Trading in the Global Currency Markets, 3rd Edition
Date: 2007-08-07 00:00:00+00:00
Keywords: Business & Economics
Description: Completely updated third edition-insights into the lucrative foreign exchange markets for both beginner and expert traders. A renowned authority on international investing brings the complex machinations of the foreign currency markets vibrantly to life. Cornelius Luca clearly and concisely analyzes the various currencies, market forces, and emerging technologies-and illuminates them all with real-world examples and graphics.
Publisher: Penguin
Rights: Copyright &#x00A9; 2007 by Penguin Group (USA) Inc.

Trading in the Global Currency Markets

THIRD EDITION

CORNELIUS LUCA

PRENTICE HALL PRESS

PRENTICE HALL PRESS

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PRINTING HISTORY

New York Institute of Finance second hardcover edition / 1999

Prentice Hall third hardcover edition / August 2007

The Library of Congress has cataloged the second edition as follows:

Luca, Cornelius.

Trading in the global currency markets/Cornelius Luca.—2nd ed.

p. cm.

Includes bibliographical references and index.

ISBN: 978-1-101-00691-7

1. Foreign exchange market.   2. Investment analysis.   I. Title.

HG3851.L83       2000

332.4’5—dc21                                                              00–037244

PRINTED IN THE UNITED STATES OF AMERICA

10  9  8  7  6  5  4  3  2  1

PUBLISHER’S NOTE: This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services. If you require legal advice or other expert assistance, you should seek the services of a competent professional.

Most Prentice Hall books are available at special quantity discounts for bulk purchases for sales promotions, premiums, fund-raising, or educational use. Special books, or book excerpts, can also be created to fit specific needs. For details, write: Special Markets, Penguin Group (USA) Inc., 375 Hudson Street, New York, New York 10014.

To my daughter, Gwendolyn,
who helped me enormously with research, analysis, and proofing despite her intense work at Stanford University.

Acknowledgments

Many thanks to William Rini, former director of international seminars at the New York Institute of Finance, for making this book possible in the first place. I also want to extend my thanks to everyone at the New York Institute of Finance, which has provided an exceptional professional environment over the years.

The revisions of the chapters were made possible by the tenacious effort and passion of Gwen Luca, my daughter, who managed to find the time to do research, analysis, and proofing despite her heavy workload as a student at Stanford University.

The charts that you can enjoy throughout the book were made possible by CQG. I have always considered CQG the leader in electronic charting, but it is so much more. Specific thanks to Stan Yabroff, Chistina Fatsis, and Srijana Savignac.

Many thanks to Robert Prechter, President, Elliott Wave International.

Finally, many thanks to John Taylor, the founder of FX Concepts, who exposed me to applied cyclical analysis and optimized Gann fan analysis.

Contents

Preface

PART 1: The Basis for Foreign Exchange Activity

1 What Is Foreign Exchange?

Why Foreign Exchange Occurs

Factors That Have Contributed to Foreign Exchange Volume Growth

PART 2: A Historical Perspective of the FX Markets

2 Historical Development of Foreign Exchange

A Historical Perspective

The Bretton Woods Accord

Why the Bretton Woods Accord Failed

After Bretton Woods

The Free-Floating Foreign Exchange Markets

FX Events

3 The European Monetary Union

Historical Background

The European Monetary System

The European Central Bank (ECB)

Conclusion

PART 3: Inside the World of Foreign Exchange

4 Currency Characteristics

The ISO Codes

The U.S. Dollar

The Euro

The Japanese Yen

The British Pound

The Swiss Franc

The Major Foreign Exchange Markets

The Major Players

Conclusion

5 Foreign Exchange Risks

Exchange Rate Risk

Interest Rate Risk

Credit Risk

Country Risk

Conclusion

6 Central Banks

The Federal Reserve

The Federal Reserve’s Role in Foreign Exchange

An Overview of the Central Banks of the Other G-7 Countries

7 Price Structure and Foreign Exchange Terminology

Spot Market

Forward Market

Futures Market

Foreign Exchange Terms

8 Corporate Trading

The Role of Foreign Exchange for Corporations

Types of Corporations

Types of Exposure

Hedging

How Foreign Exchange Is Executed

Different Points of View

9 Foreign Exchange Settlement

The Role of the Back Office

Nostro Accounts

SWIFT

Fedwire

Continuous Linked Settlement

Conclusion

10 Conducting Foreign Exchange Trading

Electronic Platform Trading

The Brokers’ Market

Direct Dealing

Electronic Platform Trading for Retail Clients

Conclusion

PART 4: Understanding the Major FX Instruments

11 The Spot Market

The Foreign Currency Spot Marketplace

Profit and Loss

Conclusion

12 The Forward Currency Market

The Forward Foreign Currency Marketplace

General Characteristics of the Forward Market

The Forward Price

Introduction to the Types of Forward Spreads

Methods of Calculating the Forward Outright Prices

The Interest Rate Differential

Currency Forward Outright Deals

Currency Swaps

The Rollover or Tom/Next Swap

Coverage Interest Rate Arbitrage

13 Currency Crosses

The Cross Foreign Currency Marketplace

Price Calculation

Relative Strength of a Currency

Trading Components

Position Calculation

Calculation of the Cross Profit and Loss

14 Currency Futures

The Currency Futures Marketplace

The International Monetary Market

Characteristics of Currency Futures

The Look of Currency Futures

Futures Market and Cash Market: Comparisons

Margins

Contract Size

Trading

Mark-to-Market

Arbitrage

Exchange for Physical (EFP)

Regulation in the United States

Conclusion

15 Currency Options

The Currency Options Marketplace

Benefits of Trading Options

Where Currency Option Are Traded

Premium

Theoretical Models: Factors Determining Option Price

Option Pricing

16 Major Option Strategies on Currency

Basic Strategies

Compound Strategies

Exotic Options

Average Options

Conclusion

PART 5: Foreign Exchange Forecasting: Fundamental Analysis

17 Economic Fundamentals

Economic Fundamentals

Theories of Exchange Rate Determination

Economic Indicators

Industrial Sector Indicators

Construction Data

Inflation Indicators

Balance of Payments

Employment Indicators

Consumer Spending Indicators

Leading Indicators

Conclusion

18 Financial and Sociopolitical Factors

The Role of Financial Factors

Political Events

Conclusion

PART 6: Foreign Exchange Forecasting: Technical Analysis

19 Technical Analysis

The Evolution of Technical Analysis

Types of Charts: A Comparison

Volume and Open Interest

The Channel Line

Retracements Analysis

The Importance of the Long-Term Charts

20 Trend Reversal Patterns

Head-and-Shoulders

Inverse Head-and-Shoulders

Double Top

Double Bottom

Triple Top and Triple Bottom

V-Formations (Spikes)

Other Patterns

21 Trend Continuation Patterns

Flag Formation

Pennant Formation

Triangle Formation

Wedge Formation

Rectangle Formation

22 Formations Unique to Bar Charts for Futures

Gaps

Island Reversals

Key Reversal Days

23 Point-and-Figure Charting

Typical Chart Formations in Point-and-Figure Charting

Classic Chart Formations in Point-and-Figure Charting

Trend Reversal Formations

Trend Continuation Formations

24 Candlestick Charting

Benefits of Using Candlesticks

Daily White Candlesticks

Daily Black Candlesticks

One-Day Reversal Patterns

Two-Day Candlestick Combinations

Sakata’s Five Methods

25 Quantitative Trading Methods

Moving Averages

Ichimoku Kinkou-Hyo

26 Oscillators and Studies

Stochastics

Moving Average Convergence-Divergence (MACD)

Momentum

Relative Strength Index (RSI)

Other Oscillators

Oscillators Wrap-Up

Other Studies

27 W. D. Gann Analysis

Geometric Forms

Geometric Angles

Geometric Ratios

The Squaring of Price and Time

The Cardinal Square

Gann’s 28 Trading Rules

28 The Elliott Wave

Basics of Wave Analysis

Impulse Waves—Variations

Diagonal Triangles

Failures (Truncated Fifths)

Fibonacci Analysis

Further Study

Conclusion

Appendix A: World Currencies and Their SWIFT Codes

Appendix B: U.S. Council on International Banking Compensation and Indemnity and Compensation Rules

Glossary

Bibliography

Index

Preface

The foreign exchange (FX) industry has had an explosive growth since the end of the Bretton Woods Accord in 1973 because of its inherent profitability, limited time exposure, and lack of, or limited, regulation. Early in the twenty-first century, currencies were widely accepted as an investment class and their low correlation with traditional investments made them perfect additions to large portfolios. The fast expansion of electronic trading finally broke down the banks’ monopoly on FX trading, and funds and corporations can trade as quickly and aggressively as banks do. In addition, electronic retail business is flourishing,

Forex is not a new industry; its origins can be traced to ancient times, when foreign coins started to be exchanged. Since stocks and bonds took several more millennia to come into existence, foreign exchange is, in fact, the oldest financial market.

The worldwide power balances are shifting dramatically and FX changes will follow. Under its thin Communist mask, China is industrializing at an unprecedented rate and the United States is aggressively feeding this expansion (and that of India as well) by outsourcing both production and services. Russia is reinventing itself from the ashes of the Soviet empire as a broker of energy and other commodities. The yuan has started its slow way to becoming a fully convertible currency, while the Russian ruble can already be found in many portfolios.

The bloody and unprecedented attacks on September 11, 2001, against U.S. civilians by religious Middle Eastern extremists triggered an aggressive military response from the United States and its allies against the Taliban forces in Afghanistan. The next step was the U.S. invasion of Iraq. The lack of a quick resolve against those extremists led to widespread resentment in the Middle East against the U.S. forces. While the immediate impact on FX was negligible, several central banks in the Middle East lowered their reserve holdings of the dollar in favor of the euro, thus eventually creating FX flows.

Traders from around the world enter positions for weeks, days, hours, or only minutes. The market can have explosive moves and steady flows, but quiet times as well. Money changes hands quickly, at a staggering daily average of about 1.9 trillion dollars—and growing.

The foreign exchange’s profitability is legendary. George Soros’s Quantum hedge fund remains the textbook example after it realized a profit in excess of a billion U.S. dollars for a couple of days’ work in September 1992. Legendary investor Warren Buffett got the FX bug in 2004 and realized $1.63 billion in the last quarter of that year by betting against the U.S. dollar. Similarly, the largest fund of the time, Long-Term Capital Management, triggered an unprecedented collapse of the dollar/Japanese yen in 1998 as it liquidated profitable currency positions in a failed attempt to alleviate enormous losses in other financial markets. This redefined risk management.

It is impossible to envision a world without foreign exchange, even though the introduction of the euro obliterated most inter-European FX transactions and the number of banks around the world was drastically reduced by mergers. Whether in the import and export of raw materials, labor, manufactured goods, or services, foreign exchange remains an integral part of the transaction.

In addition to the corporate demand, currency trading provides a leading source of income for many banks, investment houses, and funds.

There are no geographic or temporal boundaries to foreign exchange. This is a vibrant, twenty-four-hour market open to all eligible players. Profitability, technology, and portfolio-trading style will continue to expand trading volume in Forex for years to come.

This book attempts to introduce you to all the significant aspects of foreign exchange in a practical manner, to best answer your typical questions.

Why do we trade currencies?

Who are the players?

What currencies do we trade?

What makes them move?

What instruments can we trade?

How can we use them?

How can we forecast currency behavior?

How do we access the pertinent information?

The book is divided into six parts:

Part 1: Presents the basis of foreign exchange and the factors that contributed to the growth of the industry, from market developments to technological breakthroughs.

Part 2: Presents the historical developments in the market and how these elements have shaped the contemporary environment that produced and accepted the euro.

Part 3: Focuses on the mechanics of the market, the major players and markets, the risks pertinent to foreign exchange, corporate trading, methods of trading execution, and dealing settlements.

Part 4: Analyzes foreign exchange instruments and provides comprehensive coverage of the major option strategies.

Part 5: Focuses on fundamental analysis, economic indicators vital to the financial markets that may be disregarded in the currency markets, and the mind of the trader, for a point of view different at times from the typical theoretical expectation.

Part 6: Provides an exhaustive view of technical analysis, including an in-depth chart analysis comparing the major chart types, chart formations, and oscillators, and a comprehensive discussion of candlestick and point-and-figure charts as they apply to foreign currency trading.

There are no miracle answers, of course—at least in this book. In fact, I generally shy away from rules of thumb. The only solid answer I favor is, “It depends.” What you will learn is what makes the market move and traders tick.

You are presented with a comprehensive arsenal of trading weapons, many of them on the cutting edge of technology. You will decide for yourself “on what it all depends.” Based on these elements, you will be able to make your own choices, test them, and ultimately use them for your benefit.

Cornelius Luca

PART

1 THE BASIS FOR FOREIGN EXCHANGE ACTIVITY

1 What Is Foreign Exchange?

Foreign exchange has started the twenty-first century in force, as the relative decrease in returns in other financial markets elevated currencies to asset class status. Portfolio managers are attracted by the low correlation between FX and equities or fixed instruments, while retail technological development enables retail traders to access a currency market that was once the sole bastion of commercial banks and investment houses. Foreign exchange is simply the mechanism that values a currency in terms of another currency, providing a vital shock absorber for the international economic, financial, and political divergences. Given the continuously changing geopolitical and economic balances, this FX shock absorber is needed more than ever.

WHY FOREIGN EXCHANGE OCCURS

At the most basic level, tourists around the world generate substantial foreign exchange flow. Whether the American tourists abroad take advantage of the record high dollar in some years, or the foreign tourists in the United States benefit from the record low dollar in other years, they all must convert their currencies to the local currencies to pay for traveling expenses. These small individual transactions generate important cash flow when compounded.

Investors around the world, large and small, are continuously hunting for investment opportunities, particularly when rates of economic growth and inflation vary among countries. Whether in the securities markets, production, real estate, or bank deposits, any international investment must, at one point or another, go through foreign exchange. There are many instances where the enormous U.S. interest in cheap production of goods in China is paid in dollars, thus bypassing the need for FX, but even this historical phenomenon is quickly fading. To this end, the rapidly industrializing China stopped pegging its yuan to the U.S. dollar on July 21, 2005 for the first time since 1994, opting instead to tie the yuan to a basket of currencies. The initial revaluation was a paltry 2.1 percent, but other revaluations followed and will continue until the yuan will achieve the status of free-floating currency.

An American shopper may buy a fancy silk tie in an American boutique, but chances are that both the silk and the tie were produced abroad. Even if an American buys an American car from an American dealer, if the car was assembled in Canada or Mexico, foreign exchange was executed. The same goes for the Toyotas and BMWs assembled in the United States. The presence of foreign exchange in one or more stages of production is deeply ingrained, albeit not always obvious.

Global markets have become so competitive that corporations must continuously search the world for cheaper sources of labor and new markets, and now China and India provide both production and, to a lesser extent, markets. The degree of international integration generates interest rate adjustments, which in turn affect foreign exchange rates.

Political changes are also major factors in foreign exchange. For instance, the emergence of China as an economic superpower from a disastrous Communist experiment triggered demand for a convertible yuan. The antipathy some Middle Eastern countries felt against the United States in the aftermath of the U.S. invasion of Iraq was monetized in the switching of some of their currency reserves from dollars into euros. The dissolution of the Soviet Empire at the end of December 1991, despite its historic proportions, did not itself immediately affect the foreign exchange market, but eventually the Russian ruble became convertible. However, a consequence of the fall, the unification of Germany, generated a long-term rally in the deutsche mark through 1995, based on expectations of future economic might and short-term high interest rates geared against inflation. Further, that unification eased the introduction of the euro as an accounting currency in 1999 and as a physical currency in 2002.

In times of political or economic uncertainty or crises, local currencies are quickly discarded in favor of safe-haven currencies, such as U.S. dollars or Swiss francs. Examples occur every time there is a resurgence of violence in the unstable Middle East, or when emerging market crises occur, such as the Southeast Asian crisis in 1997–1998.

In future chapters we will discuss in detail the major factors affecting the foreign exchange markets. For the time being, we must remember several of their general characteristics. The foreign exchange markets are:

- sensitive to a large and continuously changing number of factors,

- open to all players in the major currencies,

- large and liquid in the major currencies,

- concentrated on several currencies, and

- extremely efficient relative to other financial markets.

FACTORS THAT HAVE CONTRIBUTED TO FOREIGN EXCHANGE VOLUME GROWTH

Foreign exchange has experienced spectacular growth in volume ever since currencies were allowed to float freely against each other in the early 1970s. While the daily turnover in 1977 was U.S. $5 billion, it increased to U.S. $600 billion in 1987, reached the U.S. $1 trillion mark in September 1992, stabilized at around $1.9 trillion in 2004, and is likely to easily surpass $2.1 trillion in the year 2007 (see Figure 1.1). In fact, volume on the FX market may exceed $3 trillion, if the forecast of TowerGroup, a financial services research consultancy, is correct.

Volume decreased between 1998 and 2001 because the introduction of the euro erased most of the European currencies, due to the consolidation in the worldwide banking industry, the adjustment from classic human brokers to electronic brokerage, and higher risk aversion following the Southeast Asian crisis.

Figure 1.1. Daily turnover in FX between 1982 and 2007.

Volume surged in market activity after 2001 because of several related factors.

First, the aggressive downtrend in the equity markets, particularly in the overinvested tech stocks, in the wake of the Y2K phenomenon focused investors on a “new” asset class: currencies. Currencies have a very low correlation with equities and other assets, so they are perfect for diversification of portfolios. When it comes to FX, beta is the return provided by simple strategies that work over time. The main betas are: trend (direction), carry (yield), and volatility (options). Trend-following models seek to identify the start of new trends and then to provide strategies to stay with the trend. They were the first models to be developed, but they underperform when the trend is not present. Yield-based models are very common and they generally favor buying high-yielding currencies and shorting low-yielding currencies. Volatility models use options to take advantage of high and low volatility conditions that are not accessible to other FX instruments. Alpha is defined as a risk-adjusted measure of the so-called excess return on a benchmark index. There is little consensus on what the currency benchmark is, so in FX trading alpha is generally achieved via superior model-trading and technical analysis-trading.

Second, the emergence of clear trends and rising volatility in FX helped the growth of model-based currency funds.

Third, divergent interest differentials supported investments in high interest rate currencies, such as the Australian and the New Zealand dollars, financed by short positions in low interest rate currencies, such as the yen. This pattern plays right into the carry models mentioned above.

Fourth, corporations increased their hedging activity, and this strategy was provided by currency overlay managers.

Finally, the improvement in technology helped the growth of retail trading.

Volume in foreign exchange cannot be measured directly the way it is in the stock or commodity markets. Foreign exchange trading is generally conducted in a decentralized manner, with the notable exceptions of currency futures and options on currency futures. What is behind this spectacular growth in volume?

EXCHANGE RATE VOLATILITY

During the last days of the fixed exchange rates system, few envisioned the volatility potential of the currency markets. People generally assumed that economic forces needed only occasional self-adjustment in an otherwise quiet activity. Were they wrong! The unchecked increase of the U.S. dollar in the 1980s had a destructive effect on American exporters’ international trade competitiveness. The U.S. dollar’s record highs were capped in September 1985 and the currency was sent into a ten-year downtrend, which trimmed about 66 percent of its value against the Japanese yen (see Figure 1.2). The impact of the exchange rate activity on the international economy and trade is more difficult to gauge in the major economies. However, the Southeast Asian crisis of 1997–1998 that sharply devalued the regional currencies to unprecedented levels had a disastrous impact on the local economies.

Figure 1.2. The U.S. dollar fell about 66 percent against the Japanese yen between 1985 and 1995.

For foreign exchange, currency volatility is a prime factor in the growth of volume. In fact, volatility is a sine qua non condition for trading. The only instruments that may be profitable under conditions of low volatility are currency options.

INTEREST RATE VOLATILITY

Economic internationalization generated a significant impact on interest rates as well. Willingly or not, economies became much more interrelated, a factor that exacerbated the need to change interest rates faster. Interest rates are generally changed in order to adjust the growth in the economy, and interest rate differentials have a substantial impact on exchange rates. Investors like holding long positions in high-yielding major currencies and shorting low-yield currencies. However, this correlation is not mechanical. This is discussed in Chapter 17, which deals with fundamental analysis.

BUSINESS INTERNATIONALIZATION

In recent decades we have witnessed unprecedented internationalization in the business world. The competition has intensified, triggering a worldwide hunt for more markets and cheaper raw materials and labor. The pace of economic internationalization picked up initially in the 1990s, due to the fall of Communism in Europe and to asymmetrical economic and financial development in both Southeast Asia and South America. These changes have been positive toward foreign exchange, since more transactional layers were added. Then, the economic emergence of China and India produced incipient interest in FX, as the yuan and the rupee have yet to reach full convertibility and to attract investing demand.

The boundaries of the New York or London or Tokyo markets are being blurred by twenty-four-hour trading.

INCREASED CORPORATE INTEREST

Foreign exchange has been perceived by many corporations as a transaction cost, albeit a rather volatile one. This passive approach proved costly for many corporations, large and small. A successful performance of a product or service overseas may be pulled down from the profit point of view by adverse foreign exchange conditions. However, the opposite is true as well: An accurate handling of the foreign exchange may enhance the overall international performance of a product or service. Experience has proven over and over again that it is worth focusing not on what you pay for foreign exchange, but on what foreign exchange can pay to you. Proper hedging of foreign exchange exposure generally adds substantially to the rate of return. Therefore, interest in foreign exchange has increased dramatically in the past decade, although the full potential has not yet been reached. Some corporations are using currencies not only for hedging, but also for capitalizing on opportunities that exist solely in the currency markets.

INCREASED PLAYERS’ SOPHISTICATION

Advances in technology and telecommunications and increased experience have enhanced the level of players’ sophistication. This enhanced traders’ confidence in their ability to both generate profits and properly handle the exchange risks. Thus, trading sophistication led toward volume increase.

DEVELOPMENTS IN TELECOMMUNICATIONS AND TECHNOLOGY

Electronic platforms that aggregate prices from multiple liquidity providers are dominating the start of the twenty-first century. But in the 1970s and early 1980s, foreign exchange trading was conducted mostly via telephone, and to a much lesser extent via the telex machine. Both mediums were slow and error-prone. The introduction of automated dealing systems in the 1980s, of matching systems in the early 1990s, and of Internet trading in the late 1990s completely altered the way foreign exchange was conducted. The dealing systems are online computer systems that link banks on a one-to-one basis, while matching systems are electronic brokers. These methods are presented in detail in Chapter 10.

Front end–back office systems provide full accounting coverage, ticket writing, back office processing, and risk management implementation at a fraction of their previous cost.

Unlike the limited technical analysis of the early 1980s, advanced software now makes it easy to generate all types of charts, augment them with sophisticated technical studies, and put them at traders’ fingertips on a continuous basis at a limited cost.

Also, currency options trading was made easier by advanced software for pricing.

NEW FX INSTRUMENTS

Among the first new FX derivatives were currency futures, which were developed on the Chicago International Monetary Market in the early 1970s—the start of modern currency trading. New products now emerge from the currency options area.

PROFITABILITY

One of the biggest fears among equity players is the bear market, as the events in 2000 and 2001 proved again. There is no such thing in the foreign exchange markets. Whether the U.S. dollar reaches record highs or record lows, the market is active and liquid. The foreign exchange market is concentrated in four major currencies—euro, Japanese yen, British pound, and Swiss franc—that are quoted against the U.S. dollar, ensuring a high degree of efficiency. Other financial markets tend to be fragmented among different issues and instruments, with much less liquidity available.

The major foreign exchange instrument is spot, which generally matures in two business days. Even the long-dated forward contracts mature a lot faster and more safely than most loans, the former bread-and-butter instrument for commercial banks. That is why commercial banks have allocated significant resources to trade currencies. Even profits from the credit card business pale in comparison to the size of foreign exchange profits. Limited risk exposure and regulation, speed of trading, and around-the-clock markets will ensure further growth of the profitable currency markets.

PART

2 A HISTORICAL PERSPECTIVE OF THE FX MARKETS

2 Historical Development of Foreign Exchange

Foreign exchange trading is a relatively new industry, having started in 1973. However, it occurred in ancient times, as coins began to be exchanged among traders. This chapter deals with the more recent developments that have shaped foreign exchange into the vibrant and complex market that exists today.

A HISTORICAL PERSPECTIVE

Foreign exchange trading as we know it began in earnest in 1973. Yet money goes back a long time, more than 4,500 years, to when the Egyptians coined the first metal money and the Babylonians wrote the first bills and receipts. The incipient foreign exchange markets can be traced back to the ancient Middle East, where money changers initiated the exchange of coins. Later, during the Middle Ages, as the number of travelers increased, people realized that metal coins might be impractical. Because of highway robberies and the sheer weight of the coins, foreign exchange started to take shape, and the Knights Templar introduced the original travelers’ checks in the fourteenth century.

Closer to the present, the twentieth century was comprised of periods of high volatility and of relative stability. Foreign exchange mostly meant commercial transactions. The idea of currency speculation has not always been regarded favorably. Money speculators were considered immoral and, at various times in history, they could even face imprisonment. In fact, following the 1993 Exchange Rate Mechanism’s crisis, voices in France only half-jokingly reminded us of the efficiency of the guillotine in combating currency speculators.

Extreme volatility and high speculation in foreign exchange immediately followed World War I; thus hedging with forward contracts became commonplace. The Great Depression, combined with the suspension of the gold standard in 1931, created a serious diminution in foreign exchange dealings. Nowadays, currencies around the world are generally quoted against the U.S. dollar. Things have not always been this way. By the mid-1930s, London had gained prominence as the leading center for foreign exchange. At the apex of the British Empire, the pound was the currency to trade and to keep as a reserve currency. Besides quid, the pound has generally been known as cable, from when foreign exchange was traded on the telex machines, or cable. In 1930, the Bank for International Settlements was established in Basel, Switzerland. Its goals were to oversee the financial efforts of the newly independent countries, along with providing monetary relief to countries experiencing temporary balance-of-payment difficulties. The implementation was not perfect. Governments were generally weak, yet reluctant to take advice. Financially, money was scarce, and the ghost of the Depression was ever-present. Germany was experiencing disastrous hyperinflation. It all seemed to create a perfect doomsday scenario. The political and economic disequilibria were overwhelming, and new geographic boundaries had to be drawn in the sand.

World War II had a crushing effect on the pound. The British economy was for all practical purposes destroyed; the empire was crumbling, and international confidence in the currency had sunk as a result of Germany’s counterfeiting the pound in its all-out war effort against England.

In the period following the United States’ entrance into World War II, the U.S. dollar became the prominent currency of the entire globe. Previously, the dollar had been perceived as a has-been, due to the stock market crash of 1929 and the subsequent Great Depression. In fact, the United States had been reluctant to enter the war so soon after the painful rebalancing of the Depression-scarred economy. In the meantime, the ravages of war were turning Europe and Japan to ashes. The lone country unscarred by war was the United States. It was only natural that the future had to be shaped by this country.

THE BRETTON WOODS ACCORD

Toward the end of the war, in July 1944, the Allies (the United States, Great Britain, and France) met at the United Nations Monetary and Financial Conference at Bretton Woods, New Hampshire to discuss and design the financial future of the new economic order. A North American location was selected because the United States was spearheading the Allies’ war efforts and had the only major economy unscathed by the ravages of war.

In contrast to the volatility in foreign exchange markets that prevailed after World War I, the post–World War II period was designed to be stable, in part due to tight governmental controls on currency values. The objective was to bring about economic growth and prosperity internationally, through stable currencies. In order to implement it, the Bretton Woods Accord focused on two major building blocks: the pegging of currencies and the International Monetary Fund (IMF).

CURRENCY PEGGING

The major trading currencies were pegged to the U.S. dollar in the sense that they were allowed to fluctuate only 1 percent on either side of that rate. When a currency exceeded this range, marked by intervention points, the central bank in charge had to buy it or sell it, and thus bring it back into range. In turn, the U.S. dollar was pegged to gold at $35 per ounce. Thus, the U.S. dollar became the world’s reserve currency.

The near-fixed monetary system served several purposes. First, it attempted to avoid the stop-and-go situation of the interwar era, when governments frequently tended to resort to floating exchange rates in the wake of economic pressures. Second, and at the time most important, the world needed a nurturing environment within which it could rebuild itself. With the majority of the world’s industrial base gone up in smoke, major social disruptions, and the prewar political balance severely distorted, the last thing the world needed was currency speculation. Moreover, immediately after the war, there really were not many currencies left aside from the dollar. The world economy needed a warm and protective cocoon, and the Bretton Woods Accord provided that by keeping currencies fixed against the U.S. dollar. The key requirement was the cooperation of the central banks to implement the intervention points. In addition to the technical aspect, this continuous and common effort was meant to assist in bringing together and eventually cementing long-lasting relationships among parties with divergent interests.

THE INTERNATIONAL MONETARY FUND (IMF)

The IMF is a cooperative institution that 184 countries have voluntarily joined. Its official purposes are: global monetary cooperation, financial stability, facilitation of international trade, promotion of high employment and sustainable economic growth, and reduction of poverty. The IMF also strives to maintain a stable system of buying and selling currencies, so that payments in foreign money can take place between countries smoothly and timely.

The IMF lends money to members who have trouble meeting financial obligations to other members, on the condition that they undertake economic reforms to eliminate these difficulties for their own good and the good of the entire membership. Though the IMF has no effective authority over the domestic economic policies of its members, and cannot force a member government to spend more on schools and hospitals and less on military expenditures, it can urge members to make the best use of scarce resources by refraining from financial excess. When members ignore this advice, the IMF can only try to persuade them of the domestic and international benefits of adopting policies favored by the membership as a whole.

The IMF has the authority only to require its members to disclose information on monetary and fiscal policies and to avoid, when possible, putting restrictions on the exchange of domestic for foreign currency and on making payments to other members.

Its members have given the IMF some authority over their payment policies because these policies are of paramount importance to the flow of money between nations and because experience has shown that without a global monitoring agency, the modern system of payments in foreign currency simply does not work.

Membership

The International Monetary Fund is open to all countries with a responsible foreign policy. Each of the 184 members is assigned a specific quota derived from the relative economic performance of that country.

Borrowing Facilities

The funds thus raised are available to its members. These resources may be increased through borrowing. Members may borrow funds under the following five facilities:

1. Reserve tranche is the most common source of funds. This facility allows a member to draw on its own reserve asset quota at the time of payment. Although proof of need is required, the IMF may not challenge it.

2. Credit tranche drawings and stand-by arrangements are the standard form of IMF loans. Once approved by the Executive Board, the loans are available in four equal tranches of 25 percent of the individual quota. Each consecutive tranche is lent under increasingly stringent conditions linked to the implementation of sound economic policies. Loans are received either directly or over the period of the stand-by arrangement.

3. The compensatory financing facility extends financial help to countries with temporary problems generated by reductions in export revenues. The financial support consists of up to 83 percent of a specific quota.

4. The buffer stock financing facility is geared toward assisting the stocking up on primary commodities in order to ensure price stability in a specific commodity. To this end, up to 45 percent of the quota may be borrowed.

5. The extended facility is designed to assist members with financial problems in amounts or for periods exceeding the scope of the other facilities.

The Special Drawing Rights (SDRs)

The special drawings rights (SDRs) are international reserve assets created and allocated by the International Monetary Fund to supplement the existing reserve assets. They were created by the IMF in 1969 to support the Bretton Woods fixed exchange rate system. The SDR has limited use as a reserve asset; it is neither a currency nor a claim on the IMF, but a potential claim on the freely usable currencies of IMF members.

The initial value of the SDR was calculated by the International Monetary Fund on a daily basis as the sum total of the weighted U.S. dollar values of the five currencies in the basket—the U.S. dollar, the deutsche mark, the British pound, the Japanese yen, and the French franc.

Effective January 1, 2006, the SDR was assigned the following weights based on their roles in international trade and finance: U.S. dollar (44 percent), euro (34 percent), Japanese yen (11 percent), and pound sterling (11 percent).

The Test of the 1990s

The turbulent 1990s tested the IMF to the maximum with historical challenges. The IMF started the decade with a massive campaign to help the countries of Central Europe, the Baltic countries, Russia, and the other countries of the former Soviet Union in the difficult shift from centrally planned to market economies. In mid-decade, a financial crisis erupted in Mexico that showed the vulnerability of members to sudden shifts in market sentiment that lead to large and unpredictable capital outflows. Mexico moved quickly to enact a strong program of policy adjustments and on February 1, 1995, the IMF swiftly approved a record financing package for a member country of $17.8 billion. This exceptional assistance was designed to give confidence to the international financial community and to prevent contagion spreading from Mexico to other members.

The Asian financial crisis resulted in a record loan of $20.9 billion to Korea in December 1997, as part of a major international support financial package. Very large loans were also extended to Indonesia ($11.2 billion in November 1997) and Thailand ($4.0 billion in August 1997). In July 1998, serious economic and financial problems in Russia led to an $11.2 billion IMF loan to that country to enhance a previous $9.2 billion loan extended in March 1996.

WHY THE BRETTON WOODS ACCORD FAILED

Certainly, the Bretton Woods Accord was not a marriage made in heaven for many of the participants. Some countries found the 1 percent allowed divergence from the value of the U.S. dollar to be constrictive. In addition, under the gold standard, the price of gold was fixed by the United States at U.S. $35 per ounce. This was dragging down on the American gold reserves and consequently on international confidence in the U.S. dollar. Despite these problems, the Bretton Woods Accord lasted from 1944 to 1971, successful for most of its life. Under its auspices, a broken Europe and Japan were able to reinvent themselves. From its inception, this system had been mostly a one-nation show. Once recovered, though, both Europe and Japan started to provide competition within the U.S. dollar block. The expenses were high, and after 1965 the United States was perceived as exporting inflation. By the late 1960s, the differences in the rates of growth and the rates of inflation among the new major economies were widening. To answer the international pressures, the intervention points were underlined. But they could not provide the answer in 1971, when the Bretton Woods system faltered, and they could not provide the answer twenty-seven years later either, when the European Monetary System (EMS) failed. The artificially designed ranges could not rein in the natural economic forces. In fact, they have just outlived their usefulness. Parallel to the demise of the Bretton Woods Accord, the United States abandoned pegging the price of gold, in effect annulling the gold standard.

AFTER BRETTON WOODS

Switching away from the fixed currency system after twenty-seven years out of necessity, not by choice, was a difficult task. The Smithsonian Agreement, reached in Washington, D.C., in December 1971, had a transitional role in the free-floating markets. This agreement failed to address the real causes behind the international economic and financial pressures, focusing instead on increasing the ranges of currency fluctuations. From 1 percent, the fluctuation band for currencies relative to the U.S. dollar was expanded to 4.5 percent. Against each other, then, foreign currencies could fluctuate as much as 9 percent.

Parallel to the Washington efforts, the European Economic Community, established in 1957, tried to move away from the U.S. dollar block toward the deutsche mark block, by designing its own European monetary system. In April 1972, West Germany, France, Italy, the Netherlands, Belgium, and Luxembourg developed the European Joint Float. Under this system, the member currencies were allowed to fluctuate within a 2.25 percent band, known as the snake, against each other, and collectively within a 4.5 percent band, known as the tunnel, against the U.S. dollar.

Unfortunately, neither the Smithsonian Agreement nor the European Joint Float addressed the independent domestic problems of the member countries from the bottom up, attempting instead to focus solely on the large international picture and maintain it by artificially enforcing the intervention points. By 1973, both systems collapsed under heavy market pressures.

The idea of regional currency stability with the goal of financial independence from the U.S. dollar block persisted. By July 1978, the members of the European Community approved the plans for the European Monetary System—West Germany, France, Italy, the Netherlands, Belgium, Great Britain, Denmark, Ireland, and Luxembourg. The system was launched in March 1979, as a revamped European Joint Float or a mini Bretton Woods Accord. Additional features, such as the threshold of divergence, were designed to protect this monetary system from the fate of the previous ones. Judging from its life span, until 1993 at least, the European Monetary System was obviously better. However, the continued focus on the macroeconomic picture at the expense of the historically significant changes in Europe at country level, and the stubborn attempts to fix natural economic divergences by means of maintaining artificial intervention points, triggered the collapse of the EMS. The heralded but widely unexpected fall of the Communist system set off a series of economic imbalances difficult enough even to fully comprehend, let alone fix by means of intervention points. Seriously shocked by the British pound’s exit under heavy foreign exchange selling in September 1992, the European Monetary System hit rock bottom at the end of July 1993. The traditional intervention bands were abandoned in favor of politically correct and insignificantly wide intervention bands. (For more details, refer to Chapter 3, the European Monetary Union.)

THE FREE-FLOATING FOREIGN EXCHANGE MARKETS

The 1973 double demise of the Smithsonian Agreement and the European Joint Float signified the official switch of the foreign exchange markets to free-floating. The switch occurred pretty much by default, since it was the only viable option. However, it is important to keep in mind that currency free-floating was not, by any means, imposed. In other words, countries are free to peg, semipeg, or free-float their currencies. In fact, only in 1978 was free-floating officially mandated by the International Monetary Fund.

FREE-FLOATING

The major currencies, such as the U.S. dollar, move independently of other currencies. The currency may be traded by anyone. Its value is a function of the current supply and demand forces in the market, and there are no specific intervention points that have to be observed. The Federal Reserve Bank does not intervene to change the value of the U.S. dollar, though it may if the currency reaches extreme levels that hurt the economy. Naturally, free-floating currencies are in the heaviest trading demand. Free-floating is not the sine qua non condition for trading. Liquidity is also an indispensable condition.

CURRENCY BLOCKS

The major currencies tend to have a polarizing effect on currencies from smaller economies. Sometimes, this phenomenon occurs as a result of former colonial ties. For instance, the former British Empire was metamorphosed into the Commonwealth. Consequently, the currencies of the Commonwealth members, such as the Indian rupee, are closer to the British pound. At times, the polarizing effect is generated by the fact that the majority of a smaller economy’s business is done with a single larger economy or with a group of economies. Therefore, currency blocks naturally occurred around the U.S. dollar, the euro, and the yen.

Since around the year 2000, there has been the tendency for currencies to polarize around the regional economic leaders. The major and even smaller European currencies were fixed versus the German mark and formed the euro, while the Asian currencies tend to emulate the Japanese yen. However, at the time of this writing, the yen acts as a proxy for the yet-to-become-fully-convertible Chinese yuan.

SEMIPEGGED CURRENCIES

The semipegged currencies have gone the way of the dinosaurs. The standard example of semipegging used to be the member currencies of the European Monetary System. They were allowed to fluctuate within 2.25 percent or, exceptionally, within 6 percent intervention bands until July 31, 1993. Following the foreign exchange crisis of the summer of 1993, the intervention rates were expanded to a whopping 15 percent. Semipegging generally had a slowing-down effect on speculative currency trading. However, trading was enhanced when currencies reached the extreme values of the allowed range.

Since the beginning of 1999, the EMS’s semipegging currencies morphed into the fully pegged values that form the euro.

PEGGED CURRENCIES

Moving away from the Bretton Woods Accord, some smaller economies naturally gyrated around larger economies with which they had the majority of their economic liaisons. For instance, many of the Caribbean nations, such as Jamaica, have pegged their currencies to the U.S. dollar. In addition, some countries have quasi-pegged their currencies to the U.S. dollar, by allowing minor divergences. For instance, the Saudi riyal spot exchange rate has been closely kept against the U.S. dollar at around 3.7500, although small divergences have occurred.

CURRENCY RESERVES

In times of economic or political uncertainty, people and corporations worldwide try to protect their investments and wealth by purchasing currencies or commodities perceived as safe haven instruments. In addition, certain international transactions are executed in currencies other than the domestic ones. These types of currencies are known as currency reserves. Prior to World War II, the reserve currency was the British pound. In the post–World War II era, the reserve currency around the world was the U.S. dollar.

As of the end of 2004, 66 percent of the known official foreign exchange reserves worldwide were held in dollars and 25 percent in euros. But the pound is not that far behind, as the European countries which already own euros want to diversify out of dollars. By the middle of 2006, the monetary authorities with the largest foreign exchange reserves were China, which held $941 billion, and Japan, which stashed away approximately $864 billion. Actually, China had a little more including the reserves of Hong Kong, adding up to $126 billion. Not bad for a country that not so long ago was decimated by its ferocious Communist leaders. These two countries, which also hold the biggest trade surplus with the United States, are followed by Russia, with $263 billion; Taiwan, with $260 billion; and North Korea, with $224 billion.

In the twenty-first century, medium and small central banks started to diversify their reserves away from dollars and into euros and pounds. It makes sense from an investment portfolio point of view, but many times the action has a political tone.

On August 3, 2006, the Bank of Italy took the most daring step made by a G7 country and switched a quarter of its foreign currency reserves into sterling at the expense of the dollar by reducing its dollar holdings from 84 percent to 63 percent. The Swiss National Bank moved 10 percent of its holdings into pounds in 2004. In the Middle East, the United Arab Emirates and the sheikhdom of Qatar both implied they planned to move away from dollars into euros. It would be more of a political statement rather than a financial slap—but they could do it.

However, the two key holders of dollars, China and Japan, which hold combined reserves of nearly $2,000 billion, are unlikely to diversify their holdings. While their staggering exports flood the U.S. markets at levels unparalleled with anywhere else, these two countries will continue to keep their dollars. Concerns they may be reducing their holdings of U.S. assets would trigger a financial crisis, and China’s and Japan’s holdings would lose value.

FX EVENTS

THE PLAZA ACCORD OF 1985

The Plaza Accord was an agreement signed on September 22, 1985, by the then G-5 nations (France, West Germany, Japan, the United States, and the United Kingdom). The G-5 agreed to devalue the U.S. dollar in relation to the yen and deutsche mark by intervening in currency markets. This started a near ten-year downtrend during which the value of the dollar versus the yen declined by over 67 percent. The reasons behind the move were to reduce the U.S. current account deficit and to help the U.S. economy emerge from recession.

THE LOUVRE ACCORD 1987

The Louvre Accord was signed by the G-6 (France, West Germany, Japan, Canada, the United States, and the United Kingdom) on February 22, 1987 to stabilize the international currency markets and stop the downtrend of the dollar triggered by the Plaza Accord. The accord had little significance.

THE EMS CRISIS OF 1992–1993

The EMS crisis of 1992–1993 had a devastating impact on European currencies and postponed the introduction of the euro. It was triggered by West Germany, which seized the opportunity to recover East Germany from the then Soviet Union. The process was inflationary, and the Bundesbank promptly hiked rates. However, the German mark was also linked to the other major European currencies via exchange rate bands. The other European central banks had to artificially keep their currencies in line with the rising mark, but strangled their economies, which had not been affected by inflation.

THE MEXICAN CRISIS OF 1994

The Mexican government liberalized the trade sector in 1985, adopted an economic stabilization plan at the end of 1987, and gradually introduced market-oriented institutions. The reforms boosted economic growth and attracted more foreign investment. The devaluation of the peso in December 1994 put an abrupt end to these capital inflows and precipitated a financial crisis. The crisis accelerated the dollar downtrend and the U.S. currency sank to record lows versus the yen, the Swiss franc, and the German mark.

THE ASIAN MARKET CRISIS IN 1997–1998

Heavily interconnected Asian economies, such as Thailand, Indonesia, Malaysia, and South Korea, slowed down in the mid-1990s and became pressed to repay huge loans to struggling Japanese banks and other international investors. The situation was exacerbated by government corruption, poor banking practices, and lack of financial sophistication.

The crisis was initiated on July 2, 1997, when the Thai government devalued the baht, triggering a fund outflow from the whole region. Thailand became the first Asian country to turn to the International Monetary Fund for loans to keep its economy going. Soon after, South Korea and Indonesia found themselves in similar situations. The failing economies created social unrest and caused further damage to lenders and investors who were slow to pull their money.

In Japan, the government failed to agree on any kind of reform policy for the struggling banking system. In the United States, where effects of the “Asian flu” remained minimal, the Dow soared to above 9,000 points for the first time on April 6, 1998.

International investors turned bearish in other emerging markets like Brazil and Russia, fearing the problems in Asia could spread. Fears of international economic turmoil began to grow in the United States and Europe. In an effort to nip in the bud the potential impact of the crisis in the United States., the Federal Reserve cut key interest rates.

By the end of the decade, Southeast Asia had rebounded, but the region remained below the levels it had reached at its peak in the mid-1990s.

THE INTRODUCTION OF THE EURO IN 1999

The euro was introduced in 1999 and was physically launched in 2002. It is the single currency of the Eurozone that replaced the sovereign currencies of Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. Before and after its introduction the FX markets were very quiet because traders needed to make their adjustments and because the risk management departments feared clearing problems.

THE ARGENTINIAN FINANCIAL CRISIS OF 2001–2002

The Argentine economic crisis was the climax of problems brewing during the late 1990s and early 2000s. Argentina quickly lost the confidence of investors and money outflows accelerated. In 2001, people withdrew large amounts of pesos from their bank accounts and exchanged them into dollars. In January 2002 the fixed 1-to-1 peso-dollar parity that had been in place for ten years was abandoned.

3 The European Monetary Union

The European Monetary Union (EMU) launched its long-planned euro on January 4, 1999, kicking off the most powerful union known to man in times of peace. It has been a great success, smoothing the emergence of the increasingly intertwined Eurozone economy. This was only a step in a long series of measures designed to fully integrate the richest, if divergent, economies of Western Europe in an all-out effort to compete head-to-head with the economic and financial might of the United States and China.

This chapter presents the historic path to this unique and historic supranational organization, its characteristics, and its future.

HISTORICAL BACKGROUND

The creation of the European Monetary Union was the result of a long and continuous series of post–World War II efforts aimed at creating closer economic cooperation among the capitalist European countries. The European Economic Community (EC) commission’s officially stated goals were to improve inter-European economic cooperation, create a regional area of monetary stability, and act as “a pole of stability in world currency markets.”

The end of World War II painted a ravaged picture of the former industrial and financial Europe. Foreign exchange was completely out of the picture, as currencies had lost their value. But even under better circumstances, trading would have been impossible, because currency fluctuations were tied in very narrow ranges against the U.S. dollar, under the Bretton Woods Accord of 1944. The accord had created a much-needed nurturing environment for the European economies. Currency stability was vital to the enormous task of rebuilding Europe.

The first steps in this rebuilding were taken in 1950, when the European Payment Union was instituted to facilitate the inter-European settlements of international trade transactions. In 1951, the Treaty of Paris established the European Coal and Steel Community, formed by West Germany, France, Italy, the Netherlands, Belgium, and Luxembourg; Great Britain declined to join. The purpose of the community was to promote inter-European trade in general, and to eliminate restrictions on the trade of coal and raw steel in particular.

The lesson one can draw from that early treaty is that the core lineup and the cultural gaps have changed little over the past fifty years. From the very beginning, the de facto European leaders have been Germany (at the time in its split Western version) and France, while the U.K. opted out. That was the case in 1951, and that remained the case on January 4, 1999.

The French National Assembly derailed plans for a joint European Defense Community in 1954. The lesson in this case is that French governments tend to have a more individualistic tone, a source of trouble within international unions, which require members to strive for the good of the whole.

In 1957, the Treaty of Rome established the European Economic Community, with the same signatories as the European Coal and Steel Community. The stated goal of the European Economic Community was to eliminate customs duties and any barriers against the transit of capital, services, and people among the member nations. The EC also started to raise common tariff barriers against outsiders. To the young reader, these goals might sound tame. For the Europeans, however, the achievement of these goals represented enormous success in grinding down centuries-old rigidities, thus allowing the flexible flow of capital and labor, the basic requirements of a modern superpower. Therefore, one might expect the current goals of the asymmetrical Eurozone economy to meet with success as well.

In 1963, the French–West German Treaty of Cooperation was signed. This pact was designed not only to end centuries of bellicose rivalry, but also to settle the postwar reconciliation between two major foes. The treaty, signed by President Charles de Gaulle and Chancellor Konrad Adenauer, stipulated that West Germany would lead economically and France, the former diplomatic powerhouse, would provide the political leadership. The premise of this treaty was obviously correct in an environment defined by a foreseeable long-term continuing cold war and a divided Germany. Later in this chapter, we discuss the implications for the modern era of this enormously expensive pact.

In 1964, a common agricultural market was instituted and uniform prices were introduced.

A conference of national leaders in 1969 set the objective of establishing a monetary union within the European Community. This goal was supposed to be implemented by 1980, when a common currency was planned to be used in Europe. The reasons for the proposed common currency unit were to stimulate inter-European trade and to weld together the individual member economies into an all-European superpower. Only this type of economy was perceived to be able to fully compete with the economies of the United States and Japan.

The monetary union strategy of semipegging the nation members’ currencies allowed a 2 percent fluctuation against each other. Of course, by the end of 1971, the Bretton Woods Accord collapsed and was replaced for two years by a transitional system, the Smithsonian Agreement. This accord raised the stakes in the currency band of fluctuation, by allowing the currencies to move within 4.5 percent against the dollar or a hefty 9 percent against each other.

Faced with the prospect of a rapidly deteriorating international monetary system, the EC members established the European Joint Float Agreement in 1972. By 1973, Great Britain, Ireland, and Denmark were also members.

The agreement allowed the member currencies to move within a 2.25 percent fluctuation band. Due to its curvaceous movement, this band was nicknamed the snake. As a joint group, the agreement allowed these currencies to gyrate within a 4.5 percent band. This larger band was nicknamed the tunnel. All in all, the entire agreement became known as the snake in the tunnel.

The economic fundamentals did not provide much support to the monetary agreement. The members pursued independent economic policies. Consequently, one by one, the British pound, the Danish krone, and the Italian lira were forced out of the snake by early 1973. By and large, the joint agreement was gone, despite efforts to prolong its life. A little later in the same fateful year, the Smithsonian Agreement collapsed as well, due to immense pressure on the U.S. dollar.

However, the ideals of economic unification, planned to be achieved in large measure through foreign exchange stability, stayed all the contrarian forces and persevered through the engulfing tide of the free-floating markets.

THE EUROPEAN UNION

The European Union, originally known as the European Community, was founded in November 1993. This unique supranational organization is not a state and is different from other international organizations.

1. The European Commission is the executive body in charge of making and observing the enforcement of the policies. Since it lacks an enforcement arm, the commission must rely on individual governments to enforce the policies. Each country selects its own representatives.

2. The European Parliament reviews and amends legislative proposals and has the power to adopt or reject budget proposals.

3. The Council of the European Union makes the major policy decisions on foreign affairs, finance, education, etc.

In addition to these three bodies, the European Union also relies on two other institutions: the European Court of Justice and the European Court of Auditors.

1. The European Court of Justice settles disputes between the EC and the member nations.

2. The European Court of Auditors checks the receipt of revenue and safeguards that all expenditures incurred in a lawful and regular manner and that the financial management of the EU budget has been sound.

Moreover, there are thirteen agencies designed to deal with specific management or scientific tasks.

Architecture of Europe

According to the Maastricht Treaty, the European Union policies were divided into three pillars, or areas:

1. the European Community, which deals with economic, social, and environmental policies;

2. the Common Foreign and Security Policy, which deals with military and foreign policy; and

3. Police and judicial cooperation in criminal matters.

Within each pillar, a different balance is allowed between the supranational and intergovernmental principles. Once the draft European Constitution is ratified by all member states, this will simplify and merge the operations of the European Union and these three pillars will be unified into a single structure.

THE EUROPEAN MONETARY SYSTEM

In 1978, the nine members of the European Community ratified a new plan for stability—the European Monetary System. After several inadvertent delays, the new system was established in 1979. Of the nine members, only seven were full members—West Germany, France, the Netherlands, Belgium, Luxembourg, Denmark, and Ireland. Great Britain did not participate in all of the arrangements and Italy joined under special conditions. Greece joined in 1981, Spain and Portugal in 1986. Great Britain joined the Exchange Rate Mechanism (ERM) in 1990. Also in 1990, West Germany became Germany as a result of its political unification with East Germany.

FEATURES OF THE EMS

The European Currency Unit (ECU)

This European Currency Unit was created by the European Monetary System with the eventual goal of replacing the individual European member currencies. While insignificant in the currency trading community, the ECU’s role was to pave the road for the high-powered euro and to create a light foundation for it. The European currency unit was a basket of the member currencies. As a composite unit, the ECU consisted of all the European Community currencies, which were individually weighted. The weights were a direct function of relative GDP and share of inter-EMS trading. These weights were examined every five years or upon request. To obtain the individual currency in the ECU composition, the following calculations were made:

The ECU had two functions—monetary and accounting.

Under the monetary function, the ECU was considered to be a reserve currency. EMS central banks used it for loans and issued ECUs for debt settlement. The ECU was quoted in American terms, just like the British pound. Attempts to launch it on the Chicago Mercantile Exchange (CME) futures market in the mid-1980s failed.

Under the accounting function, the ECU price was used as a benchmark against which the member currencies were valued. The individual currency valuation was made at the fixing time in Europe and was based on the middle rate (the average between the bid and the offer).

The Bilateral Grid

The bilateral grid linked all of the central rates of the EMS currencies in terms of the ECU. A central rate was used on a daily basis to indicate whether the member currencies were observing the bands’ fluctuation limits. These bands had been 2.25 percent for most of the members and 6 percent for Italy until 1990, and later for Spain until July 1993.

The extraordinary foreign exchange volatility of 1993 forced the EMS to expand the fluctuation band to 15 percent up or down against the central rate for all the members, and these enormously wide bands remained in place until the member currencies converged into the euro. Each central bank was responsible for shoring up its currency within the boundaries via FX intervention.

The Threshold of Divergence

The threshold of divergence was a very important safety feature of the EMS that was not transferred to the euro. This feature created an emergency exit for currencies that become the singular focus of various adverse forces. The threshold of divergence indicated when a specific country with pressured currency should take additional steps other than simple central bank intervention in the FX markets. These steps generally meant devaluation or revaluation of the currency and interest rate changes, rather than changes in economic policies. The threshold of divergence was set at 1.69 percent (with exceptions for countries in the wider 6 percent band, for which it was set at 4.5 percent) from its ECU value.

PERFORMANCE OF THE EUROPEAN MONETARY SYSTEM

There was a short maiden voyage for the EMS before problems reminiscent of the time of the snake occurred. Divergences in the rate of growth and the rate of inflation among the members continued to generate unwanted changes in interest rates and economic policies. Yet despite many obstacles and several realignments, EMS had successfully sailed through the 1980s.

The 1990s were much stormier years for the European Monetary System. Despite long opposition to full economic union in Europe, starting in 1987, Great Britain successfully, if at a high domestic inflation cost, maneuvered the pound to stay within the limits of the EMS. Great Britain had been a special member of the EMS since its inception, but not a member of the Exchange Rate Mechanism.

As one of the European powerhouses, Great Britain had to be close to the core of the discussions on the future of the European Monetary Union. Yet the British economy had been marked by high inflation and the British government opposed any type of economic or financial unification that would hinder national sovereignty, calculating that the perceived future political benefits of independence outweighed the short-term economic concerns. In September 1990, Great Britain joined the Exchange Rate Mechanism at the cross rate of sterling/deutsche mark 2.9500.

The move was widely perceived as beneficial for the British economy. Previously, the sterling/deutsche mark cross had become a sure bet to sell just under the 3.0000 level. Both the Bank of England and Bundesbank would intervene to protect that level. Upon the announcement, the FX market reacted aggressively by buying large amounts of pounds, despite a simultaneous 1 percent cut in the base rate. The 3.0000 barrier was shattered in a matter of minutes.

From the very beginning, objections had been raised regarding the high cross rate of 2.9500 deutsche mark per pound at which Great Britain joined the ERM. The British position remained consistent, that the move was part of the long-term strategy of combating inflation.

Even after entering the ERM, the British government maintained its long-standing objections to advanced economic policy coordination and control, and to a single currency. Eventually, its position softened with regard to currency unification, but not toward European federalism.

By the end of 1991, with the shocks of the swift demise of the Communist bloc and the unexpected unification of Germany still in the process of psychological digestion, the skies over the EMS looked very calm and encouraging.

In February 1992, the twelve EMS members signed the European Union Treaty that created the European Union (EU), in the Dutch city of Maastricht. This was an ambitious agreement with the stated goal of forging a “closer union among the peoples of Europe.” The twelve nations were Belgium, Denmark, France, Germany, Great Britain, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. The treaty consists of a series of amendments to the 1957 Treaty of Rome.

Some countries were reluctant to relinquish national control over their monetary policies, notably Denmark and Great Britain. On June 2, 1992, Danish voters narrowly rejected the Maastricht Treaty. However, the Danes voted their approval in May 1993. British voters ratified the treaty, but they did not generally support a common European currency. The European Union was established on November 1, 1993, after the treaty had been ratified by the twelve member states, which then became members of the EU. The EU retained the EC’s Parliament, Council, Commission, and Court of Justice.

The Maastricht Treaty was to become law only upon ratification by all the EMS members, and was supposed to be implemented by January 1993, parallel to the establishing of the single European market. According to the Maastricht Treaty, the European Community leaders would have a central bank by 1994, a single currency by January 1997 or January 1999, and a joint economic and foreign policy by 1999.

The convergence tests for the ERM members were based on inflation, interest rates, exchange rates, budget deficit, and debt stock. In terms of inflation, the individual country rate could not exceed the rate of 1.5 percent above the lowest three members in the previous year. Interest rates had to be kept within 2 percent above the lowest three members in the previous year. With regard to exchange rates, a country had to be an ERM band member for two years, without realignment. The budget deficit could not exceed 3 percent of GDP. Finally, the outstanding stock of public sector debt could not be higher than 60 percent of GDP. One major economic indicator was not included in the criteria—unemployment. Result? Double-digit unemployment in the Eurozone before and after the currency convergence of 1999.

Not all countries managed to clear the criteria; backroom politics were still in place. The German approach had been quite strict: Only those countries that cleared all criteria would enter the convergence in the first stage. The French attitude was that criteria meant a series of targets that all members would strive to achieve if they couldn’t meet the deadline. The French version won. Therefore, two countries that failed to meet the targets—Italy and Belgium—still made the cut, while Greece did not.

THE EMS CRISES OF 1992–1993

As the costs of political change in Europe started to become apparent in the early 1990s, enthusiasm among the EMS members started to wear thin. The threshold of divergence performed well in September 1992, when unusual selling pressure on the British pound set up all the defensive measures on the EMS. First, Bank of England attempted to support its battered currency by direct purchases in the interbank market. When this step failed, the other EMS members stepped in and also purchased the pound. This failed as well.

Due to the divergence of the British pound’s price from the allowed percentage on the band, the threshold of divergence was activated. The other central banks halted their costly but unsuccessful support of the pound. Bank of England raised its base rate by a hefty 5 percent in the same day, trying to shore up the massive selling pressure. Yet the market was not impressed by the magnitude of the interest rate increase, as it understood that only the crisis had triggered the rate change, not the economic policies. Therefore, the selling of the pound continued unabated.

With no alternative left, Bank of England was forced to pull its currency out of the Exchange Rate Mechanism two years after joining it. Despite the high cost of trying to keep the pound within the band (estimated to be anywhere between $6 and $20 billion), the threshold of divergence performed its emergency exit function, minimizing losses for the rest of the EMS members.

Later on, European officials found no use for a safety exit within the euro because there were no individual currencies to be targeted.

The foreign exchange shock of having the pound suspended from the ERM had a long-term impact. How could it happen?

A lot of fingers in the market pointed toward the Bundesbank’s tight monetary policy. Germans’ traditional distaste for inflation continued to be fueled by the specific inflationary characteristics of their nation’s unification. With overheated consumer demand from the former East Germany, the Bundesbank had little choice but to pursue a high interest rate policy. The policy paid off domestically, but raised huge problems abroad. Within a worldwide economic slowdown and East European political turmoil, each nation was looking to stay afloat economically. Faced with either the expensive choice of propping up their currencies to the agreed levels or the economically suffocating choice of raising interest rates, most of the EMS members felt cornered. The monetary system, after all, was designed to reduce the currencies’ gyrations, as the member economies converged. The feeling was that stronger currencies like the deutsche mark, the Dutch guilder, and the Belgian franc had to be revalued, while the other currencies had to be devalued.

Therefore, when the run on the EMS currencies finally occurred in September 1992, it looked more like a fait accomplit rather than a totally unexpected surprise. What was surprising, though, was the velocity of the forces in play in the foreign exchange markets. It was no wonder that the average daily trading volume reached the U.S. $1 trillion level toward the end of 1992.

The pound sterling and the Italian lira were not, by any means, the only currencies affected negatively. The Spanish peseta, the Portuguese escudo, and the Irish punt were devalued; the Norwegian krone and the Finnish markka were allowed to fluctuate. The Swedish central bank raised a key interest rate by 500 percent (this is no typo!), before it gave up and let the Swedish krona fluctuate freely; and the Danish krone and the French franc came under increasing pressure. Allowing the currencies to gyrate according to the law of supply and demand is a de facto devaluation.

What about the French franc crisis in 1993? The French franc became the selling target of traders around the world even though the fundamentals had seemed to be supportive of the French franc. The French government policy of maintaining the franc in the ERM without devaluation, a policy known as the franc fort, was being tested.

As the French franc sell-off fury was unleashed, the French efforts had been matched by Germany’s. To the chagrin of smaller members, the Bundesbank seemed much more inclined to help the French franc than their currencies.

Was this a surprise? Not entirely. Behind it all was the French–West German Treaty of Cooperation. France and Germany had entered a deep-reaching pact covering their exact economic and political roles relative to each other. Thirty years later the pact was being put to the test on the foreign exchange markets.

The Bundesbank not only helped with vigorous foreign exchange market interventions; it also cut interest rates. Cutting the interest rates under pressure across the board, but specifically to support the French franc, was a first for the Bundesbank. Yet, despite the all-out joint efforts, the franc fort could not be saved.

The decision made by the ERM on the last weekend of July 1993 was to expand the previous fluctuation bands of 2.25 and 6 percent to 15 percent. Although it was stated to be a temporary decision, the future of the European Monetary System as envisioned at the Maastricht Treaty was, for a while, in jeopardy.

THE EMERGENCE OF THE EURO

Here are the official irrevocable locking rates of the 11 participating European currencies in the euro (EUR). The rates were proposed by the EU Commission and approved by EU finance ministers on December 31, 1998, ahead of the launch of the euro at midnight, January 1, 1999. The real starting date was Monday, January 4, 1999. Greece started using the euro on January 1, 2002.

The conversion rates are:

1 EUR = 40.3399 BEF

1 EUR = 1.95583 DEM

1 EUR = 166.386 ESP

1 EUR = 6.55957 FRF

1 EUR = 340.750 GDR

1 EUR = 0.787564 IEP

1 EUR = 1936.27 ITL

1 EUR = 40.3399 LUF

1 EUR = 2.20371 NLG

1 EUR = 13.7603 ATS

1 EUR = 200.482 PTE

1 EUR = 5.94573 FIM

On December 31, 1998, the EU Commission also set its final fixings of the ECU, which converted 1:1 with the euro at midnight, January 1, 1999.

The Danish krone has been observing a narrow fluctuation margin of 2.25 percent around its central rate. The other two EU countries outside the euro—the U.K. and Sweden—are also staying outside ERM-2, which is designed to link currencies outside the euro to the euro. These countries received special derogations in the original Maastricht Treaty of the European Union and are not legally required to join the Eurozone unless their governments decide otherwise, by either parliamentary vote or referendum.

Europe’s economic and political stability is a magnet for many European countries that have the right to apply to become members of the European Union. The countries that joined the Union on May 1, 2004, are Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia. Along with these new member states, Bulgaria and Romania should be adopting the euro as soon as appropriate guidelines are met. The dates the ten states are expected to enter the third stage of the EMU and adopt the euro are: January 2007 for Slovenia; January 2008 for Estonia, Cyprus, Latvia, and Malta; 2009 for Lithuania and Slovakia; 2010 for the Czech Republic; 2011 for Poland; and 2012 for Hungary.

As far as Turkey is concerned, the European Council concluded that the political and economic conditions allowing accession negotiations to be envisaged were not yet satisfied, and that the European strategy to prepare Turkey for accession should be continued.

THE TRANSITION TO THE EURO

1998

- May 2: Identified the first wave of countries to adopt the single currency.

- July 1: Established the European Central Bank (ECB).

1999

- January 1: Introduction of the euro; national currencies are treated as subdivisions of the euro.

2000

- Foreign exchange transactions in euros only.

2001

- The private sector was welcomed to use the euro.

2002

- January 1: Introduction of the euro coins and notes.

- July 1: Withdrawal of national coins and notes.

- The euro is the sole legal tender.

- All transactions are in euros.

THE EUROZONE

The Eurozone economy is a division of the European Union’s Member States which have adopted the euro. The European Union has the world’s largest economy, probably larger than that of the United States. However, its economic rate of growth has lagged behind that of the United States, while its unemployment rate has generally been much higher.

WHAT IT ALL MEANS FOR THE EUROPEANS

As set out in the Maastricht Treaty, any national of a Member State is a citizen of the Union. The aim of European citizenship is to strengthen and consolidate European identity by greater involvement of the citizens in the Community integration process. Thanks to the single market, citizens enjoy a series of general rights in various areas such as the free movement of goods and services, consumer protection and public health, equal opportunities and treatment, access to jobs, and social protection.

There are four categories of specific provisions and rights attaching to citizenship in the European Union:

- freedom of movement and residence throughout the Union;

- the right to vote and stand as a candidate in municipal elections and in elections to the European Parliament in the state where the citizen resides;

- protection by the diplomatic and consular authorities of any Member State if the state of which the person is a national is a nonmember country;

- the right to petition the European Parliament and apply to the Ombudsman.

The Amsterdam Treaty of 1997 completes the list of civic rights of Union citizens and clarifies the link between national citizenship and European citizenship.

The Treaty of Amsterdam

The Treaty of Amsterdam is the result of the Intergovernmental Conference launched at the Turin European Council on March 29, 1996. It was adopted at the Amsterdam European Council on June 16 and 17, 1997, then signed on October 2, 1997 by the foreign ministers of the fifteen Member States. It is to be enforced after it has been ratified by all the Member States in accordance with their respective constitutional requirements.

From a legal angle, the purpose of the treaty was to amend certain provisions of the treaty on European Union, the treaties establishing the European Community, and certain related acts. It does not substitute for the other treaties but adds to them.

THE EUROPEAN CENTRAL BANK (ECB)

The European Central Bank was set up on June 1, 1998. Since the introduction of the single currency on January 1, 1999, the ECB has been responsible for carrying out the Community’s monetary policy. As to practicalities, the ECB’s decision-making bodies (the Governing Council and the Executive Board) will run a European System of Central Banks (ESCB) whose tasks will be to manage the money in circulation, conduct foreign exchange operations, hold and manage the Member States’ official foreign reserves, and promote the smooth operation of payment systems. The ECB is the successor to the European Monetary Institute (EMI).

OBJECTIVES AND TASKS OF THE ESCB

The primary objective of the European System of Central Banks, as defined in Article 2 of the Statute of the European System of Central Banks and of the European Central Bank, is to maintain price stability. Without prejudice to the primary objective of price stability, the ESCB must support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community. In pursuing its objectives, the ESCB shall act in accordance with the principle of an open market economy with free competition, favoring an efficient allocation of resources.

The basic tasks to be carried out by the ESCB are:

- defining and implementing the monetary policy of the Community;

- conducting foreign exchange operations;

- holding and managing the official foreign reserves of the participating Member States;

- promoting the smooth operation of payment systems; and

- contributing to the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system.

MONETARY FUNCTIONS AND OPERATIONS OF THE ESCB

The ESCB Statute specifies the monetary functions and operations of the ESCB. On the basis of these provisions, the European Monetary Institute (EMI) prepared an operational framework for the ESCB’s monetary policy. The Governing Council of the ECB will make the final decision on the operational framework. The Governing Council of the ECB may decide not to use all the available options or may change certain features of the instruments and procedures presented here.

MONETARY POLICY INSTRUMENTS

The operational framework consists of a set of instruments; the ESCB will conduct open market operations, offer standing facilities, and may require credit institutions to hold minimum reserves on accounts with the ESCB.

ORGANIZATION OF THE EUROPEAN SYSTEM OF CENTRAL BANKS

The ESCB is composed of the European Central Bank and the EU national central banks (NCBs). The NCBs of the Member States that do not participate in the euro area, however, are members of the ESCB with a special status. While they are allowed to conduct their respective national monetary policies, they do not take part in the decision making regarding the single monetary policy for the euro area and the implementation of such decisions.

CONCLUSION

There is no doubt in anybody’s mind that with the unification of 457 million people (as of 2006) in the European Union, along with a joint GDP that probably exceeds the United States’, the European Monetary Union is in a very attractive position. The European bloc is not only better suited to compete with the United States, Japan, and China; it is also positioned to become the world economic leader.

Achieving such a mighty goal cannot, in the long run, avoid economic and political realities. Despite the efforts toward economic convergence, the facts show that old-fashioned divergences, in terms of economic growth and inflation, labor immobility, high unemployment, and cultural differences, are recurring problems.

ECONOMIC DIVERGENCE

The divergent economic trends and the consequent need for divergent policies cannot help but emphasize the social differences, generally disregarded by most studies. The political unification of Germany in 1989, which capitalized on the opportunity presented by the weakening of the Communist grip in Europe, acted as a litmus test. Despite a common language, culture, and heritage, the unification proved to be an economically burdensome undertaking even nearly two decades later.

When a similar experiment is envisioned on a multination scale (with all those nations being very different), the logistics appear in a very special perspective. Of course, these barriers are slowly melting away, but are they disappearing fast enough for this generation?

Labor rigidities present another issue of substance, as typically only the youngest employees are able and willing to relocate and work in a foreign land. Even with the well-known linguistic skills many Europeans enjoy, not all are willing and able to adapt to slower or faster working schedules than their domestic counterparts. With social systems providing comfortable benefits that are incomprehensible by U.S. standards, employees are understandably reluctant to take a leap into a different trading environment.

Unemployment rates remain at ridiculously high levels at the start of the twenty-first century. This is a challenge for an aspiring world economic leader. The European governments are hard-pressed to find means of creating jobs while reducing social benefits and encouraging labor mobility. It cannot be done without some social unrest.

Convergence has been the buzzword for decades, but it was natural convergence that was meant. When the reality of the economic fundamentals is denied, it is only a matter of time before the forces of the free markets make the necessary adjustments. Simply put, artificial mechanisms have a limited life.

IMPACT ON THE FOREIGN EXCHANGE MARKET

The preparations for the euro included drastic trimming of jobs in the foreign exchange dealing rooms, as the EMS currency traders were no longer needed. Moreover, many money-center banks closed their branches in continental Europe and consolidated in London. After these drastic adjustments were made, the pruned FX community adjusted to the new trading environment and activity rebounded. Since the spring of 1999, after a short period of accommodation with trading the euro, volume has picked up considerably, reaching records in 2004 and being set for even higher levels into the end of the decade.

PART

3 INSIDE THE WORLD OF FOREIGN EXCHANGE

4 Currency Characteristics

This chapter describes the most traded currencies and the ISO codes used to refer to them.

THE ISO CODES

Foreign exchange participants and professional financial information services do not refer to currency pairs by their full name. Instead, they use standardized codes, developed by the International Organization for Standardization (ISO) and known as the ISO codes. For example, the U.S. dollar is coded USD and the euro is coded EUR (see Figure 4.1). Codification is a practical necessity in the complex but fast global environment of the foreign exchange markets. Throughout this book, we refer to currencies alternatively by their full names and their codes.

Traders, salespeople, and operations staff use the ISO codes extensively for inputting and processing data. The codes are used on an individual basis or, more commonly, in currency pairs. For instance, U.S. dollar/Swiss franc is entered as USD/CHF.

The ISO abbreviations are not used, however, in normal conversations. Traders use nicknames for the currencies. The U.S. dollar is known as the buck or greenback. The British pound sterling is generally called cable or, in the U.K., quid. The Swiss franc is commonly referred to as swissy; the Australian dollar is called aussie, the New Zealand dollar kiwi, and the Canadian dollar loonie.

Figure 4.1. Selected examples of ISO codes.

THE U.S. DOLLAR

The U.S. dollar is the world’s main currency. All currencies are generally quoted in U.S. dollar terms. In current dollar terms, the role of the dollar rose to 89 percent on one side of the transactions in 2004 from approximately 83 percent in 1995. That does not come as a surprise, since commodities and international debt are quoted in terms of the dollar.

In terms of international economic and political unrest, the dollar is the main safe-haven currency. For instance, this feature was proven during the Southeast Asian crisis of 1997–1998, when panicked investors in the beleaguered region dumped the crisis-stricken currencies in favor of dollars.

The U.S. dollar is no longer backed by gold (since 1971), but by confidence in the sheer size of the United States’ economy and its leading financial markets. Although challenged by the Eurozone and Chinese and Japanese competition, the United States remains the preeminent economy in the world, and the dollar is the world’s financial standard. In the long run, the dollar is also underpinned by the predominant U.S. military force, which has generally been vital in putting out numerous regional political fires, thus encouraging a pro-market perspective. It does not hurt that the United States has the upper hand in the microchip and software industries, while our ample available land provides an advantage for infrastructure that cannot be matched by either Europe or Japan.

The U.S. dollar became the leading currency toward the end of the Second World War and was at the center of the Bretton Woods Accord, as all the other currencies were virtually pegged against it. (Room for fluctuation against the dollar was a symbolic 1 percent.) The breakdown of the Bretton Woods system in 1971 and the introduction of the euro in 1999 reduced the dollar’s importance only marginally.

The currency was devalued by approximately 60 percent between September 1985 and March–April 1995 in a relief effort for American exporters and in an attempt to rebalance the trade deficit. In 1995, the U.S. dollar reached record lows against the Swiss franc, deutsche mark, and Japanese yen, but not against the pound (see Figure 4.2). There are no restrictions on foreign exchange trading in the United States. The Federal Reserve, along with the other major central banks, employs a minimum of interference, although it intervenes under special circumstances.

The major currencies traded against the U.S. dollar are the euro, Japanese yen, British pound, and Swiss franc (see Figure 4.3).

Figure 4.2. The dollar sank to record lows agains the Japanese yen, deutsche mark, and Swiss franc, but not against the pound during the period of March-April 1995.

Figure 4.3. Market share of the major currencies. (Source: BIS)

THE EURO

The euro has replaced the deutsche mark as the second currency of resort as of January 4, 1999. The euro was designed to become a leading currency in trading by simply being quoted in American terms. You will see the euro as the first, or base, currency in an exchange rate, such as euro/dollar, euro/yen, and euro/Canadian dollar.

The euro, which had been expected to perform better than the sum of its components, quickly gained acceptance as a major currency, as Figure 4.3 shows. The euro has encountered both ups and downs in its short life, but this is true for any major currency. After its introduction, it plunged through October 2000 and sank below parity with the dollar. Following that significant low, euro/dollar rallied to above 1.3600. In time, it has proven itself to be a significant asset and an increasing reserve currency. Consequently, some central banks, such as Bank of Italy, started to diversify their holdings into the euro at the expense of the dollar.

The currency is exposed to a wide variety of economic and political factors stemming from the diversity of the members of the Eurozone, a drastic difference from the responsibilities a currency generally encounters within a single economy. This approach changes the rules of the game, despite repeated assurances from European officials that the Eurozone concept is similar to that of the United States. Their stated position loosely disregards Europe’s long and bloody history, and the diversity of languages, culture, and work habits.

Like the U.S. dollar, the euro has a strong international presence. Whether strong or weak, the currency remains plagued by structural problems, such as unequal growth, high unemployment, and government resistance to structural changes. But the euro has become the second currency of choice for asset holdings, and the legacy currencies are only old memories.

THE JAPANESE YEN

The Japanese yen is the third most traded currency in the world; it has a much smaller international presence than the U.S. dollar or the euro. The yen is very liquid throughout the world, being traded practically around the clock.

As most foreign companies found the Japanese market tough to crack, the natural demand to trade the yen concentrated among the Japanese economic and financial conglomerates. The yen is theoretically sensitive to changes in the price or structure of the raw material markets. However, after absorbing the oil shoku of 1973, the Japanese economy learned how to weather this type of crisis successfully. Thus neither the Iraqi invasion of Kuwait in 1990 nor the 2006 oil shock significantly affected the Japanese economy or, consequently, the Japanese yen. Let’s not forget that the commodity-producing countries are more dependent on Japan than the other way around.

The yen is much more sensitive to the fortunes of the Nikkei index—the Japanese stock market—and the real estate market. The 1989 attempt of the Bank of Japan to deflate the double bubble in these two markets had a negative effect on the Japanese yen, although the impact was short-lived. Between 1989 and 1995, Japan had had more than its share of political scandals, from old-fashioned geisha affairs to bribery at the highest government levels. The political scandals had a much smaller impact on the currency, as traders became confused about the significance of those events vis-à-vis the traditional Japanese political arena. This lack of significant resolve generated a lack of interest in the foreign exchange market.

The Japanese yen reached record lows in April 1995, after then newly elected President Bill Clinton and his secretary of the treasury, Lloyd Bentsen, emphasized that the yen should reflect the might of the Japanese economy. The motivation for those statements was the worsening U.S. trade deficit with Japan. The yen had previously been revalued following the G-5’s Plaza Accord of September 1985, precisely for the same purpose. However, the yen high of around 80 against the dollar, reached in April 1995, failed to stick or make a serious dent in the Japanese trade surplus with the United States. Since then, the currency has been generally scandal-free, though there have been exceptions. Also, the Bank of Japan bought euro/yen for months throughout 2000 to bail out Japanese investors, who purchased significant euro-denominated assets after the introduction of the euro. The intervention helped these investors to exit losing investments in euro and to repatriate incomes to Japan. Another intervention occurred when the Bank of Japan sold an unprecedented 32.9 trillion yen (or bought approximately $311 billion) in the fiscal year ended March 31, 2004, as foreign investors bought record amounts of Japanese stocks, pushing the yen to a four-year high against the dollar.

Why is the yen quoted at a rate different in format from the other major currencies? In post–World War II Japan, American occupation forces had to decide on a new exchange rate for the yen. Because the day starts in Asia and the Japanese flag displays the sun, this idea was extrapolated to foreign exchange. The sun is represented as a circle, and circles have 360 degrees, so the dollar-yen spot exchange rate became 360. Et voilà!

THE BRITISH POUND

At the start of the new millennium, the pound sterling commands the fourth place in the currency market, and it seems to be closing in on the yen. Most pound transactions take place in the largest foreign exchange market—London—with volume decreasing significantly in the U.S. market and slowing down to a trickle in Asia. Therefore, in the New York market, some banks may not quote the pound past noon.

Until the end of World War II, the pound was the currency of reference. Its nickname, cable, is derived from the telex machine, which was used to trade it in its heyday. The currency is heavily traded against the U.S. dollar and the euro, but has a lesser presence against other currencies.

Historically, the pound’s behavior resembles a roller coaster, due to its domestic problems and to its love-hate relationship with the European Monetary Union.

The two-year bout with the Exchange Rate Mechanism between 1990 and 1992 had a soothing effect on the British pound, as it generally had to artificially follow the deutsche mark’s fluctuations, but the crisis conditions that precipitated the pound’s withdrawal from the ERM had a psychological effect on the currency.

Prior to the introduction of the euro, both the pound and the Swiss franc benefited from any doubts about the currency convergence, just to be dumped when these worries dissipated.

Just like the Norway krone, the pound is a petrocurrency, because the U.K. owns oil deposits in the North Sea. Therefore, cable may be sensitive to oil price gyrations.

The risk for the pound is that it may join the euro eventually, provided that the U.K. referendum is positive. It is hardly a short-term risk, as economic and political fortunes change. However, losing the pound may be detrimental to the U.K.’s complex liaisons with the United States and would increase the risk for large currency portfolios.

THE SWISS FRANC

The Swiss franc is the only currency of a major European country that belongs neither to the European Monetary Union nor to the G-7 countries. This position is, however, typical of Switzerland, a country well known for its neutrality.

Although the Swiss economy is relatively small, the Swiss franc is one of the four major currencies. Why? The Swiss franc (swissy) closely resembles the strength and quality of the Swiss economy and finance. Switzerland has no dangerous political exposure and has a very close economic relationship with Germany, and thus to the Eurozone. Swiss referendums rejected the possibility of joining the EMU, to the chagrin of Switzerland’s neighbors. When the EMS came under unprecedented pressure in 1993, swissy was one of the precious few European currencies that did not feel the pinch.

The Swiss banking system has had an unusually good reputation for service. Although its secrecy laws have been very helpful, the banking service goes well beyond that, maintaining a widespread network of customers around the world.

The Swiss franc closely resembles the patterns of the euro, but lacks its liquidity. As the demand for it exceeds supply, swissy can be more volatile than the euro.

The outlook for both the pound and the Swiss franc is somewhat cloudy early in the millennium. Economists and politicians are at logger-heads about whether these two major currencies can survive independently in a Europe dominated by the euro. In the medium term at least, the answer seems to be yes.

THE MAJOR FOREIGN EXCHANGE MARKETS

The foreign exchange markets function nonstop for nearly the entire week. The cash markets are fully decentralized, unlike the markets for currency futures and options on currency futures, which trade on special exchanges. There are no official opening and closing hours for foreign exchange trading. However, in the New York market, for instance, the unofficial standard closing time is 3 p.m. EDT.

Although the market never closes except on weekends and holidays, traders find it rather hard to get a currency quote in the New York market after 4:30 p.m. EDT, because Auckland, New Zealand, starts trading between 3 and 4 p.m. EDT. California attempted to fill this time niche in the late 1980s, but was unable to do so because of the limited number of banks in the region.

The advance in telecommunications greatly blurred the differences among the foreign exchange markets. From the trader’s point of view, the main significance of the market relates to the presence of liquidity, since more players generate more trades. Otherwise, there is little practical difference, as traders only have to use a different code when calling out directly.

However, the presence of local customers and money markets still keeps the regional foreign exchange markets separated.

The London market has had the most significant growth in foreign exchange, as a result of the FX consolidation away from continental Europe prior to the euro launch. More dollars and euros are traded in London than in either New York or Frankfurt.

The major markets are London, with 31 percent of the market; New York, with 19 percent; and Tokyo, with 8 percent. Germany and Singapore follow with 5 percent each; Hong Kong has 4 percent; and Switzerland, France, and Australia have 3 percent each (see Figure 4.4).

Figure 4.4. The major foreign exchange markets. (Source: BIS)

THE MAJOR PLAYERS

The major players in the foreign exchange arena are commercial banks, investment banks, central banks, trading institutions, hedge funds, corporations, high net-worth individuals, and individual investors (see Figure 4.5).

Figure 4.5. Diagram of the major players in foreign exchange trading.

COMMERCIAL AND INVESTMENT BANKS

Commercial and investment banks are the natural players, as all other participants must deal with banks if they want to trade foreign exchange. Currency trading started as a service added to the core of commercial banking business—deposits and loans. As currencies were allowed to float freely and as the writing of loans became less profitable, banks had to look for other sources of profit.

Foreign exchange has the perfect characteristics for banks. It is profitable; the spot market provides limited credit exposure; the forward market provides significantly less credit exposure than loans; and, because worldwide interest is concentrated on a handful of currencies, the liquidity is excellent.

Commercial and investment banks are in the FX market on behalf of both their customers and themselves.

CENTRAL BANKS

Central banks represent a different type of player. Although they are the largest banks on an individual basis in most instances, central banks are not in the market for the money—when they are in the market at all. They resemble nonprofit organizations. The major central banks do not typically speculate, as they may be more interested in providing adequate trading conditions. Some smaller central banks may intervene in the market in an attempt to adjust economic or financial imbalances, and also for commercial reasons.

Although profit is not their aim, central banks tend to be profitable because they generally trade on a long-term basis. For instance, all major central banks sold U.S. dollars against the yen in the aftermath of the Plaza Accord in September 1985, when the exchange rates were around 245 yen per dollar, and they bought back from around 121 yen per dollar in January 1988 to 80 yen per dollar in April 1995.

The currency crises of September 1992 and July 1993 had an exceptionally negative impact on the profitability of the European central banks, as the Bundesbank had to defend at high cost the other currencies linked to its mark, such as the French franc.

The interventions after 2000 have been rare and never included all the major central banks.

HEDGE FUNDS/CTAS

Hedge funds are relative newcomers to foreign exchange trading, with a history of only a couple of decades. However, they are responsible for the increase in volume in FX. A clear definition is still pending. Roughly, they are funds that employ aggressive strategies such as program trading, selling short, and derivatives, and they are exempt from many of the rules and regulations governing mutual funds. Hedge funds have limited numbers of seasoned investors, who generally invest a minimum of $250,000 and more often than not over $1 million. Many funds are entering the currency markets as international investment opportunities increase.

The initial hedge fund was George Soros’s Quantum group of funds, which grossed over $1 billion in profits in September 1992 against the British pound, and lost $600 million on a long dollar/yen position in February 1994. Both Quantum and another famed fund—Tiger—closed down. History books will describe the havoc created in October 1998, when the leading hedge fund at the time—Long-Term Capital Management—was forced out of its losing positions. Even though LTCM was specializing in interest rate arbitrage, it also held a very large dollar/yen position. When it simultaneously closed some of its losing interest rate positions and its profitable FX position, it sent dollar/yen into an 11.7-yen vortex in a single day and a total of 19.3 yen in two days.

Since then more hedge and investment funds have joined established specialists in FX, such as FX Concepts and John Henry, or added currencies to their portfolios.

As the name suggests, commodity trading advisers (CTAs) originally counseled clients on futures strategies, generally for bonds and equities. They gradually developed into fund manager types and expanded their interest to FX markets.

CORPORATIONS

Corporations used to have a love–hate relationship with foreign exchange that was difficult to manage and looked chaotic. The internationalization of business and increased competitiveness forced them to take a closer look at foreign exchange. Corporations are becoming increasingly sophisticated at risk management. The days when hedging decisions were made on an all-or-nothing basis are gone. Some corporations go beyond their commercial needs and take speculative positions by underhedging as opportunities occur.

HIGH NET-WORTH INDIVIDUALS

High net-worth individuals access foreign exchange markets through either investment banks or private banking departments. They tend to be very aggressive and have diverse levels of experience.

INDIVIDUALS

Individuals are categorized as individual traders (efficient participants) and as tourists (inefficient participants).

Individual traders who are trained in FX and want to invest their money generally trade on the Internet. This category of traders has helped boost volume in FX. Arcade trading is more popular in London and several centers in Asia than it is in the United States.

It is vital that retail traders get proper training before risking their money in a fast market and that they use reliable venues for trading. In order to avoid foreign exchange trading fraud, which affected U.S. retail business in its early days, the Commodity Futures Trading Commission listed nine warning signs:

1. Stay away from opportunities that sound too good to be true.

2. Avoid any company that predicts or guarantees large profits.

3. Stay away from companies that promise little or no financial risk.

4. Don’t trade on margin unless you understand what it means.

5. Question firms that claim to trade in the “interbank market.”

6. Be wary of sending or transferring cash on the internet, by mail or otherwise, and be especially alert to the dangers of trading online.

7. Currency scams often target members of ethnic minorities.

8. Be sure you get the company’s performance track record.

9. Don’t deal with anyone who will not give you his or her background.

Retail traders must check and use reliable and established names in the industry, such as GFT Forex, to execute their trades and to get analysis and charting services.

Tourists have a limited impact on a one-on-one basis. Most of their transactions are not speculative and are generally related to travel expenses or purchasing foreign-made products. However, when compounded, the individual trading interest may be substantial. A strong dollar will encourage U.S. tourism abroad, while a weak dollar will increase foreign tourism in the United States.

CONCLUSION

Foreign exchange trading can be a profitable game. The larger the amounts in play, the greater the opportunity for profitability. But it can also be an expensive game. In addition to the capital requirement, trading implementation is relatively expensive.

The currency markets have started to successfully attract individuals. Trading companies, and even investment and commercial banks, offer individual investors and speculators the opportunity to participate in currency trading.

The potential for this market segment has not yet been reached. As foreign exchange financial information becomes more easily available on a mass level, individual investors will be more attracted, given the opportunities for quick profits.

5 Foreign Exchange Risks

Foreign exchange is not only a very profitable industry; it is also a risky business. The multitude of players, trading increasingly sophisticated instruments in staggering amounts, naturally exacerbates the trading risks. It is therefore vital to understand where the risks lie in order to develop the correct policies to manage them.

The main categories of foreign exchange risk are:

1. exchange rate risk,
2. interest rate risk,
3. credit risk, and
4. country (sovereign) risk.

Although these risks apply to the foreign exchange market as a whole, they apply selectively to the different instruments.

EXCHANGE RATE RISK

Exchange rate risk is the effect of the continuous shift in the worldwide market supply and demand balance on an outstanding foreign exchange position. This risk is pertinent to spot, forward outrights, futures, and options. These instruments have one element in common—the spot price. Forward outrights, futures, and options are all derivative instruments. Spot deals mature in two business days. Forward outrights and futures mature past two business days. Options are drawn on both forward outrights and futures.

A trader opens a position by either buying or selling a foreign currency. For the period it is outstanding, the position will be subject to all the price changes. The position will be closed or covered when the trader executes the opposite deal (sell, if first bought, and vice versa) for the same amount of currency.

Exchange risk does not apply to swaps directly. In a swap deal, a party buys and sells the same amount of the same currency with the same counterparty, at different exchange rates and different value dates. Since the same amount of foreign currency is simultaneously bought and sold, there is no exchange risk per se. However, the exchange risk will find its way to the swaps as well, via large spot price fluctuations.

The formula (discussed in Chapter 12) for calculating the forward points, which are applied to the spot rates in order to determine the forward rates, also includes the spot price. Should the spot rate change dramatically, the forward points will also be affected. Volatility is by no means the enemy of the trader; it is in fact the vital element that creates the market. Without continuous price fluctuations, trading would not be possible. However, price volatility is good only when it is used properly.

COMPOUNDING THE RISK

From the managerial point of view, the gross dealing exposure should be measured by adding together the absolute values of all the outstanding exposures. At any given time, a dealing room may be short in some currencies and long in others. Since the positions are kept in the same currency, say U.S. dollars, the positions will partly or completely offset each other.

However, from the point of view of volatility, this offsetting process is not sound. Currencies move in different and fluctuating degrees of correlation relative to each other. Incidental tendencies for moving in tandem do not reduce the overall exchange risk. Therefore, the gross dealing exposure must always be kept in absolute values, and its total size must be carefully managed.

EXCHANGE RISK MANAGEMENT AT THE MICRO LEVEL

Exchange risks start with the traders. A good trader knows to cut losses short and ride profitable positions. In order to ensure that losses are kept within manageable limits, certain systems are in place. The most popular measures are the position limit and the loss limit.

There are two types of position limits: daylight and overnight.

1. The daylight position limit refers to the maximum amount of a certain currency a trader is allowed to carry at any single time during the regular trading hours. There is no rule or average regarding the magnitude of the position; each bank and each treasurer may have a different policy. Each trader should have a trading limit, regardless of his level of profitability or seniority. The limit should reflect both the trader’s level of trading skills and the amount at which a trader peaks. It is less important whether the daylight limit is $5 million or $50 million than whether the trader can provide a peak performance with the respective position.

2. The overnight position limit refers to any outstanding position kept overnight by traders. As a rule of thumb, overnight limits should be smaller than daylight limits. Again, the limits are a function of the policy of the banks and their treasurers, along with the skills of the traders and their specific areas of expertise. The majority of foreign exchange traders do not hold overnight positions.

Most of the trading occurs in the spot market, in terms of number of deals, and the spot positions generally have a life span of seconds to hours.

The limits, daylight or overnight, may be increased (or decreased) temporarily by a senior officer from the treasury to better encompass special market conditions. For instance, the liquidation of the Long-Term Capital Management positions in October 1998 triggered a savage and unprecedented two-day dollar/yen collapse, while dollar/Europe showed a much smaller in-sympathy decline (see Figure 5.1). The magnitude of the slide was difficult to gauge because of the lack of both precedent and apparent reason. The reason behind the collapse and the name of the fund in trouble were hidden for many days because the fund had the largest and most complex position in fixed income and its demise came extremely close to triggering worldwide financial meltdown. The LTCM impact on FX came only from the liquidation of a very large dollar/yen position it had open in the aftermath of the dollar/yen record low in 1995. The long liquidation of the profitable dollar/yen position was supposed to alleviate losses from the closing of losing fixed income positions. Despite the magnitude of the mammoth slide—more than 400 percent of a typical daily range—most players curtailed foreign exchange trading because they feared the lack of liquidity. Those caught with even small long dollar/yen positions not protected by stop-loss orders incurred large losses, and many lost their jobs. Normal position limits had to be temporarily reduced in order to avoid unacceptable levels of exchange risk. Of course, this action further reduced the liquidity. The point is that this type of market behavior is a reality and, while it is exceptional, it must be addressed properly and continuously. It’s impossible to forecast such an event, but anyone can and should leave a stop-loss order.

Figure 5.1. The savage two-day dollar/yen collapse in October 1998 exemplifies the potential for unexpectedly high volatility in foreign exchange.

The loss limit is a measure designed to avoid unsustainable losses made by traders; it is enforced by the senior officers in the dealing room. The loss limits are selected on a daily and monthly basis by top management. Psychologically, this measure is of great help, as it removes the added pressure on the trader of deciding on the size of the loss to take in an already hectic environment.

Some traders and corporations caught the wrong way may exacerbate the pain of their loss by hoping that the market will come back to where it broke from in the first place. Hope is nice human emotion, but it has no bearing in the outcome of a large market. As Figure 5.2 shows, in the post–Bretton Woods Accord, sterling/dollar coined record highs and lows in the first half of the 1980s that have not been approached even decades later. So, think twice before blindly expecting a market to recover to your coveted levels and make sure that your stop-loss order is in place and that it can actually be executed.

EXCHANGE RISK MANAGEMENT AT THE MACRO LEVEL

Management is responsible for designing a clear set of rules encompassing the policies of risk management in a trading entity. These rules refer to the dealing room’s objectives, the methods of implementation, and the general approaches to extraordinary trading circumstances. The risk management policies must be revised regularly, or in reaction to unusual market developments. Flexibility and speed of adjustment are vital requirements in the fast-changing financial markets.

Figure 5.2. In the post–Bretton Woods Accord, sterling/dollar established record highs and lows in the first half of the 1980s.

In the case of derivatives, and especially in the case of options, market participants should enter master agreements with each other. These agreements document all the outstanding and future transactions and provide for closeout and settlement netting.

All pertinent details may be found in the International Foreign Exchange and Currency Option Master Agreement, published on June 1, 2005, by the Foreign Exchange Committee in association with the British Bankers’ Association, the Canadian Foreign Exchange Committee, and the Japanese Bankers Association. The agreement can be read its entirety at www.cfec.ca/files/ifxco_booklet.pdf.

TOTAL CURRENCY EXPOSURE VERSUS FOREIGN EXCHANGE TRADING

Banks and institutions involved in foreign exchange generally have two main sources of transactions—the total currency exposure and the actual foreign exchange trading. The total currency exposure, consisting of all the foreign denominated assets and liabilities, is generally separated from the daily trading activity for management purposes. The total currency exposure may be subject to position limits as well.

SOURCES OF RISK AND REVENUE

Foreign exchange instruments have different rates of profitability and different degrees of risk. It is management’s responsibility to select the most profitable instruments, relative to the present or projected trading capability of the desk, and to identify the specific risks associated with each instrument. Only a clear understanding of business conditions enables management to design the proper risk management policies.

MARKING-TO-MARKET

Marking-to-market is the common valuation procedure used to calculate the foreign exchange exposure at current market prices.

While normal to calculate positions and profit and loss on an end-of-day basis, it’s equally common to mark-to-market on a continuous basis. The failure to mark-to-market on at least a daily basis may have disastrous consequences. Unchecked high volatility in the foreign exchange markets is highly likely to generate insurmountably adverse trading conditions.

In the United States foreign exchange markets, a common time for selecting the end-of-day revaluation rates is 3 p.m. EDT, which coincides with the end of the trading day on the transparent IMM currency futures exchange. The common practice is to use the middle rate of a specific spot rate or forward spread, which is the arithmetic average of the bid and offer. If and when administrative costs are necessary, adjustments to these revaluations must be allowed. Using the 3 p.m. rates for closing does not mean that trading is halted at that time.

The exchange rates used for revaluations should be obtained in an objective manner. Generally, the rates should be printed and updated in the computerized systems by an independent source, such as the back office. In the larger dealing rooms, the front end–back office systems linked to reliable online financial services execute this function. This approach is important in order to avoid unrealistically favorable rate inputs by a trader, who may be tempted to improve an unrealized profit and loss. Certainly, any unrealized P&L figures have only a limited significance, but they may provide substantial warning signals. The lack of “red flags” may trigger serious surprises when the P&L is finally realized.

VALUE AT RISK (VAR)

According to Derivatives: Practices and Principles, value at risk refers to “the expected loss from an adverse market movement with a specified probability over a particular period of time.” Commonly, the potential adverse change in the value of a portfolio on a daily basis may be calculated with a probability of 97.5 percent, when using two standard deviations.

The determination of the value at risk is significant, especially for more complex foreign currency portfolios, because the results may be compared to the current financial and human resources, thus allowing for decisions on the most adequate set of risk management rules.

STRESS TESTS

Although players generally understand the unexpected rises in foreign exchange volatility, few could have forecast the dollar/yen collapse in October 1998 (see Figure 5.1). That development generated some big winners, but also big losers. To better respond to this type of situation, it is imperative that management request periodic stress tests, designed to check and prepare the traders’ handling of their positions vis-à-vis periods of unusually high or low currency volatility. The historical volatility specific for each instrument is readily available from the financial services.

EXCHANGE RISK MANAGEMENT IMPLEMENTATION

The position and loss limits are very basic management and control tools that can now be implemented better and more conveniently with the help of computerized systems. After all transactions are entered in the system, the treasurer and the chief trader have continuous, instantaneous, and comprehensive access to accurate figures for all the positions and the profit and loss. In addition, this information may be relayed from all the international branches into the headquarter terminals. Problems may occur when there is a lag between the execution and the booking of transactions.

INTEREST RATE RISK

Interest rate risk refers to the profit and loss generated by fluctuations in the forward spreads, along with forward amount mismatches and maturity gaps among transactions in the foreign exchange book. This risk is pertinent to currency swaps, forward outrights, futures, and options.

An amount mismatch between a spot deal and a forward outright deal may occur during a deal between the spot trader and a customer. If the customer asks for an odd amount dated forward, the spot trader will most likely cover in the spot market in the closest standard amount possible. The difference between the spot and the forward amount is a mismatch.

For instance, if a customer buys USD/CAD 910,000 in forward outright, a trader will most likely cover USD/CAD 1,000,000 in the spot market, because it is easier to trade an even amount, and will adjust the forward pips later. A pip is the last decimal of the exchange rate. It is the fourth decimal of the exchange rate in the case of currencies such as the euro, and the second in the case of the Japanese yen. (A pip is the last decimal of the exchange rate. It is the fourth decimal of the exchange rate in the case of currencies such as the euro, and the second in the case of the Japanese yen.) However, there is an amount mismatched of USD/CAD 90,000. This is done frequently to avoid the exchange risk. Although the exchange risk is annulled, as the same amount of foreign currency was bought and sold, for the duration of time the maturity dates are different, the party that covered only the spot side of the deal is exposed to any changes in either of the applicable interest rates (the interest rate differential). By the time the spot deal is rolled over, the forward points may move against the market maker.

A typical maturity gap occurs when a customer deals in an odd maturity (say thirty-two days) and the trader covers in one month (assume thirty-one days).

For small exchange books, maturity mismatches may easily be avoided. For an active forward desk, despite increasingly sophisticated computer systems, the complete elimination of maturity gaps is virtually impossible. However, this may not be a serious problem if the amounts involved in these mismatches are small.

On a daily basis, traders balance the net payments and receipts for each currency through a special type of swap, called tomorrow/next or rollover. This type of swap, discussed in detail in Chapter 12, is geared toward the changing, or rolling over, of the old spot date to the new spot date. It is a powerful and convenient tool for handling the flow of maturing trades.

RISK MANAGEMENT IMPLEMENTATION

To minimize interest rate risk, management sets limits on the total size of mismatches. The policies differ among banks, but a common approach is to separate the mismatches, based on their maturity dates, into up to six months and past six months. All the transactions are entered in computerized systems in order to calculate the positions for all the delivery dates and the P&L. Continuous analysis of the interest rate environment is necessary to forecast any changes that may impact on the outstanding gaps. The results of this approach are good, but not perfect.

CREDIT RISK

Credit risk refers to the possibility that an outstanding currency position may not be repaid as agreed, due to a voluntary or involuntary action by a counterparty. Insolvency or prohibition of foreign exchange transactions may trigger the failure. Examples are extremely rare, but the risk must be dealt with on a continuous basis. In modern times, it started with Bankhaus I. D. Herstatt, a small private German bank, in 1974, in the early days of FX. Beside Drexel Burnham of New York, the high-riding junk bond leader of the 1980s, a more contemporary example is the sudden insolvency of Refco in 2005. Although more commonly associated with loan departments, credit or settlement risk also pertains to the foreign exchange markets.

The maturity dates may be closer than for loans, but the same characteristics apply. Credit problems occur not only in the long-dated forward contracts, but also in spot contracts, for which payments are due in only two business days. Both the credit and the trading departments are responsible for managing credit risk, which is present in all foreign exchange instruments except currency futures and options on currency futures.

In these cases, trading occurs on regulated exchanges, such as the Chicago IMM, where all trades are settled by the clearinghouse. On such exchanges, traders of all sizes can deal without any credit concern.

In order to minimize the credit risk for instruments traded off regulated exchanges, the potential and active customers’ creditworthiness is essential because commercial and investment banks, trading companies, and banks’ customers must have credit lines with each other to be able to trade. Even after the credit lines are extended, the counterparties’ financial soundness should be continuously monitored.

Traders should use the International Foreign Exchange and Currency Option Master Agreement to document FX transactions in derivative products. See www.newyorkfed.org/fxc/fxco_adherence.pdf.

Two forms of credit risk are replacement risk and settlement risk.

1. Replacement risk occurs when counterparties of the failed bank find their books unbalanced to the extent of their exposure to the insolvent party. In order to rebalance their books, these banks must enter new transactions.

2. Settlement risk occurs because of the time zones separating nations. Consequently, currencies may be credited at different times during the day. Australian and New Zealand dollars are credited first, then Japanese yen, followed by the European currencies, and ending with the U.S. dollar. Therefore, there is the risk that payment may be made to a party that will declare insolvency (or be declared insolvent) immediately after, but prior to executing its own payments.

In this case, we are no longer facing exchange risk; we are facing a sudden disappearance of capital.

In addition to opening lines of credit selectively and constantly monitoring the creditworthiness of the counterparties, another measure is available. In assessing the credit risk, end users must consider not only the market value of their currency portfolios, but also the potential exposure of these portfolios. The potential exposure may be determined through probability analysis over the time to maturity of the outstanding position.

NETTING

Netting is a process that enables institutions to settle only their net positions with one another at the end of the day, in a single transaction, not trade by trade. It is a safer procedure, as the cash flow at maturity is clearly reduced. If a bank shows signs of payment difficulty, a group of large banks will provide short-term backing from a common reserve pool. In addition, the forward credit lines are not filled, providing room for more business.

Finally, netting is distinctly cheaper. Settlement netting should fall under a single comprehensive master agreement with each counterparty, in order to provide the maximum legal coverage for credit exposure.

IMPLEMENTATION

The computerized systems are very useful in implementing credit risk policies. Credit lines are easily monitored. In addition, the matching systems introduced in foreign exchange since April 1993 and current trading platforms are used by traders for credit policy implementation as well. Traders input the total line of credit for a specific counterparty. During the trading session, the line of credit is automatically adjusted. If the line is fully used, the system will prevent the trader from further dealing with that counterparty. After maturity, the credit line reverts to its original level.

COUNTRY RISK

Country (sovereign) risk refers to the government’s interference in the foreign exchange markets. Although theoretically present in all foreign exchange instruments, currency futures are, for all practical purposes, excepted from country risk, because the major currency futures markets are located in the United States.

This type of risk should not be confused with the risk of intervention of the central banks in the foreign exchange markets, which pertains to exchange risk. Country risk occurs when governments interfere for such reasons as currency shortage, tightening control over the banking system, freezing foreign funds on deposit, or waging war.

The example of Kuwait’s takeover by Iraq in 1990, when foreign exchange transactions (along with all other transactions) were abruptly severed, signifies the difficulty of separating credit from country risk. Of course, this old example had a happy ending—at least in the financial markets. The National Bank of Kuwait, which also had a set of books in London, made all the outstanding payments. Another example is the 1981 U.S. freezing of Iranian deposits in U.S. banks following the Iranian government’s overthrow and the taking of American hostages. Again, this is an old example, but it has become an ongoing warning for potentially rogue states against depositing money with U.S. banks.

The impact of restrictions on foreign exchange is generally great if they interfere with the normal payment setup. The failure to receive an expected payment due to government interference amounts to the insolvency of an individual bank or institution, a situation described under credit risk. However, the scale is magnified with country risk, as more banks or institutions are affected.

Since the 1980s, the trend among the major countries has been one of liberalization. But outside the major economies, controls on foreign exchange activities are still present and actively implemented.

From the trader’s point of view, it is very important to know or be able to anticipate any restrictive changes concerning the free flow of currencies. If this is possible, though trading in the affected currency will dry up considerably, it is still a manageable situation. The problem occurs at its fullest if there is an element of surprise, because the recovery of funds through litigation is a lengthy and frustrating undertaking.

Country risk falls under the joint responsibility of the treasurer and the credit department.

CONCLUSION

Foreign exchange has skyrocketed in daily turnover from a mere $5 billion in 1977 to a staggering U.S. $1.9 trillion in 2004. The industry is thus far subject to limited regulation, save for minute currency futures. In addition to these factors, the spot market moves at breakneck speed. In this huge and fast-paced trading environment, risks may be substantial, so it is imperative to have sophisticated and experienced management able to impose sound policies that are best suited for the capacity of each particular trading entity.

The wide use of front end–back office systems has greatly facilitated the implementation of risk management. Instantaneous, accurate, and comprehensive information on positions, P&L, and credit lines is available to aid in this management task.

6 Central Banks

Generally speaking, a central bank’s role is to direct the domestic monetary policy of its country. Under the monetary policy, the central bank manages the flow of money and credit that is provided to the economy. Therefore, the role of the central bank vis-à-vis the economy is paramount.

When discussing the subject of the central bank in the context of foreign exchange, there is a tendency to focus on market interventions. While interventions are very important, they represent only a fraction of the total role the central banks exercise in affecting the foreign exchange market.

Before we go any further, let’s take a look at the United States’ Federal Reserve.

THE FEDERAL RESERVE

HISTORICAL BACKGROUND

The Federal Reserve (the Fed) was established in 1913, when Congress passed the Federal Reserve Act. The act held that the role of the Federal Reserve was “to furnish an elastic currency, to afford the means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.”

The act instituted a decentralized system, consisting of the Federal Reserve Board in Washington and twelve regional Federal Reserve Banks around the country. These regional banks had sufficient autonomy to manage financial conditions in their districts and they were managed by governors.

In 1923, the Open Market Investment Committee (OMIC) was established to coordinate the Reserve Bank operations. It was composed of the governors of the Federal Reserve Banks in New York, Boston, Philadelphia, Chicago, and Cleveland. In 1930, the OMIC was replaced by the Open Market Policy Conference (OMPC). It consisted of the governors and members of the Board of the twelve Federal Reserve Banks.

The strains of World War I, the stock market crash of 1929, and the subsequent Depression of the 1930s, along with a better understanding of the effects of monetary tools, were all important factors behind changes established by the Roosevelt administration in 1933. Among those changes were the creation of the Federal Deposit Insurance Corporation (FDIC); the formal recognition of the Open Market Policy Conference (OMPC), already established in 1930; and the empowerment of the Board to change the member bank reserve requirements.

The Banking Act of 1935 reshaped the structure of the Federal Reserve System into its current form. The Board was renamed the Board of Governors of the Federal Reserve System. The Board of Governors consisted of seven governors, one of whom was chairman of the Board. Also, the treasury secretary and the comptroller of the currency were disassociated from the Board meetings. The titles of the regional Reserve Bank governors were changed to presidents, and the OPMC’s name was switched to its current name, the Federal Open Market Committee (FOMC).

The FOMC decides the short-term objective for open market operations of purchasing and selling Treasury and federal agency securities, and these operations are the Federal Reserve’s principal tool for implementing monetary policy. This objective may be the size of reserves or the level of the federal funds rate.

The autonomy of the regional Reserve Banks was curtailed with regard to government debt transaction without FOMC permission. The act also held that the Board must use its powers to generate an appropriate environment for business stability.

The Federal Reserve Bank is independent of Congress and the President. However, all Federal Reserve Governors are selected by the President and must be ratified by Congress.

In 1979 the Fed linked economic performance to the growth rates of the money supply (M1). M1 is composed of currency in circulation (outside the Treasury, the Fed, and depositary institutions), traveler’s checks, demand deposits, and other checkable deposits (negotiable order of withdrawal [NOW] accounts, automatic transfer service [ATS] accounts, etc.). In 1980, the Depositary Institutions Deregulation and Money Control Act (MCA) simplified the structure of the reserve requirements and allowed the elimination of interest rate ceilings on most of the deposits (the exception was demand deposits). By 1982, however, M1 as an economic indicator was dropped in favor of M2. M2 consists of M1 plus repurchase agreements, overnight eurodollars, money market deposit accounts, savings and time deposits (in amounts under $100,000), and balances in general purposes. Since then, the FOMC has had a love–hate relationship with M2’s ability to be a reliable economic indicator.

M3 is composed of M2 plus time deposits over $100,000, term eurodollar deposits, and all balances in institutional money market mutual funds.

As of November 10, 2005, the Board of Governors of the Federal Reserve System announced that it had ceased publication of the M3 monetary aggregate. The Board reasoned that M3 does not convey any additional information about economic activity that is not already embodied in M2. The decision was apparently made because of the high costs of collecting the underlying data. If the financial markets perceive this policy change as a cover-up for monetary expansion, then foreign central banks may further diversify their holdings away from dollars and into euros and gold.

THE FEDERAL RESERVE’S ROLE IN FOREIGN EXCHANGE

The Federal Reserve affects the foreign exchange markets in two general areas:

1. interest rates, and

2. foreign exchange operations.

FEDERAL FUNDS

Federal funds, largely known as Fed funds, are the immediately available reserve balances at the Federal Reserve. The Fed funds are widely used by commercial banks or large corporations to lend to each other on an overnight basis. Although the Fed establishes their level, the prices fluctuate because they are being traded in the market. The New York Fed discontinued publication of weekly averages of the federal funds rate as of June 30, 2004.

Foreign exchange traders generally are not concerned on a daily basis with the Fed fund prices. However, changes in their levels are considered warnings of potential changes in the currency markets.

When the Fed changes the Fed funds, it does so in cycles. Naturally, the Fed fund rates will be cut to boost the economy and hiked to slow down the economy and/or the pace of inflation.

Repurchase Agreements

Repurchase agreements (repos) are almost daily operations executed by the Federal Reserve. A repurchase agreement between the Federal Reserve and a government securities dealer consists of the Fed’s purchasing a security for immediate delivery, with an agreement to sell the same security back at the same price at a predetermined date in the future (usually within fifteen days), and at a specific rate of interest. This arrangement amounts to a temporary injection of reserves into the banking system. The repurchase agreements may be either customer repos or system repos.

Matched Sale-Purchase Agreements

Matched sale-purchase agreements are just the opposite of repurchase agreements. When executing a matched sale-purchase agreement, the Fed sells a security for immediate delivery to a dealer or a foreign central bank, with the agreement to buy back the same security at the same price at a predetermined time in the future (generally within seven days). This arrangement amounts to a temporary drain of reserves.

DISCOUNT RATE

The discount rate is the interest rate at which eligible depositary institutions may borrow funds directly from the Federal Reserve Banks. This rate is controlled by the Federal Reserve and is not subject to trading. It is a benchmark interest rate and it is always lower than the Fed funds rate.

The Federal Reserve Banks have three discount window programs to depository institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate.

PRIME RATE

The prime rate is the rate used by commercial banks as a base for retail loan rates. The prime rate is based on the discount rate; it is always higher than the discount rate.

EURODOLLARS

Eurodollars are dollar-denominated deposits at commercial banks outside the United States. All currency deposits outside the country of origin are called eurocurrencies. These deposits do not have to be placed in Europe. Therefore, yen deposits outside Japan are euroyen, British pounds outside England are known as eurosterling, etc. Eurodollars have the largest share of the eurocurrency market.

Currency deposits outside the issuing country are not a novelty. At all times throughout history, some foreign currencies had more panache for their holders. In the beginning of the twentieth century, the most popular eurocurrency was the eurosterling, because the British pound was the currency of reference around the world. The end of World War II brought the end of the supremacy of the pound and indirectly helped the rise of the eurodollar market.

In the postwar period, money was scarce. The U.S. dollar was the major currency, and demand for it was widespread. The former Communist countries, especially the former Soviet Union, kept dollar deposits in London. Events in 1957—debilitating British inflation and the Suez crisis—triggered capital controls in the United Kingdom. But the Soviet Union was in no rush to move its dollar deposits from London to New York, because it feared that the United States would freeze these deposits in retaliation for the expropriation of American property in the Soviet Union.

The name “eurodollar” seems to have been coined inadvertently by a French branch of a Soviet bank, La Banque Commerciale pour l’Europe du Nord, S.A., which had as its international cable code “Eurobank.” Somehow, the name stuck with traders and has been used ever since.

United States legislation was also instrumental in the growth of this market. The Federal Reserve had passed Regulation Q, which prohibited payment of interest on demand deposits and prescribed maximum rates that banks can pay on time deposits. These ceilings had been imposed since 1933 by the United States government. According to “A Guide to Federal Reserve Regulations,” published by the Board of Governors of the Federal Reserve System, “federal law prohibits the payment of interest on demand deposits by member banks.” Regulation Q defined “interest” and restated the prohibitions. In addition, Regulation Q included rules governing the advertising of deposits by member banks. Regulation Q is no longer applicable.

When the European countries returned to free convertibility in 1958, U.S. dollars were still kept in deposits in Europe, to avoid the capped interest rates in the United States. In addition, the investment opportunities were better in Europe, where the economies had been rebuilt. Finally, the eurodollar deposits filled the niche for short-term money market instruments in Europe.

Eurodollar deposits can be created by any depositors of U.S. dollars outside the United States, regardless of whether they are American or not. For instance, they could be foreign holders of U.S. dollar deposits at American banks transferring these deposits to foreign banks, or American citizens receiving checks drawn on accounts in U.S. banks and depositing them in foreign banks.

Eurocurrencies’ rates are used by forward traders to calculate the forward spread. The formula for the forward spread is:

If the result is a positive number, then the forward spread is at a premium, and it is added to the spot price. Conversely, if the result is negative, then the spread is at discount, and it is subtracted from the spot rate. Forward spreads are covered in detail in Chapter 12.

FOREIGN EXCHANGE OPERATIONS

The major central banks are involved in foreign exchange operations in more ways than intervening in the open market. Their operations include payments among central banks or to international agencies. In addition, the Federal Reserve has entered a series of currency swap arrangements with other central banks since 1962.

The major central banks do not engage in speculative trading. Intervention in the United States foreign exchange markets by the U.S. Treasury and the Federal Reserve is geared toward restoring orderly conditions in the market or influencing the exchange rates. It is not geared toward affecting the reserves.

If, for intervention purposes, the Federal Reserve buys dollars, then it drains reserves. If it sells, then it adds reserves. The intervention is split equally between the Federal Reserve and the Treasury. If the Treasury pays for its portion in currencies from the Exchange Stabilization Fund, the intervention will not have any impact on the reserves. If the intervention is financed through a sale of special drawing rights (SDRs) from the International Monetary Fund (IMF), then it adds reserves. The change in reserves occurs because the sale of the SDRs, which are financial assets, creates money. Reserves are also increased if the Treasury exchanges foreign currencies for U.S. dollars with the Federal Reserve with the agreement to repurchase them at the same rate. This technique, called warehousing, adds reserves because the Treasury invests the funds.

The Foreign Exchange Desk at the Federal Reserve Bank of New York executes the actual intervention. There are two types of foreign exchange interventions: naked intervention and sterilized intervention.

Naked intervention, or unsterilized intervention, refers to the sole foreign exchange activity. All that takes place is the intervention itself, in which the Federal Reserve either buys or sells U.S. dollars against a foreign currency. In addition to the impact on the foreign exchange market, there is also a monetary effect on the money supply. If the money supply is impacted, then consequent adjustments must be made in interest rates, in prices, and at all levels of the economy. Therefore, a naked foreign exchange intervention has a long-term effect.

Sterilized intervention neutralizes its impact on the money supply. As there are very central banks that want the impact of their intervention in the foreign exchange markets to affect all corners of their economy, sterilized interventions have been the tool of choice. This holds true for the Federal Reserve as well.

The sterilized intervention involves an additional step to the original currency transaction. This step consists of a sale of government securities that offsets the reserve addition that occurs due to the intervention. It may be easier to visualize it if you think that the central bank will finance the sale of a currency through the sale of a number of government securities.

In addition to selling government instruments to balance the reserve injection, a central bank has two other alternatives—printing money and writing a check to itself. Although central banks are entitled to do so, these are not actual alternatives to be considered, because of the grave consequences on inflation.

Because a sterilized intervention only generates an impact on the supply and demand of a certain currency, its impact will tend to have a short- to medium-term effect.

REASONS FOR FOREIGN EXCHANGE INTERVENTIONS

It is vital for traders to understand the reason behind central banks’ interventions so they can protect their outstanding positions and capitalize on the opportunity. Some assume that central banks typically intervene to protect their currencies. This is not always a valid assumption. Central banks may intervene for the following reasons:

- to provide market liquidity,
- to protect a certain level,
- to slow down movements, or
- to reverse a trend.

Providing Market Liquidity

When a crisis hits a currency pair, the FX market might become disorderly, with one of the price sides, bid or offer, disappearing. A central bank might intervene to provide the missing side of the price. There is no guarantee the bank will operate this way, but it is an operation it might undertake on special occasions. Therefore, the impact is likely to be short-lived, as the central bank’s goal would be to provide a safety exit for traders who got caught the wrong way, not to change the direction of the market.

Protecting a Certain Level

Central banks have long since lost their 1980s ability to tell the market what range it can trade in. Range or level protection took a further step back after the ranges of the EMS currencies against the deutsche mark merged into the euro on January 1, 1999. Nevertheless, central banks still attempt to support certain levels, although on a spotty and covert basis.

Slowing Down Operations

Central banks may execute slow-down operations when they don’t mind either the direction or the exchange level, but rather the speed of movement. When a currency falls too fast, for instance, the bank might buy small amounts to slow down the descent. Traders can use the opportunity to load up on cheap currency and then sell it back after the intervention.

Reversing a Trend

Few central banks are ready and willing to intervene with this lofty goal in mind. FX markets are too big and sophisticated to give up the fight hands down. The best example of when central banks were successful was the complex, joint, and long-term intervention that followed the Plaza Accord that reversed the dollar uptrend. But that happened decades ago.

AN OVERVIEW OF THE CENTRAL BANKS OF THE OTHER G-7 COUNTRIES

In the wake of World War II, both Germany and Japan were helped to develop new financial systems. Both countries created central banks that were fundamentally similar to the Federal Reserve.

THE EUROPEAN CENTRAL BANK (ECB)

The European Central Bank (ECB) was set up on June 1, 1998, to oversee the ascent of the euro, and was designed in the mold of the former German central bank, the well-regarded Bundesbank. The ECB’s main role is to maintain the euro’s purchasing power and thus price stability in the Eurozone. During the transition to the third stage of economic and monetary union to introduce the single currency on January 1, 1999, it was responsible for carrying out the Community’s monetary policy. The ECB, which is an independent entity, supervises the activity of individual member European central banks, such as Deutsche Bundesbank, Banque de France, and Ufficio Italiano dei Cambi. The ECB’s decision-making bodies run a European System of Central Banks whose task is to manage the money in circulation, conduct foreign exchange operations, hold and manage the Member States’ official foreign reserves, and promote the smooth operation of payment systems. The ECB is the successor to the European Monetary Institute (EMI).

BANK OF JAPAN (BOJ)

The Bank of Japan, established in 1882, was designed to maintain price stability and to ensure the stability of the financial system, in order to preserve economic growth. The Bank of Japan tends to be the G7 central bank most inclined to intervene in FX. However, it still does so only on very rare occasions.

BANK OF ENGLAND (BOE)

The Bank of England, founded in 1694, strives to promote and maintain monetary and financial stability to preserve a healthy economy. However, the BoE has had statutory responsibility for setting the U.K.’s official interest rate only since 1997. It changes rates through its Monetary Policy Committee.

BANK OF CANADA (BOC)

The Bank of Canada is an independent central bank, founded in 1934, that has a tight rein on its currency. The BoC has five main areas of responsibility: monetary policy, banknote issuance, financial systems, fund management, and a retail debt program.

7 Price Structure and Foreign Exchange Terminology

This chapter presents the typical terminology in foreign exchange, from bids and offers in different instruments to the leave orders left by corporations and in the interbank market. Whereas the definitions of bids and offers are very basic and generally known in the spot market, the definitions can change in the case of other instruments. The differences are explained in this chapter.

SPOT MARKET

A spot deal takes place between two parties who deliver a certain amount of different currencies to each other, based on an agreed exchange rate, within two business days of the deal date. The exception is the Canadian dollar, in which the spot delivery is executed within one business day because Canada shares similar time zones with the United States.

Let’s take an example in the spot market. A bank quotes the USD/CHF at 1.3000/1.3005 on a monitor. In this case, the bank’s bid is 1.3000 (left side), which means that the bank is interested in buying USD/CHF at this price. The bank’s offer is 1.3005 (right side), which means that the bank is interested in selling USD/CHF at this price. The difference between the bid and the offer is called the spread. In our example, the spread between 1.3000 and 1.3005 is five pips.

Keep in mind that the prices on the monitors and at times even on individual bank platforms may not be binding. Although fairly accurate, they may be displayed as suggested prices only. If a bank posts the prices during a slow market, it is possible that it will also quote those rates in interbank dealing. Naturally, banks may be unable to update prices in a fast market, allowing for gaps between the monitor rates and the quoted prices.

A customer calls this bank for a price in USD/CHF and is quoted 1.3000/05 (short for 1.3000/1.3005). If the customer wants to buy, he or she will take the offer at 1.3005. If selling, the customer will sell at 1.3000. Conversely, if you set the price at 1.3000/05, then your bid is 1.3000, and your offer is 1.3005.

FORWARD MARKET

A forward transaction takes place between two parties who deliver a certain amount of different currencies to each other, based on an agreed exchange rate, generally past two business days of the deal date. In the forward market, a trader must be a little more careful about the meaning of bids and offers. If you quote a forward price in foreign currency, your bid is on the left side and the offer on the right side, provided that the amount traded is quoted in foreign currency. If the amount is quoted in U.S. dollars, then the right side is your bid and the left side is your offer. In order to cope with this sometimes confusing reversal, just remember that buying U.S. dollars is equivalent to selling foreign currency, and vice versa.

Example:

USD/JPY

Spot price       120.00–120.05

Forward price  20–25

If you quote 20–25, a counterparty can sell you Japanese yen 250,000,000 at 20 (your bid for foreign currency), or buy Japanese yen 250,000,000 at 25 (your offer for foreign currency), just as in the spot market. However, the counterparty can also sell you $2,000,000 at 25 (your bid for U.S. dollars), or buy $2,000,000 at 20 (your offer for U.S. dollars).

We discuss forward pricing in appropriate detail in Chapter 12.

NON-DELIVERABLE FORWARDS

Non-Deliverable Forwards (NDFs) are forward FX contracts executed in some nonconvertible emerging currencies which do not require physical delivery. At maturity, the parties settle the difference between the forward outright rate and the current spot rate in the convertible currency.

NDFs allow traders to avoid execution risk, except at the fixing at maturity, and country risk. In addition, there is typically no spread between the bid and the offer at maturity, as the NDFs are normally settled against current market rate.

FUTURES MARKET

Currency futures are a special case of forward outright transactions, or exchange deals that mature past the spot value date.

In the spot and forward markets, currencies are quoted in either European terms (i.e., Japanese yen) or American terms (i.e., British pound), depending on the generally accepted norm.

In the futures market, prices are quoted only in American terms. The bids and offers are quoted similarly to spot prices—the bid is on the left side, and the offer is on the right side. For example, if you quote Japanese futures at .8330/.8335, it means that you want to buy at .8330 and sell at .8335. If you want to trade, and this price is quoted to you by another party, you can sell at .8330 and buy at .8335. Currency futures are discussed in Chapter 14.

FOREIGN EXCHANGE TERMS

Communicating in the foreign exchange markets is an exact and minimalist matter. It could not have been any other way, given the high volatility and the high number of daily transactions.

If trading on platforms, you simply click on the “buy” or “sell” icons.

If trading on matching systems or on the phone, the following lingo is common.

SELLING

To sell, the following terms are used:

- If you hit a bid, you say or write:
“Yours,” or
“I give you,” or
“I sell.”

- If you want to sell in the brokers’ market without hitting the bid, then you say or write:
“Offer join for X amount of currency,” or
“I sell X amount of currency at (a lower offer than the current one).”

Joining or improving the offer does not guarantee the execution.

BUYING

To buy, the following terms are used:

- If you take an offer, you say:
“Mine,” or
“I take,” or
“I buy.”

- If you want to buy in the brokers’ market without taking the offer, you say or write:
“Join the bid for X amount of currency.”
“I buy X amount of currency at (a higher bid than the current one).”

Of course, joining the bid or improving the bid in the brokers’ market does not guarantee execution.

PRICE CHANGING

If you want to change the price, several options are available to you.

1. On the dealing machine, you hit the “Interrupt” key. Once this appears on the screen, the price is no longer valid.

2. On the dealing machine, on your PC, or on the phone, you can write or say “Change” or “Off” to withdraw your price.

If the counterparty still wants a quote, he or she will ask you either “How now?” or “How are you left?” or “Where are you now?”

On platforms you’ll just have to rush to delete your order.

LEAVE ORDERS

Corporations, funds, high net-worth individuals, and banks leave currency trading orders with other banks, trading firms, and even brokers because they cannot trade directly in the interbank market. Of course, they also have the option to request a two-way price and trade on that quote.

Even banks may leave orders with other banks, either because it is not efficient for them to trade certain currencies or because they want to maximize the chance of execution by working their orders twenty-four hours a day. For instance, a bank specializing in the Scandinavian currencies that receives an unusual request for a Japanese yen order might be better off leaving the order with another bank that has an active Japanese yen desk, rather than allocating untrained personnel to follow that yen item.

Working currency orders around the clock is a common practice among large banks. If the orders are not executed in a certain market, the order book is transferred to a branch, a subsidiary, or another bank in the next time zone. Provided that those orders are still not executed, then the transfer will continue to the next time zone, until the time circle is complete—New York, then Sydney or Tokyo or Singapore or Hong Kong, then London or Frankfurt or Zurich.

Order execution is obviously very important. To be properly done, it is important for the parties involved to agree on the assignment of risk before the order transfer. Both parties must be clear on what they want and what they can expect from each other.

There are two types of leave orders—profit-taking and stop-loss.

Profit-Taking Orders

Profit-taking orders may mean two different things. A trader who is long (had bought) USD/JPY 5 million at 104.00 may leave an order to sell USD/JPY 5 million at 105.00, as the trader wants to sell at a price currently unavailable to realize a profit. In this case, the trader had a position prior to leaving this order. This is an exit or position closing order.

Second, a trader may leave an order to buy or sell a currency at a price currently unavailable, without having a prior position. For instance, a trader may believe that if the GBP/USD reaches 2.0000, it is a good selling opportunity, and so leaves a selling order overnight to sell GBP/USD 3 million at that level. This is an entry order.

How does one check on the execution of the leave orders? For a bank, the best approach is use several reliable feeds to check on what the overnight trading ranges were and to check the low on the matching systems. For a corporation, the best approach is to ask several banks what the overnight trading ranges were. If the order is well within the trading range, there is no problem.

Potential problems occur when the leave order falls on the extremes of the overnight ranges. For instance, a bank’s leave order is to buy euro/dollar 5 million at 1.1500, and the overnight range from one source is 1.1500/1.1650, and 1.1501/1.1647 from another. The bank with which the order was left says that at 1.1500 only EUR/USD 2 million were bought for someone else. The leave order was, regrettably, not executed.

Was your order executed or not?

The bank with which the order was left must have access to at least one of the sources for which the low was 1.1500. Also, the two banks should have agreed on the execution rules in advance. If the agreed-upon format gives the counterparty execution latitude, then the bank leaving the order has most of the risk.

Some banks prefer to consider the order executed, based solely on price range, not on liquidity. Therefore, if 1.1500 was given, then the order was filled, despite the fact that only one other source reported that level as the low. In this case, the bank executing the order takes the full risk.

Why would a bank take this approach? Perhaps that bank would like to improve the trading relationship with the counterparty; or it might have a large book of customers, which enables it to protect itself. If there are several orders to buy around 1.1500—EUR/USD 90 million at 1.1520, EUR/USD 200 million at 1.1510, and EUR/USD 120 million at 1.1505, for instance—the chances that 1.1500 will be traded are rather small.

Both approaches are valid, as long as the parties agree beforehand on the assignment of risk.

Stop-Loss Orders

Stop-loss orders generally are position exiting orders under adverse market conditions. Following up on the previous example, assume you bought EUR/USD 5 million at 1.1500. The EUR/USD was very steady throughout the day. You left two overnight orders: a profit-taking order to sell EUR/USD 5 million at 1.1600, and a stop-loss order to sell EUR/USD at 1.1450. If your forecast that the EUR/USD will rally to 1.1600 is wrong, then you will limit your loss on the downside by closing your position at or below 1.1450.

Stop-loss orders can also be used as position entry orders. If you don’t have a current outstanding position, and if you expect the market to make a significant move once a certain level breaks, you can leave a so-called stop-loss order close to that specific level to enter a position.

For instance, let’s assume that your previous order to buy EUR/USD 5 million at 1.1500 was not executed overnight. During your trading day, however, the EUR/USD fell to 1.0440 and remained there for the balance of your trading day. You still expect the EUR/USD to rally, but you are afraid that the 1.1500 level turned from a support level into a resistance level once it was broken. Therefore, you may leave an overnight stop-loss order to buy EUR/USD 5 million at 1.1515.

Please notice that the order is placed at a higher level than the initial 1.1500. This is done to avoid potential resistance at 1.1500.

It is more difficult to execute stop-loss orders than profit-taking orders. Chances are that stops are placed at significant levels that are used by many other traders. Once those levels are reached, large stop-loss orders are going to be triggered, making it close to impossible to execute your order precisely at the requested level. Therefore, it is extremely important to have clear agreements on the type of execution.

There are four types of stop-loss order execution: next best price, at the price, discretion for range to trader, and at best.

- Next Best Price. The stop-loss order kicks in after the requested level was reached. The trader executing the order must trade on the next available price. Under this format, the risk is borne fully by the customer, who has no guarantee as to whether the order will be filled 3 or 30 or many more pips away from the targeted price. This approach may leave room for argument, as the trader may return the customer a worse execution than the actual market deal.
For example, if the stop-loss order is to sell GBP/USD 3 million at 1.5000, a fill will have to be acceptable at 1.4990, but not at 1.5000. The customer wants to be sure that the 1.5000 support level was really broken before exiting the position. This type of stop-loss order is most common.

- At the Price. The stop-loss order must be executed at the precise requested level, regardless of market conditions. The full risk is in the executor’s court. For example, if the stop-loss order is to sell GBP/USD 3 million at the 1.9000, even if the market dropped to 1.8900 under very hectic conditions and the 1.9000 bid was never posted, the order is considered to be filled. Traders may take a position to try to execute the order even if the specific price is not available in the market, but brokers cannot. If the price is not available, a broker simply cannot execute the order. The price is said to have gapped out. This approach is very rarely implemented.

- Discretion for Range to Trader. This approach is an imperfect hybrid of the first two types of stop-loss orders. The trader—either a bank or a trading firm, but not a broker—has a number of discretionary pips within which the order has to be filled. The customer usually decides the number of discretionary pips, and whether the currency price must be traded before execution.
For example, if the stop-loss order is to sell GBP/USD 3 million at 1.5000, the customer may do one of two things:

1. Instruct the trader to wait until 1.5000 is given, to wait until 1.5000 is offered, and then to fill the order within 5 pips from the level. In other words, the stop-loss order is shifted from 1.5000 to 1.4995.

2. Instruct the trader to fill the order at any price between 1.5000 and 1.4995.

The downside is that, realistically, it is close to impossible to fill a stop-loss order only a handful of pips away from a significant price level, especially if that level must first be traded and then offered, as in our example. Therefore, the trader’s discretionary buffer pips are canceled, and most of the risk is borne by the trader.

- At Best. Both profit-taking and stop-loss orders can be executed at best. This means that the trader wants to trade regardless of the price. This type of order is placed in a fast market, where specific price levels may not be seen and the need for exiting or entering a market takes precedence over the choice of price.

8 Corporate Trading

Willingly or not, corporations are significant players in foreign exchange. While currency hedging still constitutes the majority of their interest, active market participation is becoming an increasingly attractive activity among corporations of different sizes. Foreign exchange is slowly evolving from its old status as a cost of business to a legitimate source of profit.

THE ROLE OF FOREIGN EXCHANGE FOR CORPORATIONS

Currency traders start from no position, so they must buy risk in order to make a living; but corporations start from a given position and try to minimize the risk. Corporate customers do not trade among themselves the way banks do. They reach the market via commercial or investment banks.

Corporate interest in foreign exchange derives from several sources. First, companies may need to make payments for raw materials, labor, advertising, distribution, or profit repatriation, to name a few of the typical natural needs to exchange currencies. Second, future expected payments might be hedged in order to eliminate or minimize the risk of adverse currency movement. Finally, corporations may want to enhance their performance by entering foreign exchange markets purely to take advantage of expected currency fluctuations—in other words, to speculate. As currencies are an asset class, corporations are increasingly major foreign exchange players.

Unlike banks, corporations do not trade in-and-out all day long. Their outlook tends to be longer-term, not spot-oriented. The longer-term approach is valid for hedging, covering their commercial needs, and speculation.

TYPES OF CORPORATIONS

There are many types of companies involved in foreign exchange: small and large, single foreign currency–oriented and multicurrency-oriented, national and multinational. There are product makers, such as electronic services and software; consumer service firms, and investment funds. Corporations may have a temporary or long-term interest in international business.

Due to the complexity and speed that characterize the contemporary economy, these factors may overlap or quickly change. For instance, many equity and fixed income funds used to have a predominant focus on local markets. Some of the more internationally oriented funds had diversified primarily in the G-7 countries—the United States; the Eurozone’s Germany, France and Italy; Japan; the United Kingdom; and Canada. Economic and political developments since 1989, notably the fall of Communism in Eastern Europe and the economic rebirth in South America and Southeast Asia, created new high-growth stock markets and, consequently, new investment opportunities for equity, fixed income, and currency funds.

TYPES OF EXPOSURE

Exposure reflects the potential effect of currency fluctuations on shareholders’ equity.

There are three types of exposure: transaction or exchange exposure, economic exposure, and translation exposure.

TRANSACTION EXPOSURE

Transaction or exchange exposure, which is equivalent to exchange risk in the interbank market, reflects the potential profit and loss generated by current foreign exchange transactions of both national and international corporations.

Managing Transaction Exposure

To manage the exposure generated by currency transaction, management must have a clear set of rules in place. Several questions must be answered thoroughly.

- Do we want the risk?

- Can we shift the risk?

- If we can’t shift the risk, how much risk do we want to accept?

- What is our expectation for each of the currencies to which we have an exposure?

- What is the best strategy for handling the currency exposure?

- How can we implement this strategy?

The risk may be shifted if the overseas prices can be charged in U.S. dollars rather than foreign currency. Another approach could have been to enter a partnership with a local entity and convince it to take the currency risk. Provided that neither of these approaches had been taken, a company must decide whether to hold the foreign currency position with full, partial, or no hedging, or to exchange the money into U.S. dollars at once.

In order to make this decision, management would have to form a view on the behavior of the British pound vis-à-vis the U.S. dollar. A historical chart of the past decade could have indicated that the British pound had been overvalued against the U.S. dollar. Additional fundamental information regarding the state of the British economy vis-à-vis the American and European economies would have shown weak results. A fair conclusion would have been that the British pound was headed down. Therefore, management could have sold the cable in the spot market for U.S. dollars at the earliest possible time, or could have entered a forward outright deal based on a GBP/USD spot exchange rate.

If management expects the foreign currency to devalue versus the base currency, then the position in the foreign currency must be exchanged quickly at the current rates. Conversely, should management expect the base currency to ease vis-à-vis the foreign currency, then the position should be translated to the base currency at a later date.

These approaches assume that the receipts in foreign currency have to be repatriated into the base currency, U.S. dollars. However, if the foreign currency receipts can be invested in the foreign currency, the transaction exposure is eliminated, reduced, or postponed, depending on the situation.

ECONOMIC EXPOSURE

Economic exposure reflects the impact of foreign exchange fluctuations on the future competitive position of national and international companies.

For instance, let’s take the example of IBM personal computers. Developed in the United States, they had the largest segment of the world market in the early 1980s. The high and increasing value of the U.S. dollar in this period had a strong negative effect on IBM’s capacity to export PCs abroad. This was a window of opportunity for the competition, which managed to assemble surprisingly accurate clones at much lower prices. IBM not only reacted slowly to what seemed to be meek competition in the international markets, but ended up seeing its share of the domestic market reduced as well.

By the time the G-5 countries capped the U.S. dollar’s rise in September 1985 and eventually devalued it by approximately 67 percent by the spring of 1995, IBM had already lost its competitive edge in personal computers. It exited that market completely. We now all know and use Dell PCs, and can barely recall IBM laptops or PCs.

Managing Economic Exposure

Managing economic exposure is a complex and long-term task. The decision depends on the degree of elasticity of demand for specific goods, the time available for adjustment, and the direction of the base currency relative to the operational foreign currency. The base currency is the currency against which other currencies are quoted. The rule of thumb is, the more inelastic the demand, the longer the time needed for adjustment.

If demand for a product is strong in a particular market, a price increase will have a limited negative impact on demand. For example, despite the strength of the U.S. dollar in the mid-1980s and its record weakness in the mid-1990s, the demand for American commercial airplanes was not really affected. Of course, the industry’s nearly monopolistic position in the world helped as well, but that advantage has since been diluted by Europe’s Airbus.

At the other end of the spectrum is elastic demand. American demand for domestic cars has fallen drastically in favor of Japanese automobiles. The shoddy quality of American cars and the oil crisis were significant factors in the 1970s and early ‘80s, and they remain ingrained in customers’ minds in the twenty-first century.

Time for adjustment is crucial. Management may consider importing parts or even building assembly plants abroad in order to take advantage of the lower prices generated by the exchange rates. For instance, when faced with steeply declining profits due to the revaluation of the yen against the U.S. dollar, Japanese producers built assembly plants for consumer electronic products in Southeast Asia—where currencies were pegged or semipegged to U.S. dollars and labor cost only a fraction of what it would have in America and even in the United States, in the case of some auto assembly plants.

Where does foreign exchange fit in this puzzle? Consumers tend to care less about the exchange rate of their domestic currency than they do about their domestic prices, even though this rate is a significant determinant of the total price of the product. When faced with the choice between a domestic product and an import, consumers generally focus on which product has better features and a better price.

Management must have a good sense of the direction of the base currency relative to the operating currency. Based on an accurate analysis of the price elasticity of demand, expected exchange rate direction, and time to adjust, management should be able to set a sound long-term strategy. Current economic, financial, and political events must be continually monitored in order to better adjust this strategy.

A flexible approach to minimizing economic exposure is paramount, given the potentially severe swings in the currency markets.

TRANSLATION EXPOSURE

Multinational companies naturally have a variety of multiple currency exposures generated by their international subsidiaries and branches. For consolidation purposes, all these exposures are translated into a single currency—the base currency. Translation exposure reflects the risk of change in the consolidated corporate earnings as a result of past volatility in the base currency. Currency fluctuations may be sizable enough to generate challenging problems for corporate management. Several accounting rules attempted to solve this thorny issue.

FASB 52

The Financial Accounting Standards Board’s Statement Number 52 (FASB 52) was designed in 1981 to move the foreign exchange P&L from current income into shareholders’ equity.

The P&L resulting from foreign exchange translations is generally contained in an equity account until the investment is liquidated. However, the translation of the foreign exchange P&L may be deferred if the affiliate is a separate entity. This approach is taken for corporations that operate in currencies other than the U.S. dollar. The operating currency, usually the local currency, is called the functional currency. When a corporation has several units, it may use different functional currencies.

However, if one of the functional currencies happens to be a highly inflationary one, management should remeasure the results in the reporting currency. In addition, if the functional currency is actually U.S. dollars, then the foreign exchange fluctuations are reflected in current income. For more details, contact www.fasb.org.

HEDGING

To hedge or not to hedge, that is the question. The answer depends on a variety of factors, because some corporate investors are comfortable with a full currency hedge while others avoid hedging as useless and costly. Hedging decisions vary, depending on the time frame, the volatility of currency, the market view on the specific currency, management’s level of sophistication, and the level of risk a company is willing to take.

The expected time frame of the position to maturity is an important factor in deciding whether to hedge. Certain equity fund managers are reluctant to hedge the currency side of investments held for three or more years—the general definition of “long term”—but are eager to hedge short-term investments.

What is best? It depends. In the short term, the British pound lost 15 percent of its value within days in September 1992, and 25 percent in about two months. One and a half years later, the currency was quoted at the same levels. In September 1985, dollar/yen was traded at 262. In the long term, about ten years later, the U.S. dollar could fetch only 80 yen, or less than two-thirds of its old value, and while recovering eventually, it never reached its initial levels. In October 1998, dollar/yen fell over 17 percent in only two days from a high of 130.71, and it took more than three years to revisit that level. And a one-day drop of 3 percent in December 2005 has still failed to be recovered by the time of this writing.

It should be stressed that time, as a hedging factor, should only be considered along with the type of currency and the view of the specific currency. Used alone, the time factor may be unreliable.

Some currencies are more volatile than others. The management of a German company operating in both Switzerland and Japan may not feel hard-pressed enough to hedge the Swiss franc (CHF) against the euro, but it would surely consider it against the yen (JPY). While the Swiss franc tends to have a high correlation with the euro due to their economic links, generating somewhat more subdued fluctuations on the EUR/CHF cross, the correlation between euro and yen is much lower, which allows for much more fluctuation on the EUR/JPY cross.

If management perceives that the operating currency is expected to perform adversely, and therefore that the outstanding position is at risk, then it must decide on a hedging strategy. To achieve an accurate view of the market, management should use the forecasting techniques explained in Chapters 17 to 28.

Management’s level of sophistication, both in personnel and equipment, is crucial in making hedging decisions. The implementation of a hedging strategy, or the performance of the unhedged outstanding positions, must be closely monitored. At the simplest level, the position must be marked to the market at least on a daily basis. The individuals in charge must have the necessary skills, along with full access to the decision support systems, such as running rates and information and adequate software for management and control. Contingency plans for unexpected developments must be in place.

If the outstanding position is not fully or entirely hedged, stop-loss orders must be established and enforced. Conversely, the hedge may be raised if it prevents the outstanding position from generating a profit, and if the elimination of the hedge itself does not neutralize the expected profit.

The level of risk that management is willing to accept differs considerably among companies. It depends on the corporate objective regarding a specific position, the degree of diversification within the compound position, and the financial capacity to withstand adverse market behavior.

In terms of corporate objectives, management must determine whether the hedge is passive—that is, purely designed to insulate the outstanding position from the foreign exchange fluctuation—or active, meaning that it is designed to enhance the profit of the original position. The objective of a passive hedge is to realize a small profit. This type of hedge may be achieved through forward outright, futures, swaps, or options contracts. An active hedge will take more risk and is also implemented with forwards and options.

Currency overlay is also in demand because of investment and risk management trends. Currency overlay is providing an alternative source of uncorrelated returns and expected returns of traditional asset classes have declined.

FASB 133

According to the FASB summary, the FASB 133 was issued in 1998 to establish accounting and reporting standards for derivative instruments for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and that it measure those instruments at fair value. Under certain conditions, a derivative may be specifically designated as a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign-currency-denominated forecasted transaction.

For a derivative designated as hedging the foreign currency exposure of a net investment in a foreign operation, the gain or loss is reported in other comprehensive income as part of the cumulative translation adjustment. The accounting for a fair value hedge applies to a derivative designated as a hedge of the foreign currency exposure of an unrecognized firm commitment or an available-for-sale security. Similarly, the accounting for a cash flow hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of a foreign-currency-denominated forecasted transaction. For more details, contact www.fasb.org.

HOW FOREIGN EXCHANGE IS EXECUTED

Corporations do not generally trade among themselves. Corporations reach the currency markets through commercial and investment banks. Corporate customers trade in two ways—they ask for a price and trade directly, or they leave an order with the bank.

Corporations do not usually contact the traders directly. The two parties are generally linked by the banks’ sales force. These corporate traders have a multitude of tasks. They make cold calls to prospective customers, advise, take orders from customers and pass them to traders, and confirm the orders’ execution with the customers.

Corporate customers are very important to banks. Foreign exchange traders welcome the orders as a means of gauging cash flow and of enhancing their own profits. When the size of an order is large, a trader gets a good “feeling” about the cash flow.

Patterns of profit repatriation, for instance, are often quite important, at least in the short term. An example is the profit repatriation by Japanese companies, a commercial need. The Japanese fiscal semesters end in March and September. In order to repatriate their profits, Japanese companies must purchase yen, generally against U.S. dollars but also versus other major currencies, prior to these dates. Once the new fiscal semesters start in April and October, the Japanese yen is sold again for hedging purposes.

Despite spotty occurrence on the charts, this type of pattern is generally important to foreign exchange traders not only in terms of temporal repetition, but also in terms of transaction size. Because the total of Japanese exports to the United States is so large, it follows that the amounts of U.S. dollars that must be sold for Japanese yen are quite significant.

As part of their daily strategy, traders also use corporate orders. If the orders are placed at crucial support or resistance levels, traders may also deal at these levels after customer orders are filled. Therefore, both players—the corporation and the trader—will benefit from the execution of customers’ orders.

The quality of the price that banks quote their customers is a function of several factors. First, it depends on the importance the bank’s management attaches to specific customers. Customers gain in stature when they trade regularly, avoiding calls only to pick the tops and bottoms, and share significant information. The sales force generally reciprocates not only by getting better prices from traders (“Special price for this customer, mate!”), but also by quickly informing the customer of unusual market changes before the rest of the market is informed. The opposite is true when corporations have a habit of pulling orders off just before execution or throwing their weight around with the sales force.

Second, the quote for the customer reflects the position of the bank, along with the individual position. Therefore, the quote may reflect marginal (about 1 to 5 pips) skews from the running market prices. Finally, the quote to the corporate customer must reflect the long-term importance of the business relationship.

Some banks quote their customers the market running prices, similar to quoting in the interbank. The spread between the bid and offer is tight, typically below 5 pips. This approach generally occurs in the case of larger orders. In this case, there is no commission for the bank. If the orders are large, for instance over $100 million, then the trader may not gain 1 or 2 pips, but will benefit from the flow information instead.

Other banks have an understanding with their customers to quote the running market prices. Once the deals are executed, the banks charge a fixed commission of 1 or 2 pips. This approach, which ensures some income for the bank, encourages the trader to quote the price without any personal distortion. This approach seems to be the fairest to all parties involved. The company receives the “real” price, the trader does not have to disrupt his or her trading trying to “read” the customer, and the corporate salesperson does not have to skew the price, because the commission is built in.

Yet another quoting approach is to widen the spread between the bid and the offer. This approach limits the risk of the trader, since it offers the buffer of several pips against any adverse currency fluctuations.

The general consensus regarding the prices quoted by banks to corporate customers is that the larger the amounts, the tighter the spread of the quotes. In the interbank market, it is more difficult to trade $500,000 than $10 million. To partly compensate for small size, some traders may quote spreads of 10 pips or more for small amounts.

In the past, corporations would call the banks and tell them not only the currency and amount they wanted to trade, but also whether they wanted to buy or sell. Currently, few large companies will mention which side they need, if they want to trade directly, and some of them behave similarly to the large banks. They call several banks or request quotes on Internet platforms at the same time and pick the most advantageous price. This approach is not warmly received by traders because they have no margin of profit if the deal is executed, and no information if the deal goes to a different bank.

When a customer has a relatively small order to execute, perhaps less than $1 million, it is more advantageous to mention the side of interest. When this is done, traders tend to quote a better price than the customary ones reserved for small amounts.

A professional, courteous, and quick response by the sales force usually goes a long way in cementing long-term, stable business relationships.

DIFFERENT POINTS OF VIEW

In the regular foreign exchange market, the major market participants are traders, corporate traders, corporations, and brokers. Let’s see how their points of view differ.

TRADERS

Traders attempt to translate the impact of different fundamental and technical factors on the currencies and to seize the opportunities in these markets. They need volatility. The direction of the market and the price levels are very important to traders.

CORPORATE TRADERS

The economic and technical data and market behavior are important to corporate traders only for advisory purposes. They need some volatility to generate more corporate sales, but they prefer moderate volatility in a two-way market, which attracts more customer orders.

CORPORATIONS

Generally, corporations do not like volatility. They already have a natural trading demand stemming from their business. Since currencies fluctuate nevertheless, corporations must be actively involved in foreign exchange to hedge their positions. Therefore, direction and price levels are important to them.

BROKERS

Brokers, electronic or human, need market volatility. Volatility gets the market busy, and busy traders execute more deals through brokers. However, excessive volatility has a negative impact on the business. Few trades go through when the market is trading under extreme conditions. The direction of the market and the price levels are irrelevant to brokers. The best daily market is one with moderately volatile two-way activity.

9 Foreign Exchange Settlement

An average $1.9 trillion changes hands every day in the foreign exchange markets, often under volatile conditions, and this turnover will continue to rise. The execution of these payments among hundreds of banks around the world is a staggering task. Conversely, the failure to generate timely and accurate payments is sanctioned by steep fines. This chapter focuses on the operational aspect of foreign exchange, a vital part of the trading process.

THE ROLE OF THE BACK OFFICE

Foreign exchange transactions do not end when the trader agrees with another party to buy or sell a certain currency. The details of the trade have to be processed, and the amounts agreed to be exchanged must be debited and credited. The responsibility for all these activities is in the hands of the Foreign Exchange Trading Operations Department, or the back office.

The department is physically separated from the dealing room for internal control. In fact, as communications developments have made it possible, some back offices have been moved to different locations altogether in an effort to save on real estate costs.

Let’s take a look at the document that initiates the responsibilities of the operations department: the trade capture. Every single foreign exchange trade is captured mostly electronically and rarely as a paper ticket.

The information entered on the ticket can be separated into two categories: information for the benefit of the trader and information for foreign exchange accounting and operations.

The most significant information to the trader is the name and amount of the base currency, the exchange rate, and the side of the deal (buying or selling).

Note: Assume that the trader knows both what currency was quoted against the fixed currency (for instance JPY against the USD) and the maturity date (spot, one month, etc.).

Base, or fixed, currency is the primary currency which is traded against another. Generally, the fixed currency is the USD, but it may be the euro, the British pound, or only foreign currencies on a cross-deal. If you trade USD/JPY 1,000,000, then the fixed currency is the USD. If the trade is done in GBP/USD 5,000,000, then the base currency is GBP. If you trade CAD/JPY, then the base currency is CAD.

The information necessary for foreign exchange accounting and operations is:

1. The name and the location (city) of the counterparty.

2. The transaction (deal) date.

3. The maturity date (or dates in the case of swaps).

4. The name and amount of the base currency.

5. All relevant exchange rates. (There are several exchange rates in the case of cross, forward outright, and swap transactions.)

6. Buying or selling the fixed (base) currency.

7. The other foreign currency name and amount.

8. The name of the trader.

9. The method of execution: brokers’ market or direct dealing. (If the deal was executed in the brokers’ market, the trader must enter the name of the brokerage house or matching system. This information allows the back office to make the correct commission payments. In the case of a direct deal, the form of telecommunication must be specified—dealing system, phone, or telex. If the deal is transacted on the dealing system, the name of the dealing system must be entered.)

10. Payment and receiving instructions (P&R) must be entered for overseas counterparties only. The details of FX transactions with parties on the same continent are confirmed by phone.

Let’s move to the operations department to see how it processes this information.

After the time of the trade but on the same day, the department staff goes through several steps. They check all the details of the tickets generated by traders. After the tickets are checked, the back office confirms every deal by phone with the counterparties located on the same continent. If the deals are executed over the dealing or matching systems, the trade entries are checked against the printed confirmations generated by these systems, regardless of the location of the counterparty. Most banks have the electronic trades automatically downloaded into their systems. If the deals are executed through brokers, traders bear the responsibility of getting the telex confirmations for all deals with overseas counterparties.

After the time of the trade but before maturity, the department sends the payment instructions via automated systems. The system used for foreign currencies is named the Society of Worldwide Interbank Financial Telecommunications (SWIFT). The system used for U.S. dollars is called the Clearing House Interbank Payments System (CHIPS). The dollar payment instructions may also be sent by another system called Fedwire, which links Fed banks to depositary institutions.

In addition, the back office checks to make sure that all the outstanding contracts have been matched and reports any discrepancies. A separate unit specializes in investigating the discrepancies.

After the time of the trade but on the maturity day, the department checks to see if the money credited to its own bank is in the nostro, or clearing account, as instructed, and reports if it is not credited.

NOSTRO ACCOUNTS

A nostro account, or clearing account, is the account for each foreign currency in the country of origin maintained by the financial institutions for purchase and receiving (P&R) purposes. For instance, all banks have nostro accounts for yen in Japan, either with a Japanese bank or with a Japanese branch of a foreign bank. As an example, let’s say that the First Bank of IOU/New York has its CAD nostro account either in its Canadian branch or in a Canadian bank.

SWIFT

Society of Worldwide Interbank Financial Telecommunications (SWIFT) is the financial industry-owned cooperative which supplies secure, standardized messaging services for international fund transfers to seventy-eight hundred financial institutions in over two hundred countries. SWIFT’s clients include banks, broker/dealers, and investment managers, Treasury and trade.

Until 1977, all foreign exchange transactions were settled by following instructions from banks sent via cable messages, known as cable transfers. This method was extremely labor-intensive and consequently error-prone. The steep increase in foreign exchange trading volume has generated extreme pressure on operations departments that are forced to use cable transfers, which were developed in the 1920s. In September 1977, the SWIFT automated system was set up in order to send standardized payment instructions for foreign currencies among European and North American banks. Since the late 1980s, SWIFT has been expanding outside these geographical boundaries, and some three thousand institutions around the world are currently connected to the system.

SWIFT IMPLEMENTATION

SWIFT messages are used to transmit payment instructions for both domestic and international financial transactions. Financial institutions with large numbers of fund transfers establish direct SWIFT connectivity with their internal, intrabank fund transfer system. Thus, payment instructions pass through the system without human intervention unless error messages occur.

The SWIFT core application is the FIN (Financial Transaction) application, which provides a store and forward financial messaging service accessed over X.25 network connections.

There are two types of messages—financial messages between SWIFT users and system messages between users and the SWIFT system. SWIFT messages have a common structure:

Functions required in the computer-based terminal (CBT) for message exchange are:

- Connection with mainframe computer;
- Message transmission;
- Message reception; and
- Application management.

In the regional processor (RGP), messages from a number of users are concentrated, encrypted, and sent to the applicable Operating Center for processing. In the Operating Center, the SWIFT system executes four processes on the messages. They:

- Check the syntax of the messages.

- Construct a new header to convert the message to the output form.

- Add trailers to the messages.

- Copy and encrypt for storage.

Validation of the message to the sender is expressed as:

- ACK = positive acknowledgment, or

- NAK = negative acknowledgment.

Trailers are added to an output message if additional information is necessary. For instance, if the sender is uncertain that the original SWIFT message was received, a new message will be generated, bearing the trailer PDM (possible duplication message). Message numbering is done automatically via an Input Sequence Number (ISN) added to every message sent. Therefore, safety, accuracy, and ease of processing are ensured. Encryption ensures privacy for all the messages sent through SWIFT, and these messages remain private even to SWIFT.

TYPES OF SWIFT FX MESSAGES

The diagram in Figure 9.1 shows the system of FX messages required for the payments of a spot transaction.

Figure 9.1. Diagram of the system of FX messages required for the payment of a spot transaction.

Foreign Exchange:

• MT 300 | FX confirmation (see Figure 9.2)
• MT 303 | Currency option allocation instructions (see Figure 9.4)
• MT 304 | Advice/instruction of a third-party deal
• MT 320 | Fixed loan/deposit confirmation
• MT 330 | Call/notice loan/deposit confirmation
• MT 350 | Advice of loan/deposit interest payment

Figure 9.2. MT 300 FX confirmation.

The MT 300 FX confirmation spot deal information flow can be seen in Figure 9.3.

General:

• MT 390 | Advice of charges, interest, and other adjustment
• MT 391 | Request for payment of charges, interest rate, and other expenses
• MT 392 | Request for cancellation
• MT 395 | Queries
• MT 396 | Answers
• MT 398 | Proprietary message
• MT 399 | Free format message
• MT 935 | Rate change advice

Figure 9.3. The MT 300 FX confirmation spot deal information flow.

In MT 300 FX confirmations:

- For actual transfers of funds, use MT 202/205/210.

- For confirmation of credits and debits, use MT 900/910/950.

MT 303 FX nets the message instructions for options allocation (see Figure 9.4).

ADVISORY BILATERAL FOREIGN EXCHANGE NETTING SERVICE

Netting is a service that enables institutions to settle their net positions with one another at the end of the day in a single transaction instead of at the time each trade is executed.

This process has definite advantages. It is cheaper, as there is only one deal to process versus tens of deals on a daily basis. In addition, it is a valuable safety feature, as banks must make only one payment on the net balance with another bank. If this bank shows any sign of payment difficulty, a group of large banks, known as a banking cooperative, will provide short-term backing from a common reserve pool.

Figure 9.4. MT 303 FX currency option allocation instructions.

Foreign exchange netting is implemented through SWIFTNet Accord.

SWIFTNET ACCORD

SWIFTNet Accord provides matching and exception handling for currencies, money market, and OTC derivative confirmations. It may be used as both a central and an in-house system. It improves efficiency, gives a rapid and accurate picture of settlement positions, spots errors quickly, and greatly reduces operational costs (fines and labor costs). Figures 9.5, 9.6, and 9.7 show Accord services.

Figure 9.5. Submessage and message types.

Figure 9.6. Work Queue (Accord) Confirmation List.

Figure 9.7. Accord Netting Service—Reports.

CHIPS

Foreign exchange dollar settlements are executed through a computerized system called CHIPS (Clearing House Interbank Payments System). CHIPS is a privately operated, real-time, multilateral payment system that is owned by financial institutions and banking organizations with a regulated U.S. presence.

Since January 2001, CHIPS has been a real-time final settlement system that continuously matches, nets, and settles payment orders.

Participant cannot send or receive CHIPS payment orders until they transfer their opening position requirement to the CHIPS account. Opening position requirements can be transferred into the CHIPS account any time after the opening of CHIPS and Fedwire Funds Service at 9 a.m. EDT. However, all participants must transfer their requirement no later than 9 p.m. EDT.

FEDWIRE

Settlement in U.S. dollars may also be made via Fedwire. Fedwire Funds Service is a real-time gross settlement system (RTGS) which enables participants to transmit and receive payment orders among themselves and on behalf of their customers. Payment to the receiving participant is final and irrevocable when the Federal Reserve Bank either credits the amount of the payment order to the receiving participant’s Federal Reserve Bank reserve account or sends notice to the receiving participant, which ever is earlier.

The main Fedwire features are:

- Securities are transferred free or DVP (delivery versus payment).

- Balances due are paid transaction by transaction, not by netting.

- Fedwire money transfers are final, unlike CHIPS transfers, which are not final until CHIPS settles.

Fedwire is used for five types of trades:

- large payments and receipts of Fed funds from CHIPS settlement;

- Fed funds;
- eurodollar transactions;
- securities delivery; and
- funds transfer.

INTERBANK COMPENSATION

Although there is no standard method per se currently enforced around the world, the majority of the international banks apply the same set of compensation rules. Compensation rules provide consistent actions for financial institutions when a payment claim arises. Problems include: late payments, wrong amount, or funds debited or credited to the wrong account or the wrong bank.

The U.S. Council on International Banking, Inc. provides Interbank Compensation Rules to its 360 members around the world. Its rules are also followed by numerous other banks. The importance of standard (or close to standard, in this case) procedures goes beyond the financial costs; the clarity and fairness of the rules is paramount for maintaining good business relationships in a volatile financial environment. (More information is available on www.ncuic-info.org/Why/why.htm.)

CONTINUOUS LINKED SETTLEMENT

Continuous Linked Settlement (CLS) was designed in 1996 as a method for reducing and managing settlement risk within the foreign exchange market via a payment against payment settlement process. The CLS System also includes a bank, the CLSB, which is based in New York and is monitored by the Federal Reserve Bank. As of 2007, CLS Bank was owned by seventy-one of the world’s largest financial groups throughout the United States, Europe, and Asia.

The philosophy behind the CLS is that there is potential settlement risk in the enormous FX market, and the failure of a major institution would have a domino effect within the industry and beyond. The settlement risk, which is discussed in Chapter 5, might occur in dealings among foreign banks whose national payment systems are never open concurrently.

The role of the CLS is to reduce this risk by simultaneously settling both sides of a foreign exchange transaction. The idea is great, but the CLSB does not guarantee that every trade submitted will settle. On the plus side, the CLSB assures that all settlement members receive funds after the completion of the settlement.

The CLSB has central bank accounts for all major currencies, including the dollar, the euro, the pound, the yen, the Swiss franc, and the Canadian, Australian, and New Zealand dollars, along with several other European and Asian currencies.

CLS is an ongoing process of:

1. Submitting instructions—receiving payments of specified currencies from customers.

2. Funding—settling pairs of instructions that satisfy all criteria.

3. Execution—making payouts in specified currencies.

CLSB simultaneously settles both sides of trades submitted directly by CLS members. Once the settlement process begins, neither party can unilaterally cancel a transaction from the settlement process between midnight and 6:30 a.m. Central European Time (CET), but counterparties may bilaterally rescind transactions and submit same-day value instructions. CLSB then submits an initial pay-in schedule at midnight and a revised version at 6:30 a.m. CET.

CLSB settles transactions between 7 a.m. and 9 a.m. CET and will pay out proceeds between 7 a.m. and 12 p.m. CET.

Most of the beneficiaries of CLS are third parties who participate indirectly as customers of CLS members. There are three types of CLS third parties: third-party banks, fund managers, and nonbank financial institutions and corporates.

FXMARKETSPACE

FXMarketSpace is a platform that offers central clearing for cash FX trading. The system was developed by Reuters and CME. Its advantage is that clearing through CME Clearing means that CME will manage the risk of default by settling positions at original trade price on the settlement date.

STRAIGHT THROUGH PROCESSING

Straight Through Processing (STP) enables the entire FX processing and payment transactions to be conducted electronically without reentering the data manually. The process minimizes the settlement risk and reduces processing costs. STP facilitates end-to-end automation of the trading process within the trading entity and between the two trading entities, from capturing the deal to the final settlement. STP allows smooth execution and movement through price information, order capture, execution, links to settlement, clearing, and custody, thus linking the front, middle, and back offices.

CONCLUSION

The operations, or back office, department has a vital role in the continuously moving and changing world of foreign exchange. Simply, the trading activity cannot survive in its absence. Traders focus, fairly enough, on dealing. The foreign exchange transaction is not over until payment and receipt of foreign currencies around the world are accurately executed. Traders deal millions and billions day in and day out, but the real value of these enormous amounts is not always fully perceived. Nevertheless, it is the back office’s responsibility to make sure that all of these amounts are properly debited and credited. Only then is trading activity complete.

The introduction of computerized front end–back office systems in the late 1980s lightened the work schedule of the back office. However, increases in volume and instrument sophistication will keep back offices around the world quite busy for the foreseeable future.

10 Conducting Foreign Exchange Trading

Whether you trade a small number of large amounts of currency or a high number of small amounts, whether you trade on the sell side or the buy side, and whether you are a bank, fund, corporation, or individual, odds are that you are trading on an electronic platform.

Foreign exchange trading is conducted primarily bank-to-bank, but investment funds have become major players and retail business has been flourishing. Until April 1992, the interbank intermediary had always been the foreign exchange broker. Since then, matching systems, or electronic brokers, and Internet platforms have replaced most of the traditional brokers’ business.

Technological breakthroughs have also changed the manner of trading foreign exchange directly. The telephone, the communication tool of choice for over two decades, has been replaced by matching systems and Internet platforms as well. Currently, direct dealing among banks and voice brokers are only minor methods of trading currencies.

ELECTRONIC PLATFORM TRADING

These platforms may be divided into two main categories: Liquidity Providers (LPs) and Order Management System Providers (OMS).

Trading rooms seeking easy-to-implement solutions will probably select one of the top liquidity provider platforms: HotSpot, Currenex, FXall, EBS, LavaFX, FX Marker, eSpeed. Liquidity providers deliver a preselected group of banks that offer streaming prices (ESP—Electronic Streaming Prices.) and actually create a virtual closed marketplace for each subscriber. Some of the LPs support complex order types beyond the standard limit, fill or kill, or at best. Corporate clients can only trade anonymously under credit arrangements and name of the prime broker only.

Some of these systems, such as Currenex, are better known for providing on-request prices (direct dealing). Others, such as EBS and FXall, are designed for providing streaming prices, which makes them electronic brokers.

Electronic platforms started in the early 1990s by attracting various numbers of large liquidity providers. Reuters Matching System started the ball rolling and then EBS came to the fore and became the leading electronic broker. As technology developed and prices fell, more companies joined the fray; initially they fought for a slice of the profitable interbank trading pie, and then they started to link companies and funds with banks. These processes created divisions in the electronic markets. This division was enhanced by large banks that developed proprietary platforms primarily for their corporate clients.

As the field leveled in the beginning of the twenty-first century, several companies did the sensible thing and removed the market divisions by aggregating quotes from several liquidity providers. This approach increased both the transparency and the depth of the markets.

Those looking for a multitier platform that offers aggregated quotes for liquidity and enables rules-based trading systems are likely to choose one of the OMS products: FlexTrade, LavaFX, PortWare, RealTick and Tethys. They join multiple LPs to create a large pool of liquidity. These systems enable programming rules-based trading models within the order management tool kit. This is a predefined set of algorithms that can be easily customized.

The implementation of electronic trading always comes down to your specific requirements and level of sophistication. The easiest way to get started is to use one of the Electronic Communications Networks (ECNs) listed above. These platforms are Internet-based and do not require any special hardware equipment to get started. On the other hand, if you require a sophisticated OMS with multiple LPs, i.e., both banks and ECNs, then it is better to research one of the FX OMS platforms such as FlexTrade or PortWare.

Unlike equity, commodity, and fixed income prices, currency prices were slow to enter the mainstream, so corporations and funds had limited access to the “real market.” Leading companies such as EBS started to melt this fence down.

For instance, EBS Prime enables corporate clients to trade on the best prices available through an EBS Prime bank. Customers negotiate and pay fees to their EBS Prime bank and also pay a standard brokerage fee to EBS. The EBS Prime also enables model-driven trading for customers.

THE BROKERS’ MARKET

CHARACTERISTICS OF THE CURRENCY BROKERS’ PRICE

Traders show different prices on their electronic systems because they “read” the market differently due to different expectations and different interests. The system will automatically optimize the price. In other words, it will always show the highest bid and the lowest offer. Therefore, the market has access to the narrowest spread possible.

For example, a broker on the spot U.S. dollar/Japanese yen (USD/JPY) desk receives the following prices from different banks:

The highest bid is 117.12, shown by banks Bidda and Taurus, and the lowest offer is 117.17, shown by banks Offerta and Southoriented. Consequently, the optimized price is 117.12–117.17.

As you can see in the previous example, traders may only show one side of the price. This dealing approach is less aggressive, and from the trader’s point of view this option is attractive, as it involves less risk.

Let’s take a closer look at the trading choices in the broker’s market: USD/JPY 117.12–117.17.

When attempting to buy USD/JPY, a trader has three alternatives:

1. Take the offer at 117.17. This option provides the highest degree of certainty for executing the deal. However, there is no guarantee that the full amount asked by the trader will be executed. For instance, a trader trying to buy USD/JPY 10,000,000 may only be able to buy USD/JPY 6,000,000, the sole amount available in the offer at that moment.

2. Join the Bid at 117.12. This alternative provides the least certainty of having the deal executed. If you join a bid, you will place it behind previous bids. Trading is executed on a first come, first served basis
Joining the bid is the most defensive approach, but provides a price cost advantage. If your bid is hit and the USD/JPY does indeed go up as you expected, the profit will be higher by the spread between the bid and the offer, i.e., 5 pips.

3. Improve the bid, anywhere between 117.13 and 117.16, in our example. This middle-of-the-road alternative has two advantages. By marginally improving (raising) the bid, the trader can ensure that he or she has the best bid.

Although a defensive tool, improving the bid provides more certainty than joining the bid. Generally speaking, the more a trader improves the bid, the better the chances of having it dealt on.

The opposite is true if the trader were to sell USD/JPY:

1. Hit the bid at 117.12;

2. Join the offer at 117.17;

3. Improve the offer by lowering the offer between 117.16 and 117.13.

Price anonymity is an important characteristic of the brokers’ market. Let’s just assume for a second that the market is passing through a stagnant period that is not rich in fundamental or technical signals. Given a choice, traders would not hit a “big name” on the odds that the large bank may have more information than the rest of the market. Instead, they would have probably chosen the path of least resistance.

Brokers charge commissions, but traders are highly unlikely to miss a deal because of fee considerations. It is much more important to enter a profitable deal or to cut a losing position in a timely fashion than to miss the opportunity in order to avoid a broker’s commission.

The brokers’ market is divided into electronic brokers and voice brokers, but the latter ones have a very small market share.

ELECTRONIC CURRENCY BROKERS-MATCHING SYSTEMS

Electronic matching systems are essentially electronic brokers, which provide fast, anonymous trading conditions for individual traders who deal against the rest of the market. Anonymity provides market efficiency, as all players have a fair trading opportunity.

The matching systems are well suited for trading both small amounts, such as $1 million, and much larger ones.

The matching systems are characterized by speed, reliability, and safety. In addition, credit lines are automatically managed by the systems. Banks input the credit lines for each of their counterparties. When the credit lines have been filled, the system automatically disallows dealing with those particular parties by displaying “credit restrictions,” or shows the trader only the prices made by banks with which he has lines of credit. As soon as the credit line is restored, the system allows the bank to deal again.

The standard systems are EBS (see Figure 10.1) and Reuters matching system (see Figure 10.2). The new kid on the block is the CME’s Globex system, which provides side-by-side trading. As Chapter 14 describes in more detail, this system offers spot prices in parallel with futures quotes.

Figure 10.1. The EBS system. (Source: EBS)

Figure 10.2. The Reuters matching system. (Source: Reuters)

VOICE CURRENCY BROKERS

Voice foreign exchange brokers’ role was drastically diminished by electronic trading. Brokers remain in niche currency markets, such as spot exotics, spot trading in some emerging markets, and some swaps and options.

They do not take positions for themselves; they only service commercial and investment banks.

The majority of their business is executed via phone. The phone lines between brokers and banks, are dedicated. A dedicated phone line means that neither the bank nor the broker has to dial a phone number; they simply pick up the phone and trade.

DIRECT DEALING

Direct dealing is a legacy method of trading for banks. Smaller banks, currency specialized banks, or funds may still call large banks by phone, or more likely access the large banks’ electronic portals, for quotes. But thankfully medium-sized and large banks do not call each other by phone anymore. Phone dealing was error-prone and slow. Dealing errors were difficult to prove and even more difficult to settle, despite the fact that phone conversations were taped; tape recorders were able to capture, but not prevent, the trading errors.

Direct dealing was forever changed in the mid-1980s by the introduction of dealing systems.

DEALING SYSTEMS

Dealing systems link banks around the world on a one-on-one basis. This type of service is still provided only by Reuters and was an excellent method of trading in the pre-Internet era because of its speed, reliability, and safety. It was also appreciated because it allowed conversations before the introduction of e-mails and IMs; yes, there was such a time! Currently, the Reuters dealing systems are used primarily by swap and options traders for some of their business.

The receiving bank can see what bank is calling and for what currency and amount. Traders are able to have up to twenty-four simultaneous conversations on the Reuters dealing system, and switching among the conversations is easy.

ELECTRONIC PLATFORM TRADING FOR RETAIL CLIENTS

Technological developments enabled retail clients to access the bank-dominated FX market. Individuals can participate in the market through electronic platforms that provide fast, efficient, and comprehensive service. For instance, Global Forex Trading (GFT) allows clients worldwide to trade a very large number of currencies through its DealBook 360 trading software, which is backed by a twenty-four-hour dealing desk operation. Individuals can trade anything from mini accounts to bank-sized amounts. Despite catering to small accounts, the platform offers tight spreads, real-time news, and analytical tools.

CONCLUSION

The e-trading environment has increased the efficiency of currency dealing and reduced the error rate in both the front and the back offices to virtually zero in interbank trading. The confluence of banks, funds, and corporate clients in the same markets has further contributed to trading efficiency and to a decline in transaction fees. The future of e-trading will focus on further reduction of transaction costs, operational speed, ease and safety, customization for individual clients, and increased accessibility of nonbank participants to FX prices.

PART

4 UNDERSTANDING THE MAJOR FX INSTRUMENTS

11 The Spot Market

Spot trading is the most traded foreign currency instrument around the world, but it comes in second place after swaps, according to the BIS (see Figure 11.1). The fast-paced spot market is not for the fainthearted, as it features fluctuating volatility and quick profits (and losses). This chapter examines how spot trading works and shows how savvy traders stay on top of this exciting market.

Figure 11.1. Market share of the major foreign exchange instruments. (Source: Bank for International Settlements, “Central Bank Survey of Foreign Exchange Activity”)

THE FOREIGN CURRENCY SPOT MARKETPLACE

A spot deal consists of a bilateral contract between a party delivering a specified amount of a given currency against receiving a specified amount of another currency from a second counterparty, based on an agreed exchange rate, within two business days of the deal date. The exception is the Canadian dollar, in which the spot delivery is executed next business day, as Canada shares its time zones with the United States.

It is important to notice that the concept of “spot” does not mean that the currency exchange occurs the same business day the deal is executed. Currency trades which require same day delivery are called cash transactions. The two-day spot delivery for currencies was developed long before the technological breakthroughs in information processing. This length of time was necessary to check out all transactions’ details among counterparties. Although technologically feasible, the contemporary markets did not find it necessary to reduce the time to make the payments. Human errors still occur and they need to be fixed before delivery. When currency deliveries are made to the wrong party, fines are applied.

Traders check out all their daily transactions at the end of each day and the back office compares all trading details against printed records when possible. Moreover, the netting agreements developed in the major trading centers such as New York eliminate the need for executing payments for each individual trade. A single net payment is made at the end of the day to another counterparty. (Netting agreements are discussed in detail in Chapter 9.) These processes eliminate the possibility of any payments before the end of the day. Occasionally operational errors occur, but they are generally fixed by the end of the day. However, some problems will be rectified only the next business day. Consequently, for all practical purposes, not all payments could be executed the same day.

In terms of volume, currencies around the world are traded mostly against the U.S. dollar, which is the currency of reference. The U.S. dollar’s role of currency of reference reflects the United States’ dominant economic and political position in the international arena. The other major currency is the euro, followed by the Japanese yen, the British pound, and the Swiss franc. Other currencies with significant spot market shares are the Canadian and Australian dollars.

In addition, a significant share of trading also takes place in the currency crosses, a nondollar instrument, where foreign currencies are quoted against other foreign currencies, such as euro against Japanese yen.

There are good reasons for the popularity of currency spot trading. Profits and losses are realized quickly in the spot market, due to market volatility. In addition, since the spot deals mature in only two business days, the time exposure to credit risk is limited. Turnover in the spot market has been increasing dramatically thanks to the combination of advanced technology, inherent profitability, and reduced credit risk.

The spot market is characterized by high liquidity and high volatility. On an active global trading day (twenty-four hours), the euro/dollar exchange rate may change its value thousands of times (see Figure 11.2). How quickly does the exchange rate move? There is no easy answer, and trying to determine an average time is not too helpful. Exceptionally, an exchange rate may “fly” 200 pips in a matter of minutes if the market gets wind of a significant event. For example, when dollar/yen collapsed under the pressure of long liquidation by hedge fund Long-Term Capital Management in October 1998, the dollar shed about 12 yen a day for two consecutive days (see Figure 11.3).

On the other hand, the exchange rate may remain quite static for extended periods of time, even in excess of an hour, when a market trading in one time zone is almost finished and is waiting for the market in the next time zone to take over. This is a common occurrence toward the end of the New York trading day, which coincides with the end of the global day. Since California failed in the late 1980s to provide the link between the New York and Tokyo markets, there is a volume gap between around 4:30 p.m. and 6:30 p.m. EDT. In the New York market, the majority of transactions occur between 8 a.m. and 12 p.m., when the New York and European markets overlap. The activity drops sharply in the afternoon, over 50 percent in fact, when New York loses the international trading support (see Figure 11.4). Overnight trading in Asia tends to be limited.

Figure 11.2. The exchange rate in a major currency, such as the euro, may change thousands of times on an active trading day.

Figure 11.3. Dollar/yen fell approximately 12 yen a day for two consecutive days under the pressure of long liquidation by hedge fund Long-Term Capital Management in October 1998.

Figure 11.4. In the U.S. spot market, the majority of the deals are executed between 8 a.m. and noon, when the European traders are still active. The turnover drops to under 50 percent in the afternoon as the liquidity dries up. The overnight activity is limited. (Source: Bank for International Settlements, “Central Bank Survey of Foreign Exchange Activity”)

TYPICAL SPOT INTERBANK TRADES

In the spot market, any amount may be traded, odd or even, denominated in U.S. dollars or foreign currency. Given the predominance of electronic trading, multiples of one million dollars, euros, and pounds are common. However, the standards tend to be USD 5,000,000 and USD 10,000,000.

THE MAJOR PARTICIPANTS

The major participants in the spot market are naturally the commercial banks and the investment banks, since all the other players must access the FX market through banks (see Figure 11.5). They are followed by hedge funds and corporate customers. In the interbank market, the majority of the deals are international, reflecting the worldwide exchange rate competition and the advanced telecommunication systems. However, corporate customers tend to focus their foreign exchange activity domestically, or to trade through foreign banks operating in the same time zone. Although the hedge funds’ and corporate customers’ business in foreign exchange has been growing, banks remain the predominant trading force.

Figure 11.5. Diagram of the market participants in FX.

EXECUTING THE TRADE

Most spot deals are executed electronically on platforms. If still using the Reuters dealing system, spot traders will use a language of their own. They use a concise code to get their point across quickly and accurately, leaving no room for interpretation.

Let’s take a look at a typical spot trade:

Example:

A trader from Banca Prima, who just heard from contacts that a large bank is buying EUR/USD, calls AllesBanken on Monday, August 1.

Banca Prima: “EUR 10 PLS.” In translation, this means: “May I have a spot price in EUR/USD 10 million, please?”

AllesBanken’s trader replies: “35–40.” In a more complete translation, this may stand for “My price for the above amount is 1.1835–40.” The big figure (in our case 1.18) is rarely stated, as traders are assumed “to know where the market is.”

If Banca Prima’s trader likes the price and wants to buy EUR/USD at 40, she will press a preset key (B, for instance) and the software will automatically display on the screen in capital letters: “I BUY EUR/USD 10,000,000 AT 1.1840 VALUE AUGUST 3. MY USD TO Banca Prima/NEW YORK. THANKS VERY MUCH FOR YOUR NICE PRICE.”

Finally, AllesBanken confirms the deal by pressing a preset key for confirmation. The software will display the following: “TO CONFIRM I SELL USD 10,000,000 AT 1.1840 VALUE AUGUST 3. MY EUR TO AllesBanken/FFT. THKS FOR CALLING. BIFN.” BIFN stands for “Bye for now.” Done deal.

If the spot trade is done via a dedicated phone line, an increasingly disappearing act, the same information is exchanged, although the format may be slightly changed.

Example:

Banca Prima calls AllesBanken: “Spot euro in 10, please.”

AllesBanken replies: “39–40.”

Banca Prima: “Mine” (or “I buy” or “I take”).

AllesBanken: “All right, I sell you 10 at 40. Big figure is 1.18. All agreed, please?”

Banca Prima: “Yep, all agreed. Thanks, friend. Ciao.”

AllesBanken: “Aufwiedersehen.”

PROFIT AND LOSS

What spot currency traders didn’t dream of being saved from an abysmal loss to stellar profit by a significant and unexpected move? The scenario involves three players, as follows:

1. An aggressive customer, who is looking to sell a large amount of USD/JPY to a bank for hedging purposes.

2. An experienced currency trader, who believes that the USD/JPY is oversold, and expects a short term recovery.

3. A large fund, which fears that the exchange market is getting out of hand in its selling of the USD/JPY.

The customer, Ichiban, calls First International for a price in USD/JPY 100 million. The trader, Don Joe, quotes 121.40–50. Ichiban sells USD 100 million against JPY at 121.40. As Don scrambles for cover, being able to sell only USD 20 million at 121.40, the USD/JPY suddenly drops to 120.60. Understandably tense, Don is just preparing to cut his sizable loss when the large fund enters the market and buys the pair, lifting the USD/JPY all the way to 122.40, 100 pips higher than where he had originally bought. Don Joe sells the balance of the U.S. $80 million, realizing a profit of about $653,594.77, and he instantaneously becomes a folk hero in the wild world of foreign exchange.

The bottom line is important in all financial markets, but in currency spot trading the antes always seem higher as a result of the interest stemming simultaneously from all around the world.

The profit and loss can be either realized or unrealized. The realized P&L is a certain amount of money netted when a position was closed. The unrealized P&L consists of an uncertain amount of money which an outstanding position would roughly generate if it were closed at the current rate. The unrealized P&L will change continuously in tandem with the exchange rate.

Let’s take a look at the calculations. For the currencies quoted in European terms, the spot profit and loss (P&L) is calculated as follows:

Example:

Banca Due, which had no previous position in USD/JPY, executed six deals today. The trader first sold USD/JPY 10,000,000 at 117.25 before the release of economic data, expecting the figure to be worse than expected. The trader was correct, but the dollar fell only 25 pips. The trader took profit by buying USD/JPY 10,000,000 at 117.00. As the USD started to rebound, two different banks called directly on the dealing system and sold to Banca Due USD/ JPY 10,000,000 each at 117.10 and 117.05, respectively. However, the USD/DEM rebounded, and the trader at Banca Due took profit by selling USD/JPY 10,000,000 at 117.30 and USD/JPY 10,000,000 at 117.35.

Buy | Sell
USD/JPY 10,000,000 at 117.00 | USD/JPY 10,000,000 at 117.25
USD/JPY 10,000,000 at 117.10 | USD/JPY 10,000,000 at 117.30
USD/JPY 10,000,000 at 117.05 | USD/JPY 10,000,000 at 117.35

The end-of-day revaluation rate, or closing rate, is 117.20. This rate is necessary for the P&L calculation for the currencies quoted in European terms.

The average buying rate is 117.05 for USD/JPY 30,000,000. The calculation of the average is made as follows:

The average selling rate is 117.30 for USD/ JPY 30,000,000. The calculation of the average is made as follows:

For the currencies quoted in American terms, such as the British pound, the spot profit and loss (P&L) is calculated as follows:

Example:

Banco Tres, which had no previous position in GBP/USD, executed six transactions today. First it bought GBP/USD 10,000,000 at 1.8000 as the currency broke a significant resistance line. Rumors of corporate demand for GBP prompted Banco Tres to buy another GBP/USD 10,000,000 at 1.8005 and GBP/USD 10,000,000 at 1.8010. The profit was taken at 1.8025, 1.8030, and 1.8035 for GBP/USD 10,000,000 each, when the rumors were denied.

Buy | Sell
GBP/USD 10,000,000 at 1.8000 | GBP/USD 10,000,000 at 1.8025
GBP/USD 10,000,000 at 1.8010 | GBP/USD 10,000,000 at 1.8030
GBP/USD 10,000,000 at 1.8005 | GBP/USD 10,000,000 at 1.8035

The end-of-day revaluation rate is irrelevant for the realized profit and loss in the case of currencies quoted in American terms.

The average buying rate is 1.8005 for GBP/USD 30,000,000. The calculation of the average is made as follows:

The average selling rate is 1.8030 for GBP/USD 30,000,000. The calculation of the average is made as follows:

The unrealized P&L is calculated by using these same formulas. The missing rate is replaced by the revaluation rate, and the missing amount will equal the outstanding position.

Example:

La Premiere Banque has a previous long position of USD/CHF 10,000,000 at 1.4510. The position is correct, and the USD/CHF is higher today. Today, it executes six additional trades in USD/CHF. The market moves in a tight range, but the trader buys USD/CHF 10,000,000 at 1.4600 and sells it back at 1.4625; sells USD/CHF 10,000,000 at 1.4630 and buys back at 1.4610; again buys USD/CHF 10,000,000 at 1.4605 and sells this amount at 1.4635. Expecting the USD/CHF to continue to appreciate, the trader continues to hold a long USD/CHF 10,000,000 position.

Previous position: + USD/CHF 10,000,000 at 1.4510

Buy | Sell
USD/CHF 10,000,000 at 1.4600 | USD/CHF 10,000,000 at 1.4625
USD/CHF 10,000,000 at 1.4610 | USD/CHF 10,000,000 at 1.4630
USD/CHF 10,000,000 at 1.4605 | USD/CHF 10,000,000 at 1.4635

The end-of-day revaluation (closing) rate is 1.4620. For the unrealized P&L, the end-of-day, or closing, rate is important for supplementing the missing exchange rate for currencies quoted in both the European and American terms.

The average buying rate is 1.458125 for USD/CHF 40,000,000. The calculation of the average is made as follows:

SOURCES OF INFORMATION

Foreign exchange traders are information traders. Consequently, traders generally have multiple monitors displaying the most recent rates and events from around the world. The major sources of information are Bloomberg, Reuters, and CQG.

STOP-LOSS

Cutting losses is painful for every trader. The ability to cut one’s losses in time is the sign of a seasoned trader. Good traders are too busy trying to “read” the market to waste time on blind hope. Lesser traders become trapped hoping for the daily miracle. They dismiss a profitable trading pattern as lucky. Even good traders may lose on numerous individual transactions. However, the losing trades are cut quickly, while the profitable trades are allowed to “run.”

CHARACTERISTICS OF A SPOT TRADER

To be successful, spot traders must embody seemingly opposite traits. They must simultaneously be flexible and firm, patient and quick to react.

Why are such contradictory qualities necessary in the current spot market?

Traders have, or at least should have, a view on the market, several scenarios, and a strategy. This view must be backed by some reasons—maybe some fundamental factors, such as the state of the domestic economy relative to other significant economies, or some chart signals, and most of the time a combination of the two. Having such a set plan gives the trader mental toughness, and a psychological basis which will provide direction in an otherwise chaotic environment.

With the scenario in place, the trader starts trading, and the market behavior seems to coincide with the plan. But all of a sudden, the exchange rate starts moving abruptly in the “wrong” direction. There is a rumor in the market that a central bank is intervening. The trader feels that his scenario is still fundamentally correct, that in time the market will indeed trade the “right” way. In the short term, however, what is the trader supposed to do?

Imagine yourself hearing on the radio that a train is out of control, quickly running to the railroad tracks, and waiting right in the middle, believing that the train should be able to stop in time to avoid crushing you. If you are correct, that’s nice; but if you are wrong, well, you have a problem. A good spot trader soon learns that staying alive is essential to being profitable. A single encounter with the runaway train of the exchange market may prove dangerous to the trader’s health. Therefore, while it is important that a trader has a specific market view, and goes about implementing it, it is equally important to be fast and flexible enough to adjust to changing market conditions.

Spot traders must be able to quickly discern between a major adverse change and a temporary move. If the trader is long (bought) $5 million against yen at 120.00 and the exchange rate moves a little lower, to 119.50, the trader may want to buy U.S. $5 million more at the lower price, while supporting the bids, or to simply wait it out, if the move seems to be minor. If buying more, the new average price will be 119.75, so the rate must move up only by 25 pips to break even. Of course, if the trader is wrong, then the long position will be twice as much as the original one in a falling market.

The reverse is true for a perceived significant adverse exchange rate move. The trader must be able to quickly cut the loss and wait, or reverse the position. If the same long $5 million against yen at 120.00 position is in place, and the trader decides that 120.00 was toppish, he may decide at 119.70 to either cut the position by selling $5 million against yen, or to fully reverse the position, by selling $10 million against yen. The new position is short by U.S. $5 million against yen.

Spot traders must be able to readily cut through the abundance of information and quickly ascertain the significant factors. This ability is mostly an acquired trait, an art rather than a science. There is only so much quantification to be done. Past that, it is up to the trader to mentally process the information and implement the results.

TYPES OF TRADERS

Some traders have a strategic approach, and some trade “in-and-out” all day long. Both types of traders play a significant role in the market. The proprietary traders focus more on the “big picture.” They tend to trade larger positions and keep them for much longer periods of time. The “in-and-out” traders, who constitute the largest group, provide daily liquidity in the market. They rarely have a strong view on the market, focusing instead on the daily market flows. Their profit margin per deal is generally lower than that of the prop traders, but they make more deals and they provide liquidity.

Traders may also be categorized by the level of risk they are able to manage. There is no magic formula for determining the optimum level of risk for each trader. This level can only be determined through trial and error. It is less important to know how much risk a trader is willing to take than to know at what level the trader’s performance peaks. The size of the individual position should reflect, therefore, not the size of the trader’s ego, but his or her capacity for maximizing trading performance. This decision is made by the chief trader.

The more risk-adverse traders will take position after the release of the economic data, for instance, rather than going with a position into the number. Most traders do that, since they need reinforcement from the market behavior. Fewer traders will take positions before the release of the economic data. Ultimately, it is the trader’s performance that counts, the return on investment, not his or her thirst for risk-taking.

CONCLUSION

Once spot traders decide on a plan, they must stick to their guns, oblivious to any extraneous distractions. Sometimes, a trader would like to get long in a specific currency. Before that happens, however, another counterparty calls and buys from our original trader, who is now short, contrary to the plan. If squaring off now, the trader may incur a small loss, so he or she decides to wait a little longer in order to break even. Once that happens, our trader will go back to the main plan of going long on that currency. But the currency is moving higher, the loss is getting bigger, and the trader remains stuck further with a losing position. No matter how much our trader complains about the unfairness of the market, about the frustration of having the right idea but being pushed in the wrong position, nothing will change. Therefore, a trader must remember to follow his or her own judgment. Even if small losses result, successful traders should exit positions that do not fit their trading view. If the situation is not clear, it is much better for traders to sit on the fence for a while, thinking things over, than to face the runaway train, hoping blindly that it will stop.

“Let the profits run, cut the losses short” is a common saying among traders. Its methodical implementation usually extends the trading life of most players. The gambler’s approach, going for broke, generally ends in the gambler’s own finale, the sad loss. Traders must have a systematic and steady approach to the market. Smaller, consistent profits tend to be preferable to huge P&L fluctuations.

Nobody is bigger than the market. At times, large players, naturally, will be able to have a significant impact on the market. But any artificial move will be very short-lived, regardless of how many billions of dollars have been sacrificed. Since most players are generally small in size and scope, the individual impact will likely be small as well. Therefore, the challenge is not to be the market, but to read the market. Riding the wave is infinitesimally more rewarding than being hit by it.

12 The Forward Currency Market

Foreign exchange demand ranges from spot to longer delivery dates, as speculative interests intertwine with customized commercial demand. Currency exchange trades that mature beyond the spot dates are known, collectively, as forward trades.

THE FORWARD FOREIGN CURRENCY MARKETPLACE

The forward currency market consists of two instruments: forward outright deals and swaps. Generally, this market includes only cash transactions. Although currency futures contracts are a special breed of forward outright transactions, they are analyzed separately.

According to figures published by the Bank for International Settlements in its triennial survey, the percentage share of the forward market was 65 percent of an estimated daily gross turnover of U.S. $1.9 trillion in 2004. Figure 12.1 shows the evolution of the forward markets versus the spot market since 1989. The spot volume surpassed the swap volume through 1992, but since then they have reversed positions.

GENERAL CHARACTERISTICS OF THE FORWARD MARKET

In the forward market there is no norm with regard to the settlement dates, which generally range from three days to one year. It is common to trade short dates; one week or multiples of one month. Some FX bank facilities will quote prices in multiyear dates, but volume in currency forwards longer than one year, and even past six months, is light. Any date different from the spot date and within the above parameters may be a forward settlement, provided that it is a valid business day for both currencies.

Figure 12.1. The evolution of the forward markets relative to the spot market since 1989. (Source: The Bank for International Settlements)

Forward markets are decentralized, with entities around the world entering into a variety of deals either on a one-on-one basis or through brokers. In contrast, the currency futures market is a centralized market. Whereas in the futures market only a handful of foreign currencies may be traded in multiples of standardized amounts, the forward markets are open to practically all currencies in any amount.

What is the difference between the forward outright market and the swap market?

A forward outright deal is an individual trade that matures (in general) past the spot delivery date. Because its value date differs from the spot, intuitively, we must expect that the forward rate will also differ from the spot rate.

A swap deal is unusual relative to the rest of the foreign exchange instruments because of the fact that it consists of two deals, or legs. All the other transactions consist of single deals. In its original form, a swap deal is a combination of a spot deal and a forward outright deal.

Before we approach these instruments in more detail, let’s take a look at several technical aspects germane to forward pricing.

THE FORWARD PRICE

The forward price consists of two significant parts: the spot exchange rate and the forward spread. The forward spread is also known as the forward points or the forward pips. The forward spread is necessary for adjusting the current spot rate for specific settlement dates different from the spot date. It holds, then, that the maturity date is another determining factor of the forward price.

THE SPOT RATE

The spot rate is the main building block. The forward price is derived from the spot price by adjusting the spot price with the forward spread, so it follows that both forward outright and swap deals are derivative instruments.

FORWARD SPREADS

Major currencies’ forward outright spreads are aligned in order from short periods to long periods. Spot rates are followed by forward spreads for several standard forward dates: spot/next (S/N), one week, one month, two months, and so on up to one year, and preceded by tomorrow/next (T/N) and overnight (cash) transactions.

Just as in the case of the spot market, the left side of the quote is the bid side, and the right side is the offer side. Note, though, that the bid-offer relationship as just described applies only if the swap is executed in a foreign currency amount. If the swap is done in U.S. dollars, the right side of the forward quote becomes the bid and, conversely, the left side is the offer.

Example:

Your quotes are:

USD/JPY spot = 117.96/118.06

USD/JPY 3 month forward spread = 153.88/152.38

1. A customer sells and buys with you a ¥500 million (foreign currency amount) swap in three months. Therefore, you buy and sell ¥500 million swap at 153.88. Your prices are:
118.06 for spot (because buying yen is equivalent to selling dollars), and
116.521 for three months (because the forward spread is subtracted from the spot rate: 118.06 − 1.5388).

2. A customer sells and buys with you a USD/JPY 5 million (dollar amount) swap in three months. Therefore, you buy and sell USD/JPY (equivalent to selling and buying JPY) 5 million swap at 152.38 (forward spread). Your prices are:

117.96 for spot, and

116.436 for three months (because the forward spread is subtracted from the spot rate: 117.96 − 1.5238).

The typical misconception about forward prices is that they represent an expectation as to the direction of one currency in terms of another. Drawing on the previous example, the spot USD/JPY of 117.96 and the three-month forward outright USD/JPY of 116.436 would suggest that the U.S. dollar is bound to be weaker in the future. This may or may not be true.

Certainly, any currency price, spot and forward, will always reflect expectations of future price behavior. But this is not an expectation based on one currency’s being stronger or weaker than another. The forward spread is simply the result of the interest rate differential between the currencies traded, as applied to the current spot price and adjusted for the number of days until the maturity date. This market expectation of future changes in the interest rate differential is, however, essential for forward currency pricing.

As one of the main factors in the pricing formula of forward spreads, changes in the spot rate will automatically trigger changes in the forward rates. The forward pricing method is presented in the section on interest rate differential later in this chapter.

INTRODUCTION TO THE TYPES OF FORWARD SPREADS

To calculate the three-month forward outright USD/JPY rate, the forward spread was subtracted from the spot price. This type of spread is called discount. If the forward spread is added to the spot price, it is called premium. On rare occasions, the forward spread is zero, and in this case the forward price will simply equal the spot price. This type of spread is known as par.

IDENTIFYING THE TYPES OF FORWARD SPREADS

Before learning how to calculate the forward spread, let’s see how a trader is able to identify a premium spread from a discount spread.

If the bid side (left side) of the forward outright spread is smaller than the offer side (right side), that specific spread is a premium, and it must be added to the current spot price to obtain the forward price. For example, assume that the one-year forward spread in euro is 297–299 and the spot EUR/USD is 1.0542–45. Calculating the offer side, we get 1.0545 + 0.0299 = 1.0844.

Conversely, if the bid side of the forward outright spread is larger than the offer side, then it is a discount spread, and it will be deducted from the spot rate to calculate the forward outright price. For instance, assume that the one-year forward spread in Japanese yen is 634.00–630.00 and the spot USD/JPY is 117.96–06. Calculating the bid side in both the spot and the forward we get 117.96–6.34 = 111.62.

Forward bid < Forward offer = Premium spread
Forward bid > Forward offer = Discount spread

Of course, the minus sign in front of the spread is also an accurate hint that you are facing a discount spread, but you do not really need it.

To better understand the importance of the spot exchange rate and consequently the significance of the spot value date, we will discuss premium spreads, discount spreads, and at par. We focus on several diagrams and our examples are for currencies quoted in European terms.

PREMIUM SPREAD

A premium spread is a spread in which the interest rates in one foreign currency are higher than the U.S. interest rates. In such a market, as time progresses, prices increase, starting from the spot level, rather like climbing a staircase (see Figure 12.2). Alternatively, it may be easier to visualize the forward dates and the behavior of the forward prices around the spot level on a -∞/+∞ axis, with zero being replaced by the spot level. In a premium market, the prices increase past the spot price (see Figure 12.3).

Figure 12.2. In a premium market, as time passes, the forward prices are higher relative to the spot price. The exceptions are the tomorrow/next and the overnight spreads, which are lower.

Figure 12.3. In a premium market, as time passes, the forward prices are higher relative to the spot price. The exceptions are the tomorrow/next and the overnight spreads, which are lower.

DISCOUNT SPREAD

The opposite is true for a discount market. The forward prices decrease relative to the spot exchange rate (see Figure 12.4). Again, it may be easier to visualize the behavior of the forward prices relative to the forward dates and around the spot level on a +∞/-∞ axis, with zero being replaced by the spot level. In a discount market, the prices decrease past the spot price (see Figure 12.5).

Figure 12.4. In a discount market, as time passes, the forward prices are lower relative to the spot price. The exceptions are the tomorrow/next and the overnight spreads, which are higher.

Figure 12.5. In a discount market, as time passes, the forward prices are lower relative to the spot price. The exceptions are the tomorrow/next and the overnight spreads, which are higher.

METHODS OF CALCULATING THE FORWARD OUTRIGHT PRICES

Let’s see now why the sum of 1.0542 (the bid of the EUR/USD spot price) and 67 (the bid of the three-month EUR/USD forward spread) equals 1.0609. This is a common source of confusion when first approaching the forward currency markets.

By convention, traders refer to the last decimals as simply points or pips. To be mathematically correct, the three-month EUR/USD forward spread should be displayed as 0.0067–0.00673, rather than 67–67.3. Traders, being pragmatic, cut through the less important details and focus only on the essential elements. They disregard the full forward spread format, but they don’t err on their calculations.

One way to calculate the above forward price is:

1.0542 + 0.0067 = 1.0609

Now let’s calculate the bid side of the one-month EUR/USD forward price. The bid remains unchanged at 1.0542. The one-month EUR/USD spread is 20.8–21.2. Because the bid is smaller than the offer, you will easily identify a premium spread and you will therefore add this spread to the spot rate.

In order to avoid any confusion caused by the decimal points in the forward spread, you may calculate the forward price another way. Drop the decimal point only in the spot price and add it to the forward spread, as in:

10542 + 20.8 = 10562.8

Now, return the decimal point to its rightful place to obtain the correct forward price:

10562.8 1.05628

Based on the foreign exchange rates you have seen so far, you may have gotten used to seeing four decimals, or two decimals in the case of the Japanese yen. There is no problem with having more decimals, and you do not have to round up the forward exchange rates to the perceived standard number of decimals.

Of course, the two methods of calculation will reach the same result. But, if you are just starting, you may find one easier to visualize than the other.

Let’s take another example and calculate the one-year forward outright price of the USD/JPY. First, let’s identify whether it is a premium or a discount spread, in order to know whether to add or subtract the one-year forward spread from the spot price of 117.96.

The one-year forward spread in USD/JPY is 634–630. The bid is larger than the offer, signaling a discount spread, so you must deduct. If we stick to the same side of the price, the bid side, then the one-year forward price in USD/JPY looks like this:

117.96 − 6.34 = 111.62

Using a different term, three months, the forward price in USD/JPY is calculated as follows:

Now that you’re able to identify all types of forward spreads, let’s find out how they are calculated and what their relationship is to the interest rates.

THE INTEREST RATE DIFFERENTIAL

The interest rate differential is a determining factor in forward pricing. Single interest rates are not sufficient in foreign exchange, since any transaction automatically involves two currencies. Therefore, in order to be able to measure the change or the expectation of change in the future value of a currency in terms of another, two interest rates are necessary. Each of the eurocurrencies is quoted for different standard forward periods, similar to the periods in the forward currencies quotes.

Eurocurrencies provide an excellent tool for traders to calculate the forward spreads. The formula commonly used to determine the forward spread for currencies quoted in European terms, like the yen, is:

Forward spread = S × (Ef–E$) × (t/360) × 100
where

S = spot

Ef = Euro foreign currency

E$ = Eurodollar
t = days to maturity

Notes:

1. If the interest rate differential between a currency quoted in European terms and the dollar (Ef–E$) is positive, then the forward spread is positive, which indicates that the spread is a premium. If the interest rate differential (Ef–E$) is negative, then the forward spread is negative, which indicates that the spread is a discount. If the interest rate differential (Ef–E$) is zero, then the spread is at par, and the spot exchange rate equals the forward exchange rate.

2. If the interest rate differential between the dollar and a currency quoted in American terms (E$ − Ef) is positive, then the forward spread is positive, which indicates that the spread is a premium. If the interest rate differential (E$ − Ef) is negative, then the forward spread is negative, which indicates that the spread is a discount. If the interest rate differential (E$ − Ef) is zero, then the spread is at par, and the spot exchange rate equals the forward exchange rate.

3. To annualize the forward spread, the number of days to maturity is divided by 360 days for most currencies and by 365 days for some of the Commonwealth currencies, such as the pound or the Australian dollar. This is a convention.

4. It is generally irrelevant whether the trader uses the bid, the offer, or an average of the spot rate to calculate the forward spread for a swap, because the object of swap trading is the forward spread itself, not the spot rate. However, if the chief dealer insists that the future value will benefit you by using the exact side of the spot price, follow that direction.

Example:

The one-month spread in USD/CHF is calculated as follows:

S = 1.5055

Euroswiss = 4 5/8–4 3/4

Eurodollar = 3 1/16–3 3/16
t = 33 days

Forward spread (bid) = 1.5055 × (4.6252 − 3.1875) × (33 / 360) × 100 = 19.84

Forward spread (offer) = 1.5055 × (4.75 − 3.0625) × (33 / 360) × 100 = 23.29

The forward spread thus calculated is marginally wider than the broker’s price: 21–23. The tighter spread is the result of the fact that brokers have access to a larger pool of prices and consequently are able to optimize the prices.

Another method of obtaining forward spreads involves the individual calculation of the interest rates. The forward spreads are calculated as follows:

where

IRf = foreign interest rate

IR$ = U.S. interest rate

Sf = spot exchange rate in terms of the U.S. dollar

S$ = spot exchange rate in terms of itself

Ef = euro foreign currency

E$ = eurodollar
t = number of days until maturity

where

FR = forward rate

where

FS = forward spread

Example:

Using one of the previous examples:

E$ = 3 1/16 − 3 3/16
t = 33 days (about one month)

Sf = 1.5055

S$ = 1

The bid is calculated as follows:

IRf = 1.5055 × 0.04625 × (33/360) = .0064

IR$ = 1 × .031875 × (33/360) = .0029

FR = (1.5055 + .0064) / (1 + .0029) = 1.5075

FS = 1.5075 − 1.5055 = .20 or 20 forward pips

The offer is calculated as follows:

IRf = 1.5055 × 0.0475 × (33/360) = .0066

IR$ = 1 × .030625 × (33/360) = .0028

FR = (1.5055 + .0066) / (1 + .0028) = 1.5079

FS = 1.5079 − 1.5055 = .24 or 24 forward pips

This approach compares favorably with the original one.

So far, we have discussed two of the three determining factors in forward pricing: the interest rate differential and the spot exchange rate. Let’s focus now on the last factor: the maturity date.

THE MATURITY DATES

Just as the spot exchange rate is the most important rate in foreign exchange, the spot value date is the most significant maturity date. All the other maturity dates are set up based on the spot date. Remember that the spot date means that the deal matures two business days from the day the deal was made (with the exception of the Canadian dollar). The two business days must be valid in both of the countries originating the currencies.

STANDARD FORWARD VALUE DATES

There are several standard forward value dates. Any maturity date falling in one week, one month, one year, or a multiple of one month is known as standard maturity date or standard value date. Other standard maturity dates are the tomorrow/next (T/N), which means that the value date is the next business day or one day prior to the spot date; and the spot next (S/N), which matures one business day past the spot date or in three business days. Finally, there is the cash date, when the deal date coincides with the maturity or delivery date.

In addition to the standard forward value dates, there are odd maturity dates. An odd maturity date is any valid day that is not a standard value date. This characteristic emphasizes both the liquidity and the flexibility of the overall forward markets. In contrast, the currency futures markets have only four delivery dates annually.

Let’s take a look at Table 12.1 and discuss several characteristics of the value dates. As already mentioned, the forward dates are based on the spot dates. For instance, a customer who inquires about a one-month forward outright price refers to one month from the spot date, not from the deal date. In the case of the monthly standard dates, the forward, or long, date is calculated as date-to-date. That is, if the current date is July 19 and the spot date falls on July 21, then the one-month forward date should fall on August 21. Because August 21 falls on a weekend (or if it fell on a holiday), the delivery date will move ahead to the next immediate valid business day: August 23.

Table 12.1

END-OF-MONTH VALUE DATES

So far, it is all pretty straightforward. Let’s change the scenario a little: The new current date is February 24. Referring to Table 12.2, what is the one-month forward date? Tempting as the answer may be, the value date is not March 26. The reason is that the spot date falls on February 26, the last day of the month (in terms of business days). This means that the one-month forward value date is March 31, the last business day in March. When the spot date falls on the last business day of the month, then the one-month forward date or any other monthly multiple falls, by convention, on the last business day of a month as well. This exception is commonly observed in the market, so the trader or salesperson must remember it and make sure that the counterparty is aware of it. Through mistake or lack of knowledge, the end-of-month–end-of-month rule is sometimes not observed by both parties. This failure generally creates animosity among players, and at times financial penalties.

What happens if, on January 27, a customer asks for a one-month forward price? What will be the forward date? Since the spot falls on January 29, the delivery date must fall on the last business day of February, which is February 26.

Two observations are in order. First, the end-of-month–end-of-month rule allows the long date to move either forward or backward. This is different from the standard monthly delivery dates, when the long date falls on the same day date as the spot but in a different month, and will go forward to the next business day if the original long date is not a valid business date. In the previous example, the long date was moved backward. Conversely, if a one-month forward price is executed on February 24, the spot falls on February 26 and the long date will fall on March 31. In this case, the long date was moved forward.

Table 12.2.

Second, how can both January 29–February 26 and February 26–March 31 periods be called one-month terms? After all, they do have different numbers of days and different prices, even assuming a similar interest rate differential and a constant spot exchange rate. Remember the forward pricing formula presented earlier in the chapter:

where

S = spot exchange rate

Ef = euro foreign currency

E$ = eurodollar
t = days to maturity

Although the traders discussed the forward deal in terms of one month, the calculation is always made in terms of days. None of the players is open to any undue risk or opportunity when asking for a monthly termed price rather than a price on a number of days, because, solely from this point of view, the number of days in a month is irrelevant.

FORWARD PRICING FOR ODD VALUE DATES (BROKEN DATES)

Forward pricing for odd value or broken dates is executed by using the standard formula. More caution must be exercised, however, as the trader may not have the same amount of information generally available for the standard dates.

Let’s take an example.

Spot USD/CHF = 1.5055–60, value January 5

Six-month spread (185 days) = 78–82, value July 7

Nine-month spread (274 days) = 87–93 value, October 5

What is the forward spread for August 8? The number of days, counted from the spot date, is 216.

The rates for euroswiss and eurodollars for six and nine months are as follows:

The period of 216 days may be broken down into 7 months and 3 days.

One option is to receive a broker’s or a bank’s reliable quote for 7 months forward spread. Things would become considerably easier, because the residual period is only 3 days.

An alternative is to simply calculate the daily forward points average between the 6 and 9 months forward spreads and adjust the forward price for the number of days in the odd date (216).

Therefore, a 216-day forward quote may be 289–293.

Convenient as it is, this method is not perfect. This approach assumes that the yield curve will remain linear, a rather risky assumption when the time span is so wide and so far in the future. In our specific example, the eurodollar rates increase from one month to one year, with an increase of 3/16 between six and nine months, whereas the euroswiss decreases from one month to one year, with a drop of 4/16 between six and nine months. The trader must look at the preceding periods for further indications and must consider the probability of any upcoming events that may have an impact on the interest rates during the period under consideration.

CURRENCY FORWARD OUTRIGHT DEALS

As should be clear by now, a forward outright is a type of trade that matures sometime in the future, past the spot date. It is a derivative product (it is derived from the spot price and value date). Let’s review its components and what they mean for the trader.

As we have previously shown, the forward outright price consists of the spot price and a forward spread, which is added to or subtracted from the spot price. Remember that while the spot market is very volatile, conceivably changing every second, the forward prices constitute a much slower market. The trader should take advantage of these features.

In a slow market, a trader looking for a forward outright price should simply inquire for an outright price in its original form. However, in a fast market, the execution should be different. Since the exchange risk is prevalent in the spot market, the spot part of the forward outright should be executed first. Only after the exchange risk is under control, or rather after dealing at the target spot exchange rate, should the forward spread be executed.

Quoting a forward outright price is slower than quoting a spot price, which may mean that the spot rate will move from the current level by the time the trader receives the full quote.

The forward rate adjustment may be executed with the same counterparty with which the spot deal was done, or it may be executed through a swap with either the same or a different counterparty.

Example:

Let’s take the example of a one-year forward outright deal in USD/CHF.

Spot price = 1.5055

Forward spread = 92 premium

In a steady market, the trader may ask for the straight one-year forward outright price of 1.5055 + .0092 = 1.5147

In a fast market, the trader should just ask for and trade on the spot price, 1.5055, and later either ask the same party for a quote in the one-year forward spread, .0092, and execute the adjustment; or execute a swap for the CHF amount equivalent in size with the spot CHF that matures on the desired long date (one-year over spot) with the same or a different counterparty.

Either way, the same result will be achieved: 1.5147 value in one year.

Users of the forward outright deals are the common users of foreign exchange: commercial and investment banks, corporations, mutual funds, and high net-worth individuals.

Forward outrights are vulnerable to all the major risks: market, interest rate, credit, and country.

In the previous example, we stripped the spot from the forward in order to avoid the adverse impact of exchange risk. This risk results mostly from the spot rate, with some additional risk generated by the impact of the spot rate on the forward spread.

The forward spread is linked to interest rate risk, and any change in the interest rate differential triggers a change in the forward spread.

Unlike currency futures, forward outright deals are exposed to credit risk in the same way that all the other cash products are exposed. Because they mature at a date past the spot value date, the longer the time exposures, the greater the default risk of the counterparty.

Finally, country risk is present in a fashion similar to the other FX instruments. Longer exposures until maturity increase the potential country risk.

CURRENCY SWAPS

A plain vanilla currency swap consists of the simultaneous buying and selling (or the other way around) of the same amount of the same currency with the same counterparty, such that the two legs of the transaction mature on different dates (one of the dates being the spot date) and are traded at different exchange rates (one of the exchange rates being the spot rate) (see Figure 12.6).

Figure 12.6. The mechanism of a currency swap.

Other currency swap versions have different amounts of the base currency, or the spot leg being replaced by another forward outright leg (forward-forward). An example of a forward-forward currency swap deal is buying and selling CHF 50,000,000 in two months against four months.

Currency swaps have several applications:

1. Taking advantage of current and expected changes in the interest rate differentials. The difference between interest rates generates the forward points that traders deal. The expectations of change and the changes themselves are the focus of the currency forwards market.

2. Hedging. Hedging is an important application of currency swaps, because its use eliminates exchange rate fluctuations. The counterparties are not exposed to exchange risk because they buy and sell (or vice versa) the same amount of the same currency.

TRADING CURRENCY SWAPS

Pricing Currency Swaps: Premium Spread

Example:

USD/CHF spot = 1.5060–65

6-month forward spread = 78–82 (premium)

On January 5, Bank Prima calls Bank Secunda for a U.S. dollar/Swiss franc 10,000,000 swap in six months. Bank Secunda quotes 78–82. In order to sell and buy U.S. dollars, Bank Prima takes the offer at 82.

Bank Secunda agrees and confirms the details as follows: “We buy and sell (B/S) U.S. $10,000,000 against Swiss francs at 1.5060 against 1.5142 (because 1.5060 + .0082 = 1.5142) value January 7 against July 7.” We assume that both the delivery dates are valid trading days.

To make a profit, Bank Secunda must sell and buy (S/B) U.S. $10,000,000 against Swiss francs at a spread lower than 82—in a premium market. Several minutes later, Bank Secunda calls Bank Terza for a U.S. dollar/Swiss franc swap in six months in U.S. $10,000,000. Bank Terza quotes 75–80. Bank Secunda takes the 80 bid. If the same spot rate is used (the spot rate is not important, provided that the market is not too volatile), the rates are 1.5060 and 1.5140, and the dates are identical.

Overall, Bank Secunda bought the forward spread at 80 (in the second transaction) and sold it at 82 (in the first transaction), making a 2 pips profit. See Table 12.3.

Bank Secunda made a nominal profit of CHF 2,000. The profit will only be realized six months from now, on July 7, when the final exchange between the two counterparties is executed.

However, when the future profit is discounted to the present value, the current P&L is lower. The present value is calculated as follows:

Amount at future value

where

PV = present value

IR = interest rate

Tenor = number of days

Table 12.3.

Applied to our example:

CHF 2,000 / [1 + (.04625 × 180/360)] = CHF 1,954.80

Assuming a revaluation rate of 1.5000 for the U.S. dollar/Swiss franc, the P&L in U.S. dollars is CHF 1,954.80/1.5000 = $1,303.20. The longer the period, the less the current profit will be. In addition, taxes will likely reduce the profit further.

Pricing Currency Swaps: Discount Spread

Example:

USD/JPY spot = 104.38–41

Six-month forward spread = 21.5–20.5 (discount)

On January 5, Bank Prima calls Bank Secunda for a U.S. dollar/Japanese yen 10,000,000 swap in six months. Bank Secunda quotes 21.5–20.5. To sell and buy (S/B) U.S. dollars (or buy and sell (B/S) Japanese yen), Bank Prima takes the offer at 20.5.

Bank Secunda agrees and confirms the details as follows: “We buy and sell (B/S) U.S. $10,000,000 against Japanese yen at 104.38 against 104.175 (because 104.38–20.5 = 104.175) value January 7 against July 7.” We assume that both the delivery dates are valid trading days.

To make a profit, Bank Secunda must sell and buy (S/B) U.S. $10,000,000 at a higher spread. Several minutes later, Bank Secunda calls Bank Terza for a swap in six months in US $10,000,000 against Japanese yen. Bank Terza quotes 23–21. Bank Secunda takes the 21 offer. If the same spot rate is used (the spot rate is not important provided that the market is not too volatile), the rates are 104.38 and 104.17, and the dates are identical.

Table 12.4.

Bank Secunda made a nominal profit of ¥50,000. Similar to the previous example, the profit will only be realized six months from now, on July 7, when the final exchange between the two counterparties is executed.

Discounted by the net present value, the current P&L is:

¥50,000 / [1+(0.3125 × 180/360) = ¥49,230.77

At a revaluation rate of 105.00 for the U.S. dollar/Japanese yen, the P&L in U.S. dollars is:

¥49,230.77 / 105.00 = $468.86

Time and taxation will further reduce the amount of profit.

THE ROLLOVER OR TOM/NEXT SWAP

One of the most important concepts in the cash market is the rollover or tomorrow/next (tom/next, for short) swap. This swap is peculiar from several points of view. It is the only swap not designed for profit, although it will usually generate a small profit and loss. It is a swap designed for spot traders. Its main role is to change the old spot date to the current spot date.

Let’s take an example to understand how using the rollover (or tomorrow/next swap) could have prevented a trader from getting into trouble.

Assume that on March 1, a spot trader buys USD/CHF 10,000,000 at 1.5000 value March 3 (with the standard spot date: two business days). Starting from a zero position in USD/CHF, the trader decides to keep this outstanding position until tomorrow. On March 2, the trader sells USD/CHF 10,000,000 at 1.5200, value March 4. Isn’t this great? A nifty profit, and no position to reckon.

However, there is good news and bad news. The good news is that the profit is indeed there. The bad news is that, actually, there is still a small position left over from the previous transaction. The trader almost gave out an uncovered check for several million Swiss francs for a day, and such a gesture is penalized with a hefty compensation claim. Where did we go wrong? And how does the rollover (tomorrow/next swap) prevent the error?

Let’s take a more detailed look at the example.

Table 12.5.

The first spot deal executed was valued March 3, whereas the second was valued March 4. The two spot values are not identical. There is a one-day gap between the deals that results in a payment and receiving (P&R) problem.

The nostro accounts, which are the accounts kept by each bank or company for each foreign currency in the country of origin, have a positive, but close to zero, balance. On March 3, the trader in our example receives U.S. $10,000,000 (because the trader bought this amount). This operation poses no problem; receiving money has never been a problem. However, also on March 3, a reciprocal operation must take place. The trader must pay CHF 15,000,000 to the counterparty’s nostro account in a Swiss bank or a Swiss branch of a foreign bank. But our trader’s CHF nostro account on March 3 is, for all practical purposes, zero. The CHF payment cannot be executed, although the contract has been made. The payment can only be made a day later, on March 4, after our trader had sold the U.S. dollars, and consequently, bought CHF.

The problem of buying and selling U.S. $10,000,000 at different rates can easily be solved simply by remembering that the nostro accounts are kept in the foreign currency. Therefore, the original position was equivalent to selling CHF 15,000,000. When taking profit on the next day, the trader should have bought 15,000,000, not 15,200,000, or sold U.S. $10,000,000, because:

CHF 15,000,000 / 1.5200 = $9,868,421.05, not $10,000,000

Traders around the world solve payment problems by using the rollover (tomorrow/next swap). Technically, the T/N swap consists of simultaneously closing the original position, valuing the old spot value date, and reopening it in its identical form, save for the spot value date, which will be the current spot value date. Because the dates are different, it follows that the exchange rates are also different. The rates will be identical only in the rare case that the forward spread is at par. The rollover cost is generally low.

From a trader’s point of view, the tom/next swap will simply change, or roll over, the old spot value date to the new spot value date. In our example, the original spot value date, March 3, will be rolled over to March 4. This is important, because spot traders can only trade value spot, not any other values, be it tomorrow or any other date. In order for the trader to really close the position outstanding since the previous day, the value date must coincide with the current spot value date.

The T/N swap will not change the view of the trader in any way, or the original position or the profit and loss figure. All it will do is enable the trader to deal currently with an outstanding position.

From the operations department’s point of view, the tom/next swap will enable the company to make the payments stemming from the opening of any foreign exchange transaction.

The trader’s expectation of the future behavior of the currency price or the total duration of a position until closing are irrelevant details to the back office. What is relevant is the capacity of the corporation to execute the due payments.

Let’s take one last look at the details of the two spot deals, executed on consecutive days and maturing on different spot value dates.

Table 12.6.

To enable both the spot trader to correctly dispose of the overnight position and the back office to execute the P&R instructions, a T/N swap in Swiss franc must be executed. Assume the T/N forward spread to be −0.0001. The following table displays all the deals and their details pertinent to the scenario.

Table 12.7.

As of March 2, the trader is able to trade the original position, short CHF 15,000,000, value the current spot date: March 4. If, on the same day, the trader closes the position by buying CHF 15,000,000 at 1.5200, the total foreign currency position as of March 4 will be zero. But if the trader sells USD 10,000,000 at 1.5200, then the position will be positive CHF 200,000.

The T/N swap does not need to be made with the same bank with which the spot trade was executed, because it is a separate deal.

Why is this type of deal called tomorrow/next? The swap should theoretically be executed the day after the original spot deal, but the first leg of the swap will mature tomorrow (or the old spot value date) and the second will mature on the current value date (two business days). Therefore, the dates are tomorrow and the next business day.

In practice, the time of execution of this type of swap should be carefully linked to the ease or availability of trading. If it is difficult or expensive to execute the T/N swap on the next business day, simply leave an execution order on the original date of the spot deal. For instance, in the New York market it is easy to trade a T/N swap in Japanese yen during the entire business day following the spot deal. The opposite is generally true for the European currencies in the later part of the day.

In order to avoid any unpleasant consequences, it is advisable to send a leave order on the evening of the original spot trade day to a correspondent bank in the time zone of the country whose currency was traded. In this manner, a trader gains time in the morning, when the market tends to be busier, and the correspondent bank will have the opportunity to execute the T/N swap at a favorable rate.

In the European market, T/N swaps can be executed during the “normal” trading day, tomorrow, since the time zone overlaps with both the Asian and North American time zones.

CALCULATING THE T/N PRICE

Let’s focus on the calculation of the T/N price. Please keep in mind that this swap is exceptional in terms of value dates. A plain vanilla swap will mature its short leg on the spot value date and the long leg on a specific forward date. The T/N swap will mature its short leg tomorrow, or a day before spot, and the long leg on the spot date. The exception in value dates extrapolates into an exception regarding the price structure.

Drawing on the previous example, let’s use a spot rate of 1.5000 and a T/N spread of 1.5–1. You need both sides of the forward spread in order to identify whether it is a premium or a discount. Let’s use the bid side of the T/N spread. Recall the method of identification of the spread:

Applying this rule for the T/N swap and knowing the price for the long leg, which is equivalent to the spot price, 1.5000, what will be the price of the short leg: 1.5001 or 1.4999?

The forward spread is certainly a discount. To better answer this apparently obvious question, please refer to Figure 12.6. As you can see, the T/N falls before the spot. T/N is one day away from the deal date, whereas the spot date is two days away. In the case of a discount forward market, that is equivalent to a higher T/N price. Therefore, the correct answer on the T/N exchange rate, which I am sure you have already arrived at, is 1.5001.

Conversely, if the T/N spread is at premium, then it will be subtracted from the spot price. For instance, if USD/JPY spot middle rate is 160.00 and the T/N forward spread is 2–3 (premium), the exchange rate for the short leg is 159.97 (if using the offer side of the forward spread).

COVERED INTEREST RATE ARBITRAGE

Another way of taking advantage of the forward market is covered interest rate arbitrage. Arbitrage is the risk-free type of trading whereby the same instrument is bought and sold in two different markets in order to cash in on the divergence between the two markets. This approach consists of borrowing currency A, exchanging it for currency B, investing currency B for the duration of the loan, and, after taking off the forward cover on maturity, showing a profit on the entire set of deals.

Theoretically, covered interest rate arbitrage seems like an attractive option. In reality, this type of trading can be difficult to implement because of possibly serious problems. One problem is that the major currencies operate at a high level of market efficiency. Neither can traders trade blindly in the more exotic currencies just to arbitrage, because the liquidity in those currencies is generally limited. Another problem is the impact on the balance sheet. From a corporate point of view, the balance sheet will be inflated due to the additional assets (the foreign currency denominated loans) and will suffer liabilities (the domestic deposits).

Example of Currency Arbitrage:

Amount = JPY 1,000,000,000

USD/JPY spot rate = 104.40

USD/JPY 6 months forward spread = 21.50–20

Time to maturity = 180 days

Eurodollar 6 months rate = 3 3/8–3 1/2

Euroyen 6 months rate = 3–3 1/8

First step: Cost of deposit

Second step: Cost of swap

Cost of swap = USD 9,598,310.70 − USD 9,578,544.06 = USD 19,766.64

Total cost of trade = USD 149,973.60 + USD 19,766.64 = USD 169,740.24

Cost of borrowing USD through JPY

From this example we conclude that borrowing dollars through Japanese yen is more expensive than paying the other side in eurodollars.

13 Durrency Crosses

Despite international interest in the U.S. dollar and the consequent pricing of local currencies in terms of U.S. dollars, there is also a natural demand for pricing foreign currencies in terms of other currencies. At regional levels, commercial transactions between two neighboring countries may be conducted at the exchange rate between their own currencies, rather than going through the exchange rate against the U.S. dollar. At the international level, the pricing of one currency in terms of another may generate information unavailable in the standard quotes against the U.S. dollar. In this chapter you will learn the advantage of cross-currency trading, whether you trade the crosses or not.

THE CROSS FOREIGN CURRENCY MARKETPLACE

The U.S. dollar is the most actively traded currency worldwide. Currencies are generally quoted against the U.S. dollar. When currencies are traded against currencies other than the U.S. dollar, the prices are called cross rates. Therefore, a cross rate is a nondollar currency.

The most popular currency cross rates are euro/Japanese yen, euro/British pound, and euro/Swiss franc, which evolved from the original deutsche mark/Japanese yen, sterling/deutsche mark, and deutsche mark/Swiss franc cross rates after January 4, 1999.

ADVANTAGES OF CROSS-CURRENCY TRADING

Cross-currency trading has been growing significantly since the early 1980s. Although it shrank considerably in the aftermath of the euro introduction, the commercial demand for crosses remains high in the European market. A Swiss exporter to Germany who wants to repatriate profits will find it of little use to know the value of the Swiss franc and the euro in terms of the dollar. What the Swiss exporter needs to know is how many Swiss francs can be exchanged for the euros. In terms of determining on the chart which currency is stronger, it is helpful to remember that a high value means the euro is stronger relative to the Swiss franc, and vice versa (see Figure 13.1).

Figure 13.1. The euro/Swiss franc cross rate.

Moreover, the German/the Eurozone and Swiss economies have a high degree of correlation, which is reflected in their currencies as well. This is an important element for Swiss franc traders. Despite similarities, the Swiss franc market is less liquid than the euro market. Therefore, the Swiss franc traders are natural euro/Swiss franc users when they cannot trade this currency against the U.S. dollar.

Even when the economic relationships between two countries are not very close, the cross rates between their currencies may be significant. For instance, the most popular cross rate is the euro/Japanese yen rate (see Figure 13.2). Despite their gigantic economies, the Eurozone and Japan do not currently have trade liaisons at par. However, this cross rate is very popular because the euro and the Japanese yen rates are the most traded currencies vis-à-vis the U.S. dollar. Economic internationalization has been an important factor in the growth of cross-currency volume. The opening of trading in Southeast Asia, Eastern Europe, and South America triggered a significant increase in cross trading. Although the regional currencies are under limited demand, the hard currencies prevalent in these areas are under increased demand. In addition, U.S. corporations have increased their level of sophistication in global management. Cross currencies are used as an effective way of reducing financial risk, especially when a company must concomitantly trade several currencies. Instead, the company may now trade a single nondollar currency before profit repatriation.

Figure 13.2. Euro/yen cross-rate fluctuations.

Cross trading can also help traders avoid the wrath of the central banks’ intervention. Although central banks do not generally intervene in the cross markets, the Bank of Japan intervened several times in euro/yen in order to rescue Japanese investors who had been caught in unprofitable euro-denominated investments.

From the technical analysis point of view, crosses are very important sources of information. The same technical rules naturally apply to the crosses: The market reacts on signals unavailable outside the cross charts. It is common to have a significant move in the euro that cannot be forecast off the euro/dollar chart. However, on the euro/Japanese yen or the euro/Swiss franc or the euro/sterling charts, technical signals are visible.

PRICE CALCULATION

Although a currency cross is a nondollar instrument, its calculation is based on currencies’ rates in terms of U.S. dollars. For instance, the euro/Japanese yen cross is derived from the exchange rates of the euro/dollar and dollar/Japanese yen, known as components.

Cross rates are obtained by either dividing or multiplying two different currencies, or components (see Figure 13.3). To calculate the cross rates between the Japanese yen and the Swiss franc, the USD/JPY exchange rate is divided by the USD/CHF exchange rate. The currencies considered so far are all quoted in European terms, which means that the exchange rate displays the amount of foreign currency received in exchange for U.S. $1.

Figure 13.3. Diagram of cross-rate calculations for two currencies quoted in European terms.

If one of the components is a currency quoted in American terms, such as the euro and the British pound, while the other is in European terms, then the cross price is calculated by multiplying the components. An exchange rate quoted in American terms shows how many U.S. dollars will be received in exchange for one unit of foreign currency.

Example:

The average (between the bid and offer) rates of the major four currencies are:

USD/CHF = 1.5100

USD/JPY = 120.00

EUR/USD = 1.0700

GBP/USD = 1.6200

The cross rates are calculated as follows:

CHF/JPY = (USD/JPY)/(USD/CHF) = 120.00/1.5100 = 79.47

EUR/JPY = (EUR/USD) × (USD/JPY) = 1.0700 × 120.00 = 128.40

EUR/GBP = (EUR/USD)/(GBP/USD) = 1.0700/1.6200 = 0.6605

These calculations are general approximations of the cross prices. To calculate the cross price thoroughly, a two-way (bid–offer) price is necessary.

In order to avoid any errors, it is easier, in the beginning, to start from the end result and work our way backward to the components.

Example:

As shown in Figure 13.3, the exchange rate for USD/CHF is 1.5000–1.5010 and the exchange rate for USD/JPY is 100.00–100.10. The task is to calculate the two-way price for the CHF/JPY cross rate.

In other words, our end result is a bid and an offer for the CHF/JPY cross.

A CHF/JPY bid means that you want to buy the CHF and sell the JPY. Buying the CHF is equivalent to selling the USD/CHF, and selling the JPY is the same as buying USD/JPY.

A CHF/JPY offer means that you want to sell the CHF and buy the JPY. Selling the CHF is equivalent to buying the USD/CHF, and buying the JPY is the same as selling USD/JPY.

Therefore, to calculate this type of cross, you must divide one offer by the other bid and vice versa, but never one bid by the other bid, or one offer by the other offer.

Applying our figures:

CHF/JPY BID = 66.62
and

CHF/JPY OFFER = 66.73

The CHF/JPY two-way price is therefore 66.62–66.73.

In reality, this approach, although correct, is not good enough. The spread between the bid and offer is, in this case, 11 pips, unacceptable by market standards. The spread should be 3 to 5 pips, such as 66.65–68, or 66.69–72. Therefore, the traders must skew the price depending on the market conditions.

If one of the components of the cross is quoted in American terms, the calculation is different (see Figure 13.4). First, the components are multiplied. Second, a bid is multiplied by the other bid, and an offer is multiplied by the other offer.

Example:

GBP/USD = 1.6000–1.6010 USD/CHF = 1.5000–1.5010

Figure 13.4. Diagram of cross-rate calculations for a currency quoted in European terms and a currency quoted in American terms.

The GBP/CHF cross is calculated as follows:

GBP/CHF bid = 1.6000 × 1.5000 = 2.4000

GBP/CHF offer = 1.6010 × 1.5010 = 2.4031

The two-way GBP/CHF cross rate price is therefore 2.4000–2.4031.

Finally, Figure 13.5 displays the calculations for two currencies in American terms. The exchange rate for EUR/USD is 1.0500–1.0510 and the exchange rate for GBP/USD is 1.6000–1.6010. The calculation of the two-way price for the EUR/GBP cross rate is as follows:

A EUR/GBP bid means that you want to buy the EUR and sell the GBP. Buying the EUR means buying the EUR/USD, and selling the GBP is the same as selling GBP/USD.

Figure 13.5. Diagram of cross-rate calculations for two currencies quoted in American terms.

A EUR/GBP offer means that you want to sell the EUR and buy the GBP. Selling the EUR is equivalent to selling the EUR/USD, and buying the GBP is the same as buying GBP/USD.

Therefore, to calculate this type of cross, you must divide one offer by the other bid and vice versa.

Applying our figures:

EUR/GBP BID = 0.6558
and

EUR/GBP OFFER = 0.6569

The EUR/GBP two-way price is therefore 0.6558–0.6569.

RELATIVE STRENGTH OF A CURRENCY

If the Canadian dollar/Japanese yen cross rises, its increase reflects the fact that the Canadian dollar is relatively stronger than the Japanese yen, and vice versa. What is the significance of this reading for the components?

Figure 13.6. The relative strength or weakness of one currency in terms of another on the cross has different readings for the components. Understanding these possibilities expands the trading options of a cross trader.

TRADING COMPONENTS

A cross trader is not limited to buying and selling specific currency crosses. By necessity, traders also leg-in or leg-out a cross. This means that they start or end their trading with a component, rather than always trading crosses. For instance, Swiss franc traders frequently get caught with unwanted positions in the interbank market. The optimal solution in the short run to weather a rapid unfavorable market move is to leg-in a euro/Swiss franc (EUR/CHF) cross, because at times the correlation between the euro and the Swiss franc is high. When the market stabilizes, the trader can leg-out.

Another common scenario involves a trader caught in a losing cross position. Generally, a cross position makes a profit on only one of the components. Once it becomes clear which way the market is heading, the trader will leg-out the money-losing component, while keeping the profit-making component. This type of strategy can minimize a loss or generate a profit.

POSITION CALCULATION

Trading in crosses is executed in amounts of foreign currency rather than U.S. dollars, since no U.S. dollars are involved in the first place. The cross amounts are generally quoted in the first currency. This type of quoting is executed both in the case of crosses between European and American-quoted currencies: Canadian dollar (CAD) in the case of Canadian dollar/Japanese yen (CAD/JPY) or euro/Swiss franc (EUR/CHF). When one or both components are quoted in American terms, then it is the British pound (GBP) in the case of British pound/yen (GBP/JPY) or euro (EUR) for euro/sterling (EUR/GBP).

Therefore, if someone asks for a price in CAD/JPY 10 million, it is understood by both parties that the quote will be in CAD 10 million, not JPY 10 million. By the way, if the CAD/JPY cross is indeed quoted in CAD 10,000,000, what is the JPY amount? To answer this question, you need to know the cross exchange rate. Using a CAD/JPY rate of 81.58, for instance, the Japanese amount is ¥815,800,000:

CAD 10,000,000 × 81.58 = ¥815,800,000

When deciding to leg-out of this CAD/JPY cross position, the trader must know the U.S. dollar value of the components. If USD/CAD spot exchange rate is 1.5180, then the U.S. dollar amount against the Canadian dollar is $6,587,615.28:

CAD 10,000,000/1.5180 = $6,587,615.28

How about the U.S. dollar amount against the Japanese yen? Since we have the cross rate, the USD/CAD rate, and the Japanese yen amount, we can easily calculate the U.S. dollar amount:

1.5180 × 81.58 = 123.83844

¥815,800,000/123.83844 = $6,587,615.28

There is not much reason to go through the calculations, though, because the U.S. dollar amounts are always virtually identical on both sides of any cross.

CALCULATION OF THE CROSS PROFIT AND LOSS

In the previous examples we used the CAD/JPY cross rate of 81.58 and the USD/CAD rate of 1.5180. Based on these rates, we were able to calculate the USD/JPY rate of 123.8384.

Let’s assume that the trader:

- buys CAD 10,000,000 at 81.58, and

- sells CAD 10,000,000 at 81.68.

Because the trader bought low and sold high, we know that the deals generated a profit. To calculate the cross P&L, several methods may be employed.

Example:

The first method consists of translating the CAD/JPY rates into USD/JPY rates and then calculating the profit and loss by using the standard formula for the USD/JPY spot exchange rates.

81.58 × 1.5180 = 123.8384

81.68 × 1.5180 = 123.9902

CAD 10,000,000/1.5180 = $6,587,615.28

Assuming a closing/revaluation price of 124.00, the P&L can be calculated as follows:

P&L = (123.9902 − 123.8384) × $6,587,615.28 / 124.00 = $ 8,064.52

Please notice that the entire profit was calculated for the Japanese yen. In Canadian dollars there was no P&L because the same CAD amount was bought and sold at the same rate.

The second method is a little faster, because it involves only the cross rates, the cross amount, and the closing/revaluation rate for the Japanese yen:

P&L = (81.68 − 81.53) × CAD 10,000,000 / 124.00 = $ 8,064.52

The same methods are applied for a higher number of cross deals.

Example:

A trader executes the following cross deals:

The first step in calculating the P&L is averaging the buying and the selling exchange rates.

14 Currency Futures

Currency futures are specific types of forward outright deals. Because they are derived from the spot price, they are derivative instruments. They are specific with regard to the expiration date and the size of the trade amount. Whereas forward outright deals—those that mature past the spot delivery date—will trade any amount and mature on any valid date in the two countries whose currencies are being traded, futures can be traded in only fixed foreign currency amounts and mature only four times a year, on the third Wednesday of March, June, September, and December.

THE CURRENCY FUTURES MARKETPLACE

Currency futures are relatively new, but commodity futures go back a long time. The Chicago Mercantile Exchange (CME), for instance, was established in 1919, succeeding the Butter and Egg Board, which had been established in 1898. It is on regulated exchanges such as the CME that currency futures are traded.

Currency futures are traded on regulated exchanges similar to the stock markets. The largest currency futures market is the International Monetary Market (IMM) division of the Chicago Mercantile Exchange.

Foreign currency futures trading began on May 16, 1972. The exchange consists of four divisions:

1. The International Monetary Market (IMM): foreign exchange, interest rate and equity index futures, and all IMM and IOM futures, and all options on futures contracts.

2. The Chicago Mercantile Exchange (CME): any contract listed at CME.

3. The Index and Option Market (IOM), established in 1982: index futures contracts, random length lumber contracts, all options on futures contracts, and all GEM products.

4. Growth and Emerging Markets (GEM): various products, including those related to emerging market countries.

THE INTERNATIONAL MONETARY MARKET

The trading success of currency futures since 1972 triggered the introduction of options on deutsche mark futures on the IMM in 1984; on British pound and Swiss franc futures in 1985; and on Japanese yen, Canadian dollar, and ECU futures in 1986. By 1992, the IMM had also introduced its first nondollar futures and options: the deutsche mark/Japanese yen cross contracts.

The appeal of trading currency futures declined drastically toward the end of the twentieth century, as floor trading for a fixed number of hours a day became a clear anachronism in the fast-paced twenty-four-hour-a-day world of electronic trading. This concern was addressed in an unusual way: Exchange members voted to transform the not-for-profit, membership-owned organization into a for-profit, shareholder-owned corporation in June 2000. Since then, floor trading has been reduced to a trickle in favor of twenty-four-hour-a-day electronic trading, the exchange has moved away from the cumbersome futures pricing in favor of cash-style pricing, and volume in currency futures has surged. Capitalism at work!

Besides the IMM, one can trade currency futures markets on a much smaller scale on FINEX in New York City.

FINEX

FINEX is part of the New York Cotton Exchange (NYCE), the oldest futures exchange in New York (founded in 1870). The exchange lists futures on the U.S. Dollar Index, which consists of the trade-weighted geometric average of EUR (57.6%), JPY (13.6%), GBP (11.9%), CAD (9.1%), SEK (4.2%), and CHF (3.6%), and on Euro Index, which consists of the geometric average of USD (31.55%), JPY (18.91%), GBP (30.56%), SEK (7.85%), and CHF (11.13%).

It has the same maturity dates as the IMM contracts: the third Wednesday in March, June, September, and December.

CHARACTERISTICS OF CURRENCY FUTURES

Let’s take a look now at two characteristics of currency futures that make them attractive.

1. A futures market provides certain advantages to the trading of futures and options on futures:

- It is open to all market participants, individuals included, because of the small size of the currency amounts traded and because of leverage.

- It is a central market, just as efficient as the cash market, and whereas the cash market is a decentralized market, futures trading takes place under one roof. The old-fashioned “open” floor trading is virtually over, but traders continue to trade futures electronically.

- It eliminates the credit risk because the Chicago Mercantile Exchange Clearinghouse acts as the buyer for every seller, and vice versa. In turn, the clearinghouse avoids its own exposure by requiring traders to post letters of credit and margins.

What a futures market does not do is guarantee that the currency will trade at a specific price at any future time. For example, if the British pound futures’ settlement price on August 3 for expiration in September is 1.8000, it doesn’t suggest or guarantee a price of 1.8000 for the September expiration date. Therefore, one should be aware that the price simply reflects the market expectations at a certain time regarding the future price of a specific currency.

2. Several innate benefits:

- Hedging tool. Since futures are special types of forward outright contracts, corporations can use them for hedging purposes.

- Arbitrage opportunities vis-à-vis the spot market. Although the futures and spot markets trade closely together, certain divergences between the two occur, generating arbitraging opportunities.

- Special technical analysis formations. Gaps, volume, and open interest are significant tools solely available in the futures market. Their significance extrapolates well to the spot market.

- “Price discovery” if the spot market cannot provide a quick quote. But the practicality of this characteristic is limited, because the futures transactions might occur on light volume, commonly too little to satisfy the demand in the spot market.

THE LOOK OF CURRENCY FUTURES

Currency futures look different relative to the cash rates we have seen so far. The only exceptions are the euro, the British pound, and the Australian and New Zealand dollars because on the IMM all quotes are in American terms, not European. In the cash market, however, many of the exchange rates are quoted in European terms. The price difference between the futures and the cash quotes occurs because a futures contract is a forward outright, not a spot.

To calculate the futures prices for the rest of the currencies, you simply get the inverse of the outright price of the currency quoted in European terms. The outright price, as you recall, is calculated by adding or subtracting the forward pips to or from the spot price. As forward spreads decline daily toward the fixed maturity date, the outright and spot prices converge two days before maturity. Figure 14.1 shows the diagram of this price convergence.

Currency future price = 1 / (Spot price in European terms +/- forward spread)

Example:

If the spot USD/CHF price is 1.5100 and the IMM discount spread is 0.0080, then the IMM dated USD/CHF forward outright will be

1.5100 − 0.0080 = 1.5020, in European terms,
and

1/1.5020 = 0.6658, in American terms.

Figure 14.1. Diagram of the convergence between the futures and the spot prices.

Since futures are forward outright contracts, and since the forward prices are generally slow movers, the elimination of the forward spreads will transform the futures contracts into spot contracts. This is important in order to compare the two types of contracts, and it is important to the traders for hedging, arbitrage, and price discovery.

FORWARD OUTRIGHT PRICE CALCULATION

The forward outright pips (or spread) is calculated as follows:

FP = S × (Efc − E$) × (t/360)

where

FP = forward outright pips

S = spot price

E$ = eurodollar rate

Efc = eurocurrency rate
t = days to delivery

The forward outright price is calculated as:

FWD PRICE = S + FP

Example:

USD/CAD spot = 1.5000

Eurodollar 2 months = 5.20%

Eurocanada 2 months = 4.60%

T = 60 days

FP=1.5000 × (0.046 − 0.052) × (60/360) = −0.0015

FWD price = 1.5000 − 0.0015 = 1.4985 (in European terms)

The future price, or the forward outright price thus obtained and expressed in American terms, is then:

1/1.4985 = 0.6673

FUTURES MARKET AND CASH MARKET: COMPARISONS

Let’s see how the futures market (FM) compares to the cash interbank market (CM).

Market Environment

- FM. Trading takes place in a centralized market, generally electronic and marginally by “open outcry” through the few remaining floor brokers.
CM. Trading is completely decentralized, being generally executed through dealing systems and on electronic platforms.

- FM. The monitor shows live prices.
CM. The monitor shows both live prices and suggested prices.

Market Participants

- FM. Players consist of commercial banks, investment banks, corporations, financial institutions, and individual speculators.
CM. By and large, the participants are commercial and investment banks, along with large corporations; individuals or smaller corporations generally have a limited participation.

- FM. Counterparty is the exchange.
CM. The counterparties know their identities, either before the trade (Internet-based platforms and dealing systems) or after the trade (matching systems).

Quoting Style

- FM. Players quote both one-sided and two-way prices.
CM. Players quote both one-sided and two-way prices as well.

- FM. Trading is executed in foreign currency amounts only.
CM. Prices are quoted in both foreign currency and dollar terms.

- FM. Futures are traded in multiples of fixed amounts of foreign currencies, known as contracts.
CM. Generally, the trading unit is $1,000,000 (electronically); any standard or odd amount in any currency may be traded.

- FM. Prices are quoted only in American terms.
CM. Prices are quoted in both European and American terms.

Settlement Dates

- FM. The maturity dates are standardized in order to maximize the liquidity: March, June, September, and December.
CM. The settlement dates for spot and forward deals are possible on any business days common in both countries of origin.

- FM. Less than 1 percent of the trades result in physical delivery.
CM. Nearly all cash trades result in physical delivery.

- FM. Settlements are made daily through the exchange’s clearinghouse.
CM. Settlements are made through nostro accounts.

- FM. Futures may be quoted up to twelve months in advance.
CM. The long dates are open, as maturities may go well over three years.

Trading Costs

- FM. Initial and variation margins are required for all the players.
CM. Margins are not required expcept for a tiny minority that leverages.

- FM. Commissions are required on single, round-turn basis.
CM. The buyer and seller in the matching systems may pay commissions; there are no commissions in the direct market.

Volume

- FM. In terms of volume, it is only a fraction of the cash market.
CM. Out of the $1.9 trillion traded daily, most transactions are traded in the spot, then in swap and forward outright.

MARGINS

Margin is the amount of money or collateral deposited by a customer with the broker, by a broker with his clearing member, or by a clearing member with the clearinghouse in order to ensure the broker or clearinghouse against loss on outstanding futures positions.

There are two types of margins: initiation and variation or maintenance. The initiation margin, which is covered via liquid government instruments, such as T-bills, entitles a trader or a firm to trade currency futures. The trader’s daily loss cannot exceed the size of this margin.

The variation, or maintenance margin must fully cover any unrealized loss and must be posted in cash by any trader holding an overnight position with a negative P&L. It must be kept on deposit at all times.

Margins are applied differently to each currency contract and, within each currency, separately to speculative and hedging contracts.

Figure 14.2. Trading futures in cash price-style is possible via side-by-side trading on Globex. This method is attractive for more types of players.

Example:

As of July 11, 2006, some of the initiation margins for speculative accounts were as follows:

The margins posted are interest-bearing.

CONTRACT SIZE

The size of a contract in the futures market differs among currencies. The specific amounts for the major currencies futures contracts are as follows:

Currency | Symbol | Contract Size
Euro | EC | 125,000
Swiss franc | SF | 125,000
British pound | BP | 62,500
Japanese yen | JY | 12,500,000
Canadian dollar | CD | 100,000
Australian dollar | AD | 100,000
New Zealand dollar | NE | 100,000
Brazilian real | BR | 100,000
Mexican peso | MP | 500,000
Russian ruble | RU | 2,500,000
South African rand | RA | 500,000
Chinese renminbi | RMB | 1,000,000

Futures on other emerging currencies are available, but trading volume is light.

There also are two e–mini contracts traded on Globex—euro FX and yen futures, which have half the size of the major EC and JY contracts.

Price information on foreign currencies futures is available in the major newspapers and online at www.cme.com/trading/prd/fx/.

TRADING

Trading is primarily executed electronically via Globex, and to a very small extent via open outcry on the floor, which is a legacy method.

GLOBEX

Globex is an electronic trading system created through the joint venture of the Chicago Mercantile Exchange (CME), the Chicago Board of Trade (CBT), and Reuters PLC. The system was conceived in 1987 as an after-hours trading system geared toward global futures trading. The system was launched on June 25, 1992.

The current platform allows traders to trade currencies around the clock, starting on Sunday evening and continuing through Friday evening. On Globex you see “cash format,” called side-by-side, which means futures are traded simultaneously via open outcry on CME’s trading floor and on the CME Globex (see Figure 14.2). The new system, which was developed by Euronext, enables clients to use their own proprietary trading applications or the systems provided by futures brokers and independent software vendors.

TYPES OF ORDERS

- Day (Session): Orders specified as Day (Session) remain in the central order book for the duration of the current trading session, unless traded or canceled by the client.

- Good Till Canceled (GTC): GTC orders remain in the central order book until the contract’s expiration, unless traded or canceled by the client.

- Good Till Date (GTD): GTD orders remain in the central order book until the date specified by the client, unless traded or canceled by the client.

- Fill or Kill (FOK): FOK orders will either be fully executed at the best price or will be canceled.

- Fill and Kill (FAK): FAK orders will have as much quantity executed as possible at the best price, and the remaining quantity will be canceled.

OPEN OUTCRY

There are two types of traders who still deal futures on the floor: floor traders, or locals, and floor brokers. They communicate by open outcry and hand signals. Floor traders are exchange members who execute their own trades by being physically present in the pit, which is the place for futures trading. Floor brokers are individuals on the exchange floor engaged in executing orders for another person. They may also trade for their own account, but they must execute their customers’ orders first. Brokers are licensed by the federal government. CME enforces strict rules and trading activity is monitored by a computerized surveillance system.

To identify themselves on the floor, the members don trading jackets in the colors of the firm they represent. For further ease of identification, each badge also sports a unique set of initials (handle), not necessarily corresponding with the trader’s name.

TRADING HOURS

Whereas the cash market and Globex trade virtually around the clock, the futures markets trade only within certain hours. For instance, Chicago IMM trades between 7:20 a.m. and 2 p.m. CST. On the days prior to CME holidays and bank holidays, when the exchange is open, trading ends at noon CST.

The trading hours in the futures market have an important bearing on the cash market trading hours. The “unofficially official” closing time in the New York cash market is 3 p.m. EDT.

Banks do not have an obligation to quote exchange rates outside these hours. The IMM starts trading at 8:20 a.m. EDT because the most important economic data is released in the United States at 8:30 a.m. EDT. Therefore, prior to electronic trading futures traders have ten minutes to make last-minute adjustments in their positions.

MINIMUM PRICE CHANGE

Currency futures prices change in increments of 1 pip, with the exception of the British pound price, which moves in increments of 2 pips.

Value of 1 Pip. Every time a currency futures contract moves up or down, it generates a change in profit and loss (P&L) equal to the value of 1 pip.

The values of 1 pip differ among currencies:

- For EC, SF, and JY, a pip is worth $12.50.

- For BP, a pip is valued at $6.25.

- For CD and AD, a pip is priced at $10.

MARK-TO-MARKET

Mark-to-market is executed at the end of the day to account for the value of open positions relative to closing prices. It is a daily cash flow system used by futures exchanges to maintain a minimum level of margin equity for a specific currency future or option, by calculating the profit and loss at the end of each trading day, in each contract position, resulting from the price fluctuation.

The calculation of the profit and loss (P&L) for currency futures is executed as follows:

P&L futures = (PS − PB) × K × $12.50*
where

PS = average selling price

PB = average buying price

K = number of contracts traded

* = for EU, SF, and JY

Example:

You sold 100 Sep EC contracts at 11700 and 100 Sep EC contracts at 11780. You closed your position by buying back 200 Sep EC contracts at 11850. Let’s calculate your P&L.

P&L = (11850 − 11740) × 200 × $12.50 = $275,000

Nice profit.

ARBITRAGE

Arbitrage is a risk-free type of trading where the same currency is bought and sold simultaneously in two different markets in order to cash in on the divergence between these markets. Let’s take a look at the arbitrage opportunities in the futures market.

The futures market activity closely resembles the spot market activity. There is, of course, a good reason for this. Futures are forward outrights, after all. The forward spread moves slowly, but can be easily stripped. What you are left with is the spot price, as derived from the futures price. Therefore, the two prices should move in tandem, which they do most of the time. But there are some rare exceptions, and the arbitrageurs scramble to bank on these opportunities.

A Trader’s Point of View

How and when do these situations occur? In terms of volume, the futures market is only a fraction relative to the spot market. Consequently, it is easier to “move the market.” Just imagine extending two rubber bands: a thin one and a thick one—about forty times thicker. Which one can you extend easier? (Bodybuilders need not apply.)

Timing, as usual, is very important. Arbitrage opportunities occur when the market is volatile. It is close to impossible to spot a price divergence between the cash and futures in a normally busy market. Since currency futures are less liquid, ranges in portions of the day tend to overshoot during a fast market (or overextend the thinner rubber band). It’s arbitrage time.

It sounds pretty easy, doing the arbitrage. Doesn’t everybody like getting involved in a riskless operation that is so profitable? Well, there is more exchange risk than meets the eye, especially for a type of deal that is supposed to be riskless.

Whereas the range is wider for foreign currencies than the spot currencies, the liquidity is more limited. Traders may find it difficult matching the futures amounts with the spot amounts. It is much easier to execute an order on the spot side. In addition, translating the cash amounts, generally quoted against the U.S. dollar, to numbers of standardized foreign currency contracts may add to the difficulty of the task.

EXCHANGE FOR PHYSICAL (EFP)

Currency futures are forward outright deals with several special characteristics. Also, as we know by now, futures are traded on centralized markets, which operate less than a third of the day. What happens if traders want to trade outside these hours, but lack the access to Globex? A popular solution is the exchange for physical (EFP).

EFPs consist of deals executed in the cash market, outside the exchanges, for amounts equivalent to the currency futures amounts, on forward outright prices valued for the futures’ expiration. Commercial and investment banks generally quote EFPs even during the regular trading hours.

They differ from the regular forward outright deals not only from the point of view of the standardized amounts and expiration dates, but also in the paying and receiving instructions (P&R). The trader asking for and trading the EFPs must instruct the market maker to execute the payments to the appropriate currency futures broker on the exchange, not to the regular nostro accounts. Unlike a cash forward outright deal, an EFP has the same credit risk coverage as a currency futures contract. Therefore, EFPs are the instrument of choice for credit-conscious players as well.

Moreover, if there is a time difference between the futures and EFP positions, the futures positions will be subject to the margin requirements, even if the position is practically square. Since EFPs may be traded parallel to currency futures, arbitrage opportunities are theoretically possible. In reality, the costs of transactions and the tight market correlation minimize these opportunities.

REGULATION IN THE UNITED STATES

The Commodity Futures Trading Commission (CFTC) was created by Congress in 1974 as an independent agency with a mandate to regulate commodity futures and options markets in the United States. The agency’s mandate has been renewed and expanded several times since then, most recently by the Commodity Futures Modernization Act of 2000 (CFMA). The CFTC’s responsibilities are parceled as follows:

- Division of Clearing and Intermediary Oversight—oversight of derivatives clearing organizations, financial integrity of registrants, customer fund protection, stock-index margin, registration and fitness of intermediaries, sales practice reviews, National Futures Association (NFA) activities related to intermediaries, and foreign market access by intermediaries.

- Division of Market Oversight—responsibility for initial recognition and continuing oversight of trade execution.

- Division of Enforcement—The Division of Enforcement investigates and prosecutes alleged violations of the Commodity Exchange Act and CFTC regulations. Violations may involve commodity futures or option trading on domestic commodity exchanges, or the improper marketing of commodity investments.

- Office of Chief Economist—independent office responsible for providing expert economic advice to the commission.

- Office of the General Counsel (OGC)—the commission’s legal adviser.

- Office of the Executive Director (OED)—formulates and implements the management and administrative policies and functions of the agency.

The CFTC reviews the terms and conditions of proposed futures contracts and registers them through the National Futures Association.

The NFA is a self-regulatory organization that regulates every firm or individual who conducts futures trading business with public customers. It has aggressively fought fraud and abuse by channeling the retail FX business through rigorous registration requirements, comprehensive compliance rules, strong enforcement authority, and trade practice and market surveillance.

Regulatory Organizations and Associations

- Bank for International Settlements

- Committee of European Securities Regulators (CESR)

- Futures Industry Association

- IOSCO (International Organization of Securities Commissioners)

- National Association of Securities Dealers Regulation (NASD Regulation)

- National Futures Association

- North American Securities Administrators Association (NASAA)

- State Regulatory Agencies

Exchanges Designated by the CFTC as Contract Markets

- CFE (CBOE Futures Exchange)
- Chicago Board of Trade
- Chicago Climate Futures Exchange
- Chicago Mercantile Exchange
- HedgeStreet
- INET Futures Exchange
- Kansas City Board of Trade
- Minneapolis Grain Exchange
- NQLX
- New York Mercantile Exchange
- New York Board of Trade
- OneChicago
- Philadelphia Board of Trade (PBOT)
- USFE (Eurex US)

Derivatives Clearing Organizations Registered with the CFTC

- The Clearing Corporation
- CME Clearing House
- EnergyClear
- HedgeStreet

- Kansas City Board of Trade Clearing Corporation

- LCH.Clearnet Limited
- MGE Clearing House
- New York Clearing Corporation
- NYMEX Clearing House
- The Options Clearing Corporation

CONCLUSION

The establishment of the International Monetary Market by the Chicago Mercantile Exchange in 1972 was an innovative step in the long history of the commodity futures markets. Foreign currency futures have offered an alternative to the cash market and a mechanism for hedging. The IMM also opened the market to smaller investors. The IMM was beneficial to the CME as a whole, as it contributed to the overall growth of the futures industry.

The exchange has been positioning itself for technological steps in the markets. Globex provides a splendid computerized trading environment. Although its use has been hampered by the human need to adjust to changes, the trading system is strategically placed to answer the trading requirements of the twenty-first century.

15 Currency Options

A currency option is a contract between a buyer and a seller that gives the buyer the right, but not the obligation, to trade a specific amount of currency at a predetermined price and within a predetermined period of time, regardless of the market price of the currency; and that gives the seller, or writer, the obligation to deliver the currency under the predetermined terms, if and when the buyer wants to exercise the option.

Currency options are unique trading instruments, equally fit for speculation and hedging. Options allow for a comprehensive customization of each individual strategy, a quality of vital importance for the sophisticated investor. More factors affect the option price relative to the prices of other foreign currency instruments. Unlike the situation with spot or forwards, both high and low volatility may generate a profit in the options market. For some, options are a cheaper vehicle for currency trading. For others, options mean added security and exact stop-loss order execution.

This chapter’s presentation of the fundamentals of options will enable you to select the most advantageous characteristics for your own trading strategy.

THE CURRENCY OPTIONS MARKETPLACE

Currency options trading continues to grow amid increased expertise, rising hedge fund participation, and improving sophistication at the corporate level.

Options prices are based on, or derived from, the cash instruments. Therefore, an option is a derivative instrument. Options are usually mentioned vis-à-vis insurance and hedging strategies. Often, however, traders have misconceptions regarding both the difficulty and the simplicity of using options. There are also misconceptions regarding the capabilities of options. This chapter presents a balanced look at what options are and how they can be of help to you.

BENEFITS OF TRADING OPTIONS

There must be some important advantages to options; otherwise it would be impossible to justify the rush to trade them all around the world. Once you see what they are, you can then decide whether options make sense to you and, if so, how you can profitably take advantage of them.

TRADE, DO NOT GAMBLE

Let’s assume for a moment that you, along with the rest of the market, expect some important news, perhaps the release of economic data or the approach of a significant chart point. It is one of those “make it or break it” situations. Let’s safely assume that you would rather make it than break it.

The currency is likely to become very volatile after the fact. But if you wait until the information becomes available, you may find it difficult to join the consequent fast market. In the cash market, you will likely face the choice of waiting longer than you want to, or gambling and taking a 50–50 chance, plunging in either way and hoping for the best. Of course, hope hasn’t so far proven itself to be one of the leading money management theories. And gambling is conducted in institutions better equipped for that type of activity.

The answer to this kind of trading dilemma is options. Unlike in the cash market, you can buy both a call and a put, in an option strategy called a straddle, and you can realize a profit regardless of the direction of the market.

FLAT MARKET

There are few worse scenarios for currency traders than a relatively flat market, since lack of movement means lack of profit and probably high brokerage costs. Reality is that slow trading periods do occur. Again, the solution to the problem is options trading.

In a flat market, a trader may sell, or write, options. Because the writer of the option will receive a premium, or the price of the option, from the buyer of the option, this becomes good old-fashioned trading income.

Traders who expect the currency to rise buy call options from sellers, or writers. Those who expect the currency to ease buy puts from sellers, or writers. Writers either have an opposite expectation from buyers or expect a relatively stable market.

LIQUID MARKET

Once, when a group of students was asked why they would trade currency options instead of cash instruments, one of the answers stood out: “Because they are there.” It is absolutely true, at least in terms of liquidity: The market is out there, both for cash and currency futures. The options markets are deep and there are many counterparties ready and willing to intellectually duel with you on the direction or volatility of the market. Liquidity is a sine qua non condition for a successful market, and currency options markets are generally deep.

INSURANCE

It is important to understand that trading options will not necessarily provide you with any financial insurance. Traders who buy options should realize that they are not securing insurance per se, but insurance in the sense of simply knowing how much they can lose if the market performs differently from their forecast.

However, if trading options means selling, or writing, options, the insurance aspect completely and fully disappears, other things being equal. If the market makes an adverse move, the writer has no protection from the option.

Of course, things are not so terrible for the writer, who will be paid the premium; this offers a limited buffer against the adverse move. In addition, the option writer can always hedge or cover the short position.

HEDGING

At one time, the usual hedging methods for corporations revolved around swaps, forward outright contracts, and futures. However, for some time, currency hedging has become an important tool for corporations, and currency options are increasingly becoming vital tools in this process.

One advantage is that buyers know the maximum loss that they might suffer. This feature is important, as management is able to consider real costs, not expectations, when hedging is considered. Also, with the continuous overall growth of foreign exchange markets, the increased currency volatility, and the more general internationalization of trade, corporate treasurers have been presented with higher obstacles to clear. Currency options have the advantage of offering more comprehensive hedging possibilities, due to their capacity for customization.

RANGING THE EXCHANGE RISK

Not all corporations are willing to hedge the entire currency position. Some players fix either the upside or the downside risk, and these single-side risks may be fixed through basic options. Limiting the risk—and profitability—on both sides may be achieved through an option known as a fence. The ability to fix, or range, one or both sides of the exchange risk constitutes a major advantage of trading options. (Options strategies are discussed in Chapter 16.)

WHERE CURRENCY OPTIONS ARE TRADED

In the currency markets, options are available on either cash or futures. It follows, then, that they are traded either over-the-counter (OTC) or on the centralized futures markets.

THE OVER-THE-COUNTER MARKET

The majority of currency options is traded over-the-counter. The over-the-counter market is similar to the spot or swap market. Corporations may call banks and banks will trade with each other either directly or in the brokers’ market. This type of dealing allows for maximum flexibility: any amount, any currency, any odd expiration date, and any time. The currency amounts may be even or odd. The amounts may be quoted in either U.S. dollars or foreign currencies.

Any currency may be traded as an option, not only the ones available as futures contracts. Therefore, traders may quote on any exotic currency, as required, including any cross currencies. The expiration date may be quoted anywhere from several hours to several years, although the bulk of dates are concentrated around the even dates—one week, one month, two months, and so on. The cash market never closes, so options may be traded literally around the clock.

Customization does not come free. Credit and country risk are important factors in the decision-making process.

OPTIONS ON CURRENCY FUTURES

In the United States, three exchanges offer option contracts on currency futures: the Chicago Mercantile Exchange (CME), the Philadelphia Stock Exchange (PHLX), and the New York FINEX. The CME is by far the leader.

Options on deutsche mark futures were introduced on the Chicago IMM in 1984 by the Chicago Mercantile Exchange’s Index and Option Market (IOM). In 1985, options on British pound and Swiss franc futures were added. Since 1987, options on Japanese yen, Canadian dollar, French franc, and Australian dollar have been introduced as well.

The introduction of the euro in 1999 was followed by the prompt introduction of options on euro futures. Figure 15.1 shows the specifications of selected options on futures.

Trading options on futures minimizes credit and country risk, as the clearinghouse takes the opposite side on every deal. Therefore, a trader buys from or sells to the exchange, not to another trader. This way, traders can focus on dealing, rather than on securing credit lines with the other participants. However, traders must be aware of the limitations generated by the reduced number of currencies available to trade and by the standardization of currency contract sizes and expiration dates.

Trading an option on currency futures will entitle the buyer to the right, but not the obligation, to take physical possession of the currency future. Unlike with currency futures, buying currency options does not require an initiation margin. The option premium, or price, paid by the buyer to the seller, or writer, reflects the buyer’s total risk.

However, upon taking physical possession of the currency future by exercising the option, a trader will have to deposit a margin.

THE U.S. DOLLAR INDEX

FINEX, a division of the New York Cotton Exchange, offers a centralized market for trading options on the U.S. Dollar Index. This index, which consists of the weighted average of the prices of six foreign currencies against the U.S. dollar, provides the same general indication of the international value of the U.S. dollar that the Dow Jones Industrial Average provides of the value of the U.S. stock market.

Currency | Weight (%)
Euro | 57.6%
Japanese yen | 13.6%
British pound | 11.9%
Canadian dollar | 9.1%
Swedish krona | 4.2%
Swiss franc | 3.6%

Figure 15.1. Contract specifications of options on the most important currency futures on the Chicago Mercantile Exchange. (Source: CME)

PREMIUM

Premium is the price of the option paid by the buyer to the seller. It is usually paid at the time of the trade, but it may also be paid at the expiration date. Premium may be quoted in points or in percentages and may be expressed in three different ways:

1. Percentage in U.S. dollars. If both the unit of account and the premium are quoted in the same currency, then the price will be quoted in the OTC market as a percentage of the U.S. dollar amount through the strike or exercise price—the price at which the underlying currency will be delivered upon exercise.

Example:

Buy a June 5 Swiss franc call struck at CHF 1.50 for 4 percent.

If the amount is CHF 3,000,000, then the premium will be:

CHF 3,000,000/CHF 1.50 = $2,000,000

$2,000,000 × 4 percent = $80,000

2. In U.S. dollars where the option quotes are made in foreign currency per U.S. dollar (European terms) in the OTC market.

Example:

Buy a June 5 Swiss franc call struck at CHF 1.50 for $.027. If the amount is CHF 3,000,000, then the premium will be:

CHF 3,000,000 × $.027 = $81,000

3. In U.S. dollars where the option quotes are made in U.S. dollar per foreign currency unit (American terms) on the futures market.

Example:

A quotation of .88 would represent $.0088 per SF. The option premium would be $1,100 (125,000 SF × $.0088) on the CME.

THEORETICAL MODELS: FACTORS DETERMINING OPTION PRICE

Seven major factors have an impact on the option price:

1. Price of the currency.

2. Strike (exercise) price.

3. Volatility of the currency.

4. Expiration date.

5. Interest rate differential.

6. Call or put.

7. American or European option style.

In the next seven sections, we examine each of these factors in detail and provide numerous figures and examples to illustrate their impact on option prices.

PRICE OF THE CURRENCY

The currency price is the central building block, as all the other factors are compared and analyzed against it. It is the currency price behavior that both generates the need for options and affects the profitability of options.

The impact of the currency price on the option premium is measured by delta, the first of the Greek letters used to describe aspects of the theoretical pricing models in this discussion of factors determining the option price.

Delta

Delta, or commonly Δ, is the first derivative of the option-pricing model.

Delta may be viewed from three angles.

1. Generally, delta is understood to be the change of the currency option price relative to a change in the currency price. For instance, an option with a delta of .5 is expected to move at one-half the rate of change of the currency price. Therefore, if the price of a currency goes up 10 percent, then the price of an option on that particular currency is expected to rise by 5 percent.

2. Delta may also be perceived by futures traders to be the hedge ratio between the option contracts and the currency futures contracts necessary to establish a neutral hedge. Therefore, an option with a delta of .5 will need two option contracts for each of the currency futures contracts.

3. Finally, delta may be called the theoretical or equivalent share position. In this case, delta is the number of currency futures contracts by which a call buyer is long or a put buyer is short. If we use the same example of the delta of .5, then the buyer of the put option is short half a currency futures contract.

The value of delta ranges between 0 and 1. Figure 15.2 presents a graph of delta.

Dynamic Hedging

The relationship between the price of the currency and the premium of the option on that specific currency is intrinsically dynamic. To keep this relationship constant, the position must be delta hedged. Because the hedge must be adjusted continuously, this process is known as dynamic hedging. The failure to implement dynamic hedging adds market risk to the position.

Applying this method in practice may be a taxing undertaking. When volatility significantly exceeds a trader’s forecast, the cost of dynamic hedging may be very high. In addition, the hedge does not provide comprehensive protection during high volatility—crisis—situations, in which the currency prices gap. Price gapping occurs when prices jump from one level to another, rather than moving continuously to the sequential price. For instance, if the price is 1.6000, then the next price on the upside in a regular market should be 1.6001, and then 1.6002. In a gapping market, the next price after 1.6000 may be 1.6050, allowing traders no room for adjusting their positions.

Figure 15.2. Graph of delta.

Traders may be unable to secure prices in the spot, forward outright, or futures market, temporarily leaving the position delta unhedged. In order to avoid the high cost of hedging and the risk of unusually high volatility, traders may hedge their original options positions with other options. This method of risk neutralization is called gamma or vega hedging.

Gamma

Gamma (Γ) is also known as the curvature of the option (see Figure 15.3). It is the second derivative of the option-pricing model and is the rate of change of an option’s delta, or the sensitivity of the delta. For instance, an option with delta = .5 and gamma = .05 is expected to have a delta = .55 if the currency rises by 1 point, or a delta = .45 if the currency decreases by 1 point. Gamma ranges between 0 percent and 100 percent. The higher the gamma, the higher the sensitivity of the delta. It may therefore be useful to think of gamma as the acceleration of the option relative to the movement of the currency.

A Trader’s Point of View

- Gamma is at its highest for short-dated at-the-money options.

- Options buyers like high gamma options because of the advantageous leverage.

- Writers of high gamma options are taking high risk due to potentially great fluctuations in the premium caused by relatively small swerves in the spot rate.

Figure 15.3. Graph of gamma.

Strike or Exercise Price

What does it mean to say that the buyer has the right to “exercise” his or her option at a predetermined price? Exercising refers to the process in which a buyer converts the option into a currency position. In the case of a call, exercising will create a long currency position, whereas in the case of a put, the buyer will have a short currency position.

The exercise or strike price, then, is simply the price at which the underlying currency will be delivered upon exercise. How does it relate to the currency price?

In-the-Money

A call that has a present currency price higher than the strike price is called in-the-money or ITM (see Figure 15.4). A put that has the present currency price lower than the strike price is also called in-the-money (see Figure 15.5).

In-the-money currency options are the most expensive, since the strike price is better than the current price of the underlying currency, and the currency must move only moderately in order to generate a profit.

Figure 15.4. Diagram of a call in-the-money (ITM) on euro futures.

Figure 15.5. Diagram of a put in-the-money (ITM) on euro futures.

Example:

At-the-Money

If the present currency price is approximately equal to the strike price, the option is at-the-money or ATM (see Figures 15.6 and 15.7). These currency options have less expensive premiums, as the strike price is close or identical to the current price of the underlying currency.

Example:

Figure 15.6. Diagram of a call at-the-money (ATM) on euro futures.

Figure 15.7. Diagram of a put at-the-money (ATM) on euro futures.

Figure 15.8. Diagram of a call out-of-the-money (OTM) on euro futures.

Out-of-the-Money

A call that has the present currency price lower than the strike price is called out-of-the-money or OTM (see Figure 15.8). A put that has the present currency price higher than the strike price is called out-of-the-money or OTM (see Figure 15.9).

Figure 15.9. Diagram of a put out-of-the-money (OTM) on euro futures.

Example:

The premiums for OTM options are the cheapest, since the strike price is worse than the current price of the underlying currency. Therefore, the currency must make a substantial move in order to generate a good profit.

Intrinsic Value

Intrinsic value is the amount by which an option is in-the-money. In the case of a call, the intrinsic value equals the difference between the underlying currency price and the strike price.

Example:

IVcall = PCP − SP
where

IVcall = intrinsic value of a call

CP = present currency price

SP = strike price

In the case of a put, the intrinsic value equals the difference between the strike price and the present currency price, when beneficial.

Example:

IVput = SP − PCP
where

IVput = intrinsic value of a put

SP = strike price

PCP = present currency price

It follows, then, that out-of-the-money options do not have any intrinsic value.

Extrinsic Value or Time Value

The extrinsic or time value (also known as the time premium) consists of the difference between the option premium and its intrinsic value. Since out-of-the-money options do not have any intrinsic value, these options’ premium equals only the time value.

Example:

TV = P − IV
where

TV = time value

P = premium

IV = intrinsic value

In this example, you can identify each option’s premium, intrinsic value, and time (extrinsic) value, based on the currency option, currency price, and option price:

Example:

VOLATILITY OF THE CURRENCY

Volatility is the degree to which the price of currency tends to fluctuate within a certain period of time. Free-floating currencies, such as the euro or the Japanese yen, tend to be volatile against the U.S. dollar (see Figure 15.10).

Figure 15.10. Historical price volatility of the Japanese yen.

The volatility of a pegged currency, such as the Argentine peso, is nearly 0 versus the currency against which it is pegged, in this case the dollar.

Sometimes a currency not officially pegged is quasi-pegged and as a result its volatility is low. The Saudi riyal, for instance, is quasi-pegged to the U.S. dollar at the rate of 3.75 and its historical volatility vis-à-vis the U.S. dollar is very low (see Figure 15.11).

Figure 15.11. Historical price volatility of the Saudi rial.

Volatility is a key factor in option pricing. Unfortunately, measuring volatility is a rather strenuous effort.

Example:

where

V = volatility
n = number of observations

Pi = daily price

P = average price of all pi

In probability theory, the bell-shaped curve, known as the normal distribution curve, can be measured in terms of its mean, or the height of the curve, and its standard deviation (σ), or the speed at which the curve spreads out (see Figure 15.12). The standard deviation helps us measure the probability that a random event will occur. Traders use the standard deviation to measure the exact likelihood of a currency levels occurring within a certain range:

1. σ takes in 68.3 percent of all the possible outcomes (or 2/3).

2. σ take in 95.4 percent of all the possible outcomes (or 19/20).

3. σ take in 99.7 percent of all the possible outcomes (or 369/370).

Figure 15.12. The normal distribution curve.

How does this apply to a foreign exchange rate? If USD/CHF is trading today at 1.4000 and has a volatility of 12 percent, then a standard deviation price change of one over a year’s time would be:

1.4000 × 12 percent = 0.168

So, one year from now, we expect the USD/CHF to trade between:

1.2320 and 1.5680 (1.4000 +/- 0.168) for 2/3 of the time.

1.0640 and 1.7360 (1.4000 +/- 0.168) for 19/20 of the time.

.8960 and 1.9040 (1.4000 +/- 0.168) for 369/370 of the time.

Only rarely do traders concern themselves with the price movement in a year’s time, so it may help to calculate the standard deviation in shorter periods of time.

To change a volatility number from a yearly standard deviation to a weekly standard deviation:

To change a volatility number from a yearly standard deviation to a daily standard deviation

Example:

A JPY Sep futures contract trades at 89.90 and has an annual volatility of 14 percent; it will have a weekly standard deviation of

(89.90 × .14) / 7.2 = 1.75
and a daily standard deviation of:

(89.90 × .14) / 16 = 0.79

There are basically two ways to consider volatility. The first is to calculate the standard deviation in a series of rates of changes of spot currency prices that occurred in the past. This is the historical volatility. A trader can, therefore, measure the volatility over any time frame: the last ten days, thirty days, ninety days, or any other period. The second method of measuring volatility is to consider the premiums currently trading in the market, such as OTC or on the Chicago IMM, and to calculate the figure based on the level of the option premium. This approach is called the implied volatility.

Comparing the two types of volatility, you will see that, despite a certain degree of correlation, significant differences do exist. These differences emphasize the difficulty of gauging volatility.

Vega

Vega gauges volatility impact on the option premium. Vega (ç) is the sensitivity of the theoretical value of an option to a change in volatility (see Figure 15.13). For instance, a vega of .2 will generate a .2 percent increase in the premium for each percentage increase in the volatility estimate, and a .2 percent decrease in the premium for each percentage decrease in the volatility estimate.

Figure 15.13. Graph of vega.

A Trader’s Point of View

- Changes in volatility have a maximum dollar impact on at-the-money options and a maximum percentage impact on out-of-the-money options.

- An increase in volatility causes delta to converge toward .5, whereas a volatility decrease causes delta to diverge from .5.

- The impact of a change in volatility is more significant for a long-term option than for a short-term option.

EXPIRATION DATE

The option is traded for a predetermined period of time, and when this time expires, there is a delivery date known as the expiration date. A buyer who intends to exercise the option must inform the writer on or before expiration. The buyer’s failure to inform the writer about exercising the option frees the writer of any legal obligation. However, some exercise is automatic if an option is in-the-money at expiration. An option cannot be exercised past the expiration date.

The writer must be available to be contacted when the option is due to expire.

A Trader’s Point of View

Time is an important factor in an option’s pricing. The decrease in the time to expiration has a similar impact on the delta, gamma, theta (discussed next), vega, and theoretical value as a decrease in volatility.

Theta

Theta (T), also known as time decay, occurs as the very slow or nonexistent movement of the currency triggers losses in the option’s theoretical value (see Figure 15.14).

For instance, a theta of .02 will generate a loss of 0.02 in the premium for each day that the currency price is flat. Intrinsic value is not affected by time, but extrinsic value is. Time decay accelerates as the option approaches expiration, since the number of possible outcomes is continuously reduced as the time passes.

Time has its maximum impact on at-the-money options and its minimum effect on in-the-money options. Time’s effect on out-of-the-money options occurs somewhere within that range.

A Trader’s Point of View

Theta is always more significant for a short-term at-the-money option than for a long-term at-the-money option.

Figure 15.14. Graph of theta on a reversed order.

The table presented here shows the relations among the foreign currency, type of option, and delta (hedge ratio), gamma (curvature), theta (time decay), and vega (volatility) positions.

INTEREST RATE DIFFERENTIAL

Unlike other financial markets, in foreign exchange a single interest rate is insufficient for the decision makers. Every exchange rate means the simultaneous buying of one currency in terms of another.

In options trading, the premium of a call on a foreign currency increases when the U.S. interest rate increases relative to the foreign interest rate, all else being equal. This occurs either when U.S. interest rates rise and foreign interest rates are stable, or when U.S. interest rates are stable but foreign interest rates fall.

The opposite is true in the case of buying a foreign currency put. The option premium increases when U.S. interest rates decrease relative to foreign interest rates, or when foreign interest rates increase vis-à-vis American ones.

Generally, the interest rate used is the risk-free rate (r) of government instruments, such as T-bills.

Interest rates are important for options pricing for two reasons. First, the pricing formula includes the forward price, which is calculated on the differential between domestic and foreign interest rates. Second, the premium of an option must be discounted back to the present value by a risk-free interest rate.

Premium is the expected value of the option at expiration. Because the premium is paid up front, its value is discounted through the present value formula:

Premium = Expected value / [1 + IR (number of days/365)]

Interest rate parity is known among traders as the cost of carry, where the forward price is determined by the cost of borrowing money in order to hold the position. For example, the one-year forward price of EUR/USD is determined by the spot EUR/USD 1.2000 and the one-year interest rate differential: 1.2060. If the quoted prices differ, the arbitrageurs will cash in on the opportunity.

A Trader’s Point of View

The impact of interest rates on the theoretical value of options is more significant on deep in-the-money options.

CALL OR PUT

Currency Call

A call is a contract between the buyer and the seller which holds that:

- The buyer has the right, but not the obligation, to buy a specific quantity of a currency at a predetermined price and within a predetermined period of time, regardless of the market price of the currency.

- The writer assumes the obligation to deliver the specific quantity of a currency at a predetermined price and within a predetermined period of time, regardless of the market price of the currency, if the buyer wants to exercise the call option.

A call option is traded because the buyer believes that the underlying currency will rise above a certain price, whereas the seller expects that the currency will either remain stable or move lower.

Currency Put

Conversely, a put is a contract between the buyer and the seller which holds that:

- The buyer has the right, but not the obligation, to sell a specific quantity of a currency at a predetermined price and within a predetermined period of time, regardless of the market price of the currency.

- The writer assumes the obligation to take delivery of the specific quantity of a currency at a predetermined price and within a predetermined period of time, regardless of the market price of the currency, if the buyer wants to exercise the put option.

In the case of the put, the buyer expects the underlying currency to weaken to or below a specific level, while the seller believes the currency will rise, or simply trade the range.

Perhaps it is a good time to emphasize that the seller of a call is not the same as the buyer of the put. As we go along, it will become more apparent why this distinction is significant.

AMERICAN OR EUROPEAN OPTION STYLE

The exercise of an option may occur on or prior to expiry. Depending on when exercising may occur, there are two types of options: American and European style. The American-style option may be exercised on any valid business date throughout the life of the option. The European-style currency option may only be exercised on the expiry date.

Early Exercise of American-Style Options

Generally speaking, American options are not exercised prior to expiry, but there are exceptions. These occur when an option is deep in the money, when the option is approaching the expiration date and has no extrinsic value, and with call options on high-interest currencies or put options on low-interest currencies.

The logic behind the exercise of an American-style option is that a high-interest currency is likely to depreciate against the U.S. dollar, and vice versa.

The additional opportunities offered by American-style options translate into a higher cost, or premium. However, one should keep in mind that early exercise is usually not beneficial.

ADVANTAGEOUS EARLY EXERCISING SCENARIOS

- Bid–offer spreads in the market may make it too expensive to sell the option and trade forward outrights.

- If the option shifts deeply into the money, the interest rate differential gained by early exercise may exceed the value of the option.

- If the option amount is small or the expiration is close and the option value consists only of the intrinsic value, it may be better to use the early exercise.

OPTION PRICING

Due to the complexity of its determining factors, option pricing is difficult. In the absence of option pricing models, option trading is nothing but inefficient gambling. The flurry of options on equities in the 1920s had an accelerating impact on the stock market crash of 1929.

THE BLACK-SCHOLES FORMULA

The pioneering efforts of several researchers have been vital for option pricing. In 1972, professors Myron Scholes and Fischer Black published in the Journal of Political Economy a method of calculating the fair price, or premium, for a European-style call option on stocks. The method became known around the world as the Black-Scholes model. The Black-Scholes fair value model holds that a stock and the call option on that particular stock are comparable investments; thus, buying the stock and selling the option on the stock as a hedge may create a riskless portfolio. The movement of the price of the option will reflect the movement of the price of the stock, but not necessarily by the same amplitude. Therefore, it is necessary to hold only the amount of stock that will duplicate the movement of the price of the option.

C = SN (d_1) − E / eρt N(d_2)

and
d_1 = [ln (S/E) + (ρ + .5σ^2) t] / σ √t
d_2 = d_1 − σ √t
where

S = spot exchange rate

E = exercise or strike price
e = 2.71828
t = time to expiration
σ = standard deviation of the continuously compounded annual rate of change of the exchange rate
ρ = risk-free rate (T-bills)

ln = the natural logarithm

N(d) = probability that a deviation less than d will occur in a normal distribution with a mean of zero and a standard deviation of 1

The Black-Scholes option pricing model holds, in its original form, several theoretical assumptions, which may diverge from the realities of the financial world. Among those assumptions are:

- constant interest rates,
- constant and known volatility,
- no transaction or taxation costs,
- no dividends,
- no early exercise, and
- continuous trading.

One serious problem that the model in its original form is unable to answer is the expectation of “normal” or continuous trading behavior of the foreign exchange market. Despite its efficient structure, the foreign exchange market has been affected by a long series of unexpected factors that have disrupted the daily continuity of trading. The log-normal distribution is unable to include these types of aberrations.

Robert Merton, who adapted several other assumptions made by the Black-Scholes model, such as no dividends and constant interest rates, relaxed the assumption of market continuity in 1973.

Another weakness is the relationship between spot and forward prices. Despite attempts to make the forward price something more than a “guesstimate,” extraneous forces may affect the forward price. Therefore, the option pricing model tends to under price out-of-the-money currency options.

The original Black-Scholes formula can be applied only to European call options. However, there is a relationship between a call option and a put option established through the forward market. This is called the put-call-forward exchange parity (PCFP) theory.

C − P = (F − E) / (1 + r)

where

C = call

P = put

F = forward price

E = exercise price
r = interest rate

The idea is that the option of buying the domestic currency with a foreign currency at a certain price x is equivalent to the option of selling the foreign currency with the domestic currency at the same price x. Therefore, the call option in the domestic currency becomes the put option in the other, and vice versa.

Another pricing model, introduced by Cox, Ross, and Rubinstein in 1979, was meant to apply to the early exercise provision of American-style options. As it assumes that early exercise will occur only if the advantage of holding the currency exceeds the time value of the option, their binomial method evaluated the call premium by estimating the probability of early exercise for each successive day. The theoretical premium is compared to the holding cost of the cash hedge position until the option’s time value is worth less than the forward points of the currency hedge when the option should be exercised.

The practical applications of the Cox-Ross-Rubinstein model are tedious, and the binomial pricing models must compromise on the number of trials.

In 1983, Mark Garman and Steven Kohlhagen expanded the Black-Scholes model to foreign exchange by using the interest rate differential (the difference between two interest rates) rather than a single interest rate, consequently allowing for the currency forward to be traded at either premium or discount.

Also in 1983, Orlin Grabbe provided a different adaptation of the Black-Scholes model to foreign exchange. And Bodurtha and Courtadon proposed another foreign exchange option pricing model in 1987.

The Black-Scholes formula was adjusted for foreign exchange as follows:

C = e−rtf SN(d) − Ee−rtd N(d − σ √t)

and
d = [ln (S / E) + (rd − rf + σ^2 / 2) t] / σ √t
where

S = spot exchange rate

E = exercise or strike price
e = 2.71828
t = time until expiration
σ = standard deviation of the continuously compounded annual rate of change of the exchange rate
rd = domestic interest rate
rf = foreign interest rate
ln = the natural logarithm

N(d) = probability that a deviation less than d will occur in a normal distribution with a mean of zero and a standard deviation of 1

16 Major Option Strategies on Currencies

Some basic considerations prior to deciding on the best option trading strategy for you are:

- Do you expect the currency to strengthen, weaken, or stay relatively stable?

- Do you expect high or low volatility?

- Why are you choosing to trade an option over a spot, a forward outright, or a futures contract?

This chapter describes the comprehensive gamut of choices available in option trading, in detail and with numerous examples and illustrations. We start with the simple and move to options with the complexity and flexibility that have characterized option trading and turned it into a fast-growing market.

BASIC STRATEGIES

BUYING A CALL OPTION

The buyer of a euro call option acquires the right, but not the obligation, to buy a certain amount of euro at a certain price, on or before a specified value date. The buyer expects the euro to rise (whereas the seller expects the currency to remain stable or ease). The maximum risk the buyer may incur is the premium paid to the seller, or writer, of the option. The maximum benefit is theoretically unlimited but it is not known, as it is impossible to know how the euro will perform. A simple rise in the price of the euro will not guarantee a profit for the buyer, because the rise must be enough to cover the premium before any profit is earned (see Figure 16.1).

Figure 16.1. Graph of a long euro/dollar call.

The premium is the highest for the deep ITM calls and the lowest for deep OTM calls. With an OTM call option, the buyer encounters the smallest financial risk, while having the best leverage. Leverage refers to the expected return on investment, the potential profit generated by the buyer’s investment.

Of course, OTM options in general, and OTM calls specifically, stand the least chance of performing profitably, because for them to be profitable the currency needs to make a substantial price move.

BUYING A SYNTHETIC CALL OPTION

Synthetic options rarely generate arbitrage opportunities, but help one better understand the intricacies of the market. A trader can easily shift from a long call position to a long put position, or from a short call position to a short put position. However, the trader cannot turn a long call position into a short put position or a short call position into a long put position.

Figure 16.2. Graph of a long synthetic euro futures call.

A synthetic call option consists of a combination of a long currency call and a long currency put (see Figure 16.2). The same characteristics of the long call apply.

SELLING A CALL OPTION

Selling a call option is equivalent to writing a naked call on an amount of currency that the writer does not own. In return for the premium, the writer will be ready to sell the predetermined amount of euro at the predetermined exercise, or strike, price if and when the buyer chooses to do so, on or before expiration (see Figure 16.3).

The maximum benefit for the seller is the premium received from the buyer. The maximum risk for the seller is unlimited and unknown. The only financial buffer against loss is the premium. But even if the currency rises, the seller will not lose as long as the currency advancement does not exceed the amount of the premium.

Figure 16.3. Diagram of a short euro futures call.

The break-even point (BEP) is calculated as the sum of the exercise price and the premium.

BEP (call selling) = S + P
where

S = exercise or strike price

P = premium

A Trader’s Point of View

Generally, near-term call options are more desirable to write, as there is less time available for a wide price swing in currency.

A sharp rally in the price of the currency immediately following the writing of the option will generate the largest loss, given the fact that there is no time premium amortization.

In order to avoid or minimize the negative impact of a currency advance, the writer should use a stop-loss order or liquidate the position.

BUYING A PUT OPTION

The buyer of a euro put option acquires the right, but not the obligation, to sell a certain amount of euro at a certain price, on or before a specified value date. The buyer expects the euro to ease (whereas the seller expects the currency to remain stable or rise).

The maximum risk the buyer may incur is the premium paid to the seller of the option. The maximum benefit is theoretically unlimited but it is not known, as it is impossible to know how the euro will perform. A simple fall in the price of euro will not guarantee a profit for the buyer, because the currency must fall low enough to cover the premium before any profit is earned (see Figure 16.4).

The premium is highest for deep ITM calls and lowest for deep OTM calls. With an OTM call option, the buyer encounters the smallest financial risk, while having the best leverage. Of course, OTM options in general, and OTM calls specifically, stand the least chance of performing profitably, because for them to be profitable, the currency needs to make a substantial price move.

Figure 16.4. Diagram of a long euro futures put.

BUYING A SYNTHETIC PUT OPTION

A synthetic put option consists of a combination of short currency and a long currency call (see Figure 16.5). The same characteristics of the long put apply.

Figure 16.5. Graph of a synthetic long put on Japanese yen futures.

SELLING A PUT OPTION

A trader who expects a specific currency to rise or to remain relatively stable for the life of the option sells a currency put option for a premium. The trader selling the put option is known as the writer. In return for the premium, the writer will be ready to buy the predetermined amount of euro at the predetermined exercise, or strike, price, if and when the buyer chooses to do so, on or before expiration (see Figure 16.6).

The maximum benefit for the seller is the premium received from the buyer. This means that the seller needs the price of the currency to stay at any level above the strike price of the put option. The maximum risk for the seller is unlimited, and the only financial buffer against loss is the premium.

The break-even point (BEP) is calculated as the difference between the exercise price and the premium.

Figure 16.6. Graph of a short put on Japanese yen futures.

BEP (put selling) = S − P
where

S = exercise or strike price

P = premium

A Trader’s Point of View

In addition to gaining the premium income, traders also write put options in order to acquire a currency below the current market price.

If the currency price trades below the exercise price, the put will be exercised. However, the exercise is likely to occur only if the option is in-the-money and near-term.

In order to avoid or minimize a loss, the put writer can leave a stop-loss order or buy a put identical to the one originally written.

COMPOUND STRATEGIES

Two of the major problems in foreign exchange—at least for cash traders—are solved by options.

The first problem occurs when the market is very quiet and currency prices are relatively stable. The lack of volatility generally results in lack of profitability. The way out? Options writing.

The second problem appears when traders have certain expectations about a rise in volatility, but lack the confidence to take a view on the direction of the market. We have already talked about the opportunities provided by trading individual calls and puts. Now we can move a step further and combine these classes of options in search of better profits and hedges. These compound strategies are also known as currency spreads.

CURRENCY SPREADS

A spread is a long currency option and an offsetting short currency option, generally in the same currency. If the spread is executed in two different currencies, then the spread is called an intermarket spread.

We discuss two types of spreads. The first is the non-ratio, or regular, spread, which is a compound option strategy in which the number of long options is the same as the number of short options. The second is the ratio spread, in which the number of long options is different from the number of short options.

NON-RATIO (REGULAR) SPREADS

Under the combinations that pair equal numbers of long and short options, we present the following spreads:

1. Straddles
2. Strangles
3. Vertical
4. Calendar
5. Box
6. Butterfly
7. Condor
8. Combination

Straddles (Buying)

Many times, traders are faced with the specter of the release of certain economic data, the expectation of a central bank changing the discount rate, or expectations about the breakout of a currency through a special chart level. Traders are confident about a sudden release of energy in the price of a currency and in its volatility, but not quite sure about the direction of the move. Certainly, these traders would like to soar on the news, not be buried by it.

Long Straddle. A popular choice among option traders in this situation, a quiet market before the big storm, is buying a straddle. A long straddle consists of a long call and a long put on the same currency, at the same strike price and with the same expiration dates (see Figure 16.7). The buyer pays a premium on the call and a premium on the put in order to have the right, but not the obligation, to buy or sell a predetermined amount of foreign currency on or before expiration, at a predetermined price.

The buyer enters a long straddle position in anticipation of a sharp increase in volatility, in effect buying volatility. In order to make a profit, the currency must swing high or low enough to cover investment costs, but once the cost of the premiums is cleared, the profit is theoretically unlimited.

The maximum loss for the buyer is the sum of the premiums. Naturally, the buyer does not have to wait to lose the entire investment, as the position can be sold.

Figure 16.7. Graph of a long euro futures straddle.

Of course, when the price of the currency rises, the value of the call rises, while the value of the put declines. The opposite is true if the value of the currency declines.

The upside break-even point is the sum of the strike price and the premium on the straddle (which is simply the premiums on the individual call and put):

BEP (upside) = S + P
where

S = exercise or strike price

P = premium

The downside break-even point is the difference between the strike price and the premium on the straddle (which is simply the compound premium on the individual call and put):

BEP (downside) = S − P

Straddles (Selling)

Short Straddle. A short straddle consists of a short call and a short put on the same currency, at the same strike price and with the same expiration dates (see Figure 16.8). The writer expects the currency to be relatively stable. In effect, the writer sells volatility.

The maximum profit consists of the combined premium of the two individual options. The loss occurs when the level of the premium is exceeded by the currency swing; then the loss is unlimited.

Strangles (Selling)

A strangle is nothing but a straddle with a twist. The twist consists of disregarding the condition in the definition of the straddle that both options have the same strike price.

Strangles (Buying)

Long Strangle. A long strangle consists of a long call and a long put on the same currency, at different strike prices, but with the same expiration dates (see Figure 16.9). In order to minimize the risk, traders generally buy out-of-the money options. Exactly as in the case of the straddle, the buyer pays a premium on the call and a premium on the put in order to have the right, but not the obligation, to buy or sell a predetermined amount of foreign currency on or before expiration, at a predetermined price.

Figure 16.8. Graph of a shot euro futures staddle.

The buyer enters a long strangle strategy in anticipation of a sharp increase in buying volatility. In order to make a profit, the currency must swing high or low enough to cover the investment costs, but once the cost of the premiums is cleared, the profit is theoretically unlimited.

The maximum loss for the buyer is the sum of the premiums. Naturally, the buyer does not have to wait to lose the entire investment, as the position can be sold.

Of course, when the price of the currency rises, the value of the call rises, while the value of the put declines. The opposite is true if the value of the currency declines.

Short Strangle (Selling). A short strangle consists of a short call and a short put on the same currency, with the same expiration dates, but with different strike prices (see Figure 16.10). The writer expects the currency to be relatively stable. In effect, the writer sells volatility. The maximum profit consists of the combined premium of the two individual options. The loss occurs when the level of the premium is exceeded by the currency swing, and then the loss is unlimited.

Figure 16.9. Graph of a long euro futures strangle.

Vertical Spreads

A vertical spread consists of a strategy with two similar options (i.e., calls or puts), one being bought and the other sold, on the same currency with the same expiration date, but with different strike prices.

There are several types of vertical spreads:

- Vertical bull call spreads
- Vertical bull put spreads
- Vertical bear put spreads
- Vertical bear call spreads

Vertical Bull Spreads. A vertical bull spread is an option combination whose theoretical value will rise to a predetermined maximum profit if the price of the underlying currency rises, and whose maximum loss is also predetermined.

A vertical bull call spread is a compound strategy of two options with a common expiration date, when one option is a long call with a lower strike price and the other is a short call with a higher strike price (see Figure 16.11). This strategy offers a less risky alternative to buying a naked call.

Figure 16.10. Graph of a short euro futures strangle.

The buyer’s maximum profit consists of the dollar difference between the two strike prices, minus the total premium paid. The break-even point is calculated as the sum of the lower strike price and the total premium. The maximum loss is limited to the premium paid for the two options.

A vertical bull put spread is a compound strategy of two options with a common expiration date, when one option is a long put with a lower strike price and the other is a short put with a higher strike price (see Figure 16.12). This strategy is less bullish than a long call.

The buyer’s maximum profit consists of the net premium for the two options (one paid, the other received). The break-even point is calculated as the difference between the higher strike price and the net premium received. The maximum loss is limited to the dollar difference between the two strike prices, minus the total premium received.

Vertical Bear Spreads. A vertical bear spread is an option combination whose theoretical value will decline to a predetermined maximum profit if the price of the underlying currency declines and whose maximum loss is also predetermined.

Figure 16.11. Graph of a vertical bull call spread on euro futures.

A vertical bear put spread is a compound strategy of two options with a common expiration date, when one option is a long put with a higher strike price and the other is a short put with a lower strike price (see Figure 16.13). This strategy offers a less risky alternative to buying a naked put.

The buyer’s maximum profit consists of the dollar difference between the two strike prices, minus the total premium paid. The break-even point is calculated as the difference between the higher strike price and the total premium. The maximum loss is limited to the premium paid for the two options.

A vertical bear call spread is a compound strategy of two options with a common expiration date, when one option is a short call with a lower strike price and the other is a long call with a higher strike price (see Figure 16.14). This strategy offers a less risky alternative to writing a naked call.

Figure 16.12. Graph of a vertical bull put spread on Japanese yen futures.

Figure 16.13. Graph of a vertical bear put spread on Japanese yen futures.

Figure 16.14. Graph of a vertical bear call spread on euro futures.

The seller’s maximum profit is limited to the premium paid for the two options. The break-even point is calculated as the sum of the lower strike price and the total premium. The maximum loss consists of the dollar difference between the two strike prices, minus the total premium received.

Calendar Spreads

There are three types of calendar spreads, also called time and horizontal spreads: calendar spreads, calendar combinations, and calendar straddles.

A calendar spread is a combination of two similar types of options, either calls or puts, with the same strike price but different expiration dates. The dissimilarity between the expiration dates allows this type of spread to capitalize on both the impact of the time decay and the interest rate differentials.

Calendar spreads are very complex in terms of both trading and P&L calculation. P&L can only be estimated. The maximum profit will be achieved if the implied volatility of the currency is higher while the interest rate differential is narrower. The maximum loss is estimated to be the net premium, assuming that both the volatility and the interest rate differential remain stable.

Offshoots of the calendar spreads are calendar combinations. A calendar combination consists of the simultaneous call calendar spread and put calendar spread, in which the strike price of the calls is higher than the strike price of the puts.

Another offshoot is the calendar straddle. The calendar straddle consists of simultaneous buying of a longer-term straddle and a near-term straddle with a common strike price.

Box Spreads

A box spread consists of four options with a common expiration date: a long call and a short put at one strike price and a long put and a short call at a different strike price.

Butterfly Spreads

A butterfly spread consists of a combination of a bull spread and a bear spread, using either calls or puts. Therefore, in the general form, the spread may consist of either:

- four same-type options with a common expiration date, as follows: two long identical options, one short option with an immediately lower strike price, and one short option with an immediately higher strike price; or

- four same-type options with a common expiration date, as follows: two short identical options, one long option with an immediately lower strike price, and one long option with an immediately higher strike price.

Usually a butterfly spread is set up with long-term options. The maximum profit for a long butterfly occurs when the price of the currency reaches the level of the middle strike price at expiration (see Figure 16.15). The upside break-even point is the difference between the highest strike price and the net debit. The downside break-even point is the sum of the lowest strike price and the net debit. The maximum loss equals the premium paid.

The maximum profit for a short butterfly equals the premium paid, and occurs when the currency price trades outside the extreme strike prices at expiration (see Figure 16.16). The upside break-even point is the difference between the highest strike price and the net credit. The downside break-even point is the sum of the lowest strike price and the net credit. The maximum loss occurs when the price of the currency reaches the level of the middle strike price at expiration.

Figure 16.15. Graph of a long butterfly on euro futures.

Figure 16.16. Graph of a short butterfly on euro futures.

Condor Spread

A condor spread consists of either:

- same-type options with a common expiration date, as follows: two long options with consecutive strike prices, one short option with an immediately lower strike price, and one short option with an immediately higher strike price; or

- same-type options with a common expiration date, as follows: two short options with consecutive strike prices, one long option with an immediately lower strike price, and one long option with an immediately higher strike price (see Figures 16.17 and 16.18).

Combination Spreads or Synthetic Futures

A combination spread (synthetic future) consists of a long call and a short put, or a long put and a short call, with a common expiration date.

Figure 16.17. Graph of a long condor on Japanese yen futures.

Figure 16.18. Graph of a short condor on euro futures.

RATIO SPREADS

A ratio spread is a spread in which the number of long options is different from the number of short options. Therefore, there is a certain ratio between the long and short options.

The compound strategies discussed in the nonratio spread section—the straddles and the strangles—have a one-on-one ratio in their original form. But, by convention, the one-on-one ratio is not considered a ratio. In terms of these compound strategies, they may be truly “ratioed” by changing the number of one of the option classes.

The most popular ratio spreads are:

1. Ratio calls
2. Ratio puts
3. Call ratio backspreads
4. Put ratio backspreads
5. Christmas trees
6. Diagonal ratios

Before presenting these ratio spreads, I would like to introduce the concept of neutral spread, which is useful in understanding other types of spreads. A neutral spread, or a delta-neutral spread, consists of a long option position and a short option position that have their respective total delta positions relatively equal. This being established, we can move along.

Ratio Call Spread

A ratio call spread consists of a number of long calls with lower strike prices and a larger number of short calls with higher strike prices (see Figure 16.19). This type of combination is generally delta-neutral.

The maximum profit is realized when the currency price is at the higher strike price.

This combination has two break-even points. The downside break-even point consists of the sum of the lower strike price and the debit, divided by the number of long calls. The upside break-even point consists of the sum of the higher strike price and the maximum profit potential, divided by the number of naked calls.

Figure 16.19. Diagram of a ratio call spread on euro futures.

The maximum downside risk is the net premium, and the upside risk is unlimited.

Ratio Put Spread

A ratio put spread consists of a number of long puts with higher strike prices and a larger number of short puts with lower strike prices (see Figure 16.20). This ratio spread is generally designed as delta-neutral.

The maximum profit is realized when the currency price is at the lower strike price.

This combination has two break-even points. The downside break-even point consists of the difference between the lower strike price and the maximum profit potential, divided by the number of naked puts. The upside break-even point consists of the difference between the higher strike price and the debit, divided by the number of long puts.

The maximum downside risk is unlimited, and the upside risk is the net premium.

Figure 16.20. Diagram of a ratio put spread on Japanese yen futures.

Call Ratio Backspread

A call ratio backspread consists of short calls with a lower strike price and more long calls with higher strike prices. This spread is usually established as a delta-neutral ratio spread. It benefits from a price movement in either direction, but it is essentially a bullish position.

The maximum upside profit potential is unlimited and the downside profit potential consists of the total premium received. The maximum loss potential occurs when the currency price reaches the higher strike price at expiration.

Put Ratio Backspread

A put ratio backspread consists of short puts with a higher strike price and more long puts with lower strike prices (see Figure 16.21). This spread is usually established as a delta-neutral ratio spread. It benefits from a price movement in either direction, but it is essentially a bearish position.

The maximum upside profit potential consists of the total premium received, and the downside profit potential is unlimited. The maximum loss potential occurs when the currency price reaches the lower strike price at expiration.

Figure 16.21. Diagram of a put ratio backspread on euro futures.

Christmas Tree Spread

A Christmas tree spread consists of several short options at two or more strike prices.

Diagonal Spread

A diagonal spread consists of several same-type options, such that the long side and the short side have different strike prices and different expirations.

SPREADS WITH BOTH OPTIONS AND CURRENCY

The currency spreads and combinations we have presented so far have been composed of currency options only. In addition to options, three spreads also consist of the underlying currency, whether cash or futures:

1. Covered long
2. Covered short
3. Fence

Covered Long

A covered long involves selling a call against a long currency position. This strategy was designed to enhance the profitability of currency trading in a quiet market, via the option’s premium. A covered long is synonymous to a short put.

Covered Short

A covered short involves shorting a put against a short currency position (see Figure 16.21). This strategy was designed to enhance the profitability of currency trading in a quiet market, via the option’s premium. A covered short is synonymous to a short call.

Fence

Fences have become strategies of choice among corporations due to their insurance features, acquired at minimum or no cost. The idea behind the strategy is that the security against a loss is purchased at the cost of limiting the unlimited profitability offered by an individual option. The price in dollars and cents may be low, but is it worth giving up the unlimited profit potential of a currency swing?

The trade-off is not too bad, because the profit potential can be unlimited only in theory. In the real trading world, most currencies tend to have limited price activity. Therefore, a well-planned fence not only provides much-needed insurance against unfavorable currency activity at a low price, but also allows the buyer to take advantage of the trading range.

A fence consists of either:

- a long currency position, a long out-of-the-money put, and a short out-of-the-money call, when the options have the same expiration date (this strategy is also known as risk conversion); or

- a short currency position, a short out-of-the-money put, and a long out-of-the-money call, when the options have the same expiration date (this strategy is also known as risk reversal).

As an example, a buyer who wants to avoid the risk of a currency upswing at a reduced price can purchase a call and also write a put on the specific currency.

For instance, let’s assume that the spot GBP/USD trades at 1.50, and the trader buys a $1.45 six-month GBP call and sells a $1.55 put, where the premium paid (for the call) and the premium received (for the put) are identical. The P&L for the life of the options (six months, in this example) will be zero if the GBP/USD spot trades between 1.45 and 1.55 for the period. Because the option cost is zero, the break-even point is the strike price.

The downside of the fence strategy is that the maximum loss is unlimited. Should the trader want to limit the potential loss, an additional option should be bought.

EXOTIC OPTIONS[*]

The range of options strategies is continuously expanding to better encompass the diversity of needs in the financial arena. A study of the exotic options developed by Astrogamma is presented here.

BARRIER OPTIONS

Barrier options are also known as trigger options, cutoff options, cutout options, stop options, down/up-and-outs/ins, knockups, etc. They are very similar to European-style vanilla options, except that a second strike price—the trigger—is specified and, when reached in the market, automatically causes the option to be “inspired” in knock-in options or expired in knockout options.

With knockouts, the trader buys a vanilla option that goes away if the trigger is reached. With knock-ins, the trader is buying a vanilla option that does not exist until the trigger is reached. The determination as to when the trigger is hit can be based on the spot currency rate (spot style) or the forward currency underlying the option (forward style).

In standard knockouts and knock-ins, the bias of the trigger is opposite to that of the underlying vanilla option. In other words, as the likelihood of being triggered increases, the option is losing intrinsic value or becoming more out-of-the-money.

There is also another set of variants, known as reverse knockouts and reverse knock-ins, in which the likelihood of being triggered increases as the option’s intrinsic value increases. These are often referred to as in-the-money knockouts and knock-ins, because the trigger must be in-the-money with respect to the strike in order for the option to have any value at all (reverse knockout), or to be any different from a vanilla option (reverse knock-in).

Any option that is triggered when it has intrinsic value is virtually impossible to hedge near the trigger, so the reverse varieties are very rare.

KNOCKOUTS FOR CORPORATE HEDGING

From a corporate standpoint, normal knockouts are the most appealing of the barrier types. Assuming that a corporate customer is buying the underlying vanilla option for hedging purposes, it is clear that, when the trigger is reached, FX rates have moved his or her way, and the protection of the option may no longer be needed.

For example, consider a corporate customer who is long British pounds against U.S. dollars, value three months from now. Assume that cable is now 1.5500 and that the customer’s level of pain on the downside is 1.5000. The corporate customer could buy a knockout put (an up-and-out) with a strike price of 1.5000 and a trigger at 1.6000. If sterling reaches 1.6000 prior to expiration, the customer will sell the pounds there, as the option’s protection is not needed any more. Otherwise, the corporate customer either exercises the 1.5000 put or lets it expire out-of-the-money on expiration day.

The advantage of a knockout option in comparison with a pair of orders (a take-profit at 1.6000 and a stop-loss at 1.5000) is that the British pound can drop below 1.5000 without having the customer stopped out, with a possible gain if it recovers. The advantage of a knockout option in comparison with a risk reversal (whereby the customer would sell a 1.6000 call instead of leaving a sell order there) is that the position is closed as soon as 1.6000 is reached. There is no chance that the customer will have to let the 1.6000 bids go untouched because of a need for a long position in sterling to cover the short option, then watch helplessly as cable drops below 1.6000 again.

The disadvantage of a knockout option, in comparison with both the pair of orders and the pair of options, is that it costs money, but not as much as the 1.5000 put would cost by itself. How much cheaper the knockout option is than the corresponding normal option depends entirely on how far away the trigger is from the current market. If the trigger is set very close, the knockout option is very cheap, because the likelihood of the trigger’s being reached before expiration is very great. Conversely, if the trigger is very far away from the current market, the savings are minimal.

The corporate hedging rationale for the remaining types of barrier options is not so clear, particularly for reverses, which get knocked in or out when the option has intrinsic value. Reverse knock-ins seem appealing, until one realizes that the trigger has to be so far in-the-money to realize meaningful costs savings that the risk of the option never knocking in is too great to bear.

HEDGING A POSITION IN BARRIER OPTIONS

There is an almost perfect static hedge for a forward knockout option. Let’s say that the trader sold a knockout call. To cover the position, the trader buys a vanilla call with the same strike and maturity against it. Then, the trader sells a put with the same maturity struck so that when the forward reaches the trigger, the call bought and the put sold are worth the same.

The idea is that the call covers the vanilla part of the knockout exactly, the put compensates for the difference in premium, and, if the knockout expires early, the trader unwinds the two hedge options at flat.

For forward knockout options, the strike price of this put is a constant over the life of the option. The formula for forward knockouts is:

Forward knockout option strike price = Trigger^2/Strike

Therefore, the trigger is the geometric average of the strike and the hedge strike, which comes in handy when forward = trigger.

To be a perfect hedge, the hedge option should be executed in a ratio of strike/trigger for calls and trigger/strike for puts. This ratio is usually very close to 1:1.

For spot knockouts, the hedge strike unfortunately drifts. If using this hedging method, the trader will still have the residual risk up to the swap points between the spot and the forward. It still is a darn good hedge, though.

The static hedge for a knock-in option follows directly from that for the knockout. It is easy to demonstrate that buying both a knockout and knock-in with the same specifications is the same as buying a vanilla option: If the trigger is never reached, the trader owns the vanilla option from the knockout. If the trigger is reached, the trader owns the vanilla option from the knock-in. Either way, the trader owns the vanilla option. The following formula holds for reverse knocks, as well:

Knockout + Knock-in = Vanilla

From this discussion, we know that:

1. Knockout call = Vanilla call (at strike) − Vanilla put (at hedge strike)

2. Knock-in call = Vanilla call − Knockout call

Therefore, substituting from (1):

3. Knock-in call = Vanilla call − (Vanilla call − Vanilla put) = Vanilla put

It’s a little hard to believe, but the perfect static hedge for a forward knock-in call is simply a vanilla put at the same hedge strike and in the same ratio as for the knockout call. Thinking through the logic of this position makes it clear why this is the case.

The trader buys a knock-in call and hedges it by selling a vanilla put struck so that when the forward reaches the trigger, the call bought and the put sold are worth the same. When the knock-in is triggered, the trader is long a call and short a put with the same value (a classic risk reversal), and unwinds it at flat.

The same conditions apply to hedging spot knock-ins, but it is a more dynamic hedge because the trader does not know where the forward will be when spot reaches the trigger. It is still a great hedge.

There is no similarly simple hedging strategy for reverses, or for any option that gets triggered when the underlying vanilla has intrinsic value. They become virtually impossible to hedge around the trigger, especially near expiration, because on one side of the trigger they are worthless and on the other side they are worth intrinsic value, which may be substantial if the trigger is deep in-the-money with respect to strike. This “on-off” feature is much more complicated to hedge than, for example, a vanilla option at expiration.

BARRIERS II

As the preceding discussion makes clear, barrier options have “imbedded” options, in the form of the trigger, that turn traditional notions of risk management on their heads. It’s useful to point out a few of the important differences from normal options that the trader should be aware of when dealing in barriers.

The most noticeable difference between knockouts and vanilla options is the delta, which is much higher for the knockout than for the vanilla, at least for knockouts with sensible triggers. It’s easy to point to the replicating strategy and conclude that, when the trader is long a knockout, the trader is really long a risk reversal with the underlying vanilla as one leg, so the delta of the knockout is obviously higher.

But the real reason is even simpler and more intuitively appealing than that. When the knockout gets triggered, the vanilla underlying it still has time value, but as you move away from the trigger, the knockout starts to behave more like the vanilla, until the two are indistinguishable. Obviously, if the knockout loses its value more quickly as you near the trigger, the knockout is more sensitive to movements in spot across the entire range of spot movements, which means its delta must be higher.

High knockout deltas start to seem like an easy concept to grasp when you consider what happens to knock-ins: Knock-in calls have negative deltas and knock-in puts have positive deltas. Once again, this isn’t hard to understand when you look at the replicating strategy, but it also makes intuitive sense.

Take the example of a USD/CAD knock-in USD call (a down-and-in) with a strike of 1.5000 and a trigger of 1.4000. As spot moves toward 1.5000, the underlying vanilla is gaining intrinsic value, but the likelihood that the trader will ever have a vanilla option to exercise (i.e., the chance of the option being knocked in) is diminishing, so the knock-in USD call is worth less and less. On the other hand, as spot moves to 1.4000, it is becoming more and more likely that you will own a valuable vanilla option, so the value of the knock-in is increasing. As soon as the call is knocked in, its delta becomes positive. Thus, even though it is a call, the knock-in loses value when spot rises (away from the trigger) and gains value when spot falls—negative delta.

Because the deltas of standard knockouts and knock-ins are discontinuous through the trigger, the trader must be prepared to unwind the delta hedge for the knockout, or to flip the direction of the delta hedge for the knock-in, using an order. Similarly, if the trader has hedged the knock with the replicating strategy, the hedge position will need to be delta-hedged when the offsetting barrier option is triggered.

The most striking feature about the reverse knockouts is their prices, which seem disconcertingly low, unless the trigger is very far in-the-money. This is because they have the same likelihood of expiring worthless as a vanilla option; their upside is not only limited but disappears completely if the trigger is reached.

Let’s take the example of a USD/CAD reverse knockout USD call (an up-and-out) with a strike of 1.5300 and a trigger of 1.5500. Despite the fact that the option could end up with as much as 200 points of intrinsic value, it is virtually worthless, regardless of where the spot is. The reason is that anytime it gets intrinsic value, the likelihood of expiring worthless increases. This is in contrast to a straight vanilla or knockout call, which has unlimited upside, or a 1.5300:1.5500 USD call spread, which also has 200 points of intrinsic value but doesn’t lose that value when spot goes above 1.5500.

For the same reasons, long positions in the typical reverse knockout have negative vega. By contrast, the values of reverse knock-ins are virtually indistinguishable from vanilla options unless the trigger is in-the-money. The deltas of reverse knocks become very unstable near the trigger, especially when approaching expiration.

OPTIMAL OPTIONS

Previously known as lookback options, optimal options refer to the most favorable rate of the underlying currency that existed (from the holder’s perspective) during the life of the option. This rate becomes the strike in the case of optimal strike options; or it becomes the underlying, determining the intrinsic value when compared to a predetermined fixed strike in the case of optimal rate options. Optimals can be based on the spot rate (spot style) or the forward rate (forward style).

The highest underlying rate achieved during the option’s life would become the strike of an optional strike put option and the underlying rate of an optimal rate call option. Conversely, the lowest underlying rate achieved during the option’s life would become the strike of an optional strike call and the rate of an optimal rate put option.

Because these options allow the holder to transact at the most favorable rate that existed during the life of the option, they are very expensive—almost twice the premium of the at-the-money options.

OPTIMALS FOR CORPORATE HEDGING

Despite their high price, optimal options are still good hedging vehicles when the trader expects more volatility than the market does. Optimals can be hedged quite well with straddles.

RISK MANAGEMENT ASPECTS OF BARRIER OPTIONS

When looking at the price and volatility sensitivity of optimal strike options, it helps to remember that they can be replicated with straddles. Optimal strike options have virtually no spot sensitivity, but plenty of gamma, vega, and time decay.

AVERAGE OPTIONS

Average options refer to the average rate of the underlying currency that existed during the life of the option. This rate becomes the strike in the case of the average strike options; or it becomes the underlying, determining the intrinsic value when compared to a predetermined fixed strike, in the case of average rate options. Average options can be based on the spot rate (spot style) or the forward underlying the option (forward style). The average can be calculated arithmetically or geometrically, and the rates can be tabulated with a variety of frequencies.

AVERAGES FOR CORPORATE HEDGING

The appeal of average options for corporate hedging is obvious. In theory, the goal of a corporation in hedging its foreign exchange exposure is to minimize the P&L impact of foreign exchange rate fluctuations. While transacting at the average rate for a given period is not sufficient to achieve this goal, it does help avoid the uncertainties that go along with trying to second-guess the market, and it provides a reasonable measure of downside protection at about half the cost of vanilla options.

Vanilla options are also tremendously valuable in hedging nontransactional (portfolio) exposures, such as interest in a foreign subsidiary or other offshore investments. As static hedges, average rate options may be attractive because they tend to hold their intrinsic value and are not so dependent on where the spot is at expiration.

HEDGING A POSITION IN AVERAGE OPTIONS

Although the most complicated exotic options to price and manage, average options are more like vanilla options than the other exotics when it comes to hedging.

RISK MANAGEMENT ASPECTS OF AVERAGE OPTIONS

Average options are much less susceptible to market volatility than vanilla options and, therefore, are somewhat cheaper. Otherwise, the differences between the two classes of average options become more pronounced, and their relationship to vanilla options becomes muddled.

CONCLUSION

Given a choice, foreign exchange traders will not trade currency options when they are confident about the direction of the market. Dollar per dollar, the profit is lower when trading options vis-à-vis spot, forwards, or futures, simply because of the premium involved.

The reverse of the scenario, though, is that at times traders cannot forecast the direction of the market prior to certain events, but expect high volatility. In this case, the best choice is to trade options.

Lack of activity in the currency market signals another opportunity for trading options. Unlike any of the other instruments, options selling, or writing, enables a trader to produce in an otherwise unprofitable environment.

By using options, corporations are able to customize sophisticated strategies for a variety of purposes, such as hedging or insurance. Options trading also allows advanced strategies to be achieved at relatively low cost.

There are certain costs attached to options trading. These costs are pertinent to the adequate capitalization for delta (or gamma or vega) hedging and research costs.

Finally, options trading expands and improves the range of risk management tools. This is a vital feature in a market trading an average daily volume of $1.4 trillion.

NEW DIRECTIONS IN OPTIONS TRADING

Currently, the options share of the currency market is estimated at 5 percent. The increased complexity of the world economic and political environment will fuel the growth of options trading in the twenty-first century. More and more corporations around the world are getting involved in options trading for hedging, risk management, and speculation purposes.

The crises on the European Monetary System in September 1992 and July 1993 and the dollar/yen meltdown of October 1998 are perfect examples of real-life scenarios that may be disastrous for unprotected financial entities. Premiums skyrocket due to unprecedented volatility and the specific needs of various corporations.

The new currency players from emerging economies are increasing their trading efforts around the world. Since 1989, these players have started to become more involved in foreign exchange in general and options trading in particular. From South America to Southeast Asia to Eastern Europe, the demand for derivatives has become substantial.

The options market will also increase due to continuous instrument innovations. In response to diverse international demand, options strategies are continuously being developed. In addition, technological breakthroughs in hardware and software have been pillars for both increased trading sophistication and affordability.

While players around the world are by and large indifferent to the risks germane to options trading, central banks and even governments are less confident. The specter of mismanaged risks, from market to credit, fosters an ongoing concern.

[*]Excerpted from the FENICS FX options trading software Help pages. (Copyright © 1993 by Astrogamma, Inc. Reproduced with permission.)

PART

5 FOREIGN EXCHANGE FORECASTING: FUNDAMENTAL ANALYSIS

17 Economic Fundamentals

Forecasting is based on two essential types of analysis: fundamental, discussed in detail in Chapters 17 and 18; and technical, the chart study of past behavior of prices, discussed in Chapters 19 through 28. What are the fundamentals? As the name indicates, they refer to factors that either show the fundamental state of the economy or fundamentally alter the outlook of one economy relative to the world economy. This chapter focuses on the theoretical models of exchange rate determination and on the major economic factors and their likelihood of affecting the foreign exchange rates.

ECONOMIC FUNDAMENTALS

Any news that has a direct or indirect bearing on the economy may be considered fundamental. The news may refer to changes in the economy, changes in interest rates, political elections, terrorism, or natural disasters. It’s a busy, busy world.

In order to navigate through the large, complex, and changing universe of fundamentals, they may be classified into four categories: economic factors, financial factors, political factors, and crises. A rough comparison of these categories provides us with a simple but very important finding: By and large, economic factors differ from the other three factors in terms of the certainty of their release. The dates and times of economic data release are known well in advance, at least among the industrialized nations.

Political factors vary greatly in terms of the certainty of their dates and times of occurrence. For instance, the timing of presidential elections in some countries is known in advance, such as every four years in the United States, while it’s not periodic in the U.K. Terrorism has become a political factor since September 11, 2001, when Arab extremists mounted unprecedented attacks on U.S. civilians on U.S. territory. In our time wars cannot occur among the industrialized nations. But conflict seems to have taken on a life of its own between religious extremists from some emerging nations and the industrialized nations.

With financial factors, may still be a mystery, even though the largest central banks have become more and more transparent. However, central banks tend to change their key rates in cycles, and this activity occurs most of the time during scheduled meetings.

Unlike trading equities, which benefit from specific sector fundamentals, the reaction of the foreign exchange markets to fundamentals is difficult to gauge. More often than not traders yawn when they hear of the release of economic reports, but then, hardly anyone wants to miss them! When central banks simply continue cycles of tightening or easing, the reaction of the markets is muted at best. The same goes for most presidential elections. The randomness of the reactions has to do with the asymmetry between the short-term, micro and international focus of the market and the fact that most fundamentals are macro and have a long-term horizon; moreover, the economic and financial factors have a domestic focus, further diluting the significance for traders jabbing the markets for 30 pips. Nevertheless, macro imbalances may create macro reactions in foreign exchange, and these factors may produce long-term trends. Traders love trends.

THEORIES OF EXCHANGE RATE DETERMINATION

After spending a long and fruitful life within the Bretton Woods Accord cocoon, currencies around the world were allowed at last, in 1971, more freedom to move against each other, to find their own equilibrium levels, and to take the pressure off governments and central banks in terms of keeping a country’s money within the prescribed ranges. Few imagined at the time that, after twenty-seven years of virtual standstill, currencies could exhibit volatile behavior under international conditions of relative peace and prosperity. However, the U.S. dollar has displayed “roller coaster” behavior since 1973, the true start of currency free-floating.

Attempting to understand why currencies move so much is difficult. Many attempts have been made to learn the factors determining the volatility of the foreign exchange market. In this section, the three most significant theories of exchange rate determination are discussed. The three models are traditional theories, modern monetary theories on short-term exchange rate volatility, and synthesis of traditional and modern monetary views.

The traditional theories consist of the purchasing power parity (PPP) and the theory of elasticities.

PURCHASING POWER PARITY

The oldest and still the most popular of the theories is the purchasing power parity. Purchasing power parity was developed in 1556 by Martin de Azpilcueta Navarro. The theory states that the price of a good in one country should equal the price of the same good in another country, exchanged at the current rate—the law of one price.

For example, if the foreign currency is undervalued, the purchasing power of the domestic currency (USD) is higher abroad. As the flow of USD moves abroad, domestic prices fall and foreign prices rise as the domestic demand rises, or the foreign currency rises until the two currencies reach parity.

Pd = S X Pf
where

Pd = domestic price of product A

S = spot exchange rate

Pf = foreign price of product A

There are two versions of the purchasing power parity theory: the absolute version and the relative version.

The PPP Absolute Version

Under the absolute version, the exchange rate simply equals the ratio of the two countries’ general price levels, which is the weighted average of all goods produced in a country.

However, this version quickly comes under fire. First, which two countries produce or consume the same goods? None. Even if we examine the still split Koreas, two countries that have the same culture, language, and idiosyncrasies despite their political divisions, we would be hard-pressed to find similar production and consumption.

The typical PPP example publicized on a yearly basis is the price of a hamburger around the world. Now, tasty as they may be, hamburgers are much less popular outside the United States than they are here. In addition, hamburgers are targeted differently in other countries. Whereas in the United States hamburgers are generally considered an inexpensive yet satisfying fast food, in Moscow they are rather expensive imports. There are also cultures in which beef is not consumed.

Second, the absolute version assumes that transportation costs and trade barriers are insignificant. In reality, transportation costs are significant and dissimilar around the world. Trade barriers are still alive and well, sometimes obvious and sometimes hidden, and they influence costs and goods distribution.

Finally, this version disregards the importance of brand names. With many commodities, such as soybeans, price is likely to be the main factor. Cars, however, are chosen not only based on the best price for the same type of car, but also on the basis of the name. After all, as one might say in California, “You are what you drive.” Even with some commodities, brand names are important. Coffee is not just coffee, but java or espresso or vanilla flavor. Orange juice, as well, comes under different brand names. These cases show what happens to the absolute version of the purchasing power parity in the real world, where the theory fails.

The PPP Relative Version

In order to eliminate some of these problems, the purchasing power parity theory was designed in a different form—the relative version. Under the relative version, the percentage change in the exchange rate from a given base period must equal the difference between the percentage change in the domestic price level and the percentage change in the foreign price level.

For instance, when U.S. prices rose by 6 percent and German prices rose by 2.4 percent, the U.S. dollar should have risen by 3.6 percent. However, although the prices in the two countries did increase by approximately those percentages, the U.S. dollar fell about 50 percent.

Obviously, the relative version of the PPP is not free of problems. First, it is difficult or arbitrary to define the base period. Second, trade restrictions remain a real and thorny issue, just as with the absolute version. Third, different price index weighting and the inclusion of different products in the indexes make the comparison difficult. Finally, in the long term, countries’ internal price ratios may change, causing the exchange rate to move away from the relative PPP.

In conclusion, the spot exchange rate moves independently of relative domestic and foreign prices. In the short run, the exchange rate is influenced by financial market conditions, not by commodity market conditions.

Despite these problems, the theory behind the Plaza Accord of September 1985 and the subsequent Louvre Accord in February 1987, in which the G-3 countries decided to devaluate the U.S. dollar relative to the European and Japanese currencies, was purchasing power parity.

How successful was the implementation of the theory in reality? In measuring the success of the application of this theory, the problems germane to each of the versions must be emphasized.

Trade barriers, which have negatively affected the ability of the devalued U.S. dollar to achieve a more balanced international trade, are still a major problem. Despite the internationalization of both industries and consumption, countries still do not have common production or consumption. Brand names continue to maintain their importance. Satisfied consumers are loyal consumers, and it is difficult to convince them to switch brands. The trade deficit between the United States and Japan continue to carve new records.

Therefore, price by itself generally fails to be the trigger in consumers’ minds. It is value, or the perception of value, and the propensity to spend that will sway value-oriented shoppers. These are just some of the reasons the purchasing power parity theory has failed to achieve the original goals of the Plaza Accord of 1985 even decades later.

The J Curve

The application of the purchasing power parity, in reality, creates the J curve effect. The J curve theory holds that the devaluation of a currency will trigger export gains in the long term, rather than the short term. The reasons behind this theory are linked to previous contracts, existing inventories, and behavior modification.

THEORY OF ELASTICITIES

The theory of elasticities was popular in the post—World War II era, when it determined the balance of trade’s response to a change in the exchange rate. Later, this theory was modified to examine the exchange rate’s response to a disturbance in the trade balance.

The theory of elasticities holds that the exchange rate is simply the price of foreign exchange that maintains the balance of payments in equilibrium. In other words, the degree to which the exchange rate responds to a change in the trade balance depends entirely on the elasticity of demand to a change in price.

Therefore, if demand is price-inelastic, then a decline in imports and a rise in exports is small. Consequently, the exchange rate must rise steeply to eliminate the payment deficit. On the other hand, if demand is price-elastic, then the decline in imports and the rise in exports are large. Therefore, the exchange rates need little adjustment.

For instance, if the imports of country A are strong, then the trade balance is weak. Consequently, the exchange rate rises, leading to the growth of country A’s exports, and triggers in turn a rise in its domestic income, along with a decrease in its foreign income.

Whereas a rise in the domestic income (in country A) will trigger an increase in the domestic consumption of both domestic and foreign goods and, therefore, more demand for foreign currencies, a decrease in the foreign income (in country B) will trigger a decrease in the domestic consumption of both country B’s domestic and foreign goods, and therefore less demand for its own currency.

The elasticities approach is not problem-free, either. First, in the short term, the exchange rate is more inelastic than it is in the long term. Because the spot market focuses on the short term, the lack of elasticity will impact the exchange rate. Second, additional exchange rate variables arise continuously, changing the rules of the game.

The volatility of the spot exchange rate is influenced to a large extent by short-term variables not anticipated during the Bretton Woods Accord era. Despite the shortcomings, the traditional views on exchange rate determination still tend to explain the long-term behavior of foreign currencies.

The Fisher Effect

The Fisher effect holds that the nominal interest rate consists of the real interest rate plus the expected rate of inflation.

In = Ir + Ie
where

In = nominal interest rate

Ir = real interest rate

Ie = expected rate of inflation

Therefore, for countries with identical real interest rates, their nominal interest rates will differ with respect to their individual expected rates of inflation.

The International Fisher Effect

The international Fisher effect holds that investors will keep assets denominated in depreciating currencies only to the extent that the interest rates are sufficiently high to balance the expected currency losses.

This is a very important point, not only for investors but also for the governments of countries with currencies expected to depreciate. In order to attract investments to such countries, it is vital that interest rates exceed expected losses on foreign exchange.

MODERN MONETARY THEORIES ON SHORT-TERM EXCHANGE RATE VOLATILITY

The modern monetary theories on short-term exchange rate volatility take into consideration the short-term capital markets’ role and the long-term impact of the commodity markets on foreign exchange. These theories hold that the divergence between the exchange rate and the purchasing power parity is due to the supply and demand for financial assets and the international capability.

One of the modern monetary theories states that exchange rate volatility is triggered by a onetime domestic money supply increase, because this is assumed to raise expectations of higher future monetary growth.

The purchasing power parity theory is extended to include the capital markets. If, in both countries whose currencies are exchanged, the demand for money is determined by the level of domestic income and domestic interest rates, then a higher income increases demand for transaction balances while a higher interest rate increases the opportunity cost of holding money, reducing the demand for money.

Under absolute PPP, the spot exchange rate equals the ratio of the domestic price level to the foreign price level. Therefore, the two countries’ relative money supply, relative interest rates, and relative real incomes determine the spot exchange rate.

Under a second approach, the exchange rate adjusts instantaneously to maintain continuous interest rate parity, but only in the long run to maintain PPP.

Volatility occurs because the commodity markets adjust more slowly than the financial markets. This version is known as the dynamic monetary approach.

The Portfolio-Balance Approach

Whereas in previous examples it was assumed that international financial assets were interchangeable, the portfolio-balance approach holds the opposite view. Due to the differences between international assets, investors, likely to focus on only a group of financial assets, will have to purchase the specific currency or currencies. Therefore, the portfolio-balance approach holds that currency demand is triggered by the demand for financial assets, rather than the demand for the currency per se.

SYNTHESIS OF TRADITIONAL AND MODERN MONETARY VIEWS

In order to better suit the previous theories to the realities of the market, some of the more stringent conditions were adjusted into a synthesis of the traditional and modern monetary theories. A short-term capital outflow induced by a monetary shock creates a payments imbalance that requires an exchange rate change to maintain balance-of-payment equilibrium. Speculative forces, commodity market disturbances, and the existence of short-term capital mobility trigger the exchange rate volatility. The degree of change in the exchange rate is a function of consumers’ elasticity of demand.

Because the financial markets adjust faster than the commodities markets, the exchange rate tends to be affected in the short term by capital market changes and in the long term by commodities changes.

ECONOMIC INDICATORS

Economic indicators are the bread and butter of the fundamental factors. Unlike other factors, they occur in a steady stream, at certain times, and a little more often than changes in interest rates, governments, or underground activity along the San Andreas Fault in California.

Knowing the date and time of release of economic indicators from a reliable source is very important to the foreign exchange trader. Based on this information, a trader is able to enter, exit, or adjust a foreign exchange position. Eyes glued to the monitor screens, traders around the world act on the economic data.

Though this information is important, the information alone is not sufficient. It is the skill of the analyst and trader in using the information that will generate a P&L.

CHARACTERISTICS OF THE ECONOMIC DATA RELEASE

Economic data is generally released on a monthly basis. The exceptions are the Gross Domestic Product (GDP) and the Employment Cost Index (ECI), which are released quarterly.

The initial claims for unemployment benefits are released weekly. However, they are not important to foreign exchange traders, as the data is not complete and, consequently, the claims are not market shakers.

Most economic indicators are released in pairs. The first number reflects the latest period. The second number is the revised figure for the month prior to the latest period. Further revisions are possible.

For instance, in July, economic data is released for the month of June, the latest period. In addition, the release includes the revision of the same economic indicator figure for the month of May. The reason for the revision is that the department in charge of the economic statistic compilation is in a better position to gather more information in a month’s time.

This feature is important for traders. If the figure for an economic indicator is better than expected by 0.4 percent for the past month, but the previous month’s number is revised lower by 0.4 percent, then traders are likely to ignore the overall release of that specific economic data.

Economic indicators are released at different times. In the United States, economic data is generally released at 8:30 and 10 a.m. EDT. It is important to remember that the most significant data for foreign exchange is released at 8:30 a.m. EDT. Other times are 9:15, 9:45, and 12 EDT.

SOURCES OF INFORMATION

Information on upcoming economic indicators is published in all leading newspapers and business magazines. More often than not, traders use the online sources.

THE GROSS NATIONAL PRODUCT (GNP)

The gross national product is one the most fundamental economic indicators. According to Professor Paul Samuelson, GNP “measures the economic performance of the whole economy.” This indicator consists, at macro scale, of the sum of consumption spending, investment spending, government spending, and net trade.

GNP = C + I + G + T
where

C = consumption spending

I = investment spending

G = government spending

T = net trade (exports and imports)

THE GROSS DOMESTIC PRODUCT (GDP)

Whereas the gross national product refers to the sum of all goods and services produced by U.S. residents, either in the United States or abroad, the gross domestic product (GDP) refers to the sum of all goods and services produced in the United States, either by domestic or foreign companies. The differences between the two are nominal in the case of the economy of the United States. GDP figures are more popular outside the United States. In order to make it easier to compare the performances of different economies, traders focus on the GDP figures.

CONSUMPTION SPENDING

Consumption is made possible by personal income and discretionary income. The decision by consumers to spend or to save is psychological in nature. Consumer confidence is also measured as an important indicator of the propensity of consumers who have discretionary income to switch from saving to buying.

INVESTMENT SPENDING

Investment spending—or gross private domestic spending—consists of fixed investment and inventories.

GOVERNMENT SPENDING

Government spending is very influential in terms of both its sheer size and its impact on other economic indicators, due to special expenditures.

NET TRADE

Net trade is another major component of the GNP. Worldwide internationalization and the economic and political developments since 1980 have had a sharp impact on the United States’ ability to compete overseas. The U.S. trade deficit of the past decades has slowed down the overall GNP. GNP can be approached in two ways: flow of product and flow of cost.

CHARACTERISTICS

GDP is released on a quarterly basis, unlike the rest of the economic indicators. Its release is automatically paired with the release of the implicit GDP deflator, which is an important method used to adjust the GDP for inflation. The GDP deflator is calculated by dividing the current dollar GDP figures by the constant GDP figures.

Due to its quarterly release, the revision of the GDP performance from previous terms is often disregarded by foreign exchange traders, because they find it difficult to design future trading strategies based on fundamentals that occurred as long as six months ago.

INDUSTRIAL SECTOR INDICATORS

The industrial sector indicators consist of industrial production, capacity utilization, the Institute for Supply Management (ISM) Index, factory goods orders, and durable goods orders.

INDUSTRIAL PRODUCTION

Industrial production consists of the total output of a nation’s plants, utilities, and mines. From a fundamental point of view, it is an important economic indicator that reflects the strength of the economy, and by extrapolation, the strength of a specific currency. Therefore, foreign exchange traders use this economic indicator as a potential trading signal. The industrial production figures are released on a monthly basis.

CAPACITY UTILIZATION

Capacity utilization consists of total industrial output divided by total production capability. The term refers to the maximum level of output a plant can generate under normal business conditions.

In general, capacity utilization is not a major economic indicator for the foreign exchange market. However, there are instances when its economic implications are useful for fundamental analysis. A “normal” figure for a steady economy is 81.5 percent. If the figure reads 85 percent or more, the data suggests that the industrial production is overheating, that the economy is close to full capacity. High capacity utilization rates precede inflation, and expectation in the foreign exchange market is that the central bank will raise interest rates in order to avoid or fight inflation.

INSTITUTE FOR SUPPLY MANAGEMENT

The Institute for Supply Management (ISM) is a survey of industrial purchasing managers, conducted to gauge the changes in new orders, production, employment, inventories, and vendor delivery speed. A reading under 50 percent indicates a worsening economy. It has two reports: one on manufacturing and one on nonmanufacturing, which was introduced in 1998.

FACTORY GOODS ORDERS

Factory orders refer to the total of durable and nondurable goods orders. Nondurable goods consist of food, clothing, light industrial products, and products designed for the maintenance of durable goods. Durable goods orders are discussed separately. The factory goods orders report has limited significance for foreign exchange traders.

DURABLE GOODS ORDERS

Durable goods orders consist of products with a life span of more than three years. Examples of durable goods are appliances, furniture, jewelry, and toys. They are divided into four major categories: primary metals, machinery, electrical machinery, and transportation.

In order to eliminate the volatility pertinent to large military orders, the indicator includes a breakdown of the orders between defense and nondefense.

Despite high volatility, this data is fairly important to foreign exchange markets, as it gives a good indication of consumer confidence. Because durable goods cost more than nondurables, a high number in this indicator shows consumers’ propensity to spend. Therefore, a good figure is generally bullish for the domestic currency.

BUSINESS INVENTORIES

Business inventories consist of items produced and held for future sale. The compilation of this information is facile and holds little surprise for the market. Moreover, financial management and computerization help control business inventories in unprecedented ways. Therefore, the importance of this indicator for foreign exchange traders is limited.

CONSTRUCTION DATA

Construction data consists of significant economic indicators that are included in the calculation of the GDP of the United States. Moreover, housing has traditionally been the engine that has pulled the U.S. economy out of recessions since World War II. These indicators are classified into three major categories:

1. Housing starts and permits
2. New and existing one-family home sales
3. Construction spending

Private housing is monitored closely at all the major stages: permits, starts, completion, and sales. Private housing is classified based on the number of units (one, two, three, four, five, or more); region (Northeast, West, Midwest, and South); and inside or outside metropolitan statistical areas.

Construction indicators are cyclical and very sensitive to the level of interest rates (and consequently mortgage rates) and the level of disposable income. Low interest rates alone may not be able to generate a high demand for housing, though.

Despite their economic significance, construction indicators are not favorites of the foreign exchange traders. Their unusual volatility is further exacerbated by weather patterns. For a trader, it is difficult to gauge whether sunny summer weather is better for housing shopping or going to the beach. The numbers tend to fluctuate significantly from one month to another. Therefore, few traders use construction figures for their fundamental analysis.

INFLATION INDICATORS

Few other economic problems have the same infamous connotation as does inflation. The rate of inflation is the widespread rise in prices. Therefore, gauging inflation is a vital macroeconomic task.

Traders watch the development of inflation closely, because the method of choice for fighting inflation is raising the interest rates, and higher interest rates tend to support the local currency. Moreover, the inflation rate is used to “deflate” nominal interest rates and the GDP to their real values in order to achieve a more accurate measure of the data.

The values of the real interest rates or real GDP are of the utmost importance to the money managers and traders of international financial instruments, allowing them to accurately compare opportunities worldwide.

Generally, traders use several economic tools:

- Producer Price Index (PPI)
- Consumer Price Index (CPI)
- GDP Deflator

- Commodity Research Bureau’s Index (CRB Index)

Other economic data that help to gauge inflation are unemployment, consumer prices, and capacity utilization.

PRODUCER PRICE INDEX (PPI)

The producer price index has been compiled since the beginning of the twentieth century and was called the wholesale price index until 1978. The PPI gauges the average changes in prices received by domestic producers for their output at all stages of processing. The PPI data is compiled from most sectors of the economy, such as manufacturing, mining, and agriculture. The sample used to calculate the index contains about 3,400 commodities. The most important groups for the calculation of the index are food, fuel, autos, and clothing. Unlike the CPI, the PPI does not include imported goods, services, or taxes. This index is released on a monthly basis. The market focuses on the core CPI, which excludes food and energy.

CONSUMER PRICE INDEX (CPI)

The consumer price index gauges the average change in retail prices for a fixed market basket of goods and services. The CPI data is compiled from a sample of prices for food, shelter, clothing, fuel, transportation, and medical services that people purchase on a daily basis. The most important groups for the calculation of CPI are housing, food, fuel, and autos. The consumer price index is released monthly. Again, the market focuses on the core CPI, which excludes food and energy.

The two indexes, PPI and CPI, are instrumental in helping traders measure inflationary activity, although the Federal Reserve takes the position that the indexes overstate the strength of inflation.

GROSS DOMESTIC PRODUCT IMPLICIT DEFLATOR

The gross domestic product implicit deflator is calculated by dividing the current dollar GDP figure by the constant dollar GDP figure. The GDP implicit deflator is released quarterly, along with the respective GDP figures.

COMMODITY RESEARCH BUREAU’S FUTURES INDEX (CRB INDEX)

The Commodity Research Bureau’s Futures Index (the Reuters/Jefferies CRB Index since 2005) makes watching for inflationary trends easier. The CRB Index, which was developed in 1957, currently consists of the futures prices of nineteen commodities. The components of the CRB Index are:

- Precious metals: gold, silver

- Industrials: crude oil, heating oil, unleaded gas, aluminum, copper, nickel, cotton

- Grains: corn, wheat, soybeans

- Livestock and meat: cattle, hogs, pork bellies

- Imports: coffee, cocoa, sugar

- Miscellaneous: orange juice

A Trader’s Point of View

Traders have the luxury of a multitude of tools to measure inflation. However, traders cannot expect the central banks to either raise the discount rate every time one of the indicators shows a higher figure, signaling inflation, or to cut it when the opposite occurs. One month’s economic figures grab attention, but they do not generally trigger the action of a central bank, because one number does not make a trend. Central banks need confirmation of long-term changes in the inflation trend before they will counteract with equally long-term measures.

Even a trend does not guarantee the central bank’s action in the short term. For instance, the low inflation in the United States in the early 1990s, and again early in the new millennium, allowed the Federal Reserve to maintain low interest rates, which was instrumental in the steady process of economic recovery.

At times, the Fed funds rate is not perceived by the markets as being sensitive to the low or lower readings of the price indexes. If the rate is already very low, the markets expect the discount rate to be sensitive only on the upside, when inflation is perceived to have picked up. From the point of view of foreign exchange, the inflation indicators are most significant when they either increase after a period of stagnation or decrease after a series of gains.

BALANCE OF PAYMENTS

The balance of payments consists of all the international commercial and financial transactions of the residents of one country. The familiar indicator is the merchandise trade balance. In the long term, the competitiveness of a country is a function of its natural resources, industrial base, labor force skill, and cost structure. In the short term, international trade is impacted by changes in spending patterns generated by the business cycles. Other factors affecting the balance of payments are domestic and foreign investments in both goods and services. The data has a limited following by traders. However, it is important for foreign exchange on a longer-term statistical basis.

MERCHANDISE TRADE BALANCE

The merchandise trade balance is one of the most important economic indicators. Its value may trigger long-lasting changes in monetary and foreign policies. The trade balance consists of the net difference between the exports and imports of a certain economy. The data includes six categories:

1. Food
2. Raw materials and industrial supplies
3. Consumer goods
4. Autos
5. Capital goods
6. Other merchandise

The typical example of the impact of the merchandise trade balance in the financial markets must refer to the coordinated change in foreign exchange, backed by changes in interest rates conceived at the historic Plaza Accord in New York on September 1985 by the G-3 countries (United States, Japan, and Germany). At the time, the U.S. dollar was at post–Bretton Woods Accord record highs or near-record highs against the European currencies. The United States felt that the American exporters were at a disadvantage, as their high-priced products were hardly competitive in the international markets. The devaluation of the U.S. dollar was therefore earmarked to rebalance this economic disequilibrium in the medium term. Trade deficits were not something new in the United States. As a matter of fact, the last time the United States had registered a positive trade balance was in 1975. The economic theory behind this strategy was the purchasing power parity theory. The extent of the success of the U.S. dollar devaluation strategy in order to reduce the trade deficit has been minuscule. With the emergence of China as a major exporter to the United States, the trade deficit is here to stay.

EMPLOYMENT INDICATORS

The employment rate is an economic indicator with significance in multiple areas. The rate of employment, naturally, measures the soundness of an economy. In addition, the indicator is used as a major component in the calculation of the GDP.

Generally, the most commonly used employment figure is not the monthly unemployment rate, which is released as a percentage, but the nonfarm payroll rate. The rate figure is calculated as the ratio of the difference between the total labor force and the employed labor force, divided by the total labor force. The data is more complex, though, and it generates more information.

In foreign exchange, the standard indicators monitored by traders are the unemployment rate, manufacturing payrolls, nonfarm payrolls, average earnings, and average workweek. Generally, the most significant employment data are nonfarm payrolls, followed by the unemployment rate.

This data is released on a monthly basis. Although initial unemployment claims are available on a weekly basis, they are not important to the market because they are not complete. The claims, which are gathered by a different type of survey, understate the real figures, because not all workers are covered by unemployment insurance.

The household data is generally less reliable. This survey tends to show overly optimistic figures due either to individual reluctance to admit being unemployed or to discouraged unemployed workers who stop seeking work or claiming unemployment.

The unemployment rate is a lagging economic indicator. It is an important feature to remember, especially in times of economic recession. Whereas people focus on the health and recovery of the job sector, employment is the last economic indicator to rebound. When economic contraction causes jobs to be cut, it takes time to generate psychological confidence in economic recovery at the managerial level before new positions are added. At individual levels, the improvement of the job outlook may be clouded when new positions are added in small companies and thus not fully reflected in the data.

The employment reports are significant to the financial markets in general and to foreign exchange in particular. In foreign exchange, the data is truly affective in periods of economic transition—recovery and contraction. The reason for the indicators’ importance in extreme economic situations lies in the picture they paint of the health of the economy and in the degree of maturity of a business cycle. A decreasing unemployment figure signals a maturing cycle, whereas the opposite is true for an increasing unemployment indicator.

EMPLOYMENT COST INDEX (ECI)

The Employment Cost Index measures wages and inflation and provides the most comprehensive analysis of worker compensation, including wages, salaries, and fringe benefits. The ECI is one of the Fed’s favorite quarterly economic statistics.

CONSUMER SPENDING INDICATORS

RETAIL SALES

Retail sales is a significant consumer spending indicator for foreign exchange traders, as it shows the strength of consumer demand as well as consumer confidence.

As an economic indicator, retail sales is particularly important in the United States. Unlike as in other countries such as Japan, the focus in the U.S. economy is the consumer. If the consumer has enough discretionary income, or enough credit for that matter, then more merchandise will be produced or imported. Retail sales figures create an economic process of “trickling up” to the manufacturing sector.

The seasonal aspect is important for this economic indicator. The retail sales months that are most watched by foreign exchange traders are December, because of the holiday season, and September, the back-to-school month. Increasingly, November and January are becoming important months, as a result of the before- and after-Christmas sales.

Traders watch retail sales closely to gauge the overall strength of the economy and, consequently, the strength of the currency.

This indicator is released on a monthly basis as well.

CONSUMER SENTIMENT

Consumer sentiment is a survey of households that is designed to gauge the individual propensity for spending. The University of Michigan and the Conference Board Consumer Confidence Index are two of the best surveys. The confidence index measured by the Conference Board is sensitive to the job market, whereas the index generated by the University of Michigan is not.

AUTO SALES

Despite the importance of the auto industry in terms of both production and sales, auto sales is not an economic indicator generally followed by foreign exchange traders.

LEADING INDICATORS

The leading indicators consist of the following economic indicators:

- Average workweek of production workers in manufacturing

- Average weekly claims for state unemployment

- New orders for consumer goods and materials (adjusted for inflation)

- Vendor performance (companies receiving slower deliveries from suppliers)

- Contracts and orders for plant and equipment (adjusted for inflation)

- New building permits issued

- Change in manufacturers’ unfilled orders, durable goods

- Change in sensitive materials prices
- Index of stock prices
- Money supply, adjusted for inflation
- Index of consumer expectations

This index is designed to offer a six- to nine-month future outlook of economic performance. Unlike the unemployment rate, which is a lagging economic indicator, the leading indicators are, as the name implies, leading. In addition to its forecasting value, the data can be used in times of slow economic performance to gauge whether the economy is in recession. Three consecutive negative monthly readings are generally considered to indicate recession. The index, which was set up during the Depression, when the structure of the U.S. economy was vastly different from what it is now, carries little FX significance.

PERSONAL INCOME

Personal income is simply the income received by individuals, nonprofit institutions, and private trust funds. Components of this indicator include wages and salaries, rental income, dividends, interest earnings, and transfer payments (Social Security, state unemployment insurance, and veterans’ benefits). The wages and salaries reflect the underlying economic conditions.

This indicator is vital for the sales sector. Without an adequate personal income and a propensity to purchase, consumer purchases of durable and nondurable goods are limited.

For FX traders, personal income is not significant.

CONCLUSION

Economic fundamentals provide the most significant information to traders. The time of release is known in advance, a feature specific to the economic indicators. The impact of the economic data tends to be longer-term, with an impact measurable in months. This effect is generated not only by the need for a deeper understanding of the changes reflected by the data, but also by the flow of the market. The old saying “Buy on the rumor, sell on the fact” may in the short run stir in the wrong direction. Traders go long in dollars on expectation of strong U.S. economic data. They take profit by selling their long positions once the good economic data is released. The data is not truly disregarded, because it will create a buying opportunity later on.

Not all economic data is significant for the foreign exchange market. We have discussed the most important economic indicators. However, these indicators do not have the same impact on the market every time. Traders react to expectations of change or to actual changes. If the economic data fails to show changes in the economy, then the traders will have a mute reaction. If one country’s economy overperforms or underperforms relative to other economies, that specific currency will be bought or sold, respectively, generating long-term trends. If the correlation between economies is high, then currency will be less volatile as the overall change is limited.

The relativity of economic performance among countries is particularly important to foreign exchange. Whereas in other financial markets domestic data suffices, that is not the case in foreign exchange. Any FX transaction consists of simultaneous transactions in two currencies, so it is easy to grasp the importance of comparing individual economies in the international arena.

The significance of economic data tends to be cyclical. In the United States, where the trade balance has had an abysmal showing for years, that indicator has been in and out (mostly out) of the limelight, depending on the market’s perception of what the government can do and what it actually does do about it.

Also in the United States, the foreign exchange markets generally disregarded inflation numbers in the early 1990s. Because they were low for so long, these indicators allowed the Federal Reserve to maintain low interest rates. Little change, if any, was expected, so the inflation numbers, excellent otherwise for the economy, were nonevents for traders. However, interest in those numbers rose steeply in the late 1990s and mid-2000s on fear that the record bull market might show signs of waning.

Although there are quite a few economic indicators released in any given month, they do not provide all the information necessary to trade. The information is not always relevant, either because the change is insignificant or because the market has already discounted it. What these economic indicators do, however, is provide an overall background. The “feeling” of the market is the vital element in trading. If the market focuses on an aspect askew from the theoretical truth, it may be difficult for an individual trader to stop the tidal wave. That is why traders must stay close to the market, trying to gauge any change in other traders’ opinions.

This is not an argument to follow the flock, but an attempt to emphasize the importance of understanding and “feeling” the market. In the contemporary environment, access to information and the processing of information are at unprecedented levels of sophistication and speed. The monitors crowding the traders’ desks display a continuous flow of information. Currency traders are information traders.

It is up to the trader to discern what data is important, how to interpret it, and what weights to apply—instantly.

18 Financial and Sociopolitical Factors

Currency exchange rates are greatly influenced by financial factors, particularly interest rates. In fact, some market observers consider interest rates to be the primary determinant of a currency’s value. It is a misconception, however, to think that all increases in interest rates automatically trigger a rally in the domestic currency. This chapter analyzes the importance of interest rates vis-à-vis the exchange rates and explains how traders use interest rate changes in their dealings.

THE ROLE OF FINANCIAL FACTORS

Financial factors are vital to fundamental analysis. Changes in a government’s monetary or fiscal policies are bound to generate changes in the economy, and these will be reflected in the exchange rates. Financial factors should be triggered only by economic factors. Is that always the case? Regrettably, no. When governments focus on different aspects of the economy or have additional international responsibilities, financial factors may have priority over economic ones. This was painfully true in the case of the European Monetary System in the early 1990s. The realities of the marketplace revealed the underlying artificiality of this approach. Using the interest rates independently from the real economic environment translated into a very expensive strategy. As local rates were increased to maintain exchange rates at high levels versus the mark, which was the core European currency at the time, local economies came under undue pressure by 1992, and the EMS was in complete disarray by July 1993, delaying the introduction of the euro to 1999 from 1997.

Let’s take a look at the financial factors affecting currency exchange rates.

MONEY SUPPLY

According to Paul Samuelson, the supply of money, M1, incorporates “the sum of coins and currency in circulation outside the banks, plus checkable demand deposits (after various routine adjustments have been made in this magnitude).” (Paul Samuelson, Economics, 11th ed., McGraw-Hill, 1980.) The broader M2 also includes time and savings accounts. In addition, the Fed publishes another, broader money supply figure, M3, which also includes large denomination time deposits and term repurchase agreements. For further details please refer to Chapter 6.

Money supply is a major factor of the Quantity Equation of Exchange:

MV = PQ
where

M = money supply

V = velocity

P = prices

Q = real transactions

Velocity of money is the rate at which money is turning over on an annual basis to facilitate income transactions. Samuelson states that MV “equals GNP.”

The money supply data is released in the United States on a weekly basis. This data comes in handy in revealing the cyclical phase of economic recovery. For example, a larger money supply reflects a strengthening economy. Despite their implied importance, the money supply figures have lost some of their panache since the 1980s. This is due to distortions created by newer types of bank deposits, such as interest-bearing checking accounts and money market accounts. By 1993, the Federal Reserve Bank of the United States had started to find the money supply no longer useful for gauging the state of the economy, because of the statistical distortions.

INTEREST RATES

Interest rates are of paramount importance for foreign exchange. Generally, the first advice on fundamental analysis given to the junior foreign exchange trader is to “watch the interest rates.” That should refer to the interest rate products, such as five-year and ten-year notes, or thirty-year bonds. If it refers to key rates, well, this is easier said than done, as central banks are not particularly eager to change them often. The realities of the international and domestic economic environment, however, dictate more maneuvering of the key rates.

The rule of thumb is that higher interest rates generate a stronger currency, and vice versa. However, the investor must focus on the real interest rate rather than on the nominal interest rate. Nominal interest rates, unlike the real ones, take inflation into account. Also, it is critical to gauge the impact of a change in the rates on that country’s asset markets. A rate hike might hurt those markets, so the dollar would be sold. Moreover, in foreign exchange, it takes two to tango, especially when it comes to interest rates. Because foreign exchange, by definition, consists of simultaneous transactions in two currencies, then it follows that the market must focus on two respective interest rates as well. This is the interest rate differential, a basic factor in the markets.

Traders react when the interest rate differential changes, not simply when the interest rates themselves change. For example, if all the G-7 countries decided to simultaneously lower their interest rates by 25 basis points, the move would be neutral for foreign exchange, because the interest rate differentials would also be neutral. Of course, most of the time the rates are changed unilaterally, a move that generates changes in both the interest differential and the exchange rate.

Traders approach the interest rates like any other factor, trading on expectations and facts. For example, if rumor says that a rate will be cut, the respective currency may be sold before the fact. Once the cut occurs, it is quite possible that the currency may be bought back, or the other way around. An unexpected change in interest rates is likely to trigger a sharp currency move. (“Buy on the rumor, sell on the fact...”) Things are not easy in a market as complex as the foreign exchange market. Other factors affecting the trading decision are the time lag between the rumor and the fact, the reasons behind the interest rate change, and the perceived importance of the change.

The market generally prices in a rate change well in advance. Since it is a fait accompli, it is neutral to the market. If the rate was changed for political rather than economic reasons, the markets are likely to go against the central banks, sticking to the real fundamentals rather than the political ones.

Finally, traders deal on the perceived importance of a change in the interest rate differential. Is the differential divergent from the economic balance of two or more countries? If so, is it likely that the respective governments, or at least one of them, will do anything about it? Was the change in the rate significant enough to help the economy? These are just some of the important questions for which a trader must find answers. In order to be successful on the cutting edge of foreign exchange, a trader must rely on a keen analytical ability, sensitivity to the market “feeling,” and fast execution.

POLITICAL EVENTS

Political events represent an open-ended category of fundamental factors affecting the global currency market. While certain political events, such as the United States presidential elections, can be anticipated well in advance, most are nearly impossible to forecast. By and large, traders have to “play it by ear,” adjusting their reactions relative to each event. As a rule of thumb, the financial instruments, which are perceived worldwide as safe havens in times of international uncertainty, are the U.S. dollar and the Swiss franc among currencies, and gold, and even oil, among commodities. Of course, as with any other rule of thumb, investors do not follow this course blindly.

Let’s take a look at several real-life political events and examine what the reactions have been in the foreign exchange markets.

THE CLINTON–LEWINSKY AFFAIR

The markets were utterly confused when proof finally emerged in 1998 that U.S. President Bill Clinton had indulged in extramarital affairs even after entering the White House. Rumors and accusations had been haunting him for years, since his days as a young governor in Arkansas. Confusion was fueled by the very international structure of the currency markets: While many European and South American traders hold a liberal philosophy of life, morals were markedly more strict in the United States. Thus, the market lacked a single voice in this matter, and traders kept their eyes on the U.S. asset markets for clues. But it was still difficult to distinguish between the smoke of the emerging markets’ economies and the spots on the infamous dress that turned White House intern Monica Lewinsky into a trademark for Bill Clinton’s presidency. While his affairs won him the dubious distinction of being only the second U.S. President to be impeached, Clinton managed to keep the rudder straight. All in all, his alleged and proven adultery triggered only two minor sell-offs, both on Fridays, which were corrected on the following Mondays.

THE BUSH II–GORE ELECTION

The U.S. presidential election of 2000 was the closest in history. George Bush beat Democratic candidate Al Gore by only 537 votes in Florida, and it took approximately a month before the election was finally certified. Rumors on both sides abounded, naturally, but the impact in FX was virtually nonexistent.

THE IRAQI INVASION OF KUWAIT

The Iraqi invasion of Kuwait remains a significant international event because of the way currencies reacted to the exceptional situation of so many major international forces being united against a common aggressor. The event was different from NATO’s intervention in Kosovo to stop the ethnic slaughter in Yugoslavia in 1999. The reaction in the foreign exchange markets to the August 1990 Iraqi invasion of Kuwait was quick: Buy the dollar against the Japanese yen. The Japanese economy was perceived as worst-suited to a reduction of oil supply. The dollar/yen rate rallied to 160 from 150. By the beginning of 1991, with the Allied troops at the height of the operations against Iraq, the dollar/yen reversed to a meek 125. How did the Japanese yen manage this mighty comeback?

Japan was not directly involved in the military confrontation in the Persian Gulf. In accordance with its constitution at the time, it maintained a neutral stand, and only reluctantly contributed financially to the Allies’ effort. As a major customer of Gulf oil, Japan was allowed to continue its oil transports throughout the crisis. Moreover, Japan had already stockpiled large quantities of oil. Once they realized that the doomsday scenarios bore little relation to the reality of the situation, traders turned around and started buying Japanese yen. In the end, it wasn’t the U.S. dollar that had gained but the pound and the Canadian, Australian, and New Zealand dollars, which benefited from their specific double-digit deposit rates.

SEPTEMBER 11, 2001

September 11, 2001, is a date that will live in infamy for the United States and likely for all the civilized citizens of the world. Middle Eastern terrorists hijacked four planes in the United States and crashed two of them into the twin World Trade Center towers in New York. The skyscrapers soon collapsed, along with adjacent buildings. A third plane crashed into the Pentagon in Washington, D.C., while the fourth one crashed in Pennsylvania, the only plane not to hit a building. A total of 2,986 innocent civilians were slaughtered while no war was declared—nor was one intended. Since then, the name of Saudi religious extremist Osama bin Laden and his terror group al-Qaeda have become part of the lexicon. That crisis triggered a significant, but fairly short, sell-off in the currency markets and once they opened, the U.S. stock markets plunged as well. Figure 18.1 shows the reaction of the dollar against the yen. The brewing economic recession in the United States accelerated.

Figure 18.1. The reaction of the dollar against the yen on September 11, 2001, when Middle Eastern terrorists hijacked four U.S. civilian planes. They crashed two of them into the World Trade Center towers in New York and one in the Pentagon in Washington, D.C., while the fourth airliner crashed in Pennsylvania. A total of 2,986 innocent civilians were victims of these unprovoked attacks.

THE IRAQ WAR

Following the crisis of September 11, there was an uneasy feeling in the United States toward the risk posed by Middle Eastern religious extremists. Obviously, the smooth, complex, and deadly operation by a small group of individuals with only rudimentary weapons against the leading country of the world shook Americans’ faith in U.S. security and intelligence. The United States was quick to attack local warriors in the rugged mountains of Afghanistan, but what if primitive weapons were replaced by weapons of mass destruction under the protection of a rogue state? Against this background, the U.S. administration focused its attention on Iraq, with a secular government led with an iron fist by a dictator—Saddam Hussein. His administration had used weapons of mass destruction against Iran before its invasion of Kuwait. The U.S. administration invaded Iraq on March 20, 2003, based on the reason that Iraq illegally continued to hold weapons of mass destruction, in violation of UN Security Council Resolution 1441. Operation Iraqi Freedom was led by the United States and the U.K., which together provided 98 percent of the invading forces. The weapons were never found, and whether they were transferred to another country, such as Syria, or had simply been destroyed at the end of the Kuwait War, we may never find out. Apart from readers’ personal feelings toward the scope and cost of this war, the cold fact remains that its impact on foreign exchange was sporadic and minimal.

THE SWITCH IN CURRENCY RESERVES

The twenty-first century brought globalization to full flower and consequently the euro became the powerhouse it was meant to be. Against this background, smaller, but significant, central banks from Russia and some Middle Eastern countries started to diversify the structure of their reserves from the dollar to the euro. From a risk management point of view, this move makes sense, as it diversifies the portfolio of holdings. Nevertheless, some of these central banks used this restructuring as a weapon to compromise the leading role of the United States. This move weakened the dollar across the board, but especially versus the euro.

CONCLUSION

Fundamental analysis must take into account numerous events that occur in a multitude of areas. Whether they are economic, financial, or political, different fundamental factors can have a vastly different impact on foreign exchange. Sometimes the reaction is quick. At other times, the effects only appear within a time frame of six to nine months, or they occur on the “wrong” side. Astute traders learn to interpret all of these continuously evolving factors, weigh them properly, and act on them appropriately. This concerted effort, along with the technical signals, can generate accurate forecasts in an increasingly competitive trading environment.

PART

6 FOREIGN EXCHANGE FORECASTING: TECHNICAL ANALYSIS

19 Technical Analysis

One of the most significant tools available for the forecasting of financial markets is technical analysis, which is the chart study of past behavior of commodity prices that helps forecast their future performance. Although the use of chart analysis has increased significantly since the mid-1980s, it is nothing new. Such analysis has been an increasingly utilized forecasting tool over the last two centuries. Seiki Shimizu, a famous Japanese commodity trader and the author of a comprehensive study on candlestick charting, speculated that technical analysis probably occurred in Europe in the sixteenth century and in Japan in the seventeenth century. He believes that the beginning of the rice market in 1750 parallels the establishment of charting in Japan.

THE EVOLUTION OF TECHNICAL ANALYSIS

Commodity traders started to analyze past price behavior because they felt that commodity prices reflect the action of all available factors. In other words, commodity prices reflect all the changes in the balance between supply and demand as caused by traders’ reactions to economic, political, or psychological changes. Later, observations on the seasonality of crops evolved into the idea of historical repetition in the market. Finally, the empirical evidence showed that, once the market starts moving one way, the direction and momentum are likely to continue for a while, before new forces are able to change the balance between buyers and sellers and turn the tide.

These three factors—the price as the ultimate result of all the market forces; the repetition of the market price behavior; and the market tendency to move in trends—slowly crystallized in traders’ minds to set up the basis of chart analysis. Since then, there has been a vigorous and continuous effort to refine the process of technical analysis in order to profitably forecast future market behavior.

To the untrained eye, technical analysis may seem confusing at times. On one hand, it seems that everybody is talking about it, using it, and profiting from it. On the other hand, certain academicians liken it to the structure of a house of cards.

Where is the truth?

PROS

The main strengths of technical analysis may be summarized as flexibility, flexibility, and flexibility. There is flexibility with regard to the underlying instrument. A trader who deals several currencies but specializes in one may easily apply the same technical expertise to trading another currency. Traders do this when volatility in the currency in which they specialize slows down temporarily.

There is also flexibility regarding the markets. A trader who specializes in spot trading can make a smooth transition to dealing currency futures by using chart studies, because the same technical principles apply over and over again, regardless of the market.

Finally, there is flexibility regarding the time frame. Different players have different trading styles, objectives, and time frames. Yet the same technical principles apply, as they easily adapt to many different points of view.

Technical analysis also has a user-friendly feature: It is easy to compute and the technical services are becoming increasingly sophisticated and reasonably priced. Traders enjoy a multitude of financial information services that offer printed and electronic charts. Technically inclined traders have only to focus on interpreting them, not on producing them.

CONS

All good things seem to get their share of criticism, and so does technical analysis. Criticism is healthy, as it keeps the object of its attention “lean and mean.” Criticism is good for technical analysis in general and for foreign exchange analysis in particular, because it helps newcomers better understand the approach’s characteristics and the ways it can help their performance.

The technical analysis naysayers usually focus on two general aspects: the random walk theory and the self-fulfilling prophecy.

The Random Walk Theory

Developed by Paul Cooner in 1964, this theory is based on the efficient market hypothesis, which states that prices move randomly versus their intrinsic value. The random walk theory has three versions: the strong version, the semistrong version, and the weak version.

1. The strong version holds that it is impossible to forecast anything based on past or current information and that therefore past chart information is completely meaningless.

2. The semistrong version states that forecasting is impossible if it is based on publicly available information. By extrapolation, since most information in foreign exchange—including the charts reflecting that information—is publicly available, forecasting is generally precluded. Exceptions are allowed in the case of proprietary information. A trading desk receiving an order to buy a very large amount of currency will therefore be able to “forecast” the behavior of the market.

3. The weak version maintains that an efficient market with instantaneous access to information will discount everything, so past data is useless for forecasting.

Among financial markets, academicians have labeled foreign exchange as the most efficient market. If the hypothesis of market efficiency holds, then all past information has already been reflected in the price and, therefore, there is no niche for an individual trader to speculate at the expense of the rest of the market. Any “turf advantage” or any other type of “inside information” will be instantly gathered and digested by the markets. Consequently, all market participants are precluded from consistently having any advantage over the rest of the market. The instantaneous access to information around the world should only add to the validity of this theory.

All markets do have a degree of randomness. This is perhaps even more true in the foreign exchange market, which has such large volume that no individual player can have a consistent or long-term impact on the direction of a currency. However, several academic studies fully contradict the random walk theory, confirming what traders knew already.

Currencies trend well, and educated and disciplined traders will benefit at the expense of the others. In addition to the standard patterns, some currencies correlate well, at least periodically, with other currencies, commodities, and interest rate differentials, or display specific idiosyncrasies. For instance, dollar/yen shows an interesting pattern (see Figure 19.1). The dollar/yen spot rate moves in increments of 2000 pips (20 yen) in the long term. From a high at around 260, the currency dropped to 220, to 200, 180, 160, 140, back up to around 160, and then down to 140 and 120. After reaching the 120 level the third time, the dollar/yen spot rate reached and broke the 100 barrier to reach 79.75, or just about 80, in April 1995. There was a failure between June and August 1998, when dollar/yen broke above 140 but couldn’t reach even 148. The upside was thwarted initially by U.S. and Japanese intervention to alleviate Chinese concern that a weak yen would hurt their export. Dollar/yen then made a collapsing decline when the largest and most famed fund at the time, Long-Term Capital Management (LTCM), collapsed. While the collapse was triggered by liquidation of some of its prevalent fixed income arbitrage positions, the fund also closed profitable long dollar/yen positions. The pair failed because the enormity of the LTCM sales greatly surpassed demand, thus creating the largest one-day range in a major currency (October 7 and 8, 1998).

Figure 19.1. The U.S. dollar/Japanese yen spot exchange rate chart shows that the currency follows a price pattern of 2,000 pips in the long term.

Every 2000 pips, the dollar/Japanese yen spot rate found a trading plateau. This pattern was not an exception; in fact, it is still continuing.

The Self-Fulfilling Prophecy

Criticism about the self-fulfilling theory has been around for a long time, and technical analysts wouldn’t actually mind this theory—should it hold. Not only would it be a fast way of getting rich, but think of all the trader-size egos that would be touched.

The self-fulfilling prophecy, however, has too many holes to support anything but the most superficial criticism, because chart interpretation is very subjective and personal. It requires an individual, innate talent mixed with personally acquired and refined research and understanding. Also, since different traders have different objectives, time frames, and trading styles, it is rather difficult to predict which prophecy will be fulfilled. Moreover, if the time-honored law of supply and demand does not provide the backing, any technical-related price overshooting will be short-lived.

Chartists are not trying to create an artificial environment in which financial instruments may be maneuvered at will. They are merely trying to identify in the already existing environment any signals in price behavior that indicate future price activity.

HOW PAST INFORMATION IMPACTS THE FUTURE

This brings us to the matter of whether past information can predict the future. Yes, it can. One does not have to venture all the way to the foreign exchange world to see this, because the strategy of using past information to build forecasting models is rather the standard in most industries. Currency trading is not a game of darts, so precedent is very important in helping a chartist forecast a currency’s way into the future. It is the lack of historic information, not its availability, which is detrimental. It may be a lack of understanding of the lessons of the past, rather than the past itself, that triggered the debate.

Technical analysis has been proved over and over again in the financial markets. The majority of currency traders use it extensively. Very rarely, if ever, was a consistently useful tool such as charting able to make such a powerful impact on the traders’ decision process.

Despite all the technological breakthroughs, charting remains closer to art than to science. Yet the more refined a trader becomes, the better is his or her forecasting performance.

Arguments may continue to go back and forth. In the meantime, the technicians, in increasing numbers, focus their expertise on forecasting price activity in the future.

For those still interested in charting, let’s move ahead, keeping several important ideas in mind:

1. Price is a comprehensive reflection of all the market forces.

2. Price movements are historically repetitive.

3. Price movements are trend followers.

TYPES OF CHARTS: A COMPARISON

There are four types of charts, which you can quickly compare in Figure 19.2:

1. Line chart
2. Bar chart
3. Candlestick chart
4. Point-and-figure chart

LINE CHART

The line chart is the original type of chart. In order to plot it, a line connects single prices for a selected time period. The most popular line chart is the daily chart. Although any point in the day can be plotted, most traders focus on the closing price, which they perceive as the most important. But an immediate problem with the daily line chart is the fact that it is impossible to see the price activity for the balance of the day.

With so much information missing, should line charts even be considered for technical analysis?

Yes, because intraday activity does not need to be lost. Simply change the time span for which you need to see the price fluctuation to a very short period by selecting a tick chart, and virtually all prices will be plotted for you to analyze (see Figure 19.3).

Figure 19.2. Comparison of line, bar, candlestick, and point-and-figure charts in euro/U.S. dollar.

Daily line charts are also useful when looking for the big picture or the major trend because, without line charts, intraday activity would become an unimportant detail. When plotted over a long stretch of time, such as several years, a line chart may be easier to visualize.

However, like the point-and-figure chart, the line chart is a continuous chart, and this is a disadvantage because price gaps cannot be charted on a continuous chart.

Figure 19.3. Example of a tick chart in dollar/Japanese yen.

BAR CHART

The bar chart is arguably the most popular type of chart currently in use. It consists of four significant points:

- the high and the low prices, which form a vertical bar;

- the opening price, which is marked with a little horizontal line to the left of the bar; and

- the closing price, which is marked with a little horizontal line to the right of the bar (see Figure 19.4).

The opening price is not always important for this analysis.

Figure 19.4. The structure of a price range bar.

Bar charts have the obvious advantage of displaying the currency range for the period selected. The most popular period is daily, followed by weekly. Other periods, such as hourly, may be selected as well.

An advantage of this chart is that, unlike line and point-and-figure charts, the bar chart is able to plot price gaps that are formed in the currency futures market. Although currencies trade around the clock, the currency futures market is physically open for only about a third of the trading day. (Chicago IMM is open for business 7:20 a.m. to 2 p.m. CDT.) Therefore, price gaps may occur between two days’ price ranges (see Figure 19.5). In the cash market gaps occur rarely, and when they do they occur around weekends.

This chart, however, is unable to plot the whole price fluctuation, even when plotted for short time periods.

Figure 19.5. Bar charts on currency futures, such as on euro futures, show price gaps.

CANDLESTICK CHART

The candlestick chart was probably developed in China and then took roots in Japan around 1750. Despite its venerable age, it was only in the 1980s that it became internationally popular. This exposure was largely possible because of breakthroughs in electronic charting.

The candlestick chart is closely related to the bar chart. It also consists of four major prices: high, low, open, and close (see Figure 19.6). In addition to the common readings, the candlestick chart has a set of particular interpretations. It is also easier to view.

The opening and closing prices form the body (jittai) of the candlestick. To indicate that the opening was lower than the closing, the body of the bar is left blank (see Figure 19.6-A). In its original form, the body was colored red, but electronic charts allow you to select a color of your choice. If the currency closes below its opening, the body is filled (see Figure 19.6-B). In its original form, the body was colored black.

Figure 19.6. The structure of a candlestick.

It is very easy to see the intraday and weekly direction on a candlestick chart. When the high and the low differ from the opening and closing levels, the rest of the range is marked by two “shadows”; the upper shadow (uwakage) is above the body and the lower shadow (shitakage) is below the body.

For illustration purposes, we may assume that in Figure 19.7, the following price activity took place:

The GBP/USD opened at 1.7000 and closed at 1.7200. The high was 1.7230 and the low was 1.6980 (A).

The GBP/USD opened at 1.7200 and closed at 1.7000. The high was 1.7250 and the low was 1.6900 (B).

Just as with a bar chart, the candlestick chart is unable to trace every price movement during a day’s activity.

Figure 19.7. Application of the structure of a candlestick.

POINT-AND-FIGURE CHART

The point-and-figure chart takes a different approach. All other types of charts have one thing in common: The prices are always plotted against certain periods of time. The point-and-figure chart completely disregards time, concentrating fully on the price activity. Point-and-figure charts are based on tick charts, so they are particularly well suited for the twenty-four-hour trading in FX because there are no pauses between trading sessions. Currency prices are divided in equal portions, which you will include in the boxes, whether rising or declining. When the currency moves up, the fluctuations are marked with Xs. Moves on the downside are plotted with Os. This chart was designed to minimize the amount of statistical noise. The direction on the chart will change only if the currency is reversed by a certain number of pips.

A popular point-and-figure chart is 1×3—1 box to continue the previous direction and 3 boxes to reverse the current direction (see Figure 19.8). With most traders selecting 10 pips per box, it means that the currency must advance exactly 10 pips to mark an X, or reverse by precisely 30 pips before 3 Os are plotted. In this way, minor activities are ignored, allowing the trader to concentrate solely on the price fluctuation.

This chart is popular because the trading signals are easier to see on the chart, they are more precise, and no personal interpretation is necessary. Point-and-figure charting is discussed in more detail in Chapter 23.

Not all traders use all of the chart types, nor is it a prerequisite of a successful trader. It will be up to you to choose the best chart or set of charts for yourself.

Figure 19.8. Market example of point-and-figure chart in sterling/dollar.

VOLUME AND OPEN INTEREST

Volume consists of the total amount of currency traded within a period of time, usually one day. For example, by the year 2004, the total foreign currency daily trading volume was $1.9 trillion. But traders are naturally more interested in the volume of specific currencies for specific trading periods, because large trading volume suggests that there is interest and liquidity in a certain market, and low volume warns the trader to veer away from that market.

The risks of a low-volume market are usually very difficult to quantify or hedge. In addition, certain chart formations require heavy trading volume for successful development. An example is the head-and-shoulder formation, which is discussed in Chapter 20.

Therefore, despite its obvious importance, volume is not easy to quantify in most foreign exchange markets. Volume figures can be calculated for futures and for options on futures markets, because both take place on centralized exchanges and all the trades go through the clearinghouse. It is a different situation for the spot, forwards, and cash options markets, because trading is completely decentralized and therefore almost impossible to gauge.

In order to minimize this problem, traders have to learn how to estimate volume. One method is to extrapolate the figures from the futures market. Another is “feeling” the size of volume based on the number of calls on the dealing systems or phones, and the “noise” from the brokers’ market. It isn’t the easiest job in the world, but who ever thought it would be?

Open interest is the total exposure, or outstanding position, in a certain instrument. The same problems that affect volume are also present here. As I have already mentioned, figures for volume and open interest are available only for currency futures (see Figure 19.9).

Figure 19.9. The Japanese yen futures bar chart and its trading volume and open interest.

Volume and open interest figures are available from different sources, but the core source is the Chicago Mercantile Exchange.

A Trader’s Point of View

The open interest figures are important in determining or adding confidence that a currency is overbought or oversold. Get this information from the Commitment of Traders reports provided by the Commodity Futures Trading Commission at www.cftc.gov/dea/futures/ (see Figure 19.10).

Figure 19.10. Open interest figures are provided by the Commitment of Traders reports from the Commodity Futures Trading Commission.

TREND

The concept of trend is paramount to technical analysis. The familiar quote “The trend is my friend” is deeply rooted in the experience of the markets. It should be respected and attentively observed. A trend simply shows the direction of the market. Therefore, a trend may be:

1. Upward, such in euro/dollar, where you can see higher highs and higher lows (see Figure 19.11).

2. Downward, in which you can see lower lows and lower highs such as the U.S. dollar/Canadian dollar (see Figure 19.12).

3. Sideways (not exactly a trend), as in this dollar/yen chart (see Figure 19.13).

Figure 19.11. Example of uptrend euro/dollar.

Figure 19.12. Example of downtrend on the monthly U.S. dollar/Canadian dollar chart.

Figure 19.13. Example of sideways trading in dollar/yen.

Because the markets do not move in a straight line in any direction, but rather in zigzags, it is the direction of these peaks and troughs that creates the market trend.

In addition to direction, trends are also classified by time frame: major or long-term trends, secondary or medium-term trends, and near-term or short-term trends. Any number of secondary and near-term trends may occur within a major trend.

The time frames for each class vary widely. The Dow Theory, developed at the end of the nineteenth century by Charles Dow, suggests a one-year length for a major trend. Currently, for a major trend, the market expects a time span of over one year (see Figure 19.12). Secondary trends should last for a matter of months, and short-term trends for a matter of weeks.

Charles Dow is the preeminent technical analyst of Western charting who published his analysis at the end of the nineteenth century in the Wall Street Journal.

Here are Charles Dow’s six principles:

1. The market discounts everything. Prices reflect all information and market forces.

2. The market has three trends: primary, secondary, and minor. The secondary trend is a correction to the primary trend and may retrace one-third, one-half, or two-thirds from the primary trend.

3. The primary trend has three phases: accumulation, run-up/run-down, and distribution. In the accumulation phase the big accounts tend to enter new positions. In the run-up/run-down phase, the majority of the market jumps on the bandwagon. In the distribution phase, the smart money takes profits and closes positions while the general trading interest slows down in an overshooting market.

4. The averages must confirm each other. This refers to the Industrial, Transportation, and Utility Averages, not to moving averages.

5. Volume must confirm the trend. This condition is a tough one for currency traders because they don’t have accurate volume figures.

6. Trends exist until their reversals are confirmed.

SUPPORT AND RESISTANCE LEVELS

The peaks represent the price levels at which the selling pressure exceeds the buying pressure. They are known as resistance levels. The troughs, on the other hand, represent the levels at which the selling pressure succumbs to the buying pressure. They are called support levels. In an uptrend, the consecutive support and resistance levels must exceed each other respectively. The reverse is true in a downtrend. Although minor exceptions are acceptable, these failures should be considered as warning signals for trend changing.

The significance of trends is a function of time and volume. The longer the prices bounce off the support and resistance levels, the more significant the trend becomes. Trading volume is also very important, especially at the critical support and resistance levels. When the currency bounces off these levels under heavy volume, the significance of the trend increases.

The importance of support and resistance levels goes beyond their original functions. If these levels are convincingly penetrated, they tend to turn into just the opposite. A firm support level, once it is penetrated on heavy volume, will likely turn into a strong resistance level (see Figure 19.14). Conversely, a strong resistance turns into a firm support after being penetrated (see Figure 19.15).

Figure 19.14. Example of support turned into resistance in New Zealand/U.S. dollar.

Figure 19.15. Example of resistance turned into support in dollar/yen.

TRENDLINE

A trendline is the natural development in tracking a trend. It simply consists of a straight line connecting the significant highs (peaks) in a downtrend or the significant lows (troughs) in an uptrend. Following in the tracks of the trend directions, the trendlines may be classified as:

1. Rising trendline, as in the four-month-old uptrend in dollar/yen (see Figure 19.16).

2. Declining trendline, such as on the four-and-a-half-year downtrend in New Zealand/U.S. dollar (see Figure 19.17).

Drawing the trendline is rather easy, as only two points are necessary. But this trendline is merely “tentative.” Most traders prefer to see a third contact point confirmation. When a trend seems to be securely set in its tracks, we must recall an important point made in the beginning of this chapter.

Currency markets are trend followers. Therefore, we can expect the currency to maintain its general direction and velocity. The most significant trendlines occur around an angle of 45 degrees, according to renowned investor and technical analyst W. D. Gann (see Chapter 27). He noted that a trendline at a sharper angle suggests that the rally is unsustainable. Conversely, a trendline at a low level indicates that the trend is close to reversing.

Figure 19.16. Example of a rising trendline in U.S. dollar/Japanese yen.

Figure 19.17. Example of a declining trendline in New Zealand/U.S. dollar.

Not only would we like to identify as many significant trendlines as possible, but we would also like the trendlines to provide “clean” support and resistance levels. However, since the market has a life of its own, this is not possible. Many times we see minor trendline penetrations. As a rule of thumb, this type of breakout should be disregarded.

A Trader’s Point of View

1. Breakouts must occur on strong volume.

2. Weak breakouts (from a volume point of view) should be disregarded. Several players were perhaps forced to cut their losses, or attempted to spearhead a new trend but failed to stir sufficient market interest (see Figure 19.18).

3. A breakout from an uptrend must be confirmed by a close below the rising trendline (see Figure 19.19-A). Conversely, a breakout from a downtrend must be confirmed by a close above the declining trendline (see Figure 19.19-B).

Figure 19.18. Example of a weak breakout in euro/Swiss franc.

Figure 19.19. A breakout from an uptrend must be confirmed by a close below the rising trendline (A), and a breakout from a downtrend must be confirmed by a close above the declining trendline (B), illustrated on the daily euro/Swiss franc chart.

Figure 19.20. Example of a breakout followed by consolidation.

4. For more significance of the trend-changing signal, a breakout should be followed by two consecutive closes outside the trendline.

5. Even after confirmation, the breakout is still likely to be followed by a period of consolidation (see Figure 19.20).

Figure 19.21. Example of a sharp move following consolidation outside the trendline in euro/Norwegian krone.

Figure 19.22. Example of a currency retesting its trendline after breakout in euro/yen.

6. If a consolidation period does indeed occur, the longer it lasts, the steeper the following rally will be (see Figure 19.21).

7. Breakouts from uptrend tend to test the strength of the former trendline support, now turned into a resistance line (see Figure 19.22).

8. Use a price filter of 1 percent to test the validity of the breakout.

THE CHANNEL LINE

A channel line may be a parallel line that can be traced against the trendline, connecting the significant peaks in an uptrend and the significant troughs in a downtrend. Along with the trendline, the channel line may create a channel that borders the trend. In a downtrend, the channel line is at the bottom of the channel (the support line). In an uptrend, the channel line is at the top of the channel (the resistance line) (see Figure 19.23).

When the trendline and the channel line are parallel, it is a good idea to divide the channel in two. This way you will benefit from additional entry and exit points. Moreover, in unclear conditions, prices will tend to gather around the middle line (see Figure 19.24).

Figure 19.23. Example of an uptrend in euro/sterling; the channel line is at the top and the trendline is at the bottom.

Figure 19.24. Divide the channel in two if the trendline and the channel line are parallel. You will benefit from additional entry and exit points.

A Trader’s Point of View

1. A channel is a very attractive chart pattern for traders, as the number of signals increases.

2. The price failure to reach the trendline should be interpreted as possible trend acceleration (see Figure 19.25).

3. The break of the channel line confirms trend acceleration (see Figure 19.26).

4. A channel breakout suggests a target for the currency price equal to the width of the channel (see Figure 19.25).

5. Failure to reach the channel line should be construed as a case of a weakening trend (see Figure 19.27).

Figure 19.25. As the dollar/Canada chart shows, the failure to reach the declining trendline is a signal that the downtrend is accelerating. Once the channel line broke, the pair virtually doubled the width of its intial channel.

Figure 19.26. Example of trend acceleration signaled by the break of the channel line in dollar/Mexican peso.

Figure 19.27. Example of trend reversal signaled by the failure to reach the channel line in dollar/Swiss franc.

RETRACEMENTS ANALYSIS

As we are well aware by now, currencies, like all the other financial instruments, do not move straight up or down, even in the healthiest of trends. Traders watch several ratios in search of price objectives when currencies make temporary corrections against the prevailing trend.

There are three sets of ratios used to calculate retracements:

1. Charles Dow developed the traditional percentage retracements at the turn of the last century. They are 1/3, 1/2, and 2/3; or 33 percent, 50 percent, and 67 percent. A retracement past 67 percent is considered to be a trend failure, but that doesn’t mean waiting so long before exiting positions.

2. The Fibonacci ratios are the most popular, and not only among Elliott Wave followers. These ratios are .382, .50, and .618, or approximately 38 percent, 50 percent, and 62 percent. Fibonacci ratios are discussed in more detail in Chapter 28.

3. The Gann percentages attach importance to the one-eighth breakdowns. For further details and review, read Chapter 27.

However, it will be up to you to decide the application of these ratios. The standard format is horizontal lines, but this is hardly the only method to employ. This module will also deal with fan lines, arcs, free-angle retracements, price extensions, and time (vertical) extensions.

HORIZONTAL LINES

When it comes to retracements, most traders will be happy to slap on a set of three Fibonacci retracement lines. There is nothing wrong with it, as in addition to trading you also want to know what the market is looking for, but that is not enough.

If you are shooting for the Dow retracements, you’ll look at something like Figure 19.28.

If you go for the standard Fibonacci, then the three lines in Figure 19.29 will suffice. If you want to take it a step further, you may like to add two more lines at .236, which is .618^3 (or .618 × .382), and .786, which is the square root of .618 (see Figure 19.30).

Finally, Gann retracements will give you more horizontal lines, hence more entry and exit levels. Figure 19.31 shows this advantage.

Figure 19.28. A market example of Charles Dow’s retracement percentages in Australian dollar/New Zealand dollar.

Figure 19.29. An example of Fibonacci ratios retracements in U.S. dollar/Canadian dollar.

Figure 19.30. A market example of complex Fibonacci ratios retracements in euro/yen.

Figure 19.31. A market example of Gann percentage in New Zealand dollar/U.S. dollar.

FAN LINES

Fan lines were originally designed by Edson Gould, who employed Dow ratios. They were originally called Speed lines. To calculate fan lines, the total range of a trend is divided into thirds on a vertical line. The two fan lines are plotted by connecting the origin of the range (bottom for an uptrend and top for a downtrend) and the 1/3 and 2/3 levels respectively.

A price fluctuation away from the trend, which finds support at the first (1/3) fan line, indicates that the trend continues smoothly ahead. The penetration of the first (1/3) line is a trend-weakening warning; the next level to watch is the second fan line (2/3). If the currency price bounces back, we may be faced with an uncertain (or consolidation) period between the first (1/3) and second (2/3) fan lines. If the last line gives way as well, then the next target is the origin of the range. The previous rule, that a penetrated support level will turn into a resistance level, and its converse both remain valid for fan lines.

It is more popular to apply the Fibonacci ratios and the Gann ratios to the fan method (see Figures 19.32 and 19.33).

Fan lines may be applied to all charts. Their significance in the medium and long term extrapolates well to short-term charts. Should traders and analysts use one or more sets of fan lines on the same chart? The answer is: one, only if there is only one trend being retraced, and more, if more than one trend is retraced. The first may be applied to a major uptrend and the second to a secondary downtrend (countertrend). What is new is that the intersections between the fan lines going in divergent directions provide stronger than usual support and resistance areas.

Figure 19.32. An example of Fibonacci fan lines in sterling/dollar.

Figure 19.33. An example of Gann fan lines in the U.S. dollar/Japanese yen.

ARCS

The arcs provide an interesting method of targeting both the price and the timing of a retracement. In this approach, you connect the highest high and the lowest low of a downtrend (or the lowest low and the highest high of an uptrend) and on this line mark the .382, .50, and .618 ratios. With the help of a compass or software, you draw arcs from the end of the trend (needle) through the ratios on the line to extrapolate the future time and price targets for retracements (see Figure 19.34).

FREE-ANGLE RETRACEMENTS

This interesting and useful retracement method was designed by John Taylor, chairman of Investment Fund FX Concepts. Taylor argues that currencies in a trend will gather around the median of the channel in times of uncertainty. In order to better capture the area of consolidation, he applies standard Fibonacci retracement levels to a trend channel, regardless of the angle of the trend (see Figure 19.35). More details about the angle of the trend and this method are available in Chapter 27.

Figure 19.34. Arcs applied to New Zealand dollar/U.S. dollar.

Figure 19.35. Example of free-angle Fibonacci retracements on a trend channel in dollar/Canada.

EXTENSION ANALYSIS

The analysis has so far dealt with retracement analysis. However, assume that the currency is reaching new highs or new lows. You enter the right position, but you don’t know where to set the target because prices are finding their way through new territory. You can leave a tight trailing stop-loss order to protect your profit, but it would help greatly if you had a target. Solution? Extensions.

To apply this method, you extrapolate the ratios used for retracements of the previous trend to obtain new targets. Applying this method on the popular Fibonacci ratios, the immediate extensions are 1.382, 1.5, and 1.682. If you prefer Gann, then use 1.125, 1.25, 1.375, 1.5, 1.675, 1.75, and 1.875.

Typically, the best results tend to be drawn from the 1.25 and 1.382 extensions. Figure 19.36 shows an example of this method.

Figure 19.36. Example of extension analysis on the weekly dollar/Canada chart.

CYCLICAL ANALYSIS

Timing is everything, and traders know this. But getting the timing right has been a daunting task for traders from the beginning. Answering this trading need is cyclical analysis, which has been perfected by FX Concepts’ John Taylor. While this analysis is proprietary and the results are available only by subscription, here is the basic approach.

Cycles are measured in terms of amplitude, period, and phase. Amplitude shows the height of the cycle. The period shows the length of the cycle from low to low or high to high (see Figure 19.37 A). The phase points the location of a wave trough.

Bull markets have the crests of their cycles biased to the right, called right translations, while bear markets have the troughs of their cycles leaning to the left, named left translations, and they last longer.

Cycle identification is a powerful tool that can be used in both the long and the short term. The longer the term, the more significance a cycle has.

Three important rules for cyclical analysis are the following:

1. Long-term cycles break down into medium- and short-term cycles (see Figure 19.37-B).

2. Cyclical highs or lows are not always found at the actual price high or low of the market. This means that if the currency does not change direction quickly after peaking or bottoming, the cycle start will be delayed to when the market breaks out (see Figure 19.37-C).

3. Cycles extend in strong trends and contract in sideways markets (see Figure 19.37-D).

Cyclical analysis is difficult and is best left for the expert in the field, FX Concepts, which has specialized in currencies and interest rate futures since 1981.

Figure 19.37. Diagram of cyclical analysis.

Trends tend to retrace by the same Fibonacci ratios (including the 50 percent) on a time basis as well. In the example in Figure 19.38, you can see a downtrend between April 5 and May 17. Once the currency is recovering, the traders are looking for a possible end of the bounce 1.382 percent extension of the downtrend on June 2, 1.5 percent on June 7, and 61.8 percent on June 12. In this example, dollar/Canada ended its recovery only one day after the 50 percent mark.

Figure 19.38. Example of targeting the timing of the market by using Fibonacci extensions to time in euro/sterling.

PIVOT POINTS

Pivot point analysis is a simple method of defining support and resistance levels based on key prices in the previous day. The pivot consists of the average of the previous day’s high, low and close.

Using the pivot and the previous day’s high and low you can get two support levels and two resistance levels as follows:

THE IMPORTANCE OF THE LONG-TERM CHARTS

As previously mentioned, the tools of technical analysis are flexible in terms of instruments, markets, and time frames. Although the most popular charts are the daily charts, the longer-period charts (weekly and even monthly) charts are very important too. Electronic charting offers maximum convenience for the traders.

Why are weekly charts useful?

1. They make it possible to compress long-term information into a single chart.

2. Long-term charts provide important information regarding long-term trends or cycles. The trader can get a correct perspective regarding the real direction of the market in the long run, the strength or direction of the current trend occurring within that trend, or the possibility of a breakout from the long-term trend.

3. Long-term charts may also provide technical signals that are easy to ignore in the daily charts. While the daily chart was very negative on the day, Figure 19.39 shows that the 1.5 percent extrapolation target of the dollar/Canada monthly chart accurately pointed to the lowest level of the downtrend for that period, and the market promptly recovered.

Figure 19.39. Example of long-term analysis on the monthly dollar/Canada chart.

20 Trend Reversal Patterns

Chart formations are generally sorted on the basis of their significance to the current trend of the underlying currency. Formations signaling the end of a trend and the start of a new one are known as reversal patterns. Conversely, chart formations that confirm that the trend of the underlying currency is intact are called continuation patterns. This chapter presents trend reversal formations.

The most significant trend reversal patterns are:

1. Head-and-shoulders and inverse head-and-shoulders

2. Double tops and double bottoms
3. Triple tops and triple bottoms
4. V-formations

HEAD-AND-SHOULDERS

The head-and-shoulders pattern, one of the most reliable and well-known chart formations, hardly needs an introduction. As you can see in Figure 20.1, the underlying currency broke the trendline of the channel xx’-yy’. In a typical move, the currency rallied back to the previous support line, which turned into a resistance line. As the currency fell, the trend breakout was confirmed.

The head-and-shoulders pattern consists of three consecutive rallies. The first and third rallies—the shoulders—have about the same height, and the middle one—the head—is the highest. The line connecting the highest two lows, which is a support line in this case or on the resistance line in the case of the reversed head-and-shoulders formation, is known as the neckline.

Figure 20.1. Diagram of a typical head-and-shoulders pattern.

Once the trendline support (yy’) was broken, it turned into a significant resistance line, and in this idealized diagram this line capped the third rally, which is the right shoulder. The neckline offered support at points B and C. The neckline was eventually broken in point D, under heavy volume, and the trend reversal was confirmed. As the significant support line was broken, a retracement could be expected to retest the neckline (see E), now a resistance line. Since the resistance line held, the price was expected to eventually decline to around level F, which was the price target of the head-and-shoulders formation. The target is approximately equal in amplitude to the distance between the top of the head and the neckline. The price target must be measured from point D, where the neckline was broken (see the dotted lines). A market example of a head-and-shoulders reversal formation in the weekly euro/sterling chart is presented in Figure 20.2.

SIGNALS GENERATED BY THE HEAD-AND-SHOULDERS PATTERN

The head-and-shoulders formation provides excellent information:

1. The support line. This is based on points B and C.

2. The resistance line. After giving in at point D, the market may retest the neckline at point E.

3. The price direction. If the neckline resistance holds the buying pressure at point E, then the formation provides information regarding the price direction: diametrically opposed to the direction of the head-and-shoulders (bearish).

4. The price target. This is provided by the confirmation of the formation (by breaking through the neckline under heavy trading volume).

Figure 20.2. A market example of a head-and-shoulders formation in the weekly euro/sterling chart.

One of the main requirements of the successful development of this formation is that the breakout through the neckline occurs under heavy market volume. As you remember, though, gauging volume is only possible in the currency futures market. The trader will have to estimate the size of the cash market volume by extrapolating from the currency futures’ volume and the trading “noise.” A breakout on light volume is a strong warning that it is a false breakout and might trigger a sharp backlash in the currency price.

The time frame for this chart formation’s evolution is anywhere from several hours to several months. The intraday chart formations are not reliable. The longer the formation time is, the more significance should be attached to this pattern.

The target is unlikely to be reached in a very short time frame for the daily or longer horizon formations. Whereas there is no immediate suggestion regarding the length of target reaching time, common sense would link it to the duration of development of the chart pattern.

I want to emphasize the importance of measuring the target from the point where the neckline was broken. There is a tendency among new technicians to measure the target price not only from under the neckline but also from the middle of the formation. This may happen as they measure the height of the head.

Most head-and-shoulders formations, of course, look different from the one in Figure 20.1. Prices fluctuate enough to forgo any possibility of a clean-looking chart line. Also, the neckline is seldom a perfectly horizontal line.

POTENTIAL PROBLEMS

1. The height of the shoulders should be about equal. More important, though, the shoulders must not be taller than the head.

2. It is very important that the significant points B and C are tangential to the neckline. The failure of this requirement nullifies the characteristics of the formation.

3. The head-and-shoulders formation is confirmed only when the completion of the three rallies and their reversals is followed by a breach of the neckline. The failure of the price to break through the neckline on a closing basis puts on hold or negates the validity of the formation.

A Trader’s Point of View

1. Traders use many types of charts based on different time periods. It is important to remember that the breakout confirmation is a closing price outside the neckline. It is recommended that either a daily candle, or bar chart or even a daily line chart be used.

2. Most traders wait for the formation to penetrate the neckline before attempting to jump on the bandwagon. Price quotes are likely to be wide at the time and any hesitation may make it difficult to get in the market, as it is possible that the market will retest the neckline.

3. A minority of the market, the high-risk traders, take positions just prior to the breakout. If the market penetrates the neckline, they will have a good profit. In case the market fails, very tight stop-loss orders must be set, although the high speed and low liquidity of the situation may make it quite difficult to execute them without much slippage.

4. Due to the market expectation for imminent completion, it is likely that there are large positions outstanding in the direction of the target. Therefore, the chart failure is likely to trigger steep position reversals.

5. The target should be considered as simply a suggested objective. The price will only accidentally stop exactly at the target price. Generally, it may fall somewhat short or overshoot. The trader must consider any additional information to fine-tune the profit-taking level.

6. Cash traders must remember both the importance of volume and the lack of volume information. The correct estimation of volume in the cash market is a matter of personal skill.

INVERSE HEAD-AND-SHOULDERS

The inverse head-and-shoulders formation is a mirror image of the previous pattern (see Figure 20.3). Therefore, you can apply the same characteristics, potential problems, signals, and trader’s point of view from the preceding presentation.

The underlying currency broke out of the downtrend ranged by the xx’-yy’ channel. Among the three consecutive rallies, the shoulders (1 and 3) have approximately the same height, and the head is the lowest. The neckline is formed by points B and C. This line was eventually broken at point D, under heavy volume. As the significant resistance line was broken, a retracement could be expected to retest the neckline (E), now turned into support. Since it held, the price was expected to eventually rise to around level F, which is the price target of the head-and-shoulders formation.

Figure 20.3. Diagram of a typical inverse head-and-shoulders pattern.

The price objective is approximately equal in amplitude to the distance between the top of the head and the neckline, and is measured from the breakout point, D.

Figure 20.4 presents an example of an inverse head-and-shoulders pattern at work in the weekly sterling/dollar chart.

Figure 20.4. An example of an inverse head-and-shoulders pattern in the weekly sterling/dollar chart.

DOUBLE TOP

Another very reliable and common trend reversal chart formation is the double top. As the name clearly and succinctly describes, this pattern consists of two tops (peaks) of approximately equal heights (see Figure 20.5). A parallel line is drawn against a resistance line that connects the two tops. We should think of this line as identical to the head-and-shoulders’ neckline.

Figure 20.5. Diagram of a typical double-top formation.

This strong support line is anchored by point C, but eventually fails at point E. The support line turns into a strong resistance line, which holds the short-term market backlash at point F. The price objective is at level G, which is the average height of the double-top formation, measured from point E (see the dotted lines).

SIGNALS PROVIDED BY THE DOUBLE-TOP FORMATION

The double-top formation provides information on:

1. The resistance line, set between points B and D.

2. The parallel (support) line, anchored by point C.

3. The price direction. If the neckline holds the buying pressure at point F, then the formation provides information regarding the price direction: diametrically opposed to the direction of the peaks (bearish).

4. The price target, provided by the confirmation of the formation (by breaking through the neckline under heavy trading volume).

Exactly as in the case of the head-and-shoulders pattern, a vital requirement for the successful completion of the double-top formation is that the breakout through the neckline occurs under heavy market volume. Again, please remember that gauging volume in traditional ways is only possible in the currency futures market. Therefore, the trader must estimate the size of the cash market volume by extrapolating from the currency futures’ volume and the trading “noise.” A breakout on light volume is a strong case for a false breakout, which could trigger a sharp backlash in the currency price.

The time frame for this chart formation’s evolution is anywhere from several hours to several months. The intraday chart formations are less reliable. There is a good correlation between the length of time to develop the pattern and the significance of the formation.

The target is unlikely to be reached in a very short time. There is no direct suggestion regarding the length of target reaching time; but foreign exchange common sense links it to the duration of development.

It is important to measure the target from the point where the neckline was broken. Avoid the trap of measuring the target price from the middle of the formation under the neckline. This may happen as you measure the average height of the formation.

Most double-top formations look different from that in Figure 20.5. As shown in Figure 20.6, prices fluctuate enough to create a rather weathered-looking line, and the neckline is seldom a perfectly horizontal line.

Figure 20.6. An example of a double-top formation in the euro/dollar daily chart.

POTENTIAL PROBLEMS

1. The height of the peaks should be about equal.

2. It is very important that the support line anchored by point C, the neckline, is parallel to the resistance line connecting the tops.

3. The double-top formation is confirmed only when the full completion of the two rallies and their respective reversals is followed by a breach of the neckline (the closing price is outside the neckline). The failure of the price to break through the neckline puts on hold or negates the validity of the formation.

A Trader’s Point of View

1. It is important to remember that the breakout confirmation consists of a closing price outside the neckline. Therefore, it is recommended that a daily or weekly chart be used, rather than five- or fifteen-minute charts.

2. The majority of the market will wait for the confirmation of the neckline’s breaching before attempting to jump on the bandwagon. As the price quotes will likely be wide and highly volatile, this makes it difficult to join in, especially since it is possible that the market will retest the neckline.

3. The high-risk takers may take positions prior to the breakout. If the market penetrates the neckline, they will make good profits. Very tight stop-loss orders must be set, in case the market fails. Yet it may be nearly impossible to execute them, due to high speed and relatively low liquidity.

4. Due to the market expectation for imminent completion, it is likely that there are large positions outstanding in the direction of the future target. Therefore, a chart failure is likely to trigger steep position reversals.

5. The target should be considered as simply a suggested objective. The price will only accidentally stop exactly at the target price. Generally it may either fall somewhat short or overshoot. The trader must consider any additional information in order to fine-tune the profit-taking level.

6. Cash traders must remember both the importance of volume and the lack of volume information. Correctly estimating volume in the cash market is a matter of personal skill.

DOUBLE BOTTOM

The double-bottom formation is a mirror image of the previous pattern (see Figure 20.7). Therefore, you may apply the same characteristics, potential problems, signals, and trader’s point of view from the preceding presentation.

Figure 20.7. Diagram of a typical double-bottom formation.

The bottoms have about the same amplitude. A parallel line (the neckline) is drawn against the line connecting the two bottoms (B and D). This resistance line is anchored by point C, but eventually fails at point E and turns into a strong support line, which holds the market backlash at point F. The price objective is at level G, which is the average height of the bottoms, measured from point E (see the dotted lines).

Figure 20.8 presents an example of a double-bottom pattern at work in the foreign exchange markets.

Figure 20.8. An example of a double-bottom formation in dollar/Swiss franc.

TRIPLE TOP AND TRIPLE BOTTOM

The triple top is a hybrid of the head-and-shoulders and double-top trend reversal formations (see Figure 20.9). Conversely, the triple bottom is a hybrid of the inverse head-and-shoulders and double-bottom formations (see Figure 20.10). Consequently, they have the same characteristics, potential problems, signals, and trader’s point of view as the double top or double bottom.

As shown in Figure 20.9, in a typical triple-top formation, the tops have about the same height. A parallel line (the neckline) is drawn against the line connecting the three tops (A, C, and E) and this support line is anchored by points B and D. This line eventually fails at point F. The support line turns into a strong resistance line, which should hold any market backlash. The price objective is at level G, which is the average height of the triple-top formation, as measured from point F.

Figure 20.9. Diagram of a triple-top formation.

As a double top, the formation fails at point D. The price moves up steeply toward point E. The resistance line is holding once more and the price drops sharply again toward point F. At this level, the market pressure is able to penetrate the support line. After a possible retest of the neckline, the prices drop further, to eventually reach the price objective.

The opposite is true for the triple bottom.

As shown in Figure 20.10, in a triple-bottom formation, the bottoms have about the same amplitude. A parallel line (the neckline) is drawn against the line connecting the three bottoms (A, C, and E). This strong resistance is anchored by points B and D, but eventually fails at point F. The line turns into strong support, which should hold any market pullback. The price objective is at level G, which is the average length of the triple-bottom formation, as measured from point F.

Figure 20.10. Diagram of a typical triple-bottom formation.

Market examples of a triple top and triple bottom are presented in Figures 20.11 and 20.12.

Figure 20.11. An example of a triple-top formation in the U.S. dollar/yen.

Figure 20.12. An example of a triple-bottom formation in the euro/sterling.

V-FORMATIONS (SPIKES)

The V-formations—V-top and V-bottom seen in Figures 20.13 and 20.14—are different from the previous patterns because there is no consolidation prior to the trend reversal. In their case, the trend changes suddenly, and they are accompanied by heavy trading volume. Volume is significant because traders caught on the wrong foot are forced to liquidate and then reverse their positions.

Figure 20.13. A market example of a V-top formation on the weekly dollar/yen chart.

Figure 20.14. A market example of a V-bottom formation in dollar/Swiss franc.

OTHER PATTERNS

Other notable reversal patterns are the rounded and diamond formations.

ROUNDED TOP AND BOTTOM FORMATIONS

The rounded top and bottom, also known as saucers, are infrequent trend reversal chart patterns (see Figure 20.15). They consist of a very slow and gradual change in the direction of the market. These patterns reflect the indecision of the market at the end of a trend and the accumulation ahead of the new trend. The trading activity is slow. It is hard to know when the formation is indeed completed, and not for lack of trying. However, some favor this formation, which in its bullish format resembles a cup and handle. A break above the resistance that would be the brim of the cup should signal a target that extrapolates the width of the previous consolidation. Like any other consolidation pattern, the breakout may occur in either direction.

DIAMOND FORMATION

The diamond formation is a minor reversal pattern that tends to occur at the top of the trend. The price activity may be outlined by a shape resembling a diamond (see Figure 20.16). The increase and decrease in volatility closely create divergent and convergent support and resistance lines. Upon breakout, volume picks up substantially. The price target is roughly the height of the diamond, measured from the breakout point. An example of a diamond reversal formation is provided in Figure 20.17.

Figure 20.15. A market example of a rounded top bottom in the daily dollar/Canadian dollar chart.

Figure 20.16. Diagram of a typical diamond formation.

Figure 20.17. An example of a diamond formation in dollar/yen.

Among the reversal chart formations, the double top and bottom and the head-and-shoulders are by far the most common, followed by the V-formations and the triple top and bottom. Due to their significance in trend reversals, they are generally known as major reversal patterns.

21 Trend Continuation Patterns

We have previously explored the major reversal patterns. Technical analysis also provides signals that reinforce the current trends. These chart formations are known as continuation patterns. Unlike the reversal patterns, they consist of fairly short consolidation periods. The breakouts occur in the same direction as the original trend. The most important continuation patterns are:

1. Flags
2. Pennants
3. Triangles
4. Wedges
5. Rectangles

FLAG FORMATION

The flag formation is a reliable chart pattern that provides two vital signals: direction and price objective. This formation consists of a brief consolidation period within a solid and steep upward trend or downward trend. The consolidation itself tends to be sloped in the opposite direction from the slope of the original trend, or simply flat. A consolidation in the same direction with the previous direction underscores the strength of that move, which should resume quickly. The consolidation is bordered by a support line and a resistance line, which are parallel to each other or very mildly converging, making it look like a flag (parallelogram). The range of previous move is known as a flagpole.

Once the currency resumes its original trend by breaking out of the consolidation, the price objective is the total length of the flagpole, measured from the breakout price level. If the original trend is up, the formation is called a bullish flag. As Figure 21.1 shows, the original trend is sharply up. The flagpole is measured between points A and B. The consolidation period occurs between the support line D to E and the resistance line B to C. When the market penetrates the resistance line at point C, the trend resumes its rally, with the price objective F, measured from C. The price target extrapolates the flagpole’s length (A to B).

Figure 21.1. Diagram of a bull flag formation.

In the numerical example, the height of the flagpole is measured as the difference between 1.7000 and 1.6000, or 1000 pips. Once the resistance line is broken at 1.6800, the price target is 1.7800, as 1000 pips from 1.6800.

Conversely, if the original trend is going down, the formation is called a bearish flag (see Figure 21.2). As Figure 21.2 displays, the original trend is sharply down. The flagpole is measured between points A and B. The consolidation period occurs between the support line B to E and the resistance line C to D. When the market penetrates the support line at point E, the trend resumes its fall, with the price objective F, measured from E. The price target is of about equal amplitude with the flagpole’s length (A to B), measured from the breakout point through the support line (B to E).

Figure 21.2. Diagram of a bear flag formation.

In the numerical example, the height of the flagpole is measured as the difference between 140.00 and 120.00, or 2000 pips. Once the support line is broken at 125.00, the price target is 105.00, as 2000 pips from 125.00.

As you can see from Figures 21.3 and 21.4, the flag formations are very reliable. They tend to develop in a period of minutes to weeks. However, the support and resistance lines may have to be adjusted several times, due to false breakouts.

Figure 21.3. An example of a bullish flag formation in euro/dollar.

Figure 21.4. An example of a long-term bearish flag formation on the weekly dollar/Swiss franc.

PENNANT FORMATION

The pennants are closely related to the flags. The same principles apply. The sole difference is that the consolidation area better resembles a pennant, as the support and resistance lines converge. The convergence denotes the decline in volatility. If the original trend is bullish, then the chart pattern is a bullish pennant. In Figure 21.5, the pennant pole is A to B. The pennant-shaped consolidation is framed by C, B, and D. When the market breaks through the resistance line B to D, the price objective is E. The amplitude of the target price is D to E, and it is equal to the pennant pole A to B. The price target measurement starts from the breakout point.

In the numerical example, the height of the pennant pole is measured as the difference between 1.5500 and 1.4500, or 1000 pips. Once the resistance line is broken at 1.5200, the price target is 1.6200, as 1000 pips from 1.5200.

If the original trend is going down, then the formation is a bearish pennant. In Figure 21.6, the pennant pole is A to B. The pennant-shaped consolidation is framed by C, B, and D. When the market breaks through the support line B to D, the objective price is E. The amplitude of the target price is D to E, and it is equal to the pennant pole A to B. The price target measurement starts from the breakout point.

Figure 21.5. Diagram of a bullish pennant.

In the numerical example, the height of the flagpole is measured as the difference between 139.00 and 119.00, or 2000 pips. Once the support line is broken at 120.00, the price target is 100.00, as 2000 pips from 120.00.

As you can see from Figure 21.7, the pennant formations are reliable. They may develop in different time frames, from days to months. However, the support and resistance lines may have to be adjusted, due to false breakouts.

Figure 21.6. Diagram of a bearish pennant.

Figure 21.7. A market example of bullish pennants in dollar/Swiss franc.

TRIANGLE FORMATION

Triangles can be visualized as pennants with no poles. These formations work best in the medium and long terms. There are four types of triangles: symmetrical, ascending, descending, and expanding (broadening).

A symmetrical triangle consists of two symmetrically converging support and resistance lines, defined by at least four significant points (see Figure 21.8). The two symmetrically converging lines suggest that there is a balance between supply and demand in the foreign exchange market. Consequently, a break may occur on either side. In the case of a bullish symmetrical triangle, the breakout will occur in the same direction, qualifying the formation as a continuation pattern.

As Figure 21.8 shows, the converging lines are symmetrical. The declining line is defined by points B, D, and F. The rising support line is defined by points A, C, E, and G. The price target is either (1) equal to the width of the base of the triangle BB’, measured from the breakout point H (HH’); or (2) at the intersection of line BI (which is a parallel line to the rising line AG) with the price line.

Trading volume will visibly decrease toward the end of the triangle, suggesting the ambivalence of the market. The breakout is accompanied by a rise in volume.

Figure 21.8. Diagram of a bullish symmetrical triangle.

In the numerical example, the price objective is either 1.5500, as the difference between 1.5000 and 1.4000, measured from 1.4500; or 1.5300, as the difference between 1.5000 and 1.4000, measured from 1.4300. A currency market example is presented in Figure 21.9.

Figure 21.9. An example of a bearish symmetrical triangle in dollar/Swiss franc.

The ascending triangle consists of a flat resistance line and a rising support line (see Figure 21.10). The formation suggests that demand is stronger than supply. The breakout should occur on the upside, and it consists of the width of the base of the triangle as measured from the breakout point. As you can see in Figure 21.10, the resistance line defined by points A, C, and E is flat. The converging bottom line, defined by points B, D, and F, is sloped upward. The price objective is the width of the base of the triangle (AA’) measured above the resistance line from the breakout point G (GG’). In the numerical example, the price objective is 106.00, as the 200-pip difference between 105.00 and 103.00, measured from 104.00.

Figure 21.10. Diagram of typical ascending triangle.

Trading volume is decreasing steadily toward the tip of the triangle, but increases rapidly on the breakout.

The descending triangle is simply a mirror image of the ascending triangle. It consists of a flat support line and a downward sloping resistance line. This pattern suggests that supply is larger than demand. The currency is expected to break on the downside. The descending triangle also provides a price objective. This objective is calculated by measuring the width of the triangle base and then transposing it to the breakpoint. As shown in Figure 21.11, the support line, defined by points A, C, E, and G, is flat. The converging top line, defined by points B, D, F, and H, is sloped downward. The price objective is the width of the base of the triangle (AA’), measured above the support line from the breakout point I (II’).

Figure 21.11. Diagram of a descending triangle.

In the numerical example, the price objective is 1.3000, as the 100-pip difference between 1.5000 and 1.4000, measured from 1.4000.

Trading volume is decreasing steadily toward the tip of the triangle, but increases rapidly on the breakout.

The expanding (broadening) triangle is a fairly unusual pattern. It consists of a horizontal mirror image of a symmetrical triangle, where the tip of the triangle is next to the original trend, rather than its base (see Figure 21.12). Volume also follows the horizontal mirror image switch and increases steadily as the chart formation develops. As shown in the diagram, the bottom support line, defined by points B, D, and F, and the top line, defined by points A, C, and E, are divergent. The price objective should be the width, GG’, of the base of the triangle, measured from the breakout point G.

Figure 21.12. Diagram of an expanding triangle.

In the numerical example, the price objective is 102.00, as the 100-pip difference between 101.00 and 100.00, measured from 101.00.

WEDGE FORMATION

The wedge formation is a close relative of the triangle. The wedge is markedly sloped, and the breakout occurs in the direction opposite to its slope (see Figures 21.13 and 21.15), but similar to the direction of the original trend. The signal we receive from the wedge formation is direction only. There is no reliable price objective. Depending on the trend direction, there are two types of wedges: falling (see Figures 21.13 and 21.14) and rising (see Figures 21.15 and 21.16).

Figure 21.13. Diagram of a falling wedge.

Figure 21.14. An example of falling wedges in euro/yen.

Figure 21.15. Diagram of typical rising wedge.

Figure 21.16. An example of a rising wedge in dollar/Canada.

RECTANGLE FORMATION

Also known as a trading range (or congestion), the rectangle formation reflects a consolidation period. Just like triangles, it may break either way and volume should pick up. Its failure will change it from a continuation to a reversal pattern. This pattern is easy to spot.

If it occurs within an uptrend and the breakout occurs on the upside, it is called a bullish rectangle (see Figure 21.17). The price objective is the height of the rectangle. As Figure 21.17 shows, the currency moves between well-defined, flat support and resistance levels. A valid breakout may occur on either side from this consolidation period. Please note the failed double top (A, B, C, D, and E). The price target (HG) is equal to the height of the rectangle (G’H), measured from the breakout point H. In the numerical example, the price objective is 1.6200, as the 100-pip difference between 1.6100 and 1.6000, measured from 1.6100.

Figure 21.17. Diagram of a typical bullish rectangle.

If the consolidation occurs within a downtrend and the breakout continues the original trend, then it is called a bearish rectangle. As shown in Figure 21.18, the currency moves between well-defined, flat support and resistance levels. A valid breakout may occur on either side of this consolidation period. Please note the failed double bottom (A, B, C, D, and E). The price objective (HG’) is equal in size to the height of the rectangle (GH), measured from the breakout point H. In the numerical example, the price objective is 100.00, as the 100-pip difference between 102.00 and 101.00, measured from 101.00. A market example of a rectangle is presented in Figure 21.19.

Figure 21.18. Diagram of a typical bearish rectangle.

Volume should give further indication at or close to the points tangential to the support and resistance levels. As usual, heavier volume predicts or substantially increases the chance of a breakout.

Figure 21.19. A market example of a rectangle in euro/Australian dollar.

A Trader’s Point of View

1. False breakouts tend to occur fairly often. Therefore, filters should be used.

2. As false breakouts are common, especially in the case of triangles, more adjustments may be necessary.

3. Traders should consider the term “continuation pattern” with restraint. A valid breakout on the “wrong” side will turn the formation into a reversal pattern.

4. Throughout the presentation, I mention the significance of volume. I have no choice but to remind you of the difficulty of gauging volume in foreign exchange markets other than the futures.

22 Formations Unique to Bar Charts for Futures

Unlike line and point-and-figure charts, which are continuous charts, bar and candlestick charts for futures are not. Currency futures trading sessions are shorter than cash trading sessions and price gaps may occur on a daily basis, if the overnight activity occurs outside of the previous day’s range. Although the patterns presented here are applicable to both bar and candlestick charts, we analyze each type of chart separately.

The chart formations unique to bar charts are gaps, island reversals, and key reversals.

GAPS

Gaps refer to the price gaps between consecutive trading ranges. Price gaps occur when a range’s low is higher than the previous range’s high, or when the high of a range is lower than the preceding range’s low.

In order to capture these price gaps, only certain bar charts may be used. Charts plotted for weekly, daily, or hourly periods generally fail to display the gaps, as they will show some inherent overlapping due to continuity. Exceptions might occur around the weekends and on short intraday periods, such as one minute, when the market moves very fast, or “gaps.” Only currency futures markets provide the opportunity to chart these gaps on a regular basis. Since the currency futures are traded on centralized markets, which open and close at fixed times—trading roughly only a third of the day—they can naturally provide these price gaps between consecutive trading days.

The Chicago IMM trades between 7:20 a.m. and 2 p.m. CDT. If, for instance, the trading range for the previous day was 0.7700–0.7750, and today’s opening price is 0.7770, because the market bought overnight, there is a 20-pip gap relative to yesterday’s range.

There are four types of gaps: common, breakaway, runaway, and exhaustion.

THE COMMON GAP

Common gaps have the least technical significance. They do not give any indication of the market’s direction or of price objective (see Figure 22.1). Common gaps tend to occur in relatively quiet periods or in illiquid markets. When they occur in illiquid markets, such as distant currency futures expiration dates, the common gaps must be completely ignored. When occurring within regular trading ranges, the word on the street has been that gaps must be filled.

Common gaps are short term. When currency futures open higher than yesterday’s high, they will be quickly sold, targeting the level of the previous day’s high. Should the sell-off fail, the market will turn on a dime, reversing the short-term position. For instance, if the previous day’s range was 0.7030–0.7100 and today’s opening price is 0.7130, traders tend to sell the futures contracts from 0.7130 to 0.7100 to fill the price gap. If they cannot reach 0.7100, then the market will quickly turn to buying the futures contracts. The reverse is true if the market opens lower than yesterday’s low, as the traders will buy the futures contracts to fill the price gap between the current lower price and yesterday’s low. For instance, if the previous day’s range was 0.7030–0.7100 and today’s opening price is 0.7000, traders tend to buy the futures contracts from 0.7000 to 0.7030 to fill the price gap. If they cannot reach 0.7030, then the market will quickly turn to selling the futures contracts.

Figure 22.1. Examples of common gaps in pound futures.

Once again, the common gap lacks technical significance, a fact that is generally accepted among professional traders. However, at times, it is not clear whether a common gap is just a common gap or another type of gap. So the “gap-filling” temptation is likely to continue.

THE BREAKAWAY GAP

Breakaway gaps occur at the beginning of a new trend, many times at the end of a long consolidation period. They may also appear after the completion of some chart formations. They signify a brisk change in trading sentiment and they occur on very heavy trading. The price takes a secondary place to participation (see Figure 22.2). For instance, if the Japanese yen futures traded sideways in a 200-pip range—0.9520 to 0.9720—for two months and a price gap occurred between 0.9720 and 0.9750, the market would be likely to buy the yen futures further.

Figure 22.2. Example of a breakaway gap in dollar/yen cash.

A Trader’s Point of View

1. A breakaway gap provides the direction of the market.

2. Although there is no price objective per se, sustained demand for a currency will ensure a solid rally in the foreseeable future.

THE RUNAWAY OR MEASUREMENT GAP

Runaway or measurement gaps are special gaps that occur within solid trends. They are known as measurement gaps because they tend to occur about midway through the life of a trend (see Figure 22.3). For example, if a 30-pip runaway gap occurs at the top of an uptrend measuring 200 pips—between 0.6250 and 0.6050—then the price objective for the trend is 0.6480, as the previous 200-pip range is added to 0.6280.

A Trader’s Point of View

1. The runaway or measurement gap provides the direction of the market. This gap confirms the health and velocity of the trend.

2. This is the only type of gap that also provides a price objective. The price objective is the previous length of the trend, measured from the runaway gap, in the same direction as the original trend.

Figure 22.3. Example of a runaway or measurement gap in the weekly euro futures chart.

THE EXHAUSTION GAP

Exhaustion gaps occur at the top or at the bottom of a V-reversal formation. Trends change direction in a rather uncharacteristically quick manner. There is no consolidation next to the broken trendline. The trend reversal is very sharp (see Figure 22.4).

Figure 22.4. Example of an exhaustion gap in yen futures.

A Trader’s Point of View

1. The exhaustion gap provides the direction of the market.

2. In addition, this type of gap provides information on the high demand for a specific currency, which will ensure price velocity in the medium term.

ISLAND REVERSALS

One or more day ranges will be separated from the ante and post ranges. These isolated ranges are known as island reversals and they are a direct result of exhaustion gaps. Occurring at the tip of a V-formation, an island reversal consists of one or more days’ ranges, separated in an insular fashion from both the original trend and the new one (see Figure 22.5). The reversal signal is very strong.

KEY REVERSAL DAYS

A reversal day consists of a trading range that reaches a new high in a bullish market but closes within the previous day’s range. A key reversal day is similar to a reversal day in having a higher high and a lower low than the previous day’s range, but it closes outside the previous day’s range, signaling a more trustworthy reversal.

Figure 22.5. Example of an island reversal in the weekly euro futures chart.

Due to a fairly high rate of failure, traders should wait for confirmation, which consists of a solid and sustained reversal of the previous trend. In order to better and more quickly capitalize on this opportunity, a trader should use the signal only when it is supplemented with other information.

A key reversal day example is illustrated in Figure 22.6.

Figure 22.6. A market example of a key reversal day in Canadian dollar futures.

23 Point-and-Figure Charting

The point-and-figure chart originated toward the end of the nineteenth century when it was known as the book method. Interest in this type of chart has been continuously growing, due to its accuracy in providing trading signals. But it was the electronic charting of the 1980s that brought this charting system into prominence. The point-and-figure charts are based on tick charts, so they are particularly well suited for the twenty-four-hour trading in FX because there are no pauses between trading sessions.

The point-and-figure chart is the only one that plots only the price activity, whereas all the other charts plot the price in terms of time periods. Time is irrelevant for the purposes of the chart. If a chartist wants to make any personal notation regarding the time period, that is fine, of course. But time will be a nonfactor in the analysis. This means that, at times, there may be few or no entries for the standard periods of time used in other types of charts, if the market is flat. This is a different concept, as we got used to a flatter line or a short bar, but not to the prospect of no chart entry. That is why the point-and-figure chart is a purer approach to charting. In addition, just like the other continuous chart, the line chart, it reveals price fluctuations missed by the bar chart.

The point-and-figure chart was designed to better plot price activity, and one of the important things this chart does is to avoid plotting the lack of activity. All irrelevant market activity, the so-called market noise, is filtered out. To understand how it works, let’s remember how the chart is plotted. The rising prices are marked with Xs and the falling prices are entered as Os. Therefore, a point-and-figure chart looks like a series of alternating Xs and Os columns (see Figure 23.1).

Figure 23.1. A point-and-figure chart in euro/dollar.

Let’s take the very popular example of a 1×3 point-and-figure chart (also known as the 3-box reversal), in which each box, whether rising or declining, consists of the same number of pips—such as 10 pips. Begin with 10 pips in euro/dollar or sterling/dollar and probably 5 pips for euro/sterling, but optimize the size of these boxes based on currency and volatility. It’s important to optimize the number of pips for each box depending on the volatility of specific currency pairs and trading time frame (short term or long term). If you expect rising volatility, you increase the size of the box, but if you are a day trader who needs more sensitivity, you can decrease the size of the box.

Every 10-pip box that extends the original direction is entered on the chart. When the market changes direction, no entry will be posted before the price reverses by 30 pips. At that point, all three 10-pip boxes will be recorded, plus all the additional 10-pip sets that maintain the new direction. This way, all the insignificant moves are tuned out, allowing the trader to focus on the real price behavior.

Let’s apply this information. Assume that the established direction is up (X columns) and the price range is 1.1840 to 1.1880. When the price advances another ten pips, such as from 1.1880 to 1.1890, you mark an additional one X. You will disregard any price activity between 1.1899 (not 10 pips up from 1.1890) and 1.1861 (not 30 pips down from 1.1890). The direction turns down into an Os column only when the price falls 30 pips from 1.1890 to 1.1860. Then, you write three consecutive Os and the main direction is now down.

Incidentally, it is quite possible to use a 1×1 reversal box. However, it may not be the best possible choice. Since much more activity will be charted, point-and-figure will fail to filter out inherent statistical noise.

Volume is not recorded or available in the FX cash market, yet it is an integral part of the chart. Since volume creates trading activity, the heavier the volume, the more activity will be charted. Therefore, volume is alive and well, albeit in this indirect manner.

Before we take a look at the popular point-and-figure chart formations and see how clear the trading signals are, let me just point out the significance of number 3 in technical analysis in general and for point-and-figure charting in particular. Previously, empirical evidence pointed out the importance of this number—in the head-and-shoulders and in the triple-top and triple-bottom formations. There is no known scientific reasoning behind it, but it is a reality that we have to observe.

It should also be noted that the 45-degree trendline is very important for point-and-figure analysis.

TYPICAL CHART FORMATIONS IN POINT-AND-FIGURE CHARTING

BREAKOUT OF A TRIPLE HIGH

The breakout of a triple-high formation consists of three consecutive rallies. The first two attacks stop at the same price level, while the third rally breaks above this price. The breakout will typically not have a price target. However, if the rally follows a consolidation area, then you should extrapolate the width of this range from the breakout point (see Figure 23.2).

Figure 23.2. An example of the breakout of a triple-high formation in euro/dollar.

BREAKOUT OF A TRIPLE LOW

The breakout of a triple low is formed by two consecutive declines which stop at the same support level, followed by a third one, which manages to break below this level. If it follows a consolidation area, the currency’s drop will attempt to duplicate that width on the downside (see Figure 23.3). Otherwise, the breakout will typically have no price objective.

Figure 23.3. Examples of the breakout of a triple-low formation in dollar/yen.

BREAKOUT OF A SPREAD TRIPLE HIGH

The breakout of a spread triple-high pattern is a spin-off of the breakout of a triple-high formation. The difference consists of a failure of the third column of Xs to reach the resistance line (see Figure 23.4). However, the next attack (still the third) will break through the resistance level. Again, the breakout will typically not yield a price objective on its own. Exceptions may occur if the pattern is part of a bullish flag or of a bullish rectangle.

Figure 23.4. An example of the breakout of a triple-high formation in dollar/Swiss franc.

BREAKOUT OF A SPREAD TRIPLE LOW

The breakout of a spread triple-low formation is a spin-off of the breakout of a triple-low formation. A currency fails during the third consecutive sell-off to break below the horizontal support level formed by the previous two declines. However, after a temporary recovery, it turns bearish again, reaches the original support level for the third time, and continues its fall (see Figure 23.5). While there is no objective, if it follows a sideways market, then target the size to the height of the previous consolidation.

Figure 23.5. An example of a breakout of a triple-low formation in the Canadian dollar/yen chart.

THE ASCENDING TRIPLE-HIGH FORMATION

The ascending triple-high formation is another version of the breakout of a triple-high formation. In the ascending triple-high formation, each new high is higher than the previous one, generally by one box. A break above the third high generates a buying signal (see Figure 23.6).

Figure 23.6. Examples of ascending triple-high formations in dollar/Swiss franc.

UPWARD BREAKOUT OF A BULLISH RESISTANCE LINE

The upward breakout of a bullish resistance line formation is an extension of the ascending triple-high formation. This pattern consists of four or more X columns, which forms a more comprehensive accumulation of bullish momentum, before it breaks above the bullish resistance line (see Figure 23.7).

Figure 23.7. An example of the upward breakout of a bullish resistance line in the New Zealand dollar/U.S. dollar chart.

DOWNWARD BREAKOUT OF A BEARISH SUPPORT LINE

The downward breakout of a bearish support line is derived from the descending triple-low formation. Whereas the descending triple lows consisted of three O columns, the new pattern is formed by more bearish columns before the downsloping support line breaks. The strength of this bearish momentum is more evident because of the accumulation of a higher number of O columns (see Figure 23.8).

UPWARD BREAKOUT OF A BEARISH RESISTANCE LINE

The upward breakout of a bearish resistance line will likely catch the bears on the wrong foot. This pattern occurs when a currency breaks out on the upside from the bearish channel (see Figure 23.9).

Figure 23.8. An example of the downward breakout of a bearish support line in the dollar/yen chart.

Figure 23.9. An example of the upward breakout of a bearish resistance line in dollar/Swiss franc.

DOWNWARD BREAKOUT OF A BULLISH SUPPORT LINE

The difference between the downward breakout of a bullish support line and the downward breakout of a bearish support line is psychological because of the divergent directions of the breakout and of the original trend of the market. Under this scenario, you gauge a currency in a bullish channel. The occurrence of an unexpected factor generates a total change of direction. This extraneous factor carries enough real or perceived weight to generate a penetration of the support line.

Do you really have to sell? Most likely yes, regardless of your trading time frame, because the shock of the sell-off should force traders to liquidate and even reverse their original long positions. This process creates a snowball effect in the market, maintaining a good volume level at least in the short term (see Figure 23.10). Of course, you must exercise caution depending on the specific currency’s volatility and your appetite for risk.

Figure 23.10. An example of the downward breakout of a bullish support line in dollar/yen.

HORIZONTAL COUNT

The horizontal count is a formation specific to point-and-figure charts. Since a period of consolidation is followed by a sharp move, the width of the sideways activity can be converted into the price objective of the breakout. Count the number of columns that form the consolidation area and then extrapolate this number vertically up or down from the breakout price. The diagram in Figure 23.11 illustrates this method.

Figure 23.11. Diagram of horizontal count.

CLASSIC CHART FORMATIONS IN POINT-AND-FIGURE CHARTING

In addition to the above formations, all the classic reversal and continuation chart formations previously presented apply as well. However, they will look differently because the point-and-figure charts hide noise. This translates to tighter formations—you’ll see the flags much faster.

TREND REVERSAL FORMATIONS

HEAD-AND-SHOULDERS

The head-and-shoulders pattern is arguably the best-known trend reversal formation (see Chapter 20). Let’s briefly review the structure of a bearish head-and-shoulders pattern. A currency which had fluctuated in an uptrend finally managed to break the trendline. As generally happens, the price retraced temporarily toward the former trendline, but the uptrend did not continue. The previous trendline support turned into a resistance, and capped further advances. The currency should head further down to a price objective of the same size as the height of the head, as measured from the breakout point (see Figure 23.12). The opposite is true for the inverted head-and-shoulders pattern, which signals a bullish reversal.

Figure 23.12. A market example of head-and-shoulders on the dollar/yen chart.

TRIPLE TOPS AND TRIPLE BOTTOMS

The triple tops are derived from the bearish head-and-shoulders pattern, but the former has three tops of approximately the same height. The triple-bottom pattern is derived from the inverted head-and-shoulders formation. Unlike the bullish head-and-shoulders, the three bottoms have approximately the same magnitude.

DOUBLE TOPS AND DOUBLE BOTTOMS

The double top is a more common reversal formation that reverses an uptrend. It consists of two tops of approximately similar height, and once the neckline breaks it targets a price objective equal in size to the average height of the two tops (see Figure 23.13).

Conversely, the double-bottom formation signals the end of a downtrend and its price objective will be equal to the average size of the bottoms as measured from the breakout point.

Figure 23.13. Example of a double-top formation on the dollar/Swiss franc chart.

TREND CONTINUATION FORMATIONS

FLAGS

These reliable continuation formations are much easier to spot in point-and-figure charting, and for a change, flags look like actual flags. As you recall from Chapter 21, the breakout of their consolidation targets a price objective equal in size and in the same direction as the original trend (see Figure 23.14).

Figure 23.14. An example of a bearish flag and of a bearish pennant on the dollar/yen chart.

PENNANTS

Pennants, the less common spin-off of flags, are different only in the shape of the consolidation area. Therefore, their price objective is also the length of the pennant pole, as measured from the breakout point. Figure 23.15 illustrates a bullish pennant.

Figure 23.15. An example of a bullish pennant on the euro/dollar chart.

Breakout of a Symmetrical Triangle

Symmetrical triangles are more common in point-and-figure charting. Upon the breakout, these formations tend to yield a price objective equal to the base of the triangle. In Figure 23.16 you can see a bearish symmetrical triangle.

Figure 23.16. Example of a symmetrical triangle on the Canadian dollar/yen chart

24 Candlestick Charting

One of the most fascinating types of charts is the candlestick chart. Used in Japan for over two hundred years, candlestick charting has become very popular around the world. In terms of structure, the charts are similar to the bar charts and consist of opening, high, low, and closing prices. However, in terms of technical significance, they provide more information than the bar charts.

BENEFITS OF USING CANDLESTICKS

Let’s quickly review the reasons why traders should use candlestick charts for daily, weekly and even hourly analysis:

1. Candles make it easy to separate bullish periods from bearish periods. You can easily do that by looking at the different colors of the candles.

2. They make it easy to separate truly bullish and bearish periods from failed bullish and bearish ones.
Traders achieve that by avoiding bar charts. The highest high in an uptrend may look positive and suggest further bullish momentum on a bar chart, but it may show just the opposite on the candlestick chart under special conditions.

3. Candlestick charts provide specific bullish and bearish reversal patterns that are not seen with bar charts.
In addition to the standard head-and-shoulders or flag formations, candlestick charts provide one-day or two-day reversals, such as hammers or dark cloud covers. These are powerful patterns that should be used by all traders.

4. They also provide “wait-and-see” patterns.
Traders always like clear directions, and currency dealers will be equally happy with both bullish and bearish signals. However, whether we like it or not, there will be many times when the markets will be quite unclear. Candlestick charts will provide these “wait-and-see” signals, such as harami, to warn you to slow down considerably or even temporarily stop trading because you lack sufficient information.

STRUCTURE

The body consists of the range between the opening and closing price. A black (bearish) body indicates that the currency closed lower than it opened. A white (bullish) body indicates that the currency closed higher than it opened.

The Japanese consider the real body paramount in their technical interpretation. The candlestick’s body provides the most significance regarding the direction of the market.

The high and low prices create the upper and lower shadows, respectively, when different from the open or close. The upper shadow occurs if the daily high is higher than either the closing price of a bullish body or the opening price of a bearish body. The lower shadow occurs if the daily low is lower than either the closing price of a bearish body or the opening price of a bullish body.

A long body adds strength to that direction, while a small body indicates lack of confidence. On the one hand, short tails, or shadows, have no bearing on the significance of the candlestick. On the other hand, long shadows will point to failure in the direction of the shadow.

For example, let’s assume that the dollar/yen opened at 100.00 and closed at 99.00; the high was 100.30 and the low was 98.50. The candlestick’s body is black because the closing price (99.00) is lower than the opening price (100.00). The candlestick has an upper shadow between 100.00 and 100.30 and a lower shadow between 99.00 and 98.50.

In their original form, the bullish bodies were colored red and the bearish bodies black. Of course, select the color scheme of your choice, as long as they are different and you remember which color is up and which one is down. We must use white and black for printing purposes.

Let’s become familiar with the basic types of candlesticks, their characteristics, and their Japanese nicknames.

DAILY WHITE CANDLESTICKS

We focus first on the bullish candles, which show that the currency closed higher than it opened (see Figure 24.1).

Figure 24.1. Diagrams of bullish candlesticks.

Figure 24.2 displays several market examples of white candlesticks.

Figure 24.2. Examples of bullish candles in sterling/dollar.

DAILY BLACK CANDLESTICKS

Let’s take a look now at the black candles, which show that the closing price is lower than the opening (see Figure 24.3).

Figure 24.3. Diagrams of bearish candlesticks.

Several black candlestick market examples are shown in Figure 24.4.

Figure 24.4. Market examples of bearish candlesticks in U.S. dollar/Canadian dollar.

A few words about the nicknames are in order. The Japanese are quite fond of nicknames, and this characteristic was also reflected in candlestick charting. Here are some of them: A shaven head (marubozu) is a candlestick with a full body, but no shadow. This means that in the case of a bullish marubozu, the opening price is similar to the low, and the closing price is the high. In the case of a black marubozu, the opening price is similar to the high, and the closing price is the low.

ONE-DAY REVERSAL PATTERNS

Now we take a look at the one-day reversal patterns, in Figure 24.5. A word of warning: To have reversal significance, these reversals, just like head-and-shoulders, must occur at relatively extreme highs or lows.

Figure 24.5. Diagrams of daily reversal patterns in candlestick charting.

Figure 24.6. Example of a doji candlestick daily reversal pattern in candlestick charting in the weekly Australian dollar/U.S. dollar.

The nicknames, again, are very interesting. Koma is a spinning top, not quite sure which way to go (see Figure 24.5, G and H). Tonbo is a dragonfly; it signals a reversal, yet it may move either way. Tohba or tohbu is the gravestone doji. The long-legged shadows’ doji candlestick (see Figure 24.5, A through D) is one of the most recognized candlestick reversal patterns outside Japan and also a very reliable reversal formation. A doji resembles a bar. The bar does not have a real body, as the opening and closing price are identical (see Figure 24.6). This suggests that the market has reached the end of the trend and temporarily balanced before reversing itself. The market tends to reverse immediately after the signal. At times, exceptional pressure on the opposite side was able to postpone the reversal by one day. When it appears midway through a trend, the reading is neutral, and the pattern is called a rickshaw man (see Figure 24.7).

Initially known as the paper umbrella, karakasa is better known now as the hangman when it occurs at the top of the trend, because the traders who may fall in the trap and buy that currency will be caught long at the top of the range. The opposite is true when this formation occurs at the bottom of the trend (see Figure 24.5, E and F). The only difference is the name: the hammer. A market example of a hangman can be observed in Figure 24.8.

Although these candlesticks may seem to give either bullish signals at the top or bearish signals at the bottom, a closer look and a little caution should help. It is important to remember that the body is small—approximately one-third of the length of the shadow. Obviously, the signals are to sell at the top and buy at the bottom. (Don’t we always want to do just that, anyway?)

Figure 24.7. Example of a rickshaw man in euro/Swiss franc.

Figure 24.8. Example of a hangman reversal formation on the weekly euro/dollar chart.

The single candlesticks introduced so far are the fundamental tools, either by themselves or in combination. Now that we know their individual interpretations, let’s move on and mix them up, in search of further signals.

TWO-DAY CANDLESTICK COMBINATIONS

When two consecutive candlesticks show the same direction, based on the momentum of the market, we tend to look for continuation. But can we get any signal when the consecutive candlesticks point out different directions? Let’s find out.

THE BULLISH SIGNALS

The bullish candlestick signals are:

- piercing candlestick (kirikomi);
- bullish tasuki;
- upside gap tasuki; and
- bullish engulfing candlestick (tsutsumi).

The piercing candlestick, or kirikomi, is a bullish candlestick that occurs at the apparent end of a downmove or downtrend. Following a bearish candlestick, it opens lower than the previous low and closes at or above the 50 percent level of the previous day’s range of the candlestick (see Figure 24.9). The formation, which resembles an incomplete bullish key reversal, generates a powerful bullish signal. Since it involves a gap, it works better on currency futures. At times, more aggressive traders will accept the formation without the gap.

Figure 24.9. Diagram of the piercing candlestick.

The bullish tasuki candlestick argues that a one-day decline on profit taking within a rising streak will not impede, but accentuate, the bullish momentum. It is less reliable because, while it makes sense from a medium-term point of view, short-term traders might get buried going long after seeing the pattern, while the currency extends its decline a little further in the short term. The formation consists of a long bullish candlestick that has a high above the 50 percent level of the previous day’s long bullish body, and closes marginally below the previous day’s low (see Figure 24.10).

Figure 24.10. Diagram of a bullish tasuki candlestick.

The upside gap tasuki candlestick occurs in an uptrend. It is a second-day bearish candlestick that closes an overnight gap opened on the previous day by a bullish candlestick (see Figure 24.11). This is similar to a common gap in the currency futures candlestick chart that was indeed closed, but had little technical meaning otherwise, as it occurred against the direction of the trend. The signal of the upside gap tasuki candlestick is that the bullish momentum should continue.

Figure 24.11. Diagram of the upside gap tasuki candlestick.

The bullish engulfing pattern (bullish tsutsumi) occurs at the apparent end of a downmove or downtrend. It consists of a long bullish candlestick whose body surrounds the previous day’s bearish body (see Figure 24.12-A). This is the equivalent of a bullish key reversal in the candlestick charts. The difference is that a bullish engulfing pattern doesn’t have to reverse the entire range of the previous bearish range, but only the bearish body of the previous bearish candlestick (see Figure 24.12-B). A market example of the bullish engulfing pattern can be observed in Figure 24.13.

Figure 24.12. Diagram of the bullish engulfing pattern.

Figure 24.13. Example of the bullish engulfing pattern on the weekly dollar/yen chart.

THE BEARISH SIGNALS

The bearish candlestick signals are:

- dark cloud cover (kabuse);
- atekubi;
- irikubi;
- sashikomi;
- bearish engulfing pattern (tsutsumi);
- bearish tasuki; and
- downside tasuki gap.

Figure 24.14. Diagrams of dark cloud cover.

The dark cloud cover (a kabuse candlestick) occurs at the apparent top of an upmove or uptrend. It consists of a bearish candlestick that opens above the previous day’s high and closes midway through the previous day’s bullish long body. The dark cloud cover provides a deadly bearish reversal signal.

Based on the price behavior on the second day, there are three types of dark cloud cover (see Figure 24.14):

1. Long bearish closing bozu, which settles under the 50 percent level of the original white candle;

2. Bearish marubozu, which settles at or under the 50 percent level of the original white candlestick, and

3. Long bearish opening bozu, which settles under the 50 percent level of the original white candlestick.

A market example of a dark cloud cover pattern can be observed in Figure 24.15.

Atekubi, irikubi, and sashikomi are three varieties of the same pattern suggesting that weak rebound attempts via filling common gaps will not derail a solid decline.

The atekubi pattern, which is the most restrictive of the three, consists of a second-day bullish candlestick that closes at the daily high (see Figure 24.16). The current closing price equals the previous declining day’s low. This is a typical case of the market closing an overnight gap in the currency futures market, with no impact on the previous trend. The atekubi candlestick suggests further weakness.

The irikubi candlestick is a modified atekubi candlestick. All the characteristics are the same, except that the second day’s closing high is marginally higher than the original day’s low (see Figure 24.17). The signal remains bearish.

Figure 24.15. Market example of a dark cloud cover pattern in euro/yen.

Figure 24.16. Diagrams of atekubi candlesticks.

Figure 24.17. Diagram of irikubi candlesticks.

The sashikomi candlestick is, in turn, a modified irikubi candlestick (see Figure 24.18). Therefore, all the characteristics are the same, and the signal remains bearish. The difference is that the opening of the second day’s white candlestick is much lower than that of the irikubi candlesticks. Despite the wider gap thus formed, the white candlestick closes just above the previous day’s low.

Figure 24.18. Diagram of a sashikomi candlestick.

The bearish engulfing pattern (the bearish tsutsumi) can be found at the high of an upmove or uptrend. It is formed by a long bearish candlestick whose body “engulfs” the previous day’s bullish body, closing lower than the low of the first day (see Figure 24.19). This is the equivalent of a bearish key reversal in the candlestick charts, except that only the bullish bode must be reversed. A market example of the bearish engulfing pattern candlestick can be observed in Figure 24.20.

The downside gap tasuki candlestick occurs in a downtrend. It is a second-day bullish candlestick that closes an overnight gap opened on the previous day by a bearish candlestick (see Figure 24.21). This is similar to a common gap in the currency futures candlestick chart that was indeed closed, so had little technical meaning.

Figure 24.19. Diagram of the bearish engulfing pattern.

Figure 24.20. Example of the bearish engulfing pattern in the daily euro/dollar chart.

Figure 24.21. Diagram of the downside gap tasuki candlestick.

THE “WAIT AND SEE” SIGNALS

The “wait and see” candlestick signals are:

- inside range (harami);
- star; and
- tweezers (kenuki).

Figure 24.22. Diagrams of the inside ranges (harami) candlesticks.

The inside range, or harami pattern, is just the opposite of the engulfing range. The second day’s range occurs within the previous day’s body; it’s an inside range. The two consecutive ranges may have opposite directions, but it does not matter which one is first (see Figure 24.22). The market’s focus remains on the activity of the first day, so the trading volume will slow down until further information becomes available. However, when the second day’s range is a doji candlestick (C and D), then the harami candlestick may become a reversal signal. A market example is presented in Figure 24.23.

The star (hoshi) candlestick is essentially identical in nature to the harami candlestick. It consists of a tiny body that appears outside the body of the previous day’s candlestick (see Figure 24.24). It is not important whether the star reaches or surpasses the previous day’s shadows. The direction of the two consecutive ranges is also irrelevant. The reading is “wait and see.” A market example of a star is provided in Figure 24.25. The tweezers (kenuki) refers to consecutive candlesticks that have matching highs or matching lows (see Figure 24.26). In a rising market, a tweezers top occurs when the highs match. The opposite is true for a tweezers bottom. The “wait and see” interpretation may change to reversal when the formation occurs after an extended move and when the second day displays signs of reversal. A market example can be observed in Figure 24.27.

Figure 24.23. Market example of the the inside range (harami) candlestick on the weekly euro/dollar chart.

Figure 24.24. Diagrams of the star pattern.

Figure 24.25. Market example of the star formation on euro futures.

Figure 24.26. Diagrams of the tweezers pattern.

Figure 24.27. Example of the tweezers.

SAKATA’S FIVE METHODS

We have already come across several reliable reversal signals, such as the doji candlestick and the engulfing patterns. We observed that some of the uncertain signals may turn into reversal signals under certain conditions—for example, the tweezers candlesticks. Now we focus on other major patterns, known as a whole as “Sakata’s Five methods.” These strategies date back about two hundred years. They are:

1. sanzan (three mountains);
2. sansen (three rivers);
3. sangu (three gaps);
4. sanpei (three parallel candlesticks); and
5. sanpo (three methods).

Please note the omnipresence of the number 3. It seems somehow that the number 3 (san is “three” in Japanese) holds a lot of attraction for technicians, regardless of geographical or time frames.

1. When considering three mountains (sanzan), think of the triple-top formation (see Figure 24.28). This strategy holds that prices move up in three waves and then descend in three waves. If the middle “mountain” is higher than the other two, the formation becomes a three Buddha top formation. This candlestick formation is really the head-and-shoulders chart formation (see Figure 24.29).

Figure 24.28. Diagram of the three mountains.

Figure 24.29. Example of the three Buddha formation on the euro/sterling cross.

2. The three-river method (sansen) is more commonly known as the three-river evening star or three-river morning star. It consists of three daily entries. In the three-river evening star, the first day is a long bullish candlestick (a bullish move). This pattern is followed by a rising, short-ranged, one-day island. It ends with a long bearish candle (see Figure 24.30). It is easy to visualize if you remember the bearish exhaustion gap from the currency futures bar charts.

Figure 24.30. Diagram of the three-river evening star reversal formation.

A spin-off of the three-river evening star is a rather “poetically” named formation: the upside gap’s two crows (see Figure 24.31-A). It differs in the second and third candlesticks, because they are both bearish yet unable to close the exhaustion gap in the very short term. It may be remembered from the exhaustion gaps, again, this time as the two- or three-day island.

There are several other versions of the three rivers, such as the evening Southern cross, in which the star is formed by a doji, and the two crows, but they have the same reversal function (see Figure 24.31-B and C).

Figure 24.31. Diagram of the upside gap’s two crows, evening Southern cross, and the two-crow reversal formation.

The opposite of the three-river evening star is the three-river morning star (see Figure 24.32). The same rules apply, but it is at heart a bullish reversal pattern.

3. The three gaps (sangu) is a method applicable in a steeply trading commodity. The theory holds that after the third gap, once the market will reverse, it will fall enough to close at least the second gap.

Figure 24.32. Diagram of the three-river morning star reversal formation.

4. Three parallel candlestick pattern (sanpei) refers to the similarity of direction and velocity of three consecutive candles, because otherwise all the entries are parallel (see Figure 24.33). They call for further strength in an extended rally. When bullish, the formation is known as the three soldiers; when bearish, the name switches to three crows because calling it the inverted three soldiers may have caused confusion over the years. A market example of the three soldiers is presented in Figure 24.34.

Figure 24.33. Diagram of the three soldiers and the three crows reversal formations.

Figure 24.34. Market example of the three soldiers in euro/sterling.

Figure 24.35. Diagram of the three rising method and the three falling method formations.

5. Three methods pattern (sanpo) advises traders to pause occasionally when following a trend. In direct translation, no market will go straight up or down. Retracements are in order before the market will make new highs, and, respectively, new lows (see Figure 24.35). These formations are basically continuation patterns. The formations may be either bullish or bearish. A market example of the three rising method is provided in Figure 24.36.

Figure 24.36. Diagram of the three rising method in the euro/sterling cross.

25 Quantitative Trading Methods

Now that we have been introduced to all the major chart types and chart formations, we move from chart interpretation to the quantitative, or mathematical, trading methods that provide a more objective view of price activity. In addition, the quantitative methods tend to provide signals prior to their occurrence on the currency charts.

The tools of the quantitative methods are moving averages, discussed in this chapter, and oscillators and other studies, discussed in Chapter 26.

MOVING AVERAGES

A moving average is a lagging tool that works best in trending markets. In its simplest form, it consists of the average of a predetermined number of prices over a number of periods, divided by the number of entries. The higher the number of days in the average, the smoother the line is. A moving average makes it easier to visualize currency activity without daily statistical noise. It is a common tool in technical analysis and yet it is still underused. The following analysis should correct this.

As you can see from Figure 25.1, a moving average has a smoother line than the underlying currency. Moving averages are commonly calculated based on the daily closing price. The averages may also be based on the mid-range level or on the daily high or low, but these calculations are uncommon.

It is important to underscore that the moving average is a laggard, not a leader. Its signals occur after the new movement has started, not before, and they respond with delay to the currency prices.

Figure 25.1. Examples of a 40-day moving average on the daily euro/dollar chart.

TYPES OF MOVING AVERAGES

There are three types of moving averages:

1. The simple moving average or arithmetic mean.

2. The linearly weighted moving average.

3. The exponentially smoothed moving average.

As described, the simple moving average or arithmetic mean is the average of a predetermined number of prices over a number of days, divided by the number of entries. If you want a three-day average, you simply add the closing prices of the last three days and divide their sum by three. In order to make the average “move,” each day you add the new closing price to the previous sum and deduct the oldest price.

Simple moving average = (P4 + P3 + P2 + P1 − P4) / 3

You now have a simple moving average.

Traders who dislike allocating equal weights to each of the daily prices considered have the option of using a linearly weighted moving average. This type of average assigns more weight to the more recent closings, and this method makes most sense when used on longer averages. The weighted average is achieved by multiplying the last day’s price by 1, and each closer day by an increasing consecutive number. In our previous example, the fourth day’s price is multiplied by 1, the third by 2, the second by 3, and the last one by 4; then the fourth day’s price is deducted. The new sum is divided by 9, which is the sum of its multipliers.

Weighted moving average = (P4 × 1) + (P3 × 2) + (P2 × 3) + (P1 × 4) − P4 / 9

The most sophisticated moving average available is the exponentially smoothed moving average. In addition to assigning different weights to the previous prices, the exponentially smoothed moving average also takes into account the previous price information of the underlying currency.

Exponential moving average = EMAt − EMAt-1 + ESF × (Pt − EMAt-1)

where

EMAt = current EMA

EMAt-1 = previous EMA

ESF = exponential smoothing factor = 2 / (1 + n)

n = Number of periods for c

Pt = current price

The EMA weights the difference between the current price and the previous period’s EMA and adds the result to the previous period’s EMA. If the current price is above the previous period’s EMA, the difference will be positive. This difference is weighted by multiplying it by the constant and the result is added to the previous period’s EMA. Conversely, if the current price is below the previous period’s EMA, the difference will be negative. The difference is weighted by multiplying it by the constant and the result is added to the previous period’s EMA.

Figure 25.2 compares the twenty-day simple, weighted, and exponential moving averages—you will have to decide for yourself which of the styles is more suitable for you.

Traders choose a number of averages to use with a currency. A suggested number is three, as more signals may be available. But be wary of using three very close moving averages, in order to avoid confusing signs. It is helpful to use intervals that better encompass short-term, medium-term, and long-term periods, to arrive at a more complex set of signals.

Some of the more popular periods are 4, 9, and 18 days; 5, 20, and 60 days; and 7, 21, and 90 days. The longer-term traders may look at 20, 50, 100, and 200 days. The model-oriented traders may want to optimize the number of days in their sets of averages. Don’t be afraid to experiment a little.

Figure 25.2. Comparing the 20-day simple, weighted, and exponential moving averages on the daily euro/dollar chart.

REASONS TO USE MOVING AVERAGES

Some traders tend to use moving averages because they like a smoother view of the currency; this is a valid point, but not a moneymaker.

More important, traders should consider moving averages as flexible support and resistance lines. The intersection between the price and a short moving average, such as between 10 and 30 days, should provide good buy and sell signals during trending markets. For instance, in Figure 25.3 the intersections between the dollar/yen and the 21-day moving average provide a selling signal and a buying signal. Traders sell the currency pair when it falls below such a relatively short moving average and hold that position for as long as the currency stays below this average. In reverse, they buy when the currency’s pair crosses above the average and hold that position while the market holds above this average. A valid crossover is confirmed by a currency’s closing outside the moving average, possibly by a certain percentage at the discretion of the trader.

Another reason to use averages is the overbought and oversold signals that may display when compared to the currency. If the currency and the moving average are moving in the same direction but too far away from each other, this is a warning that the market might change direction. However, a divergence on its own is only a condition, not a signal, so use a different trigger, such as the break below a support or a trendline. One way to alleviate the overbought condition is for the currency to decline and intersect the lagging average. In Figure 25.4, the overbought sterling/dollar engineered a sustained decline from point B to reach and surpass its 50-day moving average. Another way to lessen the overbought condition is for the currency pair to trade sideways (see Figure 25.4-points A), thus giving time to the lagging average to catch up.

Figure 25.3. Example of a 20-day simple moving average (top at the right) as compared to a 20-day exponential moving average.

Divergences between a currency and its moving average on the daily charts tend to provide a short-term divergence signal. To spot medium-term overbought or oversold conditions, you should compare either a weekly currency and its average, or two moving averages. Figure 25.5 shows two instances where the dollar/yen was overbought on a weekly basis versus its 20-week moving average (see points A), and one example where its overbought condition was shown by the divergence between the 20-week and the 40-week moving averages (see point B). The opposite is true for oversold markets.

CROSSOVER TRADING SIGNALS

A buying signal on a two—moving-average combination is supposed to occur when the shorter term of two consecutive averages intersects the longer one upward. A selling signal is said to occur when the reverse happens, and the longer of two consecutive averages intersects the shorter one downward. Figure 25.6 shows examples of a downward crossover and of an upward crossover formed by the 10-day and 20-day moving averages on the euro/Canadian dollar cross. Please notice the time gap between the start of the new direction and the actual crossovers—the delays are created by the slow nature of the averages. Therefore, think twice before trading based solely on moving averages’ intersections, because the odds are high you missed at least part of the action. Of course, using shorter moving averages will give more timely signals, but they will also provide more false signals.

Figure 25.4. Examples of behavior of an overbought pair in sterling/dollar: direct decline (starting at point B) and sideways trading (points A).

Figure 25.5. Dollar/yen was overbought on a weekly basis versus its 20-week moving average at points A, and then at point B, due to the divergence between the 20-week and the 40-week moving averages.

Figure 25.6. Examples of a downward crossover and of an upward crossover provided by the 10-day and 20-day moving averages on the euro/Canadian dollar chart.

Japanese traders introduced a filtered version of the two–moving-average combination. There are two types of intersections. When two consecutive moving averages intersect each other as they move in opposite directions, this is called a dead cross, and the intersection should be disregarded because of high incidence of false signals. However, if the two consecutive moving averages intersect as they move in the same general direction, this is called a golden cross, and it provides a more accurate signal that the currency will continue to move in the same direction (see Figure 25.7).

A more complex method is called the triple crossover method. As the name suggests, it involves three moving averages, such as a moving-average combination of 4, 9, and 18 days. In the example in Figure 25.8, the selling warning occurs when the 4-day moving average crosses below the 9-day average, and the selling signal is said to be confirmed when the 9-day moving average crosses below the 18-day average.

Figure 25.7. Examples of dead crosses (the first two crossovers) and of a golden cross (last crossover) between the 10- and 20-day moving averages on the euro/Swiss franc chart.

Figure 25.8. Example of the triple crossover method on the euro/Swiss franc chart using the 4-, 9-. and 18-day moving averages.

The reverse is true for the buying combination. The warning appears when the 4-day average intersects upward the 9-day moving average and the buying signal appears when the 9-day moving average climbs above the 18-day average.

To conclude, moving averages are good flexible support and resistance lines that also signal overbought and oversold conditions. Their intersections are slow in showing directional changes, and entry and exit points. You should use intersections between the market price and the moving averages intersections to trade, and intersections between moving averages as confirmations for existing positions.

ENVELOPE MODEL

An early attempt to use moving averages for identifying overbought and oversold conditions resulted in the envelope model. This method employs a shorter-term average, such as 20-day, to which you add and subtract a small percentage (2 percent is suggested as a starting point). The two winding parallel lines above and below the moving average will create two bands bordering most price fluctuations. When the upper band is penetrated, the currency is said to be overbought, so a selling signal occurs. Conversely, when the lower band is penetrated, the pair should be oversold, so a buying signal occurs. Because the signals generated by the envelope model tend to be countertrend, they may fail during aggressive trends. Figure 25.9 shows how the envelope model may help to identify overbought and oversold conditions.

Figure 25.9. Examples of overbought and oversold signals provided by the envelope model on the euro/yen cross.

BOLLINGER BANDS

The Bollinger bands, developed by John Bollinger, take the envelope model to the next higher level, by combining a moving average with the currency’s volatility. The bands were designed to gauge whether prices are high or low on a relative basis via volatility. Instead of adding and subtracting a fixed percentage to the average, Bollinger added and subtracted two standard deviations to and from a 20-day simple moving average.

The bands look a lot like an expanding and contracting envelope model. When the bands contract drastically, the signal is that volatility is low and thus likely to expand. An additional signal is a succession of two top formations, one outside the band followed by one inside. If the first occurs above the upper band and the second just below it, it is a selling signal. When the first occurs below the lower band and the second just above it, it signals a possible buying opportunity. However, when the currency is entrenched in strong trends, breakouts above the upper band or below the lower band fail to show overbought and oversold conditions. Figure 25.10 shows the Bollinger bands at work: Points A show a standard oversold setup, while points B show that in a strong uptrend, the breaks outside the upper band do not show overbought conditions. For better results, use the bands in conjunction with the signals provided by the 20-day moving average. While popular among many traders, this method is especially useful in trading options, specifically trading volatility with straddles and strangles (see Chapter 16).

Figure 25.10. The Bollinger bands at work: Points A show a standard oversold setup, while points B show that in a strong uptrend, the breaks outside the upper band do not show overbought conditions.

ICHIMOKU KINKOU-HYO

The Ichimoku Kinkou-Hyo is a technical study that was developed by a Tokyo newspaper writer, Goichi Hosoda, before World War II as an all-inclusive forecasting method for financial markets. In loose translation the full name means “One look at the equilibrium prices.” The name originated with Hosoda’s pen name, “Ichimoku Sanjin,” which means “a glance of a mountain man.” This technical study consists of gauging midpoints of historical highs and lows at different lengths of time and several periods matched to those used in the MACD’s moving averages (See Chapter 26). Ichimoku provides a complex method of analyzing trends and brings additional points to retracement/extension analysis, and support and resistance from moving averages. Since the name is a bit of a mouthful for the non-Japanese, many traders simply call it Ichimoku.

The Ichimoku kinkou-hyo method consists of five lines: trendline (Kijun), signal line (Tenkan), lagging line (Chiku), and two leading lines (Senkou Span A and Span B). Figure 25.11 shows an application of this method on the daily dollar/yen chart.

Figure 25.11. Example of the complete Ichimoku’s five lines: trendline (Kijun), signal line (Tenkan), lagging line (Chiku), and leading lines (Senkou Span A and Span B) as applied on the daily dollar/yen chart.

TRENDLINE (KIJUN)

Kijun means “trend” in Japanese. When the trendline is heading down, then this is a selling signal, and when the Kijun line is advancing, then it suggests a buying signal. Figure 25.12 plots only the trendline on the daily dollar/yen chart.

The trendline is calculated as follows:

Trend (Kijun) line = (Highest high + Lowest low) / 2 for the past 26 days

If you are using only this trendline, the results may be mixed, depending on the type of market. However, the example in Figure 25.12 shows generally good buying and selling signals when dollar/yen breaks above and below the trendline. When used independently, this line also helps with identifying overbought and oversold conditions. If the pair advanced too far above the Kijun line, then it’s overbought, and if the currency pair falls too much below the trendline, then you are facing oversold conditions.

Figure 25.12. Example of the trendline (Kijun) on the daily dollar/yen chart.

SIGNAL LINE (TENKAN)

The signal line (Tenkan) works well in conjunction with the trendline (kijun). A crossover above the trendline gives a buy signal and a crossover below the selling line provides a sell signal. Figure 25.13 shows a combination of the signal (Tenkan) and Trend (Kijun) lines: Point A shows a buying signal and point B displays a selling opportunity in dollar/yen.

The formula for the signal line (Tenkan) is calculated as follows:

Signal Line (Tenkan) = (Highest high + Lowest low) / 2 for the past 9 days

Figure 25.13. Application of the Ichimoku’s signal (Tenkan) and trend (Kijun) lines on the daily dollar/yen chart. This combination has point A showing a buying signal and point B displaying a selling opportunity in dollar/yen.

With no exception, the trading signals are late relative to the start of the downward and upward moves. This is due to the same reason that crossovers between moving averages on 9 and 12 days, the same periods used in these two Ichimoku lines, would be late to signal the trading points.

LAGGING LINE (CHIKU)

The lagging line, or the Chiku line, is important for the entire Ichimoku outlook. The lagging line is simply the current close plotted 26 periods behind.

If both the Chiku line and the market are in an uptrend, then this supports a buy signal, and vice versa. Figure 25.14 adds the lagging line to the trend and signal lines. In this example, the dollar/yen daily prices were falling in sync with the lagging line, and this adds weight to the weakness of the pair.

In addition, if a selling signal is given while the lagging line is plotted below the current closing price, then this signal gains more technical strength. The opposite applies to a bullish market: If a bullish signal is formed while the lagging line is above the closing line, then this signal is more important.

Figure 25.14. Ichimoku’s trend, signal, and lagging lines applied to the dollar/yen daily prices. This chart suggests further weakness for the pair.

LEADING LINE OR SENKOU SPANS A AND B (CLOUD)

The two leading lines, or Senkou, create a cloudlike formation, or Kumo in Japanese, and this is an area of either support or resistance. The market must break above the Cloud to give a buy signal or below the Cloud to give a sell signal. The Cloud is used in a similar manner as the standard support and resistance levels.

The leading lines formulas are as follows:

Leading line A = (Trendline + Signal line) / 2, plotted 26 periods ahead

Leading line B = (Highest high + Lowest low) / 2 for the past 52 periods, plotted 26 days ahead

Let’s take a look only at the Cloud on the dollar/yen in Figure 25.15. The pair attacked several times and eventually penetrated the support of the Cloud. This translated into a severe sell-off. The Cloud has different levels of thickness. Typically, a thick Cloud suggests strong support or resistance and increased volatility. Conversely, a thin Cloud signals a period of low volatility.

Figure 25.15. The Cloud (Kumo) is formed by two leading lines, or Senkou, and they act as standard support and resistance levels.

RELATIVE STRENGTH SIGNALS

In addition to the intersection between the currency price and one or more lines, and overbought/oversold conditions, the Ichimoku provides Relative Strength Signals.

A bullish crossover that occurs above the Cloud formation adds more strength to the buying signal, while a bearish crossover forming below the Cloud signals a very bearish signal.

When the crossover occurs within the Cloud, then the buying or selling signal is only normal in significance.

A bullish crossover weakens in significance when formed below the Cloud formation. Conversely, a bearish intersection diminishes its weakness if it occurs above the Kumo.

The fact that leading span lines are plotted ahead of the market development provides support and resistance in advance, and possibly direction as well. Of course, markets above the Cloud are generally in an uptrend, while those below the Cloud are typically in a downtrend.

Figure 25.16 shows examples of Relative Strength Signals on the daily euro/New Zealand dollar chart.

Figure 25.16. An example of Relative Strength Signals on the daily euro/New Zealand dollar chart.

26 Oscillators and Studies

Markets gyrate at different rates and prices tend to overshoot targets and overextend trends. Oscillators were designed to measure the momentum of these moves and provide signals regarding overbought and oversold conditions. They come in particularly handy during “normal” markets and trading ranges, when it is more difficult to analyze the price action. As we present these tools in more detail, three rules will become apparent:

1. The signals are mostly useful at the extremes of their scales.

2. Warnings or signals are triggered when a divergence occurs between the price of the underlying currency and the oscillator.

3. Crossing the equilibrium (zero) line, when applicable, usually generates direction signals.

The major types of oscillators are: stochastics, moving averages convergence-divergence (MACD), and Relative Strength Index (RSI).

Technical signals are very useful at the extremes of their scales, but various oscillators are plotted on different scales. Just like stochastics, the Relative Strength Index is drawn on close scales between 0 and 100. Others, such as rate of change or MACD, are plotted on open positive/negative scales around the zero level.

A closed-scale oscillator doesn’t perform well in a strong and extended trend. Similarly, a high-pitched song will not reproduce well if burned on a CD because a channel on the CD has a limited width; it’s excellent for most “normal” music, but extreme notes will get muffled. That’s when music enthusiasts will resort to professional taping devices and traders will shift to MACD.

When using oscillators plotted on open scales, one must gauge the extreme levels vis-à-vis the equilibrium level. If using the RSI, then the extreme levels will simply be 0 and 100, and the equilibrium level is the 50 area. However, the RSI will not reach those extreme areas anywhere as often as the stochastics do. Therefore, traders and analysts must back-test, or at least “eye,” the historical behavior of a specific oscillator for each of the currencies of interest for several long-term and short-term periods. Simply following prescribed ratios or levels will more often than not fail to improve your trading profitability.

Warnings and even signals are triggered by divergences between the currency and the oscillator. Oscillators are based on currency fluctuations, but don’t expect them to move in sync at all times.

When the currency and its oscillator move in the same direction and have similar tops and bottoms, they are said to be in gear, and this pattern reinforces the momentum of the current direction (see Figure 26.1-A).

If the currency and its oscillator diverge, then you will get warnings of reversals. If descending tops of a bearish currency are countered by ascending tops in the oscillator, then you have bullish divergence. This suggests that the currency is oversold and should be preparing to make a bullish reversal (see Figure 26.1-C).

If, however, the ascending peaks of a bullish currency are mirrored by declining peaks in the RSI, this signals bearish divergence, which means that the uptrend is on its last legs (see Figure 26.1-B).

Divergences do not automatically trigger reversals. Since divergences may linger, you should use a trigger from a different method or several methods, such as candlestick patterns, short-term moving averages, or parabolic.

Figure 26.1. Diagrams of matching momentum (A), bearish divergence (B), and bullish divergence (C).

When the MACD and RSI cross above and below their equilibrium line, the former marked by the zero line and the latter marked by 50 percent, traders tend to get directional (up and down) signals. Brief and small penetrations of the equilibrium line should be ignored, as they suggest only sideways trading, but you know the magnitude of the crossover strictly in hindsight.

Some oscillators consist of one line, such as the RSI and Rate of Change, while others are designed as two-line studies, like stochastics and MACD. Two-line studies are preferable because their intersections provide entry and exit points or confirmations similar to those in moving averages.

The formulas for calculating most studies are based on a 14-period basis, typically 14 days. That is because at the time when these tools were designed and applied to pattern recognition, technical analysis pioneers opted for half of the lunar cycle, which is 28 days. Of course, there is no reason to blindly follow the use of the number 14. This is because 14 days amount to two weeks, of course, but luckily we do take a couple of days off for the weekend, so the more accurate number of days is 10. This being said, don’t hesitate to experiment with the number of periods for the %K line, perhaps using 5 or 20 periods.

STOCHASTICS

Unlike moving averages, which constitute a lagging indicator, stochastics are a leading method that work well in normal and sideways markets but fail in strong trends (see Figure 26.2).

The stochastics concept is based on George Lane’s observations that, as the market gets toppish, the closing prices tend to approach the daily highs; whereas in a bottoming market, the closing prices tend to draw near the daily lows.

The oscillator consists of two lines called %K and %D. Visualize %K as the plotted instrument, and %D as its moving average.

The formulas for calculating the stochastics are:

where

CCL = current closing price

L_10 = the lowest low of the past 10 days

H_10 = the highest high of the past 10 days

Figure 26.2. An example of the fast stochastics in dollar/yen. The three bottom arrows indicate buying signals and the two top arrows show selling opportunities.

and

where

H_3 = the three-day sum of (CCL–L_10)

L_3 = the three-day sum of (H_10–L_10)

The resulting lines are plotted on a 1 to 100 scale, with overbought and oversold warning signals at 70 percent and 30 percent, respectively, according to Lane. The buying (bullish reversal) signals occur under 15 percent, and conversely the selling (bearish reversal) signals come into play above 85 percent after the currency turns, Lane said. I prefer to prepare to sell when above 95 percent and to buy when below 5 percent, but the currency pair must make the first move. In addition to these signals, the oscillator-currency price divergence generates significant signals.

The intersection of the %D and %K lines generates further trading signals. In Figure 26.2, the three bottom arrows indicate buying signals and the two top arrows show selling opportunities.

There are two types of intersections between the %D and %K lines:

1. The left crossing, when the %K line crosses prior to the peak of the %D line.

2. The right crossing, when the %K line occurs after the peak of the %D line.

Lane suggests using only the right intersection trading signals.

SLOW STOCHASTICS

The slower version of the stochastics called slow stochastics is popular among those traders who believe that the one-period delay provides more accurate signals. The new slow %K line consists of the original %D line. The new slow %D line formula is calculated off the new %K line (see Figure 26.3).

A Trader’s Point of View

It is important to remember that the scale of the stochastics ranges from 0 to 100. As the %K line reaches the extremes of the scale, it should not be interpreted to mean that the currency will necessarily reverse in the immediate period. The currency may reverse, but at any time between the next day and the next several days or longer (in the case of a daily chart). So, follow the signal only after the currency actually starts the expected move. This is important to remember, since most traders have loss-limit constraints that may inadvertently be triggered in the very short run. The correct price reaction, even a day later, may offer little comfort and sympathy.

Figure 26.3. Example of the fast stochastics and slow stochastics in sterling/dollar.

MOVING AVERAGE CONVERGENCE-DIVERGENCE (MACD)

The moving average convergence-divergence oscillator, developed by Gerald Appel, is built on exponentially smoothed moving averages. The MACD consists of two exponential moving averages that are plotted against the zero line, as follows:

1. the difference between two exponential moving averages on 12-day and 26-day, respectively.

2. a 9-day exponential moving average, which acts as a trigger or signal line.

In addition to the signals generated by the averages’ intersection with the zero line and by divergence, additional signals occur as the shorter average line intersects the longer average line. The buying signal is displayed by an upward crossover, and the selling signal by a downward crossover. Figure 26.4 highlights the strengths of the MACD on a dollar/Canada chart. The crossover of the MACD lines indicates two buying opportunites and one selling opportunity. The chart also shows a bearish divergence, as the highest high in dollar/Canada is not matched by the MACD.

Figure 26.4. An example of MACD in dollar/Canada. The crossover of the MACD lines show two buying opportunites and one selling opportunity. The chart also indicates a bearish divergence, as the highest high in dollar/Canada is not matched by the MACD.

MOMENTUM

Momentum is a basic oscillator designed to measure the rate of price change, not the actual price level. This oscillator consists of the net difference between the current closing price and the oldest closing price from a predetermined period.

The formula for calculating the momentum (M) is:

where

CLt = current closing price

CLt-1 = previous closing price

The new values thus obtained will be either positive or negative numbers, and they will be plotted around the zero line, as the momentum is measured on an open scale. At extreme positive values, momentum suggests an overbought condition, whereas at extreme negative values, the indication is an oversold condition. Figure 26.5 shows an example in euro/Swiss franc. In addition to the breaks above and below the zero line, which work with various degrees of success, this chart also identifies a bearish divergence, which correctly points to a decline in the cross.

Figure 26.5. An example of the momentum oscillator in euro/Swiss franc. In addition to the breaks above and below the zero line, which work with various degrees of success, this chart also shows a bearish divergence, which correctly points to a decline in the cross.

Traders must figure out exactly what an extreme overbought or oversold condition means for different currency pairs. On the simplest level, the relativity of the situation may be addressed by analyzing the previous historical data and determining the approximate levels that delineate the extremes.

In terms of time frame, needless to say, the shorter the number of days included in the calculations, the more responsive the momentum will be to short-term fluctuations, and vice versa.

The signals triggered by the crossing of the zero line remain in effect. However, they should be followed only when they are consistent with the ongoing direction.

THE RELATIVE STRENGTH INDEX (RSI)

The Relative Strength Index is a popular oscillator devised by Welles Wilder. The RSI measures the relative changes between the higher and lower closing prices.

The formula for calculating the RSI is:

where

RS = (average of X days up closes/average of X days down closes)

X = predetermined number of days

The original number of days, as used by its author, was 14 days. A 10-day period is more adequate.

The RSI is plotted on a 0 to 100 scale. The 70 and 30 values are used as warning signals, whereas values above 85 indicate an overbought condition (selling signal) and values under 15 indicate an oversold condition (buying signal). Wilder identified the RSI’s forte as its divergence versus the underlying price.

Figure 26.6 shows an example in dollar/yen. While the RSI rarely goes above the 70 or below the 30 marks, the chart shows its ability for pointing out divergence, in this case bullish, and dollar/yen was soon on its way up.

Figure 26.6. An example of the Relative Strength Index (RSI) in dollar/yen. The RSI rarely goes above the 70 or below the 30 mark, but the chart shows its ability for identifying divergence, in this case bullish.

OTHER OSCILLATORS

RATE OF CHANGE (ROC)

The Rate of Change is a popular version of the momentum oscillator. The difference lies in the fact that, while the momentum’s formula is based on subtracting the oldest closing price from the most recent, the RoC’s formula is based on dividing the previous closing price into the current one. Thus, use one or the other, but not both (see Figure 26.7).

Figure 26.7. An example of the Rate of Change (ROC) oscillator in dollar/South African rand. The chart also shows the momentum indicator, pointing out the similarities of the two oscillators.

where

CLt = current closing price

CLt-1 = previous closing price

The standard momentum rules of interpretation apply.

Larry Williams %R

The Larry Williams %R is a close version of the fast stochastics’ fast line (%K). It consists of the difference between the high price of a predetermined number of days and the current closing price, which is divided by the total range. The interpretations are similar to those discussed under stochastics (see Figure 26.8).

Figure 26.8. An example of the Larry Williams %R oscillator in sterling/dollar. This chart also compares the %R oscillator with the similar fast stochastics’ %K line.

Commodity Channel Index (CCI)

The Commodity Channel Index (CCI) was developed by Donald Lambert. It consists of the difference between the mean price of the currency and the average of the mean price over a predetermined period of time. A buying signal is generated when the price exceeds the upper (+100) line, and a selling signal occurs when the price dips under the lower (-100) line (see Figure 26.9).

Figure 26.9. An example of the commodity channel index in sterling/dollar.

Swing Index (SI)

The Swing Index (SI) is an oscillator developed by Welles Wilder. This momentum is plotted on a scale of −100 to +100. The spikes reaching the extremes suggest reversal.

Accumulation Swing Index (ASI)

The Accumulation Swing Index (ASI) is based on the swing index (SI). A buying signal is generated when the daily high exceeds the previous SI significant high, and a selling signal occurs when the daily low dips under the significant SI low.

Trix Index

The Trix Index was devised by Jack Hutson. As analyzed by Martin Pring, it consists of a one-day RoC calculation of a triple exponentially smoothed moving average of the closing price. This momentum oscillator may be plotted in several ways. Because we do not have the space to analyze it here, I will only mention that it is useful either for indicating that a minor downward move following the completion of a chart formation means a reversal of the uptrend, or for indicating that its own top reversal is a warning that a head-and-shoulders formation will have an extended lower target.

OSCILLATORS WRAP-UP

Oscillators are favorite tools among traders. Some use them as the “main dish,” and take the majority of their trading signals from oscillators. However, most traders use them as a “side dish,” and try to avoid acting prematurely on a reversal signal. Regardless of the importance each individual trader attaches to them, oscillators are vital to the continuous search for more accurate technical forecasting.

OTHER STUDIES

THE PARABOLIC SYSTEM (SAR)

This is a technical tool designed by Welles Wilder that works very well in trending markets. The Parabolic System is a stop-loss system based on price and time.

SAR stands for stop and reverse. The stop moves daily in the direction of the new trend. The built-in acceleration factor pushes the SAR to catch up with the currency price. If the new trend fails, the SAR signal will be generated.

The name of the system is derived from its parabolic shape, which follows the price gyrations. It is represented by a dotted line. When the parabola is placed under the price, it acts as support and suggests a long position. Conversely, when placed above the price, the parabola provides resistance and indicates a short position (see Figure 26.10).

Figure 26.10. An example of the SAR parabolic study on the daily sterling/dollar chart.

To calculate SAR, start at an extreme high or low price, and use an acceleration factor to multiply the extreme prices until the position is stopped out. The acceleration factor starts at 0.02 and can extend up to 0.2.

where

SARt = current SAR

SARt-1 = previous SAR

EP = extreme point

AF = acceleration factor

THE DIRECTIONAL MOVEMENT INDEX (DMI)

The Directional Movement Index (DMI) is supposed to gauge the strength of a trend in the currency. This is done actually by a derivative of the DMI, called Average Directional Movement Index (ADX). The line simply rates the price directional movement on a scale of 0 to 100. The higher the number, the better the trend potential of a movement, and vice versa. The ADX is easily confused by any correction in the trend. In addition, there are two lines reflecting the positive and negative values of a Directional Indicator. When these two lines fail to cross over, the trend is continuing; when they cross over numerous times, it means that the market is choppy. These lines tend to provide better gauging of the health of the trend (see Figure 26.11). DMI is beyond the scope of our discussion here, but is described in full detail in my other book, Technical Analysis Applications.

Figure 26.11. Example of the directional movement index, with ADXR, and +DI and -DI in sterling/dollar.

Figure 26.12. Example of oscillator combinations used for daily trading in euro/dollar.

Figure 26.13. Example of oscillator combinations used for daily trading in dollar/yen.

Traders use different combinations of technical tools in their daily trading and analysis. Some of the more popular oscillators are the fast and slow stochastics and the MACD, as shown in Figure 26.12, the fast stochastics and the Relative Strength Index, and the MACD, as shown in Figure 26.13.

27 W. D. Gann Analysis

One of the most influential approaches to technical analysis was developed by William Delbert Gann (1878–1955), the eminent stock and commodity trader. His complex set of mathematical methods based on time and price analysis helped Gann make 264 successful trades out of 286 transactions in various stocks in only twenty-five market days during the month of October 1909.

Gann identified four phases of the market, and his research methods can be applied to all of them.

The four types of markets he analyzed are:

1. Bull market
2. Peaking bull market
3. Bear market
4. Bottoming bear market

The most important features of Gann analysis are:

1. Geometric forms
2. Geometric angles
3. Ratios
4. The squaring of price and time
5. The cardinal square

GEOMETRIC FORMS

Gann used basic forms of geometry, such as the square, the circle, and the triangle, in his analysis. For instance, his famed 45-degree angle of the trendline comes from dividing a square diagonally (see Figure 27.1). The resulting fan lines will be discussed under geometric angles.

Figure 27.1. The origin of the 45-degree angle of the trendline.

A circle has 360 degrees, and this number, along with fractions of 360, is widely present in his research on time. In order to reach his time targets, Gann extrapolated 30, 90, 120, 180, and 360 periods (days, weeks and months) from significant chart points. These forward periods are potential reversal dates. The secondary reversal dates are 45, 135, 225, and 315 (see Figure 27.2).

If you now spread one year’s weeks around a circle and divide the circle into quarters, you will get the following numbers: 13 weeks, 26 weeks, 39 weeks, and of course 52 weeks (see Figure 27.3). You can also see these numbers on the square in Figure 27.1.

Figure 27.2. Potential reversal dates based on circle and circle arches.

Figure 27.3. The weekly cycle of a geometric square.

THE GANN EMBLEM

Another method to target possible price reversal dates is the Gann Emblem. The Emblem is formed by a square and a triangle inscribed in a circle, where the square and the triangle have a common corner. The common corner is named the Emblem Pointer (see Figure 27.4).

Since there are 365 or 366 days in a year and only 360 degrees in a circle, divide the number of days by the number of degrees to get a more accurate target: 365/360 ≈ 1.0139. The square divides the circle in quarters and the triangles into thirds. The pointer should identify a significant price, high or low, and you should have five possible reversal targets on the circle, which needs to have the degrees on. Then, multiply those targets by 1.0139 for more accurate time objectives.

Figure 27.4. Diagram of the Gann Emblem.

GEOMETRIC ANGLES

Focusing on the relation between time and price, Gann drew his fan lines from significant highs and lows at specific angles. Thus, the Gann fan lines are used to project future trajectory and also to provide retracement targets when the trend deteriorates or changes direction.

As mentioned in Chapter 19, the most important one is the 45-degree angle, and you now know the origin of this angle. A divergence from the 45-degree line signals a strengthening or weakening in the trend of the currency.

The 45-degree angle is the result of a combination of price and time ratio of 1×1.

1 × 8 = 82.5 degrees

1 × 4 = 75 degrees

1 × 3 = 71.25 degrees

1 × 2 = 63.75 degrees

1 × 1 = 45 degrees

2 × 1 = 26.25 degrees

3 × 1 = 18.75 degrees

4 × 1 = 15 degrees

8 × 1 = 7.5 degrees

Steeper trendlines are determined by a ratio of 1×2, 1×3, 1×4, and 1×8. Due to their steepness, they have little applicability. What you need to carefully follow are the flatter fan lines, which are determined by price ratios of 2×1, 3×1, 4×1, and 8×1. The penetration of one line suggests that the price will move to the next line. The standard fan lines tend to work best on medium- and long-term charts, but they produce valuable results on the daily charts as well (see Figures 27.5 and 27.6).

Analysts use more than one set of Gann fan lines, as Figure 27.6 shows. The intersection of two fan lines provides strong resistance (in this example) or support.

FX Concepts analysts use optimized “45-degree” angles because in-depth research proved that different currencies have different tendencies of trending. Since the core angle varies slightly, the other angles will obviously be affected as well.

In order to calibrate the correct 1×1 ratio between price and time, analysts must back-test their currencies.

Figure 27.5. Application of the Gann fan lines on an uptrend in the weekly euro/dollar.

Figure 27.6. Application of the two sets of Gann fan lines on a downtrend and on an uptrend in U.S. dollar/Swiss franc.

GEOMETRIC RATIOS

Gann divided price movements into both thirds, following the analysis of Charles Dow, and eighths, the same percentages he used to calculate price retracements. Gann used eighths because that was the typical pricing for equity at the time. These ratios provided more detail than the standard Fibonacci and Dow retracement levels. As Chapter 19 showed, the resulting percentages are:

| 12.5 percent
| 25 percent
| 33.3 percent
| 37.5 percent
| 50 percent
| 62.5 percent
| 66.6 percent
| 75 percent
| 87.5 percent

How do they compare to the Fibonacci and the Dow ratios?

Gann ratios | Fibonacci ratios | Dow ratios
.125 | .146 |
.25 | .236 |
.375 | .382 | .33
.5 (really) | .5 (not really) | .5 (really)
.625 | .618 | .67
.75 | .764 |
.875 | .854 |

The most important number is 50 percent, which can be considered the center of gravity; the other numbers’ importance decreases symmetrically on the upper and lower side.

In addition, remember that all of the Gann ratios can be used for extension targets, and they are as follows: 1.125 percent, 1.25 percent, 1.375 percent, etc.

THE SQUARING OF PRICE AND TIME

The squaring of price and time refers to Gann’s technique of converting a significant price of the currency pair into time units (from days to years) and adding these time periods to the day the significant price was reached. When the time targets are reached, time and price are squared, and the market is likely to reverse. For instance, the euro/dollar peaked at 1.3666 on December 30, 2004, so let’s approximate the price to either 136 or 137. Counting 136 days from the peak, you get July 8, 2005. The lowest low for that downtrend was on July 5 (1.1870), and the second low was on July 8 (1.1876).

THE SQUARE OF 9

The Square of 9 is an ancient method that Gann took to the next level in order to obtain support and resistance levels in terms of both price and time. It consists of a clockwise spiral that starts with number 1, and this number becomes the center of a square (see Figure 27.7). Starting from the lower left corner of the grid, you see the odd numbers 3, 5, 7, 9, and 11 providing their squares: 9, 25, 49, 81, and 121. The even squares of 4, 6, 8, and 10 go from the center up to the top right-hand corner (16, 36, 64, and 100). So, that is where the angles of 90 degrees, 180 degrees, and 270 degrees come into play. This method suggests that the key support and resistance of a currency will generally fall in the consecutive numbers in a row or on one of the diagonals. The distance from 16 (the square of four) to 25 (the square of five) is 180 degrees around the chart, so that is why Gann called for trend changes at 180 degrees.

If starting from a significant low, move clockwise by 90 degrees, 180 degrees, 270 degrees and 360 degrees; if starting from a significant peak, then move counterclockwise by 90 degrees, 180 degrees, 270 degrees, and 360 degrees.

For instance, the record low in dollar/yen was approximately 80 (April 1995). This number is housed in lower left corner of the square in Figure 27.7. The three numbers underneath it are: 120, 119, and 118. There were several weekly peaks in February, March, April, and July 2003 around the 120 handle. The lowest levels after the uptrend that followed the record low at around 80.00 were just under 102.00 in November 2004 and January 2005. You can find 102 in the upper right corner, and this is on the diagonal from 80. For good order, dollar/yen made higher highs than 120 since bottoming at 80.00. The highest highs were 146.78 in June 1998 and 147.62 in August 1998. You will find the 146 handle on the same diagonal where you found 102. Not exactly terrible targets, are they?

Figure 27.7. The Square of 9.

If you are attempting to target possible times of reversals, consider that Gann attached significance to the start of the solar start of the year on March 21 (spring equinox). Thus, a 180-degree move from there would take you to the fall equinox on around September 21 to 23; 90 degrees would mean the summer solstice, around June 22, and of course, the winter solstice is around December 22 (270 degrees). Where is the date of the significant high or low price relative to the spring equinox? If you are counting days, don’t forget to use the adjusted standard numbers of 90, 180, etc. by multiplying them by 1.01389 (as discussed under the Gann Emblem). You will then get 91.25, 182.5, etc. If using weeks, try using 45 and 135 as well.

For instance, dollar/yen formed a significant low on the week of January 17, 2005. The forty-five-week target for a possible top for the uptrend from January 17 was the week of November 28. As you can see in Figure 27.8, that was not entirely correct—it took a few days longer, but then the dollar/yen plunged. I would say that was a pretty good warning signal, wouldn’t you?

Combining time and price, let’s try this method: Jot down the date of the significant high or low price and locate that date on the Square of 9. Map the standard angles from that cell but make sure that they intersect the center cell (1). Prices that fall on your trajectories may be targets for possible lows or highs.

It is worth pointing out that the Square of 9 expands at a constant numeric rate, but the expansion rate declines. For example:

9 to 25 | = 2.777
25 to 49 | = 1.960
49 to 81 | = 1.653
81 to 121 | = 1.494

Meanwhile, the Fibonacci spiral expands at a constant rate of 161.8 percent.

Figure 27.8. Targeting the timing for trend reversals with the Square of 9.

NATURAL SQUARES

Natural Squares, such as those seen on the lower left diagonal in the Square of 9, may be used for targeting support and resistance levels, length of moves, and time targets.

When seeking price objectives, Natural Squares may be a big hero. In Figure 27.8 the high price is 121.40. For simplicity purposes, let’s say this is 121, the square of 11.

If looking for a possible target for the length of the rally or decline, consider adding the Natural Squares from the start of the move. For instance, the highest high in the euro/dollar chart in Figure 27.9 is 1.2978. Once the downmove begins, give yourself a series of price objectives for the length of that decline. In this case, two targets worked well: the squares of 21 (441) and of 22 (484). If you subtract 441 pips from the 1.2978 high you get 1.2537 (initial low was 1.2531). If you repeat this method and subtract 484 pips from 1.2978 you obtain 1.2494 (the real low was 1.2479). Finally, target the time for possible peaks and bottoms by extrapolating Natural Square periods from significant lows and highs.

Figure 27.9. Natural Squares help target the range of new moves.

SQUARE OF 144

The Square of 144, which is a Fibonacci number, consists of an area that is 144 units high and 144 units wide. It maps the market and is designed to provide areas of price support and resistance. This tool tends to work better on long-term charts,

In terms of time, the Square of 144 may be used as follows:

144 × 144 = 20,736

Then, you can divide 20,736 into days, weeks, months, and years to forecast possible turns in trend.

SQUARE OF 90

Another Gann application regarding the possible reversal days is based on the number 90. The first set of days is: 11, 22, 33, 45, 56, 67, and 78. The second set of days is: 101, 112, 123, 135, 146, 157, and 168.

Other squares suggested by Gann are the Square of 52 and the Square of 12. In addition, Gann considered 7 a significant number.

THE CARDINAL SQUARE

The Cardinal Square is a technique for forecasting future significant chart points by counting from the all-time low price of the currency. It consists of a square divided by a cross into four quadrants. The all-time low price is housed in the center of the cross. All of the following higher prices are entered in clockwise order. The numbers positioned in the cardinal cross are the most significant chart points because they are 50-pip pivot points. There are secondary numbers on the diagonals originating from the center, but they are less reliable, so we will not address them.

Some of these pivots in dollar/yen are: 112.90, 114.20, 115.50, 116.85, 118.25, 119.65, 121.05, 122.50, 124.00, 125.50, and 127.00.

Let’s take the example of the 124.00 50-pip pivot point in dollar/yen at a time when the spot rate is 123.35. A rally should be thwarted at 124.00, and the downside target is 123.50. However, if this level is penetrated on good volume, the currency is likely to rally to 124.50, its upside target. Figure 27.10 shows an application of the Cardinal Square to the U.S. dollar/Japanese yen.

Figure 27.10. Application of the Gann Cardinal Square on the U.S. dollar/Japanese yen. (Source: Copyright © 1995 by Cornelius Luca)

GANN’S 28 TRADING RULES

Based on his own trading experience, Gann offered 28 rules, and hopefully at least some of these rules have been intertwined in previous chapters of this book. How does your trading methodology compare to his?

1. Capital management: Divide your capital into ten equal parts and never risk more than one part on a single trade.

2. Always protect your trades with stop-loss orders.

3. Never overtrade (see Rule 1).

4. Never let a profit run into a loss. Just use trailing stop-loss orders.

5. Do not buck the trend.

6. When in doubt, exit the market, and don’t reenter if still in doubt.

7. Trade only in active markets.

8. Distribute risk among two or three different commodities (currencies in our case), if possible.

9. Never limit your orders or fix a buying or selling price. Trade at the market.

10. Do not cancel stop-loss orders.

11. Don’t close your trades without a good reason.

12. Never buy or sell just to get a scalping profit.

13. Never exit markets just because you have lost patience or enter markets just because you are anxious.

14. Accumulate a surplus and save some for less profitable times.

15. Never average a loss.

16. Avoid taking small profits and big losses.

17. Avoid getting in and out of the market too often.

18. Be as willing to go short as you are to go long.

19. Never buy just because the price is low or sell just because the price is high.

20. Be careful about pyramiding at the wrong time.

21. Select the currencies that are trending upward to pyramid on the buying side and the ones that are trending downward to sell.

22. Never hedge. If you are long on a currency and it starts to go down, just exit the market and wait for another opportunity.

23. Never change your position in the market without a good reason.

24. Avoid increasing your trading after a period of profitable trades.

25. Don’t guess when the market is peaking or bottoming; wait for proof.

26. Reduce trading after first loss.

27. Avoid getting in wrong and exiting wrong; getting in right and exiting wrong.

28. Do not follow advice unless you know the adviser has been reliable in the past.

28 The Elliott Wave

Ralph Nelson Elliott (1871–1948) developed his approach to technical analysis in the latter part of a life he spent as an accountant. Elliott discovered—through an exhaustive study of the DJIA—that the ever-changing stock market reflects a basic harmony found in nature. From this discovery, he developed a rational system of stock market analysis. He postulated that price movements in financial markets are repetitive in form but not necessarily in time or amplitude, and he claimed predictive value for what is now called the Elliott Wave Principle.

In essence, the Elliott Wave Principle is a system of empirically derived rules for interpreting action in the markets. It is a tool of unique value, whose most striking characteristics are generality and accuracy. Its generality gives market perspective most of the time, and its accuracy in identifying changes in direction is at times remarkable. For the trader, it is important to know that the rules of wave analysis have stood the test of time and that market action can be understood usefully within the context of Elliott’s principles.

BASICS OF WAVE ANALYSIS

The basic objective of wave analysis is to follow and interpret correctly the development of patterns in the markets. The Wave Principle’s rules and guidelines provide an objective basis both for making these interpretations and for trading signals.

In a series of articles published in 1939 by Financial World magazine, Elliott pointed out that the stock market unfolds according to a basic rhythm or pattern of five waves in the direction of the trend at one larger scale and three waves against that trend. In a rising market, this five-wave/three-wave pattern forms one complete bull market/bear market cycle of eight waves. The five-wave upward movement as a whole is referred to as an impulse wave, while the three-wave countertrend movement is described as a corrective wave. This basic structure is illustrated in Figure 28.1.

Within the five-wave bull move, waves 1, 3, and 5 are themselves impulse waves, subdividing into five waves of smaller scale; while waves 2 and 4 are corrective waves, subdividing into three smaller waves each. As shown in Figure 28.1, subwaves of impulse sequences are labeled with numbers, while subwaves of corrections are labeled with letters.

Following the cycle shown in the illustration, a second five-wave upside movement begins, followed by another three-wave correction, followed by one more five-wave upmove. This sequence of movements constitutes a five-wave impulse pattern at one larger degree of trend, and a three-wave corrective movement at the same scale must follow. Figure 28.2 shows this larger-scale pattern in detail. As the illustration shows, waves of any degree in any series can be subdivided and resubdivided into waves of smaller degree or expanded into waves of larger degree. This structure is an example of “fractal” geometry, incorporating self-similarity and scaling symmetry, and is consistent with numerous scientific insights into the nature of growth and evolution.

Figure 28.1. The basic Elliott Wave pattern.

Figure 28.2. The larger-scale pattern in detail.

Three essential rules govern the interpretation of these patterns:

1. A second wave may never retrace more than 100 percent of a first wave; for example, in a bull market, the low of the second wave may not go below the beginning of the first wave.

2. The third wave is never the shortest wave in an impulse sequence; often, it is the longest (see Extensions in the next section).

3. A fourth wave can never enter the price range of a first wave, except in one specific type of wave pattern (see the section on Diagonal Triangles).

Overall, the form of market movements is essentially the same, irrespective of the size or duration of the movements. Furthermore, smaller-scale movements link up to create larger-scale movements possessing the same basic form. Conversely, large-scale movements consist of smaller-scale subdivisions with which they share a geometric similarity. Because these movements link up in increments of five waves and three waves, they generate sequences of numbers that the analyst can use (along with the rules of wave formation) to help identify the current state of pattern development, as shown in Figure 28.3.

Figure 28.3. A complete market cycle.

IMPULSE WAVES—VARIATIONS

EXTENSIONS

In any given five-wave sequence, a tendency exists for one of the three impulse subwaves (i.e., wave 1, wave 3, or wave 5) to be an extension—an elongated movement, usually with internal subdivisions. At times, these subdivisions are of nearly the same amplitude and duration as the larger-degree waves of the main impulse sequence, giving a total count of nine waves of similar size rather than the normal count of five for the main sequence. In a nine-wave sequence, it is sometimes difficult to identify which wave is extended. However, this is usually irrelevant, because a count of nine and a count of five have the same technical significance. Figure 28.4 shows why this is so; examples of extensions in various wave positions make it clear that the overall significance is the same in each case.

Extensions can provide a useful guide to the lengths of future waves. Most impulse sequences contain extensions in only one of their three impulsive subwaves. Thus, if the first and third waves are of about the same magnitude, the fifth wave will probably be extended, especially if volume during the fifth wave is greater than during the third. On the other hand, if wave 3 has already extended, wave 5 should simply be constructed and should resemble wave 1.

Figure 28.4. Wave extensions.

Extensions can also occur within extensions. Although extended fifth waves are not uncommon, extensions of extensions occur most often within third waves, as shown in Figure 28.5.

DIAGONAL TRIANGLES

Two types of diagonal triangle have been identified. Both types are found relatively rarely, and each has highly specific implications for future market movements. (These formations should not be confused with the more common corrective triangles found in fourth-wave positions within impulse waves and B-wave positions within corrections; see Corrective Waves in the next section.)

The diagonal triangle type 1 occurs only in fifth waves and in C waves, and it signals that the preceding move has “gone too far, too fast,” as Elliott put it. Essentially a rising wedge formation defined by two converging trendlines, type 1 diagonal triangles indicate exhaustion of the larger movement. Unlike other impulse waves, all of the patterns’ subwaves, including waves 1, 3, and 5, consist of three-wave movements, and their fourth waves often enter the price range of their first waves, as shown in Figures 28.6 and 28.7.

Figure 28.5. Wave extensions.

A rising diagonal triangle type 1 is bearish, because it is usually followed by a sharp decline, at least to the level where the formation began. In contrast, a falling diagonal type 1 is bullish, because an upward thrust usually follows.

The diagonal triangle type 2 occurs even more rarely than type 1. This pattern, found in first-wave or A-wave positions in very rare cases, resembles a diagonal type 1 in that it is defined by converging trendlines and its first wave and fourth wave overlap, as shown in Figure 28.8. However, it differs significantly from type 1 in that its impulsive subwaves (waves 1, 3, and 5) are normal, five-wave impulse waves, in contrast to the three-wave subwaves of type 1. This is consistent with the message of the type 2 diagonal triangle, which signals continuation of the underlying trend, in contrast to the type 1’s message of termination of the larger trend.

Figure 28.6. A bullish pattern.

Figure 28.7. A bearish pattern.

Figure 28.8. Diagram of the diagonal triangle type 2.

FAILURES (TRUNCATED FIFTHS)

Elliott used the word “failure” to describe an impulse pattern in which the extreme of the fifth wave fails to exceed the extreme of the third wave. Figures 28.9 and 28.10 show examples of failures in bull and bear markets. As the illustrations show, the truncated fifth wave contains the necessary impulsive (i.e., five-wave) substructure to complete the larger movement. However, its failure to surpass the previous impulse wave’s extreme signals weakness in the underlying trend, and a sharp reversal usually follows.

Figure 28.9. Bull market failure.

Figure 28.10. Bear market failure.

CORRECTIVE WAVES

Stock market swings of any degree tend to move more easily with the trend of one larger degree than against it. As a result, corrective waves can be highly complex and “choppy” and are often difficult to interpret precisely until they are finished. Thus, the terminations of corrective waves are less predictable than those of impulse waves, and the wave analyst must exercise greater caution when the market is in a meandering, corrective mood than when prices are in a clearly impulsive trend. Moreover, while only three main types of impulse wave exist, there are a total of ten basic corrective wave patterns, and all can link up to form extended corrections of great complexity.

The single most important thing to remember about corrections is that they can never be “fives.” Only impulse waves can be fives. Thus, an initial five-wave movement against the larger trend is never a complete correction, but only part of it.

Corrective patterns fall into four main categories:

1. Zigzags (5–3–5)
2. Flats (3–3–5)
3. Triangles (3–3–3–3–3)
4. Combined structures

Zigzags

A zigzag is a simple three-wave pattern, subdivided into a 5–3–5 structure, in which the extreme of wave B remains a significant distance from the beginning of wave A. Figures 28.11 to 28.14 show examples in bull and bear markets. (A zigzag rally within a bear market is sometimes referred to as an inverted zigzag.)

Figure 28.11

Figure 28.12

Figure 28.13

Figure 28.14

Occasionally, in larger formations, two zigzags can occur in succession, separated by intervening three-wave structures of any type. This produces a double zigzag, illustrated in Figure 28.15. Although double zigzags are uncommon, they occur often enough that the analyst should be aware of their existence.

Flats

Flat corrections subdivide as 3–3–5 structures, as shown in Figures 28.16 to 28.19. The initial movement, wave A, seems to lack sufficient force to develop into a full five waves, as in a zigzag. Wave B appears to share this lack of countertrend pressure and often ends at or beyond the start of wave A; and wave C usually terminates near the extreme of wave A, rather than significantly beyond it, as in a zigzag.

Flat corrections, overall, do less damage than zigzags to the larger trend. They appear to indicate strength underlying the larger trend and thus often precede or follow extensions. As a rule, the longer the flat, the more dynamic the next impulse wave.

Figure 28.15. Double zigzag.

Four types of flats have been identified:

1. Regular, in which wave B ends at or very slightly beyond the level of the start of wave A, and wave C ends at or slightly beyond the level of the extreme of wave A.

Figure 28.16

Figure 28.17

Figure 28.18

Figure 28.19

2. Expanded, in which wave B significantly exceeds the level of the start of wave A, and wave C significantly exceeds the level of the extreme of wave A (see Figures 28.20 to 28.23).

3. Irregular, in which wave B ends near the start of wave A, as in a regular flat, but wave C fails to move all the way to the extreme of wave A (see Figures 28.24 to 28.27).

4. Running, a rare formation in which wave B carries well beyond the level of the start of wave A and wave C fails to carry back past that level. In other words, the end of wave C in a downward correction ends above the beginning of wave A, and in an upward correction below the level of the beginning of wave A (see Figure 28.28).

Figure 28.20

Figure 28.21

Figure 28.22

Figure 28.23

Figure 28.24

Figure 28.25

Figure 28.26

Figure 28.27

This formation signals strength in the larger trend and occurs when the market moves so quickly that corrective patterns have no time to develop normally. It is essential that the internal subdivisions of a running correction adhere to the Wave Principle’s rules. For example, the B wave must contain only three subwaves and not five, which would probably make it, instead, the first wave of an impulse pattern of the next larger degree.

Triangles

Generally, triangles occur only in positions just prior to the final movement in the direction of the larger trend. They tend to be protracted and reflect a balance of forces that creates a sideways movement, usually associated with relatively low volume and low volatility. All triangles consist of five waves, labeled A-B-C-D-E, subdivided into three waves each. Four main types exist, as shown in Figure 28.29. (Corrective triangles must not be confused with the impulsive patterns called diagonal triangles. See Impulse Waves—Variations earlier in this chapter.)

Figure 28.28

The trendlines that contain a triangle usually are highly accurate; that is, touchpoints rarely fall short of or exceed these boundaries. The one exception is wave E, which often overshoots the trendline, especially in expanding and contracting triangles.

After completion of a triangle, the final impulse wave of the larger trend is usually swift and travels a distance approximately equal to the widest part of the triangle. This movement is known as a thrust.

Combined Structures

In wave analysis, a zigzag or flat is often referred to as a three. Occasionally, these patterns, as well as triangles, may combine into more complex double three or triple three formations, consisting of two or more “threes” separated by smaller three-wave movements labeled as X waves. Figures 28.30 and 28.31 illustrate the basic structure of these formations. A double three may consist of a flat, a smaller zigzag forming wave X, and a second flat; or of a zigzag, a smaller flat in wave X, and a second zigzag; or of any similar combination.

Figure 28.29

Figure 28.30

Figure 28.31

The combined structures appear to reflect hesitation in the market, as if stock prices are waiting for economic fundamentals to catch up with investor expectations. Usually, these formations move more or less sideways, although Elliott indicated that the entire formation could slant against the larger trend. Action subsequent to a double or triple three often is quite strong.

As far as has been determined, the formations listed here are all that can be identified in the movements of financial markets. As a result of detailed study of a large number of charts at every conceivable time frame, from fifteen-minute bar charts covering a few days’ action to monthly charts covering nearly three centuries of market history, we are convinced that no other formations exist.

FIBONACCI ANALYSIS

Perhaps Elliott’s most important contribution to the study of patterns in the markets was his discovery that movements of the same degree tend to be related to one another by a specific mathematical ratio, known variously as the Fibonacci ratio, the golden ratio, or phi. With this discovery, Elliott was able to place social change, as reflected in the financial markets, into a continuum of evolution reaching from the molecular scale to the cosmological.

The Fibonacci ratio is named after Leonardo of Pisa, or Leonardo Pisano, also known as Fibonacci (after his father, Guglielmo Bonacci). Fibonacci was an Italian mathematician of the late twelfth and early thirteenth centuries, who introduced Hindu-Arabic numerals to Western Europe in a work titled Liber Abaci. In the same book, in a problem concerning the dynamics of population growth in rabbits, he introduced an additive numerical series that has come to be called the Fibonacci sequence in his honor.

To obtain the Fibonacci sequence, begin with 1 and add 1 to it. Take the sum of this operation (2) and add it to the previous term in the sequence (1). Then take the sum of his second operation (3) and add it to the previous term in the sequence (the sum of the first operation, i.e., 2). Continue iterating in this manner, adding the most recent sum to the previous term, which is itself the sum of the two previous terms, etc. This yields the following series of numbers:

1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597, 2584, 4181 (etc.)

These numbers exhibit several remarkable relationships, in particular the ratio of any term in the series to the next higher term. This ratio tends asymptotically to 0.618.…In addition, the ratio of any term to the next lower term in the sequence tends asymptotically to 1.618, which is the inverse of 0.618. Similarly constant ratios exist between numbers two terms apart, three terms apart, and so on. The ratio 0.618, referred to as the Fibonacci ratio, is an irrational number (i.e., it never resolves to a single solution no matter how many decimal places one carries it to), calculated as

Because 3 and 5 are Fibonacci numbers (i.e., numbers in the basic Fibonacci sequence), combinations of 3s and 5s will tend to add up to larger Fibonacci numbers. For example, Elliott’s basic 5–3–5–3–5 impulse wave sequence adds up to 21, which is a Fibonacci number. Adding a 5–3–5 corrective wave sequence raises the total to 34, which is also a Fibonacci number. Thus, there are Fibonacci numbers and ratios embedded in the number of waves at various degrees.

The Fibonacci ratio underlies the geometry of the logarithmic spiral, a geometric form found widely in nature. The log spiral’s expansion (or contraction) is determined by the cotangent of the angle of the radius vector to the tangent. In the case when that cotangent equals

-π / 2 × log (0.618)

The figure is sometimes referred to as the golden spiral. This figure also possesses the noteworthy property that the ratio of the length of the arc to its diameter is 1.618, the inverse of 0.618.

Golden spirals appear in a variety of natural objects, from seashells to hurricanes to galaxies. Many other natural forms exhibit additional Fibonacci proportions in various ways. In the human body, the bronchial tubes branch fractally in a pattern that exhibits the Fibonacci ratio. The double helix of the DNA molecule possesses precise Fibonacci geometry. Indeed, the Fibonacci ratio occurs at every scale from the molecular to the cosmological, and it is most associated with processes of growth.

The financial markets exhibit Fibonacci proportions in a number of ways. As noted earlier, most five-wave sequences contain an extension in one impulse wave. The two nonextended waves tend to be approximately equal in magnitude, and the extended wave tends to be a Fibonacci multiple (most often 1.618 times) of the nonextended waves. Corrective waves tend to retrace a Fibonacci percentage (most often 61.8 percent, 38.2 percent, or 23.6 percent) of the preceding impulse wave. Within corrective waves, Fibonacci relationships often exist among the subwaves.

These relationships, combined with Elliott’s detailed rules and guidelines, constitute a powerful tool for calculating price targets and placing stops. For example, if a corrective wave is expected to retrace 61.8 percent of the preceding impulse wave, an investor might place a stop slightly below that level. This will ensure that if the correction is of a larger degree of trend than expected, the investor will not be exposed to excessive losses. On the other hand, if the correction ends near the target level, this outcome will increase the probability that the investor’s preferred wave interpretation is accurate.

Figure 28.32. A market application of Elliott Wave.

FURTHER STUDY

This discussion has touched on only the most basic concepts of wave analysis. Successful forecasting and trading using the Wave Principle require a thorough knowledge of the method’s rules and guidelines. Elliott Wave Principle: Key to Stock Market Profits, by A. J. Frost and Robert R. Prechter, Jr. (Elliott Wave International, P.O. Box 1618, Gainesville, GA 30503, USA, 404–536–0309), is the standard textbook of wave analysis, presenting the highly sophisticated technical analysis method in comprehensive detail.

CONCLUSION

This concludes our exploration of the main tools currently used by traders. We have covered all types of charts, major chart formations, quantitative methods, theories, and studies. Some of these topics may look more familiar to you than others. Few traders are familiar with all the technical tools. Perhaps the mere analysis of all the formations would take too much away from trading time. Luckily, most traders will be able to reach significant signals from a much lighter load of technicals, especially since their analysis time has been greatly reduced and their analytical sharpness seriously enhanced by the splendid online electronic charting services and weekly printed charts.

What the best technical combination is for you is really only up to you. You have the opportunity to see for yourself what is available in the fascinating world of technical analysis. If you feel familiar and confident with certain techniques, and especially if they prove profitable to you, then you have probably got it.

Appendix A

World Currencies and Their SWIFT Codes

A

Afghanistan Afghani | AFA
Albanian Lek | ALL
Algerian Dinar | DZD
Andorran Franc | ADF
Andorran Peseta | ADP
Angolan Kwanza | AOA
(Netherlands) Antillian Guilder | ANG
(United) Arab Emirates Dirham | AED
Argentine Austral | ARA
Argentine Peso | ARS
Armenian Dram | AMD
Aruban Florin (old guilder) | AWG
Australian Dollar | AUD
Azerbaijan Manat | AZM

B

Bahamian Dollar | BSD
Bahraini Dinar | BHD
Bangladeshi Taka | BDT
Barbados Dollar | BBD
Belarusian Ruble | BYR
Belize Dollar | BZD
Bermudian Dollar | BMD
Bhutan Ngultrum | BTN
Bolivian Boliviano | BOB
Bosnia and Herzegovina Convertible Mark | BAM
Botswana Pula | BWP
Brazilian Real | BRL
British Pound | GBP
Brunei Dollar | BND
Bulgarian Lev | BGN
Burundi Franc | BIF

C

CFA Franc BCEAO (for Benin, Burkino Faso, Cote D’Ivoire, Mali, Niger, Senegal, and Togo) | XOF
CFA Franc BEAC (for Cameroon, the Central African Republic, Chad, Congo, Equatorial Guinea, and Gabon) | XAF
Kampuchean (Cambodian) Riel | KHR
Canadian ollar | CAD
Cape Verde Escudo | CVE
Cayman Islands Dollar | KYD
Chilean Peso | CLP
Chinese Yuan Renminbi | CNY
Colombian Peso | COP
Comoros Franc | KMF
Congolese Franc | CDF
Costa Rican Colon | CRC
Croatian Kuna | HRK
Cuban Peso | CUP
Cyprus Pound | CYP
Czech Koruna | CZK

D

Danish Krone | DKK
Djibouti Franc | DJF
Dominican Peso | DOP
Dutch Guilder | NLG

E

Ecuador Sucre | ECS
Egyption Pound | EGP
El Salvador Colon | SVC
Estonian Kroon | EEK
Ethiopian Birr | ETB
Euro | EUR

F

Falkland Islands Pound | FKP
Fiji Dollar | FJD

G

Gambian Dalasi | GMD
Georgian Lari | GEL
Ghanaian Cedi | GHC
Gibraltar Pound | GIP
Guatemalan Quetzal | GTQ
Guinean Franc | GNF
Guinea-Bissau Peso | GWP
Guyanan Dollar | GYD

H

Haitian Gourde | HTG
Honduran Lempira | HNL
Hong Kong Dollar | HKD
Hungarian Forint | HUF

I

Iceland Krona | ISK
Indian Rupee | INR
Indonesian Rupiah | IDR
Iranian Rial | IRR
Iraqi Dinar | IQD
Israeli New Shekel | ILS

J

Jamaican Dollar | JMD
Japanese Yen | JPY
Jordanian Dinar | JOD

K

Kampuchean Riel | KHR
Kazakhstan Tenge | KZT
Kenyan Schilling | KES
Korean Won | KRW
Kuwaiti Dinar | KWD
Kyrgyzstanian Som | KGS

L

Lao Kip | LAK
Latvian Lats | LVL
Lebanese Pound | LBP
Lesotho Loti | LSL
Liberian Dollar | LRD
Libyan Dinar | LYD
Lithuanian Litas | LTL

M

Macau Pataca | MOP
Macedonian Denar | MKD
Malagasy Franc | MGF
Malawi Kwacha | MWK
Malaysian Ringgit | MYR
Maldive Rufiyaa | MVR
Maltese Lira | MTL
Mauritanian Ouguiya | MRO
Mauritius Rupee | MUR
Mexican Peso | MXN
Moldovan Leu | MDL
Mongolian Tugrik | MNT
Moroccan Dirham | MAD
Mozambique Metical | MZM
Myanmar Kyat | MMK

N

Namibian Dollar | NAD
Nepalese Rupee | NPR
Netherlands Antillian Guilder | ANG
New Zealand Dollar | NZD
Nicaraguan Cordoba Oro | NIO
Nigerian Naira | NGN
North Korean Won | KPW
Norwegian Kroner | NOK

O

Omani Rial | OMR

P

Pakistan Rupee | PKR
Panamanian Balboa | PAB
Papua New Guinea Kina | PGK
Paraguay Guarani | PYG
Peruvian Neuevo Sol | PEN
Philippine Peso | PHP
Polish Zloty | PLN
Pound Sterling | GBP

Q

Qatari Rial | QAR

R

Romanian Leu | RON
Russian Rouble | RUB
Rwandan Franc | RWF

S

Smoan Tala | WST
Sao Tome and Principe Dobra | STD
Saudi Riyal | SAR
Serbian Dinar | CSD
Seychelles Rupee | SCR
Sierra Leone Leone | SLL
Singapore Dollar | SGD
Slovak Koruna | SKK
Slovenian Tolar | SIT
Solomon Islands Dollar | SBD
Somali Shilling | SOS
South African Rand | ZAR
Sri Lanka Rupee | LKR
St. Helena Pound | SHP
Sudanese Dinar | SDD
Sudanese Pound | SDP
Suriname Dollar | SRD
Suriname Guilder | SRG
Swaziland Lilangeni | SZL
Swedish Krona | SEK
Swiss Franc | CHF
Syrian Pound | SYP

T

Taiwan Dollar | TWD
Tanzanian Shilling | TZS
Thai Baht | THB
Tongan Pa’anga | TOP
Trinidad and Tobago Dollar | TTD
Tunisian Dinar | TND
Turkish Lira | TRY
Turkmenistan Manat | TMM

U

Uganda Shilling | UGX
Ukraine Hryvnia | UAG
Ukraine Karbovanets | UAK
United Arab Emirates Dirham | AED
Uruguayan Peso | UYU
U.S. Dollar | USD

V

Vanuatu Vatu | VUV
Venezuelan Bolivar | VEB
Vietnamese Dong | VND

Y

Yugoslav Dinar | YUN

Z

Zambian Kwacha | ZMK
Zimbabwe Dollar | ZWD

Appendix B

U.S. Council on International Banking Compensation and Indemnity and Compensation Rules[*]

PART I. GENERAL

Rule I.1. Scope.

The U.S. Council on International Banking’s Interbank Compensation Rules, (the “Rules”) govern the settlement of claims for compensation between U.S. Council on International Banking member banks (“banks”), including their head offices and overseas branches, but excluding their subsidiaries, arising from interbank funds payments (other than ACH payments) in United States dollars regardless of:

i. | the original source or ultimate beneficiary of any payment, whether foreign or domestic;
ii. | the manner of payment (e.g., Fedwire, CHIPS, check, telex);
iii. | the type of funds involved (e.g., same day funds, next day funds);
iv. | the nature of the underlying transaction (e.g., securities transaction, foreign exchange); or
v. | the departments of the banks involved in initiating, processing or receiving the transaction.

Rule I.2. Nature of the Rules.

a. Not every possible situation involving a claim for compensation is explicitly addressed. Notwithstanding any provision of these Rules, when a claim for compensation meriting special attention is identified, it is expected that the banks involved will settle such claim so that no bank shall be unjustly enriched or injured by the actions of another member bank.

b. Unless otherwise specified, compensation in connection with a claim meriting special attention shall not exceed the benefit derived by the bank obligated to pay compensation. This limitation may be invoked, for example, in the case of Rule 3, 4 or 5 of Part II, if a beneficiary withdraws the funds from its account so that its bank does not have use of funds.

c. Payment or attempted payment of compensation pursuant to these Rules does not constitute and should not be construed as an admission of negligence or fault on the part of any of the banks involved.

Rule I.3. Manner of Payment.

Compensation under the Rules shall be paid in United States dollars. A compensation payment may be made by CHIPS, Fedwire or check. Banks may alter the manner of payment of compensation by prior mutual agreement.

Rule I.4. Ordering Parties/Beneficiaries.

The Rules do not confer any right or responsibility on any person, entity or organization not a member of the U.S. Council on International Banking.

Rule I.5. Third Parties.

The Rules do not apply to claims for compensation arising from actions of third parties who are nonmembers of the U.S. Council on International Banking.

Rule I.6. Disputes.

Disagreements which arise between member banks, over the application of the rules, may be submitted in writing to the U.S. Council on International Banking Rules Committee for arbitration.

PART II. INTERBANK FUNDS PAYMENTS

Rule II.1. Definitions.

a. “Business day” means a Monday, Tuesday, Wednesday, Thursday or Friday which is not a day on which banking institutions in the United States are authorized or obligated by law or executive order to close.

b. “Fed. Funds Rate” means the average of each day’s Federal Funds rate, as published on a daily basis by the Federal Reserve Bank of New York, for the days that a bank must include in the applicable formula(s) in calculating compensation. The daily Fed. Funds Rate for any day on which a published rate is not available shall be deemed to be the same as the immediately preceding published rate.

Rule II.2. Back Valuation.

a. A bank which sent a payment may request the bank which received the payment to back value such payment. Generally, such request is accompanied by a payment for the amount of compensation owed pursuant to the formula below. If compensation is paid, the receiving bank is obligated to back value the payment to the date requested, unless (i) its customer instructs it not to back value such payment; (ii) the account has been closed; (iii) the sending bank requests a back valuation to a date more than one year prior to the payment date; or (iv) the compensation payment is received more than one year after the payment date.

b. The rules do not require the sending bank to obtain back value. The rules only stipulate the amount required when back valuation is requested by the sending bank.

c. If the receiving bank back values the payment pursuant to the request of the sending bank, the sending bank must pay the receiving bank compensation according to the following formula (without regard to whether or not the beneficiary’s account was actually in an overdraft position):

(Dollar Amount of Payment) × (Fed. Funds Rate) ×
(No. of Days Back Valued) + $200*
Compensation = 360

Rule II.3. Forward Valuation.

a. A bank which sent a payment may request the bank which received the payment to adjust the payment to a future value date. The receiving bank is not obligated to make such an adjustment.

b. If a receiving bank adjusts the payment to a future value date pursuant to the request of the sending bank, the receiving bank must, upon receiving a claim for compensation within 60 days from the date on which the requested adjustment was made, pay the sending bank compensation according to the following formula:

(Dollar Amount of Payment) × (100% − Reserve Requirement) × (Fed. Funds Rate) × (No. of Days Forward Value) − $200** Compensation = 360

Rule II.4. Return of Payment “Missent Payment.”

a. There may be circumstances in which a bank that has sent a payment may request the bank that received such payment to return the funds. For example, a bank that has (i) sent a payment that should not have been sent; (ii) sent a payment to the wrong bank; or (iii) sent a duplicated payment or has made an overpayment (each such payment or part thereof constituting an overpayment is hereafter referred to as a “missent payment”), may request the bank which received the payment to return it. To induce the receiving bank to return a missent payment the sending bank may issue an Indemnity conforming to the format of the U.S. Council on International Banking’s Compensation Indemnity and Responses (the Indemnity) (Appendix A). The receiving bank is not obligated to return the payment in reliance on the Indemnity.

b. Except as provided under Rule 7 of this Part II (Netting of Compensation), if a receiving bank returns a missent payment, it shall, upon receiving a claim for compensation within 60 days from the date on which it returned the missent payment, pay the sending bank compensation according to the following formula:

(Dollar Amount of Payment) × (100% − Reserve Requirement) × (Fed. Funds Rate) × (No. of Days Not to Exceed 180) − Applicable Deduction Compensation = 360
c. A request for compensation received beyond 60 days from the date the missent payment was returned, need not be honored by the receiving bank.

d. A request for compensation included in the body of the Indemnity is a legitimate claim under the new Rules and fulfills the 60 day requirement.

e. If a missent payment is retained by the receiving bank for more than 180 days, the Fed. Funds Rate means the Fed. Funds Rate in effect during the most recent 180 day time period.

APPENDIX: U.S. COUNCIL ON INTERNATIONAL BANKING COMPENSATION AND INDEMNITY AND RESPONSES (THE “INDEMNITY”)

1. Purpose. In order to induce a bank receiving a payment (the “Receiving Bank”) to return in an expeditious manner, a payment sent to the wrong bank, an overpayment, a duplicated payment or to adjust a credit to the correct account on a payment made to the correct Receiving Bank but for credit to an incorrect or no account, the bank sending such a payment (the “Paying Bank”) may issue the Indemnity which appears below to the Receiving Bank. The Receiving Bank may, but is not obligated to act as a result of the Indemnity. The Indemnity may be issued only in connection with payments made in United States dollars.

2. Method of Transmission. A Paying Bank should transmit the Indemnity and a Receiving Bank should transmit any response or release thereof, by telex, SWIFT, any other mutually agreed upon means of electronic transmission, or by letter. It is recommended that the Indemnity be sent by means of electronic transmission. If transmitted by telex, the telex must be tested. If transmitted by SWIFT or any other means of electronic transmission, the transmission must be authenticated. If transmitted by letter, the letter must be executed by an authorized signatory of the sender and must be hand delivered to the receiver by an authorized messenger from the sender. The receiver shall acknowledge in writing receipt of such a letter. Such acknowledgement shall be considered proof that such letter was properly delivered by the sender to the receiver. If transmitted by letter, each Indemnity must be enclosed in a readily identifiable envelope addressed to the Receiving Bank clearly marked with the notation “Indemnity.”

3. “Format.”

a. The Indemnity must be in the following format:

REF. NO._____

INDEMNITY

With reference to our payment date _____ by means of (Fedwire # _____ (CHIPS # _____), (SWIFT _____), or (check # _____), for U.S. $_____ in your favor for the account of _____, by order of _____, we request that you:

[] Adjust the credit from the acount of to the account of;

[] Refund the amount of U.S. $, which was intended for you;

[] Refund the amount of U.S. $, because the aforementioned payment was a duplication of (Fedwire #), (CHIPS #), (SWIFT #), or (check #);

[] Refund the amount of U.S. $, which was an overpayment. The correct amount should be U.S. $;

[] Pay us compensation calculated pursuant to the U.S. Council on International Banking’s Interbank Compensation Rules from (payment date) to the date on which you fulfill this request.

In consideration of your complying with the terms of this Indemnity we agree to indemnify you, your officers and employees against any and all claims, liabilities, losses, expenses, (including the reasonable fees and disbursements of your counsel) suits or damages resulting there from (each of the foregoing is hereinafter referred to as “loss”).

You agree to notify us of any such loss within ten (10) business days of your receipt of notification of any such loss.

We represent and warrant that we are duly authorized by all necessary and appropriate corporate action to execute this Indemnity and that this Indemnity is a valid and legally binding obligation of our bank.

Pursuant to a Recall of Funds notification as provided under the U.S. Council on International Banking’s Compensation Indemnity and Responses we will return on demand the amount refunded by you or reimburse you on demand for the amount of the adjustment.

You agree to contact your customer immediately to obtain its debit authorization. Upon receiving such debit authorization, our obligations under this Indemnity will cease and you will notify us of your release hereunder. Please make the appropriate response to this Indemnity.

b. The Indemnity may be sent in an abbreviated format when it bears the statement: “We agree to indemnify you according to the Compensation Indemnity and Responses contained in the U.S. Council on International Banking’s Guideline for Issuing and Responding to an Indemnity.” Such statement will be deemed to incorporate the entire text of the Indemnity set forth above. The following information must also be provided in the abbreviated format:

1. Date of transfer

2. Amount of transfer

3. Method of transfer

4. Payment system identification
a) Fedwire number
b) CHIPS number
c) SWIFT number
d) Check number
e) Account number or name of party to whom payment was originally sent
f) Account number or name of party to be credited

5. By order party

6. Description of action requested (including claim for compensation).

c. The Indemnity may be sent by using structured format transaction codes established by procedures in the CHIPS Systems and Operations Manual for CHIPS participants to send and receive such indemnities. Such procedures permit the Paying Bank to cause CHIPS to transmit to the receiving bank a CHIPS Service Message that contains either the statement: “We indemnify you under NYCHA or USCIB Compensation Rules as applicable (Ref. No.______________)” or a structured format transaction code established by such Manual for such indemnities. Such CHIPS Service Message will be deemed to incorporate the entire text of the U.S. Council on International Banking Indemnity set forth in its Compensation Rules between a New York Clearing House Association member bank and a USCIB member bank or between two USCIB member banks. The following information must also be provided in the CHIPS Service Message:

1. Identification of the CHIPS payment message by which the transfer was made as follows:

a. Paying Bank’s payment sequence number (“PSN”)

b. Amount of transfer
c. Date of transfer

2. Identification of the parties (by name or account number or both where available) as follows:

a. Party to whom payment was originally sent
b. By order party
c. Party to whom corrected payment shall be made (if applicable).

4. Responses.

a. When a Receiving Bank determines it will return principal pursuant to an Indemnity, principal should be returned by CHIPS or Fedwire; and the Receiving Bank should notify the Paying Bank as follows: “Returning your (Fedwire #), (CHIPS #), (SWIFT #), or (check #) dated for $ pursuant to your Indemnity Ref. No. dated. (We are forwarding the appropriate compensation.)”

b. When in reliance on an Indemnity a Receiving Bank determines to adjust the beneficiary’s account and account number, the Receiving Bank should notify the Paying Bank as follows: “On (date), we adjusted your (Fedwire #), (CHIPS #), (SWIFT #), or (check #) to read (beneficiary and amount) pursuant to your Indemnity Ref. No. dated. Please forward compensation of $.”

c. When a Receiving Bank determines to take no action on an Indemnity because it contains insufficient information or is not in the standard format, the Receiving Bank should notify the Paying Bank as follows: “Your Indemnity delivered by (SWIFT, telex, letter) Ref. No. dated for $ covering instructions via (Fedwire #), (CHIPS #), (SWIFT #), or (check #) dated by order of cannot be acted upon because it contains (Incorrect Format, Incomplete Information, or Inappropriate Transmittal).”

d. When Receiving Bank in its sole discretion determines not to take action requested by XXX Indemnity, the Receiving Bank shall notify the Paying Bank as follows: “We have determined to take no action pursuant to your Indemnity delivered by (SWIFT, telex, letter) Ref. No. dated for $ covering instructions via (Fedwire #), (CHIPS #), (SWIFT #), or (check #) dated by order of. (We are treating the matter as an inquiry and are today, (date), seeking debit authorization from our customer. We shall advise you of its response).”

5. Confirmation. If the Receiving Bank determines to take the action requested by the Indemnity, it shall attempt to procure confirmation of its action from the party whose account was debited. The Receiving Bank shall notify such party as follows: “On (date), we debited your account # for $ in reversal of a credit entry dated, our Ref. No., customer Ref. No. by the order of for the order of. The paying bank notified us that it had incorrectly instructed us to credit your account. Please confirm to us that you have no objection to our debiting your account to correct said error.”

6. Release. After the Receiving Bank has obtained debit authorization from its customer, the Paying Bank is released from its liabilities and obligations under the Indemnity. The Receiving Bank must notify the Paying Bank as follows promptly upon obtaining said debit authorization: “We hereby notify you that you have been released from all obligations and liabilities arising from and in connection with your Indemnity delivered by (SWIFT, telex letter) Ref. No. dated for $ covering instructions via (Fedwire #), (CHIPS #), (SWIFT #), or (check #) dated by order of.”

Once the Receiving Bank has received debit authorization from its customer or notifies the Paying Bank that it releases the Paying Bank of its obligations and liabilities arising from and in connection with such Indemnity, the Paying Bank, shall no longer be liable to the Receiving Bank on the Indemnity in connection with any matter related to, or arising from such Indemnity.

7. Recall of Funds. If the beneficiary whose account has been debited by the Receiving Bank pursuant to a request in the Indemnity from a Paying Bank, requests the return of the amount so debited, the Paying Bank must, as the case may be, return, or reimburse the Receiving Bank for such amount upon receipt of the following notice from the Receiving Bank: “Please (return to us or reimburse us) in the amount of $ which we refunded to you via (Fedwire #), (CHIPS #), or (check #) (or credited to the account of) pursuant to the Indemnity delivered by (SWIFT, telex, letter) Ref. No., dated covering instructions via (Fedwire #), (CHIPS #), (SWIFT #), or (check #) dated by order of because our customer has demanded a return of funds.”

[*](Effective: 1/2/90)

Glossary

Accumulation Swing Index (ASI) An oscillator based on the swing index (SI). A buying signal is generated when the daily high exceeds the previous SI significant high, and a selling signal occurs when the daily low dips under the significant SI low.

Alpha Risk-adjusted measure of the so-called excess return on a benchmark index There is little consensus on what the currency benchmark is, so in FX trading alpha is generally achieved via superior model-trading and technical analysis-trading.

American-style currency option An option which may be exercised on any valid business date throughout the life of the option.

Arbitrage A risk-free type of trading where the same instrument is bought and sold simultaneously in two different markets in order to cash in on the divergence between these markets.

Ascending triangle A triangle continuation formation with a flat resistance and a rising support (see Triangle).

Ascending triple high A bullish point-and-figure chart formation which suggests that the currency is likely to break a resistance line the third time it reaches it. Each new top is higher than the previous one.

At-the-money (ATM) option An option whose present currency price is approximately equal to the strike price.

Atekubi A bearish two-day candlestick combination. It consists of a blank bar that closes at the daily high; the current closing price equals the previous day’s low. The original day’s range is a long black bar.

At par forward spread Forward price is zero; therefore, the spot price is similar to the forward price. It reflects the fact that the foreign interest rate is similar to the U.S. interest rate for that particular period.

At the price stop-loss order A stop-loss order which must be executed at the precise requested level, regardless of market conditions.

Average options Options which refer to the average rate of the underlying currency that existed during the life of the option. This rate becomes the strike in the case of the average strike options, or it becomes the underlying, determining the intrinsic value when compared to a predetermined fixed strike in the case of average rate options. Average options can be based on the spot rate (spot style) or the forward underlying the option (forward style). The average can be calculated arithmetically or geometrically, and the rates can be tabulated with a variety of frequencies.

Balance-of-payments All the international commercial and financial transactions of the residents of one country.

Bank of Canada (BoC) The central bank of Canada.

Bank of England (BoE) The central bank of the United Kingdom. It is a less independent central bank. The government may overwrite its decision.

Bank of France (BoF) The central bank of France.

Bank of Italy (BoI) The central bank of Italy.

Bank of Japan (BoJ) The Japanese central bank. Although its Policy Board is still fully in charge of the monetary policy, changes are still subject to the approval of the Ministry of Finance (MoF). The BoJ targets the M2 aggregate.

Bar chart A type of chart which consists of four significant points: the high and the low prices, which form the vertical bar; the opening price, which is marked with a little horizontal line to the left of the bar; and the closing price, which is marked with a little horizontal line to the right of the bar.

Barrier options (trigger options, cutoff options, cutout options, stop options, down/up-and-outs/ins, knockups) Options very similar to European-style vanilla options, except that a second strike price (the trigger) is specified which, when reached in the market, automatically causes the option to be expired (knockout options) or “inspired” (knock-in options).

Bearish tasuki A bearish two-day candlestick combination. It consists of a long blank bar which has a low above the 50 percent of the previous day’s long black body, and closes marginally above the previous day’s high. The second day’s rally is temporary, as it is caused only by profit taking. The sell-off is likely to continue the next day.

Bearish tsutsumi (the engulfing pattern) A bearish two-day candlestick combination. It consists of a second-day bearish candlestick whose body “engulfs” the previous day’s small bullish body.

Beige Book An economic report prepared by the Federal Reserve for FOMC meetings.

Beta The return provided by simple strategies that work over time in the currency markets, such as trend and volatility.

Bilateral grid An exchange rate system which links all of the central rates of the EMS currencies in terms of the ECU.

Black closing bozu A bearish candlestick formation which consists of a long black bar (upper shadow).

Black marubozu (shaven head) A bearish candlestick formation which consists of a long black bar (no shadow).

Black opening bozu A bearish candlestick formation which consists of a long black bar (lower shadow).

Black-Scholes fair value model The original option pricing model which holds that a stock and the call option on the particular stock are comparable investments and thus a riskless portfolio may be created by buying the stock and selling the option on the stock, as a hedge. The movement of the price of the stock will be reflected by the movement of the price of the option, but not necessarily by the same amplitude. Therefore, it is necessary to hold only the amount of the stock to duplicate the movement of the price of the option.

Blank closing bozu A bullish candlestick formation which consists of a long blank bar (lower shadow).

Blank marubozu (shaven head) A bullish candlestick formation which consists of a long blank bar (no shadows).

Blank opening bozu A bullish candlestick formation which consists of a long blank bar (upper shadow).

Bollinger bands A quantitative method which combines a moving average with the instrument’s volatility. The bands were designed to gauge whether the prices are high or low on relative basis. They are plotted two standard deviations above and below a simple moving average. The bands look like an expanding and contracting envelope model. When the band contracts drastically, the signal is that volatility will expand sharply in the near future. An additional signal is a succession of two top formations, one outside the band followed by one inside. If it occurs above the band, it is a selling signal. When it occurs below the band, it is a buying signal.

Book method Point-and-figure chart’s original name.

Breakaway gap A price gap which occurs in the beginning of a new trend, many times at the end of a long consolidation period. It may also appear after the completion of major chart formations.

Breakout of a triple high A bullish point-and-figure chart formation which suggests that the currency is likely to break a resistance line the third time it reaches it.

Breakout of a triple low A bearish point-and-figure chart formation which suggests that the currency is likely to break a support line the third time it reaches it.

Breakout of a spread triple high A bullish point-and-figure chart formation which suggests that the currency is likely to break a resistance line the third time it reaches it. The currency failed to reach the resistance line once.

Breakout of a spread triple low A bearish point-and-figure chart formation which suggests that the currency is likely to break a support line the third time it reaches it. The currency failed to reach the support line once.

Bullish tasuki A bullish two-day candlestick combination. It consists of a long black bar which has a high above 50 percent of the previous day’s long blank body, and closes marginally below the previous day’s low.

Box spread A compound option strategy which consists of four options with a common expiration date: a long call and a short put at one strike price and a long put and a short call at a different strike price.

Bullish tsutsumi (the engulfing bar) A bullish two-day candlestick combination. It consists of a second bullish candlestick whose body “engulfs” the previous day’s small bearish body.

Bundesbank The German central bank.

Business Inventories An economic indicator which consists of the items produced and held for future sale.

Butterfly spread A compound option strategy which consists of a combination of a bull spread and a bear spread, using either calls or puts.

Calendar combination A compound option strategy which consists of the simultaneous call calendar spread and put calendar spread, in which the strike price of the calls is higher than the strike price of the puts.

Calendar spread A combination option of two similar types of options, either calls or puts, with the same strike price but different expiration dates. The dissimilarity between the expiration dates allows this type of spread to capitalize on both the impact of the time decay and the interest rate differentials.

Calendar straddle A compound option strategy which consists of simultaneous buying of a longer-term straddle and near-term straddle with a common strike price.

Call ratio backspread A compound option strategy which consists of short calls with a lower strike price and more long calls with a higher strike price. The profit is twofold. The maximum upside profit potential is unlimited. The downside profit potential consists of the total premium received. The maximum loss potential occurs when the currency price reaches the higher strike price at expiration.

Candlestick chart A type of chart which consists of four major prices: high, low, open, and close. The body (jittai) of the candlestick bar is formed by the opening and closing prices. To indicate that the opening was lower than the closing, the body of the bar is left blank. If the currency closes below its opening, the body is filled. The rest of the range is marked by two “shadows”: the upper shadow (uwakage) and the lower shadow (shitakage).

Capacity utilization An economic indicator which consists of total industrial output divided by total production capability. The term refers to maximum level of output a plant can generate under normal business conditions.

Cardinal Square A Gann technique of forecasting future significant chart points by counting from the all-time low price of the currency. It consists of a square divided by a cross into four quadrants. The all-time low price is housed in the center of the cross. All of the following higher prices are entered in clockwise order. The numbers positioned in the cardinal cross are the most significant chart points.

Channel line A parallel line that can be traced against the trendline, connecting the significant peaks in an uptrend and the significant troughs in a downtrend.

Chaos theory A theory which holds that statistically noisy behavior may occur randomly, even in simple environments. This seemingly random behavior may be predicted with decreasing accuracy if the source is known.

CHIPS (Clearing House Interbank Payments System) A computerized system used for foreign exchange dollar settlements.

Christmas tree spread A compound option strategy which consists of several short options at two or more strike prices.

Classes of options The types of options: calls and puts.

Combination spread (synthetic future) A compound option strategy which consists of a long call and a short put, or a long put and a short call, with a common expiration date.

Commodity Channel Index (CCI) An oscillator which consists of the difference between the mean price of the currency and the average of the mean price over a predetermined period of time. A buying signal is generated when the price exceeds the upper (+100) line, and a selling signal occurs when the price dips under the lower (-100) line.

Commodity Futures Trading Commission (CFTC) An independent agency created by Congress in 1974 with a mandate to regulate commodity futures and options markets in the United States.

Commodity Research Bureau’s (CRB) Futures Index Index formed of commodity futures prices

Common gap A price gap which occurs in relatively quiet periods or in illiquid markets. It has a limited technical significance.

Condor spread A compound option strategy which consists of either four same-type options with a common expiration date-two long options with consecutive strike prices, one short option with an immediately lower strike price, and one short option with an immediately higher strike price; or four same type options with a common expiration date—two short options with consecutive strike prices, one long option with an immediately lower strike price, and one long option with an immediately higher strike price.

Consumer Price Index (CPI) An economic indicator which gauges the average change in retail prices for a fixed market basket of goods and services.

Consumer sentiment A survey of households designed to gauge the individual propensity for spending.

Continuation patterns Technical signals which reinforce the current trends.

Continuous Linked Settlement (CLS) A method designed to reduce and manage settlement risk within the foreign exchange market via a payment-against-payment settlement process.

Cost of carry The interest rate parity, where the forward price is determined by the cost of borrowing money in order to hold the position.

Country (sovereign) risk A trading risk emerging from a government’s interference in the foreign exchange markets.

Council of Ministers The legislative body of the European Economic Community in charge of making the major policy decisions. It is composed of ministers from all the twelve member nations. The presidency rotates every six months among all twelve members, in alphabetical order. The meetings take place in Brussels or in the capital of the nation holding the presidency.

Covered interest rate arbitrage An arbitrage approach which consists of borrowing currency A, exchanging it for currency B, investing currency B for the duration of the loan, and, after taking off the forward cover on maturity, showing a profit on the entire set of deals.

Covered long A compound option strategy which consists of selling a call against a long currency position. A covered long is synonymous with a short put.

Covered short A compound option strategy which consists of shorting a put against a short currency position. A covered short is synonymous to a short call.

Cox, Ross, and Rubinstein pricing model An option pricing model which takes into consideration the early exercise provision of the American-style options. As it assumes that early exercise will occur only if the advantage of holding the currency exceeds the time value of the option, this binomial method evaluates the call premium by estimating the probability of early exercise for each successive day. The theoretical premium is compared to the holding cost of the cash hedge position, until the option’s time value is worth less than the forward points of the currency hedge and the option should be exercised.

Credit risk The possibility that an outstanding currency position may not be repaid as agreed, due to a voluntary or involuntary action by a counterparty.

Cross rates Currencies traded against currencies other than the U.S. dollar. A cross rate is a nondollar currency.

Currency call A contract between the buyer and seller which holds that the buyer has the right, but not the obligation, to buy a specific quantity of a currency at a predetermined price and within a predetermined period of time, regardless of the market price of the currency. The writer assumes the obligation of delivering the specific quantity of a currency at a predetermined price and within a predetermined period of time, regardless of the market price of the currency, if the buyer wants to exercise the call option.

Currency futures A specific type of forward outright deal with regard to the expiration date and the size of the amount.

Currency option A contract between a buyer and a seller, also known as a writer, which gives the buyer the right, but not the obligation, of trading a specific quantity of a currency at a predetermined price and within a predetermined period of time, regardless of the market price of the currency, and the seller the obligation of delivering or buying the currency under the predetermined terms, if and when the buyer wants to exercise the option.

Currency put A contract between the buyer and the seller which holds that the buyer has the right, but not the obligation, to sell a specific quantity of a currency at a predetermined price and within a predetermined period of time, regardless of the market price of the currency. The writer assumes the obligation of buying the specific quantity of a currency at a predetermined price and within a predetermined period of time, regardless of the market price of the currency, if the buyer wants to exercise the call option.

Current account balance The broadest current dollar measure of United States trade, which incorporates services and unilateral transfers into the merchandise trade data.

Daylight position limit The maximum amount of a certain currency a trader is allowed to carry at any single time, between the regular trading hours.

Dead cross An intersection of two consecutive moving averages which move in opposite directions and which should technically be disregarded.

Dealing systems Online electronic platforms which link the contributing banks around the world on a one-on-one basis.

Delta (1) The change of the currency option price relative to a change in the currency price; (2) the hedge ratio between the option contracts and the currency futures contracts necessary to establish a neutral hedge; (3) the theoretical or equivalent share position. In this case, delta is the number of currency futures contracts a call buyer is long or a put buyer is short. Delta ranges between 0 and 1.

Descending triangle A triangle continuation formation with a flat support and a declining resistance (see Triangle).

Descending triple bottom Bearish point-and-figure chart formation which suggests that the currency is likely to break a support line the third time it reaches it. Each new bottom is lower than the previous one.

Diagonal spread A compound option strategy which consists of several same-type options, in which the long side and the short side have different strike prices and different expirations.

Diamond A minor reversal pattern which resembles a diamond shape.

Direct dealing An aggressive approach in which banks contact each other.

Directional Movement Index A signal of trend presence in the market. The line simply rates the price directional movement on a scale of 0 to 100. The higher the number, the better the trend potential of a movement, and vice versa.

Discount forward spread A forward price which is deducted from a spot price to calculate a forward price. It reflects the fact that the foreign interest rate is lower than the U.S. interest rate for that particular period.

Discount rate The interest rate at which eligible depository institutions may borrow funds directly from the Federal Reserve Banks. This rate is controlled by the Federal Reserve and is not subject to trading.

Discretion for range to trader stop-loss order A stop-loss order which gives the trader a number of discretionary pips within which the order has to be filled.

Double bottoms A bullish reversal pattern which consists of two bottoms of approximately equal size. A parallel (resistance) line is drawn against a line which connects the two bottoms. The break of the resistance line generates a move equal in size to the price difference between the average height of the bottoms and the resistance line.

Double tops A bearish reversal pattern which consists of two tops of approximately equal heights. A parallel (support) line is drawn against a resistance line which connects the two tops. The break of the support line generates a move equal in size to the price difference between the average height of the tops and the support line.

Downside tasuki gap A bearish two-day candlestick combination. It consists of a second-day blank bar which closes an overnight gap opened on the previous day by a black bar.

Downward breakout from a consolidation formation A bearish point-and-figure chart formation which resembles the inverse flag formation.

Downward breakout of a bearish support line A bearish point-and-figure chart formation which confirms the currency’s breakout of a support line the third time it reaches it.

Downward breakout of a bullish support line A bearish point-and-figure chart formation which confirms the currency’s breakout of a support line the third time it reaches it. The support line is sloped upward.

Durable Goods Orders An economic indicator which measures the changes in sales of products with a life span in excess of three years.

Economic exposure Reflects the impact of foreign exchange changes on the future competitive position of a company.

Elliott Wave Principle A system of empirically derived rules for interpreting action in the markets. It refers to a five-wave/three-wave pattern which forms one complete bull market/bear market cycle of eight waves.

Envelope model A band created by two winding parallel lines above and below a short-term moving average that borders most price fluctuations. When the upper band is penetrated, a selling signal occurs, and when the lower band is penetrated, a buying signal is generated. Since the signals generated by the envelope model are geared to be very short term and occur many times against the ongoing direction of the market, speed of execution is paramount.

Eurocurrency Currency deposit outside the country of origin.

Eurodollars U.S. dollar deposits placed in commercial banks outside the United States.

European Coal and Steel Community European entity established in 1951 by the Treaty of Paris, with the purpose of promoting inter-European trade in general and eliminating restrictions on the trade of coal and raw steel in particular. West Germany, France, Italy, the Netherlands, Belgium, Luxembourg, and Great Britain formed this community.

European Commission The executive body of the European Economic Community in charge of making, observing, and enforcing policy.

European Court of Justice The European Economic Community body in charge of settling disputes between the EC and member nations.

European currency unit A basket of the member currencies. As a composite unit, the ECU consists of all the European Community currencies, which are individually weighted. It was created by the European Monetary System with the eventual goal of replacing the individual European member currencies.

European Economic Community A community established by the Treaty of Rome in 1957, with the goals of eliminating customs duties and any barriers against the transit of capital, services, and people among the member nations. The signatories were West Germany, France, Italy, the Netherlands, Belgium, and Luxembourg.

European Joint Float Agreement European monetary system established in April 1972 by the EC members: West Germany, France, Italy, the Netherlands, Belgium and Luxembourg: Great Britain, Ireland, and Denmark were all admitted by January 1973. The agreement allowed the member currencies to move within a 2.25 percent fluctuation band (nicknamed “the snake”). As a joint group, the agreement allowed these currencies to gyrate within a 4.5 percent band (nicknamed “the tunnel”). The entire agreement was known as the snake in the tunnel.

European Monetary Cooperation Fund EMS fund established to manage the EMS credit arrangements.

European Monetary Institute (EMI) The new European Central Bank created to govern the EMS. As of March 1994 it did not have any power over inter-EMS monetary policy.

European Monetary System European monetary system established in March 1979 by seven full members: West Germany, France, the Netherlands, Belgium, Luxembourg, Denmark, and Ireland. Great Britain did not participate in all of the arrangements and Italy joined under special conditions. New members: Greece in 1981 and Spain and Portugal in 1986. Great Britain joined the Exchange Rate Mechanism in 1990. Also in 1990, West Germany became Germany as a result of its political unification with East Germany.

European Parliament The European Economic Community body in charge of reviewing and amending legislative proposals. It has the power to reject the budget proposals. It consists of 518 members who are elected and is based in Luxembourg, although its sessions take place in Strasbourg or Brussels.

European Payment Union European entity instituted in 1950 to facilitate the inter-European settlements of international trade transactions.

European-style currency option An option which may be exercised only on the expiry date.

European Union Treaty Treaty signed by the EMS members on February 1992 in the Dutch city of Maastricht, with the stated goal of a “closer union among the peoples of Europe.”

Exchange for physical (EFP) Consists of deals executed in the cash market, outside the exchanges, for amounts equivalent to the currency futures amount, on forward outright prices valued for the futures’ expiration. EFPs are generally quoted by commercial and investment banks, even during regular trading hours.

Exchange rate risk (1) Foreign exchange risk which is the effect of the continuous shift in the worldwide market supply and demand balance on an outstanding foreign exchange position. (2) Trading risk pertinent to the market fluctuation.

Exercise (strike price) The price at which the underlying currency will be delivered upon exercise.

Exhaustion gap Price gap which occurs at the top or bottom of a V-reversal formation. The trend changes direction in a rather uncharacteristically quick manner.

Expanding (broadening) triangle A triangle continuation formation which looks like a horizontal mirror image of a triangle, where the tip of the triangle is next to the original trend, rather than its base (see Triangle).

Expiry date The delivery date.

Exponentially smoothed moving average A moving average which also takes into account the previous price information of the underlying currency.

Factory orders An economic indicator which refers to the total orders of durable and nondurable goods. The nondurable goods orders consist of food, clothing, light industrial products, and products designed for the maintenance of the durable goods.

Fan lines Angled support or resistance lines plotted between the origin of a trend and the Fibonacci or Gann ratio levels.

FASB 8 (Financial Accounting Standards Board’s Statement Number 8) The original accounting rules regarding foreign exchange were standardized in 1975, which set the procedures for foreign currency translations into U.S. dollars in the consolidated balance sheets of U.S. multinational corporations.

FASB 52 (Financial Accounting Standards Board’s Statement Number 52) A complex set of rules, designed in 1981, whose main objective is to move the foreign exchange P&L from the current income into the shareholders’ equity.

Federal funds (Fed funds) Immediately available reserve balances at the federal reserves. The Fed funds are widely used by commercial banks or large corporations to lend to each other on an overnight basis.

Federal Open Market Committee (FOMC) A committee established in 1935, through the Banking Act, to replace the Open Market Policy Conference (OMPC). Currently active.

Federal Reserve The central bank of the United States. It was established in 1913, when Congress passed the Federal Reserve Act. The act held that role of the Federal Reserve was “to furnish an elastic currency, to afford the means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.”

Federal Reserve Board The board consists of a governor and four other regular members. The secretary of the treasury and the comptroller of the currency are closely consulted. The twelve regional Federal Reserve Banks around the country have sufficient autonomy to manage financial conditions in their districts. They are also managed by governors.

Fedwire An automated communications and settlement system linking the Federal Reserve Banks with other banks and with depository institutions.

Fence A compound option strategy which consists of either a long currency position, a long out-of-money put, and a short out-of-money call, where the options have the same expiration date (risk conversion); or a short currency position, a short out-of-money put, and a long out-of-money call, where the options have the same expiration date (risk reversal).

Fibonacci percentage retracements Price retracements of .382 and .618, or approximately 38 percent and 62 percent.

Fibonacci ratios 0.618 and 0.312.

Fibonacci sequence Takes a sequence of numbers which begins with 1 and adds 1 to it, takes the sum of this operation (2) and adds it to the previous term in the sequence (1). Then it takes the sum of this second operation (3) and adds it to the previous term in the sequence (the sum of the first operation, i.e., 2). The Fibonacci sequence continues iterating in this manner, adding the most recent sum to the previous term, which is itself the sum of the two previous terms, etc.

FINEX A currency market that is part of the New York Cotton Exchange.

Fisher effect A theory holding that the nominal interest rate consists of the real interest rate plus the expected rate of inflation.

Flag A continuation formation which resembles the outline of a flag. It consists of a brief consolidation period within a solid and steep upward trend or downward trend. The consolidation itself tends to be sloped in the opposite direction from the slope of the original trend, or simply flat. The consolidation is bordered by a support line and a resistance line, which are parallel to each other or very mildly converging, making it look like a flag (parallelogram). The previous sharp trend is known as the flagpole. Once the currency resumes its original trend by breaking out of the consolidation, the price objective is the total length of the flagpole, measured from the breakout price level.

Foreign exchange The mechanism which values foreign currencies in terms of another currency.

Foreign exchange brokers Intermediaries among banks who bring together buyers and sellers to the market, optimize the price they show to their customers, and do not take positions for themselves.

Foreign exchange exposure The potential effect of currency fluctuations on shareholders’ equity.

Foreign exchange rate The price of one currency in terms of another.

Forward outright Foreign exchange deal which matures at a day past the spot delivery date (generally two business days).

Forward spread (forward points or forward pips) Forward price used to adjust a spot price to calculate a forward price. It is based on the current spot exchange rate, interest rate differential, and the number of days to delivery.

Fractal geometry Geometry theory which refers to the fact that certain irregular objects have a fractal number of dimensions. In other words, an object cannot fill an integer number of dimensions.

French-West German Treaty of Cooperation A treaty, signed in 1963 by President Charles de Gaulle and Chancellor Konrad Adenauer, which established that West Germany will lead economically through the cold war, and France, the former diplomatic powerhouse, will provide the political leadership.

Fuzzy logic Method which attempts to weigh the quality of the patterns recognized by neural networks. Since not all patterns have equal financial significance for foreign currency forecasting, this method qualifies the degree of certainty of the results.

FX Market Space A platform developed by Reuters and CME to offer central clearing for cash FX trading.

Gamma The rate of change of an option’s delta, or the sensitivity of the delta.

Gann percentage retracements The Gann theory focuses mostly on the 1/8s, along with retracements in 1/3s.

Gap The price gap between consecutive trading ranges (i.e., the low of the current range is higher than the high of the previous range).

Genetic algorithms Method used to optimize a neural network. Trial and error is applied to an evolution-like system, which generates natural selection for financial forecasting purposes.

Golden cross An intersection of two consecutive moving averages which move in the same direction; it suggests that the currency will move in the same direction.

Globex An electronic trading system conceived in 1987 as an after-hours trading system and geared toward global futures trading, created through the joint venture of the Chicago Mercantile Exchange (CME), the Chicago Board of Trade (CBT), and Reuters PLC.

Gross national product The sum of government expenditure, private investment, and personal consumption.

Gross national product implicit deflator Deflator tool designed to adjust the gross national product for inflation. It is calculated by dividing the current dollar GNP figure by the constant dollar GNP figure.

Harami bar A “wait-and-see” two-day candlestick combination. It consists of two consecutive ranges having opposite directions, but it does not matter which one is first. The second day’s range results fall within the previous day’s body.

Head-and-shoulders A bearish reversal pattern which consists of a series of three consecutive rallies, where the first and third rallies (the shoulders) have about the same height and the middle one (the head) is the highest. The rallies are based on the same support line, known as the neckline. When the neckline is broken, the price target is approximately equal in amplitude to the distance between the top of the head and the neckline.

Hedging A method used to minimize or eliminate the risk of exchange rate fluctuations.

High-low band A band created by two winding parallel lines above and below a short-term moving average that borders most price fluctuations. The moving average is based on the high and low prices. The resulting two moving averages define the edges of the band. A close above the upper band suggests a buying signal and one below the lower band gives a selling signal.

Hoshi (star) A “wait-and see” two-day candlestick combination. It consists of a tiny body which appears the following day outside the original body. It is not important whether the star reaches the previous day’s shadows. The direction of the two consecutive ranges is also irrelevant.

Households survey Consists of the unemployment rate, the overall labor force, and the number of people employed.

Ichimoku Kinkou-Hyo A technical study developed by a Tokyo newspaper writer, Goichi Hosoda, before World War II as an all-inclusive forecasting method for financial markets.

Implied volatility Method of measuring volatility by considering the premiums currently trading in the market and calculating the figure based on the level of the option premium.

Industrial production An economic indicator which consists of the total output of a nation’s plants, utilities, and mines.

Initiation margin A margin paid by the trading party in order to trade currency futures. The trader’s daily loss cannot exceed the size of this margin.

Institute for Supply Management (ISM) A survey of industrial purchasing managers, conducted to gauge the changes in new orders, production, employment, inventories, and vendor delivery speed. It has two reports: one on manufacturing and one on nonmanufacturing, which was introduced in 1998.

Interest rate risk Amount of mismatches and maturity gaps among transactions in the foreign exchange book.

International Fisher effect Theory holding that investors will hold assets denominated in depreciating currencies only to the extent that the interest rates are sufficiently high to balance the expected currency losses.

International Monetary Market The major market for currency futures and options. It is a division of the Chicago Mercantile Exchange in Chicago.

In-the-money (ITM) call A call which has the present currency price higher than the strike price.

In-the-money (ITM) put A put which has the present currency price lower than the strike price.

Intrinsic value The amount by which an option is in-the-money. In the case of a call, the intrinsic value equals the difference between the underlying currency price and the strike price. In the case of the put, the intrinsic value equals the difference between the strike price and the present currency price, when beneficial.

Inverse head-and-shoulders A bullish reversal pattern which consists of a series of three consecutive sell-offs. Among the three consecutive sell-offs, the shoulders have approximately the same amplitude, and the head is the lowest. The formation is based on a resistance line called the neckline. After the neckline is penetrated, the target is approximately equal in amplitude to the distance between the top of the head and the neckline.

Irikubi A bearish two-day candlestick combination. It consists of a modified atekubi bar. All the characteristics are the same, except that the second day’s closing high is marginally higher than the original day’s low.

Island reversal An isolated range or ranges which occur at the tip of a V-formation.

ISO codes Standardized currency codes developed by the International Organization for Standardization (ISO).

J curve theory Devaluation of a currency will trigger export gains in the long term, rather than short term, because of previous contracts, existing inventories, and behavior modification.

Jittai Body of the candlestick (see Candlestick charts).

Kabuse (dark cloud cover) A bearish two-day candlestick combination. It consists of a second-day long black bar which opens above the high of the previous day’s blank bar and closes within the previous day’s range (in an uptrend).

Karakasa (hangman at the top, hammer at the bottom) A bearish candlestick at the top of the trend, bullish at the bottom of the trend. The candlestick can be either blank or black. The body of the candlestick is very small and only half of the length of the shadow.

Kenuki (tweezers) A “wait-and-see” two-day candlestick combination. It consists of consecutive bars which have matching highs or lows. In a rising market, a tweezers top occurs when the highs match. The opposite is true for a tweezers bottom.

Key reversal day When the daily price range on the bar chart of the reversal day fully engulfs the previous day’s range and the close is outside the preceding day’s range.

Kirikomi A bullish two-day candlestick combination. It consists of a blank marubozu bar which opens the second day lower (than the previous low of a long black line) and closes above the 50 percent level of the previous day’s range.

Knock-ins A plain vanilla option which does not exist until the trigger is reached.

Knockouts A plain vanilla option which goes away if the trigger is reached.

Koma (spinning tops) A reversal candlestick formation which consists of a short bar, either blank or black. This candlestick may also suggest lack of direction.

Larry Williams %R A version of the stochastics oscillator. It consists of the difference between the high price of a predetermined number of days and the current closing price, which difference in turn is divided by the total range. This oscillator is plotted on a reversed 0 to 100 scale. Therefore the bullish reversal signals will occur under 80 percent and the bearish signals will appear above 20 percent. The interpretations are similar to those discussed under stochastics.

Leading Indicators Index An economic indicator designed to offer a six- to nine-month future outlook of economic performance. It consists of the following economic indicators: average workweek of production workers in manufacturing; average weekly claims for state unemployment; new orders for consumer goods and materials (adjusted for inflation); vendor performance (companies receiving slower deliveries from suppliers); contracts and orders for plant and equipment (adjusted for inflation); new building permits issued; change in manufacturers’ unfilled orders for durable goods; change in sensitive materials prices; index of stock prices; money supply, adjusted for inflation; and the index of consumer expectations.

Line chart The line connecting single prices for each of the time periods selected.

Linearly weighted moving average A moving average which assigns more weight to the more recent closings.

Long legged shadows’ doji A reversal candlestick formation which consists of a bar in which the opening and closing prices are equal.

Long straddle A compound option which consists of a long call and a long put on the same currency, at the same strike price, and with the same expiration dates. The maximum loss for the buyer is the sum of the premiums. The upside break-even point is the sum of the strike price and the premium on the straddle. The downside break-even point is the difference between the strike price and the premium on the straddle. The profit is unlimited.

Long strangle A compound option which consists of a long call and a long put on the same currency, at the different strike prices, but with the same expiration dates. The profit is unlimited.

MI Money supply measure which is composed of currency in circulation (outside the Treasury, the Fed, and depository institutions), traveler’s checks, demand deposits, and other checkable deposits (negotiable order of withdrawal [NOW] accounts, automatic transfer service [ATS] accounts, etc.).

M2 Money supply measure which consists of M11 plus repurchase agreements, overnight eurodollars, money market deposit accounts, savings and time deposits (in amounts under $100,000, and balances in general purposes.

M3 Money supply measure which is composed of M2 plus time deposits over $100,000, term eurodollar deposits, and all balances in institutional money market mutual funds.

Margin The amount of money or collateral deposited by a customer with a broker, by a broker with a clearing member, or by a clearing member with the clearinghouse in order to insure the broker or clearinghouse against loss on outstanding futures positions.

Mark-to-market Daily cash flow system used by the United States futures exchanges to maintain a minimum level of margin equity for a specific currency future or option by calculating the profit and loss at the end of each trading day in each contract position resulting from the price fluctuation.

Matched sale-purchase agreements Daily operations executed by the Federal Reserve, in which the Fed sells a security for immediate delivery to a dealer or a foreign central bank, with the agreement to buy back the same security at the same price at a predetermined time in the future (generally within seven days). This arrangement amounts to a temporary drain of reserves.

Matching systems Electronic systems duplicating the traditional brokers’ market. A price shown by a bank is available to all traders.

Maturity date The date when a foreign exchange contract expires.

Merchandise trade balance An economic indicator which consists of the net difference between the exports and imports of a certain economy. The data includes food, raw materials and industrial supplies, consumer goods, autos, capital goods, and other merchandise.

Momentum An oscillator designed to measure the rate of price change, not the actual price level. This oscillator consists of the net difference between the current closing price and the oldest closing price from a predetermined period. The momentum is measured on an open scale around the zero line.

Moving average An average of a predetermined number of prices over a number of days, divided by the number of entries.

Moving average convergence/divergence (MACD) An oscillator which consists of two exponential moving averages (other inputs may be chosen by the trader as well) which are plotted against the zero line. The zero line represents the times the values of the two moving averages are identical. The buying signal is generated when this intersection is upward, whereas the selling signal occurs when the intersection takes place on the downside.

Moving averages oscillator An oscillator in which the values of two consecutive moving averages are subtracted from each other (the larger number of days from the previous one) and the new values are plotted.

Naked intervention (unsterilized intervention) A central bank type of intervention in the foreign exchange market which consists solely of the foreign exchange activity. This type of intervention has a momentary effect on the money supply and a long-term effect on foreign exchange.

National Futures Association (NFA) A self-regulatory organization which consists of futures commission merchants (FCMs), commodity pool operators (CPOs), commodity trading advisers (CTAs), introducing brokers (IBs), leverage transaction merchants (LTMs), commodity exchanges, commercial firms, and banks. It is responsible for certain aspects of the regulation of FCMs, CPOs, CTAs, Ibs, and LTMs, focusing primarily on qualifications and proficiency, financial conditions, retail sales practices, and business.

Netting A process which enables institutions to settle only their net positions with one another at the end of the day, in a single transaction, not trade by trade.

Neural networks Computer systems which recognize patterns. They may be used to generate trading signals or to be part of trading systems.

Neutral spread (delta neutral spread) A compound option strategy which consists of a long option position and a short option position which have their respective total delta positions relatively equal.

Next best price stop-loss order A stop-loss order which must be executed after the requested level is reached.

Nonfarm payrolls survey Survey of the payroll, workweek, hourly earnings, and total hours of employment in the nonfarm sector.

Nostro account (clearing account) The account for each foreign currency in the country of origin maintained by the financial institutions for purchase and receiving (P&R) purposes.

Open interest The total outstanding position in a currency.

Open Market Investment Committee (OMIC) Committee established in 1923 in order to coordinate the Reserve Bank operations. It was composed of the governors of the Federal Reserve Banks in New York, Boston, Philadelphia, Chicago, and Cleveland. Not currently active.

Open Market Policy Conference (OMPC) Committee established in 1930 to replace the OMIC. It consisted of twelve Federal Reserve Bank governors and the members of the board. Not currently active.

Optimal options Options which refer to the most favorable rate of the underlying that existed (from the holder’s perspective) during the life of the option. This rate becomes the strike in the case of optimal strike options, or it becomes the underlying, determining the intrinsic value when compared to a predetermined fixed strike in the case of optimal rate options. Optimals can be based on the spot rate (spot style) or the forward rate (forward style).

Option currency spread A long currency option and an offsetting short currency option, generally in the same currency.

Option writers Option sellers.

Out-of-the-money (OTM) call A call whose present currency price is lower than the strike price.

Out-of-the-money (OTM) put A put which has the present currency price higher than the strike price.

Overnight position limit A position kept overnight by traders.

Oscillators Quantitative methods designed to provide signals regarding the overbought and oversold conditions.

Parabolic system A stop-loss technical system, based on price and time devised for trending markets.

Pennants A continuation formation which resembles the outline of a pennant. It consists of a brief consolidation period within a solid and steep upward or downward trend. The consolidation itself tends to be sloped in the opposite direction from the slope of the original trend, or simply flat. The consolidation is bordered by a support line and a resistance line, which converge, creating a triangle. The previous sharp trend is known as the pennant pole. Once the currency resumes its original trend by breaking out of the consolidation, the price objective is the total length of the pole, measured from the breakout price level.

Personal income An economic indicator which consists of the income received by individuals, nonprofit institutions, and private trust funds. Some of the components of this indicator are wages and salaries, rental income, dividends, interest earnings, and transfer payments (Social Security, state unemployment insurance, and veteran benefits).

Philadelphia Stock Exchange (PHLX) The oldest U.S. securities exchange which offers currency futures and options on currency futures.

Point-and-figure chart A type of chart which plots price activity without regard to time. When the currency moves up, the fluctuations are marked with Xs. The moves on the downside are plotted with Os. The direction on the chart will change only if the currency reversed by a certain amount of pips.

Premium The price of the option paid by the buyer to the seller.

Premium forward spread Forward price which is added to a spot price to calculate a forward price. It reflects the fact that the foreign interest rate is higher than the U.S. interest rate for that particular period.

Prime rate The rate that the commercial banks charge customers, which is based on the discount rate.

Producer Price Index (PPI) An economic indicator which gauges the average changes in prices received by domestic producers for their output at all stages of processing.

Purchasing power parity (PPP) Model of exchange rate determination stating that the price of a good in one country should equal the price of the same good in another country, exchanged at the current rate (the law of one price).

Put ratio backspread A compound option strategy which consists of short puts with a higher strike price and more long puts with a lower strike price. The profit is twofold. The maximum upside profit potential consists of the total premium received. The downside profit potential is unlimited. The maximum loss potential occurs when the currency price reaches the lower strike price at expiration.

Put-call-forward exchange parity (PCFP) theory A relationship between a call option and a put option established through the forward market. The theory holds that the option of buying the domestic currency with a foreign currency at a certain price X is equivalent to the option of selling the foreign currency with the domestic currency at the same price X. Therefore, the call option in the domestic currency becomes the put option in the other, and vice versa.

Random walk theory An efficient market hypothesis stating that prices move randomly versus their intrinsic value. Therefore, no one can forecast market activity based on the available information.

Rate of change A momentum oscillator in which the oldest closing price is divided into the most recent one.

Ratio call spread A compound option strategy which consists of a number of long calls with lower strike prices and a larger number of short calls with a higher strike price. The maximum profit is realized when the currency price is at the higher strike price. This combination has two break-even points. The downside break-even point consists of the sum of the lower strike price and the debit, divided by the number of long calls. The upside break-even point consists of the sum of the higher strike price and the maximum profit potential, divided by the number of naked calls. The maximum loss is twofold. The maximum downside risk is the net premium. The upside risk is unlimited.

Ratio put spread A compound option strategy which consists of a number of long puts with higher strike prices and a larger number of short puts with a lower strike price. The maximum profit is realized when the currency price is at the lower strike price. This combination has two break-even points. The downside break-even point consists of the difference between the lower strike price and the maximum profit potential, divided by the number of naked puts. The upside break-even point consists of the difference between the higher strike price and the debit, divided by the number of long calls. The maximum loss is also twofold. The maximum downside risk is unlimited. The upside risk is the net premium.

Ratio spread A compound option strategy in which the number of long options is different from the number of short options.

Rectangle A continuation formation which resembles the outline of a parallelogram. The price objective is the height of the rectangle.

Regulation Q Regulation passed by the Federal Reserve which prohibited payment of interest on demand deposits and prescribed maximum rates banks pay on time deposits. These ceilings had been imposed since 1933 by the United States government. The regulation is not currently in effect.

Relative Strength Index An oscillator that measures the relative changes between the higher and lower closing prices.

Replacement risk A form of credit risk which holds that counterparties of failed banks will find their books unbalanced to the extent of their exposure to the insolvent party. In order to rebalance their books, these banks must enter new transactions.

Repurchase agreements (repos) Daily operations executed by the Federal Reserve. A repurchase agreement between the Federal Reserve and a government securities dealer consists of the Fed’s purchasing a security for immediate delivery, with the agreement to sell the same security back at the same price at a predetermined date in the future (usually within fifteen days). It amounts to a temporary injection of reserves in the banking system.

Resistance level The peaks representing the price level where the supply exceeds the demand.

Reversal patterns Patterns that occur at the end of the trend, signaling the trend change.

Rollover (tomorrow/next, or tom/next) swap A swap designed for spot trades’ maintenance. It was designed to change the old spot date to the current spot date (on the front office’s side) and to enable the bank to make the payments to the counterparty (on the back office’s side).

Rounded bottom A bullish reversal pattern which consists of a very slow and gradual change in the direction of the market.

Rounded top (saucer) A bearish reversal pattern which consists of a very slow and gradual change in the direction of the market.

Runaway or measurement gap A price gap which occurs within solid trends. It is also called a measurement gap because it tends to occur about midway through the life of a trend.

Sangu (three gaps) A reversal candlestick method applicable in either a steeply rising or falling market, where the daily limits will break the trading. The theory holds that after the third gap, the market will reverse at least to the second gap.

Sanpei (three parallel bars) A reversal candlestick combination. It refers to the similarity of direction and velocity of three consecutive bars, as otherwise all the entries are parallel. They generate a reversal formation after an extended rally. When bullish, the formation is known as the “three soldiers.” When bearish, the name is the “three crows.”

Sanpo (three methods) A candlestick combination which advises that retracements are in order before the market will reach new highs and new lows.

Sansen (three rivers) method A reversal candlestick combination. It consists of three daily entries. The first day is a long blank bar (a bullish move), followed by a bullish but short-range one-day island, and ending with a bearish long black line.

Sanzan (three mountains) A reversal candlestick combination. It consists of a triple-top formation.

Sashikomi A bearish two-day candlestick combination. It consists of a modified irikubi bar. The difference is that the opening of the second day’s blank bar is much lower than that of the irikubi bars. Despite the wider gap thus formed, the blank candlestick closes only just above the previous day’s low.

Settlement risk A form of credit risk which may occur due to the time zones separating the nations. Payment may be made to a party which will declare insolvency (or be declared insolvent, whatever the case may be) immediately after receipt, but prior to executing its own payments.

Shitakage Lower shadow of the candlestick (see Candlestick charts).

Short straddle A compound option which consists of a short call and a short put on the same currency, at the same strike price and with the same expiration dates. The maximum profit consists of the combined premium of the two individual options. The loss occurs once the level of the premium is overpassed by the currency swing, and is unlimited.

Short strangle A compound option which consists of a short call and a short put on the same currency, with the same expiration dates, but with different strike prices. The maximum profit consists of the combined premium of the two individual options. The loss is unlimited.

Simple moving average or arithmetic mean An average of a predetermined number of prices over a number of days, divided by the number of entries.

Slow stochastics A version of the original stochastic oscillator. The new slow %K line consists of the original %D line. The new slow %D line formula is calculated off the new %K line.

Snake The nickname of the European Joint Float Agreement’s 2.25 percent fluctuation band of the European currencies against each other, due to its curvaceous movement.

Spot deal A foreign exchange deal which consists of a bilateral contract between a party delivering a certain amount of a currency against receiving a certain amount of another currency from a second counterparty, based on an agreed exchange rate, within two business days of the deal date. The exception is the Canadian dollar, in which the spot delivery is executed within one business day.

Spot next (S/N) A foreign exchange deal which matures one business day past the spot date (T+1), or three business days.

Square of 9 An ancient method that Gann took to the next level in order to obtain support and resistance levels in terms of both price and time.

Sterilized intervention A central bank type of intervention in the FX market which consists of sales of government securities to offset reserve injections. The money market activity sterilizes the impact of the foreign exchange intervention on the money supply. Sterilized interventions have a short- to medium-term effect.

Stochastics An oscillator which consists of two lines called %K and %D on a 1 to 100 scale that signals directional changes in normal markets.

Straight Through Processing (STP) A method that enables the entire FX processing and payment transactions to be conducted electronically without reentering the data manually.

Strike price See Exercise (strike price).

Support level The troughs representing the level where the demand exceeds the supply.

Swap deal A foreign exchange deal which consists of a spot deal and a forward outright deal. A party simultaneously buys and sells (or sells and buys) the same amount of a currency with the another counterparty, where the two legs of the transaction mature on different dates (one of the dates being the spot date) and are traded at different exchange rates (one of the exchange rates being the spot rate). Exceptions may be made with regard to the value dates (forward-forward) and amount (different amounts).

SWIFT (Society of Worldwide Interbank Financial Telecommunications) An automated system set up to send standardized payment instructions for foreign currencies among international banks.

Swing Index (SI) A momentum oscillator which is plotted on a scale of −100 to +100. The spikes reaching the extremes suggest reversal.

Symmetrical triangle A triangle continuation formation in which support and resistance lines converge (see Triangle).

Synthetic call option A combination of a long currency and a long currency put.

Synthetic put option A combination of a short currency and a long currency call.

Tankan economic survey The Japanese equivalent of the Fed’s Beige Book which is released by the Bank of Japan. The survey is released on a quarterly basis.

Technical analysis The chart study of past behavior of commodity prices for forecasting their future performance.

Theory of elasticities A model of exchange rate determination stating that the exchange rate is simply the price of foreign exchange which maintains the BOP in equilibrium. The degree to which the exchange rate responds to a change in the trade balance depends entirely on the elasticity of demand to a change in price.

Theta (T) or time decay Occurs as the very slow or nonexistent movement of the currency triggers losses in the option’s theoretical value.

Three Buddha top formation A candlestick reversal combination. It consists of a head-and-shoulders formation, or three consecutive rallies in which the first and the third are of approximately the same height, and the second is the highest.

Threshold of divergence A safety feature for the EMS which provides an emergency exit for member currencies. The threshold of divergence indicates when the specific country with the pressured currency should take additional steps other than simple central bank intervention in the foreign exchange markets.

Time decay See Theta.

Time value (time premium or extrinsic value) The difference between the option premium and its intrinsic value.

Tomorrow/next (T/N) deal A foreign exchange deal which matures the next business day, or one day prior to the spot date.

Tonbo (dragonfly) A candlestick reversal formation.

Tohbu (gravestone doji) A candlestick reversal formation.

Traditional (Charles Dow) percentage retracements Occur at 33 percent, 50 percent, and 67 percent.

Transaction exposure Potential profit and loss generated by current foreign exchange transactions.

Translation exposure The risk of change of the consolidated corporate earnings as a result of past volatility in the base currency.

Trend The general direction of the market, as shown by the significant peaks and troughs of the currency fluctuations.

Trendline A straight line connecting the significant highs (peaks) in a downtrend, and the significant lows (troughs) in an uptrend.

Triangles A continuation formation which resembles the outline of a pennant, but without the pole. It consists of a brief consolidation period within a solid and steep upward or downward trend. The consolidation is bordered by converging support and resistance lines, making it look like a triangle. The price objective is the height of the triangle, measured from the breakout price level.

Triple bottom A bullish reversal pattern which consists of three bottoms of approximately equal heights. A parallel—resistance—line is drawn against a line which connects these tops. The break of the resistance line generates a move equal in size to the price difference between the average height of the bottoms and the resistance line.

Triple top A bearish reversal pattern which consists of three tops of approximately equal heights. A parallel—support—line is drawn against a resistance line which connects these tops. The break of the support line generates a move equal in size to the price difference between the average height of the tops and the support line.

Trix Index An oscillator that consists of a one-day ROC calculation of a triple exponentially smoothed moving average of the closing price.

Tunnel The nickname of the European Joint Float Agreement’s total fluctuation band of the European currencies.

Unemployment rate An economic indicator released as a percentage which is calculated as the ratio between the difference of the total labor force and the employed labor force, divided by the total labor force.

Upside gap tasuki Bullish two-day candlestick combination. It consists of a second-day black bar which closes an overnight gap opened on the previous day by a blank bar.

Upward breakout from a consolidation formation Bullish point-and-figure chart formation which resembles the flag formation. A valid upside breakout from the consolidation formation has a price target equal in size to the length of the previous uptrend.

Upward breakout of a bearish resistance line Bullish point-and-figure chart formation which confirms the currency’s breakout of a resistance line the third time it reaches it. The resistance line is sloped downward.

Upward breakout of a bullish resistance line Bullish point-and-figure chart formation which confirms the currency’s breakout of a resistance line the third time it reaches it.

USDX Currency index which consists of the weighted average of the prices of some foreign currencies against the U.S. dollar.

Uwakage Upper shadow of the candlestick (see Candlestick charts).

Value at risk The expected loss from an adverse market movement, with a specified probability over a particular period of time.

Variation (maintenance) margin Margin paid by the trading party in order to fully cover any unrealized loss. Any trader holding an overnight position with a negative P&L must post it in cash. It must be kept on deposit at all times.

Vega The sensitivity of the theoretical value of an option to a change in volatility.

Velocity of money The rate at which money is turning over on an annual basis to facilitate income transactions.

Vertical bear call spread A compound option strategy of two options with a common expiration date, where one option is a short call with a lower strike price and the other is a long call with a higher strike price. The seller’s maximum profit is limited to the premium paid for the two options. The break-even point is calculated as the sum of the lower strike price and the total premium. The maximum loss consists of the dollar difference between the two strike prices, minus the total premium received.

Vertical bear put spread A compound option strategy of two options with a common expiration date, where one option is a long put with a higher strike price and the other is a short put with a lower strike price. The buyer’s maximum profit consists of the dollar difference between the two strike prices, minus the total premium paid. The break-even point is calculated as the difference between the higher strike price and the total premium. The maximum loss is limited to the premium paid for the two options.

Vertical bear spread An option combination whose theoretical value will decline to a predetermined maximum profit if the price of underlying currency declines and whose maximum loss is also predetermined.

Vertical bull call spread A compound option strategy of two options with a common expiration date, where one option is a long call with a lower strike price and the other is a short call with a higher strike price. The buyer’s maximum profit consists of the dollar difference between the two strike prices, minus the total premium paid. The break-even point is calculated as the sum of the lower strike price and the total premium. The maximum loss is limited to the premium paid for the two options.

Vertical bull put spread A compound option strategy of two options with a common expiration date, where one option is a long put with a lower strike price and the other is a short put with a higher strike price. The buyer’s maximum profit consists of the net premium paid for the two options (one paid, the other received). The break-even point is calculated as the difference between the higher strike price and the total premium received. The maximum loss is limited to the dollar difference between the two strike prices, minus the total premium received.

Vertical bull spread An option combination whose theoretical value will rise to a predetermined maximum profit if the price of underlying currency rises and whose maximum loss is also predetermined.

Vertical spread A compound option which consists of two similar options (i.e., calls or puts), one being bought and the other sold, on the same currency with the same expiration date, but with different strike prices.

V-formations (spikes) Reversal formation which shows sudden trend changes and is accompanied by a heavy trading volume. This pattern may include a key reversal day, or an island reversal and an exhaustion gap.

Volatility The degree to which the price of currency tends to fluctuate within a certain period of time.

Volume The total amount of currency traded within a period of time, usually one day.

Vostro account A nostro account from the point of view of the counterparty.

Wedges A continuation formation which resembles the outline of a pennant, but without the pole. It consists of a brief consolidation period within a solid and steep upward or downward trend. The consolidation is sharply angled in the opposite direction from the slope of the original trend. The consolidation is bordered by a support line and a resistance line which converge, making it look like a sharply angled triangle. Once the currency resumes its original trend by breaking out of the consolidation, the price objective is the height of the wedge, measured from the breakout price level.

Bibliography

Bank for International Settlements. “Central Bank Survey of Foreign Exchange Market Activity in April 1992.” Basle, March 2005.

Bergstrand, Jeffrey H. “Selected Views of Exchange Determination after a Decade of ‘Floating.’ “New England Economic Review, Federal Reserve Bank of Boston, May/June 1983.

Frost, A. J., and Prechter, Jr., Robert R. Elliott Wave Principle, 5th ed. New Classics Library, 1985.

Levich, Richard. Empirical Studies of Exchange Rates: Price Behavior, Rate Determination and Market Efficiency—Handbook of International Economics. Elsevier Science Publishers B.V., 1985.

Luca, Cornelius. Introduction to Technical Analysis. Euromoney/DC Gardner, 1997.

Luca, Cornelius. Technical Analysis Applications in the Global Currency Markets. Prentice Hall, Inc., 1997.

Luca, Cornelius. Trading in the Global Currency Markets, 1st ed. Prentice Hall, Inc., 1995.

Luca, Cornelius. Trading in the Global Currency Markets, 2nd ed. Prentice Hall, Inc., 2000.

Luca, Cornelius. Technical Analysis Applications. McGraw-Hill, Inc., 2005.

Meulendyke, Ann-Marie. “U.S. Monetary Policy and Financial Markets.” Federal Reserve Bank of New York, 1989.

Murphy, John J. Technical Analysis of the Futures Markets. New York Institute of Finance, 1986.

Plocek, Joseph E. Economic Indicators. New York Institute of Finance, 1991.

Pring, Martin J. Martin Pring on Market Momentum. International Institute for Economic Research, Inc., 1993.

Samuelson, Paul A. Economics, 11th ed. McGraw-Hill Book Company, 1980.

Shimizu, Seiki. The Japanese Chart of Charts. Tokyo Futures Trading Publishing Co., 1986.

Stigum, Marcia. After the Trade: Dealer and Clearing Bank Operations in Money Market and Government Securities. Dow Jones-Irwin, 1988.

Sutton, W. H. Trading in Currency Options. New York Institute of Finance, 1987.

CHART SERVICES

CQG Inc., Independence Plaza, 1050 17th St., Suite 2000, Denver, CO 80265 www.cqg.com/

Index

Accord Netting Service reports, 102

Accumulation Swing index (ASI), 403

ACK, positive acknowledgment, SWIFT, 98

Adenauer, Konrad, 26

ADRI, see Average Directional Movement Index (ADRI)

advisory bilateral foreign exchange netting service, 100–101
alpha, defined, 6

American or European option style, as factor in theoretical model of currency options pricing, 186, 203–204

American-style option, defined, 202

Appel, Gerald, 398
arbitrage:

with currency futures, 165
in futures markets, 174
arcs, in technical analysis, 301

Argentinian financial crisis of 2001–2002, 24
ascending triangle, 330
ascending triple-high formation, 347

ASI, see Accumulation Swing index (ASI)

“Asian flu,” 24

Asian market crisis in 1997–1998, 23–24
at best stop-loss order, 83
atekubi, 365, 366, 367
at the price stop-loss order, 82
at-the-money, in currency option pricing, 191
example, 191–192
aussie, as nickname, 43

Australia, as major foreign exchange market, 50

Australian dollar, contract size, in futures market, 170
auto sales, as economic indicator, 260
autos, as category of merchandise trade balance, 258

Average Directional Movement Index (ADRI), 405
average options, 237–238
average weekly claims for state unemployment, as leading indicator, 260
average workweek of production workers in manufacturing, as leading indicator, 260

Babylonian bills and receipts, 13
back office, role of, 94–96
balance of payments, as economic indicator, 257–258

Bank for International Settlements:

establishment of, 14
on forward currency market, 128
role of, in futures markets, 176

Bank of Canada, functions, 75

Bank of England:

and EMS crisis of 1992–1993, 32–33
functions, 75

Bank of Italy, and switch of currency reserves, 22

Bank of Japan, functions, 75
banking cooperative, defined, 101
banks, as participants in spot market, 119
bar chart, 278, 279–280
barrier options, 231–232, 235–236
bear market, as phase of market in Gann analysis, 408
bearish candlestick, 359
signals, 365–369
bearish engulfing pattern, 365, 369
bearish flag, 324
bearish pennant, 327, 328
bearish rectangle, 334
beta, defined, 6
bilateral grid, 30

Black-Scholes formula, in option pricing, 203–205

Bollinger bands, 386
bottoming bear market, as phase of market in Gann analysis, 408
box spread, as options strategy, 214, 223
bozu:

bearish, 359
bullish, 358
long bearish, 366
breakaway gap, 338–339
breakout:

spread triple high, 346
spread triple low, 346–347
triple high, 344, 345
triple low, 344, 345
breakouts, in technical analysis, 291

Bretton Woods Accord, 14–18
effect on Europe after World War II, 26
exchange rate determination after, 244–245
failure of, 18, 26

British Bankers’ Association, 59

British pound, see pound
brokers:

as participants in spot market, 119
point of view, 93
brokers’ market, currency, 108–111
buck, as nickname, 43
buffer stock financing facility of IMF, 17
bull market, as phase of market in Gann analysis, 408
bullish candlestick, 358
signals, 363–365
bullish crossover, and relative strength, 391
bullish engulfing candlestick, 363, 364, 365, 368
bullish flag, 324
bullish pennant, 326, 327
bullish rectangle, 334

Bundesbank, role of, in EMS crisis of 1992–1993, 33

Bush—Gore election, effect of, on exchange rates, 268
business internationalization, as factor in growth of FX market, 6
business inventories, as economic indicator, 254
butterfly spread, as a options strategy, 214, 223–224
buying call, as strategy, 207–208
buying in foreign exchange, 79
buying put, as strategy, 211
buying signal, in MACD, 398
buying synthetic call option, as strategy, 208–209
buying synthetic put option, as strategy, 212
cable, as nickname, 43
calendar spread, as a options strategy, 214, 222–223
call or put, as factor in theoretical model of currency options pricing, 186, 201–202
call ratio backspreads, 226, 339
call:

buying, as strategy, 207–208
defined, 201
selling, as strategy, 209–210

Canadian dollar, contract size, in futures market, 170

Canadian Foreign Exchange Committee, 59
candlestick charting, 356–376
benefits, 356–357
candlestick chart, 278, 281–282
capacity utilization, as economic indicator, 253
capital goods, as category of merchandise trade balance, 258

Cardinal Square, as feature of Gann analysis, 408, 418–419
carry (yield) as beta, 6
cash date, in forward market, 138
cash market, compared to futures market, 167–169
cash transactions, defined, 116

CBOE Futures Exchange, role of, in futures markets, 176

CCI, see Commodity Channel Index (CCI) central banks, 67–75
as participants in spot market, 119
as players in foreign exchange markets, 52
role of, 67

CESR, see Committee of European Securities Regulators (CESR)

CFTC, see Commodity Futures Trading Commission (CFTC)

change in currency option price, in currency option pricing, 187
change in manufacturers’ unfilled orders, durable goods, as leading indicator, 261
change in sensitive materials prices, as leading indicator, 261
channel line, in technical analysis, 294–296
charts in technical analysis, 278–283

Chicago Board of Trade, role of, in futures markets, 176

Chicago Climate Futures Exchange, role of, in futures markets, 176

Chicago Mercantile Exchange Clearinghouse, 165

Chicago Mercantile Exchange, 163, 164
currency options trading on, 181
in futures markets trading, 171
role of, in regulating futures markets, 176

Chiku, 387, 389–390

China, and currency reserves, 22

CHIPS, see Clearing House Interbank Payments System

Christmas trees, 226, 230
classic chart formations in point-and-figure charting, 351–353

Clearing Corporation, role of, in regulating futures markets, 177

Clearing House Interbank Payments System (CHIPS), 102
clearinghouse, role of, 63

Clinton—Lewinsky affair, effect of, on exchange rates, 267
closing price on bar chart, 279–280

Cloud, 390, 391

CLS, see Continuous Linked Settlement (CLS)

CLSB, see Coninuous Linked Settlement Bank

CME Clearing House, role of, in regulating futures markets, 177

CME’s Globex, 110
combination spread, as a options strategy, 214, 225–226
combined structures, in Elliott Wave Theory, 429, 434–436
commercial and investment banks, as players in foreign exchange markets, 51

Committee of European Securities Regulators (CESR), role of, in futures markets, 176

Commodity Channel Index (CCI), 402–403

Commodity Futures Trading Commission (CFTC), 175

Commodity Futures Trading Commission’s warning signs, 52–53

Commodity Fuures Modernization Act of 2000, 175

Commodity Research Bureau’s (CRB) Index, as economic indicator, 255, 256–257

Common Foreign and Security Policy, 28
common gap, 337–338
compensatory financing facility of IMF, 17
compounding foreign exchange risk, 56
computer-based terminal, 97
condor spread, as a options strategy, 214, 225
consolidation, in flag formation, 323–324
construction data, as economic indicator, 254–255
construction spending, as economic indicator, 254
consumer goods, as category of merchandise trade balance, 258
consumer price index (CPI), as economic indicator, 255, 256
consumer sentiment, as economic indicator, 260
consumer spending indicators, as economic indicators, 259–260
consumption spending, as economic indicator, 252
continuation patterns, defined, 307

Continuous Linked Settlement (CLS), 104–105

Continuous Linked Settlement Bank (CLSB), 104
contract size, in futures markets, 170–171
contract specifications, in currency options trading, 183–185
contracts and orders for plant and equipment (adjusted for inflation), as leading indicator, 261
convergence tests for ERM members, 32
convergence, as buzzword, 39

Cooner, Paul, 275
corporate hedging:

increase in, as factor in growth of FX market, 6, 8
use of average options in, 237
use of knockouts in, 232–233
use of optimals in, 236
corporate traders, point of view, 93
corporations, point of view, 93
corporations:

as players in foreign exchange markets, 53, 84–93
types of, 85
corrective waves, in Elliot Wave Theory, 429–430

Council of the European Union, 28
country risk, 64–65
cover short spread, 231
covered interest rate arbitrage, 151–152
example, 151–152
covered long spread, 231

CPI, see consumer price index (CPI)

credit risk, 63–64
defined, 63

forms of, 63–64
credit tranche of IMF, 16
crises:

Argentinian financial crisis of 2001–2002, 24

Asian market crisis in 1997–1998, 23–24

EMS crises of 1992–1993, 32–34

Exchange Rate Mechanism crisis, 14

Mexican crisis of 1994, 23
cross foreign currency marketplace, 153–154
cross rate, 154–155
in currency crosses, 156
crossover trading signals, 381–385
buying signal, 381–383
selling signal, 381–383
currency:

characteristics of, 43–54
gold standard, suspension of, 14
pegging, 15
volatility of, in hedging, 89
currency blocks, 20–21
free-floating foreign exchange markets, 20–22
currency call, 201–202
currency crosses, 153–162
advantages. 154–155
examples of pricing, 156, 157–158
most popular, 154
price calculation, 156–159
relative strength, 159
trading, 159–160
currency forward outright deals, 142–143
characteristics, 165–166
example, 143
currency futures, 163–177
example of pricing, 167
marketplace, 163–164
options on, 181–182
pricing, 166–167
currency options, 178–206
benefits of trading, 179–181
currency of, 178–179
marketplace, 181–185
new directions, 238–239
premium, 185–186
pricing, 203–206
strategies, 207–238
theoretical models, 186–203
currency put, 202
currency reserves, 21–22
switch in, effect of, on exchange rates, 270
currency spreads, as a options strategy, 214
currency swaps, 143–147
curvature, in currency option pricing, 189
cutoff options, see barrier options
cutout options, see barrier options
cyclical analysis, 303–305

%D, 395, 396, 397
daily black candlesticks 359–360
daily line chart, 279
daily white candlesticks, 358
dark cloud cover, 365, 366, 367

Day (Session) order, in futures markets, 171
daylight position limit, 56–57
de Aspilcueta Navarro, Martin, 245
de Gaulle, Charles, 26
dead cross, 383, 384
dealing systems, 112
declining trendline, in technical analysis, 290
delivery versus payment (DVP), 103
delta, in currency option pricing, 187
descending triangle, 330, 331
diagonal ratio spreads, 226, 230
diagonal triangles, in Elliot Wave Theory, 425–426
diamond formation, 320, 321–322
direct dealing, 111–112

Directional Movement Index (DRI), 405–407
discount forward spread, 151
discount rate, 70
discount spread, 131, 133
example, 133
pricing, 146–147
discretion for range stop-loss order, 82–83

Division of Clearing and Intermediary Oversight (CFTC), 175

Division of Enforcement (CFTC), 175–176

Division of Market Oversight (CFTC), 175
doji, 360, 361
double bottoms, 307, 315–316
in point-and-figure charting, 352–353
double tops, 307, 312–315
in point-and-figure charting, 352–353
potential problems, 314–315
signals generated by, 313–314

Dow ratios, compared to Gann geometric ratios, 413

Dow Theory, 287

Dow, Charles, 287
and retracement lines, 297

Dow’s six principles, 287
down/up-and-outs/ins, see barrier options
downtrend in equity markets, as factor in growth of FX market, 6, 8
downward breakout:

of bearish support line, 348, 349
of bullish support line, 350
downward trend, in technical analysis, 286
dragonfly, in candlestick charting, 361

DRI, see Directional Movement Index (DRI)

durable goods orders, as economic indicator, 254

DVP, see delivery versus payment
dynamic hedging, in currency option pricing, 187–188
early exercise of American-style options, 202–203

EBS Prime, 108

EBS, 110

ECB, see European Central Bank

ECI, see Employment Cost Index (ECI)

ECNs, see Electronic Communications Networks (ECNs)

economic divergence, as problem in new century, 39
economic exposure, 86–887
economic fundamentals, 243–244
economic indicators, 250–252
economic uncertainty, and foreign exchange, 4

ECU, see European Currency Unit

EFP, see exchange for physical (EFP)

Egyptian coins, 13
electronic brokers, in brokers’ market, 109–110

Electronic Communications Networks (ECNs), 107
electronic matching systems, 110
electronic platform trading, 106–108

Electronic Streaming Prices (ESP), 107

Elliott Wave Principle, 421–423

Elliott Wave Principle: Key to Stock Market Profits (Frost and Prechter), 438

Elliott Wave, 421–438

Elliott, Nelson, 421

EMA, see exponential moving average (EMA)

Employment Cost Index (ECI), as economic indicator, 259
employment indicators, as economic indicator, 258–259

EMS crises of 1992–1993, 23, 32–34

EMS, see European Monetary System

EMU, see European Monetary Union
encryption, SWIFT, 98
end-of-month value dates, 139–141
end-of-month-end-of-month rule, 139

EnergyClear, role of, in regulating futures markets, 177
envelope model, 385
euro:

contract size, in futures market, 170
as currency block, 20
effect of, on pound, 48
emergence of, 34–35
impact of, on foreign exchange market, 39–40
introduction of, 24, 25
as second currency of resort, 46–47
transition to, 35–36

Eurodollars:

term coined, 71
defined, 70

European Central Bank (ECB):

functions, 73–74
monetary functions and operations of, 38
monetary policy instruments of, 38
organization of, 37–38

European Commission, 28

European Court of Auditors, 28

European Court of Justice, 28

European Currency Unit (ECU):

defined, 29
functions of, 29–30

European Defense Community, 26

European Economic Community:

goals of, 25
start of, 19

European Joint Float, 19, 26
demise of, 20

European Monetary Institute (EMI), 37

European Monetary System (EMS), 19–20
failure of, 18
organization of, 29–33
performance of, 30
and semipegging, 21

European Monetary Union, 25–20, 31
provisions and rights, 36
history, 25–27
organization, 28

European Parliament, 28

European Payment Union, 26

European System of Central Banks (ESCB), 37
objectives and tasks, 37–38
organization of, 38

European-style option, defined, 202

Eurozone, 24, 25, 26
defined, 36
and euro, 46
evening Southern cross, 374
exchange for physical (EFP), 174–175
exchange rate determination, theories of, 244–250

Exchange Rate Mechanism crisis, 14, 33

Exchange Rate Mechanism, 29
and pound, 48
exchange rate risk, 55–61
ranging with currency options, 181
examples, 194–195
exchange rate volatility, theories on, 249
exchange risk management implementation, 61
exhaustion gap, 340
exotic options, 231–237
expanded flat, 432
expanding (broadening) triangle, 331–332
expiration date, as factor in theoretical model of currency options pricing, 186, 199–200
exponentially smoothed moving average, 378, 379
exponential moving average (EMA), 379
exposure, in foreign exchange, 85–88
extended facility of IMF, 17
extension analysis, 303
extensions, in Elliot Wave Theory, 424–425
extrinsic (time) value, 194
factory goods orders, as economic indicator, 253
failures, in Elliot Wave Theory, 428–436
falling wedge, 332, 333
false breakouts, in continuation patterns, 335
fan lines:

in Gann analysis, 411–413
in technical analysis, 300–301

FASB 52, and translation exposure in foreign exchange, 88

FASB 133, and hedging, 89

Fed, see Federal Reserve
federal funds, 69

Federal Open Market Committee (FOMC), 68

Federal Reserve, 67–69
history, 67–68
general role of, 20, 45
monitoring of CLSB, 104
role of, in foreign exchange, 69–74

Federal Reserve Act, 67

Federal Reserve Board, 67

Fedwire, explained, 103
fence, 231–232

Fibonacci analysis, 436–438

Fibonacci ratio:

compared to Gann geometric ratios, 413
defined, 435
in extension analysis, 303
and fan lines, 300
and retracement lines, 297

Fibonacci sequence, defined, 436

Fibonacci spiral, in Square of 9, 416

Fill and Kill (FAK) orders, in futures markets, 172

Fill or Kill (FOK) orders, in futures markets, 172

FIN, see Financial Transaction
financial influences on exchange rates, 264–267
financial messages, SWIFT, defined, 97

Financial Transaction (FIN), 97

Financial World, 421

FINEX, 164
in currency options trading, Fisher effect, 248
five wave/three wave pattern, in Elliot Wave Principle, 421–424
flags, 323–326
in point-and-figure charting, 353, 354
flat market, in currency options, 179–180
flats, 429, 430–433

FlexTrade, 107
floor brokers, in futures markets, 172
floor traders, in futures markets, 172
food, as category of merchandise trade balance, 258
forecasting, 241–270

Foreign Exchange Committee, 59

Foreign Exchange Trading Operations Department, 94
foreign exchange:

basis for, 1–10
buying, 79
development of, 13–24
free-floating, 20–22
execution in, 91–92
exposure in, 85–88
general characteristic, 5
history, 11–40
leave orders, 79–80
major markets, 49–50
operations by the Federal Reserve, 72–74
participants in foreign exchange, points of view, 93
price changing, 79
price structure, 76–78
profit-taking orders, 80–81
reasons for, 3–5
role of, for corporations, 84–85
selling, 78–79
spot market, 115–127
stop-loss orders, 81–83
terms, 78–83
trading, versus total currency exposure, 59
forward currency market. 77–78, 128–152
characteristics of, 128–130
compared to swap market, 129
example of transaction, 77
marketplace, 128

Non-Deliverable Forwards (NDFs), 77–78
forward outrights:

maturity, 55
pricing calculation, 167
example, 167
forward pricing for odd value dates (broken dates), 141–142
forward spreads, 130–133
types of, 131–133

45-degree angle, in Gann analysis, 408–409

France, as major foreign exchange market, 50

Frankfurt, as major foreign exchange market, 50
free-angle retracements, in technical analysis, 301–302
freedom of movement and residence, as provision of EU, 36
free-floating, defined, 20

French frank crisis of 1993, 34

French–West German Treaty, 26–27
front end–back office systems, use of, to limit risks, 66

Frost, A. J., 438
fundamental analysis, 243–261
future, effect on, of past information, 276
futures market, 78
compared to cash market, 167–169
trading, 171–173
futures, maturity, 55

FXMarketSpace, defined, 105

G-5:

and Japanese yen, 47
nations of, 22
signing of Plaza Accord, 22

G-6:

nations of, 23
signing of Louvre Accord, 23

G-7, 22
central banks, 73–74
gamma, in currency option pricing, 189

Gann analysis, 408–420

Gann Emblem, 410

Gann fan lines, 411–413

Gann percentages:

in extension analysis, 303
and fan lines, 300
and retracement lines, 297

Gann, William Delbert 408

Gann’s 28
trading rules, 419–420
gaps, 336–340

GDP deflator, as economic indicator, 255, 256

GDP, see Gross Domestic Product (GDP)

geometric angles, as feature of Gann analysis, 408, 411–412
geometric forms, as feature of Gann analysis, 408–410
geometric ratios, as feature of Gann analysis, 408, 413
compared to Fibonacci and Dow ratios, 413

Germany, as major foreign exchange market, 50–54
global markets, and foreign exchange, 4

Globex Forex Trading (GFT), 112
in futures markets trading, 171

GNP, see gross national product (GNP)

gold standard, suspension of, 14, 44
golden cross, 383
golden spiral, defined, 436

Good Till Canceled orders, in futures markets, 172

Good Till Date orders, in futures markets, 172
government spending, as economic indicator, 252

Great Britain, as participant in EMS, 30–31

Great Depression, 14
greenback, as nickname, 43
gross domestic product (GDP), as economic indicator, 250–252
gross national product (GNP), as economic indicator, 251
hammer, in candlestick charting, 361
hangman, in candlestick charting, 361, 362
harami, 369, 370
head, of head-and-shoulders, 307–308
head-and-shoulders, 307–311
in point-and-figure charting, 351–352
potential problems, 309
signals generated by, 308–309
hedge funds/CTAs:

as participants in spot market, 119
as players in foreign exchange markets, 52
hedge ratio, in currency option pricing, 187

HedgeStreet, role of:

in futures markets, 176
in regulating futures markets, 177
hedging, 88–90
with average options, 237–238
with barrier options, 233–234
with currency futures, 165
with currency options, 180
and currency swaps, 144
high net-worth individuals:

as participants in spot market, 119
as players in foreign exchange markets, 53
high prices on bar chart, 279–280

Hong Kong, as major foreign exchange market, 50
horizontal count, 350–351
horizontal retracement lines, 297–299
hoshi, 370
housing starts, as economic indicator, 254

Hutson, Jack, 403
ichimoku kinkou-hyo, 387–392

IMF, see International Monetary Fund

IMM, see International Monetary Market (IMM)

implementation via computerized systems, to limit credit risk, 64
improve the bid, as option in broker’s market, 109
impulse waves, in Elliot Wave Theory, 424–425
increased player sophistication, as factor in growth of FX market, 8

Index and Option Market (IOM), 164, 182
index of consumer expectations, as leading indicator, 261
index of stock prices, as leading indicator, 261
individuals, as players in foreign exchange markets, 53

Indonesia, and IMF, 18
industrial production, as economic indicator, 253
industrial sector indicators, 253–254

INET Futures Exchange, role of, in futures markets, 176
inflation indicators, as economic indicators, 255–257
information:

necessary for settlement in foreign exchange, 95–96
sources of:

on economic indicators, 251–252
in spot market, 124
initiation margin, 169
inside range, 369, 370

Institute for Supply Management, as economic indicator, 253
instruments, 113–238
as factor in growth of FX market, 9
insurance, in currency options, 179–180

Interbank Compensation Rules, 103
interbank compensation, CHIPS, 103
interbank trades, in spot market, 119
interest rate differential, 135–138
and currency swaps, 144
defined, 266
examples, 136, 137
as factor in theoretical model of currency options pricing, 186, 201
interest rate risk, 61–62
defined, 61
example, 62
interest rates:

as influence on exchange rates, 265–267
role of Federal Reserve in, 69–70
intermarket spread, as a options strategy, 214

International Organization of Securities Commissioners (IOSCO), role of, in futures markets, 176
international Fisher effect, 248–249

International Foreign Exchange and Currency Option Master Agreement, 59, 63

International Monetary Fund (IMF), 15
borrowing facilities, 16–17
founding, 15–16
membership, 16
special drawing rights, 17

International Monetary Market (IMM), 163, 164

International Organization for Standardization (ISO), 43, 44
intersections of %K and %D, 396–397
in-the-money, in currency option pricing, 189–191
example, 191
intrinsic value, 194
examples, 194
inverse head-and-shoulders, 307, 311–312
investment spending, as economic indicator, 252

IOM, see Index and Option Market (IOM)

IOSCO, see International Organization of Securities Commissioners (IOSCO)

Iraqi invasion of Kuwait, effect of, on exchange rates, 65, 268

Iraqi war, effect of, on exchange rates, 269–270
irregular flat, 432, 433
irikubi, 365, 366
island reversals, 336, 340

ISO codes, 41–44
selected examples, 44

ISO, see International Organization for Standardization

J curve, 247

Japan, as holder of U.S. dollars, 22

Japanese Bankers Association, 59

Japanese yen, see yen
jittai, 281
join the bid, as option in broker’s market, 109

%K, 395–396, 397
kabuse, 365, 366, 367

Kansas City Board of Trade Clearing Corporation, role of, in regulating futures markets, 177

Kansas City Board of Trade, role of, in regulating futures markets, 177

karakasa, 360, 361
kenuki, 369, 371
key reversals, 336, 340–341

Kijun, 387, 388
kirikomi, 363
kiwi, as nickname, 43

Knights Templar and travelers’ checks, 13
knock-ins, 232
knockouts, 232
knockups, see barrier options
koma, 360, 361

Korea, and IMF, 18
labor rigidities, as problem in new century, 39
lagging line, 387, 389–390

Lane, George, 395, 397

Larry Williams %R, 402

LavaFX, 107

LCH.Clearnet Limited, role of, in regulating futures markets, 177
leading indicators, as economic indicators, 260–261
leading lines, 387, 390
leave orders, 79–80

Leonard de Piso (Pisano, aka Fibonacci), 436

Liber Abaci, 436
line chart, 278–279
linearly weighted moving average, 378–379
liquid market, in currency options, 180

Liquidity Providers (LPs), 106–107
liquidity, in spot market, 117

London, as major foreign exchange market, 50

Long-Term Capital Management (LTCM), 52
liquidation of positions in, 57
in spot market, 117
long-term charts, importance of, in technical analysis, 306
long term, defined, 89
loonie, as nickname, 43
loss limit, purpose of, 58

Louvre Accord, 23
low prices on bar chart, 279–280

M1, defined, 68

M2, defined, 68–69

M3, defined, 69

Maastricht Treaty, and architecture of Europe, 28–29, 31–32, 35, 36

MACD, see moving averages convergence-divergence (MACD)

maintenance margin, 169
margin, in futures markets, 169–170
defined, 169
example, 170
mark-to-market, in futures markets, 173
example, 173
market liquidity, as reason for FX operations by Fed, 72
markets, major foreign exchange, 49–50
marking-to-market, as risk management policy, 60
marubozu:

bearish, 359, 366
bullish, 358
defined, 360
matched sale-purchase agreements:

as executed by Federal Reserve, 70
maturity dates, in forward currency market, 138
maturity gap, 62
merchandise trade balance, as economic indicator, 257–258
message numbering, SWIFT, 98

Mexican crisis of 1994, 23

Mexico and IMF, 18

MGE Clearing House, role of, in regulating futures markets, 177

Middle East, exchange of coins, 13

Minneapolis Grain Exchange, role of, in regulating futures markets, 177
model-based currency funds, growth of, 6
momentum, 399–400
money supply:

adjusted for inflation, as leading indicator, 261
as influence on exchange rates, 265
morning star, 374
moving averages convergence-divergence (MACD), 393–395, 398
moving averages, 377–386
defined, 377
reasons for using, 380–387
types of, 378–380

MT 300, FX confirmations, 99

MT 303, currency option allocation instructions, 99

MT 304, advice/instruction of a third-party deal, 99

MT 320, fixed loan/deposit confirmation, 99

MT 330, call/notice loan/deposit confirmation, 99

MT 350, advice of loan/deposit interest payment, 99

MT 390, advice of charges, interest, and other adjustment, 99

MT 391, request for payment of charges, interest rate, and other expenses, 99

MT 392, request for cancellation, 99

MT 395, queries, 99

MT 396, answers, 100

MT 398, proprietary message, 100

MT 399, free format message, 100

MT 935, rate change advice, 100

MT 970, Netting Statement, 102

MT 971, Netting Balance Report, 102

MT 972, Netting Interim Statement, 102

NAK, negative acknowledgement, SWIFT, 98

NASAA, see North American Securities Administrators Association (NASAA)

National Association of Dealers (NASD) Regulation, role of, in futures markets, 176
national central banks (NCBs), 38

National Futures Association (NFA), 176

Natural Squares, 417

NDFs, see Non-Deliverable Forwards (NDFs)

neckline, of head-and-shoulders, 307–308
net trade, as economic indicator, 252
netting, defined, 100
netting, defined, 64
new and existing one-family home sales, as economic indicator, 254
new building permits issued, as leading indicator, 261
new orders for consumer goods and materials (adjusted for inflation), as leading indicator, 260

New York Board of Trade, role of, in regulating futures markets, 177

New York Clearing Corporation, role of, in regulating futures markets, 177

New York Cotton Exchange (NYCE), 164

New York Mercantile Exchange, role of, in regulating futures markets, 177

New York, as major foreign exchange market, 50
next best price stop-loss order, 82

NFA, see National Futures Association (NFA)

nicknames, in candlestick charting, 361

Non-Deliverable Forwards (NDFs), 77–78
non-ratio (regular) spreads, as a options strategy, 214

North American Securities Administrators Association (NASAA), role of, in futures markets, 176
nostro account, defined, 96

NQLX, role of, in regulating futures markets, 177

NYCE, see New York Cotton Exchange (NYCE)

NYMEX Clearing House, role of, in regulating futures markets, 177

OED, see Office of the Executive Director (OED) (CFTC)

Office of Chief Economist (CFTC), 175

Office of the Executive Director (OED) (CFTC), 175

Office of the General Counsel (OGC) (CFTC), 175

(OGC), see Office of the General Counsel (OGC) (CFTC) 175
oil shoku, in Japan, 47

1×1 box, 344

1×3 box, 282, 343–344

OneChicago, role of, in regulating futures markets, 177
one-day reversal patterns, in candlestick charting, 360–362
open interest, importance of, in technical analysis, 283–285

Open Market Investment Committee (OMIC), 67
open outcry, in futures markets, 172
opening price on bar chart, 279–280
optimal options, 236
options on currency futures, 181–182

Order Management System Providers (OMS), 106–107
orders, types of, in futures markets trading, 171–172
oscillators, 393–404
defined, 393

OTC, see over-the-counter (OTC) market
other merchandise, as category of merchandise trade balance, 258
out-of-the-money, 193
example, 193
overnight position limit, 57
over-the-counter (OTC) market, in currency options, 181
paper umbrella, in candlestick charting, 361

Parabolic System (SAR, stop and reverse), 404–405
participants:

in cash versus futures markets, 168
in foreign exchange, points of view, 93
in spot market, 119
payment and receiving instructions (P&R), 95
peaking bull market, as phase of market in Gann analysis, 408
pegged currencies, defined, 21
pennants, 323, 326–328
in point-and-figure charting, 353–354
pension funds, as participants in spot market, 119
personal income, as leading indicator, 261

Philadelphia Board of Trade (PBOT), role of, in regulating futures markets, 177

Philadephia Stock Exchange (PHLX), currency options trading on, 181

PHLX, see Philadephia Stock Exchange (PHLX)

phone, use of, by voice brokers, 111
piercing candlestick, 363
pip:

on point-and-figure chart, 282
value of, 173
pivot points, 305
players, in foreign exchange markets, 51

Plaza Accord, 22–23
and Japanese yen, 47
point-and-figure chart, 278, 282, 342–355
police and judicial cooperation in European Union, 28
political changes, and foreign exchange, 4
portfolio balance approach, 249

PortWare, 107
position calculation, currency cross, 160
possible duplicate message (PDM), SWIFT, 98
pound:

contract size, in futures market, 170
as currency reserve before World War II, 21
during EMS crisis of 1992–1993, 32–33
as fourth most traded currency, 48–49
after World War II, 14, 48

PPI, see producer price index (PPI)

PPP absolute version, 245–246

PPP relative version, 246–247

PPP, see purchasing power parity (PPP)

Prechter, Robert R., 438
premium spread:

for currency swap, pricing, 14–146
premium, in currency options trading, 185
examples, 186
price changing in foreign exchange, 79
price discovery, in currency futures, 166
price gapping, in currency option pricing, 188
price objective, in runaway gap, 341
price of the currency, as factor in theoretical model of currency options pricing, 186, 187
price quotes, by banks, 91
price structure of foreign exchange, 76–78
calculating in forward market, 134–135
of cross currency, 156–159
of currency futures, 166–167
currency swaps, 144–147
of tomorrow/next swap, 150–151
prime rate, 70

Pring, Marting, 403
producer price index (PPI), as economic indicator, 255–256
profit and loss:

of currency cross, 161–162
examples, 161–162
in spot market, 120–124
examples, 121–124
realized, 121
unrealized, 121
profit repatriation, 91–92
profitabiliy, as factor in growth of FX market, 9–10
profit-taking orders, 80–81
proprietary shops, as participants in spot market, 119
protecting a certain market level, as reason for FX operations by Fed, 72, 73
protection by diplomatic and consular authorities, as provision of EU, 36
purchasing power parity (PPP), 245–247
put ratio backspread, 226, 229–230
put:

buying, as a strategy, 211
defined, 202
selling, as a strategy, 212–213
quantitative trading methods, 377–392

Quantity Equation of Exchange, 265
quid, as nickname, 43
quotations, in cash versus futures markets, 168
random walk theory, 275–276
rate of change, 393, 395, 401–403
ratio call spreads, 226, 227–228
ratio put spreads, 226, 228
ratio spreads, 226–231
raw materials and industrial supplies, as category of merchandise trade balance, 258

RealTick, 107
real-time gross settlement system (RTGS), 103
rectangles, 323
reference currency, in spot market, 116
regional processor (RGP), SWIFT, 97–98
regular flat, 431
regulation, of futures markets, in United States, 175–176

Regulation Q, 71

Relative Strength Index (RSI), 393–395, 400–401
formula, 400–401
relative strength of currency, 159
relative strength signals, in ichimoku kinkou-hyo, 391–392
replacement risk, defined, 63
repurchase agreements, as executed by Federal Reserve, 70
reserve tranche of IMF, 16
resistance levels, in technical analysis, 287–289
retail clients, electronic platform trading for, 112
retracement analysis, in technical analysis, 297–305

Reuters Matching System, 107, 110, 112
revenue, sources of, 60
reversal patterns:

one-day, in candlestick charting, 360–362
in technical analysis, defined, 307
reverse knock-ins, 232
reverse knockouts, 232
reversing a trend, as reason for FX operations by Fed, 72, 73
rickshaw man, in candlestick charting, 362
right to petition, as provision of EU, 36
right to vote and stand as a candidate, as provision of EU, 36
rising trendline, in technical analysis, 290
rising wedge, 333
risk conversion, in fence, 231
risk in foreign exchange markets, 55–66
compounding, 56
economic exposure, 86–887
macro management, 58–59
management with barrier options, 237
managing by hedging, 88–89
micro management, 56–57
sources of, 60
transaction exposure, 85–86, 88
risk reversal, in fence, 231
rollover swap, see tomorrow/next (rollover) swap
rounded top and bottom formations, 320, 321

RTGS, see real-time gross settlement system
runaway (measurement) gap, 340–341
running flat, 432

Sakata’s Five methods, 372–376
san, 372
sangu, 372, 374–375
sanpei, 372
sanpo, 372, 376
sansen, 372, 373–374
sanzan, 372–373
sashikomi, 365, 366, 368

SDRS, see special drawing rights
self-fulfilling prophecy, in technical analysis, 276–277
selling call, as a strategy, 209–210
selling in foreign exchange, 78–79
selling put, as a strategy, 212–213
selling signal, in MACD, 398
semipegged currencies, defined, 21
semipegging strategy of European Union, 26
semistrong version of random walk theory, 275

Senkou, Spans A and B, 387, 390

September 11, 2001, effect of, on exchange rates, 268–269
settlement risk, defined, 63–64
settlement, 94–105
dates, cash versus futures markets, 168–169
shitakage, 281
shoulders, of head-and-shoulders, 307–308

SI, see Swing Index (SI)

sideways trend, in technical analysis, 286
signal line, 387, 388–389
simple moving average, 378–379

Singapore, as major foreign exchange market, 50
slow stochastics, 397
slowing down operations, as reason for FX operations by Fed, 72, 73

Smithsonian Agreement, 19
demise of, 20
as transitional agreement, 26

SMT 371, Report of Matched Confirmations, 101

SMT 372, Detailed Report of Confirmations, 101

SMT 373, Report of Unmatched Confirmations, 101

SMT 374, Report of Mismatched Confirmations, 101
snake, defined, 26
snake in the tunnel, defined, 26

Society of Worldwide Interbank Financial Telecommunications (SWIFT):

implementation, 96–98
role of, in settlement, 97–103
types of messages, 98–100
sociopolitical influences on exchange rates, 267–270
sovereign risk, 64–65

Soviet Union, effect of dissolution, 17–18, 31
special drawing rights, 17
speculation after World War I, 14
spinning top, in candlestick charting, 361
spot deals, 76–77
example of transaction, 76–77
maturity, 55
spot market, 115–127
trading in, 57
spot next (S/N), in forward market, 138
spot rate, 130
spot trader:

characteristics of, 124–125
types of, 125
spread, in prices quoted by banks, 92

Square of 9, 414–416

Square of 90, 418

Square of 144, 18
squaring of price and time, as feature of Gann analysis, 408, 414–418
standard forward value dates, 138–139
standard maturity date, in forward market, 138
stand-by arrangements of IMF, 6
star, 369, 370, 371
state regulatory agencies, role of, in futures markets, 176
stochastics, 395–397
define, 395
stop options, see barrier options
stop-loss orders, 81–83
stop-loss, in spot market, 124

STP, see Straight Through Processing
straddles, as a options strategy, 214
buying, 214–215
long straddle, 215–216
short, 216

Straight Through Processing (STP), defined, 105
strangles, as a options strategy, 214
buying, 216–217
selling, 216
short, 217–218
strategies, currency options, 207–238
streaming prices, see Electronic Streaming Prices (ESP)

stress tests, for traders, 61
strike (exercise) price, as factor in theoretical model of currency options pricing, 186, 189–195
strong version of random walk theory, 275
subwaves, in Elliot Wave Theory, 424–425
support levels, in technical analysis, 287–289
swap market, compared to forward market, 129

SWIFT, see Society of Worldwide Interbank Financial Telecommunications

SWIFTNet Accord, 101–102

Swing Index (SI), 403

Swiss banking system, 49

Swiss franc, 49
contract size, in futures market, 170

Swiss National Bank, and switch of currency reserves, 22

Switzerland, as major foreign exchange market, 50
symmetrical triangle, 328
bearish, 329
breakout, in point-and-figure charting, 354, 355
bullish, 328, 329
synthetic call option, buying, as a strategy, 208–209
synthetic put option, buying, as a strategy, 212
system messages, SWIFT, defined, 97
take the offer, as option in broker’s market, 108
tasuki, 363, 364
bearish tasuki, 365, 368
downside tasuki gap, 365, 368, 369

Taylor, John, 303

Technical Analysis Applications (Luca), 407
tech stocks, overinvesting in, 6
technical analysis formations:

in currency futures, 165
unique to futures, 336–341
technical analysis, 271–438
history, 273
cons, 274
pros, 274
technological improvement, as factor in growth of FX market, 6, 9

Tenkan, 387, 388–389

Tethys, 107

Thailand, and IMF, 18

The Options Clearing Corporation, role of, in regulating futures markets, 177
theoretical or equivalent share position, in currency option pricing, 187
theory of elasticities, 247–248
theta, in currency options trading, 199–200
three gaps, 372, 374–375
three methods, 372, 376
three mountains, 372–373
three parallel candlesticks, 372, 375
three rivers, 372, 373–374
three soldiers, 375, 376
threshold of divergence, 30

Tokyo, as major foreign exchange market, 50
tomorrow/next (rollover) swap, 148–150
in forward market, 138
pricing, 150–151
use of, for risk management, 62
tonbo, 360, 361
total currency exposure versus foreign exchange trading, 59
trade capture, 94–95
trading:

currency crosses, 159–160
in foreign exchange, 106–112
in futures markets, 171–173
quantitative methods, 377–392
in the spot market, 119–120
versus gambling in currency options, 179
trading costs, cash versus futures markets, 169
trailers, SWIFT, 98
transaction exposure, 85–86
translation exposure, 88

Treaty of Amsterdam, 37

Treaty of Paris, 26

Treaty of Rome, 26
trend (direction), as beta, 6
trend continuation patterns, 323–335
trend reversal patterns, in technical analysis, 307–321
trend, importance of, in technical analysis, 285–287
trendline, 387, 388
trendline, in technical analysis, 290–294
triangles, 323, 328–332
in Elliott Wave Theory, 429, 433–434
trigger options, see barrier options
triple bottoms, 307, 317–319
in point-and-figure charting, 352
triple crossover method, 383–385
triple tops, 307, 317
in point-and-figure charting, 352

Trix Index, 403
tsutsumi, 363, 364, 365
tunnel, defined, 26

Turkey, and admission to EU, 35
tweezers, 369, 371, 372
two crows, 374, 375
two-day candlestick combinations, 363–372
two-moving-average combination, 381–383

U.S. Council on International Banking, Inc., 103

Compensation and Indemnity and Compensation Rules, 444–451

U.S. Dollar Index, 182

U.S. dollar:

as currency block, 20
as currency reserve after World War II, 21
and failure of Bretton Woods Accord, 18
and pegging, 15, 21, 45
quoting against, 14
and trading in spot market, 116
as world’s main currency, 45–46
after World War II, 14
unemployment rates, as problem in new century, 39
upward breakout:

of bearish resistance line, 348–349
of bullish resistance line, 348
upward trend, in technical analysis, 285

USFE (Eurex US), role of, in regulating futures markets, 177
uwkage, 281
value at risk (VAR), determination of, 60–61

VAR, see value at risk
vega, in currency options trading, 198–199
velocity of money, 265
vendor performance, as leading indicator, 260
vertical spread, as a options strategy, 214
bear call, 220–221
bear put, 220–221
bull call, 218–219
bull put, 219

V-formations (spikes), 307, 319–320
and island gap, 340
voice brokers, in brokers’ market, 109, 111
volatility:

as beta, in options trading, 6
of currencies, 89
in exchange rate, 6–7
theories on, 249
as factor in growth of FX market, 6
in interest rates, 7–8
in spot market, 117
after World War I, 14
volatility of the currency, as factor in theoretical model of currency options pricing, 186, 195–199
examples, 195–198
volume:

cash versus futures markets, 169
importance of, in technical analysis, 283–283
in point-and-figure charting, 344
in rectangles, 334
in triangles, 328
volume growth of foreign exchange, 5

W. D. Gann analysis, see Gann analysis
wait and see signals, in candlestick charting, 369–371
weak version of random walk theory, 275
wedges, 323

Wilder, Welles, 400, 404

Work queue confirmation list, Accord, 102

World War I:

and Federal Reserve, 68
volatility after, 14

World War II:

and Bretton Woods Accord, 15
effect of, on Europe, 25–26
yen:

contract size, in futures market, 170
as currency block, 20
and political scandals, 47
as third most traded currency, 47–48
zigzags, 429–430