Posted: Tue Feb 10, 2009 12:18 pm Post subject: A Primer On The Forex Market
A Primer On The Forex Market
With the increasingly widespread availability of electronic trading networks, trading on the currency exchanges is now more accessible than ever. The foreign exchange market, or forex, is notoriously the domain of government central banks and commercial and investment banks, not to mention hedge funds and massive international corporations. At first glance, the presence of such heavyweight entities may appear rather daunting to the individual investor. But the presence of such powerful groups and such a massive international market can also work to the benefit of the individual trader. The forex offers trading 24-hours a day, five days a week, and the daily dollar volume of currencies traded in the currency market exceeded $3 trillion in 2007 (according to the 2007 Triennial Central Bank Survey of Foreign Exchange and Derivative Market Activity), making it the largest and most liquid market in the world.
Trading Opportunities The sheer number of currencies traded serves to ensure a rather extreme level of volatility on a day-to-day basis. There will always be currencies that are moving rapidly up or down, offering opportunities for profit (and commensurate risk) to astute traders. Yet, like the equity markets, forex offers plenty of instruments to mitigate risk and allows the individual to profit in both rising and falling markets. Forex also allows highly leveraged trading with low margin requirements relative to its equity counterparts. Perhaps best of all, forex charges zero dealing commissions!
Many of the instruments utilized in forex - such as forwards and futures, options, spread betting, contracts for difference and the spot market - will appear similar to those used in the equity markets. Since the instruments on the forex often maintain minimum trade sizes in terms of the base currencies (the spot market, for example, requires a minimum trade size of 100,000 units of the base currency), the use of margin is absolutely essential for the person trading these instruments.
Buying and Selling Currencies Regarding the specifics of buying and selling on forex, it is important to note that currencies are always priced in pairs. All trades result in the simultaneous purchase of one currency and the sale of another. This necessitates a slightly different mode of thinking than what you might be used to. While trading on the forex, you would execute a trade only at a time when you expect the currency you are buying to increase in value relative to the one you are selling. If the currency you are buying does increase in value, you must sell the other currency back in order to lock in a profit. An open trade (or open position), therefore, is a trade in which a trader has bought or sold a particular currency pair and has not yet sold or bought back the equivalent amount to close the position.
Base and Counter Currencies and Quotes Currency traders must become familiar also with the way currencies are quoted. The first currency in the pair is considered the base currency; and the second is the counter or quote currency. Most of the time, U.S. dollar is considered the base currency, and quotes are expressed in units of US$1 per counter currency (for example, USD/JPY or USD/CAD). The only exceptions to this convention are quotes in relation to the euro, the pound sterling and the Australian dollar - these three are quoted as dollars per foreign currency.
Forex quotes always include a bid and an ask price. The bid is the price at which the market maker is willing to buy the base currency in exchange for the counter currency. The ask price is the price at which the market maker is willing to sell the base currency in exchange for the counter currency. The difference between the bid and the ask prices is referred to as the spread.
The cost of establishing a position is determined by the spread, and prices are always quoted using five numbers (for example, 134.85), the final digit of which is referred to as a point or a pip. For example, if USD/JPY was quoted with a bid of 134.85 and an ask of 134.90, the five-pip spread is the cost of trading this position. From the very start, therefore, the trader must recover the five-pip cost from his or her profits, necessitating a favorable move in the position in order simply to break even.
More about Margin Trading in the currency markets requires a trader to think in a slightly different way also about margin. Margin on the forex is not a down payment on a future purchase of equity but a deposit to the trader's account that will cover against any currency-trading losses in the future. A typical currency trading system will allow for a very high degree of leverage in its margin requirements, up to 100:1. The system will automatically calculate the funds necessary for current positions and will check for margin availability before executing any trade.
Rollover In the spot forex market, trades must be settled within two business days. For example, if a trader sells a certain number of currency units on Wednesday, he or she must deliver an equivalent number of units on Friday. But currency trading systems may allow for a "rollover", with which open positions can be swapped forward to the next settlement date (giving an extension of two additional business days). The interest rate for such a swap is predetermined, and, in fact, these swaps are actually financial instruments that can also be traded on the currency market.
In any spot rollover transaction the difference between the interest rates of the base and counter currencies is reflected as an overnight loan. If the trader holds a long position in the currency with the higher interest rate, he or she would gain on the spot rollover. The amount of such a gain would fluctuate day-to-day according to the precise interest-rate differential between the base and the counter currency. Such rollover rates are quoted in dollars and are shown in the interest column of the forex trading system. Rollovers, however, will not affect traders who never hold a position overnight since the rollover is exclusively a day-to-day phenomenon.
Conclusion As one can immediately see, trading in forex requires a slightly different way of thinking than the way required by equity markets. Yet, for its extreme liquidity, multitude of opportunities for large profits due to strong trends and high levels of available leverage, the currency market are hard to resist for the advanced trader. With such potential, however, comes significant risk, and traders should quickly establish an intimate familiarity with methods of risk management.
Posted: Wed Feb 11, 2009 8:22 am Post subject: The Greatest Currency Trades Ever Made
The Greatest Currency Trades Ever Made
The foreign exchange (forex) market is the largest market in the world because currency is changing hands whenever goods and services are traded between nations. The sheer size of the transactions going on between nations provides arbitrage opportunities for speculators, because the currency values fluctuate by the minute. Usually these speculators make many trades for small profits, but sometimes a big position is taken up for a huge profit or, when things go wrong, a huge loss. In this article, we'll look at the greatest currency trades ever made.
How the Trades Are Made First, it is essential to understand how money is made in the forex market. Although some of the techniques are familiar to stock investors, currency trading is a realm of investing in and of itself. A currency trader can make one of four bets on the future value of a currency:
Shorting a currency means that the trader believes that the currency will go down compared to another currency.
Going long means that the trader thinks the currency will increase in value compared to another currency.
The other two bets have to do with the amount of change in either direction - whether the trader thinks it will move a lot or not much at all - and are known by the provocative names of strangle and straddle.
Once you're decided on which bet you want to place, there are many ways to take up the position. For example, if you wanted to short the Canadian dollar (CAD), the simplest way would be to take out a loan in Canadian dollars that you will be able to pay back at a discount as the currency devalues (assuming you're correct).
This is much too small and slow for true forex traders, so they use puts, calls, other options and forwards to build up and leverage their positions. It's the leveraging in particular that makes some trades worth millions, and even billions, of dollars..)
No. 3: Andy Krieger Vs. The Kiwi In 1987, Andy Krieger, a 32-year-old currency trader at Bankers Trust, was carefully watching the currencies that were rallying against the dollar following the Black Monday crash. As investors and companies rushed out of the American dollar and into other currencies that had suffered less damage in the market crash, there were bound to be some currencies that would become fundamentally overvalued, creating a good opportunity for arbitrage. The currency Krieger targeted was the New Zealand dollar, also known as the kiwi.
Using the relatively new techniques afforded by options, Krieger took up a short position against the kiwi worth hundreds of millions. In fact, his sell orders were said to exceed the money supply of New Zealand. The kiwi dropped sharply as the selling pressure combined with the lack of currency in circulation. It yo-yoed between a 3% and 5% loss while Krieger made millions for his employers.
One part of the legend recounts a worried New Zealand government official calling up Krieger's bosses and threatening Bankers Trust to try to get Krieger out of the kiwi. Krieger later left Bankers Trust to go work for George Soros.
No. 2: Stanley Druckenmiller Bets on the Mark - Twice Stanley Druckenmiller made millions by making two long bets in the same currency while working as a trader for George Soros' Quantum Fund.
Druckenmiller's first bet came when the Berlin Wall fell. The perceived difficulties of reunification between East and West Germany had depressed the German mark to a level that Druckenmiller thought extreme. He initially put a multimillion-dollar bet on a future rally until Soros told him to increase his purchase to 2 billion German marks. Things played out according to plan and the long position came to be worth millions of dollars, helping push the returns of the Quantum Fund over 60%.
Possibly due to the success of his first bet, Druckenmiller also made the German mark an integral part of the greatest currency trade in history. A few years later, while Soros was busy breaking the Bank of England, Druckenmiller was going long in the mark on the assumption that the fallout from his boss's bet would drop the British pound against the mark. Druckenmiller was confident that he and Soros were right and showed this by buying British stocks. He believed that Britain would have to slash lending rates, thus stimulating business, and that the cheaper pound would actually mean more exports compared to European rivals. Following this same thinking, Druckenmiller bought German bonds on the expectation that investors would move to bonds as German stocks showed less growth than the British. It was a very complete trade that added considerably to the profits of Soros' main bet against the pound.
No. 1: George Soros Vs. The British Pound The British pound shadowed the German mark leading up to the 1990s even though the two countries were very different economically. Germany was the stronger country despite lingering difficulties from reunification, but Britain wanted to keep the value of the pound above 2.7 marks. Attempts to keep to this standard left Britain with high interest rates and equally high inflation, but it demanded a fixed rate of 2.7 marks to a pound as a condition of entering the European Exchange Rate Mechanism (ERM).
Many speculators, George Soros chief among them, wondered how long fixed exchange rates could fight market forces, and they began to take up short positions against the pound. Soros borrowed heavily to bet more on a drop in the pound. Britain raised its interest rates to double digits to try to attract investors. The government was hoping to alleviate the selling pressure by creating more buying pressure.
Paying out interest costs money, however, and the British government realized that it would lose billions trying to artificially prop up the pound. It withdrew from the ERM and the value of the pound plummeted against the mark. Soros made at least $1 billion off this one trade. For the British government's part, the devaluation of the pound actually helped, as it forced the excess interest and inflation out of the economy, making it an ideal environment for businesses.
A Thankless Job Any discussion around the top currency trades always revolves around George Soros, because many of these traders have a connection to him and his Quantum Fund. After retiring from active management of his funds to focus on philanthropy, Soros made comments about currency trading that were seen as expressing regret that he made his fortune attacking currencies. It was an odd change for Soros who, like many traders, made money by removing pricing inefficiencies from the market. Britain did lose money because of Soros and he did force the country to swallow the bitter pill of withdrawing from the ERM, but many people also see these drawbacks to the trade as necessary steps that helped Britain emerge stronger. If there hadn't been a drop in the pound, Britain's economic problems may have dragged on as politicians kept trying to tweak the ERM.
A country can benefit from a weak currency as much as from a strong one. With a weak currency, the domestic products and assets become cheaper to international buyers and exports increase. In the same way, domestic sales increase as foreign products go up in price due to the higher cost of importing. There were very likely many people in Britain and New Zealand who were pleased when speculators brought down the overvalued currencies. Of course, there were also importers and others who were understandably upset. A currency speculator makes money by forcing a country to face realities it would rather not face. Although it's a dirty job, someone has to do it.
Posted: Wed Feb 11, 2009 11:36 am Post subject: Dual And Multiple Exchange Rates
Dual And Multiple Exchange Rates
When faced with a sudden shock to its economy, a country can opt to implement a dual or multiple foreign-exchange rate system.With this type of system, a country has more than one rate at which its currencies are exchanged. So, unlike a fixed or floating system (to learn more about these, see Floating And Fixed Exchange Rates), the dual and multiple systems consist of different rates, fixed and floating, that are used for the same currency during the same period of time.
In a dual exchange rate system, there are both fixed and floating exchange rates in the market. The fixed rate is only applied to certain segments of the market, such as "essential" imports and exports and/or current account transactions. In the meantime, the price of capital account transactions is determined by a market driven exchange rate (so as not to hinder transactions in this market, which are crucial to providing foreign reserves for a country).
In a multiple exchange rate system, the concept is the same, except the market is divided into many different segments, each with its own foreign exchange rate, whether fixed or floating. Thus, importers of certain goods "essential" to an economy may have a preferential exchange rate while importers of "non-essential" or luxury goods may have a discouraging exchange rate. Capital account transactions could, again, be left to the floating exchange rate.
Why More Than One? A multiple system is usually transitional in nature and is used as a means to alleviate excess pressure on foreign reserves when a shock hits an economy and causes investors to panic and pull out. It is also a way to subdue local inflation and importers' demand on foreign currency. Most of all, in times of economic turmoil, it is a mechanism by which governments can quickly implement control over foreign currency transactions. Such a system can buy some extra time for the governments in their attempts to fix the inherent problem in their balance of payments. This extra time is particularly important for fixed currency regimes, which may be forced to completely devalue their currency and turn to foreign institutions for help.
How Does It Work? Instead of depleting precious foreign reserves, the government diverts the heavy demand for foreign currency to the free-floating exchange rate market. Changes in the free floating rate will reflect demand and supply.
The use of multiple exchange rates has been seen as an implicit means of imposing tariffs or taxes. For example, a low exchange rate applied to food imports functions like a subsidy, while the high exchange rate on luxury imports works to "tax" people importing goods which, in a time of crisis, are perceived as non-essential. On a similar note, a higher exchange rate in a specific export industry can function as a tax on profits.
Is It the Best Solution?
While multiple exchange rates are easier to implement, most economists agree that the actual implementation of tariffs and taxes would be a more effective and transparent solution: the underlying problem in the balance of payments could thus be addressed directly.
While the system of multiple exchange rates may sound like a viable quick-fix solution, it does have negative consequences. More often than not, because the market segments are not functioning under the same conditions, a multiple exchange rate results in a distortion of the economy and a misallocation of resources. For example, if a certain industry in the export market is given a favorable foreign exchange rate, it will develop under artificial conditions. Resources allocated to the industry will not necessarily reflect its actual need because its performance has been unnaturally inflated. Profits are thus not accurately reflective of performance, quality, or supply and demand. Participants of this favored sector are (unduly) rewarded better than other export market participants. An optimal allocation of resources within the economy can thus not be achieved.
A multiple exchange rate system can also lead to economic rents for factors of production benefiting from implicit protection. This effect can also open up doors for increased corruption because people gaining may lobby to try and keep the rates in place. This, in turn, prolongs an already inefficient system.
Finally, multiple exchange rates result in problems with the central bank and the federal budget. The different exchange rates likely result in losses in foreign currency transactions, in which case the central bank must print more money to make up for the loss. This, in turn, can lead to inflation.
An initially more painful, but eventually more efficient mechanism for dealing with economic shock and inflation is to float a currency if it is pegged. If the currency is already floating, another alternative is allowing a full depreciation (as opposed to introducing a fixed rate alongside the floating rate). This can eventually bring equilibrium to the foreign exchange market. On the other hand, while floating a currency or allowing depreciation may both seem like logical steps, many developing nations are faced with political constraints that do not allow them to devalue or float a currency across the board: the "strategic" industries of a nation's livelihood, such as food imports, must remain protected. This is why multiple exchange rates are introduced - despite their unfortunate capacity to skew an industry, the foreign exchange market, and the economy as a whole.
Posted: Wed Feb 11, 2009 11:37 am Post subject: Floating And Fixed Exchange Rates
Floating And Fixed Exchange Rates
Did you know that the foreign exchange market (also known as FX or forex) is the largest market in the world? In fact, over $1 trillion is traded in the currency markets on a daily basis. This article is certainly not a primer for currency trading, but it will help you understand exchange rates and why some fluctuate while others do not.
What Is an Exchange Rate?
An exchange rate is the rate at which one currency can be exchanged for another. In other words, it is the value of another country's currency compared to that of your own. If you are traveling to another country, you need to "buy" the local currency. Just like the price of any asset, the exchange rate is the price at which you can buy that currency. If you are traveling to Egypt, for example, and the exchange rate for USD 1.00 is EGP 5.50, this means that for every U.S. dollar, you can buy five and a half Egyptian pounds. Theoretically, identical assets should sell at the same price in different countries, because the exchange rate must maintain the inherent value of one currency against the other.
Fixed There are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen, or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.
If, for example, it is determined that the value of a single unit of local currency is equal to USD 3.00, the central bank will have to ensure that it can supply the market with those dollars. In order to maintain the rate, the central bank must keep a high level of foreign reserves. This is a reserved amount of foreign currency held by the central bank which it can use to release (or absorb) extra funds into (or out of) the market. This ensures an appropriate money supply, appropriate fluctuations in the market (inflation/deflation), and ultimately, the exchange rate. The central bank can also adjust the official exchange rate when necessary.
Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed "self-correcting", as any differences in supply and demand will automatically be corrected in the market. Take a look at this simplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and thus stimulating demand for local goods and services. This in turn will generate more jobs, and hence an auto-correction would occur in the market. A floating exchange rate is constantly changing.
In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also influence changes in the exchange rate. Sometimes, when a local currency does reflect its true value against its pegged currency, a "black market" which is more reflective of actual supply and demand may develop. A central bank will often then be forced to revalue or devalue the official rate so that the rate is in line with the unofficial one, thereby halting the activity of the black market.
In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid inflation; however, it is less often that the central bank of a floating regime will interfere.
The World Once Pegged
Between 1870 and 1914, there was a global fixed exchange rate. Currencies were linked to gold, meaning that the value of a local currency was fixed at a set exchange rate to gold ounces. This was known as the gold standard. This allowed for unrestricted capital mobility as well as global stability in currencies and trade; however, with the start of World War I, the gold standard was abandoned.
At the end of World War II, the conference at Bretton Woods, in an effort to generate global economic stability and increased volumes of global trade, established the basic rules and regulations governing international exchange. As such, an international monetary system, embodied in the International Monetary Fund (IMF), was established to promote foreign trade and to maintain the monetary stability of countries and therefore that of the global economy
It was agreed that currencies would once again be fixed, or pegged, but this time to the U.S. dollar, which in turn was pegged to gold at USD 35/ounce. What this meant was that the value of a currency was directly linked with the value of the U.S. dollar. So if you needed to buy Japanese yen, the value of the yen would be expressed in U.S. dollars, whose value in turn was determined in the value of gold. If a country needed to readjust the value of its currency, it could approach the IMF to adjust the pegged value of its currency. The peg was maintained until 1971, when the U.S. dollar could no longer hold the value of the pegged rate of USD 35/ounce of gold.
From then on, major governments adopted a floating system, and all attempts to move back to a global peg were eventually abandoned in 1985. Since then, no major economies have gone back to a peg, and the use of gold as a peg has been completely abandoned.
The reasons to peg a currency are linked to stability. Especially in today's developing nations, a country may decide to peg its currency to create a stable atmosphere for foreign investment. With a peg the investor will always know what his/her investment value is, and therefore will not have to worry about daily fluctuations. A pegged currency can also help to lower inflation rates and generate demand, which results from greater confidence in the stability of the currency.
Fixed regimes, however, can often lead to severe financial crises since a peg is difficult to maintain in the long run. This was seen in the Mexican (1995), Asian and Russian (1997) financial crises: an attempt to maintain a high value of the local currency to the peg resulted in the currencies eventually becoming overvalued. This meant that the governments could no longer meet the demands to convert the local currency into the foreign currency at the pegged rate. With speculation and panic, investors scrambled to get out their money and convert it into foreign currency before the local currency was devalued against the peg; foreign reserve supplies eventually became depleted. In Mexico's case, the government was forced to devalue the peso by 30%. In Thailand, the government eventually had to allow the currency to float, and by the end of 1997, the bhat had lost its value by 50% as the market's demand and supply readjusted the value of the local currency.
Countries with pegs are often associated with having unsophisticated capital markets and weak regulating institutions. The peg is therefore there to help create stability in such an environment. It takes a stronger system as well as a mature market to maintain a float. When a country is forced to devalue its currency, it is also required to proceed with some form of economic reform, like implementing greater transparency, in an effort to strengthen its financial institutions.
Some governments may choose to have a "floating," or "crawling" peg, whereby the government reassesses the value of the peg periodically and then changes the peg rate accordingly. Usually the change is devaluation, but one that is controlled so that market panic is avoided. This method is often used in the transition from a peg to a floating regime, and it allows the government to "save face" by not being forced to devalue in an uncontrollable crisis.
Although the peg has worked in creating global trade and monetary stability, it was used only at a time when all the major economies were a part of it. And while a floating regime is not without its flaws, it has proven to be a more efficient means of determining the long term value of a currency and creating equilibrium in the international market.
Forex market is rising. When the market goes down, the market is down. That is it. There are many systems that analyze past trends, but no one can accurately predict the future. But if you recognize yourself that everything that happens at any point is that the market is just on the way, you will be surprised how difficult it is to blame others.
Financial experts around the world have their own opinions of the forex market. Each will have different thoughts on forex trading, but are most likely to whole heartedly recommend it to anybody serious about investing.
Trading the Forex market has become very popular in the last years. Why is it that traders around the world see the Forex market as an investment opportunity? We will try to answer this question in this article.
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