The Fastest-Growing Market of Our Time
The foreign exchange market is the generic term for the worldwide institutions
that exist to exchange or trade currencies. Foreign exchange is often referred to as
“forex” or “FX.” The foreign exchange market is an over-the-counter (OTC) market,
which means that there is no central exchange and clearinghouse where orders are
matched. FX dealers and market makers around the world are linked to each other
around the clock via telephone, computer, and fax, creating one cohesive market.
Over the past few years, currencies have become one of the most popular
products to trade. No other market can claim a 57 percent surge in volume over a
three-year time frame. According to the Triennial Central Bank Survey of the foreign
exchange market conducted by the Bank for International Settlements and published
in September 2004, daily trading volume hit a record of $1.9 trillion, up from $1.2
trillion (or $1.4 trillion at constant exchange rates) in 2001. This is estimated to be
approximately 20 times larger than the daily trading volume of the New York Stock
Exchange and the Nasdaq combined. Although there are many reasons that can be
used to explain this surge in activity, one of the most interesting is that the timing of
the surge in volume coincides fairly well with the emergence of online currency
trading for the individual investor.
EFFECTS OF CURRENCIES ON STOCKS AND BONDS
It is not the advent of online currency trading alone that has helped to increase
the overall market’s volume. With the volatility in the currency markets over the past
few years, many traders are also becoming more aware of the fact that currency
movements also impact the stock and bond markets. Therefore, if stocks, bonds, and
commodities traders want to make more educated trading decisions, it is important
for them to follow the currency markets as well. The following are some of the
examples of how currency movements impacted stock and bond market movements
in the past.
EUR/USD and Corporate Profitability
For stock market traders, particularly those who invest in European corporations
that export a tremendous amount of goods to the United States, monitoring exchange
rates are essential to predicting earnings and corporate profitability. Throughout 2003
and 2004, European manufacturers complained extensively about the rapid rise in the
euro and the weakness in the U.S. dollar. The main culprit for the dollar’s sell-off at
the time was the country’s rapidly growing trade and budget deficits. This caused the
EUR/USD (euro-to-dollar) exchange rate to surge, which took a significant toll on
the profitability of European corporations because a higher exchange rate makes the
goods of European exporters more expensive to U.S. consumers. In 2003, inadequate
hedging shaved approximately 1 billion euros from Volkswagen’s profits, while
Dutch State Mines (DSM), a chemicals group, warned that a 1 percent move in the
EUR/USD rate would reduce profits by between 7 million and 11 million euros.
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Unfortunately, inadequate hedging is still a reality in Europe, which makes monitoring
the EUR/USD exchange rate even more important in forecasting the earnings
and profitability of European exporters.
Nikkei and U.S. Dollar
Traders exposed to Japanese equities also need to be aware of the developments
that are occurring in the U.S. dollar and how they affect the Nikkei rally. Japan has
recently come out of 10 years of stagnation. During this time, U.S. mutual funds and
hedge funds were grossly underweight Japanese equities. When the economy began
to rebound, these funds rushed in to make changes to their portfolios for fear of
missing a great opportunity to take advantage of Japan’s recovery. Hedge funds
borrowed a lot of dollars in order to pay for increased exposure, but the problem was
that their borrowings are very sensitive to U.S. interest rates and the Federal Reserve’s
monetary policy tightening cycle. Increased borrowing costs for the dollar
could derail the Nikkei’s rally because higher rates will raise the dollar’s financing
costs. Yet with the huge current account deficit, the Fed might need to continue
raising rates to increase the attractiveness of dollar-denominated assets. Therefore,
continual rate hikes coupled with slowing growth in Japan may make it less
profitable for funds to be overleveraged and overly exposed to Japanese stocks. As a
result, how the U.S. dollar moves also plays a role in the future direction of the
Nikkei
George Soros
In terms of bonds, one of the most talked-about men in the history of the FX
markets is George Soros. He is notorious for being “the man who broke the Bank of
England.” This is covered in more detail in our history section (Chapter 2), but in a
nutshell, in 1990 the U.K. decided to join the Exchange Rate Mechanism (ERM) of
the European Monetary System in order to take part in the low-inflationary yet stable
economy generated by the Germany’s central bank, which is also known as the
Bundesbank. This alliance tied the pound to the deutsche mark, which meant that the
U.K. was subject to the monetary policies enforced by the Bundesbank. In the early
1990s, Germany aggressively increased interest rates to avoid the inflationary effects
related to German reunification. However, national pride and the commitment of
fixing exchange rates within the ERM prevented the U.K. from devaluing the pound.
On Wednesday, September 16, 1992, also known as Black Wednesday, George Soros
leveraged the entire value of his fund ($1 billion) and sold $10 billion worth of
pounds to bet against the Exchange Rate Mechanism. This essentially “broke” the
Bank of England and forced the devaluation of its currency. In a matter of 24 hours,
the British pound fell approximately 5 percent or 5,000 pips. The Bank of England
promised to raise rates in order to tempt speculators to buy pounds. As a result, the
bond markets also experienced tremendous volatility, with the one-month U.K.
London Interbank Offered Rate (LIBOR) increasing 1 percent and then retracing the
gain over the next 24 hours. If bond traders were completely oblivious to what was
going on in the currency markets, they probably would have found themselves dumbstruck
in the face of such a rapid gyration in yields.
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Chinese Yuan Revaluation and Bonds
For U.S. government bond traders, there has also been a brewing issue that has
made it imperative to learn to monitor the developments in the currency markets.
Over the past few years, there has been a lot of speculation about the possible
revaluation of the Chinese yuan. Despite strong economic growth and a trade surplus
with many countries, China has artificially maintained its currency within a tight
trading band in order to ensure the continuation of rapid growth and modernization.
This has caused extreme opposition from manufacturers and government officials
from countries around the world, including the United States and Japan. It is
estimated that China’s fixed exchange rate regime has artificially kept the yuan 15
percent to 40 percent below its true value. In order to maintain a weak currency and
keep the exchange rate within a tight band, the Chinese government has to sell the
yuan and buy U.S. dollars each time its currency appreciates above the band’s upper
limit. China then uses these dollars to purchase U.S. Treasuries. This practice has
earned China the status of being the world’s second largest holder of U.S. Treasuries.
Its demand has kept U.S. interest rates at historical lows. Even though China has
made some changes to their currency regime, since then, the overall revaluation was
modest, which means more is set to come. More revaluation spells trouble for the
U.S. bond market, since it means that a big buyer may be pulling away. An
announcement of this sort could send yields soaring and prices tumbling. Therefore,
in order for bond traders to effectively manage risk, it is also important for them to
follow the developments in the currency markets so that a shock of this type does not
catch them by surprise.
COMPARING THE FX MARKET WITH FUTURES AND
EQUITIES
Traditionally FX has not been the most popular market to trade because access
to the foreign exchange market was primarily restricted to hedge funds, Commodity
Trading Advisors who manage large amounts of capital, major corporations, and
institutional investors due to regulation, capital requirements, and technology. One of
the primary reasons why the foreign exchange market has traditionally been the
market of choice for these large players is because the risk that a trader takes is fully
customizable. That is, one trader could use a hundred times leverage while another
may choose to not be leveraged at all. However, in recent years many firms have
opened up the foreign exchange market to retail traders, providing leveraged trading
as well as free instantaneous execution platforms, charts, and real-time news. As a
result, foreign exchange trading has surged in popularity, increasing its attractiveness
as an alternative asset class to trade.
Many equity and futures traders have begun to add currencies into the mix of
products that they trade or have even switched to trading currencies exclusively. The
reason why this trend is emerging is because these traders are beginning to realize
that there are many attractive attributes to trading FX over equities or futures.
FX versus Equities
Here are some of the key attributes of trading spot foreign exchange compared
to the equities market.
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FX Market Key Attributes
• Foreign exchange is the largest market in the world and has growing
liquidity.
• There is 24-hour around-the-clock trading.
• Traders can profit in both bull and bear markets.
• Short selling is permitted without an uptick, and there are no trading curbs.
• Instant executable trading platform minimizes slippage and errors.
• Even though higher leverage increases risk, many traders see trading the
FX market as getting more bang for the buck.
Equities Market Attributes
• There is decent market liquidity, but it depends mainly on the stock’s daily
volume.
• The market is available for trading only from 9:30 a.m. to 4:00 p.m. New York
time with limited after-hours trading.
• The existence of exchange fees results in higher costs and commissions.
• There is an uptick rule to short stocks, which many day traders find frustrating.
• The number of steps involved in completing a trade increases slippage and
error.
The volume and liquidity present in the FX market, one of the most liquid
markets in the world, have allowed traders to access a 24-hour market with low
transaction costs, high leverage, the ability to profit in both bull and bear markets,
minimized error rates, limited slippage, and no trading curbs or uptick rules. Traders
can implement in the FX market the same strategies that they use in analyzing the
equity markets. For fundamental traders, countries can be analyzed like stocks. For
technical traders, the FX market is perfect for technical analysis, since it is already
the most commonly used analysis tool by professional traders. It is therefore
important to take a closer look at the individual attributes of the FX market to really
understand why this is such an attractive market to trade.
Around-the-Clock 24-Hour Market One of the primary reasons why the FX
market is popular is because for active traders it is the ideal market to trade. Its 24-
hour nature offers traders instant access to the markets at all hours of the day for
immediate response to global developments. This characteristic also gives traders the
added flexibility of determining their trading day. Active day traders no longer have
to wait for the equities market to open at 9:30 a.m. New York time to begin trading.
If there is a significant announcement or development either domestically or overseas
between 4:00 p.m. New York time and 9:30 a.m. New York time, most day traders
will have to wait for the exchanges to open at 9:30 a.m. to place trades. By that time,
in all likelihood, unless you have access to electronic communication networks
(ECNs) such as Instinet for premarket trading, the market would have gapped up or
gapped down against you. All of the professionals would have already priced in the
event before the average trader can even access the market.
In addition, most people who want to trade also have a full-time job during the
day. The ability to trade after hours makes the FX market a much more convenient
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market for all traders. Different times of the day will offer different trading
opportunities as the global financial centers around the world are all actively
involved in foreign exchange. With the FX market, trading after hours with a large
online FX broker provides the same liquidity and spread as at any other time of day.
As a guideline, at 5:00 p.m. Sunday, New York time, trading begins as the
markets open in Sydney, Australia. Then the Tokyo markets open at 7:00 p.m. New
York time. Next, Singapore and Hong Kong open at 9:00 p.m. EST, followed by the
European markets in Frankfurt (2:00 a.m.) and then London (3:00 a.m.). By 4:00 a.m.
the European markets are in full swing, and Asia has concluded its trading day. The
U.S. markets open first in New York around 8:00 a.m. Monday as Europe winds
down. By 5:00 p.m., Sydney is set to reopen once again.
The most active trading hours are when the markets overlap; for example, Asia
and Europe trading overlaps between 2:00 a.m. and approximately 4:00 a.m., Europe
and the United States overlap between 8:00 a.m. and approximately 11:00 a.m., while
the United States and Asia overlap between 5:00 p.m. and 9:00 p.m.. During New
York and London hours all of the currency pairs trade actively, whereas during the
Asian hours the trading activity for pairs such as the GBP/JPY and AUD/JPY tend to
peak.
Lower Transaction Costs The existence of much lower transaction costs also
makes the FX market particularly attractive. In the equities market, traders must pay
a spread (i.e., the difference between the buy and sell price) and/or a commission.
With online equity brokers, commissions can run upwards of $20 per trade. With
positions of $100,000, average round-trip 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 transaction costs. Costs are further reduced by the efficiencies
created by a purely electronic marketplace that allows clients to deal directly with the
market maker, eliminating both ticket costs and middlemen. Because the currency
market offers around-the-clock liquidity, traders receive tight competitive spreads
both intraday and at night. Equities traders are more vulnerable to liquidity risk and
typically receive wider dealing spreads, especially during after-hours trading.
Low transaction costs make online FX trading the best market to trade for shortterm
traders. For an active equity trader who typically places 30 trades a day, at a $20
commission per trade you would have to pay up to $600 in daily transaction costs.
This is a significant amount of money that would definitely take a large cut out of
profits or deepen losses. The reason why costs are so high is because there are several
people involved in an equity transaction. More specifically, for each trade there is a
broker, the exchange, and the specialist. All of these parties need to be paid, and their
payment comes in the form of commission and clearing fees. In the FX market,
because it is decentralized with no exchange or clearinghouse (everything is taken
care of by the market maker), these fees are not applicable.
Customizable Leverage Even though many people realize that higher leverage
comes with risks, traders are humans and few of them find it easy to turn away the
opportunity to trade on someone else’s money. The FX market caters perfectly to
these traders by offering the highest leverage available for any market. Most online
currency firms offer 100 times leverage on regular-sized accounts and up to 200
times leverage on the miniature accounts. Compare that to the 2 times leverage
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offered to the average equity investor and the 10 times capital that is typically offered
to the professional trader, and you can see why many traders have turned to the
foreign exchange market. The margin deposit for leverage in the FX market is not
seen as a down payment on a purchase of equity, as many perceive margins to be in
the stock markets. Rather, the margin is a performance bond, or good faith deposit, to
ensure against trading losses. This is very useful to short-term day traders who need
the enhancement in capital to generate quick returns. Leverage is actually
customizable, which means that the more risk-averse investor who feels comfortable
using only 10 or 20 times leverage or no leverage at all can elect to do so. However,
leverage is really a double-edged sword. Without proper risk management a high
degree of leverage can lead to large losses as well.
Profit in Both Bull and Bear Markets In the FX market, profit potentials
exist in both bull and bear markets. Since currency trading always involves buying
one currency and selling another, there is no structural bias to the market. Therefore,
if you are long one currency, you are also short another. As a result, profit potentials
exist equally in both upward-trending and downward-trending markets. This is
different from the equities market, where most traders go long instead of short stocks,
so the general equity investment community tends to suffer in a bear market.
No Trading Curbs or Uptick Rule The FX market is the largest market in the
world, forcing market makers to offer very competitive prices. Unlike the equities
market, there is never a time in the FX markets when trading curbs would take effect
and trading would be halted, only to gap when reopened. This eliminates missed
profits due to archaic exchange regulations. In the FX market, traders would be able
to place trades 24 hours a day with virtually no disruptions.
One of the biggest annoyances for day traders in the equity market is the fact
that traders are prohibited from shorting a stock in a downtrend unless there is an
uptick. This can be very frustrating as traders wait to join short sellers but are only
left with continually watching the stock trend down before an uptick occurs. In the
FX market, there is no such rule. If you want to short a currency pair, you can do so
immediately; this allows for instant and efficient execution.
Online Trading Reduces Error Rates In general, a shorter trade process
minimizes errors. Online currency trading is typically a three-step process. A trader
would place an order on the platform, the FX dealing desk would automatically
execute it electronically, and the order confirmation would be posted or logged on the
trader’s trading station. Typically, these three steps would be completed in a matter
of seconds. For an equities trade, on the other hand, there is generally a five-step
process. The client would call his or her broker to place an order, the broker sends the
order to the exchange floor, the specialist on the floor tries to match up orders (the
broker competes with other brokers to get the best fill for the client), the specialist
executes the trade, and the client receives a confirmation from the broker. As a result,
in currency trades the elimination of a middleman minimizes the error rates and
increases the efficiency of each transaction.
Limited Slippage Unlike the equity markets, many online FX market makers
provide instantaneous execution from real-time, two-way quotes. These quotes are
the prices at which the firms are willing to buy or sell the quoted currency, rather
than vague indications of where the market is trading, which aren’t honored. Orders
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are executed and confirmed within seconds. Robust systems would never request the
size of a trader’s potential order, or which side of the market he’s trading, before
giving a bid/offer quote. Inefficient dealers determine whether the investor is a buyer
or a seller, and shade the price to increase their own profit on the transaction.
The equity market typically operates under a “next best order” system, under
which you may not get executed at the price you wish, but rather at the next best
price available. For example, let’s say Microsoft is trading at $52.50. If you enter a
buy order at this price, by the time it reaches the specialist on the exchange floor the
price may have risen to $53.25. In this case, you will not get executed at $52.50; you
will get executed at $53.25, which is essentially a loss of three-quarters of a point.
The price transparency provided by some of the better market makers ensures that
traders always receive a fair price.
Perfect Market for Technical Analysis For technical analysts, currencies
rarely spend much time in tight trading ranges and have the tendency to develop
strong trends. Over 80 percent of volume is speculative in nature, and as a result the
market frequently overshoots and then corrects itself. Technical analysis works well
for the FX market and a technically trained trader can easily identify new trends and
breakouts, which provide multiple opportunities to enter and exit positions. Charts
and indicators are used by all professional FX traders, and candlestick charts are
available in most charting packages. In addition, the most commonly used
indicators—such as Fibonacci retracements, stochastics, moving average
convergence/divergence (MACD), moving averages, (RSI), and support/resistance
levels—have proven valid in many instances.
Figure 1.1 GBP/USD Chart
(Source: eSignal. www.eSignal.com)
In the GBP/USD chart in Figure 1.1, it is clear that Fibonacci retracements,
moving averages, and stochastics have at one point or another given successful
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trading signals. For example, the 50 percent retracement level has served as support
for the GBP/USD throughout the month of January and for a part of February 2005.
The moving average crossovers of the 10-day and 20-day simple moving averages
also successfully forecasted the sell-off in the GBP/USD on March 21, 2005. Equity
traders who focus on technical analysis have the easiest transition since they can implement
in the FX market the same technical strategies that they use in the equities
market.
Analyze Stocks Like Countries
Trading currencies is not difficult for fundamental traders, either. Countries can
be analyzed just like stocks. For example, if you analyze growth rates of stocks, you
can use gross domestic product (GDP) to analyze the growth rates of countries. If
you analyze inventory and production ratios, you can follow industrial production or
durable goods data. If you follow sales figures, you can analyze retail sales data. As
with a stock investment, it is better to invest in the currency of a country that is
growing faster and is in a better economic condition than other countries. Currency
prices reflect the balance of supply and demand for currencies. Two of the primary
factors affecting supply and demand of currencies are interest rates and the overall
strength of the economy. Economic indicators such as GDP, foreign investment, and
the trade balance reflect the general health of an economy and are therefore
responsible for the underlying shifts in supply and demand for that currency. There is
a tremendous amount of data released at regular intervals, some of which is more
important than others. Data related to interest rates and international trade is looked
at the most closely.
If the market has uncertainty regarding interest rates, then any bit of news
relating to interest rates can directly affect the currency market. Traditionally, if a
country raises its interest rate, the currency of that country will strengthen in relation
to other countries as investors shift assets to that country to gain a higher return.
Hikes in interest rates are generally bad news for stock markets, however. Some
investors will transfer money out of a country’s stock market when interest rates are
hiked, causing the country’s currency to weaken. Determining which effect
dominates can be tricky, but generally there is a consensus beforehand as to what the
interest rate move will do. Indicators that have the biggest impact on interest rates are
the producer price index (PPI), consumer price index (CPI), and GDP. Generally the
timing of interest rate moves is known in advance. They take place after regularly
scheduled meetings by the Bank of England (BOE), the U.S. Federal Reserve (Fed),
the European Central Bank (ECB), the Bank of Japan (BOJ), and other central banks.
The trade balance shows the net difference over a period of time between a
nation’s exports and imports. When a country imports more than it exports the trade
balance will show a deficit, which is generally considered unfavorable. For example,
if U.S. dollars are sold for other domestic national currencies (to pay for imports), the
flow of dollars outside the country will depreciate the value of the dollar. Similarly, if
trade figures show an increase in exports, dollars will flow into the United States and
appreciate the value of the dollar. From the standpoint of a national economy, a
deficit in and of itself is not necessarily a bad thing. If the deficit is greater than
market expectations, however, then it will trigger a negative price movement.
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FX versus Futures
The FX market holds advantages over not only the equity market, but also the
futures market. Many futures traders have added currency spot trading to their
portfolios. After recapping the key spot foreign exchange attributes, we compare the
futures attributes.
FX Market Key Attributes
• It is the largest market in the world and has growing liquidity.
• There is 24-hour around-the-clock trading.
• Traders can profit in both bull and bear markets.
• Short selling is permitted without an uptick, and there are no trading curbs.
• Instant executable trading platform minimizes slippage and errors.
• Even though higher leverage increases risk, many traders see trading the FX
market as getting more bang for the buck.
Futures Attributes
• Market liquidity is limited, depending on the month of the contract traded.
• The presence of exchange fees results in more costs and commissions.
• dependent on the product traded; each product may have different opening and
closing hours, and there is limited after-hours trading.
• Futures leverage is higher than leverage for equities, but still only a fraction of
the leverage offered in FX.
• There tend to be prolonged bear markets.
• Pit trading structure increases error and slippage.
Like they can in the equities market, traders can implement in the FX market the
same strategies that they use in analyzing the futures markets. Most futures traders
are technical traders, and as mentioned in the equities section, the FX market is
perfect for technical analysis. In fact, it is the most commonly used analysis tool by
professional traders. Let’s take a closer look at how the futures market stacks up
against the FX market.
Comparing Market Hours and Liquidity The volume traded in the FX market
is estimated to be more than five times that of the futures market. The FX market is
open for trading 24 hours a day, but the futures market has confusing market hours
that vary based on the product traded. For example, trading gold futures is open only
between 7:20 a.m. and 1:30 p.m. on the New York Commodities Exchange
(COMEX), whereas if you trade crude oil futures on the New York Mercantile
Exchange, trading is open only between 8:30 a.m. and 2:10 p.m. These varying hours
not only create confusion, but also make it difficult to act on breakthrough announcements
throughout the remainder of the day.
In addition, if you have a full-time job during the day and can trade only after
hours, futures would be a very inconvenient market product for you to trade. You
would basically be placing orders based on past prices and not current market prices.
This lack of transparency makes trading very cumbersome. With the FX market, if
you choose to trade after hours through the right market makers, you can be assured
that you would receive the same liquidity and spread as at any other time of day. In
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addition, each time zone has its own unique news and developments that could move
specific currency pairs.
Low to Zero Transaction Costs In the futures market, traders must pay a
spread and/or a commission. With futures brokers, average commissions can run
close to $160 per trade on positions of $100,000 or greater. The over-the-counter
structure of the FX market eliminates exchange and clearing fees, which in turn
lowers transaction costs. Costs are further reduced by the efficiencies created by a
purely electronic marketplace that allows clients to deal directly with the market
maker, eliminating both ticket costs and middlemen. Because the currency market
offers around-the-clock liquidity, traders receive tight, competitive spreads both
intraday and at night. Futures traders are more vulnerable to liquidity risk and
typically receive wider dealing spreads, especially during after-hours trading.
Low to zero transaction costs make online FX trading the best market to trade
for short-term traders. If you are an active futures trader who typically places 20
trades a day, at $100 commission per trade, you would have to pay $2,000 in daily
transaction costs. A typical futures trade involves a broker, a Futures Commission
Merchant (FCM) order desk, a clerk on the exchange floor, a runner, and a pit trader.
All of these parties need to be paid, and their payment comes in the form of
commission and clearing fees, whereas the electronic nature of the FX market
minimizes these costs.
No Limit Up or Down Rules/Profit in Both Bull and Bear Markets There is
no limit down or limit up rule in the FX market, unlike the tight restriction on the
futures market. For example, on the S&P 500 index futures, if the contract value falls
more than 5 percent from the previous day’s close, limit down rules will come in
effect whereby on a 5 percent move the index is allowed to trade only at or above this
level for the next 10 minutes. For a 20 percent decline, trading would be completely
halted. Due to the decentralized nature of the FX market, there are no exchangeenforced
restrictions on daily activity. In effect, this eliminates missed profits due to
archaic exchange regulations.
Execution Quality and Speed/Low Error Rates The futures market is also
known for inconsistent execution in terms of both pricing and execution time. Every
futures trader has at some point in time experienced a half hour or so wait for a
market order to be filled, only to then be executed at a price that may be far away
from where the market was trading when the initial order was placed. Even with
electronic trading and limited guarantees of execution speed, the prices for fills on
market orders are far from certain. The reason for this inefficiency is the number of
steps that are involved in placing a futures trade. A futures trade is typically a sevenstep
process:
1. The client calls his or her broker and places a trade (or places it online).
2. The trading desk receives the order, processes it, and routes it to the FCM
order desk on the exchange floor.
3. The FCM order desk passes the order to the order clerk.
4. The order clerk hands the order to a runner or signals it to the pit.
5. The trading clerk goes to the pit to execute the trade.
6. The trade confirmation goes to the runner or is signaled to the order clerk
and processed by the FCM order desk.
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7. The broker receives the trade confirmation and passes it on to the client.
An FX trade, in comparison, is typically only a three-step process. A trader
would place an order on the platform, the FX dealing desk would automatically
execute it electronically, and the order confirmation would be posted or logged on the
trader’s trading station. The elimination of the additional parties involved in a futures
trade increases the speed of the FX trade execution and decreases errors.
In addition, the futures market typically operates under a “next best order”
system, under which traders frequently do not get executed at the initial market order
price, but rather at the next best price available. For example, let’s say a client is long
five March Dow Jones futures contracts at 8800 with a stop order at 8700; if the price
falls to this level, the order will most likely be executed at 8690. This 10-point
difference would be attributed to slippage, which is very common in the futures
market.
On most FX trading stations, traders execute directly off of real-time streaming
prices. Barring any unforeseen circumstances, there is generally no discrepancy
between the displayed price and the execution price. This holds true even during
volatile times and fast-moving markets. In the futures market, in contrast, execution
is uncertain because all orders must be done on the exchange, creating a situation
where liquidity is limited by the number of participants, which in turn limits
quantities that can be traded at a given price. Real-time streaming prices ensure that
FX market orders, stops, and limits are executed with minimal slippage and no partial
fills.
WHO ARE THE PLAYERS IN THE FX MARKET?
Since the foreign exchange market is an over-the-counter (OTC) market without
a centralized exchange, competition between market makers prohibits monopolistic
pricing strategies. If one market maker attempts to drastically skew the price, then
traders simply have the option to find another market maker. Moreover, spreads are
closely watched to ensure market makers are not whimsically altering the cost of the
trade. Many equity markets, in contrast, operate in a completely different fashion; the
New York Stock Exchange (NYSE), for instance, is the sole place where companies
listed on the NYSE can have their stocks traded. Centralized markets are operated by
what are referred to as specialists, while market makers is the term used in reference
to decentralized marketplaces. (See Figures 1.2 and 1.3.) Since the NYSE is a
centralized market, a stock traded on the NYSE can have only 1 bid/ask quote at all
times. Decentralized markets, such as foreign exchange, can have multiple market
makers—all of whom have the right to quote different prices. Let’s look at how both
centralized and decentralized markets operate.
Centralized Markets
By their very nature, centralized markets tend to be monopolistic: with a single
specialist controlling the market, prices can easily be skewed to accommodate the
interests of the specialist, not those of the traders. If, for example, the market is filled
with sellers from whom the specialists must buy but no prospective buyers on the
other side, the specialists will be forced to buy from the sellers and be unable to sell a
commodity that is being sold off and hence falling in value. In such a situation, the
specialist may simply widen the spread, thereby increasing the cost of the trade and
preventing additional participants from entering the market. Or specialists can simply
drastically alter the quotes they are offering, thus manipulating the price to
accommodate their own needs.
Figure 1.2 Centralized Market Structure
Figure 1.3 Decentralized Market Structure
Hierarchy of Participants in Decentralized Market
While the foreign exchange market is decentralized and hence employs multiple
market makers rather than a single specialist, participants in the FX market are
organized into a hierarchy; those with superior credit access, volume transacted, and
sophistication receive priority in the market.
At the top of the food chain is the interbank market, which trades the highest
volume per day in relatively few (mostly G-7) currencies. In the interbank market,
the largest banks can deal with each other directly, via interbank brokers or through
electronic brokering systems like Electronic Brokering Services (EBS) or Reuters.
The interbank market is a credit-approved system where banks trade based solely on
the credit relationships they have established with one another. All the banks can see
the rates everyone is dealing at; however, each bank must have a specific credit relationship
with another bank in order to trade at the rates being offered.
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Other institutions 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 institutional investors do not have access to these rates because
they have no established credit lines with big banks. This forces small participants to
deal through just one bank for their foreign exchange needs, and often this means
much less competitive rates for the participants further down the participant
hierarchy. Those receiving the least competitive rates are customers of banks and exchange
agencies.
Recently technology has broken down the barriers that used to stand between the
end users of foreign exchange services and the interbank market. The online trading
revolution 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 as a gateway to the liquid FX market. Average traders can now trade
alongside the biggest banks in the world, with 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 as big banks. FX is no longer an old boys club, which means
opportunity abounds for aspiring online currency traders.
Dealing Stations—Interbank Market The majority of FX volume is transacted
primarily through the interbank market. The leading banks of the world trade with
each other electronically over two platforms—the EBS and Reuters Dealing 3000-
Spot Matching. Both platforms offer trading in the major currency pairs; however,
certain currency pairs are more liquid and generally more frequently traded over
either EBS or Reuters D3000. These two companies are continually trying to capture
each other’s market shares, but as a guide, here is the breakdown of which currencies
are most liquid over the individual platforms:
EBS Reuters
EUR/USD GBP/USD
USD/JPY EUR/GBP
EUR/JPY USD/CAD
EUR/CHF AUD/USD
USD/CHF NZD/USD
Cross-currency pairs are generally not traded over either platform, but instead
are calculated based on the rates of the major currency pairs and then offset using the
“legs.” For example, if an interbank trader had a client who wanted to go long
AUD/JPY, the trader would most likely buy AUD/USD over the Reuters D3000
system and buy USD/JPY over EBS. The trader would then multiply these rates and
provide the client with the respective AUD/JPY rate. These currency pairs are also
known as synthetic currencies, and this helps to explain why spreads for cross currencies
are generally wider than spreads for the major currency pairs.
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Historical Events in the FX Market
Before diving into the inner workings of currency trading, it is important for
every trader to understand a few of the key milestones in the foreign exchange
marker, since even to this day they still represent events that are referenced
repeatedly by professional forex traders.
BRETTON WOODS: ANOINTING THE DOLLAR AS THE
WORLD CURRENCY (1944)
In July 1944, representatives of 44 nations met in Bretton Woods, New
Hampshire, to create a new institutional arrangement for governing the international
economy in the years after World War II. After the war, most agreed that
international economic instability was one of the principal causes of the war, and that
such instability needed to be prevented in the future. The agreement, which was
developed by renowned economists John Maynard Keynes and Harry Dexter White,
was initially proposed to Great Britain as a part of the Lend-Lease Act—an American
act designed to assist Great Britain in postwar redevelopment efforts. After various
negotiations, the final form of the Bretton Woods Agreement consisted of several key
points:
1. The formation of key international authorities designed to promote fair trade
and international economic harmony.
2. The fixing of exchange rates among currencies.
3. The convertibility between gold and the U.S. dollar, thus empowering the
U.S. dollar as the reserve currency of choice for the world.
Of the three aforementioned parameters, only the first point is still in existence
today. The organizations formed as a direct result of Bretton Woods include the
International Monetary Fund (IMF), World Bank, and General Agreement on Tariffs
and Trade (GATT), which are still in existence today and play a crucial role in the
development and regulation of international economies. The IMF, for instance,
initially enforced the price of $35 per ounce of gold that was to be fixed under the
Bretton Woods system, as well as the fixing of exchange rates that occurred while
Bretton Woods was in operation (and the financing required to ensure that fixed
exchange rates would not create fundamental distortions in the international
economy).
Since the demise of Bretton Woods, the IMF has worked closely with another
progeny of Bretton Woods: the World Bank. Together, the two institutions now
regularly lend funds to developing nations, thus assisting them in the development of
a public infrastructure capable of supporting a sound mercantile economy that can
contribute in an international arena. And, in order to ensure that these nations can
actually enjoy equal and legitimate access to trade with their industrialized
counterparts, the World Bank and IMF must work closely with GATT. While GATT
was initially meant to be a temporary organization, it now operates to encourage the
dismantling of trade barriers—namely tariffs and quotas.
The Bretton Woods Agreement was in operation from 1944 to 1971 when it was
replaced with the Smithsonian Agreement, an international contract of sorts
pioneered by U.S. President Richard Nixon out of the necessity to accommodate for
Bretton Woods' shortcomings, unfortunately, the Smithsonian Agreement possessed
the same critical weakness: while it did not include gold/U.S. dollar convertibility, it
did maintain fixed exchange rates—a facet that did not accommodate the ongoing
U.S. trade deficit and the international need for a weaker U.S. dollar. As a result, the
Smithsonian Agreement was short-lived.
Ultimately, the exchange rates of the world evolved into a free market, whereby
supply and demand were the sole criteria that determined the value of a currency.
While this did and still does result in a number of currency crises and greater
volatility between currencies, it also allowed the market to become self-regulating,
and thus the market could dictate the appropriate value of a currency without any
hindrances.
As for Bretton Woods, perhaps its most memorable contribution to the
international economic arena was its role in changing the perception regarding the
U.S. dollar. While the British pound is still substantially stronger, and while the euro
is a revolutionary currency blazing new frontiers in both social behavior and
international trade, the U.S dollar remains the world’s reserve currency of choice, for
the time being. This is undeniably due lately in part to the Bretton Woods
Agreement: by establishing dollar/gold convertibility, the dollars role as the world's
most accessible and reliable currency was firmly cemented. And thus, while Bretton
Woods may be a doctrine of yesteryear, its impact on the U.S. dollar and
international economics still resonates today.
END OF BRETTON WOODS: FREE MARKET CAPITALISM IS
BORN (1971)
On August 15, 1971, it became official: the Bretton Woods system, a system
used to fix the value of a currency to the value of gold, was abandoned once and for
all. While it had been exorcised before, only to subsequently emerge in a new form,
this final eradication of the Bretton Woods system was truly its last stand: no longer
would currencies be fixed in value to gold, allowed to fluctuate only in a 1 percent
range, but instead their fair valuation could be determined by free market behavior
such as trade flows and foreign direct investment.
While U.S. President Nixon was confident that the end of the Bretton Woods
system would bring about better times for the international economy, he was not a
believer that the free market could dictate a currency's true valuation in a fair and
catastrophe-free manner. Nixon, as well as most economists, reasoned that an entirely
unstructured foreign exchange market would result in competing devaluations, which
in turn would lead to the breakdown of international trade and investment. The end
result, Nixon and his board of economic advisers reasoned, would be global
depression.
Accordingly, a few months later, the Smithsonian Agreement was introduced.
Hailed by President Nixon as the "greatest monetary agreement in the history of the
world," the Smithsonian Agreement strived to maintain fixed exchange rates, but to
do so without the backing of gold. Its key difference from the Bretton Woods system
was that the value of the dollar could float in a range of 2.25 percent, as opposed to
just 1 percent under Bretton Woods.
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Ultimately, the Smithsonian Agreement proved to be unfeasible as well. Without
exchange rates fixed to gold, the free market gold price shot up to $215 per ounce.
Moreover, the U.S. trade deficit continued to grow, and from a fundamental
standpoint, the U.S. dollar needed to be devalued beyond the 2.25 percent parameters
established by the Smithsonian Agreement. In light of these problems the foreign
exchange markets were forced to close in February 1972.
The forex markets reopened in March 1973, and this time they were not bound
by a Smithsonian Agreement: the value of the U.S. dollar was to be determined
entirely by the market, as its value was not fixed to any commodity, nor was its
exchange rate fluctuation confined to certain parametric. While this did provide the
U.S. dollar, and other currencies by default, the agility required to adapt to a new and
rapidly evoking international trading environment, it also set the stage for
unprecedented inflation. The end of Bretton Woods and the Smithsonian Agreement,
as well as conflicts in the Middle East resulting in substantially higher oil prices,
helped to create stagflation—the synthesis of unemployment and inflation—in the
U.S. economy. It would not be until later in the decade, when Federal Reserve
Chairman Paul Volcker initiated new economic policies and President Ronald
Reagan introduced a new fiscal agenda, that the U.S. dollar would return to normal
valuations. And by then, the foreign exchange markets had thoroughly developed,
and were now capable of serving a multitude of purposes: in addition to employing a
laissez-faire style of regulation for international trade, they also were beginning to
attract speculators seeking to participate in a market with unrivaled liquidity and
continued growth. Ultimately, the death of Bretton Woods in 1971 marked the
beginning of a new economic era, one that liberated international trading while also
proliferating speculative opportunities.
PLAZA ACCORD—DEVALUATION OF U.S. DOLLAR (198S)
After the demise of all the various exchange rate regulatory mechanisms that
characterized the twentieth century—the gold standard, the Bretton Woods standard,
and the Smithsonian Agreement—the currency market was left with virtually no
regulation other than the mythical "invisible hand" of free market capitalism, one that
supposedly strived to create economic balance through supply and demand.
Unfortunately, due to a number of unforeseen economic events—such as the
Organization of Petroleum Exporting Countries (OPEC) oil crises, stagflation
throughout the 1970s, and drastic changes in the U.S. Federal Reserve's fiscal
policy—supply and demand, in and of themselves, became insufficient means by
which the currency markets could be regulated. A system of sorts was needed, but
not one that was inflexible. Fixation of currency values to a commodity, such as gold,
proved to be too rigid for economic development, as was also the notion of fixing
maximum exchange rate fluctuations. The balance between structure and rigidity was
cute that had plagued the currency markets throughout the twentieth century, and
while advancements had been made, a definitive solution was still greatly needed.
And hence in 1985, the respective ministers of finance and central bank
governors of the world's leading economies—France, Germany. Japan, the United
Kingdom, and the United Slates—convened in New York City with the hopes of
arranging a diplomatic agreement of sorts that would work to optimize the economic
20
effectiveness of the foreign exchange markets. Meeting at the Plaza Hotel, the
international leaders came to certain agreements regarding specific economies and
the international economy as a whole.
Across the world, inflation was at very low levels. In contrast to the stagflation
of the 1970s where inflation was high and real economic growth was low—the global
economy in 1985 had done a complete 180-degree turn, as inflation was now low but
growth was strong.
While low inflation, even when coupled with robust economic growth, still
allowed for low interest rates—a circumstance developing countries particularly
enjoyed—there was an imminent danger of protectionist policies like tariffs entering
the economy. The United States was experiencing a large and growing current
account deficit, while Japan and Germany were facing large and growing surpluses.
An imbalance so fundamental in nature could create serious economic
disequilibrium, which in turn would result in a distortion of the foreign exchange
markets and thus the international economy.
The results of current account imbalances, and the protectionist policies that
ensued, required action. Ultimately, it was believed that the rapid acceleration in the
value of the U.S. dollar, which appreciated more than 80 percent against the
currencies of its major trading partners, was the primary culprit. The rising value of
the U.S. dollar helped to create enormous trade deficits. A dollar with a lower
valuation, on the other hand, would be more conducive to stabilizing the international
economy, as if would naturally bring about a greater balance between the exporting
and importing capabilities of all countries.
At the meeting in the Plaza Hotel, the United States persuaded the other
attendees to coordinate a multilateral intervention, and on September 22, 1985, the
Plaza Accord was implemented. This agreement was designed to allow for a
controlled decline of the dollar and the appreciation of the main antidollar currencies.
Each country agreed to changes to its economic policies and to intervene in currency
markets as necessary to gel the dollar down. The United Slates agreed to cut its
budget deficit and to lower interest rates. France, the United Kingdom, Germany, and
Japan all agreed to raise interest rates, Germany also agreed to institute tax cuts while
Japan agreed to let the value of the yen "fully reflect the underlying strength of the
Japanese economy." However, the problem with the actual implementation of the
Plaza Accord was that not every country adhered to its pledges. The United Stales in
particular did not follow through with its initial promise to cut the budget deficit.
Japan was severely hurt by the sharp rise in the yen, and its exporters were unable to
remain competitive overseas, and it is argued that this eventually triggered a 10-year
recession in Japan. The United Slates, in contrast, enjoyed considerable growth and
price stability as a result of the agreement.
The effects of the multilateral intervention were seen immediately, and within
two years the dollar had fallen 46 percent and 50 percent against the deutsche mark
(DEM) and the Japanese yen (JPY), respectively. Figure 2-1 shows this depreciation
of the U.S. dollar against the DEM and the JPY. The U.S. economy became far more
export-oriented as a result, while other industrial countries like Germany and Japan
assumed the role of importing. This gradually resolved the current account deficits
for the time being, and also ensured that protectionist policies were minimal and
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nonthreatening. But perhaps most importantly, the Plaza Accord cemented the role of
the central banks in regulating exchange rate movement: yes, the rates would not be
fixed, and hence would be determined primarily by supply and demand; but
ultimately, such an invisible hand is insufficient, and it was the right and responsibility
of the worlds central banks to intervene on behalf of the international economy
when necessary.
Figure 2.1 Plaza Accord Price Action
GEORGE SOROS—THE MAN WHO BROKE THE BANK OF
ENGLAND
When George Soros placed a $10 billion speculative bet against the U.K. pound
and won, he became universally known as "the man who broke the Bank of
England." Whether you love him or hate him, Soros led the charge in one of the most
fascinating events in currency trading history.
The United Kingdom Joins the Exchange Rate Mechanism
In 1979, a Franco-German initiative set up the European Monetary System
(EMS) in order to stabilize exchange rates, reduce inflation, and prepare for monetary
integration. The Exchange Rate Mechanism (ERM), one of the EMS's main
components, gave each participatory currency a central exchange rate against a
basket of currencies, the European Currency Unit (ECU). Participants (initially
France, Germany, Italy, the Netherlands, Belgium, Denmark, Ireland, and
Luxembourg) were then required to maintain their exchange rates within a 2.25
percent fluctuation band above or below each bilateral central rate. The ERM was an
adjustable-peg system, and nine realignments would occur between 1979 and 1985.
22
While the United Kingdom was not one of the original members, it would eventually
join in 1990 at a rate of 2.95 deutsche marks to the pound and with a fluctuation band
of +/- 6 percent.
Until mid-1992, the ERM appeared to be a success, as a disciplinary effect had
reduced inflation throughout Europe under the leadership of the German
Bundesbank. The stability wouldn't last, however, as international investors started
worrying that the exchange rate values of several currencies within the ERM were
inappropriate. Following German reunification in 1989, the nation’s government
spending surged, forcing the Bundesbank to print more money. This led to higher
inflation and left the German central hank with little choice but to increase interest
rates. But the rate hike had additional repercussions—because it placed upward
pressure on the German mark. This forced other central banks to raise their interest
rates as well, so as to maintain the pegged currency exchange rates (a direct application
of Irving Fishers interest rate parity theory). Realizing that the United
Kingdom's weak economy and high unemployment rate would not permit the British
government to maintain this policy for long, George Soros stepped into action.
Soros Bets Against Success of U.K. Involvement in ERM
The Quantum hedge fund manager essentially wanted to bet that the pound
would depreciate because the United Kingdom would either devalue the pound or
leave the ERM. Thanks to the progressive removal of capital controls during the
EMS years, international investors at the time had more freedom than ever to take
advantage of perceived disequilibriums, so Soros established short positions in
pounds and long positions in marks by borrowing pounds and investing in markdenominated
assets. He also made great use of options and futures. In all, his
positions accounted for a gargantuan $10 billion. Soros was not the only one: many
other investors soon followed suit. Everyone was selling pounds, placing tremendous
downward pressure on the currency.
At first, the Bank of England tried to defend the pegged rates by buying 15
billion pounds with its large reserve assets, but its sterilized interventions (whereby
the monetary base is held constant thanks to open market interventions) were limited
in their effectiveness. The pound was trading dangerously close to the lower levels of
its fixed band. On September 16, 1992, a day that would later be known as Black
Wednesday, the bank announced a 2 percent rise in interest rates (from 10 percent to
12 percent) in an attempt to boost the pound’s appeal. A few hours later, it promised
to raise rates again, to 15 percent, but international investors such as Soros could not
be swayed, knowing that huge profits were right around the corner. Traders kept
selling pounds in huge volumes, and the Bank of England kept buying them until,
finally, at 7:00 p.m. that same day, Chancellor Norman Lamont announced Britain
would leave the ERM and that rates would return to their initial level of 10 percent.
The chaotic Black Wednesday marked the beginning of a steep depreciation in the
pounds effective value.
Whether the return to a floating currency was due to the Soros-led attack on the
pound or because of simple fundamental analysis is still debated today. What is
certain, however is that the pound's depreciation of almost 15 percent against the
deutsche mark and 25 percent against the dollar over the next five weeks (as seen in
23
Figure 2.2 and Figure 2.3) resulted in tremendous profits for Soros and other traders.
Within a month, the Quantum Fund rushed in on approximately $2 billion by selling
the now more expensive deutsche marks and buying back the now cheaper pounds.
“The man who broke the Bank of England” showed how central banks can still be
vulnerable to speculative attacks.
Figure 2.2 GBP/DEM After Soros
Figure 2.3 GBP/USD After Soros
ASIAN FINANCIAL CRISIS (1997-1998)
Falling like a set of dominos on July 2, 1997, the relatively nascent Asian tiger
economies created a perfect example in showing the interdependence of global
capital markets and their subsequent effects throughout international currency
forums. Based on several fundamental breakdowns, the cause of the contagion
stemmed largely from shrouded lending practices, inflated trade deficits, mid
24
immature capital markets. Added together, the factors contributed to a "perfect
storm" that left major regional markets incapacitated and once-prized currencies
devalued to significantly lower levels. With adverse effects easily seen in the equities
markets, currency market fluctuations were negatively impacted in much the same
manner during this time period.
The Bubble
Leading up to 1997, investors had become increasingly attracted to Asian
investment prospects, focusing on real estate development and domestic equities. As
a result, foreign investment capital flowed into the region as economic growth rates
climbed on improved production in countries like Malaysia, the Philippines,
Indonesia, and South Korea. Thailand, home of the baht, experienced a 13 percent
growth rate in 1988 (falling to 6.5 percent in 1996). Additional lending support for a
stronger economy came from the enactment of a fixed currency peg to the more
formidable U.S. dollar. With a fixed valuation to the greenback countries like
Thailand could ensure financial stability in their own markets and a constant rate for
export trading purposes with the world's latest economy. Ultimately, the regions
national currencies appreciated as underlying fundamentals were justified, and
speculative positions in expectation of further climbs in price mounted.
Ballooning Current Account Deficits and Nonperforming Loans
However, in early 1997, a shift in sentiment had begun to occur as international
account deficits became increasingly difficult for respective governments to handle
and lending practices were revealed to be detrimental to the economic infrastructure.
In particular, economists were alerted to the fact that Thailand's current account
deficit had ballooned in 1996 to $14.7 billion (it had been climbing since 1992).
Although comparatively smaller than the U.S. deficit, the gap represented 8 percent
of the country's gross domestic product. Shrouded lending practices also contributed
heavily to these breakdowns as close personal relationships of borrowers with highranking
banking officials were well rewarded and surprisingly common throughout
the region. This aspect affected many of South Korea's highly leveraged
conglomerates as total nonperforming loan values sky-rocketed to 7.5 percent of
gross domestic product.
Additional evidence of these practices could be observed in financial institutions
throughout Japan. After announcing a $136 billion total in questionable and
nonperforming loans in 1994, Japanese authorities admitted to an alarming $400
billion total a year later. Coupled with a then crippled stock market, cooling real
estate values, and dramatic slowdowns in the economy, investors saw opportunity in
a depreciating yen. subsequently adding selling pressure to neighbor currencies.
When Japan's asset bubble collapsed, asset prices fell by $10 trillion, with the fall in
real estate prices accounting for nearly 65 percent of the total decline, which was
worth two years of national output. This fall in asset prices sparked the banking crisis
in Japan. It began in the early 1990s and then developed into a full-blown systemic
crisis in 1997 following the failure of a number of high-profile financial institutions.
In response, Japanese monetary authorities warned of potentially increasing benchmark
interest rates in hopes of defending the domestic currency valuation.
25
Unfortunately, these considerations never materialized and a shortfall ensued.
Sparked mainly by an announcement of a managed float of the Thai baht, the slide
snowballed as central bank reserves evaporated and currency price levels became
unsustainable in light of downside selling pressure.
Currency Crisis
Following mass short speculation and attempted intervention, the aforementioned
Asian economies were left ruined and momentarily incapacitated. The
Thailand baht, once a prized possession, was devalued by as much as 48 percent,
even slumping closer to a 100 percent fall at the turn of the New Year. The most
adversely affected was the Indonesian rupiah. Relatively stable prior to the onset of a
“crawling peg" with the Thai baht, the rupiah fell a whopping 228 percent from its
previous high of 12,950 to the fixed U.S. dollar. These particularly volatile price
actions are reflected in Figure 2.4. Among the majors, the Japanese yen fell
approximately 23 percent from its high to its low against the U.S. dollar in 1997 and
1998, its shown in Figure 2.5.
Figure 2.4 Asian Crisis Price Action
The financial crisis of 1997-1998 revealed the interconnectivity of economies
and their effects on the global currency markets. Additionally, it showed the inability
of central banks to successfully intervene in currency valuations when confronted
with overwhelming market forces along with the absence of secure economic
fundamentals. Today, with the assistance of IMF reparation packages and the
implementation of stricter requirements, Asia’s four little dragons are churning away
once again. With inflationary benchmarks and a revived exporting market, Southeast
Asia is building back its once prominent stature among the world’s industrialized
economic regions. With the experience of evaporating currency reserves under their
26
bells, the Asian tigers now take active initiatives to ensure that they have a large pot
of reserves on hand in ease speculators attempt to attack their currencies once again.
Figure 2.5 USD/JPY Asian Crisis Price Action
INTRODUCTION OF THE EURO (1999)
The introduction of the euro was a monumental achievement, marking the
largest monetary changeover ever. The euro was officially launched as an electronic
trading currency on January 1, 1999. The 11 initial member states of the European
Monetary Union (EMU) were Belgium, Germany, Spain, France, Ireland, Italy,
Luxembourg, the Netherlands, Austria, Portugal, and Finland. Greece joined two
years later. Each country fixed its currency to a specific conversion rate against the
euro, and a common monetary' policy governed by the European Central Bank
(ECU) was adopted. To many economists, the system would ideally include all of the
original 15 European Union (EU) nations, but the United Kingdom, Sweden, and
Denmark decided to keep their own currencies for the time being. Euro notes and
coins did not begin circulation until the first two months of 2002. In deciding
whether to adopt the euro, EU members all had to weigh the pros and cons of such an
important decision.
While ease of traveling is perhaps the most salient issue to EMU citizens, the
euro also brings about numerous other benefits:
• It eliminates exchange rate fluctuations, thereby providing a more stable
environment to trade within the euro area.
• The purging of all exchange rate risk within the zone allows businesses to plan
investment derisions with greater certainty.
• Transaction costs diminish (mainly those relating to foreign exchange
operations, hedging operations, cross-border payments, and the management of
several currency accounts).
27
• Prices become more transparent as consumers and businesses can compare
prices across countries more easily. This, in turn, increase competition.
• The huge single currency market becomes more attractive for foreign
investors.
• The economy's magnitude and stability allow the ECB to control inflation with
lower interest rates thanks to increased credibility.
Yet the euro is not without its limitations, leaving aside political sovereignty
issues, the main problem is that, by adopting the euro, a nation essentially forfeits
any independent monetary policy. Since each country's economy is not perfectly
correlated to the EMU's economy, a nation might find the ECB hiking interest rates
during a domestic recession. This is especially true for many of the smaller nations.
As a result, countries try to rely more heavily on fiscal policy, but the efficiency of
fiscal policy is limited when it is not effectively combined with monetary policy.
This inefficiency is only further exacerbated by the 3 percent of GDP limit on budget
deficits, as stipulated by the Stability and Growth Pact.
Some concerns also exist regarding the ECB’s effectiveness as a central bank.
While its target inflation is slightly below 2 percent, the euro areas inflation edged
above the benchmark from 2000 to 2002, and has of late continued to surpass the
self-imposed objective. From 1999 to late 2002, a lack of confidence in the unions
currency (and in the union itself) led to a 24 percent depreciation, from
approximately $1.15 to the dollar in January 1999 to $0.88 in May 2000, forcing the
ECB to intervene in foreign exchange markets in the last few mouths of 2000. Since
then, however, things have greatly changed; the euro now trades at a premium to the
dollar, and many analysts claim that the euro will someday replace the dollar as the
world's dominant international currency (Figure 2.6 shows a chart of the euro since it
was launched in 1999).
Figure 2.5 EUR/USD Price Since Launch
There are 10 more members stated to adopt the euro over the next few years.
The enlargement, which will grow the EMU's population by one-filth, is both a
28
political and an economic landmark event: Of the new entrants, all but two are
former Soviet republics, joining the EU after 15 years of restructuring. Once
assimilated, these countries will become part of the world's largest free trade zone, a
bloc of 450 million people. Consequently, the three largest accession countries,
Poland, Hungary, and the Czech Republic—which comprise 79 percent of new
member combined GDP—are not likely in adopt the euro anytime soon. While euro
members are mandated to cap fiscal deficits at 3 percent of GDP, each of these three
countries currently runs a projected deficit at or near 6 percent. In a probable
scenario, euro entry for Poland, Hungary, and the Czech Republic are likely to be
delayed until 2009 at the earliest. Even smaller states whose economies at present
meet EU requirements fare a long process in replacing their national currencies.
States that already maintain a fixed euro exchange rate—Estonia and Lithuania—
could participate in the ERM earlier, but even on this relatively fast track, they would
not be able to adopt the euro until 2007.
The 1993 the Maastricht Treaty set five main convergence criteria for member
states to join the EMU.
Maastricht Treaty: Convergence Criteria
1. The country's government budget deficit could not be greater than 3 percent of
GDP.
2. The country's government debt could not be larger than 60 percent of GDP.
3. The country’s exchange rate had to be maintained within ERM hands without
any realignment for two years prior to joining.
4. The country's inflation rate could not be higher than 1.5 percent above the
average inflation rate of the three EU countries with the lowest inflation rates.
5. The country’s long-term interest rate on government bonds could not be higher
than 2 percent above the average of the comparable rates in the three countries
with the lowest inflation.
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What Moves the Currency Market
in the Long Term?
There are two major ways to analyze financial markets: fundamental analysis
and technical analysis. Fundamental analysis is based on underlying economic
conditions, while, technical analysis uses historical prices in an effort to predict
future movements. Ever since technical analysis first surfaced, there has been an
ongoing debate as to which methodology is more successful. Short-term traders
prefer to use technical analysis, focusing their strategies primarily on price action,
while medium-term traders tend to use fundamental analysis to determine a
currency's proper valuation, as well as its probable, future valuation.
Before implementing successful trading strategies, it is important to understand
what drives the movements of currencies in the foreign exchange market. The best
strategies tend to be the ones that combine both fundamental and technical analysis.
Too often perfect technical formations have failed because of major fundamental
events. The same occurs with fundamentals; there may be sharp gyrations in price
action one day on the back of no economic news released, which suggests that the
price action is random or based on nothing more than pattern formations. Therefore,
it is very important for technical traders to be aware of the key economic data or
events that are scheduled for release and, in turn, for fundamental traders to be aware
of important technical levels on which the general market may be focusing.
Fundamental analysis
Fundamental analysis focuses on the economic, social, and political forces that
drive supply and demand. Those using fundamental analysis as a trading tool look at
various macroeconomic indicators such as growth rates, interest rates, inflation, and
unemployment. We list the most important economic releases in Chapter 10 as well
as the most market-moving pieces of data for the U.S. dollar in Chapter 4.
Fundamental analysts will combine all of this information to assess current and future
performance. This requires a great deal of work and thorough analysis, as there is no
single set of beliefs that guides fundamental analysis. Traders employing
fundamental analysis need to continually keep abreast of news and announcements
that can indicate potential changes to the economic, social, and political environment.
All traders should have some awareness of the broad economic conditions before
placing trades. This is especially important for day traders who are trying to make
trading decisions based on news events because even though Federal Reserve
monetary policy decisions are always important, if the rate move is already
completely priced into the market, then the actual reaction in the EUR/USD, say,
could be nominal.
Taking a step back, currency prices move primarily based on supply and
demand. That is, on the most fundamental level, a currency rallies because there is
demand for that currency. Regardless of whether the demand is for hedging,
speculative, or conversion purposes, true movements are based on the need for the
currency. Currency values decrease when there is excess supply. Supply and demand
should be the real determinants for predicting future movements. However, how to
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predict 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, such as capital
flows, trade flows, speculative needs, and hedging needs.
For example, the U.S. dollar was very strong (against the euro) from 1999 to the
end of 2001, a situation primarily driven by the U.S. Internet and equity market boom
and the desire for foreign investors to participate in these elevated returns. This
demand for U.S. assets required foreign investors to sell their local currencies and
purchase U.S. dollars. Since the end of 2001, when geopolitical uncertainty rose, the
United States started cutting interest rates and foreign investors began to sell U.S.
assets in search of higher yields elsewhere. This required foreign investors to sell
U.S. dollars, increasing supply and lowering the dollars value against other major
currencies. The availability of funding or interest in buying a currency is a major
factor that can impact the direction that a currency trades. It has been a primary
determinant for the U.S. dollar between 2002 and 2005. Foreign official purchases of
U.S. assets (also known as the Treasury international capital flow or TIC data) have
become one of the most important economic indicators anticipated by the markets.
Capital and Trade Flows
Capital flows and trade flows constitute a country's balance of payments, which
quantifies the amount of demand for a currency over a given period of time.
Theoretically, a balance of payments equal to zero is required for a currency to
maintain its current valuation. A negative balance of payments number indicates that
capital is leaving the economy at a more rapid rate than it is entering, and hence
theoretically the currency should fall in value.
This is particularly important in current conditions (at the lime of this book's
publication) where the United States is running a consistently large trade deficit
without sufficient foreign inflow to fund that deficit. As a result of this very problem,
the trade-weighted dollar index fell 22 percent in value between 2003 and 2005. The
Japanese yen is another good example. As one of the world's largest exporters, Japan
runs a very high trade surplus. Therefore, despite a zero interest rate policy that
prevents capital flows from increasing, the yen has a natural tendency to trade higher
based on trade flows, which is the other side of the equation. To be more specific,
here is a detailed explanation of what capital and trade flows encompass.
Capital Flows: Measuring Currency Bought
and Sold
Capital flows measure the net amount of a currency that is being purchased or
sold due to capital investments. A positive capital flow balance implies that foreign
inflows of physical or portfolio investments into a country exceed outflows. A
negative capital flow balance indicates that there are more physical or portfolio
investments bought by domestic investors than foreign investors. Let's look at these
two types of capital flows—physical flows and portfolio flows.
Physical Flows. Physical flows encompass actual foreign direct investments by
corporations such as investments in real estate, manufacturing, and local acquisitions.
All of these require that a foreign corporation sell the local currency and buy the
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foreign currency, which leads to movements in the FX market. This is particularly
important for global corporate acquisitions that involve more cash than stock.
Physical flows are important to watch, as they represent the underlying changes
in actual physical investment activity. These flows shift in response to changes in
each country’s financial health and growth opportunities. Changes in local laws that
encourage foreign investment also serve to promote physical flows. For example, due
to China's entry into the World Trade Organization (WTO), its foreign investment
laws have been relaxed. As a result of its cheap labor and attractive revenue
opportunities (population of over 1 billion), corporations globally have flooded China
with investments. From an FX perspective, in order to fund investments in China,
foreign corporations need to sell their local currency and buy Chinese renminbi
(RMB).
Portfolio Flows. Portfolio flows involve measuring capital inflows and outflows
in equity markets and fixed income markets.
Equity Markets. As technology has enabled greater ease with respect to
transportation of capital, investing in global equity markets has become far more
feasible. Accordingly, a rallying stork market in any part of the world serves as an
ideal opportunity for all, regardless of geographic location. The result of this has
become a strong correlation between a country's equity markets and its currency: if
the equity market is rising, investment dollars generally come in to seize the
opportunity. Alternatively, frilling equity market could prompt domestic investors to
sell their shares of local publicly traded firms to capture investment opportunities
abroad.
Figure 3.1 Dow Jones Industrial Average and USD/EUR
The attraction of equity markets compared to fixed income markets has
increased across the years. Since the early 1990s, the ratio of foreign transactions in
U.S. government bonds over U.S. equities has declined from 10 to 1 to 2 to 1. As
indicated in Figure 3.1, it is evident that the Dow Jones Industrial Average had a high
correlation (of approximately 81 percent) with the U.S. dollar (against the deutsche
mark) between 1994 and 1999. In addition, from 1991 to 1999 the Dow increased
