appointed. The board is led by achairman and a vice chairman, each appointed by the president and approvedby the Senate for four year terms. The current chair is Alan Greenspan, who hasbeen chairman since 1987. His latest term expires in 2006.There are 12 regional Federal Reserve Banks located in major cities aroundthe country that operate under the supervision of the Board of Governors.Reserve Banks act as the operating arm of the central bank and do most of thework of the Fed. The banks generate their own income from four main sources:1. Services provided to banks2. Interest earned on government securities3. Income from foreign currency held4. Interest on loans to depository institutionsThe income generated from these activities is used to finance day-to-dayoperations, including information gathering and economic research. Any excessincome is funneled back into the U.S. Treasury.
History of Currency Trading
13
The system also includes the Federal Open Market Committee, betterknown as the FOMC. This is the policy-creating branch of the Federal Reserve.Traditionally the chair of the board is also selected as the chair of the FOMC.The voting members of the FOMC are the seven members of the Board ofGovernors, the president of the Federal Reserve Bank of New York, and presidents of four other Reserve Banks who serve on a one-year rotating basis. AllReserve Bank presidents participate in FOMC policy discussions whether ornot they are voting members. The FOMC makes the important decisions oninterest rates and other monetary policies. This is the reason they get most of theattention in the media.The primary responsibility of the Fed is “to promote sustainable growth,high levels of employment, stability of prices to help preserve the purchasingpower of the dollar, and moderate long-term interest rates.”In other words, the Fed’s job is to foster a sound banking system and ahealthy economy. To accomplish its mission the Fed serves as the banker’s bank,the government’s bank, the regulator of financial institutions, and as the nation’smoney manager.The Fed also issues all coin and paper currency. The U.S. Treasury actuallyproduces the cash, but the Fed Banks then distributes it to financial institutions.It is also the Fed’s responsibility to check bills for wear and tear, taking damagedcurrency out of circulation.The Federal Reserve Board (FRB) has regulation and supervision responsibilities over banks. This includes monitoring banks that are members of thesystem, international banking facilities in the United States, foreign activities ofmember banks, and the U.S. activities of foreign-owned banks. The Fed alsohelps to ensure that banks act in the public’s interest by helping in the development of federal laws governing consumer credit. Examples are the Truth inLending Act, the Equal Credit Opportunity Act, the Home Mortgage DisclosureAct, and the Truth in Savings Act. In short, the FED is the policeman for banking activities within the United States and abroad.The FRB also sets margin requirements for investors. This limits theamount of money you can borrow to purchase securities. Currently, the requirement is set at 50 percent, meaning that with $500 you have the opportunity topurchase up to $1000 worth of securities.
Securities and Exchange Commission,1933–1934When the stock market crashed in October 1929, countless investors lost theirfortunes. Banks also lost great sums of money in the Crash because they hadinvested heavily in the markets. When people feared their banks might not be
14
THEN AND NOW
able to pay back the money that depositors had in their accounts, a “run” on thebanking system caused many bank failures.With the Crash and ensuing depression, public confidence in the marketsplummeted. There was a consensus that for the economy to recover, the public’sfaith in the capital markets needed to be restored. Congress held hearings toidentify the problems and search for solutions.Based on the findings in these hearings, Congress passed the Securities Actof 1933 and the Securities Exchange Act of 1934. These laws were designed torestore investor confidence in capital markets by providing more structure andgovernment oversight. The main purposes of these laws can be reduced to twocommon-sense notions:1. Companies that publicly offer securities for investment dollars musttell the public the truth about their businesses, the securities they areselling, and the risks involved in investing.2. People who sell and trade securities—brokers, dealers, and exchanges —must treat investors fairly and honestly, putting investors’ interests first.
The Bretton Woods System,1944–1973The post-World War II period saw Great Britain’s economy in ruins, its infrastructure having been bombed. The country’s confidence with its currency wasat a low. By contrast, the United States, thanks to its physical isolation, was leftrelatively unscathed by the war. Its industrial might was ready to be turned tocivilian purposes. This then has led to the dollar’s rise to prominence, becomingthe reserve currency of choice and staple to the international financial markets.Bretton Woods came about in July 1944 when 45 countries attended, atthe behest of the United States, a conference to formulate a new internationalfinancial framework. This framework was designed to ensure prosperity in thepost-war period and prevent the recurrence of the 1930s global depression.Named after a resort hotel in New Hampshire, the Bretton Woods system formalized the role of the U.S. dollar as the new global reserve currency, with itsvalue fixed into gold. The United States assumed the responsibility of ensuringconvertibility while other currencies were pegged to the dollar.Among the key features of the new framework were:• Fixed but adjustable exchange rates• The International Monetary Fund• The World Bank
History of Currency Trading
15
The End of Bretton Woodsand Floating Exchange RatesAfter close to three decades of running the international financial system,Bretton Woods finally went the way of history due to growing structural imbalances among the economies, leading to mounting volatility and speculation ina one-year period from June 1972 to June 1973. At the time the UnitedKingdom, facing deficit problems, initially floated the sterling. Then it wasdevaluated further in February of 1973 losing 11 percent of its value along withthe Swiss franc and the Japanese yen. This eventually led to the EuropeanEconomic Community floating their currencies as well.At the core of Bretton Woods’ problems were deteriorating confidence inthe dollars’ ability to maintain full convertibility and the unwillingness of surpluscountries to revalue for its adverse impact in external trade. Despite a last-ditcheffort by the Group of Ten finance ministers through the Smithsonian Agreementin December 1971, the international financial system from 1973 onwards sawmarket-driven floating exchange rates taking hold. Several times efforts forreestablishing controlled systems were undertaken with varying levels of success.The most well known of these was Europe’s Exchange Rate Mechanism of the1990s which eventually led to the European Monetary Union.
International Monetary MarketIn December 1972, the International Monetary Market (IMM) was incorporated as a division of the Chicago Mercantile Exchange (CME) that specializedin currency futures, interest-rate futures, and stock index futures, as well asfutures options.
Commodity Futures Trading CommissionIn 1974 Congress created the Commodity Futures Trading Commission(CFTC) as an independent agency with the mandate to regulate commodityfutures and options markets in the United States. The agency is chartered to protect market participants against manipulation, abusive trade practices, and fraud.Through effective oversight and regulation, the CFTC enables the markets to better serve their important functions in the nation’s economy, providinga mechanism for price discovery and a means of offsetting price risk. The CFTCalso seeks to protect customers by requiring three things: that registrants disclose market risks and past performance information to prospective customers,that customer funds be kept in accounts separate from those maintained by the
16
THEN AND NOW
firm for its own use, and that customer accounts be adjusted to reflect the current market value at the close of trading each day.
National Futures AssociationThe National Futures Association (NFA), created in 1982, is a quasi-private,self-regulatory agency established by the CFTC and participants in the futuresmarkets. The NFA sets standards for the registration of professionals with theauthority to impose limited fines for breach of conduct. NFA is the premierindependent provider of efficient and innovative regulatory programs that safeguard the integrity of the derivatives markets and directs the regulatory actionsof the CFTC into the marketplace.
Commodity Futures Modernization Actof 2000The Commodity Futures Trading Commission (CFTC) proposed rules relatingto trading facilities to implement the Commodity Futures Modernization Act of2000 (CFMA). On December 15, 2000, Congress passed, and on December21, 2000, the president signed into law, the CFMA, which substantially alteredthe Commodity Exchange Act. The CFMA amended the law to establish threecategories of markets: designated contract markets, derivative transaction execution facilities, and markets exempt from CFTC regulation. The three categoriesmatch the degree of regulation to the varying nature of the products and thenature of the participant having access to the market.Beginning in the 1980s, cross-border capital movements accelerated withthe advent of computers and technology, extending market continuum throughAsian, European, and American time zones. Transactions in foreign exchangerocketed from about $70 billion a day in the 1980s to more than $1.85 trilliona day two decades later.Keep in mind that the Modernization Act pertains mostly to futures andforwards, not cash/spot markets. However, the CFTC seems to be gaining moreand more momentum for some form of FOREX cash regulation within theboundaries of the United States.The NFA stipulates that members cannot transact with non-members. So,for example, if your FOREX broker/dealer is an NFA member, he or she mustconsent to being regulated and is not allowed to do business with non-NFAmoney managers. We would not accept a broker simply because he or she is anNFA member; nor would we condemn one who is not a member. It is still a“buyer beware” marketplace.Currency trading remains much less regulated than either the stock orfutures markets. This means the prospective trader must be especially knowledge-
History of Currency Trading
17
able, alert, and realistic. As the market has opened up to the small speculator, ithas also opened up the market for less-than-scrupulous companies and individuals. Remember: If it’s too good to be true—it probably is! The non-centralizednature of FOREX makes the level of regulation seen in the futures marketunlikely to be attained.Check in on the CFTC and NFA Web sites from time to time for actionsagainst broker/dealers and for updates on any pending regulation that mightaffect U.S.–based FOREX traders.Refer to the Appendix entitled “Regulatory Agencies and Central Banks”for information on obtaining the complete text of the Modernization Act.
Regulation in Other CountriesNearly every major country around the globe has created a government agencyresponsible for overseeing the conduct of trading securities and protectinginvestors from fraudulent dealers and scam artists. In the United Kingdom, thisagency is called the Financial Services Authority (FSA) and in Australia it is calledthe Australian Securities and Investment Commission (ASIC). Refer to theAppendix entitled “Regulatory Agencies and Central Banks” for further details.
The Arrival of the EuroOn January 1, 2002, the Euro became the official currency of twelve Europeannations that agreed to remove their previous currencies from circulation prior toFebruary 28, 2002. See Table 2.1.TABLE 2.1
European Monetary Union
Austria
schilling
Belgium
franc
Finland
markka
France
franc
Germany
mark
Greece
drachma
Ireland
punt
Italy
lira
Luxembourg
franc
Netherlands
guilder
Portugal
escudo
Spain
peseta
THEN AND NOW
18
The Euro was considered an immediate success and is now the secondmost frequently traded currency in FOREX markets. More details on the Eurocan be found in the Appendix of this book.Table 2.2 depicts the major events in FOREX history and regulation.
TABLE 2.2
Timeline of Foreign Exchange
1913—U.S. Congress creates the Federal Reserve System.1933—Congress passes the Securities Act of 1933 to counter the effects of theGreat Crash of 1929.1934—The Securities Exchange Act of 1934 creates the beginnings of theSecurities and Exchange Commission.1936—The Commodity Exchange Act is enacted in direct response to manipulatinggrain and futures markets.1944—The Bretton Woods Accord is established to help stabilize the globaleconomy after World War II.1971—The Smithsonian Agreement is established to allow for a greater fluctuationband for currencies.1972—The European Joint Float is established as the European community triesto move away from their dependency on the U.S. dollar.1972—The International Monetary Market is created as a division of the ChicagoMercantile Exchange.1973—The Smithsonian Agreement and European Joint Float fail, signifying theofficial switch to a free-floating system.1974—Congress creates the Commodity Futures Trading Commission to regulatethe futures and options markets.1978—The European Monetary System is introduced to again try to gainindependence from the U.S. dollar.1978—The Free-floating system is officially mandated by the International Monetary Fund.1993—The European Monetary System fails to make way for a worldwide,free-floating system.1994—Online currency trading makes its debut.2000—Commodity Modernization Act establishes new regulations forsecurities derivatives, including currencies in futures or forwardsform.2002—The Euro becomes the official currency of twelve European nations onJanuary 1.
History of Currency Trading
Summary
• Until the late 1960s the currency markets were extremely stable andvery much a closed club. Things were about to change rapidly!• Currency trading is probably the world’s second-oldest profession!• The Euro, introduced in 2002, is the official currency of twelveEuropean countries: Austria, Belgium, Finland, France, Germany,Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, andSpain.• Key dates and events—1973, 1978, 1994, 2002• The trend is towards more regulation of cash/spot currency markets.Traders should watch the actions of the Commodity Futures TradingCommission (CFTC) and its quasi-independent administration arm,the National Futures Associations (NFA). Do not take regulation as anexcuse for not doing your own homework!
19
3Chapter
Currency Futuresand the IMM
Futures ContractsA futures contract is an agreement between two parties: a short position, theparty who agrees to deliver a commodity, and a long position, the party whoagrees to receive a commodity. For example, a grain farmer would be the holderof the short position (agreeing to sell the grain) while the bakery would be theholder of the long (agreeing to buy the grain).In a futures contract, everything is precisely specified: the quantity andquality of the underlying commodity, the specific price per unit, and the dateand method of delivery. The price of a futures contract is represented by theagreed-upon price of the underlying commodity or financial instrument that willbe delivered in the future. For example, in the grain scenario, the price of thecontract might be 5,000 bushels of grain at a price of four dollars per bushel andthe delivery date may be the third Wednesday in September of the current year.
Currency FuturesThe FOREX market is essentially a cash or spot market in which over 90 percent of the trades are liquidated within 48 hours. Currency trades held longer thanthis are normally routed through an authorized commodity futures exchangesuch as the International Monetary Market. IMM was founded in 1972 and is adivision of the Chicago Mercantile Exchange (CME) that specializes in currencyfutures, interest-rate futures, and stock index futures, as well as options on21
THEN AND NOW
22
futures. Clearing houses (the futures exchange) and introducing brokers are subject to more stringent regulations from the SEC, CFTC, and NFA agencies thanthe FOREX spot market (see www.cme.com for more details).It should also be noted that FOREX traders are charged only a transactioncost per trade, which is simply the difference between the current bid and askprices. Currency futures traders are charged a round-turn commission thatvaries from broker house to broker house. In addition, margin requirements forfutures contracts are usually slightly higher than the requirements for theFOREX spot market.
Contract SpecificationsTable 3.1 is a list of currencies traded through IMM at the Chicago MercantileExchange and their contract specifications.Size represents one contract requirement though some brokers offer minicontracts, usually one-tenth the size of the standard contract. Months identifythe month of contract delivery. The tick symbols H, M, U, Z are abbreviationsfor March, June, September, and December respectively. Hours indicate the
TABLE 3.1
Currency Contract Specifications
Commodity
Contract Size
Months
Hours
MinimumFluctuation
Australiandollar
100,000 AUD
H, M, U, Z
7:20–14:00
0.0001 AUD = $10.00
British pound
62,500 GBP
H, M, U, Z
7:20–14:15
0.0002 GBP = $12.50
Canadiandollar
100,000 CAD
H, M, U, Z
7:20–14:00
0.0001 CAD = $10.00
Eurocurrency
62,500 EUR
H, M, U, Z
7:20–14:15
0.0001 EUR = $ 6.25
12,500,000 JPY
H, M, U, Z
7:00–14:00
0.0001 JPY = $12.50
JapaneseyenMexicanpeso
500,000 MXN
All months 7:00–14:00
0.0025 MXN= $12.50
New Zealanddollar
100,000 NZD
H, M, U, Z
7:00–14:00
0.0001 NZD = $10.00
Russianruble
2,500,00 RUR
H, M, U, Z
7:20–14:00
0.0001 RUR = $25.00
South Africanrand5,000,000 ZAR
All months 7:20–14:00
0.0025 ZAR = $12.50
Swiss franc
H, M, U, Z
0.0001 CHF = $12.50
62,500 CHF
7:20–14:15
Currency Futures and the IMM
23
local trading hours in Chicago. The minimum fluctuation represents thesmallest monetary unit that is registered as one pip in price movement atthe exchange and is usually one-ten thousandth of the base currency.
Currencies Trading VolumeTable 3.2 summarizes the trading activity of selected futures contracts in currencies, precious metals, and some financial instruments. The volume and open interest readings are not trade signals. They are intended only to provide a brief synopsisof each market’s liquidity and volatility based on the average of 30 trading days.TABLE 3.2
Futures Volume and Open Interest
Market
Sym
Exch
Vol
OI
S&P 500 e-mini
ES
CME
489.1
377.9
Nasdaq 100 e-mini
NQ
CME
237.6
158.4
Eurodollar
ED
CME
93.9
772.5
S&P 500
SP
CME
59.3
531.4
Eurocurrency
EC
CME
49.5
112.9
Mini Dow
YM
CBOT
48.1
30.2
10-year T-note
TY
CBOT
43.1
676.4
Gold
GC
NYMEX
33.7
163.0
5-year T-note
FV
CBOT
29.6
582.8
30-year T-bond
US
CBOT
25.9
324.1
Japanese yen
JY
CME
18.6
132.1
Canadian dollar
CD
CME
18.0
64.2
Nasdaq 100
ND
CME
13.3
65.4
British pound
BP
CME
12.2
58.3
Silver
SI
NYMEX
10.0
84.2
Swiss franc
SF
CME
9.3
45.6
Mexican peso
ME
CME
8.8
30.5
Dow Jones
DJ
CBOT
8.7
29.5
Aussie dollar
AD
CME
7.8
55.7
2-year T-note
TU
CME
7.0
108.6
Copper
HG
NYMEX
4.2
32.8
Legend: Sym: Ticker symbol, Exch: Futures exchange on which contract is traded,Vol: 30-day average daily volume, in thousands, OI: Open interest, in thousands.Source: Active Trader Magazine, January 16, 2004 (www.activetradermag.com).
THEN AND NOW
24
TABLE 3.3Currency
U.S. Dollar IndexWeight %
Eurocurrency
57.6
Japanese yen
13.6
British pound
11.9
Canadian dollar
9.1
Swedish krona
4.2
Swiss franc
3.6
U.S. Dollar IndexThe U.S. Dollar Index (ticker symbol = DX) is an openly traded futures contract offered by the New York Board of Trade. It is computed using a tradeweighted geometric average of six currencies. See Table 3.3.IMM currency futures traders monitor the U.S. Dollar Index to gauge thedollar’s overall performance in world currency markets. If the Dollar Index istrending lower, then it is very likely that a major currency that is a componentof the Dollar Index is trading higher. When a currency trader takes a quickglance at the price of the U.S. Dollar Index, it gives the trader a good feel forwhat is going on in the FOREX market worldwide.For traders who are interested in more details on commodity futures, werecommend Todd Lofton’s paperbound book, Getting Started in Futures (2001:John Wiley & Sons, Inc.).
2Part
WhatEvery TraderMust Know
4Chapter
FOREX Terms
s in any worthwhile endeavor, each industry tends to create its ownunique lingo. The FOREX market is no different. You, the novicetrader, must thoroughly comprehend certain terms before makingyour first trade.
A
Currency PairsEvery FOREX trade involves the simultaneous buying of one currency and theselling of another currency. These two currencies are always referred to as thecurrency pair in a trade.
Major and Minor CurrenciesThe seven most frequently traded currencies (USD, EUR, JPY, GBP, CHF,CAD, and AUD) are called the major currencies. All other currencies arereferred to as minor currencies. The most frequently traded minors are the NewZealand dollar (NZD), the South African rand (ZAR), and the Singapore dollar(SGD). After that, the frequency is difficult to ascertain because of perpetuallychanging trade agreements in the international arena.
27
28
WHAT EVERY TRADER MUST KNOW
Cross CurrencyA cross currency is any pair in which neither currency is the U.S. dollar. Thesepairs may exhibit erratic price behavior since the trader has, in effect, initiatedtwo USD trades. For example, initiating a long (buy) EUR/GBP trade is equivalent to buying a EUR/USD currency pair and selling a GBP/USD. Cross currency pairs frequently carry a higher transaction cost. The three most frequentlytraded cross rates are EUR/JPY, GBP/EUR, and GBP/JPY.
Base CurrencyThe base currency is the first currency in any currency pair. It shows how muchthe base currency is worth as measured against the second currency. For example, if the USD/CHF rate equals 1.6215, then one USD is worth CHF 1.6215.In the FOREX markets, the U.S. dollar is normally considered the “base” currency for quotes, meaning that quotes are expressed as a unit of $1 USD per theother currency quoted in the pair. The primary exceptions to this rule are theBritish pound, the Euro, and the Australian dollar.
Quote CurrencyThe quote currency is the second currency in any currency pair. This is frequently called the pip currency and any unrealized profit or loss is expressed inthis currency.
PipsA pip is the smallest unit of price for any foreign currency. Nearly all currencypairs consist of five significant digits and most pairs have the decimal pointimmediately after the first digit, that is, EUR/USD equals 1.2812. In thisinstance, a single pip equals the smallest change in the fourth decimal place, thatis, 0.0001. Therefore, if the quote currency in any pair is USD, then one pipalways equals 1⁄100 of a cent.One notable exception is the USD/JPY pair where a pip equals $ 0.01(one U.S. dollar equals approximately 107.19 Japanese yen). Pips are sometimescalled points.
FOREX Terms
29
Pips
Ticks
FIGURE 4.1
Pip-tick relationship.
TicksJust as a pip is the smallest price movement (the y-axis), a tick is the smallestinterval of time (the x-axis) that occurs between two trades. When trading themost active currency pairs (such as EUR/USD or USD/JPY) during peak trading periods, multiple ticks may (and will) occur within the span of one second.When trading a low-activity minor cross pair (such as the Mexican peso and theSingapore dollar), a tick may only occur once every two or three hours.Ticks, therefore, do not occur at uniform intervals of time. Fortunately,most historical data vendors will “group” sequences of streaming data andcalculate the open, high, low, and close over regular time intervals (1-minute,5-minute, 30-minute, 1-hour, daily, and so forth.). See Figure 4.1.
MarginWhen an investor opens a new margin account with a FOREX broker, he orshe must deposit a minimum amount of monies with that broker. This minimum varies from broker to broker and can be as low as $100.00 to as high as$100,000.00.Each time the trader executes a new trade, a certain percentage of theaccount balance in the margin account will be earmarked as the initial marginrequirement for the new trade based upon the underlying currency pair, itscurrent price, and the number of units traded, (called a lot). The lot size
30
WHAT EVERY TRADER MUST KNOW
always refers to the base currency. An even lot is usually a quantity of 100,000units, but most brokers permit investors to trade in odd lots (fractions of100,000 units).
LeverageLeverage is the ratio of the amount used in a transaction to the required security deposit (margin). It is the ability to control large dollar amounts of a securitywith a comparatively small amount of capital. Leveraging varies dramatically withdifferent brokers, ranging from 10:1 to 100:1. Leverage is frequently referred toas gearing. The formula for calculating leverage is:Leverage = 100/Margin Percent
Bid PriceThe bid is the price at which the market is prepared to buy a specific currencypair in the FOREX market. At this price, the trader can sell the base currency. Itis shown on the left side of the quotation. For example, in the quote USD/CHF1.4527/32, the bid price is 1.4527; meaning you can sell one U.S. dollar for1.4527 Swiss francs.
Ask PriceThe ask is the price at which the market is prepared to sell a specific currencypair in the FOREX market. At this price, the trader can buy the base currency.It is shown on the right side of the quotation. For example, in the quoteUSD/CHF 1.4527/32, the ask price is 1.4532; meaning you can buy one U.S.dollar for 1.4532 Swiss francs. The ask price is also called the offer price.
Bid/Ask SpreadThe spread is the difference between the bid and ask price. The “big figurequote” is the dealer expression referring to the first few digits of an exchangerate. These digits are often omitted in dealer quotes. For example, a USD/JPYrate might be 117.30/117.35, but would be quoted verbally without the firstthree digits as “30/35.”
FOREX Terms
TABLE 4.1
31
Examples of Quote Convention
EUR/USD
1.2604/07
GBP/USD
1.5089/94
CHF/JPY
84.40/45
Quote ConventionExchange rates in the FOREX market are expressed using the following format:Base Currency /Quote Currency Bid/AskExamples can be found in Table 4.1.Normally only the final two digits of the bid price are shown. If the askprice is more than 100 pips above the bid price, then three digits will be displayed to the right of the slash mark (that is, EUR/CZK 32.5420/780). Thisonly occurs when the quote currency is a very weak monetary unit.
Transaction CostThe critical characteristic of the bid/ask spread is that it is also the transactioncost for a round-turn trade. Round-turn means both a buy (or sell) trade and anoffsetting sell (or buy) trade of the same size in the same currency pair. In thecase of the EUR/USD rate in Table 4.1, the transaction cost is three pips. Theformula for calculating the transaction cost is:Transaction Cost = Ask Price − Bid Price
RolloverRollover is the process whereby the settlement of an open trade is rolled forwardto another value date. The cost of this process is based on the interest rate differential of the two currencies.
Putting It All TogetherTrading currencies on margin lets you increase your buying power. If you have$2,000 cash in a margin account that allows 100:1 leverage, you could purchase
32
WHAT EVERY TRADER MUST KNOW
up to $200,000