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Candlestick Chart

The candlestick chart is closely related to the bar chart. It also consists of four major prices: high, low, open, and close. (See Figure 5.6.) In addition to the common readings, the candlestick chart has a set of particular interpretations. It is also easier to view.The opening and closing prices form the body (jittai) of the candlestick. To indicate that the opening was lower than the closing, the body of the bar is left blank.

In its original form, the body was colored red. Current standard electronic displays allow you to keep it blank or select a color of your choice. If the currency closes below its opening, the body is filled. In its original form, the body was colored black, but the electronic displays allow you to keep it filled or to select a color of your choice. The intraday (or weekly) direction on a candlestick chart can be traced by means of two "shadows": the upper shadow (uwakage) and the lower shadow (shitakage).
Just as with a bar chart, the candlestick chart is unable to trace every price movement during a day's activity.

Types of charts

The line chart is the original type of chart. In order to plot it, a line connects single prices for a selected time period. The most popular line chart is the daily chart. Although any point in the day can be plotted, most traders focus on the closing price, which they perceive as the most important. (See Figure 5.4.) But an immediate problem with the daily line chart is the fact that it is impossible to see the price activity for the balance of the day.Line charts are considered for technical analysis because due to the sophistication of current charting services, daily price activity does not need to be lost. Daily line charts are useful when looking for the big picture or the major trend because, without line charts, intraday activity would be-come an unimportant detail. When plotted over a long stretch of time, such as several years, a line chart is easier to visualize. Also, technical analysis goes well beyond chart formation; in order to execute certain models and techniques, line charts are better suited than any of the other charts.
However the line chart is a continuous chart, and this is a disadvantage because price gaps cannot be charted on a continuous chart.

Bar Chart
The bar chart is arguably the most popular type of chart currently in
use. It consists of four significant points (See figure 5.5.):
• the high and the low prices, which are united by a vertical bar;
• the opening price, which is marked with a little horizontal line to the left of the bar;
• the closing price, which is marked with a little horizontal line to the right of the bar.
The opening price is not always important for analysis. Bar charts have the obvious advantage of displaying the currency range for the period selected. The most popular period is daily, followed by weekly. Other periods may be selected as well. An advantage of this chart is that, unlike line charts, the bar chart is able to plot price gaps that are formed in the currency futures market. Although the currency futures market trades around the clock, physically it is open for only about a third of the trading day. (Chicago IMM is open for business 7:20 am to 2 pm CDT.)

Therefore, price gaps may occur between two days' price ranges. Incidentally, the bar chart is the chart of choice among currency futures traders.

Volume and Open Interest

Volume consists of the total amount of currency traded within a period of time, usually one day. For example, by year 2000, the total foreign currency daily trading volume was $1.4 trillion. But traders are naturally more interested in the volume of specific instruments for specific trading periods, because large trading volume suggests that there is interest and liquidity in a certain market, and low volume warns the trader to veer away from that market.
The risks of a low-volume market are usually very difficult to quantify or hedge. In addition, certain chart formations require heavy trading volume for successful development. An example is the head-and-shoulder formation. Therefore, despite its obvious importance, volume is not easy to quantify in all foreign exchange markets.
One method to estimate volume is to extrapolate the figures from the futures market. Another is "feeling" the size of volume based on the number of calls on the dealing systems or phones, and the "noise" from the brokers' market. Open interest is the total exposure, or outstanding position, in a certain instrument. The same problems that affect volume are also present here. As it was already mentioned, figures for volume and open interest are available for currency futures. If you have access to printed or electronic charts on futures, you will be able to see these numbers plotted at the bottom of the futures charts.
Volume and open interest figures are available from different sources, although one day late such as the newswires (Bridge Information Systems, Reuters, Bloomberg), newspapers (the Wall Street Journal, the Journal of Commerce), Weekly printed charts (Commodity Perspective, Commodity Trend Service).

The Fundamentals Of Technical Analysis

Technical analysis is appointed to analyze market movement (the movement of prices, volumes and open interests) using the information obtained for a past time. Mainly, it is the chart study of past behavior of currencies prices in order to forecast their future performance. It is one of the most significant tools available for the forecasting of financial markets. Such analysis has been an increasingly utilized forecasting tool over the last two centuries.

The main strength of technical analysis is the flexibility with regard to the underlying instrument, regarding the markets and regarding the time frame. A trader who deals several currencies but specializes in one may easily apply the same technical expertise to trading another currency. A trader who specializes in spot trading can make a smooth transition to dealing currency futures by using chart studies, because the same technical principles apply over and over again, regardless of the market. Finally, different players have different trading styles, objectives, and time frames.

Technical analysis is easy to compute what is important while the technical services are becoming increasingly sophisticated and reasonably priced. Prior to this historic open market intervention, technical analysis provided ample selling signals.

Price
The Fundamental Principles of Technical Analysis are based on the Dow Theory with the following main thesis:

• The price is a comprehensive reflection of all the market forces. At any given time, all market information and forces are reflected in the currency prices.
• Price movements are historically repetitive.
• Price movements are trend followers.
• The market has three trends: primary, secondary, and minor. The primary trend has three phases: accumulation, run-up/run-down, and distribution. In the accumulation phase the shrewdest traders enter new positions. In the run-up/run-down phase, the majority of the market finally "sees" the move and jumps on the bandwagon.
Finally, in the distribution phase, the keenest traders take their profits and close their positions while the general trading interest slows down in an overshooting market. The secondary trend is a correction to the primary trend and may retrace one third, one-half or two-thirds from the primary trend.
• Volume must confirm the trend.
• Trends exist until their reversals are confirmed.

Financial and Sociopolitical Factors

The Role of Financial Factors
Financial factors are vital to fundamental analysis. Changes in a government's monetary or fiscal policies are bound to generate changes in the economy, and these will be reflected in the exchange rates. Financial factors should be triggered only by economic factors. When governments focus on different aspects of the economy or have additional international responsibilities, financial factors may have priority over economic factors. This was painfully true in the case of the European Monetary System in the early 1990s. The realities of the marketplace revealed the underlying artificiality of this approach. Using the interest rates independently from the real economic environment translated into a very expensive strategy. Because foreign exchange, by definition, consists of simultaneous transactions in two currencies, then it follows that the market must focus on two respective interest rates as well. This is the interest rate differential, a basic factor in the markets. Traders react when the interest rate differential changes, not simply when the interest rates themselves change. For example, if all the G-5 countries decided to simultaneously lower their interest rates by 0.5 percent, the move would be neutral for foreign exchange, because the interest rate differentials would also be neutral. Of course, most of the time the discount rates are cut unilaterally, a move that generates changes in both the interest differential and the exchange rate. Traders approach the interest rates like any other factor, trading on expectations and facts. For example, if rumor says that a discount rate will be cut, the respective currency will be sold before the fact. Once the cut occurs, it is quite possible that the currency will be bought back, or the other way around. An unexpected change in interest rates is likely to trigger a sharp currency move. "Buy on the rumor, sell on the fact...” Other factors affecting the trading decision are the time lag between the rumor and the fact, the reasons behind the interest rate change, and the perceived importance of the change. The market generally prices in a discount rate change that was delayed. Since it is a fait accompli, it is neutral to the market. If the discount rate was changed for political rather than economic reasons, what is a common practice in the European Monetary System, the markets are likely to go against the central banks, sticking to the real fundamentals rather than the political ones. This happened in both September 1992 and the summer of 1993, when the European central banks lost unprecedented amounts of money trying to prop up their currencies, despite having high interest rates. The market perceived those interest rates as artificially high and, therefore, aggressively sold the respective currencies. Finally, traders deal on the perceived importance of a change in the interest rate differential.


Political Events and Crises
Political events generally take place over a period of time, but political crises strike suddenly. They are almost always, by definition, unexpected. Currency traders have a knack for responding to crises. Speed is essential; shooting from the hip is the only fighting option. The traders' reflexes take over. Without fast action, traders can be left out in the cold. There is no time for analysis, and only a split second, at best, to act. As volume drops dramatically, trading is hindered by a crisis. Prices dry out quickly, and sometimes the spreads between bid and offer jump from 5 pips to 100 pips. Getting back to the market is difficult.

Economic Indicators

Economic indicators occur in a steady stream, at certain times, and a little more often than changes in interest rates, governments, or natural activity such as earthquakes etc. Economic data is generally (except of the Gross Domestic Product and the Employment Cost Index, which are released quarterly) released on a monthly basis. All economic indicators are released in pairs. The first number reflects the latest period. The second number is the revised figure for the month prior to the latest period. For instance, in July, economic data is released for the month of June, the latest period. In addition, the release includes the revision of the same economic indicator figure for the month of May. The reason for the revision is that the department in charge of the economic statistics compilation is in a better position to gather more information in a month's time. This feature is important for traders. If the figure for an economic indicator is better than expected by 0.4 percent for the past month, but the previous month's number is revised lower by 0.4 percent, then traders are likely to ignore the overall release of that specific economic data.

Economic indicators are released at different times. In the United States, economic data is generally released at 8:30 and 10 am ET. It is important to remember that the most significant data for foreign exchange is released at 8:30 am ET. In order to allow time for last-minute adjustments, the United States currency futures markets open at 8:20 am ET. Information on upcoming economic indicators is published in all leading newspapers, such as the Wall Street Journal, the Financial Times, and the New York Times; and business magazines, such as Business Week. More often than not, traders use the monitor sources—Bridge Information Systems, Reuters, or Bloomberg—to gather information both from news publications and from the sources' own up-to-date information.

The Gross National Product (GNP)
The Gross National Product measures the economic performance of the whole economy. This indicator consists, at macro scale, of the sum of consumption spending, investment spending, government spending, and net trade. The gross national product refers to the sum of all goods and services produced by United States residents, either in the United States or abroad.

The Gross Domestic Product (GDP)
The Gross Domestic Product (GDP) refers to the sum of all goods and services produced in the United States, either by domestic or foreign companies. The differences between the two are nominal in the case of the economy of the United States. GDP figures are more popular outside the United States. In order to make it easier to compare the performances of different economies, the United States also releases GDP figures.

Consumption Spending
Consumption is made possible by personal income and discretionary income. The decision by consumers to spend or to save is psychological in nature. Consumer confidence is also measured as an important indicator of the propensity of consumers who have discretionary income to switch from saving to buying.

Investment Spending
Investment—or gross private domestic spending - consists of fixed investment and inventories.

Government Spending
Government spending is very influential in terms of both sheer size and its impact on other economic indicators, due to special expenditures. For instance, United States military expenditures had a significant role in total U.S. employment until 1990. The defense cuts that occurred at the time increased unemployment figures in the short run.

Net Trade
Net trade is another major component of the GNP. Worldwide internationalization and the economic and political developments since 1980 have had a sharp impact on the United States' ability to compete overseas. The U.S. trade deficit of the past decades has slowed down the overall GNP.

GNP can be approached in two ways:
• flow of product
• Flow of cost.

Industrial Production
Industrial production consists of the total output of a nation's plants, utilities, and mines. From a fundamental point of view, it is an important economic indicator that reflects the strength of the economy, and by extrapolation, the strength of a specific currency. Therefore, foreign exchange traders use this economic indicator as a potential trading signal.

Capacity Utilization
Capacity utilization consists of total industrial output divided by total production capability. The term refers to the maximum level of output a plant can generate under normal business conditions. In general, capacity utilization is not a major economic indicator for the foreign exchange market. However, there are instances when its economic implications are useful for fundamental analysis. A "normal" figure for a steady economy is 81.5 percent. If the figure reads 85 percent or more, the data suggests that the industrial production is overheating, that the economy is close to full capacity.

High capacity utilization rates precede inflation, and expectation in the foreign exchange market is that the central bank will raise interest rates in order to avoid or fight inflation.

Factory Orders
Factory orders refer to the total of durable and nondurable goods orders. Nondurable goods consist of food, clothing, light industrial products, and products designed for the maintenance of durable goods. Durable goods orders are discussed separately. The factory orders indicator has limited significance for foreign exchange traders.

Durable Goods Orders
Durable goods orders consist of products with a life span of more than three years. Examples of durable goods are autos, appliances, furniture, jewelry, and toys. They are divided into four major categories: primary metals, machinery, electrical machinery, and transportation. In order to eliminate the volatility pertinent to large military orders, the indicator includes a breakdown of the orders between defense and nondefense. This data is fairly important to foreign exchange markets because it gives a good indication of consumer confidence. Because durable goods cost more than nondurables, a high number in this indicator shows consumers' propensity to spend. Therefore, a good figure is generally bullish for the domestic currency.

Business Inventories
Business inventories consist of items produced and held for future sale. The compilation of this information is facile and holds little surprise for the market. Moreover, financial management and computerization help control business inventories in unprecedented ways. Therefore, the importance of this indicator for foreign exchange traders is limited.

Modern Monetary Theories on Short-Term Exchange Rate Volatility

The modern monetary theories on short-term exchange rate volatility take into consideration the short-term capital markets' role and the long-term impact of the commodity markets on foreign exchange. These theories hold that the divergence between the exchange rate and the purchasing power parity is due to the supply and demand for financial assets and the international capability.
One of the modern monetary theories states that exchange rate volatility is triggered by a one-time domestic money supply increase, because this is assumed to raise expectations of higher future monetary growth. The purchasing power parity theory is extended to include the capital markets. If, in both countries whose currencies are exchanged, the demand for money is determined by the level of domestic income and domestic interest rates, then a higher income increases demand for transactions balances while a higher interest rate increases the opportunity cost of holding money, reducing the demand for money.

Under a second approach, the exchange rate adjusts instantaneously to maintain continuous interest rate parity, but only in the long run to maintain PPP. Volatility occurs because the commodity markets adjust more slowly than the financial markets. This version is known as the dynamic monetary approach.

The Portfolio-Balance Approach
The portfolio-balance approach holds that currency demand is triggered by the demand for financial assets, rather than the demand for the currency per se.

Synthesis of Traditional and Modern Monetary Views
In order to better suit the previous theories to the realities of the market, some of the more stringent conditions were adjusted into a synthesis of the traditional and modern monetary theories. A short-term capital outflow induced by a monetary shock creates a payments imbalance that requires an exchange rate change to maintain balance of payments equilibrium. Speculative forces, commodity markets disturbances, and the existence of short-term capital mobility trigger the exchange rate volatility. The degree of change in the exchange rate is a function of consumers' elasticity of demand. Because the financial markets adjust faster than the commodities markets, the exchange rate tends to be affected in the short term by capital market changes, and in the long term by commodities changes.

Economic Fundamentals

Theories of Exchange Rate Determination
Fundamentals may be classified into economic factors, financial factors, political factors, and crises. Economic factors differ from the other three factors in terms of the certainty of their release. The dates and times of economic data release are known well in advance, at least among the industrialized nations. Below are given briefly several known theories of exchange rate determination.

Purchasing Power Parity
Purchasing power parity states that the price of a good in one country should equal the price of the same good in another country, exchanged at the current rate—the law of one price. There are two versions of the purchasing power parity theory: the absolute version and the relative version. Under the absolute version, the exchange rate simply equals the ratio of the two countries' general price levels, which is the weighted average of all goods produced in a country. However, this version works only if it is possible to find two countries, which produce or consume the same goods. Moreover, the absolute version assumes that transportation costs and trade barriers are insignificant. In reality, transportation costs are significant and dissimilar round the world. Trade barriers are still alive and well, sometimes obvious and sometimes hidden, and they influence costs and goods distribution.

Finally, this version disregards the importance of brand names. For example, cars are chosen not only based on the best price for the same type of car, but also on the basis of the name ("You are what you drive").

The PPP Relative Version
Under the relative version, the percentage change in the exchange rate from a given base period must equal the difference between the percentage change in the domestic price level and the percentage change in the foreign price level. The relative version of the PPP is also not free of problems: it is difficult or arbitrary to define the base period, trade restrictions remain a real and thorny issue, just as with the absolute version, different price index weighting and the inclusion of different products in the indexes make the comparison difficult and in the long term, countries'internal price ratios may change, causing the exchange rate to move away from the relative PPP. In conclusion, the spot exchange rate moves independently of relative domestic and foreign prices. In the short run, the exchange rate is influenced by financial and not by commodity market conditions.

Theory of Elasticities
The theory of elasticities holds that the exchange rate is simply the price of foreign exchange that maintains the balance of payments in equilibrium. For instance, if the imports of country A are strong, then the trade balance is weak. Consequently, the exchange rate rises, leading to the growth of country A's exports, and triggers in turn a rise in its domestic income, along with a decrease in its foreign income. Whereas a rise in the domestic income (in country A) will trigger an increase in the domestic consumption of both domestic and foreign goods and, therefore, more demand for foreign currencies, a decrease in the foreign income (in country B) will trigger a decrease in the domestic consumption of both country B's domestic and foreign goods, and therefore less demand for its own currency. The elasticities approach is not problem-free because in the short term the exchange rate is more inelastic than it is in the long term and the additional exchange rate variables arise continuously, changing the rules of the game.

Foreign Exchange Volume Growth

Foreign exchange trading is generally conducted in a decentralized manner, with the exceptions of currency futures and options. Foreign exchange has experienced spectacular growth in volume ever since currencies were allowed to float freely against each other. While the daily turnover in 1977 was U.S. $5 billion, it increased to U.S. $600 billion in 1987, reached the U.S. $1 trillion mark in September 1992, and stabilized at around $1,5 trillion by the year 2000.

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


• Interest Rate Volatility
Economic internationalization generated a significant impact on interest rates as well. Economics became much more interrelated and that exacerbated the need to change interest rates faster. Interest rates are generally changed in order to adjust the growth in the economy, and interest rate differentials have a substantial impact on exchange rates.

• Business Internationalization
In recent decades the business world the competition has intensified, triggering a worldwide hunt for more markets and cheaper raw materials and labor. The pace of economic internationalization picked up even more in the 1990s, due to the fall of Communism in Europe and to up-and-down economic and financial development in both Southeast Asia and South America. These changes have been positive toward foreign exchange, since more transactional layers were added.

• Increasing of Corporate Interest
A successful performance of a product or service overseas may be pulled down from the profit point of view by adverse foreign exchange conditions and vice versa. An accurate handling of the foreign exchange may enhance the overall international performance of a product or service. Proper handling of foreign exchange generally adds substantially to the rate of return. Therefore, interest in foreign exchange has increased in the past decade. Many corporations are using currencies not only for hedging, but also for capitalizing on opportunities that exist solely in the currency markets.

• Increasing of Traders Sophistication
Advances in technology, computer software, and telecommunications and increased experience have increased the level of traders' sophistication. This enhanced traders' confidence in their ability to both generate profits and properly handle the exchange risks. Therefore, trading sophistication led toward volume increase.

• Developments in Telecommunications
The introduction of automated dealing systems in the 1980s, of matching systems in the early 1990s, and of Internet trading in the late 1990s completely altered the way foreign exchange was conducted. The dealing systems are online computer systems that link banks on a one-to-one basis, while matching systems are electronic brokers. They are reliable and much faster, allowing traders to conduct more simultaneous trades. They are also safer, as traders are able to see the deals that they execute. The dealing systems had a major role in expanding the foreign exchange business due to their reliability, speed, and safety.

• Computer and Programming development
Computers play a significant role at many stages of conducting foreign exchange. In addition to the dealing systems, matching systems simultaneously connect all traders around the world, electronically duplicating the brokers' market. The new office systems provide full accounting coverage, ticket writing, back office processing, and risk management implementation at a fraction of their previous cost. Advanced software makes it possible to generate all types of charts, augment them with sophisticated technical studies, and put them at traders' fingertips on a continuous basis at a rather limited cost.

Recent Foreign Exchange Development

The main phases of the further development of the Forex in modern times were:
* Signing of the Bretton Woods Accord;
* Constitution of the international monetary fund (IMF);
* Emergency of the free-floating foreign exchange markets;
* Creation of currency reserves;
* Constitution of the European Monetary Union and the European
* Monetary Cooperation Fund;
* Introduction of the Euro as a currency

The Bretton Woods Accord was signed in July 1944 by the United States, Great Britain, and France which agreed to make the currency market stable, particularly due to governmental controls on currency values. In order to implement it, two major goals were: emphasized: to provide the pegging (backing of prices) of currencies and to organize the International Monetary Fund (IMF).


In accordance to the Bretton Woods Accord, the major trading currencies were pegged to the U.S. dollar in the sense that they were allowed to fluctuate only one percent on either side of that rate. When a currency exceeded this range, marked by intervention points, the central bank in charge had to buy it or sell it, and thus bring it back into range. In turn, the U.S. dollar was pegged to gold at $35 per ounce. Thus, the U.S. dollar became the world's reserve currency. The purpose of IMF is to consult with one another to maintain a stable system of buying and selling the currencies, so that payments in foreign money can take place between countries smoothly and timely.


The IMF lends money to members who have trouble meeting financial obligations to other members, on the condition that they undertake economic reforms to eliminate these difficulties for their own good and the good of the entire membership. In total the main tasks of the IMF are:

* To promote international cooperation by providing the means for members to consult and collaborate on international monetary issues;
* To facilitate the growth of international trade and thus contribute to high levels of employment and real income among member nations;
* to promote stability of exchange rates and orderly exchange agreements, and [to] discourage competitive currency depreciation;
* To foster a multilateral system of international payments, and to seek the elimination of exchange restrictions that hinder the growth of world trade;
* To make financial resources available to members, on a temporary basis and with adequate safeguards, to permit them to correct payments imbalances without resorting to measures destructive to national and international prosperity.


To execute these goals the IMF uses such instruments as Reserve tranche which allows a member to draw on its own reserve asset quota at the time of payment, Credit tranche drawings and stand-by arrangements are the standard form of IMF loans, the compensatory financing facility extends financial help to countries with temporary problems generated by reductions in export revenues, the buffer stock financing facility which is geared toward assisting the stocking up on primary commodities in order to ensure price stability in a specific commodity and the extended facility designed to assist members with financial problems in amounts or for periods exceeding the scope of the other facilities. Since 1978 free-floating of currencies were officially mandated by the International Monetary Fund.

That is the currency may be traded by anybody and its value is a function of the current supply and demand forces in the market, and there are no specific intervention points that have to be observed. Of course, the Federal Reserve Bank irregularly intervenes to change the value of the U.S. dollar, but no specific levels are ever imposed. Naturally, free-floating currencies are in the heaviest trading demand. Free-floating is not the sine qua non condition for trading. Liquidity is also an indispensable condition.


A tool for people and corporations to protect investments in times of economic or political instability is currency reserves for international transactions. Immediately after the World War II the reserve currency worldwide was the U.S. dollar. Currently there are other reserve currencies: the euro and the Japanese yen. The portfolio of reserve currencies may change depending on specific international conditions, for instance it may include the Swiss franc. The creation of the European Monetary Union was the result of a long and continuous series of post-World War II efforts aimed at creating closer economic cooperation among the capitalist European countries. The European Community (EC) commission's officially stated goals were to improve the inter-European economic cooperation, create a regional area of monetary stability, and act as "a pole of stability in world currency markets."

The first steps in this rebuilding were taken in 1950, when the European Payment Union was instituted to facilitate the inter-European settlements of international trade transactions. The purpose of the community was to promote inter-European trade in general, and to eliminate restrictions on the trade of coal and raw steel in particular.
In 1957, the Treaty of Rome established the European Economic Community, with the same signatories as the European Coal and Steel Community. The stated goal of the European Economic Community was to eliminate customs duties and any barriers against the transit of capital, services, and people among the member nations. The EC also started to raise common tariff barriers against outsiders

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

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

In 1978, the nine members of the European Community ratified a new plan for stability—the European Monetary System. The new system was practically established in 1979. Seven countries were then full members—West Germany, France, the Netherlands, Belgium, Luxembourg, Denmark, and Ireland. Great Britain did not participate in all of the arrangements and Italy joined under special conditions. Greece joined in 1981, Spain and Portugal in 1986. Great Britain joined the Exchange Rate Mechanism in 1990.

The European Monetary Cooperation Fund was established to manage the EMS' credit arrangements. In order to increase the acceptance of the ECU, countries that hold more ECU deposits, or accept as loan repayment more than their share of ECU, receive interest on the excess ECU deposits, and vice versa. The interest rate is the weighted average of all the EMS members' discount rates.

In 1998 the Euro was introduced as an all-European currency. Here are the official locking rates of the 11 participating European currencies in the euro (EUR). The rates were proposed by the EU Commission and approved by EU finance ministers on December 31, 1998, ahead of the launch of the euro at midnight, January 1, 1999. The real starting date was Monday, January 4, 1999. The conversion rates are:
1 EUR = 40.3399 BEF 1 EUR = 1.95583 DEM
1 EUR = 166.386 ESP 1 EUR = 6.55957 FRF
1 EUR = 0.787564 IEP 1 EUR = 1936.27 ITL
1 EUR = 40.3399 LUF 1 EUR = 2.20371 NLG
1 EUR = 13.7603 ATS 1 EUR = 200.482 PTE
1 EUR = 5.94573 FIM
The euro bills are issued in denominations of 5, 10, 20, 50, 100, 200 and 500 euros. Coins are issued in denominations of 1 and 2 euros, and 50, 20,10, 5, 2, and 1 cent.

Kinds Of Foreign Exchange Market

* Spot Market
* Forward Market
* Futures Markets
* Currency Options

* Spot Market
The fast-paced spot market is not for the fainthearted, as it features high volatility and quick profits (and losses). A spot deal consists of a bilateral contract whereby a party delivers a specified amount of a given currency against receipt of a specified amount of another currency from a counterparty, based on an agreed exchange rate, within two business days of the deal date. The exception is the Canadian dollar, in which the spot delivery is executed next business day.


The name "spot" does not mean that the currency exchange occurs the same business day the deal is executed. Currency transactions that require same-day delivery are called cash transactions. The two-day spot delivery for currencies was developed long before technological breakthroughs in information processing. This time period was necessary to check out all transactions' details among counterparties. Although technologically feasible, the contemporary markets did not find it necessary to reduce the time to make payments. Human errors still occur and they need to be fixed before delivery. When currency deliveries are made to the wrong party,fines are imposed. In terms of volume, currencies around the world are traded mostly against the U.S. dollar, because the U.S. dollar is the currency of reference.

The other major currencies are the euro, followed by the Japanese yen, the British pound, and the Swiss franc. Other currencies with significant spot market shares are the Canadian dollar and the Australian dollar. In addition, a significant share of trading takes place in the currencies crosses, a non-dollar instrument whereby foreign currencies are quoted against other foreign currencies, such as euro against Japanese yen. There are several reasons for the popularity of currency spot trading.
Profits (or losses) are realized quickly in the spot market, due to market volatility. In addition, since spot deals mature in only two business days, the time exposure to credit risk is limited. Turnover in the spot market has been increasing dramatically, thanks to the combination of inherent profitability and reduced credit risk. The spot market is characterized by high liquidity and high volatility. Volatility is the degree to which the price of currency tends to fluctuate within a certain period of time. Free-floating currencies, such as the euro or the Japanese yen, tend to be volatile against the U.S. dollar.

In an active global trading day (24 hours), the euro/dollar exchange rate may change its value 18,000 times.
An exchange rate may "fly" 200 pips in a matter of seconds if the market gets wind of a significant event. On the other hand, the exchange rate may remain quite static for extended periods of time, even in excess of an hour, when one market is almost finished trading and waiting for the next market to take over. This is a common occurrence toward the end of the New York trading day.

Since California failed in the late 1980s to provide the link between the New York and Tokyo markets, there is a technical trading gap between around 4:30 pm and 6 pm EDT. In the United States spot market, the majority of deals are executed between 8 am and noon, when the New York and European markets overlap (See Figure 3.2). The activity drops sharply in the afternoon, over 50 percent in fact, when New York loses the international trading support. Overnight trading is limited, as very few banks have overnight desks. Most of the banks send their overnight orders to branches or other banks that operate in the active time zones.

* Forward Market
The forward currency market consists of two instruments: forward outright deals and swaps. A swap deal is unusual among the rest of the foreign exchange instruments in the fact that it consists of two deals, or legs. All the other transactions consist of single deals. In its original form, a swap deal is a combination of a spot deal and a forward outright deal. Generally, this market includes only cash transactions. Therefore, currency futures contracts, although a special breed of forward outright transactions, are analyzed separately. According to figures published by the Bank for International Settlements, the percentage share of the forward market was 57 percent in 1998 (See Figure 3.1). Translated into U.S. dollars, out of an estimated daily gross turnover of US$1.49 trillion, the total forward market represents US$900 billion.

In the forward market there is no norm with regard to the settlement dates, which range from 3 days to 3 years. Volume in currency swaps longer than one year tends to be light but, technically, there is no impediment to making these deals. Any date past the spot date and within the above range may be a forward settlement, provided that it is a valid business day for both currencies. The forward markets are decentralized markets, with players around the world entering into a variety of deals either on a one-on-one basis or through brokers. In contrast, the currency futures market is a centralized market, in which all the deals are executed on trading floors provided by different exchanges.


Whereas in the futures market only a handful of foreign currencies may be traded in multiples of standardized amounts, the forward markets are open to any currencies in any amount. The forward price consists of two significant parts: the spot exchange rate and the forward spread. The spot rate is the main building block. The forward price is derived from the spot price by adjusting the spot price with the forward spread, so it follows that both forward outright and swap deals are derivative instruments. The forward spread is also known as the forward points or the forward pips. The forward spread is necessary for adjusting the spot rate for specific settlement dates different from the spot date. It holds, then, that the maturity date is another determining factor of the forward price. Just as in the case of the spot market, the left side of the quote is the bid side, and the right side is the offer side.

* Futures Market
Currency futures are specific types of forward outright deals which occupy in general a small part of the Forex market (See Figure 3.1). Because they are derived from the spot price, they are derivative instruments. They are specific with regard to the expiration date and the size of the trade amount. Whereas, generally, forward outright deals—those that mature past the spot delivery date—will mature on any valid date in the two countries whose currencies are being traded, standardized amounts of foreign currency futures mature only on the third Wednesday of March, June, September, and December.

There is a row of characteristics of currency futures, which make them attractive. It is open to all market participants, individuals included. This is different from the spot market, which is virtually closed to individuals – except high net-worth individuals—because of the size of the currency amounts traded. It is a central market, just as efficient as the cash market, and whereas the cash market is a very decentralized market, futures trading takes place under one roof. It eliminates the credit risk because the Chicago Mercantile Exchange Clearinghouse acts as the buyer for every seller, and vice versa. In turn, the Clearinghouse minimizes its own exposure by requiring traders who maintain a non-profitable position to post margins equal in size to their losses.


Moreover, currency futures provide several benefits for traders because futures are special types of forward outright contracts, corporations can use them for hedging purposes. Although the futures and spot markets trade closely together, certain divergences between the two occur, generating arbitraging opportunities. Gaps, volume, and open interest are significant technical analysis tools solely available in the futures market. Yet their significance extrapolates to the spot market as well. Because of these benefits, currency futures trading volume has steadily attracted a large variety of players.

For traders outside the exchange, the prices are available from on-line monitors. The most popular pages are found on Bridge, Telerate, Reuters, and Bloomberg. Telerate presents the currency futures on composite pages, while Reuters and Bloomberg display currency futures on individual pages shows the convergence between the futures and spot prices.

* Currency Options
A currency option is a contract between a buyer and a seller that gives the buyer the right, but not the obligation, to trade a specific amount of currency at a predetermined price and within a predetermined period of time, regardless of the market price of the currency; and gives the seller, or writer, the obligation to deliver the currency under the predetermined terms, if and when the buyer wants to exercise the option. Currency options are unique trading instruments, equally fit for speculation and hedging. Options allow for a comprehensive customization of each individual strategy, a quality of vital importance for the sophisticated investor. More factors affect the option price relative to the prices of other foreign currency instruments. Unlike spot or forwards, both high and low volatility may generate a profit in the options market. For some, options are a cheaper vehicle for currency trading.

For others, options mean added security and exact stop-loss order execution. Currency options constitute the fastest-growing segment of the foreign exchange market. As of April 1998, options represented 5 percent of the foreign exchange market. (See Figure 3.1) The biggest options trading center is the United States, followed by the United Kingdom and Japan. Options prices are based on, or derived from, the cash instruments. Therefore, an option is a derivative instrument. Options are usually mentioned vis-à-vis insurance and hedging strategies. Often, however, traders have misconceptions regarding both the difficulty and simplicity of using options. There are also misconceptions regarding the capabilities of options. In the currency markets, options are available on either cash or futures. It follows, then, that they are traded either over-the-counter (OTC) or on the centralized futures markets.

The majority of currency options, around 81 percent, are traded over the - counter. (See Figure 3.3) The over-the-counter market is similar to the spot or swap market.
Corporations may call banks and banks will trade with each other either directly or in the brokers' market. This type of dealing allows for maximum flexibility: any amount, any currency, any odd expiration date, any time. The currency amounts may be even or odd. The amounts may be quoted in either U.S. dollars or foreign currencies. Any currency may be traded as an option, not only the ones available as futures contracts. Therefore, traders may quote on any exotic currency, as required, including any cross currencies.

Foreign Exchange in a Historical Perspective

Currency trading has a long history and can be traced back to the ancient Middle East and Middle Ages when foreign exchange started to take shape after the international merchant bankers devised bills of exchange, which were transferable third-party payments that allowed flexibility and growth in foreign exchange dealings.


The modern foreign exchange market characterized by the consequent periods of increased volatility and relative stability formed itself in the twentieth century. By the mid-1930s London became to be the leading center for foreign exchange and the British pound served as the currency to trade and to keep as a reserve currency. Because in the old times foreign exchange was traded on the telex machines, or cable, the pound has generally the nickname “cable”. In 1930, the Bank for International Settlements was established in Basel, Switzerland, to oversee the financial efforts of the newly independent countries, emerged after the World War I, and to provide monetary relief to countries experiencing temporary balance of payments difficulties.


After the World War II, where the British economy was destroyed and the United States was the only country unscarred by war, U.S. dollar became the prominent currency of the entire globe. Nowadays, currencies all over the world are generally quoted against the U.S. dollar.

Foreign Exchange as a Financial Market

Currency exchange is very attractive for both the corporate and individual traders who make money on the Forex - a special financial market assigned for the foreign exchange. The following features make this market different in compare to all other sectors of the world financial system.

* Heightened sensibility to a large and continuously changing number of factors.
* Accessibility to all traders in the major currencies.
* Guaranteed quantity and liquidity of the major currencies.
* Increased consideration for several currencies, round-the clock business
hours which enable traders to deal after normal hours or during national
holidays in their country finding markets abroad open.
* Extremely high efficiency relative to other financial markets.

This goal of this manual is to introduce beginning traders to all the essential aspects of foreign exchange in a practical manner and to be a source of best answers on the typical questions as why are currencies being traded, who are the traders, what currencies do they trade, what makes rates move, what instruments are used for the trade, how a currency behavior can be forecasted and where the pertinent information may be obtained from. Mastering the content of an appropriate section the user will be able to make his/her own decisions, test them, and ultimately use recommended tools and approaches for his/her own benefit.

What is Trading

Trading is the purchase or sale of a specific goods or a security. It can be either an equity or currency (Forex) or debenture, and this is done via a brokerage firm. Individuals can have trades done through a registered representative (a licensed Financial Industry Regulatory Authority broker) and make trades online or offline with a trading firm.

Trading can be done either in a cash account or through a margin account. Cash accounts require all transactions to be paid for in full by the settlement date three days after the trade execution. Margin accounts allow the investor to borrow money for the purchase of securities in hopes that they will not go down in price and a margin call for the difference is demanded by the brokerage firm.