Foreign Exchange (FOREX)
is the arena where a nation's currency is exchanged for that of another. The foreign exchange market is the largest financial market in the world, with the equivalent of over $1.9 trillion changing hands daily; more than three times the aggregate amount of the US Equity and Treasury markets combined. Unlike other financial markets, the Forex market has no physical location and no central exchange. It operates through a global network of banks, corporations and individuals trading one currency for another. The lack of a physical exchange enables the Forex market to operate on a 24-hour basis, spanning from one zone to another in all the major financial centers. Traditionally, retail investors' only means of gaining access to the foreign exchange market was through banks that transacted large amounts of currencies for commercial and investment purposes. Trading volume has increased rapidly over time, especially after exchange Forex is an interbank market that was created in 1971 when international trade transitioned from fixed to floating exchange rates. Since then the rates of currencies relative to each other are determined by the most obvious means which is the exchange at a mutually agreed rate.This market surpasses the others in its volume. For example, the daily turnover of world securities market is estimated at $300 billion, while Forex approaches 1 to 3 TRILLION US dollars in the same amount of time.However, Forex is not a market in a traditional sense. It doesn't have a fixed location of the trading floor as, for example, futures market does. The trading is done over the telephone and at the computer terminals in hundreds of banks around the world simultaneously.Futures and securities markets have one more significant feature distinguishing them from Forex, and at the same time restricting them. The trading is suspended at the end of each day and resumed only next morning. Thus, should certain significant developments occur in the USA, the opening of Russian market next morning could quite surprise you, if you're trading there.Forex is open 24 hours a day, and the currency exchange operations are maintained throught working days of the week. Almost every time zone (London, New York, Tokyo, Hong Kong, Sydney) has dealers willing to quote currencies. rates were allowed to float freely in 1971.
Today, importers and exporters, international portfolio managers, multinational corporations, speculators, day traders, long-term holders and hedge funds all use the FOREX market to pay for goods and services, transact in financial assets or to reduce the risk of currency movements by hedging their exposure in other markets. MG Financial Group’s combination of low margin and high leverage has changed the way the Interbank currency market operates. We have done this by opening the doors of Forex to retail investors, giving them the professional tools and services needed to trade effectively in an independent atmosphere. MG Financial Group, now operating in over 100 countries, serves all manner of clients, comprising speculators and strategic traders. Whether it’s day-traders looking for short-term gains, or fund managers wanting to hedge their non-US assets, MG's DealStation™ allows them to participate in FOREX trading by providing a combination of live quotes, Real-Time charts, and news and analysis that attracts traders with an orientation towards fundamental and/or technical analysis.
Forex - The Foreign exchange rate market.FOREX or The Foreign exchange rate market is an international market where various currency exchange transactions take place; this is in the shape of simultaneously buying one currency and selling another. The most commonly traded currencies are referred to as “Majors”; over 85% of daily transactions on Forex trading involve the Majors. These seven currencies are the US Currency (Dollar, USD), Japanese Yen (JPY), Euro (EUR), British Pound (GBP), Swiss Franc (CHF), Canadian Dollar (CAD) and Australian Dollar (AUD). The Forex system in operation today was established in the 1970s when free currency exchange rates were introduced, this period also saw the US Dollar overtake the British Pound as the benchmark currency. Prior to this and in particular during World War II, exchange rate remained more stable. Forex trading in simplest terms is the buying of one currency and the selling of another. Forex trading, also referred to, as “FX” is open to corporations, small businesses, commercial banks, investment funds and private individuals, it is the largest financial market in the world averaging a daily turnover of over $1 trillion dollars, making it a diverse and exciting market. It is a 24-hour market enabling it to accommodate constant changing world
Friday, July 27, 2007
Thursday, July 26, 2007
Forex Trading: Mistakes in a Trading Environment
When it comes to trading, one of the most neglected subjects are those dealing with trading psychology. Most traders spend days, months and even years trying to find the right system. But having a system is just part of the game. Don't get us wrong, it is very important to have a system that perfectly suits the trader, but it is as important as having a money management plan, or to understand all psychology barriers that may affect the trader decisions and other issues. In order to succeed in this business, there must be equilibrium between all important aspects of trading.
In the trading environment, when you lose a trade, what is the first idea that pops up in your mind? It would probably be, “There must be something wrong with my system”, or “I knew it, I shouldn't have taken this trade” (even when your system signaled it). But sometimes we need to dig a little deeper in order to see the nature of our mistake, and then work on it accordingly.
When it comes to trading the Forex market as well as other markets, only 5% of traders achieve the ultimate goal: to be consistent in profits. What is interesting though is that there is just a tiny difference between this 5% of traders and the rest of them. The top 5% grow from mistakes; mistakes are a learning experience, they learn an invaluable lesson on every single mistake made. Deep in their minds, a mistake is one more chance to try it harder and do it better the next time, because they know they might not get a chance the next time. And at the end, this tiny difference becomes THE big difference.
Mistakes in the trading environment
Most of us relate a trading mistake to the outcome (in terms of money) of any given trade. The truth is, a mistake has nothing to do with it, mistakes are made when certain guidelines are not followed. When the rules you trade by are violated. Take for instance the following scenarios:
First scenario: The system signals a trade.
- Signal taken and trade turns out to be a profitable trade.
Outcome of the trade : Positive, made money.
Experience gained: Its good to follow the system, if I do this consistently the odds will turn in my favor. Confidence is gained in both the trader and the system.
- Signal taken and trade turns out to be a loosing trade.
Outcome of the trade: Negative, lost money.
Experience gained: It is impossible to win every single trade, a loosing trade is just part of the business; our raw material, we know we can't get them all right. Even with this lost trade, the trader is proud about himself for following the system. Confidence in the trader is gained.
Mistake made : None.
- Signal not taken and trade turns out to be a profitable trade.
Outcome of the trade: Neutral.
Experience gained: Frustration, the trader always seems to get in trades that turned out to be loosing trades and let the profitable trades go away. Confidence is lost in the trader self.
Mistake made: Not taking a trade when the system signaled it.
- Signal not taken and trade turns out to be a loosing trade.
Outcome of the trade: Neutral.
Experience gained: The trader will start to think “hey, I'm better than my system”. Even if the trader doesn't think on it consciously, the trader will rationalize on every signal given by the system because deep in his or her mind, his or her “feeling” is more intelligent than the system itself. From this point on, the trader will try to outguess the system. This mistake has catastrophic effects on our confidence to the system. The confidence on the trader turns into overconfidence.
Mistake made: Not taking a trade when system signaled it
Second Scenario: System does not signal a trade.
- No trade is taken
Outcome of the trade: Neutral
Experience gained: Good discipline, we only need to take trades when the odds are in our favor, just when the system signals it. Confidence gained in both the trader self and the system.
Mistake made: None
- A trade is taken, turns out to be a profitable trade.
Outcome of the trade: Positive, made money.
Experience gained: This mistake has the most catastrophic effects in the trader self, the system and most importantly in the trader's trading career. You will start to think you need no system, you know better from them all. From this point on, you will start to trade based on what you think. Confidence in the system is totally lost. Confidence in the trader self turns into overconfidence.
Mistake made: Take a trade when there was no signal from the system.
- A trade is taken, turned out to be a loosing trade.
Outcome of the trade: negative, lost money.
Experience gained: The trader will rethink his strategy. The next time, the trader will think it twice before getting in a trade when the system does not signal it. The trader will go “Ok, it is better to get in the market when my system signals it, only those trade have a higher probability of success”. Confidence is gained in the system.
Mistake made: Take a trade when there was no signal from the system
As you can see, there is absolutely no correlation between the outcome of the trade and a mistake. The most catastrophic mistake even has a positive trade outcome, made money, but this could be the beginning of the end of the trader's career. As we have already stated, mistakes must only be related to the violation of rules a trader trades by.
All these mistakes were directly related to the signals given by a system, but the same is applied when getting out of a trade. There are also mistakes related to following a trading plan. For example, risking more money on a given trade than the amount the trader should have risked and many more.
Most mistakes can be avoided by first having a trading plan. A trading plan includes the system : the criteria we use to get in and out the market, the money management plan : how much we will risk on any given trade, and many other points. Secondly, and most important, we need to have the discipline to follow strictly our plan. We created our plan when no trade was placed on, thus no psychology barriers were up front. So, the only thing we are certain about is that if we follow our plan, the decision taken is on our best interests, and in the long run, these decisions will help us have better results. We don't have to worry about isolated events, or trades that could had give us better results at first, but then they could have catastrophic results in our trading career.
How to deal with mistakes
There are many possible ways to properly manage mistakes. We will suggest the one that works better for us.
Step one: Belief change.
Every mistake is a learning experience. They all have something valuable to offer. Try to counteract the natural tendency of feeling frustrated and approach mistakes in a positive manner. Instead of yelling to everyone around and feeling disappointed, say to yourself “ok, I did something wrong, what happened? What is it?
Step two: Identify the mistake made.
Define the mistake, find out what caused the mistake, and try as hard as you can to effectively see the nature of that mistake. Finding the mistake nature will prevent you from making the same mistake again. More than often you will find the answer where you less expected. Take for instance a trader that doesn't follow the system. The reason behind this could be that the trader is afraid of loosing. But then, why is he or she afraid? It could be that the trader is using a system that does not fit him or her, and finds difficult to follow every signal. In this case, as you can see, the nature of the mistake is not in the surface. You need to try as hard as you can to find the real reason of the given mistake.
Step three: Measure the consequences of the mistake.
List the consequences of making that particular mistake, both good and bad. Good consequences are those that make us better traders after dealing with the mistake. Think on all possible reasons you can learn from what happened. For the same example above, what are the consequences of making that mistake? Well, if you don't follow the system, you will gradually loose confidence in it, and this at the end will put you into trades you don't really want to be, and out of trades you should be in.
Step four: Take action.
Taking proper action is the last and most important step. In order to learn, you need to change your behavior. Make sure that whatever you do, you become “this-mistake-proof”. By taking action we turn every single mistake into a small part of success in our trading career. Continuing with the same example, redefining the system would be the trader's final step. The trader would put a system that perfectly fits him or her, so the trader doesn't find any trouble following it in future signals.
Understanding the fact that the outcome of any trade has nothing to do with a mistake will open your mind to other possibilities, where you will be able to understand the nature of every mistake made. This at the same time will open the doors for your trading career as you work and take proper action on every mistake made.
The process of success is slow, and plenty of times it is attributed to repeated mistakes made and the constant struggle to get past these mistakes, working on them accordingly. How we deal with them will shape our future as a trader, and most importantly as a person.
Incorporating Price Action into a Forex Trading System
Trading the Forex market has become very popular in the last few years. But how difficult is it to achieve success in the Forex trading arena? Or let me rephrase this question, how many traders achieve consistent profitable results trading the Forex market? Unfortunately very few, only 5% of traders achieve this goal. One of the main reasons of this is because Forex traders focus in the wrong information to make their trading decisions and totally forget about the most important factor: Price behavior.
Most Forex trading systems are made off technical indicators (a moving average (MA) crossover, overbought/oversold conditions in an oscillator, etc.) But what are technical indicators? They are just a series of data points plotted in a chart; these points are derived from a mathematical formula applied to the price of any given currency pair. In other words, it is a chart of price plotted in a different way that helps us see other aspects of price.
There is an important implication on this definition of technical indicators. The fact that the readings obtained from them are based on price action. Take for instance a long MA crossover signal, the price has gone up enough to make the short period MA crossover the long period MA generating a long signal. Most traders see it as “the MA crossover made the price go up,” but it happened the other way around, the MA crossover signal occurred because the price went up. Where I'm trying to get here is that at the end, price behavior dictates how an indicator will act, and this should be taken into consideration on any trading decision made.
Trading decisions based on technical indicators without taking price action into consideration will give us less accurate results. For example, again a long signal generated by a MA crossover as the market approaches an important resistance level. If the price suddenly starts to bounce back off that important level there is no point on taking this signal, price action is telling us the market doesn't want to go up. Most of the time, under this circumstances, the market will continue to fall down, disregarding the MA crossover.
Don't get us wrong here, technical indicators are a very important aspect of trading. They help us see certain conditions that are otherwise difficult to see by watching pure price action. But when it comes to pull the trigger, price action incorporation into our Forex trading system will definitely put the odds in our favor, it will generate higher probability trades.
So, how to create a perfect Forex trading system?
First of all, you need to make sure your trading system fits your trading personality; otherwise you will find it hard to follow it. Every trader has different needs and goals, thus there is no system that perfectly fits all traders. You need to make your own research on various trading styles and technical indicators until you find a concept that perfectly works for you. Make sure you know the nature of whatever technical indicator used.
Secondly, incorporate price action into your system. So you only take long signals if the price behavior tells you the market wants to go up, and short signals if the market gives you indication that it will go down.
Third, and most importantly, you need to have the discipline to follow your Forex trading system rigorously. Try it first on a demo account, then move on to a small account and finally when feeling comfortably and being consistent profitable apply your system in a regular account.
The Currency Exchange Market
The currency exchange market is an inter-bank or inter-dealer market that was established in 1971 when floating exchange rates began to materialize. In addition, it is an Over-The-Counter market, meaning that transactions are conducted between any two counter parties that agree to trade via the telephone or electronic network. Trading is thus not centralized, as is the case with many stock markets (i.e., NYSE, ASE, CME) or as the case for currency futures and currency options, which trade on special exchanges. Dealers often "advertise" exchange rates using a distribution network, such as the one provided by Reuters or Bridge. Dealers then use the information obtained there (or directly) to "agree" to a rate and a trade.
The major dealing centers today are: London, with about 30% of the market, New York, with 20%, Tokyo, with 12%, Zurich, Frankfurt, Hong Kong and Singapore, with about 7% each, followed by Paris and Sydney with 3% each.
In terms of trading volume, the currency exchange market is the worlds largest market, with daily trading volumes in excess of $1.5 trillion US dollars. This is orders of magnitude larger than the bond or stock market. For example, the New York Stock Exchange has a daily trading volume of approximately $60 billion. Thus, the currency exchange market is by far the most liquid market in the world today. Because of the volume in trading, it is impossible for individuals or companies to affect the exchange rates. In fact, even central banks and governments find it increasingly difficult to affect the exchange rates of the most liquid currencies, such as the US dollar, Japanese Yen, Euro, Swiss Frank, Canadian Dollar or Australian Dollar.
The currency exchange market is a true 24-hour market, 5 days a week. There are dealers in every major time zone. Trading begins Monday morning in Sydney (which corresponds to 3pm EST, Sunday) and then daily moves around the globe through the various trading centers until closing Friday evening at 4:30pm EST in New York.
Today, over 85% of all currency exchange transactions involve a few major currencies: the US Dollar (USD), Japanese Yen (JPY), Euro (EUR), Swiss Frank (CHF), British Pound (GBP), Canadian Dollar (CAD), and Australian Dollar (AUD). In the currency exchange market, most of the currencies are traded only against the US Dollar. The term cross rate refers to an exchange rate between two non-dollar currencies. Trading between two non-dollar currencies usually occurs by first trading one against the US Dollar and then trading the US Dollar against the second non-dollar currency. Because of this, the spread in the exchange rate between two non-dollar currencies is often higher. (There are a few non-dollar currencies that are traded directly, such as GBP/EUR or EUR/CHF.) The following directly traded currency pairs make up the vast majority of the trading volume and are thus considered to be the most important ones: EUR/USD, USD/JPY, EUR/JPY, USD/CAD, EUR/GBP, GBP/USD, USD/CHF, AUD/USD, and AUD/JPY.
THE FOREIGN EXCHANGE MARKET
The foreign exchange market enables companies, fund
managers and banks to buy and sell foreign currencies, if
necessary in large amounts. The motivations behind this
demand for foreign currency include capital flows arising
from trade in goods and services, cross-border
investment and loans and speculation on the future level
of exchange rates. The sums involved are very large:
estimated global turnover in all currencies in April 1998
was $1,490 billion, an increase of 26 percent over the
past three years. Deals are typically for amounts
between $3 million and $10 million, though much larger
transactions are often done.
Foreign exchange trading may be for spot or forward
delivery. Generally, spot transactions are undertaken
for an actual exchange of currencies (delivery or
settlement) two business days later (the value date).
Forward transactions involve a delivery date further
into the future, possibly as far as a year or more ahead.
By buying or selling in the forward market a bank can,
on its own behalf or that of a customer, protect the
value of anticipated flows of foreign currency, in
terms of its domestic currency, from exchange rate
volatility.
Unlike some financial markets, the foreign exchange
market has no single location - foreign exchange is not
dealt across a trading floor. Instead, trading is via
telephone and computer links between dealers in
different centres and, indeed, different continents.
London is the world’s largest foreign exchange centre:
average daily turnover is $637 billion. This is
approximately the same as the combined level of
trading in the United States, Japan and Singapore
(see Box 1).
London’s leading position arises partly from the large
volume of international financial business generated
here - insurance, bonds, shipping, equities,
commodities and banking. London also benefits from
its geographical location which enables firms located
here to trade not only with each other and with firms
based in Europe throughout the day, but also with the
US and the Far East, whereas their time difference
makes it difficult for firms in those two centres to trade
with each other. When banks in London begin trading
at 8 am they can deal with banks in Tokyo, Hong Kong
or Singapore whose trading day is just ending. From
about 1 pm onwards, London banks can trade with
banks in New York; before they close at 4 pm their
counterparties may be in Los Angeles or San Francisco.
This is important because the foreign exchange market
trades 24 hours a day: 66 percent of trades involving a
firm in London are transacted with a counterparty
located abroad.
THE PARTICIPANTS
Broadly speaking, there are three types of participant in the
market: customers, banks and brokers. Customers, such as
multinational corporations, are in the market because they
require foreign currency in the course of their cross border
trade or investment business. For example, an engineering
firm based in the United Kingdom might use the foreign
exchange market to buy the dollars it needs to pay to a firm in
America selling it raw materials; in this instance it would sell
sterling and buy dollars. Commercial banks are by far the
most active participants in the foreign exchange market
(see Box 4). Some deal with other financial institutions and
corporations who contact them, typically by telephone, to ask
for their rates, and may then buy foreign currency from, or
sell, to the bank at those rates. This is known as market
making: the banks will at all times quote buying or selling
rates for pairs of currencies - dollars to the pound, Japanese
yen to the dollar and so on. The market makers earn a profit
on the difference between their buying and selling rates, but
THE FOREIGN
EXCHANGE MARKET
AVERAGE DAILY FOREIGN EXCHANGE Box 1
MARKET TURNOVER IN THE MAIN CENTRES
April 1998 US$ Billions
United Kingdom 637
United States 351
Japan 149
Singapore 139
Germany 94
Switzerland 82
Hong Kong 79
France 72
Source: Surveys conducted by national central banks,
co-ordinated by the Bank for International Settlements
A P R I L 2 0 0 0
FACT SHEET
they have to be ready to change their prices very quickly in
order to avoid holding a currency whose value is falling
(depreciating), or being short of a currency which is rising
(appreciating). Banks also deal on behalf of corporations and
other, typically smaller, banks. The third type of participant,
the brokers, act as intermediaries between the banks. They
are specialist companies with computer links or telephone
lines to banks throughout the world so that at any time they
should know which bank has the highest bid (buying) rate for
a currency, and which the lowest offer (selling) rate. By
using a broker it should, therefore, be possible for banks to
find the best dealing rate currently available. The broker
does not deal on its own account, but charges a commission
for its services.
DEALING IN THE SPOT & FORWARD MARKETS
To execute a spot deal in the market, a dealer contacts his
counterpart at a market-making bank and asks for his price in,
for example “sterling-dollar” (i.e US dollars to the British
pound). The market maker normally quotes a two-way price -
that is he stands ready to bid for or offer up to some standard
amount. The difference between these two prices is known as
the spread. For the sake of convenience, the market
convention where trading is between banks is not to quote the
“big figures” (i.e pounds and pence, dollars and cents); instead,
dealers tend to quote only the points (the last two figures of the
price). For example, if the rate for pounds against the dollar
was £1 = US$ 1.6315-25 then the market maker would quote
“fifteen-twenty five”: he bids for pounds at $1.6315 and offers
them at $1.6325. If the market maker wishes to deal he will
hit, that is accept, one side of the price. Written confirmation
of this oral contract will be exchanged and instructions
concerning payment given, and passed on to the settlements
staff who ensure that the respective currency amounts are
transferred into the designated accounts on the value date.
Quotation of prices and dealing in the forward market are
rather different from spot dealing. Theoretically it is possible
for the forward price of a currency to equal its spot price. But
because the interest rate that can be earned by holding different
currencies usually varies, in practice the forward price is
normally higher or lower than (at a premium or a discount to)
the spot rate (see Box 2 for the method of calculation). For
convenience, forward prices are not quoted outright, and
instead dealers quote the differential (the premium or
discount). This practice has a number of benefits. Premiums
and discounts are subject to much less fluctuation than are spot
rates, so quoting the differentials requires far fewer changes to
published prices. Furthermore, foreign exchange swaps
(combining a spot purchase with a simultaneous forward sale,
or vice-versa) are based on the differentials with the actual spot
rate being of relatively little consequence.
Premiums and discounts reflect the interest rate differentials
between currencies at the time the deal is done; the
determination of the forward rate does not depend directly on
THE DETERMINATION OF FORWARD RATES Box 2
The forward rate is equivalent to the spot rate plus a
premium or minus a discount. The forward premium or
discount is determined by means of the following general
equation which is adjusted to take account of whether the
discount/premium or the bid/offered rate is being
calculated:
Spot rate x (interest rate differential, i.e. $ interest rate - EUR interest rate) x days/360
1 + (EUR interest rate x days/360)
To calculate, for example, the six month forward rate for
the Euro against the Dollar by determining the necessary
adjustment (premium/discount), the following information
is also needed:
BID OFFER
Spot exchange rate (€/=$US) 0.9720 0.9725
6 month $ interest rate 61/4% 63/8%
6 month Euro interest rate 35/8% 33/4%
So offer rate equation is:
0.9725 x (.06375 - .03625) x 182/360)
1 + (.003625 x 182/360)
= -.013280
And the bid rate equation is:
0.9720 x (.0625 - .0375) x 182/360
1 + (.0375 x 182/360)
= -.012056
So the forward rates are 0.9841 (bid) and 0.9858 (offered)
FUTURES AND OPTIONS Box 3
Currency futures are forward transactions with standard
contract sizes and maturity dates (e.g US dollars 125,000
for settlement in December) which are traded on a
formal exchange. Because futures contracts are
standardised, they are less flexible than forward
contracts. Dealing in futures also involves certain
transactions costs, such as the costs of being, or trading
through, a member of the exchange. But, futures do
provide the opportunity to deal in smaller amounts than
in the spot/forward markets and to obtain a considerable
exposure with a small capital outlay, since the initial
capital outlay is small relative to the contract size.
Currency options provide the buyer with the right, but
not the obligation, to sell or buy an amount of foreign
currency at an exchange rate and date specified in
advance. The buyer must pay a premium to the writer of
the option (which is often a bank). Currency options
allow the user to guarantee the buying price (call) or
selling price (put) of a currency without foregoing the
opportunity to benefit from favourable exchange rate
movements, as the user can buy or sell in the spot market
if the price is better. The writer of an option benefits
from the premiums received but, because it stands
committed to buy or sell currency at the pre-agreed
exchange, it faces the risk of losses arising from
exchange rate movements.
any estimation of what the future exchange rates in question
are likely to be. Thus, if a currency with a high interest rate
is sold forward in exchange for a currency with a lower
interest rate, then the seller continues to enjoy the benefit of
the higher interest rate for the period until the value date.
However, the buyer must wait to obtain the currency on
which it can earn the higher interest rate. This imbalance is
compensated by the purchaser receiving a discount on the
spot exchange rate in a deal undertaken for forward
settlement.
A forward transaction can be “closed out” at any time by
means of another forward transaction to sell or repurchase the
foreign currency for the original value date.
Forward transactions are a flexible and commonly used
method of protecting the value of future flows of foreign
currency in terms of the domestic currency of a firm or bank.
As the foreign exchange market has grown, so other
instruments such as futures and options (see Box 3) have
developed to facilitate the protection, or hedging, of foreign
exchange commitments.
THE DETERMINATION OF EXCHANGE RATES
In the long run, the demand for one country’s currency in
terms of another country’s currency is determined by real
economic factors. The exchange rate is influenced by relative
inflation, growth and interest rates and trade and investment
flows between countries. Foreign exchange dealers therefore
closely monitor announcements of new economic statistics on
the major world economies. When economic releases are out
of line with forecasts, dealers alter the rates they are quoting
to reflect the implied change in their assessment of the
currency’s value.
Since changes within and between different governments
often lead to changes in economic and financial policies,
political developments can also affect the foreign exchange
market. The market may therefore react to changes in public
opinion polls or other news items which have implications for
future political developments. But expected news, whether
economic or political, rarely moves exchange rates - the
effect will already have been anticipated or “discounted”.
Unexpected news, such as a country changing the regime it
favours for managing its currency, or unanticipated problems
in a nation’s economy, however, can lead to sudden and sharp
exchange rate movements.
Alongside these fundamental considerations, banks and
brokers undertake “technical analysis”, studying market
movements by means of charts showing the movement of
exchange rates over time. Charts can be used to extrapolate
from past movements. Technical analysis is based on the
underlying assumption that price movements follow broadly
predictable patterns which reflect market psychology, and
that past patterns can thus give an indication to possible
future trends.
THE MARKET IN LONDON Box 4
Participants
The vast majority of foreign exchange business in London
is accounted for by trading between banks: in April 1998,
domestic and international inter-bank transactions
accounted for 83 percent of trading, up from 75 percent in
1995. Of the remainder of banks’ trading activity, 9.5
percent was with other, non-bank financial institutions such
as pension funds and asset managers; non-financial
institutions, such as multinational corporations, account for
just over 7 percent.
The proportion of principals’ business handled by brokers
is now 27 percent, down from 35 percent in 1995.
However, electronic broking systems have continued to
take market share away from traditional, telephone-based,
voice brokers: the proportion of business conducted by
voice brokers has fallen to 16 percent, from 30 percent in
1995; the share of electronic brokers such as Reuters and
EBS has risen from 5 percent to 11 percent.
Spot transactions
Over the past 15 years, spot business has not grown as fast
as forward business: forward transactions now account for
65 percent of turnover, compared with 27 percent in 1986.
In the forward market, most of the transactions are swaps,
which are often used to hedge currency risk and manage
liquidity.
Currency composition
The most widely traded currency pairs are US$/€, US$/¥
and £/US$. A wide range of currencies are traded in
London; unlike other European financial centres, trading in
the domestic currency accounts for a small proportion of
turnover. Only 18 percent of turnover in the UK involves
sterling; this compares with domestic currency trading
accounting for 66 percent of turnover in Germany,
41 percent in France and 39 percent in Switzerland.
Market share of overseas banks
About 15 percent of the foreign exchange business in
London transacted by banks is done by UK institutions and
the remaining 85 percent by overseas banks. North
American principals are the most active, with a 49 percent
share, followed by UK principals (15 percent) and Japanese
(7 percent)
Source: Bank of England Survey, April 1998
Cross-border interbank 57.9%
(approx. $369.3 bn per day)
Domestic interbank 25.2%
(approx. $160.9 bn per day)
Other financial institutions 9.5%
(approx. $60.5 bn per day)
Non-financial institutions 7.3%
(approx. $46.6 bn per day)
Average daily turnover by counterparty
THE ROLE OF GOVERNMENT AND CENTRAL BANKS
Not only is the exchange rate influenced by real economic
variables, but its level and volatility also have an impact (both
direct and indirect) on these same economic factors. Even
modest changes in the value of a currency can have significant
effects on business and the national economy more generally.
If a currency were to weaken excessively, it would put
upward pressure on domestic inflation as imports and
internationally tradeable goods produced domestically rose in
price: the cost, in terms of the domestic currency, of buying
foreign currency is higher at a weaker exchange rate.
Conversely, a strengthening currency might lead to a fall in
import prices and lower domestic inflation: the cost of
buying foreign currency in terms of the domestic currency is
lower at a stronger exchange rate. Domestic producers
would need to contain their costs in order to remain
internationally competitive. Otherwise their profitability and
the level of growth and employemnt in the economy as a
whole might fall.
The pound (‘sterling’) is currently allowed to “float” freely
against all other currencies. This means that the authorities
are not committed to maintaining the market value of sterling
within a pre-announced range against any other currency.
Sterling was a member of the Exchange Rate Mechanism of
the European Monetary System from 8 October 1990 until
16 September 1992. During this period sterling’s ability to
fluctuate against the other participating currencies was
constrained by the central banks of participating countries,
who were committed to holding sterling within a margin of
6 percent on either side of its agreed central rates against each
of the other participating currencies.
The authorities have a number of means of influencing the
exchange rate. The Bank of England can intervene in the
foreign exchange market by buying or selling pounds which
would alter the supply of sterling relative to other currencies.
However, although intervention could be effective in
smoothing short-term fluctuations in the value of the pound,
it cannot resolve underlying economic problems, which have
to be addressed by more fundamental policy measures.
Although monetary policy can influence the level of the
exchange rate, the overall objective of monetary policy in the
UK is the achievement of domestic price stability, as defined
by the inflation target set by the Government.
The Government’s foreign exchange reserves are
approximately $35 billion; in addition, the Bank of England
has approximately $4 billion of holdings of foreign currency
and gold. A principal source of the reserves is borrowing by
the government in foreign currency. The other main source is
intervention. When the Bank of England intervenes to buy
foreign currencies (and sells sterling), the proceeds will be
added to the reserves. On the other hand, sales of foreign
currencies to protect the value of sterling will reduce the
reserves. However, this does not mean that the reserves have
been spent: the foreign exchange reserve “asset” has merely
been converted into a sterling one.
THE EFFECTIVE EXCHANGE RATE Box 5
An effective exchange rate is a measure of the value of a
currency against several other currencies (a “basket”) at
once. It is calculated as a weighted geometric average of
exchange rates and expressed as an index relative to a
base year. (In the chart below the base year is 1990,
when the sterling’s average level was 100). Because the
effective exchange rate is an average of a currency’s
exchange rates, it is often more useful when looking at
the value of a currency over a long period than a single
exchange rate (such as sterling-dollar). The higher the
index figure, the stronger the currency. In the chart
below the weight given to each currency in the basket is
derived from the trade flows in manufactured goods and
represents the relative importance of the country in
question as a competitor in export markets. The weights
are revised periodically to accommodate countries’
changing economic circumstances.
managers and banks to buy and sell foreign currencies, if
necessary in large amounts. The motivations behind this
demand for foreign currency include capital flows arising
from trade in goods and services, cross-border
investment and loans and speculation on the future level
of exchange rates. The sums involved are very large:
estimated global turnover in all currencies in April 1998
was $1,490 billion, an increase of 26 percent over the
past three years. Deals are typically for amounts
between $3 million and $10 million, though much larger
transactions are often done.
Foreign exchange trading may be for spot or forward
delivery. Generally, spot transactions are undertaken
for an actual exchange of currencies (delivery or
settlement) two business days later (the value date).
Forward transactions involve a delivery date further
into the future, possibly as far as a year or more ahead.
By buying or selling in the forward market a bank can,
on its own behalf or that of a customer, protect the
value of anticipated flows of foreign currency, in
terms of its domestic currency, from exchange rate
volatility.
Unlike some financial markets, the foreign exchange
market has no single location - foreign exchange is not
dealt across a trading floor. Instead, trading is via
telephone and computer links between dealers in
different centres and, indeed, different continents.
London is the world’s largest foreign exchange centre:
average daily turnover is $637 billion. This is
approximately the same as the combined level of
trading in the United States, Japan and Singapore
(see Box 1).
London’s leading position arises partly from the large
volume of international financial business generated
here - insurance, bonds, shipping, equities,
commodities and banking. London also benefits from
its geographical location which enables firms located
here to trade not only with each other and with firms
based in Europe throughout the day, but also with the
US and the Far East, whereas their time difference
makes it difficult for firms in those two centres to trade
with each other. When banks in London begin trading
at 8 am they can deal with banks in Tokyo, Hong Kong
or Singapore whose trading day is just ending. From
about 1 pm onwards, London banks can trade with
banks in New York; before they close at 4 pm their
counterparties may be in Los Angeles or San Francisco.
This is important because the foreign exchange market
trades 24 hours a day: 66 percent of trades involving a
firm in London are transacted with a counterparty
located abroad.
THE PARTICIPANTS
Broadly speaking, there are three types of participant in the
market: customers, banks and brokers. Customers, such as
multinational corporations, are in the market because they
require foreign currency in the course of their cross border
trade or investment business. For example, an engineering
firm based in the United Kingdom might use the foreign
exchange market to buy the dollars it needs to pay to a firm in
America selling it raw materials; in this instance it would sell
sterling and buy dollars. Commercial banks are by far the
most active participants in the foreign exchange market
(see Box 4). Some deal with other financial institutions and
corporations who contact them, typically by telephone, to ask
for their rates, and may then buy foreign currency from, or
sell, to the bank at those rates. This is known as market
making: the banks will at all times quote buying or selling
rates for pairs of currencies - dollars to the pound, Japanese
yen to the dollar and so on. The market makers earn a profit
on the difference between their buying and selling rates, but
THE FOREIGN
EXCHANGE MARKET
AVERAGE DAILY FOREIGN EXCHANGE Box 1
MARKET TURNOVER IN THE MAIN CENTRES
April 1998 US$ Billions
United Kingdom 637
United States 351
Japan 149
Singapore 139
Germany 94
Switzerland 82
Hong Kong 79
France 72
Source: Surveys conducted by national central banks,
co-ordinated by the Bank for International Settlements
A P R I L 2 0 0 0
FACT SHEET
they have to be ready to change their prices very quickly in
order to avoid holding a currency whose value is falling
(depreciating), or being short of a currency which is rising
(appreciating). Banks also deal on behalf of corporations and
other, typically smaller, banks. The third type of participant,
the brokers, act as intermediaries between the banks. They
are specialist companies with computer links or telephone
lines to banks throughout the world so that at any time they
should know which bank has the highest bid (buying) rate for
a currency, and which the lowest offer (selling) rate. By
using a broker it should, therefore, be possible for banks to
find the best dealing rate currently available. The broker
does not deal on its own account, but charges a commission
for its services.
DEALING IN THE SPOT & FORWARD MARKETS
To execute a spot deal in the market, a dealer contacts his
counterpart at a market-making bank and asks for his price in,
for example “sterling-dollar” (i.e US dollars to the British
pound). The market maker normally quotes a two-way price -
that is he stands ready to bid for or offer up to some standard
amount. The difference between these two prices is known as
the spread. For the sake of convenience, the market
convention where trading is between banks is not to quote the
“big figures” (i.e pounds and pence, dollars and cents); instead,
dealers tend to quote only the points (the last two figures of the
price). For example, if the rate for pounds against the dollar
was £1 = US$ 1.6315-25 then the market maker would quote
“fifteen-twenty five”: he bids for pounds at $1.6315 and offers
them at $1.6325. If the market maker wishes to deal he will
hit, that is accept, one side of the price. Written confirmation
of this oral contract will be exchanged and instructions
concerning payment given, and passed on to the settlements
staff who ensure that the respective currency amounts are
transferred into the designated accounts on the value date.
Quotation of prices and dealing in the forward market are
rather different from spot dealing. Theoretically it is possible
for the forward price of a currency to equal its spot price. But
because the interest rate that can be earned by holding different
currencies usually varies, in practice the forward price is
normally higher or lower than (at a premium or a discount to)
the spot rate (see Box 2 for the method of calculation). For
convenience, forward prices are not quoted outright, and
instead dealers quote the differential (the premium or
discount). This practice has a number of benefits. Premiums
and discounts are subject to much less fluctuation than are spot
rates, so quoting the differentials requires far fewer changes to
published prices. Furthermore, foreign exchange swaps
(combining a spot purchase with a simultaneous forward sale,
or vice-versa) are based on the differentials with the actual spot
rate being of relatively little consequence.
Premiums and discounts reflect the interest rate differentials
between currencies at the time the deal is done; the
determination of the forward rate does not depend directly on
THE DETERMINATION OF FORWARD RATES Box 2
The forward rate is equivalent to the spot rate plus a
premium or minus a discount. The forward premium or
discount is determined by means of the following general
equation which is adjusted to take account of whether the
discount/premium or the bid/offered rate is being
calculated:
Spot rate x (interest rate differential, i.e. $ interest rate - EUR interest rate) x days/360
1 + (EUR interest rate x days/360)
To calculate, for example, the six month forward rate for
the Euro against the Dollar by determining the necessary
adjustment (premium/discount), the following information
is also needed:
BID OFFER
Spot exchange rate (€/=$US) 0.9720 0.9725
6 month $ interest rate 61/4% 63/8%
6 month Euro interest rate 35/8% 33/4%
So offer rate equation is:
0.9725 x (.06375 - .03625) x 182/360)
1 + (.003625 x 182/360)
= -.013280
And the bid rate equation is:
0.9720 x (.0625 - .0375) x 182/360
1 + (.0375 x 182/360)
= -.012056
So the forward rates are 0.9841 (bid) and 0.9858 (offered)
FUTURES AND OPTIONS Box 3
Currency futures are forward transactions with standard
contract sizes and maturity dates (e.g US dollars 125,000
for settlement in December) which are traded on a
formal exchange. Because futures contracts are
standardised, they are less flexible than forward
contracts. Dealing in futures also involves certain
transactions costs, such as the costs of being, or trading
through, a member of the exchange. But, futures do
provide the opportunity to deal in smaller amounts than
in the spot/forward markets and to obtain a considerable
exposure with a small capital outlay, since the initial
capital outlay is small relative to the contract size.
Currency options provide the buyer with the right, but
not the obligation, to sell or buy an amount of foreign
currency at an exchange rate and date specified in
advance. The buyer must pay a premium to the writer of
the option (which is often a bank). Currency options
allow the user to guarantee the buying price (call) or
selling price (put) of a currency without foregoing the
opportunity to benefit from favourable exchange rate
movements, as the user can buy or sell in the spot market
if the price is better. The writer of an option benefits
from the premiums received but, because it stands
committed to buy or sell currency at the pre-agreed
exchange, it faces the risk of losses arising from
exchange rate movements.
any estimation of what the future exchange rates in question
are likely to be. Thus, if a currency with a high interest rate
is sold forward in exchange for a currency with a lower
interest rate, then the seller continues to enjoy the benefit of
the higher interest rate for the period until the value date.
However, the buyer must wait to obtain the currency on
which it can earn the higher interest rate. This imbalance is
compensated by the purchaser receiving a discount on the
spot exchange rate in a deal undertaken for forward
settlement.
A forward transaction can be “closed out” at any time by
means of another forward transaction to sell or repurchase the
foreign currency for the original value date.
Forward transactions are a flexible and commonly used
method of protecting the value of future flows of foreign
currency in terms of the domestic currency of a firm or bank.
As the foreign exchange market has grown, so other
instruments such as futures and options (see Box 3) have
developed to facilitate the protection, or hedging, of foreign
exchange commitments.
THE DETERMINATION OF EXCHANGE RATES
In the long run, the demand for one country’s currency in
terms of another country’s currency is determined by real
economic factors. The exchange rate is influenced by relative
inflation, growth and interest rates and trade and investment
flows between countries. Foreign exchange dealers therefore
closely monitor announcements of new economic statistics on
the major world economies. When economic releases are out
of line with forecasts, dealers alter the rates they are quoting
to reflect the implied change in their assessment of the
currency’s value.
Since changes within and between different governments
often lead to changes in economic and financial policies,
political developments can also affect the foreign exchange
market. The market may therefore react to changes in public
opinion polls or other news items which have implications for
future political developments. But expected news, whether
economic or political, rarely moves exchange rates - the
effect will already have been anticipated or “discounted”.
Unexpected news, such as a country changing the regime it
favours for managing its currency, or unanticipated problems
in a nation’s economy, however, can lead to sudden and sharp
exchange rate movements.
Alongside these fundamental considerations, banks and
brokers undertake “technical analysis”, studying market
movements by means of charts showing the movement of
exchange rates over time. Charts can be used to extrapolate
from past movements. Technical analysis is based on the
underlying assumption that price movements follow broadly
predictable patterns which reflect market psychology, and
that past patterns can thus give an indication to possible
future trends.
THE MARKET IN LONDON Box 4
Participants
The vast majority of foreign exchange business in London
is accounted for by trading between banks: in April 1998,
domestic and international inter-bank transactions
accounted for 83 percent of trading, up from 75 percent in
1995. Of the remainder of banks’ trading activity, 9.5
percent was with other, non-bank financial institutions such
as pension funds and asset managers; non-financial
institutions, such as multinational corporations, account for
just over 7 percent.
The proportion of principals’ business handled by brokers
is now 27 percent, down from 35 percent in 1995.
However, electronic broking systems have continued to
take market share away from traditional, telephone-based,
voice brokers: the proportion of business conducted by
voice brokers has fallen to 16 percent, from 30 percent in
1995; the share of electronic brokers such as Reuters and
EBS has risen from 5 percent to 11 percent.
Spot transactions
Over the past 15 years, spot business has not grown as fast
as forward business: forward transactions now account for
65 percent of turnover, compared with 27 percent in 1986.
In the forward market, most of the transactions are swaps,
which are often used to hedge currency risk and manage
liquidity.
Currency composition
The most widely traded currency pairs are US$/€, US$/¥
and £/US$. A wide range of currencies are traded in
London; unlike other European financial centres, trading in
the domestic currency accounts for a small proportion of
turnover. Only 18 percent of turnover in the UK involves
sterling; this compares with domestic currency trading
accounting for 66 percent of turnover in Germany,
41 percent in France and 39 percent in Switzerland.
Market share of overseas banks
About 15 percent of the foreign exchange business in
London transacted by banks is done by UK institutions and
the remaining 85 percent by overseas banks. North
American principals are the most active, with a 49 percent
share, followed by UK principals (15 percent) and Japanese
(7 percent)
Source: Bank of England Survey, April 1998
Cross-border interbank 57.9%
(approx. $369.3 bn per day)
Domestic interbank 25.2%
(approx. $160.9 bn per day)
Other financial institutions 9.5%
(approx. $60.5 bn per day)
Non-financial institutions 7.3%
(approx. $46.6 bn per day)
Average daily turnover by counterparty
THE ROLE OF GOVERNMENT AND CENTRAL BANKS
Not only is the exchange rate influenced by real economic
variables, but its level and volatility also have an impact (both
direct and indirect) on these same economic factors. Even
modest changes in the value of a currency can have significant
effects on business and the national economy more generally.
If a currency were to weaken excessively, it would put
upward pressure on domestic inflation as imports and
internationally tradeable goods produced domestically rose in
price: the cost, in terms of the domestic currency, of buying
foreign currency is higher at a weaker exchange rate.
Conversely, a strengthening currency might lead to a fall in
import prices and lower domestic inflation: the cost of
buying foreign currency in terms of the domestic currency is
lower at a stronger exchange rate. Domestic producers
would need to contain their costs in order to remain
internationally competitive. Otherwise their profitability and
the level of growth and employemnt in the economy as a
whole might fall.
The pound (‘sterling’) is currently allowed to “float” freely
against all other currencies. This means that the authorities
are not committed to maintaining the market value of sterling
within a pre-announced range against any other currency.
Sterling was a member of the Exchange Rate Mechanism of
the European Monetary System from 8 October 1990 until
16 September 1992. During this period sterling’s ability to
fluctuate against the other participating currencies was
constrained by the central banks of participating countries,
who were committed to holding sterling within a margin of
6 percent on either side of its agreed central rates against each
of the other participating currencies.
The authorities have a number of means of influencing the
exchange rate. The Bank of England can intervene in the
foreign exchange market by buying or selling pounds which
would alter the supply of sterling relative to other currencies.
However, although intervention could be effective in
smoothing short-term fluctuations in the value of the pound,
it cannot resolve underlying economic problems, which have
to be addressed by more fundamental policy measures.
Although monetary policy can influence the level of the
exchange rate, the overall objective of monetary policy in the
UK is the achievement of domestic price stability, as defined
by the inflation target set by the Government.
The Government’s foreign exchange reserves are
approximately $35 billion; in addition, the Bank of England
has approximately $4 billion of holdings of foreign currency
and gold. A principal source of the reserves is borrowing by
the government in foreign currency. The other main source is
intervention. When the Bank of England intervenes to buy
foreign currencies (and sells sterling), the proceeds will be
added to the reserves. On the other hand, sales of foreign
currencies to protect the value of sterling will reduce the
reserves. However, this does not mean that the reserves have
been spent: the foreign exchange reserve “asset” has merely
been converted into a sterling one.
THE EFFECTIVE EXCHANGE RATE Box 5
An effective exchange rate is a measure of the value of a
currency against several other currencies (a “basket”) at
once. It is calculated as a weighted geometric average of
exchange rates and expressed as an index relative to a
base year. (In the chart below the base year is 1990,
when the sterling’s average level was 100). Because the
effective exchange rate is an average of a currency’s
exchange rates, it is often more useful when looking at
the value of a currency over a long period than a single
exchange rate (such as sterling-dollar). The higher the
index figure, the stronger the currency. In the chart
below the weight given to each currency in the basket is
derived from the trade flows in manufactured goods and
represents the relative importance of the country in
question as a competitor in export markets. The weights
are revised periodically to accommodate countries’
changing economic circumstances.
A Detailed Overview of the Forex Market
Introduction
The following facts and figures relate to the foreign exchange market. Much of the information is drawn from the Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity conducted by the Bank for International Settlements (BIS) in April 2004, and published in March 2005. 52 central banks and monetary authorities participated in the survey, collecting information from approximately 1200 market participants.
Structure
- Decentralised, over-the-counter market, also known as the 'interbank' market
- Main participants: Central Banks, commercial and investment banks, hedge funds, pension funds, corporations & private speculators
- The free-floating currency system began in the early 1970's and was officially ratified in 1978
- Online trading began in the mid to late 1990's
Source: BIS Triennial Survey 2004
Trading Hours
- 24 hour market
- Sunday 5pm EST through Friday 4pm EST.
- Trading begins in New Zealand, followed by Australia, Asia, the Middle East, Europe, and America
Size
- Largest financial market in the world
- $1.9 trillion average daily turnover, equivalent to:
- More than 10 times the average daily turnover of global equity markets1
- 40 times the average daily turnover of the NYSE2
- $300 a day for every man, woman, and child on earth
- An annual turnover more than 10 times the value of all the world's goods and services combined (GDP)3
- The spot market accounts for about one-third of daily turnover
1. About $167 billion - World Federation of Exchanges aggregate 2004
2. About $46 billion - NYSE 2004
3. About $36 trillion - World Bank 2003
Source: BIS Triennial Survey 2004
Major Markets
- The US & UK markets account for more than 50% of turnover
- Major markets: London, New York, Tokyo
- Trading activity is heaviest when major markets overlap4
- Nearly two-thirds of NY activity occurs in the morning hours while European markets are open5
5. NY Federal Reserve
Average Daily Turnover by Country
Concentration in the Banking Industry
- 16 banks account for 75% of turnover in the U.K.
- 11 banks account for 75% of turnover in the U.S.
- 11 banks account for 75% of turnover in Japan
Note: The reference here is to individual banking offices rather than banking organisations.
Source: BIS Triennial Survey 2004
Trading
- Retail brokers research: 90% of traders lose money, 5% break even, 5% make money
Technical Analysis
Commonly used technical indicators:
- Moving averages
- RSI
- Fibonacci retracements
- Stochastics
- MACD
- Momentum
- Bollinger bands
- Pivot point
- Elliott Wave
Currencies
- The US dollar is involved in approximately 90% of all foreign exchange transactions, equivalent to over US$1.5 trillion per day
Currency Codes
- USD = US Dollar
- EUR = Euro
- JPY = Japanese Yen
- GBP = British Pound
- CHF = Swiss Franc
- CAD = Canadian Dollar
- AUD = Australian Dollar
- NZD = New Zealand Dollar
Average Daily Turnover by Currency
N.B. Because two currencies are involved in each transaction, the sum of the percentage shares of individual currencies totals 200% instead of 100%.
Source: BIS Triennial Survey 2004
Currency Pairs
- Majors: EUR/USD, USD/JPY, GBP/USD, USD/CHF
- Dollar bloc: USD/CAD, AUD/USD, NZD/USD
- Major crosses: EUR/JPY, EUR/GBP, EUR/CHF
Average Daily Turnover by Currency Pair
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