @ limit order at 1.5700. If the market reaches that rate, the client wil be closed out of the trade hstarily, and will immodiatoly be awarded-the corresponding profit for the trade as well 40 Stop-Loss Orders ‘A stop-loss ordor works ike a limit ordor, but in an opposite fashion: it specifies the maximum loss that a trador is will ing to accept on a given position. For example, if a trader is long USDIUPY at 121.50 with a limit at 121.70, he may wish to maximize the loss he is wiling to accapt by pacing 2 stoprloss order at 121.30, In such a case, i the market reached 121.30, he would be stopped out of the position and would have suffered a loss no greater than 20 pips. Similarly, if trader bs short USDAJPY at 121.50 with a limit at 121.30 and only wants to suffer a loss of 20 pips, then he would place a stop order at 121.70. Accoicingly, if the: market roachos 121.70, the trader will be stopped outof the position and would have cuffered a loss ne greater than 20, Pips. Entry Order All entry orders are essentially contingent orders: they will only be filed if the market reaches that rate. For example, ‘suppose you are trading USDIJPY, and the current quote is 120.50-55. You can place an entty order to buy at 120.15, for example, so that your order wil only be filed ifthe mar~ ket reaches 120.18, Utimately, there are two types of entry orders: stop entry orders and limit entry orders. Limit Entry Orders Limit entry orders are classified as entry orders whereby the rate specified is elther below the current market rate if it 18 a buy orcer, of. allematwely, above the market rate it it Is a sell order. Limit entry orders are often conducve to strategies pertaining to range-tound markets, whereby clients can place orders to buy at the botiom of the range ‘and sell atthe top. Suppose the currant market rete forthe EURYUSD is at 1.0800-04; in other words, traders can enter ‘the market to soll at 1.0800, but must buy at 1.0804. There re two typos of limit entry orders that a trader could place In such a situation 1) They could place an order to cell ata price above than the current market rate. So, for instance,PART 2: Currency Trading Basics Types of Orders they could place an order to set at 1,0820; if the sell rate in the spot market roachos 1.0820, their sall order would be activated, In this case, the trader expects that the market wil each 1.0820 and then reverse its direction 2) Traders can place a limit antry orderto buy ata price that is below the current market rate So, Ifthe current market rate 1S 1.0800-04, a trader coule place a limit entry order to buy at a rate below the current buying price of 1.0804, So, for instance, ithe trader placed fan order to buy at 1.0790, his order would only be actvat ed ~ meaning it would only begin to affect his P/L ~ if the buy rate reached 1.0790. In this example as well. the trad fr is expecting reversal of the trend after the market reaches the rate halshe specified. nother words, the trad er will profit if the market bounces off the 1.0790 level ‘Since both buy and sell Imit entry orders assume the reversal of @ trend, they are most commenly used by traders ‘who believe the market s trading within an upper and lower range, and that it wil not break out of this range. Stop Entry Orders Stop ontry orders rely on rationale that is the opposite of ‘mit entry orders. IF you wish to buy at a price above the current markt rate, or, alternatively, sell at 2 price below the current markat price, than you are placing a stop entry order. Stop entry orders are conducive to “breakout” strate dies. whereby the trader believes that ifthe specified rate is reached, the trend's movement & confirmed anc thus wil continue in that direction, Suppose the current market rate for the USDJPY Is at 117.08; in other words, traders can enter the market to ssl at 117.04, and can buy at 117.09. There are two types of stop entry orders that a trader could place in such a situa sien 1) They could place an order to sell at 2 price below the current markat rata. So, for instance, they couls place an order at to sel at 116.75: if the sel ate in the spot market reaches 116.75, their sell order would be activated. In this case, the tradar expects that the market wil reaches ths level twill break out and continue in this direction 2) Traders can place a stop entry order to buy at a price that 's above the curent market rate, So, if the current market fate is 117.04, a trader could place a limit entry order to buy ata rate above the current buying price of 117.04. So, for Instance, Ifthe trader placed an order to buy at 117.85, his order would only be activated ~ meaning it would only begin to affect his PIL ~ if the buy rete toached 117.86. In the exemple, the trader is expecting a breakout if the mer ket reachos the rate he/she specified. In other words, the trader wil break through the 1.0790 level. Since both buy and sell slop ently orders assume 2 breskout, they are ‘most commonly used by traders who believe the market will make a big move.ve Etiqui ‘Although most trades are placed online, traders ainays have tho option of calling the dealing desk to place an order tis important for spot traders to get their point across quickly and accurately, leaving no room for interpretation or error. Let's take 2 look at a typical spot trade: Please give me a price on USOUPY (or USDICHF. or EUR/USD, of GBPIUSD) for (number of lots you want 10 wade) lots). a cy r ee CcPART 3: What Moves the Market Movements of curtencies are ultimately based upon supply and domand, That is, a curroncy rallios because there is domand for that currancy, Regardless of whether the domand ie for hedging, speculative or conversion purposes ‘rue movements are based upon the need for the currency Currency values decrease when there is excess supply ‘Supply and demand should be the real determinants for precicting future movements, However, predicting supply and demand is not as simple as many would think, There are many factors that contribute to the net supply and demand for a currency. This indudes capital lows, trade flows, speculative needs and hedging needs. hore are two major ways to analyze financial markets: fundamental analysis and technical analysis. analysis is based upon underlying economic conditions, ‘while technical analysis uses historical prices to predict future movements. There is an ongoing debate as to wich methodology is more successful. Short-term traders preter louse technical analysis, focusing inei strategies peimanly on price action; while fundamentel traders focus their efforts on determining @ currency’s proper current as well a future valuation. Fundamental Fundamental Analysis Fundamental analysis focuses on the economic, social and politcal foros that drive supply and derrand, Fundamental analysts look at various macroeconomic indicators such as feconorric growth rates, interest rates. inflation, and unemployment, They combine ail of this information to assess current and future performance. This requires @ lot! work and thorough analysis, as there is no single set of belles that guides fundamental analysis. In addivon, fundamental analysts need to continualy keep abreast of news and announcements, as they can indicate potential changes to the economic, social and poliial environment, There ore mary waye to value currencies from al fundamental per spective, including belance of payments and purchasing powor parity, Al of this will be discussed in further datal! under the explanation of fundamental analysis. 43 There are two main factors that impact exchange rate movements from 2 fundamental perspective: capital flows and trade flows. Both of thaea components constitute a countty’s balanes of payments. The balance of payments quantifies the amount of demand for a currency over a given period of time. Theoretical, a balance of payments equal to zero is required for @ currency to maintain its current valuation, A negative balance of payments number tellec's that capil is leaving the economy at a more rapic rate than itis entering, and hence it should fall in valve,PART 3: What Moves the Market Technical Analysis Prior tthe mid 1980s, fundamental traders primariy dom: inated the FX market, However. with the rising popularty of technical analysis and the advent of new technologies, the influence of technical trading on the FX market has Increased significantly. The availabliy of Figh leverage has le to an increased number of momentum or mode! tunes, who have become important partcpants in the FX market, with the ability to influence currency prices. Technical enalysis focuses on the study of price movements, Tecinical analysts use historical currency data to forocest the direction of future prices. The promiso of toch | analysis Is thal ali curront market information ic ready refloctod in the price of that currency; thoratore, studying price action is al that is required to make informed trading dacisions. In addtion, techrical analysis works under the assumption that history tends to repeat itself Technical analysis is a very popular too! for short to med tum term traders. It works especially wall in the currency markets because short-term cutrancy price fluctuations are primarily driven by human emotions ar market perceptions, Charts are the mary too! in technical analysis. Charts are uused to identify trends and patterns in order to find profit ‘opportunities, Ths most basic concept of technical analysis Is that markets nave a tendency to trend. Being able to dently trends in their earliest stage of development Is the key to technical analysis. Technical analysis integrates price action and momentum to construct a pictorial repre- sentation of past currency price action to predict future per fornance. Technical analysis indicators such as Fibonacci retracoment lavels, moving averages, oscifaters, candi. stick charts and Bollinger bands provide further information nthe value of emotional extremes of buyers and sellers to direct waders to levels where greed and fear are the strongest Source: Stretagem Charts 44PART 3: What Moves the Market Key Factors in Fundamental Analysis There are two main factors that impect exchange rate ‘movomert from a fundamental perspective’ capital lows and trade flows, those components: Bolow is a more detailed expianation on Capital Flows Capital los measure the net amount of @ currency that is being purchased or sold due to capital invesiments. A pos- lhe captal Now balance implies thet foreign inflows of physical or portfolio investments into 8 country exceed out flows. A negative capital flow balance indicates that there fare mere physical or portfolo investments bought by domastic investors than foreign investors. To clearly explain this, suppose for example, that the UK’ ‘economy is booming, and that is stock market is ralying as well. Meanwhile, in the United States, @ lackluster economy is creating a shortage of investment opportunities. In such a Scenario, the natural result would be for US resigents to soll their dollars and buy GBP to allow for particpaton in the ratying UK economy. This would result in capital outiow of capital for the US and inflow of capital for the UK. From ‘an exchange rate perspective, this would induce a fallin the USD coupled with a rise in the GBP os demand for USD dectnas and tha demand for GBP incroasos; in othor words, the GRP/USD would risa Capital flaws ean be divided ito two catageries Physical Flows anc Portfolio Flows: Physical Flows Physical flows encompass actual foreign ckrect investments by corporations such as investments in real estate, manu factuting and local acquisitions. All of these require that @ foreign corperation gel thei local currency and buy the for sign curreney, which loads to movements in the FX markot This is particularly important for global corporate acquisitions that involve more cash than stock 45 Physical flows are important to watch, as they represent the underlying changes in actual physical invactment activity These flows shift in response to changas in each country's financial health and growth opportunities. Changes in local Jaws that encourage foreign investment also serve to promote physical flows. For exemple, due to China's entry in the WTO. their foreign investment laws have been relaxed [AS a result of their cheap labor and attractive revenue ‘opportunities (population of over tbillon), global corpora: tions have flooded chine with investments. From a FX per- ‘spective, in order to fund investments in China, foreign cor erations will need to soll their local currency and buy Chinese Renmindi (RMB). Portfolio Flows Equity Markets: As technology has enabled greater ease with respect fo transportation of capital investing in global ‘equity markets has become far more feasible, According, 4 rallying stock market in any par ofthe world serves as an Ideal opportuntty for all, egaidiess of geographic location. ‘The result of this has become a strong correlation between country’s equity markets and its currency: if the equity market is raing, investment dollars are coming in to size the opportunity, Altematively, fang equity markets will have domestic investors selling thoir shares of local pub- lidy traded firms only to seize investment opportunities abroad The attraction of equities markets over fixed income markets has increasad over the years. Since the early 1990s, the ratio of foreign transactions in US government bonds, over US equilles has deciined from 10:1 10 2:1. From the chart below, itis evident that the Dow has a high correlation with the USD (against the EUR). The time period from 1894 to 1999 shows 3 78.0% positive correlation between tho two. In addition, from 1991-1999, the Dow incroasod 300%, while the USD index appreciated nearly 30% for the same time period. As a resul., currency traders closely fol low the global equity markets to predict short and interme diate term equity based capital flows. The most commoniyPART 3: What Moves the Market Watched stock indices are the Dow Jones Industiial Index (Dow), S8P 500, NASDAQ, NIKKEI, DAX and FTSE. The: Dow is the most influential index on the dollar. The Nikkei performance impacts the JPY, while the FTSE impacts the GBP and the DAX impacts the EUR. ae ] DJIA and US Dollar +18 seo: DMA 6 IE td «SE Ate Oat «AE Oe? 0.008 tet «0.800» TRE ae al Sancta ee hE | 9500 ai 1 sno c ogs 7600 = omy SEuro.... RAS on a 2 ; Source http:/iwww kshiti.com/researchidowdollar shtml In tons of relative strength, historical evidence shows that the stronger the performance of a country’s equity market, the sirorger its currency apprecation, Relative strength of ‘an equity Index measures the number of periods tne index finishes up instead of down for a specified ime frame. AS evidenced in the 12-month relative strength data below, countries such as New Zeeland has hed @ high relative strength, which hae correlated with a cignticant approcia- tion of tho NZD/USD. oe eee rT BIPART 3: What Moves the Market Fixed Income Markets: Just as the equity merket is corre- fated with exchange rate movement, 80 too is the fixed income market. In times of global uncertainty, fixed income invostments can become particularly appealing, due to the inherent safety they possess. As a result, economies boasting the most valuable fixed income opportunities will be canable of attracting foreign investment - which will natu- rally frst require the purchasing of the county's respective curreney, ‘A good gauge of fixed income capital flows are the short {and long-term yields of Intemational goverment bonds. It {s important to monitor the spread diferontial between the yield on the 10.year US Treasury note and that en foreign bonds. Reason bsing that international investors tend to place thelr funds in countries with the highest yielding assets. Therefore if US assets have one of the highest vilelds, this would encourage more investments in US financial instiuments, hence benefiting the USD. Investors can also use short-term yialds such as the spreads on 2-year government notes to gauge short-lerm flow of internation al funds. Current yield spreads are approximately. en on Japan tire ay eo Reece 47 {Aside from government bond yields, Fed fund futures can also be used to estimate movement of US funds, as they price in the expectation of future fed interest rate policy Euribor futures are a barometer for the Euro region's ‘expected future intorast rates and can give an indication of Euro region future policy movements. Trade Flows: Measuring Exports vs. Imports Trade flows are the basis of all intemational transactions, ‘Just 2s the investment environment of a given economy is 2 prime cause in determining is currency valuation, trade flows represent a country’s net trade balance, Countries ‘that are ret exporters ~ meaning they export more to inter~ ‘ational clients than they import from Intemational produc rs, will oxperience @ net trade surplus. Countries wih @ net export are more likely to have thelr currency rise in value, as from the perspective of Intemational trade, their curren cys being bought mare than itis sold: international cliants interested in buying the exported product/service must first buy the appropriate currency. thus creating demand for the currency of the exporter Japan is an example of an export criven economy witty 2 ‘rade surplus. Japan's trade surplus is the major reason that the JPY has not depreciated sharply as a result oftheir severe economic weakness. They are a net exporter with ‘a currant account surplus rapresonting 3% of thoir GDP.PART 3: What Moves the Market This is the highest of the G-7 countries, and creates @ strong inhocent demand for the currency for trade purpes: 96, rogardless of their economic conditions, ‘Countries that are net importers - meaning they make more Intemational purchases than international sales - exper ‘ence what is known as.a trade deficit, which in turn has the potential to drive the value of the currency down. in order to engage in international purchases, importers must sell {thelr currency to purchase that ofthe retailer of the good oF service; accordingly, this could have the effect of driving the currency down. For example, the US is a net importer, with 2 very high trade defic that requires $1.9 tillon in daily inflow to provont a further trade-based depreciation of the uso. Clearly a change in the balance of payments has a direct, effect on currency levels. Therefore, it is. important for fraders to keep abreast of economic data relating to this balance and understand the implications of changes in the balance of payments. 48PART 3: What Moves the Market Other Fundamental Factors That Impact Currency Movements Purchasing Power Parity: Purchasing power parity (PPP) is @ valuation-besed theory that states that currency rales should be determined rola- tivo to the prices of goods in each country. This means that the exchange rate of two countries should be equal to the ‘ali cf the two countries’ price level based on a fixed has- kel of goods and services Therefore, i prices increase or inflation oocurs, currencies should depreciate to adjust for the arbitrage opportunity. An arbitrage opportunity occurs \when there are cifferent prices for the same product, allow ing buyers and sellets to take advantage of short-term price differentials. Under PPP, an exchange rate is determined by comparing the prices of the same product in two different countries. ‘The simplest example would be the folowing Can of Coka costs: 2.3 Euros in $200 nthe US {Based on PPP: EURIUSD = 2.9/2.00= 1 I current market rate is » 1.1500 ——= excharge rate overstates current values, should depreciate until it reach ‘06 the PPP value If currant market rate ie < 11500 ——= exchange rate lunderstates current values, should apprectate until it reach- esthe PPP value Generally. the formula used to calculate PPP is Exchange Rate = Price of goods in country A / Price of goods in county 8 It is important remember that PPP is rot calculated based ‘on ene good, but instoad a basket of goods and services. ‘hie baskot can vary based upon the entty analyzing the data, but a comprehensive basket would include consumer goods and services, government services, equipment ‘90046 and constnuction project, “The OECD (Organization for Economic © Development) publishes PPP values for all currencies ‘every few years, Fortheir calculation, theirbasket of goods. ‘and services includes 2,500 consumer goods and services, ‘34 occupations in government, education and health sere ‘ces, 185 types of equipment goods and 20 construction projecss. ‘Tho primary use of PPP is as the first step to comparing ‘wo countries, because it can be used te translate GOP into ‘2.common currency. However, PPP is long-term indcator ‘and does not take into account short term fluctuations: ‘based upon market news or rumors. In addon, there are Inconsistencies that are not accounted for under PPP, such 2 trade restrictions and differencing tax regulatons, This also includes non-tradable inputs. such as differences. in rant in NYC compared to rent for a comparable store selling the exact same goods and services in Mexico. ‘Theretore, PPF is a good barometer for currency analysis but is not useful for short term trading. PPP equiltxium val Les con be viewed as values toward which exchange rates ‘should converge to over the very long term. You can access the latest OECD report showing current PPP values at ww occd org tetany Rem ary rc) rr) ee ee 49PART 3: What Moves the Market Productivity / Economic Growth ‘Aside from capitel and trade flows, perceptions of eoonom- is growth and intorost rate policy also servo to impact cur- taney movements. Therefore itis important to keep abreast fof monetary and fiscal policy. Central banks regulatly publish reports after their meotings that reflect their views on their economy and their biasis for changes in polcy. The: major central bank websites are tne folowing: Australia wwrvirba gov au canada wonw-bankofcanasda.cat Denmark vw natlonalbanken ck/uk Euro Union www.ccb.int Japan ww.bo) orjplanindex him New Zealand —wyrw.ronz-goxt.nz Nerway ww norges-bank no/ Sweden worw.riksbank se Switzerland ww sn ch United Kingdom wow tankotengland.co.uk United States wuw.fecerares (Our currency profiles section includes @ general outlook on the major currencies and what impacis their movements. 50PART 3: What Moves the Market How To Use Strategy #1: carry trades 1g interest rates for Carry Trai The carry trade stratagy is a long-term strategy thal Is very popular in the FX Market and is used by Investment banks and large macio hadge funds. A carry Wrade is an interest ‘ale arbitrage strategy whereby an investor takes advan- age of the interest rate differentials between major economies, while also hoping to benefit from te general direction oF tend of the currency pait. Cea tiers artery co 3 ey mid of target rang ‘This strategy would bo implomented by selling (borrowing) the lowest yielding curency, while buying (lending) the highest yielding currency. The most commonly used our rency pairs fer cary trades are AUDIIPY. NZDIJPY, (GBPIJPY, and GBPICHF. To minimize dividual currency ‘exposure and portlio voiatiity, institutions will generally buy a baskat of these currencies (ex: Invest in GBPIIPY, AUDKIPY, GBP/CHF and NZDUPY instead of only investing in GBPUPY), “This strategy can also be implemented in corjurtion with technical indicators. That is. if the AUDLIPY, NZDUUPY, GBP/PY or GBPICHF chart moves above the 200 day moving average, this can serve as further indication that aside from benefiting from postive interest, the investor ‘could also benefit from the upside potential of the currency 51 Fundamental Analysis in Trading pale Although the cary trade strategy has made bilkons of dot lars for many hedge funds, tis not foo! proof. Mary profes sional investors have also lost a signifcant amount of ‘money while using this strategy. Here are the most common reasons that this strategy fails: 1) Improper time horizon. A carry trade isa long term strat egy. An investor must be able to commit time horizon of @ ‘minimum of 6 to 12 months, This is because currency vak uations reflect economic fundamentals over time. Thore ore frequently temporary imbalances between the currency pair and its true economic picture that is difficult to acct rately predict 2) Misuse of Leverage: Interest rate differentials tend to be ‘airy small and the way to increase returns 18 by using Jeverage. The application of too much leverage will lead to the inabilty of the investor to weather short-term fluctua tions in the market 3) Fundamental Shits: In The Capital Flow Picture: While interest rate differentiole ere s faidy accurate way of deter mining where portfolio flows go; in meny aconomies there ‘ate exceptions. The advent of an equity investmant culture in the United States has made this strategy very tough to trade using the US dolar. Equity invastors tand to value lower interest rates and wil reward countries with ower Interest rates. which goes against everything that the carry trade is meant to accomplish, 4) Risk Enuironnient Risk aversion is an important driver of FX markets, Cay vades tend to be most successful in @ tisk-secking environment, and least successful in a risk aversion envicenmant. That isin risk seeking environments, investors tond to rashufilo their portfolios and soll low rik, but high value assets and buy higher risk and low value assets. Risk your currencies with large current account deficits are forced to higher interest rates to compensate investors for the risk of a sharper depreciation than thatPART 3: What Moves the Market How To Use Fundamental Analysis in Trading predicted by uncovered interest rate party. The profit rem 2 carry trade is an investor's payment for taking this isk Carry trades are more likely to go wrong in times of risk aversion. In euch times, the riskier currancies - upon which carry trades rely for their retums - tend to deprecate Typically. rskier currencies have current account deficits and, as risk appetite wanes. investors retreat to the safety of their home markets, making these defics harder to fund, It makes sense to unwind carry trades in times of rising risk aversion, sine adverse currency moves tend to at least partly offset the interest rate advantage. Many investment banks have developed measures of early warning signals, for rising risk aversion, This Includes monitoring of emsrg ing markat bond spreads, swap spreads, high yield spreads, FX volatiitios and equity market volatiles. Tighter bond, swap and high yield sproads are risk-seoking indicators. White lower FX and equity market volallties Indicate risk aversion, ‘Although there are nsks to camry traces, proper diverstica- tion and clase attention fo levels risk aversion will improve returns, Strategy #2: trade FX Using equity markets to How Can the Equity Markets be Used to Predict Currency Movements? Equity markets have a signticant impact on exchange rate movements because they are a major place for high volume ‘currency movements (portfolio flows). Movements of currencies will occur when foreign invesiors move thelr money 10 @ particular equity market in search of betier returns Thus they conver their capital in a domestic currency and push up the demand for that particular currency, Equity Market Rises: Domestic Currency Rises, Foreign Currencies Decline 52 When a domestic equity market rises, we expect to see @ tiga in consumer and business confidence, which wil lead to.an inflow of foreign funds. For example, in the US, ifthe US equity market ralliod, this will ikely fuel USD strength across the board since there will be strang demand for USD. in terms of capital flow. Foreign investors who are attract- to the potentiat of high retums from the US equty mar- ‘Ket wil need to sel thelr local currency and buy USD. The same Is trve for performance in the FTSE and the DAX, The FTSE is Biltain’s equity market. 111k ralies, we expect to 500 the GBP rise and forsign currencies, such as the EUR and USD decline, The DAX ie Germany's equity market, a9 well as 9 barometer for Euro strength. When the AX rallies. the EUR will tond to appreciate, Equity Market Declines: Domestic Currency Declines, Foreign Currencies Rise When capital markets performance (s.sluggish, foreign lnvesiors tend 0 repatiiate Uelr funds back into their domestic currency creating a lack of demand in the local currency. This lack of demand or selling of current equity holdings Would put pressure on the exchange rats. For ‘example ifthe demand for US assets dectine, we expectto see the USD take a hit across the board as forsign investors sell their US equity holdings. The same argument {is applicable for noticeable weaknass in the DAX and FTSE. As investors retreal from investing in European markets, the demand for pounds and euro vill decrease, while foreign currences wil appreciate, as invesiors convert teir funds back into their local currencies.PART 3: What Moves the Market How To Use Fundamental Analysis in Trading Strategy #3: Use Bond or Fixed Income Markets te Trade FX Using Fixed Income Markets to Predict Currency Movements Interest rate diferentials between foreign bonds are important to follow, as they are stvona indicators of potenti currency movements. With fixed: Income markets, economies boasting the most valuable xed micome opportunities with the highest yields wil be capable of attracting foreign investment, Euribors and Eurodollars: Gauge International Yield Spreads For example. traders may consider locking at the differentials between Eurodotars and Euribors, Eurodoliars are USD denominated assets held outside of the US, Euribors ‘are fixed income products reflecting Europes short-term Interest rates. Since the US and Europe have the most ‘developed fixed income and equity markets, if Eunbors are ‘offering premiums to Eurodollats, investors would beemere be more induced to sell their US assets and purchase for eign assets. The selling of US fixed income or equity ‘assets would influence the currency market because that would require saling the USD and buying the foreign curroncy. If the positive differential batween Euribors and Euredollars decrease, this implies that Europe is offering loss of a yield premium to US assets. This decreases the attractiveness of European assets to US assets. which may Induce investors to sal their European assets Gilts, Euribors and Eurodollars: Fixed Income Spreads Throughout the Europe Giits are the UK's fixed income product. Traders of tho GBP/USD and EUR/GSP need to pay particulsratiention to the differentials between Gits (UK), Euribors (Europe) and, Euradoliars (US). As the positive intorast rate diferentials, ‘between the UK's rates and the rates of Europe and the US decing, the UK's fixed income invastment opportunities become less attracve to forvign investors. This may induce profit taking in the GBP as investors sal their GBP ‘denominated assets in search for higher yields elsewhere Other Countries: Looking at the International Fixed Income Market ‘Traders aiso need to pay attention to the fixed income prod ‘ucts and their yield differentials in other countries besides: the UK, US and Europe. For example, Australia and New Zealand offer attractive yields, which may drive investors to soll their local currencies and buy AUD or NZD. This is ‘especially tue ifthe interest ratos in tho othr major coun- ‘ries decline. If interest rales in US, UK and Europe increase, this could possibly drive funds away from Australia and New Zealand, hence puting pressure on those currencies It's therefore apparent that vaders can use fked Income products to predict FX movements. Dally Nuctuations and developments in any of the fixed income markets can {eflect movement of foreign portfolio investments, which would require forsign exchange transactions, Key Technical Analysis Indicators a orn era following: Nae i eed eee 4) Cand 5) Bellinger Bands §3PART 3: What Moves the Market Candlesticks What is it? Cendlosticks are @ Japanese charting technique that was dovelopod as carly as the 1800's, when thoy wore usod for predicting rica prices - rica fulures was one of the world's first futures markets, In light of the military environment of the Japanese feudal system during that tine, Japanese {radiers gave colorful names to the candlestick formations, \wih many references to miltary terminology. This charting technique has been used successfully by the Japanese financial community for hundreds of years, but has only gained populaity over the past decade in the US and Europegn financial community. Ths technique is now fre quontly ueed in all nancial markots, but ospocially in tho FX market. Duo to this popularly, itis imperative for all FX \radere to have a sound knowledge of the most commonly used candlestick formations and the corresponding trading signals, Candlesticks are very simiar to bar charts, but the easy 10 read color depiction of the price action makes it simpier for traders to gauge market psychology and price action, Candlestick bars are composed of a currency pair's open, high, low and close, The candlestick consists of a rectan- {ular section and two thin lines above or below this section, “This rectenguler section is known as the bedy, while lines above or below the body are the wicks. The body of the candlestick ropresonte the difference between the open and the close, This body will be shaded green ifthe price closed up and red if the: price closed down, The wicks depict the high and low of the respective time period (daily, hourly, 15 min etc) ee ~] ~— ee oa OPEN s0vy i- =a S cx 55 How can Candlesticks be Used for Trading? ‘Candlostick formations can bo used to trade raversale in price orto confirm a trend continuation. The following is an ‘explanation of the most impertant patterns and the corre. sponding trading signal Hammer | Hanging Man: Trend Reversais Hammer and hanging man formations have long lower wicks and smat bedies ‘Tho hammer patiom appears aflor a eur roncy pair has had a significant dawn move and is typically viewed as 2 bullish signal, implying a base anc a trend reversal, This formation is particularly important if t appears after a number of sige nifcant down days (1. more than 3 pert ods) and it must close as a hemmer to confirm the tend reversal, There ate two ways that hammers are typicaly traded. Some traders will buy ence @ hammer formation ‘appears, in case the market doas not have @ pull back and the reversal occurs immediately. Otver traders will buy ater the curroncy pair attempts to retest the hammer level and oes not break through, which would imply that the hammer area provides 2 sold support level, confirming the trend reversalPART 3: What Moves the Market Candlesticks ‘The chart below shows a graphical depiction of a hammer formation in EUR/USD (note: the Stratagem charts use blue can- des to represent uprend, which is the same as green candles) = -eeeRe gE ore The hanging man pattern appears after because the long lower wick of the hanging man candle 2 currency peir has had a significant shows thet there i sill srength in the price action, The next rally and is typically viawed asa bestish _ period's candle must close undar the hanging man's bedy. signal, implying a top and a trend rever- The chart below shows a graphical depiction of» hanging sal, This fs a bearish signal bacause it man formation in USDICAD. shows that the currency was not able to lose on @ positive note, which would Indicate weakening markat sentment, However, wih a hanging man pattern, itis important to wat for the next perk ods close to confirm the trend reversal. This is key 54PART 3: What Moves the Market CandlesticksPART 3: What Moves the Market Candlesticks Bearish Engulfing Pattern Forecasts Reversal “The bearish engulfing pattern is trend revarsal patio that requires two candles. This pattem typically occurs after 2 severe uptrend and is formed when a red candle engulfs’ a green candle. This shows that sellers have ‘gained control of the market. The importance of the bearish engulfing pattem is dependert on the sizes of the can- ‘des, the smaller the green cande end the larger the red. ‘candle, the more significant the pattem signal. The chart below shows bearish engulfing pattem in GBP/USD, ‘Typically, traders who are looking for bearish engulfing pat toms wil sell once the currency pair closes in this forma: tion, won ERURETEOTT Bearish Engulfing ‘WagePART 3: What Moves the Market Candlesticks Doji | Dow Marketplace je Doji: Indeci in the ‘A dojiis one of the most important canckestick formations, This pattem implies indecision in the merkeiplace, as buyers and sellers are exerting equal pressure on the markets, In adation, this pattern shows that there has been a large trading range, but the price does not close on an upside or downside bias. A true doi formation has a horizontal line Instead of # body, with Jong wicks, If the market is range trading, a doji indicates a nautral market. I the market is rallying, doj is a signal that the rally may be losing steam ‘and the price may start fo decline from here, IF the market is declining, a doii signals that the decline may be ending ‘and the market may star to rally. Therefore, a doji provides: signals of potential market tops or bottoms. However, itis also important io compare the do} to recent price action. If there has been a Saties of “near doi" or small candies, the {dof formation is tess significant. A doji formation is signi cant fit appears after a long green cance in an uptrend or ‘long red candie in @ downtrend. A double doll shows that buyers and sellers are stl in equilibrium, which further ind catas that a trend reversal is probably imminent. The chart below shaws a doji formation in GBPIUSD. tH Double Doji DojiPART 3: What Moves the Market Candlesticks Bullish Engulfing Forecasts Reversals geet; Te trge tu peed bocare sear oe rowan bcawe fete carat aso ce ierPART 3: What Moves the Market Candle: Pi ‘cing Lino as a Bullish Indicator The piercing line pattorn is a bulish signal that involves the bady of 2 green candie closing within the body of the pre: vious red candle, This pattern shows that there is strong buying power at lower levels and that the downward pres: Sure 's Starting to subside, The more the green candle “piereas" into the red candle, the more significant the bull ish signal, Ifthe green candle only pierces @ smal part of the red candle, I imples that there are not enough buyers te counter the selling prossure. Tho chart below shows piercing line pattern in USD/CHF. 60PART 3: What Moves the Market Candlesticks Dark Cloud Cover Signifying Bearish Reversal AA dark cloud cover is a bearish reversal pattern that signi fios weakoning buying pressure. This patton involves the body of 2 rad candle closing within the body of the previous green candle. Graphically, this pattern shows that despite 2 strong session, the currency pair is meeting resistance at higher levels. If the green candle does not close at least halway into the body of the red candle traders need to be careful with the formation, as it may be aiving @ false signal, In such cases, its probably prudent for vaders to walt for a vend reversal confirmation in the ext candle. The deeper the second candle covers the frst candle, the strongor the signal. The chart below shows 2 {dark cloud cover formation in USONPY.PART 3: What Moves the Market Candlesticks Shooting Star: Reversal Pattern ‘A shooting star is @ reversal pattern that typically ovcurs ‘after gaps. This is a bearish signal that involves a long wick and a small body that is near the end of the trading range This pattorn shows that the market rallied and atlempted to make new high, but met with intonse soling pressure, which forcad the currency pair to end up closing near the bottom ef the range, A shooting star can have either a red ‘or green body. The chat below shows a shooting star formation in GBP/USD. Traders will typically sell f thay see the currency pair closes the period with the formation, t Body can be either red or green. 62PART 3: What Moves the Market Candlesticks Harami: Weakening Trend el aes Saas Oar TH yn = Tn Li . ft 63PART 3: What Moves the Market Candlesticks Evening Star: When the Market Comes Down “The evening star formation oscurs in an uptrend and is a reversal pattern that indicates that sellers have caned con vol of the market, after the market has made a new high “This formation involves three candles; rst a green cande witha long body, followed by small candle with a short body (can be red or green) and ther a long red body card that does not touch the body of the second candle and doses ‘well into the body of the first candle. The pattern appears in tho diagram below. To confirm the reversal pattom, the third candle must close with this formation. Tradors who are trading based on evening stars should not piace trades Luni after seeing the third candle They must wait for the: third candle to appear and close before selling the curren ‘cy pait. The chart below shows an evening star pattern in tne GBPIUSD, Rae et ee rf . here Wie Evening tae iPART 3: What Moves the Market Candlesticks Morning Star: When the Market Will Rise ‘The moming star paitern occurs in a downirend and is 2 bullish reversal pattern that indicates a buyers matket after ide a new low. This formation the currency pair has n ‘involves three candies: fst a red candle with a tong body. then a small red of oreen candie with a small body and a ‘green candle with a long body that does not touch the body Of the second candle and closes well into the body of the fist candle. The morning siar pattern appears in the dia gram below, Similar to the evening ster pation, traders ‘must vail for the third candle to close prior to buying the: currency par. The chart below shows a morning ster for ‘mation in the USD/CAD. TT ae (ree fe > ROR SE uy 65PART 3: What Moves the Market Candlesticks Putting It All Together Al of the tectiical analysis incicators outined in this man. val are the most commonly used indicators. Alone, none these indicators yield great results. However, when com bined end used in unison, they can give traders the extra ‘edge needed to better understand short term trading dynamics. Thorofore itis important for traders to look for relationships between the different indicators as muttiple signals can provide the most accurate trading predictions. We have added a number of indicators onto the charts below and will explain how they can be used in unsson. The GBP/USD chan below uses the stochastic, Fibonacci retracements, exponential moving average Indicators as well 25 candlesticks. Taken apart, we can see that thore is a piorcing line cart dioctick pattern, stochastics showed a divargence, which is ‘a bulish signal, and GEPIUSD found support at the 87.8% retracement and 200-day EMA, Coupled together, these tools confirm that in the area circled. a trend reversal appeared imminent, as all of the indicators are providing bullsh signals, Technical traders who are able to under. stand these indicators and use them together en this chart ‘could have taken advantage of the 500 pip move that occurred afterwards. 66PART 3: What Moves the Market Candlesticks The EUR/USD chart on this page wees the exponsntial moving average (EMA), relative strength index (RSI) and candlesticks. In the continued upirend, traders could have combined these Indicators to lock for profitable entry points. In the area circled, the higher lows in the RS! com firmed the strength of the uptrend, while the EUR/USD continually found support atthe 20-day EMA. The candlesticks ‘show that ater the pair pulled back to te 20-day EMA, the next candle closed wit a bulish engulfing pattern, which was confirmed after the slong break of the 3 period resist- ‘ance. Tredere who bought at this point, would have been able to benafit from the 400 pip rally that occurred after wards nos Ebbubae eine te ‘Another good exampie of muttipie ‘echinicals pointing towards a good ‘opportunty. Wide Range Candie Breakout, good Indication of new trend. ‘putsin a bulish ‘engulfing pattern. ‘Moving averages revert "6 proper order, we Bagi looking to enter @ pullback, ~~" = ‘upward trend by putting inhigherlows 67PART 3: What Moves the Market Candlesticks This EURIGEP chart on this page uses candlesticks, Bolinger bands, and MACD. The narrower Bolinger bands Ingicate that volatility is contracting substantaly, alerting to potential laiger move, When the MACD crossed the signal and "0" line, i indicated bulishness. When the pair broke the upper range ofthe Bollinger bend and found sup- pott at the top of the band, this confrmed the broakout Short-term traders could have used the indicators and taken advantage of the 50 pip move that occurred atter- wards, with a stop below the breakout level.PART 3: What Moves the Market Fibonacci Retracement Levels What is it? Leonerée Pisano Fibonace| is @ renowned European math tematician who lived during the Roman Empire, His fame stoms from the unique series of numbers that he discov- ered. He found thal 38.2%, 50% and 67.8% hold a very peculiar mathematica relationship, as they continually "pop Up’ throughout nature (reproduction rates, planetary rela tionships, et) Based upon historical studies, it has been determined that after @ significant move in currency prices and the rate begins to retrace, it teres 10 find support or resistance at 38.2%, 50% and 61.8% of tho largor move. Theso lovols represent areas where there is a high likohood that the retracament will slop and the larger move will resume. Many traders also beliave these peroantages have become a self-fulfiling prophecy as the use of these numbers has become more and more popular. Regardless, Fibonacc: relationships re signicant and widely watched, and used in conjunction with otner indicators can serve as a lucrative trading ool How can it be used for trading? Fibonacci levels are used by drawing a trend line betwean ‘wo significant points: usually from a base to a recent high, ‘and insertng percentage levels. The red lines in the NZD/USD chart below shows the low and high points from which the retracement levels are ineasured. The blue Ines fepresent the corresponding Fivonacc! revaceren! lave, which are 38.2%, 50% and 61.8%. The move from the low to the high was 848 pips. 38.2% of that move is 324 pips, 50% i 424 pips, while 61.8% Is 624 pips. Subtracting ‘hese numbers from the high point will show that the NZD Would be expected to retrace is larger bull trend and stall ‘910.4862, 0.4582 andlor 0.4482. When price moves to one ofthe levals and stops, iis likely thatthe correction may be over and the trond willresume, If the trend is a downtrena, the retracement of the correction would be up. If the tena |S an uptrend, he retracement will be down, {a the atove graph shows the Following Move tem to 8 was 248 pps 32.2% ol move = 324 50% of move Bie of move = 924 Bubrect mumbors Mom 8, which give you the retracoment levels ‘Fibonace! calculation is availabl 69 on most charting packPART 3: Fibonacci Retracement Levels Fibonacci retracement levels can also be used to determine ‘oniry pcirts. In the chart below, GBP/USD pulls back from ls larger uptrend and is finding support at the 38.2% ratracement level Traders at this point can consider going long near this level with a stop placed siightly betow the retrecenient level, Aggressive traders prefer to see pairs only retrace 38.2% of the move, as they fee! any deeper correction puts the irend's validly at risk. Other traders Using Fibonacci 1) The tanger the tme frame, the more important the retracement level 2) I'there are two diferent retrace 38.2% on a daly c ofa monthly chart and a mort lovels 3) Rates must alo beyond the retrace 4) thes Stochastics, this inc {s @ coniirmation of the suppor or resistan .ases the probability that the co: 70 i his increases the significance of the © ni favels to signify thet the levels have ben broken, in other studies, such as RSI oF tion will end at these re What Moves the Market may prefer entries at deeper correction levels such as 161.20, as they feel the trade is safer alter other traders are ‘shaken out oftheir positions. In the chart below, the termi. nation of the bull tend would have oceurred when the GBPIUSD broke below the 61 8% retracement level on a closing basis. Terminations of bear trends would occur when the currency pair rales above the 61.8% retracement ‘of the primary move, cay Ay strong aol D). Stop pl Oe ee er et re cee ty such as a 60% ret eee eee oe rections as they fo eeePART 3: What Moves the Market Moving Average What is it? “Tho moving avorage Is one of tho most popular indicators in tochnical analyeis as it holps oliminato minor fluctuations and gives traders a clear, smocthed depiction of price over a standard period of ime, Moving averages can be builtin ‘a number of diferent ways, but the most commonly used ‘ones are simple exponential and moving average envelopes. The prmary aference between simale moving averages and exponential moving averages 'S that expo- ental moving averages are weighled and give more importance to recent data. Moving average envelopes are moving averages shifted up is th choson moving average envelope percentage, the ‘moving average envelopes would be the moving average times one plus the percent and one minus the percent, How are moving averages used? Moving averages can be used in a number ways: 1) Determine entry points Buy signal when the price is rising and closes above the moving average, Sell signal when the price is falling and closes below the: moving average. Buy signal when @ fast moving average crosses above @ slower moving average. Sell signal when @ fast moving average crosses below @ slower moving average ‘Ae shown in the USOLIPY chat below, when the 200-day EMA crossed over 50-day EMA, it provitod a soll signal that could have indicated the potential for the larger downtrand 4 ‘that occurred later, eee eed eee eee ey ee ee Cd ES Cee een Se ee ee ee eer Deere y pena 2) Determine support or resistance levels “The moving averages are frequertly locked at as support and resistance points. As shown in the EURICAD chart below, the 20.day EMA served as a significant level of support for the enti trend. A prudent place to place a stop or an exit order could be a few pips below the EMAPART 3: What Moves the Market Moving Average Using Moving Averages Te Jer and sll gradual rising. ea Se ium ee eda Ren nmi Cy Ena. 7 Sere 3) Reversion to the mean The Moving Average envelopes are signals for overbought and oversold concitions. There are two ways that these envelopes can be interpreted. Traders can trade against the envelope. assuming that the price wil revert back to the: ‘mean, or closer to the center of the band. which would iadi- cate a neutral price level, This means that i the price is at ‘he top of the envelope, itis a sell signal. Ifthe price i at the bottom of the envelope, that would indicate @ buy sig nial. Alematively, if the price is near the top or bottom of the band, some traders may view this 2s indications for & potential broskout sconerio. When just looking at a single moving average (i. simplo or exponential), revarsion to the mean may indicate the ten- deney for a currency to revert back to average levels after having mace a more extreme move. 4) Slopes of moving averages can incicate strengty of trend Traders can also use the slopes of the moving averages to OR ee gauge the strength of 2 trend. A moving average wih a ‘steep slope would imply @ strong trend, while a moving aver ‘age with @ flatter slope would imply @ weak trend. In addi tion, visually. an upward sloping moving average immedi ately tells traders that the currency is in an uptrend, while & downward sloping moving average immediately tals traders that the currency is in a downtrend. Moving averages alone are less accurate, However, when it |s combined with other indicators, it is a useful for pinpoint ing important trading levels, ‘This indicator is ¢0 commonly sed that itis important for any ond all currency tradars to watch and understand.PART 3: What Moves the Market Bollinger Bands What is it? Bollinger bands are very cimilar to moving avoragot. John Bollinger of Bollinger Captal Managoment invented the, Bollinger bands because he felt that the bands should be correlated with the price action of the curancy rather than 2 fixed percentage amount (which is what is used in moving average envelopes). In order 1 incorporste price action, the calculation includes two standard deviations, whvch in statistical theory implies that 95% of price movement should be contained within the two bands. The statistical component aiso allows the bands to self adjust to changing ‘market condiions. ‘Tho bands are plotted at two standard daviations above or bolow the moving average. This is typically based off of the ‘imple moving average, but an exponential moving average can be used 10 increase the sensitivity of the indicator Increased sensitvity, however. implies increased market noise. How can Bollinger Bands be used for trading? Bolinger bands sre typicslly used by traders to detect ‘extremely unsustainable price moves, capture changes in Using Bollinger Bands trends, identity supportresistance levels and spot contrac- tionslexpansions in velatilly. There are a number of ways to Interpret Bolinger Bands, Method #1 - Sreakouts ‘Some traders believe that when the price breaks above o below the upper or lower band, IL an Indication that a breakout is occurring. These traders will then take @ pos tion in the direction of the breakout Methed #2 - Overbought | Oversold Indisaters [Aliomatively, some traders use Bolinger Bands as an overbought and oversold indicator. As shownin the chart below, when the price touches the top of the band, traders wil sell assuming that the currency pairs overbought and wil want to revan back to mean or the middle moving average band, Ifthe price touches the bottom of the band, traders will buy the currency pair, assuming that itis oversois ang wil raly back towards the top of the band. The spacing or width of the band Is dependent upon volatiity of the prices. Typically, the higher the volatity, the wider the band; the lower the volatility, the narrower the band. B), Reverse Homme eed Beer rtd ee ees oo etrePART 3: What Moves the Market Oscillators Relative Strength In: What ist? “The relative strength index or RSI is probably the mes! pop- lular oscillator used by the FX trading community. It was, ‘developed by J. Welles Wilder Jr to gauge the strength or ‘momentum of a currency pair. This indicator is calculated by comparing @ currency pair's current performance against ts past performance, or its up days versus its down days. RSlis ona scale of 1-100, where any point above 70, Is considered overbought, while any point below 30 is considered oversold, The standard lime freme for this meas ure is 14 poriods, although 9 and 25 periods are also commonly used. Genarally, more periods tend to yield more accurate, data Using RSI How can RSI be used for trading? 1) RS! can be used to identify extreme conditions or rever- ‘als, 2) Patterns in RS! filer out “noise” on price charts to clark {y tracing patterns, 3) RSI can be used to indicate divergence. ‘As mentioned earier, RSI above 70 Is considered overbought and indicating a sel signal. RSI delow 30 Is com sidered oversoid, which would imply @ buy signal ‘A diversion between the RSI escitater and the current prise ‘vend is an accurate indisator that 6 market tuming point is imminent. This is apparent in the EUR/USD chart below where the EUR/USD was continuing its rally while the RSI was starting to turn downwards. This divergence provided 4 sell signal that forecasted the decline that occurred from 0.9960 10 0.9720. car eee pete Titetane ViTereriee Pee a Ned ee Eid) 74PART 3: Stochastics What is it? ‘The stochastic escilator measures the curent currency price compared to its historical price for a given time peri od. This indicator is one of the most commoniy followed ingicalors in he FX market, It looks fo gauge the strength ‘and momantum of a cureney pai’ pice acton by measuring the degree by which a currency is overbought or oversold, The scale forthe indicator is 0 10 100. Readings above B0 indicate overbought conditons, as reflects the fact that the currency is tong and the prioe is Cosing near the high f the trading range. Readings below 20 indicate oversold conditions ene reflects the fact that the cucency is weak ands closing near the low of the teding range There are 2 lines in the stochastic indicator. One ine is the 4K line, which is the fast ine, and the other is the &%D line, Which is the slow line. Tho 84K line is calculated using the high, low, and closing data. %D is the moving average of %6K. A moving average is an average of the %K for the specified period of tina. it "moves" because for each calculation ituses the latest data multiply number of ime pen od for the data. Using Stochasties 75 What Moves the Market How can stochastics be used for trading? 1) Detect overbo gh ard oversold conditions The most common way to analyze stochastics is to sal! when the reading is above £0, which implies overbought ‘conditions, and to buy when the reading is below 20, which imptes oversold conditions. 2) Divergence ‘Stochastics can show divergence when Slow YK and Slow %0 values decline and closing price values increase, oF Slow %K and Slow %D values increase and closing price values decrease, The stochastic values are moving in one direction and the price values are moving in the opposite direction, Divergances can be used as reliable indicators of possible trend reversals. ‘The GBP/JPY chart below shows that when the %K crossed over the %D indicatng overbought concitions: ‘around 192.80, this confirmed the dawntrend and forecasted tne further decine to 189.00,PART 3: What Moves the Market Stochastics 3) Trade signals, Professional technical analysts find that stochastics are very useful for timing the market, The most important buy and sell signals occur when the %K and %D ines cross For example, a strong overbought signal occurs when a stock makes @ new high and the %D and the %K Ines cross abave the 80 level. Conversely, @ stock Is severely oversold and ready to reverse when It makesa new low and the %D and %K tines cross below the 20 level to contin thatlow. Traders should use time intervals that best sult ther trading stratagy. A tima intorval that is too short increases the sensitivity of the indicator to short term market noise, Therefore the indicator would provide signals too fraquent. 'y, which decreases the accuracy of the signal. On the other hand, @ tme soan that is too long may not generate ‘enough signals and may not pick up important moves. Only major trend reversals would force the stochastic to gener- ale a signal, An example of too fast of atime interval could be 1 period, whereas too siow of a time interval could be 500 periods, The primary difference betwoan the fast and slew stochas lic is that the fast stochastic is based upon the actual price data (consifered raw data), whereas each data point for the slow stochastic is based upon the avarage of tha fast stochastic for the specified time period. Therefore the slow stochastic usually provides more accurate trading sans, The popularity of stochastics has risen tremendously over the past couple of decades, as technology has advanced making the indicator easier to calculate, Judging from its recent track record, many FX traders are likly to continue Using it, making it an important tool that should bo undor: ‘stood and closoly watchod by all traders, 76PART 3: What Moves the Market Moving Average Convergence/Divergence (MACD) ‘The MACD is another popular oscillator used by currency traders. Ths is s momentum indicator and can be used io confirm trends, while also indicating reversals, or over bought/oversold conditions, The MACD is cabulated by taking the difference between 2 exponental moving aver- ‘ages. The two often used are the 26day and 12-day moving averages. How can MACD be used for trading? “The MACD is most commonly used during volatile trading markets. Itcan be used to indicate crossovers, divergences, oF overbought/oversold conditions. ‘The most common way to use the MACD 's to buyisell a currency pair when it crosses the signal ine or zero, A sell signal occurs when the MACD falls below the signal line, ‘white a buy signal occurs when the MACD rallies above the signal ine. Oscillators - MACD 2) Overbought / Oversold The MACD can also be used as an overboughtloverseld indicator. When the shorter moving average moves. away significantly from the longer moving average (le. the MACD rises), itis likely that the currency’s price move: ments are starting to exhaust and will soon return to more realstc levels, 3) Divergences When the MACD diverges from tho trond of the currency price, this may signal » trend reversal. In addition, if the MACD makes a new low whie the currency pair does not also make a new low, this is a bearish divergence, indicat ing a possible oversold condition. Alternatively, if the MACD is making new highs while the currency pair fails to Confirm these highs, this a bulish divergence, indicating 2 possible overbougnt condition. The USDIJPY chart below shows 2 divergence wher the price makes a new high, while the MACD does not make a fnew high, This is 4 bearsty indication that forecasted the trend reversal and a further move from 125.20 to 119.60. ee Oe ees] Cree ae a ee Peete eee FRED TerePart 4: Currency Profiles and Outlook United States Economic Overview The US Is the worlds leading economic power, with GOP. valued at over US$10TH! In 2001. Thisis the highest in the world ang based upon FPF, Wis 3 mes the size of Japan's output, 5 times the size of Germany's and 7 times the size of the UK's, As the most liquid equity and fixed income markets in the world are in the United States, foreign Investors have consistently increased their purchases. of US assets, This is evident in tho figure below, which shows foreign direct investments to be approximately 40% cf tolal alotal net inflows for US: On a net basis, the US atsorbs 71% of total foreign savings. This means that if foreign investors are not satisfed with their retums in US asset ‘markets and they decide to repatriate thelr funds, this would have a significant effect on US asset values and the USD. ‘Specilicaly, foreign investors sel US assets in search of ogre Uh.Unbed Sees Ca eine ree re 19s) 1 Yr 1981 J0m 2008 Smt 78 The import and export volume of the US also exceeds that of any other country. This is due to the country’s sheer size, as true impor and export volume represent only approximately 11% of GDP. Despite this large activity, on a netied bass, the US is runing a very large trade defict ‘of nearly $5000In, This means that the country is import Ing significantly more goods than its exporting. in addition, the large absolute number indicates that the US is heavily rellant on capital fows and the dollar fs highly sensitive to ‘changes in those flows. In fact In order fo prevent a further decline in the USD as a result of the trade dofct, the US. would need to attract cloee to $1.9 tilion in capital inflows perday. The breakdown of the mostimportant trading port ners for the US are as followingPart 4: Currency Profiles and Outlook The US Is also the largest trading partner for most coun: tries, representing 20% of total world trade, The figure below details countries that conduct significant trade act. ity with the US and correspondingly, the percentages that US trade represents for their total import and export actvi- ties. Source: Economist 12/02 report (2001 data) The US is primarily a service-orianted country with neany 80% of their GDP coming from real estate, transportation, firance, healthcare, and business servces. With the advent of new technoiogy such as the internet, productive \yin the US has consistantly increased. This is pasticuler- ly Interesting in light of the US's recent economic dowre lui, Many economists argue that despite the current downlum, increased productivity indicates that wo are in o “new economy.” The importance of this comment is that if the US is indoed in a "new economy,” previous reactions to recessionary condltions may not repeat themselvas in this downturn Monetary & Fiscal Policy Makers ‘The Federal Reserve Board (Fed) isthe central bank o! the United States. They are responsible for setting and imple ‘menting monetary policy. The board consists of a 12- member committee. which comprise the Feders! Open Market Committee (FOMC). The voting mombers of the FOMC ate the seven Govemors of tho Fedora Reserve 79 Board, plus five presidents of the (welve district reserve banks, The FOMC holds 8 meetings per year, which are widely watched for interest rate announcements or changes in growth expectations. The Fed has @ high degree of independence to set monetary authonty. They are less subject to politcal infuences, as most members are accorded long terms that allow ther to remain in office through periods of alternate party dom ance in both the White House and Congress. The Federal Reserve issues a biannual Monetary Policy Report in February and Juy, followed by the Humphray. Hawkins testimony where the Federal Reserve Chairman responds to questions from both the Congress and the Banking Committeas in ragards to this report. This report is important to watch, as it contains the FOMC forecasts for GDP growin, inflation and unemployment The Fed, unike most other cantrals banks, has # mandate or “long-run objectives of "price stabilty and sustainable economic growth.* In order to adhere to these goals, the Fed has to use monetary policy to limit inflation, unemploy ‘ment and to achieve balanced growth. The most popular tools that the Fed usee to control monetary policy include the following: Open Market Operations These involve Fed purchases of government securties, Including Treasury bils, notes and bonds. This used to be ‘one of the most popular methods for he Fed to signal and Implement policy changes. As the Fed purchases govern iment securities, they in effect decrease interest rates When the Fed selle government securities, interest ratos Fed Funds Target ‘This rates the key policy targe! of the Fed. itis in essence, the level of borrewing that the Fed offers its member banks,Part 4: Currency Profiles and Outlook Tho Fed tends to increase this rate to curb inflation or decrease this rate 10 promote growth and consumption ‘Changes in this rate tend to imply major changes in policy ‘and typically has large ramifications for global fied income and equity markets. ‘Over the past few decades, the Treasury anc Fed officials, have maintained a "strong dollar” bias. This & particulaily true under former Treasury secretary Paul O'Neill who was ‘requenily very vocal in advoceting @ strong doller. Under the new Treasury secretary, John Snow, the dolar policy ‘currontly romaine unchanged. Important Characteristics of the US Dollar ‘Over 90% of all currency deais involve the USD The most liquid currencies are EUR/USD. USDVPY, (GBP/USD and USDICHF. These currencies represent the most frequertly traded currencies, and clearly all of these pairs involve the USD. Therefore itis important keep abreast of US developments and movements of the USD. index, as thay will Impact the majority of curroncy positions Prior to 9/11, the USD was the world's premier "sale. haven’ currency ‘The reason why the USD was previously considered one oF the word's premier “safe-naven” currencies was because Dror to 9/11, the risk of severe US instability was very low. This sale haven status allowed the US to attract investment at a discounted rate of retumn. Therefore, seventy-six per- ‘cent of global currency reserves are held in USD. Another reason why currency reserves are hold in USD is the fect that the USD i the dominant factoring currency, but the safe haven status has been a factor as well when other central banks decide to overweight their USD holdings within their reserve portfolio. However, afier September 11 200}, foreign holders of US assets. including central banks have pered their USD holdings as a result of increased US 80 uncartainty and decreased intorastratas, Gold and LSD tend to have inverse relationships ‘As ingicated in the chart below, gold and the USD have historical nad and an inverse relationship: that is when gold rises, the USD falls and vice versa, TNs inverse relationship has developed as a result ofthe fact that gold is meas~ ured in dollars. Recent USD depreciation due to gba uncertainty has been the primary reason for gold apprecir tion, as gold is commonly viewed as the utimats store of valuePart 4: Currency Profiles and Outlook ren ie Many emerging market countries "peg" their local currencies to the usp \aea ining the USD as a >egaing a currency to the USD pertains to the bask ta gor ment agrees to ma feserve currency by offering to buy or sell any amount of Jomesvc currency at the pegged rate for the reserve cur ‘ency, In addition, the government typically must a'so promise to hold ‘ey at least equal to the amount ef joel currancy in circulation. fencies poggod to the USD include Mexico and China, This ie particularly important countries such as these will take an active interast in managing their fixed o float Ing pegs. China is a vary active participant in the curren: Jes market because their maximum al per day is con trolied win a narrow band based upon the previous day's weighted-average rate against the USD. Ary fluctuations beyond this bend wal be subject (o intervention by the cer tral bark, which will inckide buying oe selling USD. 81 The Treasury and Fed favor a “strong dollar” policy As me reasury and Fed officials have maint a “strong dollar bias, This i particularly tue under former Treasury secre ‘ary Paul O'Neill wha was frequently very vocal in advocat ing a strong dollar. Undor the now Troasury secretary, John the dollar watch for potential chang waver, as the economy weakens, It may be important t Interest Rate Differentials between US treasuries and foreign bonds ensued tials between US tre Js ato important to follow, a9 it Th ceator of potential currency movernonts Investors are looking for aesete with 0 Should yields in the US decrease or if Increase, this would indice investors to sell thele and purchase foreign assets. Sefing US fixed income ofPart 4: Currency Profiles and Outlook ‘equity assets would influence the currency market because that would require saling the USD and buying the foreign ‘currency. IFUS ylalds incroase or foreign yields decrease, investors would be more inclined to purchase US assets, therefore boosting the USD. Following the USD Index Market panicipants closely follow the US Dollar Index as a gauge {0 ovarall USD sirengtn oF weakness, The USD Indexis a futures contract traded on the NY Boerd of Trade that is calculated using the trade-weighted geometiic aver age of sir currencies It is important to follow this index because when market participants are reporting general USD weakness or decline In the trade-weightad USD, thoy are typically referring ‘o this index US currency trading impacted by stock and bond markets There is @ strong correlation between a country’s equity land fixed income markets and its currency: if the equity ‘market Is tsing. investment dollars are coming in to seize investment opportunities. If equity markets are falling, domestic investors wil be selling their shares of local pub: lidy traded firms only to sotze investment opportunitios abroad. With fixed income markets, economies boasting the most valuable fixed income opportunities with the high ‘st yields will be capable of attracting foreign investment. Daily fluctuations and developments in any of these mar kets reflect movement of foreign portfolio investments, Which would require foreign exchange transactions. 82Part 4: Currency Profiles and Outlook Employment Report to Gauge Unemployment The Employment roport is the most important and widaly watched indicator on the economic calendar. is importance Is mostly dus to political influence rather than pure eco- ernie reasons, as the Fed is under strict pressure to keep unemployment under control. As a resull interest rate poll- cy 18 directly influenced by employment conditions. The ‘monthly raport conssts of data from two different surveys, the Establishment Survey and the Household Survey. The Establishment survey takes dala from nonferm payroll ‘employment, average hourly workweek and the aggregate houre index. The Household Survay gives information on ‘ho labor ferce, household omployment and the unomploy ‘ment rate. Curreney traders tond to focus on soasonally agjusted monthly unemployment rates and any meaningful cchangas in non-farm payrols, Determi g Inflation Through CPI The Consumer Price Index is a kay gauge of infation, The index measures the prices on a fiked basket of consumer goods. Economists tend to focus more on the CPI-U or the Core inflation rate which excludes the volaile food and energy components, The indicators widely watched by the FX markate as it drives a lot of activity, PPI: Gauging Business Prices The Producer Price Index (PPI) is a family of indexes that measures average changes in selling pnces received by domestic producers for their output. The PPI tracks changes in prices for nearly every good-producing industry In the domestic economy, including agriculture, electicity ‘and natural gas, forestry, fisheries, manufacturing, and mining. Foreign exchange markets tend to focus on seasonally adjusted finished goods PPI and how the index has roacted on a nvm, q/q, hin and yly basis. 83 GDP to Determine Aggregate Economic Health ‘Gross Domestic Product is a measure of the total produc: tion ané consumption of goods and sarvices:in the U.S. The Bureau of Economie Analysis constructs two complemen tary measures of GOP, one based on income and the other ‘nasad on expenditures. The advance release of GOP, ‘which occurs the month after each quarter ends, contains some BEA estimates for data not yet released including inventories and trade balance, and is the most important Other releases of GDP are typicaly not very significant unless a major revision is made. International Trade Balance The balance of trade represents the difference between ‘exports and imports of foreign trade in goods and services, Merchandise data are provided for U.S. total foreign trade with all countries, detals for trade wth specific countries land regions of the world, as well as for inatvicual com: modities. Traders tend to focus on seasonaly adjusted trade numbers over a tnree-morth perlod 2 single-rnonth trade periods are regarded to be unvetabie, The Fed's Indicator of Choice: ECI The employment cost index data is based on a survey of ‘employer payrols in the 3rd month of the quarter for the pay petiod ending on the 12th day of the month, The survey is a probablity sample of approximately 3.600 private Industry employers and 700 state and focal govermments public Schoos and pubic hospitals. The big advantage of CI is that it includes non-wage costs, which can add as much a 30% to total labor costs. Reaction to the EC however, is often muted as itis generally very stable. It should be noted that itis a favorte indicator of the Fed ISM (Formerly NAPM) Survey to Forecast Manufacturing Growth The Institute for Supply Management releases a monthlyPart 4: Currency Profiles and Outlook Important E 1ic Indicators f composite index based on surveys of 900 purchasing man: agers nationwide representing 20 difforent industries ‘egarding manufacturing activity. Index valuos above 50 indicate on expanding economy, while values below 50 are indicative of contraction The number is widely watched, as Greenspan cnca stated itis one of his favorite indicators Industrial Productio! Physical Output Determining The Index of Industial Production is a set of indexes that measures the monthiy physical output of US factories, mings and uillties. The index is broken down by industry type and market type. Foreign exchange markets focus ‘mostly on the seasonally adjusted monthly change in aggregate figuro, Inereasos in the index are typically dolar postive. Consumer Confidence to Gauge Market Sentiment The Consumer Confidence Survay measures He Jevels of confidence individual households have in the performance of the economy. Survey questionneires are sent out to a nationwide representative sample of 5,000 housshelds, of which approximotely 9,500 respond. Housaholds aro askod five questions that include; (1) a rating of business condi. tions in the household's atea, (2) 2 rating of business conditions in six months:(3) job avaiablity in the area: (4) job availablity in sic months: and (5) fariy income in six months. Responses are seasonally adjusted and an index is constructed for each response and then a composite Index Is fashioned based on the aggregate responses. ‘Market panicipants perceive ising consumer confidence as fa precursor to higher consumer spending. Higher consumer spending is often seen as a spark that accelerates inflation. Is there Spending or 84 The Retail Sales Index measures the Iota! goods sold by 9 sempling of retail stores over the course of a month, This index ie used as 2 gauge of consumer consumption and consumer confidence. The most number typically does not include autos, as auto sales. can vary month-to-month, Retail sales can be quite volatile, due to seasonality: how: ‘ever itis an important incicator of the general heath of the economy,Part 4: Currency Profiles and Outlook Economic Performance Canada is the 7th lergost country in the world with 2 GDP ‘of $700 bilion in 2001. The country has boon growing con sistertly since 1991. I is typically known as a resource. based economy, as the country’s early economic develop ment hipged upon exploitation and export of natural resources. Itis now the worlds 5th tergest producer of gol and the 14th largest producer of ol, However. in actualy ‘nearly two-thirds of the country’s GDP comes from the service secior, which also empbys every 3 out 4 Canadians, The stength in the service sector is party attributed to the trend by businesses to subcontract a large portion of their services. Despite this, manufacturing and resqurese are stil very important for the Canadian econo. ‘my, a8 represents over 26% of tho country’s exports-ané 's the primary source of income for © number of provinces. The Canadian economy started to advance with the depro- elation of ts currency against the US dollar and the Free Trade Agreement that came into effect on January 1, 1989, This agreement eliminates almost al tarifs on trade between the US and Canada, As a result, Canada now exports over 85% of lis goods to the US. Further negotae ‘ions to incorporate Mexico created the North American Free Trade Agreement (NAFTA), which took into effect on Jonuary 1, 1994. This more advanced treaty eliminated most tariffs on trading batwocn all three countries. The fol lowing a breakdown of Canada's treding partners: Monetary & Fiscal Policy The Bank of Canada (BoC) is the central bank of Canada The Governing Council of the Bank of Canada is the board that is responsibie for seting monetary palicy. This counct consists of seven members: the Governor and six Deputy Governors. The Bank of Canada does not have regular periodic policy setling meetings. Instead, the council meets ‘on a daily basis and changes in policy can be medo at any time. The Bank of Canada’s focus is on maintaining the ‘integrity ‘and value ofthe currency’ This primarily involves ensuring price stability. Price stabity is maintained by adhering !oan 85 inflation target agreed upon with the Department of Finance. This inflation target is currently set between 1% - 3%. The Bank believes that high inflation can be damaging to the functioning of the economy, Low inflation would equate to price stability. which can help foster susianable tong-tarm economic growth. The 80S controls inflation thvough shor-torm interest rates. If inflation Is above the taiget. the Bank will apply tighter monetary conditions. 11 J below the target, the Bank wil loosen monelary policy. The greph on the nex! page shows that inflation has boon successfully maintained within the Inflation targot band since 1998. Monetary conditions tighten when short-term tales increase or the trade weightad Canadian dollar appre. latesPart 4: Currency Profiles and Outlook ; | 4 Total FI =~ Gore cPI —Intaion target range The Bank measures monetary conditions using its Monetary Conditions Index, which is a weighted sum of changes in the 90-day commercial paper rate, and G-10 trade weighted exchange rates. The weight ofthe interest rate varsus the exchange rate is 3 to 1. which is the result of a change in interest rates on the exchange rate based upon historical studies. This means that a 1% increase in short-lerm interest rates fs the same as a 3% appreciation of the trade weighted exchange rate. In order to change moneiary policles, te Bank wouk! manipulate the Bank Rate, which would affect the exchange rate. Ifthe curren= cy appreciates to undesirable levels, the BoC can decrease Interest rates to offset the tise, If it depreciates, the BoC can raige ratos. However, intorest rate changes are not used for the purpose of manipulating the exchange rate. Instead itis used to contro inflation, The following are the most commonly used tools by the BoC 10 imglemiant monetary poticy 86 WH 1 WH OS MS BY we BB ow aM me ‘Source: Bank of Ganaca Bank Rate: This is tho main rate used to contel inflation, This is the rate of interest that the Bank of Canada charges to com. mercial banks. Changes to this rate wil affect other interest rates. including morigage rates and prime rates charges by commercial barks. Therefore changes to this rate wil iter nto the overall economy. Open Market Operations: ‘The Large Value Transfer System (LVTS) isthe framework {or the BC's implementation of monetary policy. It is through this framework that Canada's commercial banks borrow and lend overnight money to each other in order to fund thelr daily transactions. The LVTS is an electronic platform through which these financial institutions conduct large transactions. The interest rate charged on these ‘overnight loans is called the overnight rate or bank rate The BOC can manipuiate the ovemiant rate by offering toPart 4: Currency Profiles and Outlook Important Chai of the Canadian dolla lord at ate lower or higher than the current markt fete # ‘Strong correlation with the US the ovemight ending rate is trading above oF below the tar get banks The US Inpore 85% of Canals exporis, Canada has been running marchandiee rade surpluses wth the US Or a regular basis, the bank releases a numberof pubica- since the 1960s. The curent zccoun surplus wih the US ons that re imortant to waien. This ncuses a annual reached recerd hon of USStabin in 200%. Stong Monetary Polcy Report hat contains an assessment ofthe demanc from the US and song energy prices led to record carrer economic environment ard implications or raion nigh in the Value of energy exports of approximately anc quartdy Gank of Canada Review tha includes eco- _USS90bIn n 2001, Therefowe the Canadian economy Is nome commentary, featured artes, speeches by mem _nhly save fo changes the US economy. AS the US bese of the Governing Counel and impertan announce- economy acceleales, trade creases with Canadien com- iments, ponies, berefting he perfomance of te overal economy However, as the US economy slows, the Canadian economy wil be hurt ignificanty as US companies reduce thet Important Characte: Canadian dollar importing activities. Commodiy-tinked currency Mergers and acquisitions Canadas economy is highly cependent on commodities. Due to the proximity of the US and Canada, cross border ‘As mentioned earlier, tey are currently the world’s 5th mergers and acquisitions are very common as companies: largest gold producer andthe 14th largest oll producer. The worldwide stive for globalization. These mergers and posiive correlation between tie Canadian dollar and com- acquisitions lead to money Rowing between the Iwo coun: modity prices is clase to 60%, This strong correlation is ries. which ultimately impacts the currencies. Specifically, fviciont in the figuro bolow, which comparss tho CAD rato the significant US acquisition of Canadian energy compa- with commodity prices. Strong commodity prices benefit nies in 200 lad to US corporations injecting over US$25bIn domestic producers and increase their income from into Canada. In order to purchase these companios, the exports US companies needed to sell USD and buy CAD. Interest rate differentials Interest rate differentials between the cash rates of Canada {and the short term interest rate yields of other Industria Ized counties ate closely watched by professional CADS traders, These differentials can be good indicators of petentia! money flows as they incicate how much premium yield CADS shert term fixed income assets are offering over foreign short term fixed inoorme asso's, oF vise versa. This diferential provides radars with indications of potential currency movements as investors are always looking for assets with the highest yields. This is particularly important to cary traders who enter and exit their positions based Source: Bank of Canada 87Part 4: Currency Profiles and Outlook eristics of the Canadian dollar xo sou ssousson Carry trades Tho Canadian dollar bocamo a popular cxerency to use for carry trades aftor its 3/4 point rate increases between Apri and July of 2002. A carry trade involves buying or lending 2 currency with a high interest rate and selling of borrowing 2 currency with a low interest rate. The poputanty of the carry trade has contributed to tne ‘ise of the CADS, as ‘mary foreign investors are looking for a high yield. 1f glob» al central banks ingiease thelr interest rates, the positive Inorest rate differertial between Canada and other cour fries would narrow. In such situations, pressure would be ppul on the CADS when carry traders start to close their postions 88Part 4: Currency Profiles and Outlook onomic Indicators fo’ important E Unemployment The unemployment rate represents the number of unom: ployod persons exprossed as a percentage of the labor force Consumer Price Index (CPI) This measures the average rate of increase in prices, ‘When economists speak of inflation as an economic prob lem, they generally mean @ persistent increase in the general price level over @ period of time, resulting in a decline in @ currency’ purchasing power, Inflation is often measured asa porcentage increase in the consumer price index (CP), Canada's inflation policy, as eet out by the fedaral government and the Bank! Canada, sims to keap inflation within a target range of 1 to 3 per cent. Ifthe rate of inflation is 10 percent a year, $100 worth of purchases last year will on average, cost §110 this year. At the same inflation ‘ate, those purchases will cost $121 next year, and so on, Gross Domestic Product (GDP) The total value of al goods and services producsd within Canada curing a given yoar. It is a measure af the income generated by production within Canada. GDP is also referred to ae economic output. To avoid counting the same output more than once, GOP includes only final goods and services - not those that are used to make another product GOP would not include the wheal usd to make bread, tut would include the bread itselt Balance of Trade The balance of trade is @ statement of a country's trade in goods (merchandise) and services. It covers trade in prod lucis such as manufactured goods, raw materials and agri cultural goods, as well as travel and transportation, The bal ance of trade is the difference between the value of the goods and services that a country exports and the value of the goods and services that it imports. If 2 country's 1ada 89 ‘exports exceed its imports, it has a trade surplus and the ‘rade balance is said 10 be postive. If imports excood ‘exports, the country has a trade deficit and its trade bal ance § said to be negative, Producer Price Index ‘The Producer Price Index (PP) 's a family of indexes that measures average changes in seling prices reveved by domestic producers for their output. The PPI racks changes in prices for nearly every goods producing indus try in the domeste economy, including agriculture, electric: ‘ty and natural gas, forestry, fisheries, menufacturing. and mining. Foreign exchange markets tend to focus on sea ‘sonally adjusted finished goods PPI and how the index has reacted on a mim, qiq, hh and yly basis. Consumer Consumption This is @ expenditure by households and producers of private: non- profit services to households. it includes purchases of durable as woll as non-durable goods. However, it excluxies national accounts measure that reflects current ‘expenditure by persons on the purchase of dwollings and ‘expenditure of @ capital nature by unincorporated ontor prises,Part 4: Currency Profiles and Outlook ted Kingdorr Economic Overview Tho United Kingdom is the worlds fourth largest economy With GDP valued at ever USDS 14TH in 2001, The eccnomy 's very healthy, with low unemployment, expanding output and resilient consumpiion, The strength of consumer consumption has in large part been due to @ strong housing ‘market, whch Is currently 16% above the peak in 1988, The UK has @ service-oriented economy, with manufactur. lng representing an increasingly smaller portion of GOP, equivalent to only one-fith of national outpu, Their capital market systems are one of the most developed in the worl, and as a result finance and banking have become the strongost contrbutors to GDP. Although the majority of the UK's GOP is from servioas, itis important to know that they ‘are also ona of the largest producers and exporters of nat. ural gas in the EU, The energy production industry accounts for 10% of GOP. one of the highest shares of any Industrialized nation. This is particularly important, as Increases In energy prices (such as oi), will significantly benefit the large number of UK oll exporters. ‘Overall, the UK is a net importer of goods with e consistent trode deficit. Its largest trading partner is the EU, with trade between the two constituencies accounting for over 60% of allo the country’s import and export activities, The US, on ‘an indlidual basis, stil romains the UK's largest trading partner. The breakdowns of the most Important trading partners for the UK are the following: 90 ‘The cantrat esue that he UK fs grappling with ie whether or ‘not to join the Euro. The decision on Euro entry has signif. leant ramifications for the UK economy. Currently, this is the key politcal and economic topic on the government's agenda. The Treasury has specified five economic tests that must be met prior to Euro entry. These tests are: UK's Five Economic Tests for Euro 1s there sustainable convergence in business cycles and ‘cconomic structures between the UK and other EMU mam bors. so that the UK cttizene could le comfortably with ‘ure intoreet rates on a parmanant basis? 2)|8 there enough fextbilly to cope with economic change? 3) Would joining the EMU create an environment that would ‘encourage finns to invest in he UK? 4) Would joining tie EMU nave @ postive impact on the competitiveness of the UK's financiat services industry? '5) Would joining the EMU be geod for promating stability and growth in omploymant’? Tho UK is a very poltical country where goverment olf clas are highly concemad with voter approval. IFvoters do ‘not support Euro entry. the fikelincod of EMU entry would decine. “The folowing are some of the arguments for and against adopting the Eure: Arguments Eure in favor of adopting the ~ Reduced exchange rate uncertainty for UK businesses ‘and lower exchange rate transaction costs or risks ‘The prospect of sustainad low inflation under the gover nance of the European Central Bank should reduce long- term interest rates and stimulate sustained economic growth - Single currency promotes price transparencyPart 4: Currency Profiles and Outlook Inited K op = The integration of national financial markets of the EU will load to highor officiency in the allocation of capital in Europe: ‘The Euro ie the second most itnportant reserve currency after the USD - Should the UK join the Euro, the politcal clout of the EMU would increase dramatically Arguments against adopting the Euro: ~ Currency unions have collapsed in the past ~ Economic oF poitical instablities of one country would impact the Euro, which would have exchange rate ramifica tions for otherwise healthy countries ‘Stick EMU enteria Eniry would mean a permanent transfer of domestic mon etary authority to the European Central Bank Joining a currency union with no monetary flexibilty would ‘require the UK to have more fexibilty in the labor and housing markets There are fears about which couniries might dominate the ECB + Acjusting te @ new currency wil requir large transaction costs One of the primary reasons for not joining the Euro is that the UK government has sound macroeconomic policies that have worked very well for the country. Their success. ful monetary and fiscal policies have led them fo outpertorm most major economies in the ewrent economic downturn, including the EU 91Part 4: Currency Profiles and Outlook Monetary & Fiscal Policy Makers The Bank of England (B0E)is the United Kingdom's central bank. The Monotay Policy Commitee (MPC) i a rine: ‘momber cornmittoe that sats monetary policy for the UK. It consists of a Governor, two Deputy Governors, two exacu- live directors of the central bank and four outside expert. The committee was granted operational independence in setting monetary policy In 1997, Despite this independence, their monetary policies are centered around achiev Ing an infation target dictated by the Treasury Chancellor Currently, tis target is RPIX (Retail Price index) inflation of 2.5%, The central bank has the power to change interest rales to levels that they believe wil allow ther to meat this target. The MPC holds monthly meetings. which are closely followed for announcements on changes in monetary pol icy, inckiding changos in the interest rate (bank repo rate). The MPC pubtshes statements after every meeting, along with @ quarterly Inflaton Report detating the MPC’s forecasts fr the next two years of growth and inflaton and jus tiflcation for their policy movements, In addition, another publication, the Quarterly Bulletin provides information on past monetary policy movements and analysis of the international economic environment and lis impact on the UK. economy. All of these reports contain detailed information fon the MPCs policies and biases for future policy move. mont. The main policy tools used by the MPC and BoE ar Bark Repo Rate: This isthe key rate used in monetary pol- Icy to meet te Treasurys inflation target. This rate Is set for the bank's own operations in the market, such as their ‘short term lending activiles. Chienges to this rae affect te rales set by the commercial banks for their savers and bor rowers. In tum, this rate will affect spending and output in the economy, and eventually coeis and pricas. An incrosso in this rato would imply an attempt to curb inflation, while a decrease in this rate would be an attempt to stimulate growth and expansion, 92 Open Market Operations: Tho goal of open market operations is to implement the changes in the bank repo rate, while assuting adequate li bidity in the market and continues stabilty in the banking system. This is reflectve of the three main objectives of the BoE: maintaining the integrity and value of the curren cy, maintaining the stabilty of the financial system, and seeking to ensure the effectiveness of the United Kingdom's nancial services, To ensure liquidity, he Bank Conducts daily open market operations to buy or sell short- term goverment fixed-income instruments. If this were not sufficiont to meet Iquidity needs, the Bank would also con duct additional overnight operations.Part 4: Currency Profiles and Outlook he British Poun' very liquid Eurosterling futures can give indic, tions for intorest rate movements GBP/USD is ono of tho most liquid curroncios in tho world, with 6% of al eurrancy trades involving GBP as either the Since the UK intorest rate or bank repo rate is the primary bbase of counter currency. It is one of the four rrost liquid too! used in monatary policy. its important to keep abreast currencies, which are EUR/USD, GBP/USD, USDIUPY and —_of potential changas to the interest rate. Comments trom USDICHF. One of the reasons for the curtency's liquidity is goverment officials is one way to gauge biases for poten- the county's highly developed capital markets, Many for- tial rate changes, but te BoE 1s one of the only cena ign investors seeking investment opportunites ther than banks that require members of the Monetary Policy the US have sent thair funds to the UK. In order to create Committee to publish their voting records. This personal these Investments, foreigners need to sell their local cure _accountabiity indicates that comments by individual com- reney and buy GBP. mittee members represent their own opinions and not that ofthe BoE. Therefore, it is necessary to look for other ind GBP carry trades cation of potential BoE rate movements. The 3-Month Euro storing futuras reflect market expectations on eurosterling GBP has one of the highostinterest rates among the devel. interest ratas 3 months into the future. These contracts are oped counties. Australia and New Zealand have higher also usaful in predicting UK interest rate changes. which inferest rates, but their francial markets are not as devel. will ulimately affect the GBP. oped. As a result, many investors who are currently in oF are interested in panicipating in carry rades, use tie GBP Comments on Euro by UK politicians as the lending currency. A cary wade involves buying or «Wil Impact the Euro lending a currency witha higher interest and selling or borrowing a currency with a lower interest rate. In recent Any speeches, remarks (especially from the Prime Minister years. camy \rades have increased in popularty, which has or Treasury Chancellor) or polls in regards to the Euro wil positively benefited the GBP. impact the currancy markets. Positive indications of the UK adopting tho Euro tonds to put downward prossure on GBP, Rate differentials between Gilts and while further opposition to Euro entry vil typically boost the foreign bonds are closely followed GBP, Reason being thal in order for the GBP to come in line with the Euro, interest rates would have to decrease Imerest rate differentials between UK Gills'US Treasuries significantly (at the time of this writing. UK interest rates is and UK Gits/German Bunds are widely watches by FX 4%, versus Euro interest rates of 275%). A decrease in market participants. These dfferentials indicate how much _the interest rate, would Induce carry trade investors to cose premium yield UK fixed income assels are offering over US thelr positions, oF in essence sell GBP. GBP would aso and European (German Bunds is usually used asa barom- decline beceuse of the uncertainties Involved with Euro eter for European yield) fixed income assets, or vice versa. adoption. The UK is performing very well under the direc This differential provides traders with indications of poten- tien ofits current monetary authority. The EMU is current. lial currency movements, 2s investors are always leoking —_ly encountering many difficulties with member countrios for acoets with the highest yields. The UK currontly pro. breaching EMU ofiteria, With one monetary authority die. vides these yields, while also providing the safaty of having _tating 12 countries (plus UK would be 19), the EMU has yet the same credit stability as the US. to prove that it has developed a monetary policy suitable for all member states. 93Part 4: Currency Profiles and Outlook GBP has positive correlation with energy prices ‘Tho UK houses some of the largest energy companies in the world, including British Petroleum. Energy production represents 10% of GDP. As a result, the GBP has a positive corratation with energy prices. Specifically, since many members of the EU import oll from the UK. If oil prices: Increase, they wil have to buy more GEP to func their energy purchases, In addition, rises in the price of ofl wil also benefit the earnings of the nations’ energy exporters, GBP crosses [Although tha GBP/USD is more fquid than EURIGBP, the EURIGBP ie typically the leading gauge for GBP strength “The reason is because Britain's primary trade and investment partner is Europe. AS a result, moves in the EURIGBP cross can fiter inio movements in GBPIUSD. OF course, movements in G8P/USD wif aso affect the EURIGBP rale, The EUR/GBP rae should be exacily ‘equal the rate of EURVUSD divided by GBPIUSD. Smal differences in these rates are often exploted by market participants 94Part 4: Currency Profiles and Outlook European M ¥ Union (EUR) Economic Overview The European Union (EU) was developed as an institution al framework for the construction of united Europe. The EU consists of 15 member countries: Austria, Belgium Denmark, Finland, France, Germany, Greece, ireland. lial, Luxembourg, The Netherlands, Portugal. Spain, Sweden, and the United Kingdom, All of hese countries stare the Euro asa common currency, except for Denmark, Sweden and the Unted Kingdom. Aside from a common currency, these couniries also share a single monetary policy dicta ‘ed by the European Central Bank or (ECB), These common currency coumtries constitute the European Monetary Union (EMU) The EMU is the word's second largest economic power, with a GDP valued at over US $8 tilion in 2002. With a highly developed fixed income, equity and futures market the EMU has the second most attractive investment market for domestic and Intemational investors. In the past, the EMU has had dificult attracting foreign direct investment or large capital flows. In fact, the EMU is a net supplier of foreign direct investments, accounting for approximately 459% of total world capital outflows and only 19% of capital inflows. The primary reason being that historically, US ‘aezots have had solid returns. As-a result the US absorbs 719% of total foreign savings, However, with much higher EMU interact rates compared to US intorest rates, this lead 's declining, In 2002, Europe incuired capital inflows in xcess of $110 Billion, as compared to capital outtlons of 510 Billon last year ‘The EMU is both 2 rade and capital low diiven econerny, therefore trade Is very important to the economies within the EMU. Unlike most major economies, the ENU does not have a large trade dafict or surplus. In fact, the EMU went from 2 smal trade deficit in 2001 to.a.emall rede surplus ie 2002. EU exports comprise approximately 19% of world ‘rade, while EU imports account for anly 17% of total wold Imporis. Bue ta the size of the EMU's trade with the rest of the word, it has significant power in the international trade 95 ‘rena. Internaticnal clout is one of the primary goals in the {formation cf the EU, because it allows the individual coun. tries to group as one enity and negotiate on an equal play ing field with the US, who Is their largest trading partner. ‘The breakdown of the most imporiant trading partners for the EU are the following The EMU is primarily @ service-oriented economy. Services in 2001 accounted for approximately 70% ef GDP, while manufacturing, mining and utiles only accounted for 22% of GDP. In fact, 2 large number of the companios whose primary purpose is to produce finished produc, stil concentrate ther EU activily on innovation, research, design and marketing, while outsourcing rrost of their man facturing activities to Asia, The EU's growing role in international trade has important Implications for the role of the Euro as a reserve currency. {tis important for counties to rave large amount of reserve: currencies lo reduce exchange risk and transaction costs, Traditionally, most international trade transactions involve the British Pound, the Jepanese Yen, andlor the US Dollar. Before the ostablishmert of the Euro, t was unreasonable to hold large amounts of ovary individual EU national cur- fency. As a resuk, currency reserves tended toward the dollar. At the end of the 1990s, approximately 85% of the worlds reserves were held in US dollars, but with the intro-Part 4: Currency Profiles and Outlook mportant Econom ators ft Al of the following indicators are important for the UK. However, since the UK is primarily a service-criented ocon- ‘omy, i particularly Important to pay attonton to numbers. from the service sector. Employment Situation This is @ monly survey conducted by the Office of National Siailsics. The objectives of the survey are to divide the working-age population into three separate clas sifcations: employed, unemployed and not in the labor force, and to provide descriptive and explanatory data on each of these catagories. Data from tho survey providas market participants with information on major labor market ttends such as shifts in employment actos industrial sec- tors, hours worked, labor force participation and unemploy- ‘ment rates. The timeliness of the survey makes ita closely watched statslic by the currency markets as it 6 a good barometer of the strenath of the UK economy, Retail Price Index The RPI is a measure of the change in prices of a basket ‘of consumer goods. The markets howaver focus on the undorying RPI or RPLX, which oxcludos mortgage intorost paymants. The RPLX is closoly watched as the treasury ‘sets inflation targeis for the BoE, currently dafinad as 2.5% annual growth in RPLX. Gor Quarterly report conducted by the Bureau of Statistic. GOP isa measure ofthe total production and consumption of goods and services in the UK. GDP is measured by adding expenditures by houscholds, businesses, gover ‘mont and not forsign purchases, The GDP price deflator is ced fo convart output measured at current prices into con. start-dollar GDP. This data is used to gauge where in the business cycle the UK finds itself. Fast growth often is perceived inflationary while low (or negative) growth indicates 2 recessionary or weak growth. the UK 96 Industrial Production The induttisl production (IP) index measures the change ‘n outputin U.K. manufacturing, mining and quarrying, and electricity, gas, and water supply. Output refers to the phys- ‘cal quantity of tems produced, unike sales value, which combines quantity and price. The index covers the produc- ‘ion of goods and power for domestic sales in the U.K. and for export, Because IP is responsible for dose to a quarter of gross domestic product, IP is widely watched as it provides good insight into the currert state of the economy. PML Monthly Survey conducted by the Chartered Institute of Purchasing and Supply. The index is based on a weighted average of seasonally adjusted measures of output, new lorders, inventory and employment. Index values above 50 indicate an expanding economy, while values below 50 are indicative of contraction UK Housing Starts Housing starts measure the number ef residential building ‘construction projects that have begun during any particular month, This is important data for the UK as the housing ‘market is the primary industry that is sustaining the econo. y's performance,Part 4: Currency Profiles and Outlook European Monetary Union (EUR) duction of the euro, foreign reserve assets ere shifting in favor ofthe euro, This trend is expacted to continue as the EU becomes one of the major trading partner for most countries around the world. Monetary & Fiscal Policy Makers ‘The European Central Bank (ECB) is the governing body responsible for determining the monetary policy of the ‘counties participating in the EMU, The Executive Board of the EMU consists of the President of the ECB, the Vice Presi¢ent of the EOB and four other members. These indi viduals along with the governors of the national central banks comprise the Governing Council, The ECB is set up in that the Executive Board implements the pofcies dictat: fd by the Govaming Council New monetary policy decisions are typically made by majority vote, with the President having the casting vote in the event of a tle in biweekly meetings The EMU's primary objective is to maintain price stabllty and to promote growin, Monetary and fiscal policy changes are made to ensure that this objective fs met, Wah the formation of the EMU, the Maasticht Treaty was devel- ‘oped by the Union to apply a set of ertera for each mom. bor county, Thess crteria were developed by the EMU to help them achieve thelr objective. Daviations from these criteria by any country will suit in heavy fins. Listed below are the EMU orteria, It is apparent based upon these critena that the ECB has a strict mandate fecused on inftion and deficit General, the ECB strives to maintain annual growth in HGPI (Harmonized Consumer Price Index) below 2% and M3 (Money Supply) annual growth around 4.5% Tho EOB and the ESCB (Eurcpean Systom of Contral Banke) aro indopendontincttutions from both national gov- ‘ernments and other EU institutions, granting them complete control over monetary poicy. This operational independ ence is accorded to them as per Article 108 of the Maastricht Treaty, which states that any member of the Boe ey Se coke ernment Gatch that decision making bodies cannot Seek or take instructions ‘rom any community institutions, any government of 2 member state or any other body. The primary tools te ECB uses to control monetary policy is the folowing: Open Market Operation: ‘Tho ECB has four main categorios of open market opora- tions to stoor intorest rates, manage liquidity, and signal monetary policy stance. These include: 97Part 4: Currency Profiles and Outlook European Mor EUR) ary Unior Main r} inancing operation: “These are regular liquidity-providing reverse transactions conducted woekly with @ maturity of wo weeks, which pro- vido the bulk of refinancing to the financia sector. Longer-erm refinancing operations: ‘These are liquidty-providing reverse transactions with a monthly frequency and a maturity of three months, which provide counterparties with addtional longer-term refinancing. Fine-tuning operations: ‘These are executed on an ad hoc basis withthe aim of both managing the Iquldity situation in the market and steering Interest rates, in porticularin order to smooth the effects on interast rates caused by unexpected liquilty fluctuations. ‘Structural operations: These involve the issuance of debt certificates, reverse transactions and outright transactions. These aperatons will be executed whenever the ECB wishes to adjust the structural positon of the Eurosysiem vs-2-ws the financial sector (on @ regular oF non-regular basis). ECE Minimum Bid Rate (Repo Rate): ‘This rates the key policy target for the ECB. tis the love! of borrowing that the ECB offars to the central banks of ts Mombor Statos. This is the rato that is eubject to change at the biweekly ECB meetings. Since inflation is of high concem to the ECB, they are more inclined to keep interest rates at lofly levels to prevent inflation, Changes in the ECE's minimum bid rate have large ramifications for the EUR. ‘The ECS does nol have an exchange rate target, but will factor in exchange rates in their policy deliberations, as exchange rates impact price stabilty. Therefore, the ECB is not prevented from intervening in the foraign exchange markets if thoy beliove that inflation ic a concam. As a rosuit, comments by members of the Gaverning Council 98 are widely watched by FX market participants and fre- ‘quently move the EUR, The ECB publishes a monthly bullatin detaling analysis of economic developments and changes to their peroaptions of economic conditions, which is important to follow for S- nals to changes in the bias of monetary policy Important Characteristics of the Euro EURJUSD is ths most liquid pair; all Euro crosses are very liquid “The Euro was introduced as an electronic currency in Jan 01, 1999, At this time, the Euro replaced all pre-EMU currencies, except for the Greeca's currency. which was cer verted to the Euro in Jan 2001. As a result, the EUR/USD cross 1s now the most liquid currency in the word and as movements are used as the primary gauge of botn genera European and US strengthiweakness, EURNPY and EUR/CHF are very liquid currencies that are usually the gauge for general JPY or CHF strength/weak- oss. Tha USDICHF cross ic loss liquid and tonds to gap. ‘The EURIUSD and EURIGEP crosses are groat trading currencies, as they have tight spreads, make orderly moves and have very litte gapping movements, Euro Risks: Since the Euro is 2 new currency, there are number of fac» tors that need to be considered a risks to the Euro that are not factors for other currencies. Namely, the ECB is fre quently considered an untested central bank, due to ts shott history, This chon history dos not give merket per ticipants a good gauge of how the contal bank would rasct under different economic and politcal conditions. in addition, since the Euro is the currency for 12 member countries, ts highly sensitive to political and economical insta. biltias in any one country,Part 4: Currency Profiles and Outlook JR ropean Monetary Union (EU ‘Spread betwsen US Treasuries and Bunds indicate Euro sentiment ‘The ten-year government bonds serve as an important indi- ctor of future euro exchange rales, especially against the US dollar. The diferential between the 10-year US govem- ‘ment Dond and the 10-year German Bund rates can provide {4 good indication for Euro movement. If Bund rates ere higher tran treasuyy rates and the differential increases, oF the spread widens. this implies EUR bulishness. A decrease in the differential, or spread tightening is EUR bearish. The 10-year German Bund is typically used to rep resent the Eurozone. CLLEGE Predictions for Euro area money flows Another useful interest rate the S-Month Interest Rate, also known as the Euro interbank offer rate or the Euribor rale. This is the rate offered from one large bank to ancity eon interbank term deposits. Traders tend to compare the Euriber futures rate with the Eurodollar futures rate, Eurodolars aro deposits denominated in US. dollars at banks and ethor financial institutions outside the United Statos. Because investors like high yielding assets, European fixed income assats bacome more attractive as ‘he spread between Euribor futures and Eurodollar futures: widens, in favor of the Eurbors. As the spread narrows, European assets become less attractive, whereby impiving 99 2 potential decrease in money flows into the Eur. MBA activity also has important implications for EUR/USD movements. Recent years have sean increased M&A activ. ‘ty between EU and US muttinationals. Large deals, espe- ‘ally if in cash, often have significant shor-term impacts on the EUR. Important Indicators for the Euro [AE of the following economic indicators are important for the Euro, However, since the EMU consists of 12 counties, itis important to keep abroast of political and economic devalopments such as GDP growth, inflation, and unemployment for all member countries. The largast cauniries within the EMU are Germany, France and Italy. Therefore, in addition to the overall EMU econome data, the economic data of these tnree countries are the most important m3 M3 is @ broad measure of money supply, which includes everything from notes and coins to bank deposits. The ECE closoly monitors M3 as they view it os 2 key moasure of Inflation, At ite sossion in Dacombor 1998 the Governing Council of the ECB sot its fist reference value for 143 arowth al 4.5%. This value supports inflation below 2%, trend growth of 2-2.5% and a long-term decline in the velocty of money by 0.5-1%, The growin rate fs monitored fon a S-month moving average basis in order to prevent monthly volatity to distor’ the information gwen by the aggregate, The ECB's approach to monetary targeting leaves considerable room for maneuver and interpretation Because the ECB does not impose bands on M3 growth, as the Bundestank used to do, there wil be no automatic action whon M3 growth diverges from the reference value Moreover, although the ECB considers NI3 to be the kay Indicator, It will also take into account the changes in other monetary aggregatesPart 4: Currency Profiles and Outlook European Monetary Union (EUR) HoIP ‘Tho EU Harmonized Indox of Consumer Prices (HICP) published by Eurostat is designed for international compar. ieon as requred by EU law. Eurostat has published the Index since January 1995. Since January 1998, Eurostat has published a specific index for the EMU-11 area called MUIGP. information on prices are retieved by each natonal statistical agency. They are required to provide Eurosiat ‘withthe 100 indices used to compute the HIGP, The nation: al HICPS are totaled by Eurostat as a weighted average of these sub-indices. The weights used are country-specific ‘The HIGP is released at the end of the month fellowing the: roforonce potiod, which is about ten days after the publica- tions of the national CPs from Spain and France, the final EMLU.5 counties to release their CPls. Evan if the informa. lion is already party in the market when the HICP is released, itis an important release becausa t serves as the reference infiation index for the ECB. The ECB aims to keep Euroland consumer price inflation in a range of 0-2% German Unemployment The release by the Labor Office contains information on the number of unemployed, as well as the changes on the pre: vious month, in beth seasonally (SA) and non-soasonally (NSA) adjusted terms. The NSA unemployment rate is provided, along with data on vacancies, shortshift working arangements and the number of employees (temporarily suspended in 1999). Within an hour alter the FLO release, the Bundesbank releases the SA unemployment rate. The day anead o! te release, there Is often 2 leak of the off cal data from a trade-union source, The leak 1s usually of the NSA level of unemployment in millions. When a precise figure is reported on Reuters as given by "Sources! for the NSA level of unemployment, the leak usually reflects the official figures.Rumors often circulate up to one weok bolore the official raloase. These are notoriously imprecise. Moreover, comments by German offciais have in the past bean mistransiated by the Intemational press, so care needs to be exercised in interpreting news reports. of 100 German Industrial Production The data are seasonally adjusted (SA) and include a break: ‘down into four major subcategories: mining, manufacturing ‘ene'gy, and construction, The manufacturing aggregate ‘omprises four main product groups: basic & producer ‘goods, capital goods, consumer durables, and consumer non-durables. The market tends to pay attention (0 the ‘annusl rate of change and the seasonally adjusted month- ‘on-month figure: Additionally, the Finance Ministry high- lights the two-month comparison to avoid ovar emphasizing ‘one-month aberrations. The initial release is based on a narrower data sample and hence subject to revision when the full sample has become available. The Ministry occa sionally incicates the expectec direction of the revision in, the intial data release. Pr jiminary GDP Preliminary GDP is issued when Eurostat has collected data from a sufficient number of counties to produce an fectimate, This usually includes Francs, Germany and the Netherlands. Howover, Italy i not included in the pralim- nary releaso and is only added in the final number. The yearly agaregates fo EU-15 and EMU-11 are a simple sum of national GDP. For tha quarterly accounts, the aggrega- tion is more complex since some countries (Greece, Ireland ‘and Luxembourg) do not yet produce quarterly national accounts cata. Moreover, Portugal produces only partial quarterly accounts witha significant lag. Thus, bot the EU- 15 and EMU-11 quarterly paths are the result of estimates from quatterly data based on a group of countries eccount- ing for more than 95% of total EU GDP (aco the foreword {for a detailed description of the weights of each country in the EU). Indi jual Country Budget Deficits Stabilty and Growth Pact states that deficits must be KeptPART 3: What Moves the Market below 3% of GDP. Countries also have targets setto further reduce their deficits. Failure to mest these targets is wido- ly watched by market paricpants IFO Survey Germany is by far the largast economy in Europe and is responsible for over 30% of total GDP. Any insight into German business conditons seen as an insight into Europe as a whole, The IFO is a monthly survey conducted by the IFO institute in which over 7,000 German firms are ‘osked for the'r assessment of the German business clmate and their short-term plans, The initis! publication of the results consists of tho businoss climate headline figure and its two equally weighted sub-indices: current business con. ditons and business expectations, The typical range is from 0 to 120. Where a higher number indicates greater business confidence The measure is most valuable how- ‘ever when measured against previous data. 101Part 4: Currency Profiles and Outlook Japan (JF Economic Overview Japan js the third largest economy in the world with GDP. ‘valued at over USS4TH in 2002 The country is aiso one of the worlds largest exporters and is responsible for over $400bIn in exports par year. Manufacturing and exports of products such as electronics and cars are the signature rivers of the ecenomy, accounting for nearly 20% of GDP. This has resulted in a cons'stent trade surplus. which creates an inherent demand ‘or te JPY. despite severe struc- prices sparked the banking crisis in Japan. It began in the ‘early 1990s and then developed into a full biown systemic tise in 1997 following the failure of number of high pro- fil financial institutions. Many of these banks and financial institutions extended loans to the builders and real estata dovelopers at the height of the asset bubble in the 1980s, with the land 2s the collateral, A rumber of these develop- ers defaulted after the assel bubble collapse, leaving the ‘country's banks saddled wth bad debt and coliateral worth Sometimes 60-80% fess than wher the loans were taken ‘ural deficiencies. Aside from being an exporter, Japan is also @ large importer of raw materials for the production ot thelr goods. As evidenced in the figures below, the primary trade partners for Jepan in terms of both imports and exporis are the US and China, China fs becoming an increasingly important trade partner, as China’s inexpen: sive goods have allowed it o gain a larger share of Japan's import market. In the 1980, Japan's capital market was cne of the most attractive markats for intamational investors seeking investment opportunities in Asia. They had the most developed capital markets in the region and their barking system was ‘considered to be the one of strongest in the world, The ‘country was expenienicng above-irend economic growth and nearzero infation, This resulted in rapid. growth expectations, boosted asset prices and rapid crodit expan sion, leading to the development of an esset bubble Between 1980-87, the asset bubble colapsed, inducing @ USDS10tl fall in asset pricos, with the fall in real estate prices accounting for nearly 65% of the total decline, which 's worth two years of national output. This fall in asset ‘out. Due to the large size of these banking institutions and their role in corporate funding, the crsis had profound effects on both the Japanese anc global economy. AS 2 ‘result, enormous bad debis, falling stock prices and a cok lapsing real estate sector have crippled the Japanese ‘economy for almost two decades, ‘The figure below shows that the non-performing loans ‘ownoé by Japanese banks havo only incroasod since the onset of this crisis. With Japan oxporioncing deflationary consitions, each succeeding month of defiation raises the ‘eal burden of the banks' outstancing debt. To date, the Japanese Ministry of Finance and Bank of Japan is sill ‘grappling with this problem and has only injected capital Into these ating banks as @ solution to prevent bankrupt Ges. Since the beginning of the cris, hey have hoped that the banks would grow their way back to health 102

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