The Forex Market

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For this eBook we’ll focus on understanding the following concepts:

How the Global Currencies Markets Affect

You on a Daily Basis

The Difference Between “Money”

and “Currency

The Difference Between Currencies Futures

and the Interbank Market

Currency Pair Symbols and Currency

Pair Pricing

Currency Margin and Leverage

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How the Global Currencies Markets Affect You on a Daily Basis Remember the last time you traveled abroad? Before you ever saw the foreign landscape you saw large illuminated signs in the airport lobby: “Money Exchange.” Recognizing the need to have a bit of cash on hand, you probably took a hundred dollars or so and traded it at the exchange for some local cash to pay for a taxi, and other small cash purchases. You may even remember the exchange rate.

Whatever it was, there’s little doubt that the exchange rate offered to you was much lower than you could get from your bank at home, or from trading that particular currency pair on the Interbank markets and, the exchange never works in your favor.

If you happen to travel to another country in the near future, take a look at the currency exchange rates when you arrive. There’s always a wide difference between the “wholesale” or Buy price and the “retail” or Sell price. Here’s an example: Suppose you’ve just arrived in London, and you’re looking to exchange US Dollars for British Pounds Sterling. From the sign above the exchange counter, you find that the “Sell” rate is that the “Sell” rate is 0.6129 GBP (Great Britain Pound) to 1 USD (United States Dollar). This means that your 4

$100 US will buy you £63.16 GBP. This might be an OK exchange rate to BUY your British Pounds, but wait until you’re ready to leave the country and fly back home! That’s when the exchange bank really makes their money. How? They’re the ones that control the “spread” or the difference between what they’ll give you in GBP for your Dollars, and what they’ll give you back in Dollars for your GBP when you’re ready to trade back into Dollars. Suppose you stayed one week. When you return to the airport the exchange rate is 1.35 US Dollars to one Sterling Pound. If you never spent your £63.16 GBP, you would only get back $85.266 US Dollars for the $100 that you originally exchanged.

Let’s suppose, however, that when you return to the airport a week later you could sell the Sterling for $1.85 because the exchange rate has changed. You would have made money on your trip - You came with $100 US Dollars and returned with $116.85.

The foreign exchange market is a way of life for the foreign traveler.

It is also a way of life for much of the world. Our head trader, Shawn often recalls spending some time working in Budapest, Hungary. This was in 1992, shortly after the communist economy crumbled opening the way to a Capitalist market system. Inflation was rampant. Many people would insist on being paid in German marks. Once a week they would go to the flea market to change just enough of the week’s 5

earnings to buy the staples; bread, milk, flour, and salt. Because of the effects of inflation, they were careful to only exchange exactly what they needed. If they exchanged their entire earnings, there would only be a fraction left by the end of the week.

Having the knowledge of currency trading, an astute trader could identify the fundamental economic factors that were driving the hyper-inflation and profited from a short position in the Hungarian Forint compared to the German Mark or the US Dollar.

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How the Forex Market Works In a world with a single currency, there would be no foreign exchange market, no foreign exchange rates, and no foreign exchange. But in our world of diverse currencies, the foreign exchange market plays an indispensable role for making payments across borders, transferring funds from one currency to another, and determining the exchange rate. Over the past twenty-five years, the foreign exchange market has performed those tasks with precision. The world environment is constantly changing and so is Foreign Exchange.

History of the Forex Markets Since the early 1970s, there has been a steady increase in the demand for international financial transactions. Since that time, the foreign exchange market has been profoundly transformed, not only in size, but in coverage, architecture, and mode of operation. The transformation is the result of structural shifts in the world economy and in the international financial system. During this short time, significant developments have changed the way we view currency and currency valuations. Several things have been monumental in the development of the modern currencies market. We’ll explain some of them...

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Retirement of the Gold Standard There has been a major change in the international monetary system from the fixed exchange rate “gold value” requirements of the BrettonWoods Agreement that existed until the early 1970s to the flexible legal structure of the markets today. As a result, nations have the choice of “floating” their exchange rates or following the historical precedence of a fixed exchange rate based on some underlying asset. This often leads to disagreements between countries who argue about the unfair manipulation of one country’s currency value over another through artificial value manipulation. China is often accused of this, for example. The practice has a tendency of keeping the price of goods and services artificially low in order to make them more competitive in the global marketplace at the expense of countires who are unable to compete in a fair and equitable manner.

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Deregulation There has been a tidal wave of financial deregulation throughout the world. Everywhere it seems, Countries are relinquishing government controls and restrictions, resulting in greater freedom for national and international financial transactions. This deregulation greatly increased competition among financial institutions both within and across national borders.

It’s no financial wild west, though. Organizations such as the NFA (National Futures Association) still maintain governing regulations that can and do change today.

Incentives for Foreign Investment With this deregulation, there has been a fundamental move towards international investment. Fund managers and institutions around the globe have vastly larger investment resources available, with which they are able to diversify and invest in unique ways and in ever larger amounts as they seek to maximize client returns. Often, this investment capital finds it’s way into multi-national investment opportunities, creating essentially borderless profit potential.

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Increasing Foreign Trade Now more than ever, there has been a broadening and deepening trend toward international trade liberalization, within a framework of multilateral trade agreements, such as the Tokyo and the Uruguay Rounds of the General Agreement on Tariffs and Trade (GATT), the North American Free Trade Agreement (NAFTA), and U.S. bilateral trade initiatives with China, Japan, and the European Union.

Technological Advancements Major advances in technology have made it possible to view instantaneous real-time transmission of vast amounts of market data worldwide. Sophisticated computer programs provide for immediate analysis and manipulation of that data to identify and trade market opportunities. Technology has also provided for the rapid and reliable execution of financial transactions. All this has occurred with a level of efficiency and reduced costs not dreamed possible a generation earlier.

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New Thinking in Financial Theory Breakthroughs in the theory and practice of finance have resulted not only in the development of innovative new financial instruments and derivative products, but also in our understanding of the financial system and our techniques for operating within it.

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Market Interrelationships The common theme underlying all of these developments is the role of the forex markets—the growth and development of forex market, the enhanced freedom and competition, the improvements in the efficiency, the increased reliance on market forces and mechanisms, and the creation of better market techniques and instruments.

The interplay of these forces, feeding off each other in a dynamic and synergistic way, created a global environment of creativity. In the 1970s, exchange rates became more volatile and imbalances in international payments grew much larger for well-known reasons: the advent of a floating exchange rate system, deregulation, and major macroeconomic shifts in the world economy. That caused financing needs to expand, which—at a time of rapid technological advancement—provided fertile ground for the development of new financial products and mechanisms. These innovations helped market participants circumvent existing controls and encouraged further moves toward deregulation, which led to additional new products, facilitated the financing of still larger imbalances, and encouraged a trend toward institutionalization of savings and diversification of investment. Financial markets grew progressively larger and more sophisticated, integrated, and efficient.

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In that environment, foreign exchange trading increased rapidly and changed intrinsically. The market has expanded from one of banks to one in which many other kinds of financial and non-financial institutions also participate... including corporations, investment firms, pension funds, and hedge funds. Its focus has broadened from servicing importers and exporters to handling the vast amounts of overseas investment and other capital flows that currently take place. It has evolved from a series of loosely connected national financial centers to a single integrated international market that plays a far more extensive and direct role in our economies, affecting all aspects of our lives and our prosperity.

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Money and Currency In order to trade currencies you need to understand “currency.” If you’re already experienced trading stocks or options, you had to learn what a share is and what a share represents. In this section we will answer some similar questions about currency.

Almost every nation has its own national monetary unit whether it’s a Dollar, the Peso, or the Rupee, etc. A nation’s money supply is used for making and receiving payments within its own national borders.

Often, in the course of doing business, a foreign monetary unit is needed to pay for goods or services across national borders. Thus, in any nation whose residents conduct business abroad there must be a system for providing access to foreign money.

In developing the framework to distinguish currency from money, consider a bottle of Pepsi. Money is used to purchase a bottle of Pepsi. Assume that in the United States, it costs $6 USD to purchase a bottle of Pepsi. We know that if we give a vendor a $1 bill and a $5 bill he will give us a Pepsi. We also know that if we provide a $10 bill, we will get four $1 bills back. This is money.

If you take a bottle of Pepsi to Japan and try to sell it, chances are you will not be paid $6 USD, you will be paid in Japanese Yen. But 14

how much do you charge? The answer depends on the relative value of dollars to yen. What happens if the yen loses value relative to the dollar? The bottle of Pepsi will cost more Yen in Tokyo, but it will remain the same price in dollars. This fluidly changing, relative value of money from one country to the next is what we refer to as currency.

Money represents a monetary means of domestic exchange; the value of money is fixed within the border of the nation that issues it.

The value of currency, on the other hand, is relative, and changes with the influence of local supply and demand. The value of currency is not fixed. Money and currency are similar, but operate in different forums for different purpose.

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Currency Parity and Value To better grasp the concept of foreign exchange you must understand the concept of parity and currency valuation. Simply stated, parity is a measurement of relationship. Currency parity is the value relationship between two or more currencies.

To illustrate parity, think of an ice cream parlor. When you walk into the Parlor you notice a sign that says “1 scoop… $1.” There is parity between ice cream and Dollars at $1.00 per scoop. The relative value of one scoop of ice cream is $1.00. When the owner of the ice cream parlor decides to raise the price of a scoop of ice cream, he is changing the parity of dollars to ice cream. Now ice cream parity is $1.25 per scoop, and you could say that either value of the money has decreased (inflation) or the value of ice cream has increased.

Currency parity is the relative value of one currency to another. It is difficult to measure and most governments exert great effort to monitor and regulate the value of their currency. Currency value is calculated by the relationship of the currency to goods or services.

The US government has developed a measuring stick called the Consumer Price Index (CPI) to measure the parity, or relationship between the US dollar and a basket of common goods and services.

This gives the government a basis by which they can measure and 16

track the relative value of the US dollar over time. If the price of gas doubles, the value of the dollar goes down. When value of US currency changes it directly affects US consumers for better or for worse.

This brings us to a critical key point...

Commodities and the currencies have an inverse relationship.

Generally, when commodity prices go up, currency values go down.

When the commodity prices go down, currency values go up.

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Major Currencies In the wake of currency manipulation of the 60’s and 70’s and the end of the Bretton Woods Agreement, a collection of the world’s seven most powerful economies formed an alliance to stabilize the worlds new floating currency. The Group of 7, or G7, was formed to negotiate and regulate central bank intervention. G7 soon discovered that intervention had little effect on the intermediate and long term forces of the currencies market, but the impact of these seven super powers has had a lasting effect on currency trading. Today, the G7 members meet to collaborate on international economic and monetary issues.

The G7 consists of the following nations: G7 Nation

Currency

Symbol

United States

U.S. Dollar

USD

Japan

Japanese Yen

JPY

United Kingdom

Pound Sterling

GBP

Canada

Canadian Dollar

CAD

France

Euro

EUR

Germany

Euro

EUR

Italy

Euro

EUR

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The G7 has become a significant influence in the currencies market.

In the US, you are accustomed to hearing news when the Federal Reserve Board meets to discuss economic policies. The G7 can be likened to the Federal Reserve Board, when they discuss economic and monetary policies you should take note. You may also hear it more recently called G8, with the addition of Russia.

Currency Pairs The foreign exchange market differs from the equities market in that you do not trade shares of a currency. Currencies transactions are always made in pairs. When you buy one currency you simultaneously sell the other. The exchange rate is a price—the number of units of one nation’s currency that must be sold in order to acquire one unit of another nation’s currency. Think of it like the travel example earlier.

In forex, there is always a sale of one currency and the simultaneous purchase of another. Reading a foreign exchange quote may seem a bit confusing at first. However, it’s really quite simple if you remember two things: The first currency listed first is the base currency and The value of the base currency is always “1” 19

Below is a list of some of the most commonly traded currency pairs in the forex market. More commonly traded pairs are called “majors.”

How many majors there are isn’t always agreed upon, though.

For three of the 6 majors listed below (USD/JPY, USD/CHF, and USD/CAD) quotes are expressed as a unit of $1 USD per the second currency quoted in the pair. For example, a quote of USD/JPY 80.01 means that one U.S. dollar is equal to 80.01 Japanese yen.

Pair

Currencies

EUR/USD

Euro vs. US Dollar

GBP/USD

Pound Sterling vs. US Dollar

AUD/USD

Australian Dollar vs. US Dollar

USD/JPY

US Dollar vs. Japanese Yen

USD/CHF

US Dollar vs. Swiss Franc

USD/CAD

US Dollar vs. Canadian Dollar

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When the U.S. dollar is the base unit and a currency quote goes up, it means the dollar has appreciated in value and the other currency has weakened relatively. If the USD/JPY quote we previously mentioned increases from 80.01 to 83.01, the dollar is stronger because it will now buy more yen than before.

Currency pairs that do not involve the U.S. dollar are called “cross currencies,” but the premise is the same. For example, a quote of EUR/JPY 127.95 signifies that one Euro is equal to 127.95 Japanese yen.

Returning to a concept from the first module, when trading forex you will see a two-sided quote, consisting of a ‘bid’ and ‘ask’. The ‘bid’ is the price at which you can sell the base currency (at the same time buying the counter currency). The ‘ask’ is the price at which you can buy the base currency (at the same time selling the counter currency).

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A Review of Pips Let’s go over what pips are again. Since each currency is based on a different unit, a uniform system of comparing two different values was needed to establish a currencies market. It was determined that currencies would trade in PIPs. Pips represent the smallest fluctuation in the exchange rate of a currency. This is similar to the concept of a “tick” for stocks. So how much is a pip worth? The value of a pip depends on the size of the contract (or lot) that is traded. Most interbank brokers offer regular contracts (or lot) sizes of 100,000 units of the base currency. With this figure in mind, we could determine what a pip is worth. Let’s take the quote example of EUR/USD = 1.2125. If 1 euro equals 1.2125 dollars, then 1 lot (or contract) of 100,000 euros should be worth 121,250 dollars and a fluctuation of 0.0001 (1 pip) should be worth 100,000 x 0.0001 = 10 dollars. Therefore, every time the price of the Euro versus the Dollar fluctuates by one pip, the value of each contract changes by 10 dollars. If you’re trading in US Dollars, it’s easiest to think of one full contract as $10 per pip.

Recently, brokers and dealers have started adding another decimal level. If the fourth decimal place is the pip, then the fifth decimal place is a “point.” There are 10 points per pip. Traders usually talk in terms of pips.

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Currency Margin and Leverage Trading in the currency markets requires a trader to think of margin differently than in the stock market. Margin in forex is not a down payment on a future purchase of equity, but a deposit to the trader’s account that will cover any currency trading losses in the future. A typical currency trading system will allow for a high degree of leverage in its margin requirements, up to 50:1 in the United States, with some overseas brokers allowing anywhere up to 100:1 and even 500:1 in some cases.

This tremendous amount of leverage means you only need to put up a small amount of money in order to control a large amount of currency. Typically, $1,000 in margin is sufficient to control $50,000 of currency. If you open an account with $10,000, then you can control $500,000 in currency!

As an example, you believe the British Pound is about to rise strongly against the US Dollar. You have a funded Apiary trading account with $10,000 - enough to control the disposition of $500,000 US Dollars.

You buy the equivalent of US$500,000 in British Pounds at the price of 1.6500. Three months later, the Pound has soared against the Dollar to 1.85.

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Buying $500,000 at 1.65 equals GBP ÂŁ 303,030 Selling GBP ÂŁ 303,030 at 1.85 equals $560,605.50 Although GBP has moved up 20% against the US Dollar, you have made $60,605 in profit and you only used $10,000 in margin. This type of leverage is up to five times that of futures trading, and 50 times as high as stock trading.

Be careful, however, you may not receive a margin call before your positions are liquidated. You should monitor your margin balance on a regular basis and utilize stop-loss orders on every open position to limit downside risk.

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Margin Call All traders fear the dreaded margin call. This occurs when your broker notifies you that your margin deposits have fallen below the required minimum level because an open position has moved against you.

Trading on margin can be a profitable investment strategy, but it is important that you take the time to understand the risks. You should make sure you fully understand how your margin account works. Be sure to read the margin agreement between you and your broker.

Talk to your broker if you have any questions.

The positions in your account could be partially or totally liquidated should the available margin in your account fall below a predetermined threshold. You may not receive a margin call before your positions are liquidated.

Margin calls can be effectively avoided by monitoring your account balance on a regular basis and by utilizing stop-loss orders on every open position to limit risk. For ease of use, most online trading platforms automatically calculate the profit and loss of your open positions.

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Bringing It All Together...

If this is your first time trading, these details may be a little overwhelming. Don’t worry if it doesn’t all make sense right off the bat.

You’ve probably seen that we will revisit key concepts several times to explain them in slightly different ways. If you get too stressed, just take a breather and walk away for a while. Remember, you’re doing this in order to obtain some level of financial freedom. Success includes your own ability to sit back and relax. At the Apiary Investment Fund, it is in our best interest to help you become successful at whatever pace is most comfortable for you.

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