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Day Trading & Swing Trading Currency Market .pdf



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Titolo: Kathy Lien : Day Trading & Swing Trading The Currency Market™ √PDF √eBook ✔Download
Autore: Technical and Fundamental Strategies to Profit from Market Moves

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Day Trading
and Swing
Trading the
Currency
Market

Day Trading
and Swing
Trading the
Currency
Market
Second Edition
Technical and Fundamental
Strategies to Profit from
Market Moves

KATHY LIEN
Director of Currency Research, GFT

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Contents

Preface

vii

Acknowledgments
CHAPTER 1

Foreign Exchange—The Fastest-Growing
Market of Our Time

xiii

1

CHAPTER 2

Historical Events in the FX Market

21

CHAPTER 3

What Moves the Currency Market in the
Long Term?

37

CHAPTER 4

What Moves the Market in the Short Term? 59

CHAPTER 5

What Are the Best Times to Trade for
Individual Currency Pairs?

67

What Are Currency Correlations and How
Do Traders Use Them?

75

Seasonality—How It Applies to the
FX Market

81

Trade Parameters for Different Market
Conditions

91

CHAPTER 6

CHAPTER 7

CHAPTER 8

CHAPTER 9

Technical Trading Strategies

109

CHAPTER 10

Fundamental Trading Strategies

165

v

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vi

CONTENTS

CHAPTER 11

How to Trade Like a Hedge Fund Manager 207

CHAPTER 12

Profiles and Unique Characteristics of
Major Currency Pairs

215

About the Author

273

Index

275

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Preface

ince the first edition of Day Trading the Currency Market, which
was published in 2005, the foreign exchange market has changed dramatically. The most notable change is the fact that daily average volume now exceeds $3 trillion, a 70 percent jump over the past three years.
As a direct result of this surge in interest, more participants have flooded
the markets with different ways to trade currencies.
The popularity of the Day Trading the Currency Market book has encouraged me to give the second edition a twist—this time I have added
swing trading strategies!
After having taught seminars across the country on how to trade currencies, I have received a lot of good feedback about the book (thank you!),
and I hope that everyone will enjoy the new techniques in the second edition just as much as you have enjoyed the strategies and lessons in the first!

S

The original book focuses heavily on fundamentals, but the new edition includes chapters on trading methodologies, statistical analysis, and,
of course, additional strategies.
I have also added comprehensive sections on how to trade like a hedge
fund manager and the impact of seasonality in the currency market.
If you are picking up a copy of Day Trading and Swing Trading the
Currency Market for the very first time, you will not be disappointed. As a
trader first and an analyst second, in this book I focus on what matters most
to currency traders. The first edition has been one of the top resources for
those looking for a good primer on how the currency markets work—the
technical and fundamental drivers as well as actionable trading strategies.
There is something for everyone in this book, as it is designed for both
the beginner and the advanced trader. In this book, I try to accomplish two
major goals: to touch on the basics of the FX market and the currency characteristics that all traders, particularly day traders, need to know, as well
as to give you practical strategies to start trading. Day Trading and Swing
Trading the Currency Market goes beyond what other currency trading

vii

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PREFACE

books cover and delves into such interesting topics as the top marketmoving indicators for the U.S. dollar and what currency correlations are
and how to use them. Here’s a brief road map to whet your appetite on the
topics covered in this book.

FOREIGN EXCHANGE—THE
FASTEST-GROWING MARKET OF OUR TIME
If you are wondering whether you should get into the FX market, take a
look at some of the reasons why the largest market in the world has always been the market of choice for the big players such as hedge funds
and institutional investors. Learn about why the FX market has exploded
over the past three years and the advantages that the FX spot market has
over the more traditional equities and futures markets—something that the
most seasoned traders of the world have known for decades.

HISTORICAL EVENTS IN THE FX MARKET
How can you trade the currency market without knowing some of the
major milestones that helped to shape the market into what it has become today? There are countless events that are still talked about and
brought up despite the many years that have passed since they occurred.
This chapter covers Bretton Woods, the end of the Bretton Woods, the
Plaza Accord, George Soros and how he came to fame, the Asian financial crisis, the launch of the euro, and the bursting of the technology
bubble.

DIFFERENT WAYS TO TRADE
THE FX MARKET
Over the past few years, the FX market has evolved significantly. Many
products have been introduced as alternative ways to invest in or trade
currencies. Foreign exchange spot is the oldest of these markets and represents the underlying asset for a lot of the new derivative products. Options, futures, and forwards are the next oldest, but forwards are generally
limited to a nonretail audience. An entire book can be dedicated to the differences between all of the new derivative products, but for the purpose

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ix

of this new edition, I provide some basic descriptions as well as general
advantages and disadvantages (there may be many others that are not included in this new section).

WHAT MOVES THE CURRENCY MARKET?
What moves the currency market is probably one of the most common
questions asked by new traders. Currency fluctuations can be dissected
into short-term and long-term movements. Chapter 3 covers some of the
more macro longer-term factors that impact currency prices. This chapter
was thrown in to keep traders from losing sight of the bigger picture and
how these longer-term factors on both a technical and a fundamental basis
will always come back into play regardless of the shorter-term fluctuations,
which are covered in Chapter 4. We also explore the different valuation
models for forecasting currency rates, which can help more quantitative
fundamental traders to develop their own methodology for predicting currency movements.

WHAT ARE THE BEST TIMES TO TRADE FOR
INDIVIDUAL CURRENCY PAIRS?
Timing is everything in currency trading. In order to devise an effective
and time-efficient investment strategy, it is important to note the amount of
market activity around the clock in order to maximize the number of trading opportunities during a trader’s own market hours. This section outlines
the typical trading activity of major currency pairs in different time zones
to see when they are the most volatile.

WHAT ARE THE MOST MARKET-MOVING
ECONOMIC DATA?
For day traders, knowing which pieces of U.S. data move the market the
most can be extremely valuable. System traders need to know when it is
worthwhile to turn their systems off, while breakout traders will want to
know where to place their big bets based on what economic releases typically set off the largest movements. This section, with updated data, not
only ranks the importance of U.S. data, but it also reports on the knee-jerk

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PREFACE

reaction in pip values and whether there is usually a follow-through over
the remainder of the day.

WHAT ARE CURRENCY CORRELATIONS AND
HOW DO TRADERS USE THEM?
Everything in the currency market is interrelated to some extent, and
knowing the direction and strength of the relationships between different
currency pairs can be an added advantage for all traders. When trading in
the FX market, one of the most important facts to remember in creating
a strategy is that no currency pair is isolated. Knowing how closely correlated the currency pairs are in your portfolio is a great way to measure
exposure and risk. Many traders may find themselves thinking that they are
diversifying their portfolio by investing in different currency pairs, but few
realize that many pairs actually have a tendency to move in the same direction or opposite to each other historically. The correlations between pairs
can be strong or weak and last for weeks, months, or even years, which
makes learning how to use and calculate correlation extremely important.
New correlations have been added for this edition.

HOW TO TRADE LIKE A HEDGE
FUND MANAGER
This new chapter on how to trade like a hedge fund manager is really about
the steps to developing a successful trading strategy. Having worked with
many money managers and been involved in the process of launching
managed fund products, I have realized that all money managers work in
a similar way. Their strategies may be different, but the way they go about
developing these strategies is not. This section includes the five steps to
thinking and trading like a hedge fund manager.

SEASONALITY IN THE CURRENCY MARKET
Most traders attempt to analyze the future direction of currencies by using
either fundamental or technical analysis or, if they’re feeling particularly
crafty, a combination of both. However, many traders may not realize that
the clearest way to analyze past price behavior may be to look at price
activity itself, without the noise of indicators. One way to do this is through

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xi

seasonality, which may be a concept familiar to many stock traders. This
new chapter discusses seasonality in the currency market.

TRADE PARAMETERS FOR DIFFERENT
MARKET CONDITIONS
The most important first step for any trader, regardless of the market that
you are trading in, is to create a trading journal. However, the FX trading
journal is not just any trading journal. Aside from the typical listing of your
trade ideas and executed trades with targets and stops, the FX trading journal also teaches you how to create a currency pair checklist that takes approximately 10 minutes to fill out and gives you a near-immediate insight
on the exact technical picture for each currency pair. Trading effectively
means having a game plan, and we systematically dissect a game plan for
you in this chapter, teaching you how to first profile a trading environment
and then know which indicators to apply for that trading environment.

TECHNICAL TRADING STRATEGIES
This is the meat of the book for advanced traders. This section covers some
of my favorite trading strategies for day and swing traders. Each strategy
comes with rules and examples. Three new strategies have been added to
this chapter, including how to trade news, how to effectively time market turns, and how to capture a new shift in momentum. Many of these
strategies exploit specific characteristics of the FX market that have been
observed across time. There are strategies for all types of traders—range,
trend, and breakout.

FUNDAMENTAL TRADING STRATEGIES
The fundamental strategies chapter is more for medium-term swing traders
who go not for 15 to 20 points but for 150 to 200 points or more. This section will teach you how to trade off commodity prices, fixed income instruments, and option volatilities. It also covers intervention-based trades,
macro-event-driven trades, and the secret moneymaking strategies used
by hedge funds between 2002 and 2004, which is the leveraged carry
trade.

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PROFILES AND UNIQUE CHARACTERISTICS
OF THE MAJOR CURRENCY PAIRS
The final chapter of this book is probably one of the most valuable. This updated material goes over the unique characteristics of each major currency
pair: when they are most active, what drives their price action, and which
economic data releases are most important. A broad economic overview
and a look into each central bank’s monetary policy practices are given.
I hope you enjoy the book!

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Acknowledgments

hank you to my wonderful team for their invaluable research and
support:

T

Boris Schlossberg
Richard Lee
Sam Shenker
Melissa Tuzzolo
Daniel Chen
Bosco Cheng
Jenny Tang
Vincent Ortiz
John Kicklighter
Ehren Goossens

And others:
Kristian Kerr
Randal Nishina
The Entire Staff at FXCM

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CHAPTER 1

Foreign
Exchange—The
Fastest-Growing
Market of
Our Time

he foreign exchange market is the generic term for the worldwide
institutions that exist to exchange or trade currencies. Foreign exchange is often referred to as “forex” or “FX.” The foreign exchange
market is an over-the-counter (OTC) market, which means that there is no
central exchange and clearinghouse where orders are matched. FX dealers
and market makers around the world are linked to each other around the
clock via telephone, computer, and fax, creating one cohesive market.
Over the past few years, currencies have become one of the most popular products to trade. No other market can claim a 71 percent surge in volume over a three-year time frame. According to the Triennial Central Bank
Survey of the foreign exchange market conducted by the Bank for International Settlements and published in October 2007, daily trading volume hit
a record of $3.2 trillion, up from $1.9 trillion in 2004. This is estimated to
be approximately 20 times larger than the daily trading volume of the New
York Stock Exchange and the Nasdaq combined. Although there are many
reasons that can be used to explain this surge in activity, one of the most
interesting is that the timing of the surge in volume coincides fairly well
with the emergence of online currency trading for the individual investor.

T

EFFECTS OF CURRENCIES ON STOCKS
AND BONDS
It is not the advent of online currency trading alone that has helped to
increase the overall market’s volume. With the volatility in the currency
markets over the past few years, many traders are also becoming more
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aware of the fact that currency movements also impact the stock and bond
markets. Therefore, if stocks, bonds, and commodities traders want to
make more educated trading decisions, it is important for them to follow
the currency markets as well. The following are some of the examples of
how currency movements impacted stock and bond market movements in
the past.

EUR/USD and Corporate Profitability
For stock market traders, particularly those who invest in European corporations that export a tremendous amount of goods to the United States,
monitoring exchange rates are essential to predicting earnings and corporate profitability. Since 2003, European manufacturers have complained
extensively about the rapid rise in the euro and the weakness in the U.S.
dollar. The main culprit for the dollar’s sell-off has been the country’s
rapidly growing trade and budget deficits. This caused the EUR/USD (euroto-dollar) exchange rate to surge, which took a significant toll on the profitability of European corporations because a higher exchange rate makes
the goods of European exporters more expensive to U.S. consumers. In
2003, inadequate hedging shaved approximately 1 billion euros from Volkswagen’s profits, while Dutch State Mines (DSM), a chemicals group,
warned that a 1 percent move in the EUR/USD rate would reduce profits by between 7 million and 11 million euros. Unfortunately, inadequate
hedging is still a reality in Europe in 2008, which makes monitoring the
EUR/USD exchange rate even more important in forecasting the earnings
and profitability of European exporters.

Nikkei and U.S. Dollar
Traders exposed to Japanese equities also need to be aware of the developments that are occurring in the U.S. dollar and how they affect the
Nikkei rally. Japan has recently come out of 10 years of stagnation. During this time, U.S. mutual funds and hedge funds were grossly underweight Japanese equities. When the economy began to rebound, these
funds rushed in to make changes to their portfolios for fear of missing
a great opportunity to take advantage of Japan’s recovery. Hedge funds
borrowed a lot of dollars in order to pay for increased exposure, but the
problem was that their borrowings are very sensitive to U.S. interest rates
and the Federal Reserve’s monetary policy tightening cycle. Increased borrowing costs for the dollar could derail the Nikkei’s rally because higher
rates will raise the dollar’s financing costs. Yet with the huge current account deficit, the Fed might need to continue raising rates to increase the
attractiveness of dollar-denominated assets. Therefore, continual rate

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hikes coupled with slowing growth in Japan may make it less profitable
for funds to be overleveraged and overly exposed to Japanese stocks. As a
result, how the U.S. dollar moves also plays a role in the future direction of
the Nikkei.

George Soros
In terms of bonds, one of the most talked-about men in the history of
the FX markets is George Soros. He is notorious for being “the man who
broke the Bank of England.” This is covered in more detail in our history
section (Chapter 2), but in a nutshell, in 1990 the U.K. decided to join the
Exchange Rate Mechanism (ERM) of the European Monetary System in
order to take part in the low-inflationary yet stable economy generated
by the Germany’s central bank, which is also known as the Bundesbank.
This alliance tied the pound to the deutsche mark, which meant that the
U.K. was subject to the monetary policies enforced by the Bundesbank.
In the early 1990s, Germany aggressively increased interest rates to avoid
the inflationary effects related to German reunification. However, national
pride and the commitment of fixing exchange rates within the ERM
prevented the U.K. from devaluing the pound. On Wednesday, September
16, 1992, also known as Black Wednesday, George Soros leveraged the
entire value of his fund ($1 billion) and sold $10 billion worth of pounds
to bet against the Exchange Rate Mechanism. This essentially “broke” the
Bank of England and forced the devaluation of its currency. In a matter
of 24 hours, the British pound fell approximately 5 percent or 5,000 pips.
The Bank of England promised to raise rates in order to tempt speculators
to buy pounds. As a result, the bond markets also experienced tremendous volatility, with the one-month U.K. London Interbank Offered Rate
(LIBOR) increasing 1 percent and then retracing the gain over the next
24 hours. If bond traders were completely oblivious to what was going
on in the currency markets, they probably would have found themselves
dumbstruck in the face of such a rapid gyration in yields.

COMPARING THE FX MARKET
WITH FUTURES AND EQUITIES
Traditionally FX has not been the most popular market to trade because
access to the foreign exchange market was primarily restricted to hedge
funds, Commodity Trading Advisors who manage large amounts of capital,
major corporations, and institutional investors due to regulation, capital
requirements, and technology. One of the primary reasons why the foreign
exchange market has traditionally been the market of choice for these large

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players is because the risk that a trader takes is fully customizable. That is,
one trader could use a hundred times leverage while another may choose
to not be leveraged at all. However, in recent years many firms have opened
up the foreign exchange market to retail traders, providing leveraged trading as well as free instantaneous execution platforms, charts, and real-time
news. As a result, foreign exchange trading has surged in popularity, increasing its attractiveness as an alternative asset class to trade.
Many equity and futures traders have begun to add currencies into the
mix of products that they trade or have even switched to trading currencies
exclusively. The reason why this trend is emerging is because these traders
are beginning to realize that there are many attractive attributes to trading
FX over equities or futures.

FX versus Equities
Here are some of the key attributes of trading spot foreign exchange compared to the equities market.
FX Market Key Attributes

r Foreign exchange is the largest market in the world and has growing
r
r
r
r
r

liquidity.
There is 24-hour around-the-clock trading.
Traders can profit in both bull and bear markets.
There are no trading curbs.
Instant executable trading platform minimizes slippage and errors.
Even though higher leverage increases risk, many traders see trading
the FX market as getting more bang for the buck.

Equities Market Attributes

r There is decent market liquidity, but it depends mainly on the stock’s
daily volume.

r The market is available for trading only from 9:30 a.m. to 4:00 p.m. New
York time with limited after-hours trading.

r The existence of exchange fees results in higher costs and commissions.

r There is an uptick rule to short stocks, which many day traders find
frustrating. Trading curbs may be frustrating for day traders as well.

r The number of steps involved in completing a trade increases slippage
and error.
The volume and liquidity present in the FX market, one of the most liquid markets in the world, have allowed traders to access a 24-hour market

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with low transaction costs, high leverage, the ability to profit in both bull
and bear markets, minimized error rates, limited slippage, and no trading
curbs or uptick rules. Traders can implement in the FX market the same
strategies that they use in analyzing the equity markets. For fundamental
traders, countries can be analyzed like stocks. For technical traders, the FX
market is perfect for technical analysis, since it is already the most commonly used analysis tool by professional traders. It is therefore important
to take a closer look at the individual attributes of the FX market to really
understand why this is such an attractive market to trade.
Around-the-Clock 24-Hour Market One of the primary reasons why
the FX market is popular is because for active traders it is the ideal market
to trade. Its 24-hour nature offers traders instant access to the markets
at all hours of the day for immediate response to global developments.
This characteristic also gives traders the added flexibility of determining
their trading day. Active day traders no longer have to wait for the equities
market to open at 9:30 a.m. New York time to begin trading. If there is a
significant announcement or development either domestically or overseas
between 4:00 p.m. New York time and 9:30 a.m. New York time, most day
traders will have to wait for the exchanges to open at 9:30 a.m. to place
trades. By that time, in all likelihood, unless you have access to electronic
communication networks (ECNs) such as Instinet for premarket trading,
the market would have gapped up or gapped down against you. All of the
professionals would have already priced in the event before the average
trader can even access the market.
In addition, most people who want to trade also have a full-time job
during the day. The ability to trade after hours makes the FX market a much
more convenient market for all traders. Different times of the day will offer different trading opportunities as the global financial centers around
the world are all actively involved in foreign exchange. With the FX market, trading after hours with a large online FX broker provides the same
liquidity and spread as at any other time of day.
As a guideline, at 5:00 p.m. Sunday, New York time, trading begins as
the markets open in Sydney, Australia. Then the Tokyo markets open at
7:00 p.m. New York time. Next, Singapore and Hong Kong open at 9:00 p.m.
EST, followed by the European markets in Frankfurt (2:00 a.m.) and then
London (3:00 a.m.). By 4:00 a.m. the European markets are in full swing,
and Asia has concluded its trading day. The U.S. markets open first in New
York around 8:00 a.m. Monday as Europe winds down. By 5:00 p.m., Sydney
is set to reopen once again.
The most active trading hours are when the markets overlap; for example, Asia and Europe trading overlaps between 2:00 a.m. and approximately
4:00 a.m., Europe and the United States overlap between 8:00 a.m. and

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approximately 11:00 a.m., while the United States and Asia overlap between 5:00 p.m. and 9:00 p.m. During New York and London hours all
of the currency pairs trade actively, whereas during the Asian hours the
trading activity for pairs such as the GBP/JPY and AUD/JPY tend to peak.
Lower Transaction Costs The existence of much lower transaction
costs also makes the FX market particularly attractive. In the equities market, traders must pay a spread (i.e., the difference between the buy and sell
price) and/or a commission. With online equity brokers, commissions can
run upwards of $20 per trade. With positions of $100,000, average roundtrip commissions could be as high as $120. The over-the-counter structure
of the FX market eliminates exchange and clearing fees, which in turn lowers transaction costs. Costs are further reduced by the efficiencies created
by a purely electronic marketplace that allows clients to deal directly with
the market maker, eliminating both ticket costs and middlemen. Because
the currency market offers around-the-clock liquidity, traders receive tight
competitive spreads both intraday and at night. Equities traders are more
vulnerable to liquidity risk and typically receive wider dealing spreads, especially during after-hours trading.
Low transaction costs make online FX trading the best market to trade
for short-term traders. For an active equity trader who typically places 30
trades a day, at a $20 commission per trade you would have to pay up to
$600 in daily transaction costs. This is a significant amount of money that
would definitely take a large cut out of profits or deepen losses. The reason
why costs are so high is because there are several people involved in an
equity transaction. More specifically, for each trade there is a broker, the
exchange, and the specialist. All of these parties need to be paid, and their
payment comes in the form of commission and clearing fees. In the FX market, because it is decentralized with no exchange or clearinghouse (everything is taken care of by the market maker), these fees are not applicable.
Customizable Leverage Even though many people realize that higher
leverage comes with risks, traders are humans and few of them find it easy
to turn away the opportunity to trade on someone else’s money. The FX
market caters perfectly to these traders by offering the highest leverage
available for any market. Most online currency firms offer 100 times leverage on regular-sized accounts and up to 200 times leverage on the miniature accounts. Compare that to the 2 times leverage offered to the average
equity investor and the 10 times capital that is typically offered to the professional trader, and you can see why many traders have turned to the foreign exchange market. The margin deposit for leverage in the FX market
is not seen as a down payment on a purchase of equity, as many perceive
margins to be in the stock markets. Rather, the margin is a performance

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bond, or good faith deposit, to ensure against trading losses. This is very
useful to short-term day traders who need the enhancement in capital to
generate quick returns. Leverage is actually customizable, which means
that the more risk-averse investor who feels comfortable using only 10 or
20 times leverage or no leverage at all can elect to do so. However, leverage is really a double-edged sword. Without proper risk management a high
degree of leverage can lead to large losses as well.
Profit in Both Bull and Bear Markets In the FX market, profit potentials exist in both bull and bear markets. Since currency trading always
involves buying one currency and selling another, there is no structural
bias to the market. Therefore, if you are long one currency, you are also
short another. As a result, profit potentials exist equally in both upwardtrending and downward-trending markets. This is different from the equities market, where most traders go long instead of short stocks, so the
general equity investment community tends to suffer in a bear market.
No Trading Curbs or Uptick Rule The FX market is the largest
market in the world, forcing market makers to offer very competitive
prices. Unlike the equities market, there is never a time in the FX markets
when trading curbs would take effect and trading would be halted, only
to gap when reopened. This eliminates missed profits due to archaic exchange regulations. In the FX market, traders would be able to place trades
24 hours a day with virtually no disruptions.
Online Trading Reduces Error Rates In general, a shorter trade
process minimizes errors. Online currency trading is typically a three-step
process. A trader would place an order on the platform, the FX dealing
desk would automatically execute it electronically, and the order confirmation would be posted or logged on the trader’s trading station. Typically,
these three steps would be completed in a matter of seconds. For an equities trade, on the other hand, there is generally a five-step process. The
client would call his or her broker to place an order, the broker sends the
order to the exchange floor, the specialist on the floor tries to match up
orders (the broker competes with other brokers to get the best fill for the
client), the specialist executes the trade, and the client receives a confirmation from the broker. As a result, in currency trades the elimination of a
middleman minimizes the error rates and increases the efficiency of each
transaction.
Limited Slippage Unlike the equity markets, many online FX market
makers provide instantaneous execution from real-time, two-way quotes.
These quotes are the prices at which the firms are willing to buy or sell

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the quoted currency, rather than vague indications of where the market is
trading, which aren’t honored. Orders are executed and confirmed within
seconds. Robust systems would never request the size of a trader’s potential order, or which side of the market he’s trading, before giving a bid/offer
quote. Inefficient dealers determine whether the investor is a buyer or a
seller, and shade the price to increase their own profit on the transaction.
The equity market typically operates under a “next best order” system,
under which you may not get executed at the price you wish, but rather at
the next best price available. For example, let’s say Microsoft is trading at
$52.50. If you enter a buy order at this price, by the time it reaches the specialist on the exchange floor the price may have risen to $53.25. In this case,
you will not get executed at $52.50; you will get executed at $53.25, which
is essentially a loss of three-quarters of a point. The price transparency
provided by some of the better market makers ensures that traders always
receive a fair price.
Perfect Market for Technical Analysis For technical analysts, currencies rarely spend much time in tight trading ranges and have the tendency to develop strong trends. Over 80 percent of volume is speculative
in nature, and as a result the market frequently overshoots and then corrects itself. Technical analysis works well for the FX market and a technically trained trader can easily identify new trends and breakouts, which
provide multiple opportunities to enter and exit positions. Charts and indicators are used by all professional FX traders, and candlestick charts
are available in most charting packages. In addition, the most commonly
used indicators—such as Fibonacci retracements, stochastics, moving average convergence/divergence (MACD), moving averages, (RSI), and support/resistance levels—have proven valid in many instances.
In the GBP/USD chart in Figure 1.1, it is clear that Fibonacci retracements, moving averages, and stochastics have at one point or another
given successful trading signals. For example, the 50 percent retracement
level has served as support for the GBP/USD throughout the month of
January and for a part of February 2005.The moving average crossovers of
the 10-day and 20-day simple moving averages also successfully forecasted
the sell-off in the GBP/USD on March 21, 2005. Equity traders who focus
on technical analysis have the easiest transition since they can implement
in the FX market the same technical strategies that they use in the equities
market.
Analyze Stocks Like Countries Trading currencies is not difficult for
fundamental traders, either. Countries can be analyzed just like stocks. For
example, if you analyze growth rates of stocks, you can use gross domestic product (GDP) to analyze the growth rates of countries. If you analyze

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FIGURE 1.1 GBP/USD Chart
(Source: www.eSignal.com)

inventory and production ratios, you can follow industrial production or
durable goods data. If you follow sales figures, you can analyze retail sales
data. As with a stock investment, it is better to invest in the currency of a
country that is growing faster and is in a better economic condition than
other countries. Currency prices reflect the balance of supply and demand
for currencies. Two of the primary factors affecting supply and demand of
currencies are interest rates and the overall strength of the economy. Economic indicators such as GDP, foreign investment, and the trade balance
reflect the general health of an economy and are therefore responsible for
the underlying shifts in supply and demand for that currency. There is a
tremendous amount of data released at regular intervals, some of which is
more important than others. Data related to interest rates and international
trade is looked at the most closely.
If the market has uncertainty regarding interest rates, then any bit of
news relating to interest rates can directly affect the currency market. Traditionally, if a country raises its interest rate, the currency of that country
will strengthen in relation to other countries as investors shift assets to
that country to gain a higher return. Hikes in interest rates are generally
bad news for stock markets, however. Some investors will transfer money
out of a country’s stock market when interest rates are hiked, causing
the country’s currency to weaken. Determining which effect dominates
can be tricky, but generally there is a consensus beforehand as to what

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the interest rate move will do. Indicators that have the biggest impact on
interest rates are the producer price index (PPI), consumer price index
(CPI), and GDP. Generally the timing of interest rate moves is known in
advance. They take place after regularly scheduled meetings by the Bank
of England (BOE), the U.S. Federal Reserve (Fed), the European Central
Bank (ECB), the Bank of Japan (BOJ), and other central banks.
The trade balance shows the net difference over a period of time between a nation’s exports and imports. When a country imports more than
it exports the trade balance will show a deficit, which is generally considered unfavorable. For example, if U.S. dollars are sold for other domestic
national currencies (to pay for imports), the flow of dollars outside the
country will depreciate the value of the dollar. Similarly, if trade figures
show an increase in exports, dollars will flow into the United States and
appreciate the value of the dollar. From the standpoint of a national economy, a deficit in and of itself is not necessarily a bad thing. If the deficit is
greater than market expectations, however, then it will trigger a negative
price movement.

FX versus Futures
The FX market holds advantages over not only the equity market, but also
the futures market. Many futures traders have added currency spot trading to their portfolios. After recapping the key spot foreign exchange attributes, we compare the futures attributes.
FX Market Key Attributes

r
r
r
r

It is the largest market in the world and has growing liquidity.
There is 24-hour around-the-clock trading.
Traders can profit in both bull and bear markets.
Short selling is permitted without an uptick, and there are no trading
curbs.
r Instant executable trading platform minimizes slippage and errors.
r Even though higher leverage increases risk, many traders see trading
the FX market as getting more bang for the buck.
Futures Attributes

r Market liquidity is limited, depending on the month of the contract
traded.

r The presence of exchange fees results in more costs and commissions.
r Market hours for futures trading are much shorter than for spot FX
and are dependent on the product traded; each product may have

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different opening and closing hours, and there is limited after-hours
trading.
r Futures leverage is higher than leverage for equities, but still only a
fraction of the leverage offered in FX.
r There tend to be prolonged bear markets.
r Pit trading structure increases error and slippage.
Like they can in the equities market, traders can implement in the FX
market the same strategies that they use in analyzing the futures markets.
Most futures traders are technical traders, and as mentioned in the equities section, the FX market is perfect for technical analysis. In fact, it is
the most commonly used analysis tool by professional traders. Let’s take a
closer look at how the futures market stacks up against the FX market.
Comparing Market Hours and Liquidity The volume traded in the
FX market is estimated to be more than five times that of the futures market. The FX market is open for trading 24 hours a day, but the futures market has confusing market hours that vary based on the product traded. For
example, trading gold futures is open only between 7:20 a.m. and 1:30 p.m.
on the New York Commodities Exchange (COMEX), whereas if you trade
crude oil futures on the New York Mercantile Exchange, trading is open
only between 8:30 a.m. and 2:10 p.m. These varying hours not only create
confusion, but also make it difficult to act on breakthrough announcements
throughout the remainder of the day.
In addition, if you have a full-time job during the day and can trade
only after hours, futures would be a very inconvenient market product for
you to trade. You would basically be placing orders based on past prices
and not current market prices. This lack of transparency makes trading
very cumbersome. With the FX market, if you choose to trade after hours
through the right market makers, you can be assured that you would receive the same liquidity and spread as at any other time of day. In addition,
each time zone has its own unique news and developments that could move
specific currency pairs.
Low to Zero Transaction Costs In the futures market, traders must
pay a spread and/or a commission. With futures brokers, average commissions can run close to $160 per trade on positions of $100,000 or greater.
The over-the-counter structure of the FX market eliminates exchange and
clearing fees, which in turn lowers transaction costs. Costs are further
reduced by the efficiencies created by a purely electronic marketplace
that allows clients to deal directly with the market maker, eliminating
both ticket costs and middlemen. Because the currency market offers
around-the-clock liquidity, traders receive tight, competitive spreads both

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intraday and at night. Futures traders are more vulnerable to liquidity risk
and typically receive wider dealing spreads, especially during after-hours
trading.
Low to zero transaction costs make online FX trading the best market
to trade for short-term traders. If you are an active futures trader who typically places 20 trades a day, at $100 commission per trade, you would have
to pay $2,000 in daily transaction costs. A typical futures trade involves a
broker, a Futures Commission Merchant (FCM) order desk, a clerk on the
exchange floor, a runner, and a pit trader. All of these parties need to be
paid, and their payment comes in the form of commission and clearing fees,
whereas the electronic nature of the FX market minimizes these costs.
No Limit Up or Down Rules/Profit in Both Bull and Bear
Markets There is no limit down or limit up rule in the FX market, unlike the tight restriction on the futures market. For example, on the S&P
500 index futures, if the contract value falls more than 5 percent from the
previous day’s close, limit down rules will come in effect whereby on a
5 percent move the index is allowed to trade only at or above this level
for the next 10 minutes. For a 20 percent decline, trading would be completely halted. Due to the decentralized nature of the FX market, there are
no exchange-enforced restrictions on daily activity. In effect, this eliminates missed profits due to archaic exchange regulations.
Execution Quality and Speed/Low Error Rates The futures market is also known for inconsistent execution in terms of both pricing and
execution time. Every futures trader has at some point in time experienced
a half hour or so wait for a market order to be filled, only to then be executed at a price that may be far away from where the market was trading
when the initial order was placed. Even with electronic trading and limited
guarantees of execution speed, the prices for fills on market orders are far
from certain. The reason for this inefficiency is the number of steps that are
involved in placing a futures trade. A futures trade is typically a seven-step
process:
1. The client calls his or her broker and places a trade (or places it

online).
2. The trading desk receives the order, processes it, and routes it to the
FCM order desk on the exchange floor.
3. The FCM order desk passes the order to the order clerk.
4. The order clerk hands the order to a runner or signals it to the pit.
5. The trading clerk goes to the pit to execute the trade.

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6. The trade confirmation goes to the runner or is signaled to the order

clerk and processed by the FCM order desk.
7. The broker receives the trade confirmation and passes it on to the

client.
An FX trade, in comparison, is typically only a three-step process. A
trader would place an order on the platform, the FX dealing desk would
automatically execute it electronically, and the order confirmation would
be posted or logged on the trader’s trading station. The elimination of the
additional parties involved in a futures trade increases the speed of the FX
trade execution and decreases errors.
In addition, the futures market typically operates under a “next best
order” system, under which traders frequently do not get executed at the
initial market order price, but rather at the next best price available. For
example, let’s say a client is long five March Dow Jones futures contracts
at 8800 with a stop order at 8700; if the price falls to this level, the order
will most likely be executed at 8690. This 10-point difference would be attributed to slippage, which is very common in the futures market.
On most FX trading stations, traders execute directly off of real-time
streaming prices. Barring any unforeseen circumstances, there is generally
no discrepancy between the displayed price and the execution price. This
holds true even during volatile times and fast-moving markets. In the
futures market, in contrast, execution is uncertain because all orders must
be done on the exchange, creating a situation where liquidity is limited
by the number of participants, which in turn limits quantities that can be
traded at a given price. Real-time streaming prices ensure that FX market
orders, stops, and limits are executed with minimal slippage and no
partial fills.

DIFFERENT WAYS TO TRADE FX
Over the past few years, the FX market has evolved significantly. Many
products have been introduced as alternative ways to invest in or trade
currencies. Foreign exchange spot is the oldest of these markets and
represents the underlying for many of the new derivative products. Options, futures, and forwards are the next oldest, but forwards are generally
limited to a nonretail audience. An entire book can be dedicated to the differences between all of the new derivative products, but for the purpose of
this book, here are some basic descriptions as well as general advantages
and disadvantages (there may be many others that are not included in
this list).

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Spot
The FX spot market is the largest market in the world with a daily turnover
of over $3 trillion.
Quoting Convention Spot forex is quoted in pairs. If the EUR/USD exchange rate is 1.50, for example, it means that every euro buys 1.5 U.S.
dollars. A one-pip move represents a change in the last decimal place, and
for the EUR/USD it is worth $10 on a 100K lot.
Advantage The biggest advantages of trading the spot market are its
simplicity, liquidity, tight spreads, and around-the-clock trading. There is
no expiration or time decay, and accounts can also be opened with very
small initial balances. Real-time charts, news, and research are provided
free by many brokers.
Disadvantage The biggest disadvantage of the spot market is the fact
that it is an over-the-counter market, meaning that spot is not exchange
traded. Usually customers deal directly with their FX broker, who sources
their price feed from the interbank market. Unfortunately, not all brokers
are regulated, though this is expected to change in the coming years.
Additional Comment A characteristic of the spot market that can be
looked at as both an advantage and a disadvantage is leverage, because
in the spot market leverage is very high. Some brokers offer as much as
400-to-1 leverage. Many people view the generous leverage in the FX spot
market as a benefit, but leverage is a double-edged sword, meaning that it
exacerbates losses as well as gains. Too much leverage is also the primary
reason why many traders have difficulties turning a profit. Traders have the
option to change their leverage, but they usually don’t.

Futures
FX futures were created by the Chicago Mercantile Exchange (CME) in
1972 and were the first financial futures contracts ever created. The daily
notional volume is approximately $60 billion.
Quoting Convention Futures contracts are standardized and are subject to physical delivery. The prices of futures contracts are all quoted in
terms of U.S. dollars per unit of other currency being traded. For example,
the quotes would be given in U.S. dollars per euro or per Japanese yen.
Each tick or point equals 0.0001. Each contract for the euro, for example,
involves trading the value of 125,000 euros.

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Advantage The biggest advantage of trading futures is the fact that the
transactions are conducted over an exchange. The market is very liquid
and is well regulated. As the counterparty to every trade, CME Clearing
eliminates the risk of credit default by any single counterparty. Price and
transaction information is readily available, and the top five bids and offers
can be seen by electronic traders.
Disadvantage The contracts are standardized, which means that the
options are limited. Unless traders keep up with expiring contracts, they
are subject to physical delivery. Futures margins can be higher, which is
seen as a disadvantage by some traders, and account minimums are generally higher. Commissions and brokerage fees may also be higher.
Leverage is usually 5 to 1.

Options
There are many different ways to trade currency options. The Philadelphia
Stock Exchange, the International Securities Exchange (ISE), and the
Chicago Mercantile Exchange all offer options trading on currencies.
Quoting Convention With currency options, quoting conventions vary
depending on where the option is traded. At the Philadelphia Stock
Exchange, for example, euro currency options are quoted in terms of
U.S. dollars per unit of underlying currency, and each contract is worth
10,000 euros. The point value is $100 (i.e., one full Eurocent = currency
value × 100). At the International Securities Exchange, FX options have
underlying values expressed in foreign currency units per U.S. dollar that
are modified to create an indexlike underlying. For example, if the current exchange rate for USD/EUR is 0.7829, the underlying value for the
USD/EUR ISE FX option would be 78.29 (0.7829 × 100). This format is designed to help investors easily adapt the trading strategies they currently
use for equity and index options. One point is equal $100. The Chicago Mercantile Exchange, by contrast, offers options trading on futures contracts.
The trading unit is one CME futures contract (in euros, one contract =
125,000 euros), and the minimum tick size is 0.0001 per euro, which is the
equivalent point value of $12.50.
Advantage Like futures contracts, options are exchange traded. They
allow for limited risk because the premium is the predetermined maximum
loss. They also are inherently leveraged products, which may be attractive
to some traders.

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Disadvantage The biggest disadvantage of trading FX options is the
time decay. Also, there are limited trading hours for some of the different
currency option products.

Exchange-Traded Funds
Exchange-traded funds (ETFs) are the newest entries into the FX world,
with Rydex Investments launching its first CurrencyShares in 2005. PowerShares have also entered the market, but only with DB U.S. Dollar Index
Bullish and Bearish funds. CurrencyShares are traded on the New York
Stock Exchange (NYSE) like any other exchange-listed security.
Quoting Convention CurrencyShares are traded like any stock or traditional exchange traded fund on the NYSE Arca. Shares are traded in
one or more blocks of 50,000 shares. A share in the CurrencyShares Euro
ETF for example is the equivalent of 100 Euros. PowerShares on the other
hand usually represent a basket of currencies. The shares are traded on the
American Stock Exchange (AMEX).
Advantage For many equity market traders, the biggest advantage of
trading Rydex’s CurrencyShares is their simplicity, because currencies are
traded in the same way as U.S. stocks and on the same exchange.
Disadvantage The biggest disadvantage is that the CurrencyShares are
available for trading only until 4:15 p.m., and trading does not restart until
the NYSE opens the next day. Because the market closes, exchange-traded
currency funds cater primarily to long-term traders. Also, since they are
traded on the NYSE, they are subject to standard stock commissions and
they have expense ratios.

WHO ARE THE PLAYERS
IN THE FX MARKET?
Since the foreign exchange market is an over-the-counter (OTC) market
without a centralized exchange, competition between market makers prohibits monopolistic pricing strategies. If one market maker attempts to
drastically skew the price, then traders simply have the option to find another market maker. Moreover, spreads are closely watched to ensure market makers are not whimsically altering the cost of the trade. Many equity
markets, in contrast, operate in a completely different fashion; the New
York Stock Exchange (NYSE), for instance, is the sole place where companies listed on the NYSE can have their stocks traded. Centralized markets
are operated by what are referred to as specialists, while market makers is

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the term used in reference to decentralized marketplaces. (See Figures 1.2
and 1.3.) Since the NYSE is a centralized market, a stock traded on the
NYSE can have only 1 bid/ask quote at all times. Decentralized markets,
such as foreign exchange, can have multiple market makers—all of whom
have the right to quote different prices. Let’s look at how both centralized
and decentralized markets operate.

Centralized Markets
By their very nature, centralized markets tend to be monopolistic: with
a single specialist controlling the market, prices can easily be skewed to

FIGURE 1.2 Centralized Market Structure

FIGURE 1.3 Decentralized Market Structure

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accommodate the interests of the specialist, not those of the traders. If,
for example, the market is filled with sellers from whom the specialists
must buy but no prospective buyers on the other side, the specialists will
be forced to buy from the sellers and be unable to sell a commodity that is
being sold off and hence falling in value. In such a situation, the specialist
may simply widen the spread, thereby increasing the cost of the trade and
preventing additional participants from entering the market. Or specialists
can simply drastically alter the quotes they are offering, thus manipulating
the price to accommodate their own needs.

Hierarchy of Participants in
Decentralized Market
While the foreign exchange market is decentralized and hence employs
multiple market makers rather than a single specialist, participants in the
FX market are organized into a hierarchy; those with superior credit access, volume transacted, and sophistication receive priority in the market.
At the top of the food chain is the interbank market, which trades
the highest volume per day in relatively few (mostly G-7) currencies. In
the interbank market, the largest banks can deal with each other directly,
via interbank brokers or through electronic brokering systems like Electronic Brokering Services (EBS) or Reuters. The interbank market is a
credit-approved system where banks trade based solely on the credit relationships they have established with one another. All the banks can see
the rates everyone is dealing at; however, each bank must have a specific
credit relationship with another bank in order to trade at the rates being
offered. Other institutions such as online FX market makers, hedge funds,
and corporations must trade FX through commercial banks.
Many banks (small community banks, banks in emerging markets),
corporations, and institutional investors do not have access to these rates
because they have no established credit lines with big banks. This forces
small participants to deal through just one bank for their foreign exchange
needs, and often this means much less competitive rates for the participants further down the participant hierarchy. Those receiving the least
competitive rates are customers of banks and exchange agencies.
Recently technology has broken down the barriers that used to stand
between the end users of foreign exchange services and the interbank market. The online trading revolution opened its doors to retail clientele by
connecting market makers and market participants in an efficient, lowcost manner. In essence, the online trading platform serves as a gateway to
the liquid FX market. Average traders can now trade alongside the biggest
banks in the world, with similar pricing and execution. What used to be a
game dominated and controlled by the big boys is slowly becoming a level

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playing field where individuals can profit and take advantage of the same
opportunities as big banks. FX is no longer an old boys club, which means
opportunity abounds for aspiring online currency traders.
Dealing Stations—Interbank Market The majority of FX volume
is transacted primarily through the interbank market. The leading banks
of the world trade with each other electronically over two platforms—the
EBS and Reuters Dealing 3000-Spot Matching. Both platforms offer trading
in the major currency pairs; however, certain currency pairs are more liquid and generally more frequently traded over either EBS or Reuters D3000.
These two companies are continually trying to capture each other’s market
shares, but as a guide, here is the breakdown of which currencies are most
liquid over the individual platforms:
EBS

Reuters

EUR/USD
USD/JPY
EUR/JPY
EUR/CHF
USD/CHF

GBP/USD
EUR/GBP
USD/CAD
AUD/USD
NZD/USD

Cross-currency pairs are generally not traded over either platform, but
instead are calculated based on the rates of the major currency pairs and
then offset using the “legs.” For example, if an interbank trader had a
client who wanted to go long AUD/JPY, the trader would most likely buy
AUD/USD over the Reuters D3000 system and buy USD/JPY over EBS. The
trader would then multiply these rates and provide the client with the respective AUD/JPY rate. These currency pairs are also known as synthetic
currencies, and this helps to explain why spreads for cross currencies are
generally wider than spreads for the major currency pairs.

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CHAPTER 2

Historical Events
in the
FX Market

efore diving into the inner workings of currency trading, it is important for every trader to understand a few of the key milestones in the
foreign exchange market, since even to this day they still represent
events that are referenced repeatedly by professional forex traders.

B

BRETTON WOODS: ANOINTING
THE DOLLAR AS THE WORLD
CURRENCY (1944)
In July 1944, representatives of 44 nations met in Bretton Woods, New
Hampshire, to create a new institutional arrangement for governing the international economy in the years after World War II. After the war, most
agreed that international economic instability was one of the principal
causes of the war, and that such instability needed to be prevented in
the future. The agreement, which was developed by renowned economists
John Maynard Keynes and Harry Dexter White, was initially proposed to
Great Britain as a part of the Lend-Lease Act—an American act designed to
assist Great Britain in postwar redevelopment efforts. After various negotiations, the final form of the Bretton Woods Agreement consisted of several
key points:
1. The formation of key international authorities designed to promote fair

trade and international economic harmony.
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2. The fixing of exchange rates among currencies.
3. The convertibility between gold and the U.S. dollar, thus empowering

the U.S. dollar as the reserve currency of choice for the world.
Of the three aforementioned parameters, only the first point is still in
existence today. The organizations formed as a direct result of Bretton
Woods include the International Monetary Fund (IMF), World Bank, and
General Agreement on Tariffs and Trade (GATT), which are still in existence today and play a crucial role in the development and regulation of
international economies. The IMF, for instance, initially enforced the price
of $35 per ounce of gold that was to be fixed under the Bretton Woods
system, as well as the fixing of exchange rates that occurred while Bretton
Woods was in operation (and the financing required to ensure that fixed exchange rates would not create fundamental distortions in the international
economy).
Since the demise of Bretton Woods, the IMF has worked closely with
another progeny of Bretton Woods: the World Bank. Together, the two institutions now regularly lend funds to developing nations, thus assisting
them in the development of a public infrastructure capable of supporting
a sound mercantile economy that can contribute in an international arena.
And, in order to ensure that these nations can actually enjoy equal and legitimate access to trade with their industrialized counterparts, the World
Bank and IMF must work closely with GATT. While GATT was initially
meant to be a temporary organization, it now operates to encourage the
dismantling of trade barriers—namely tariffs and quotas.
The Bretton Woods Agreement was in operation from 1944 to 1971,
when it was replaced with the Smithsonian Agreement, an international
contract of sorts pioneered by U.S. President Richard Nixon out of the necessity to accommodate for Bretton Woods’ shortcomings. Unfortunately,
the Smithsonian Agreement possessed the same critical weakness: while
it did not include gold/U.S. dollar convertibility, it did maintain fixed exchange rates—a facet that did not accommodate the ongoing U.S. trade
deficit and the international need for a weaker U.S. dollar. As a result, the
Smithsonian Agreement was short-lived.
Ultimately, the exchange rates of the world evolved into a free market, whereby supply and demand were the sole criteria that determined
the value of a currency. While this did and still does result in a number of
currency crises and greater volatility between currencies, it also allowed
the market to become self-regulating, and thus the market could dictate
the appropriate value of a currency without any hindrances.
As for Bretton Woods, perhaps its most memorable contribution to
the international economic arena was its role in changing the perception

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23

regarding the U.S. dollar. While the British pound is still substantially
stronger, and while the euro is a revolutionary currency blazing new frontiers in both social behavior and international trade, the U.S. dollar remains
the world’s reserve currency of choice for the time being. This is undeniably due largely in part to the Bretton Woods Agreement: by establishing
dollar/gold convertibility, the dollar’s role as the world’s most accessible
and reliable currency was firmly cemented. And thus, while Bretton Woods
may be a doctrine of yesteryear, its impact on the U.S. dollar and international economics still resonates today.

END OF BRETTON WOODS: FREE
MARKET CAPITALISM IS BORN (1971)
On August 15, 1971, it became official: the Bretton Woods system, a system
used to fix the value of a currency to the value of gold, was abandoned
once and for all. While it had been exorcised before, only to subsequently
emerge in a new form, this final eradication of the Bretton Woods system
was truly its last stand: no longer would currencies be fixed in value to
gold, allowed to fluctuate only in a 1 percent range, but instead their fair
valuation could be determined by free market behavior such as trade flows
and foreign direct investment.
While U.S. President Nixon was confident that the end of the Bretton
Woods system would bring about better times for the international economy, he was not a believer that the free market could dictate a currency’s
true valuation in a fair and catastrophe-free manner. Nixon, as well as most
economists, reasoned that an entirely unstructured foreign exchange market would result in competing devaluations, which in turn would lead to the
breakdown of international trade and investment. The end result, Nixon
and his board of economic advisers reasoned, would be global depression.
Accordingly, a few months later, the Smithsonian Agreement was introduced. Hailed by President Nixon as the “greatest monetary agreement
in the history of the world,” the Smithsonian Agreement strived to maintain fixed exchange rates, but to do so without the backing of gold. Its key
difference from the Bretton Woods system was that the value of the dollar
could float in a range of 2.25 percent, as opposed to just 1 percent under
Bretton Woods.
Ultimately, the Smithsonian Agreement proved to be unfeasible as
well. Without exchange rates fixed to gold, the free market gold price shot
up to $215 per ounce. Moreover, the U.S. trade deficit continued to grow,
and from a fundamental standpoint, the U.S. dollar needed to be devalued beyond the 2.25 percent parameters established by the Smithsonian

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Agreement. In light of these problems, the foreign exchange markets were
forced to close in February 1972.
The forex markets reopened in March 1973, and this time they were
not bound by a Smithsonian Agreement: the value of the U.S. dollar was
to be determined entirely by the market, as its value was not fixed to any
commodity, nor was its exchange rate fluctuation confined to certain parameters. While this did provide the U.S. dollar, and other currencies by
default, the agility required to adapt to a new and rapidly evolving international trading environment, it also set the stage for unprecedented inflation.
The end of Bretton Woods and the Smithsonian Agreement, as well as conflicts in the Middle East resulting in substantially higher oil prices, helped
to create stagflation—the synthesis of unemployment and inflation—in the
U.S. economy. It would not be until later in the decade, when Federal Reserve Chairman Paul Volcker initiated new economic policies and President Ronald Reagan introduced a new fiscal agenda, that the U.S. dollar
would return to normal valuations. And by then, the foreign exchange
markets had thoroughly developed, and were now capable of serving a multitude of purposes: in addition to employing a laissez-faire style of regulation for international trade, they also were beginning to attract speculators
seeking to participate in a market with unrivaled liquidity and continued
growth. Ultimately, the death of Bretton Woods in 1971 marked the beginning of a new economic era, one that liberated international trading while
also proliferating speculative opportunities.

PLAZA ACCORD—DEVALUATION OF U.S.
DOLLAR (1985)
After the demise of all the various exchange rate regulatory mechanisms
that characterized the twentieth century—the gold standard, the Bretton
Woods standard, and the Smithsonian Agreement—the currency market
was left with virtually no regulation other than the mythical “invisible
hand” of free market capitalism, one that supposedly strived to create
economic balance through supply and demand. Unfortunately, due to
a number of unforeseen economic events—such as the Organization of
Petroleum Exporting Countries (OPEC) oil crises, stagflation throughout the 1970s, and drastic changes in the U.S. Federal Reserve’s fiscal
policy—supply and demand, in and of themselves, became insufficient
means by which the currency markets could be regulated. A system of sorts
was needed, but not one that was inflexible. Fixation of currency values to
a commodity, such as gold, proved to be too rigid for economic development, as was also the notion of fixing maximum exchange rate fluctuations.

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The balance between structure and rigidity was one that had plagued the
currency markets throughout the twentieth century, and while advancements had been made, a definitive solution was still greatly needed.
And hence in 1985, the respective ministers of finance and central bank
governors of the world’s leading economies—France, Germany, Japan, the
United Kingdom, and the United States—convened in New York City with
the hopes of arranging a diplomatic agreement of sorts that would work
to optimize the economic effectiveness of the foreign exchange markets.
Meeting at the Plaza Hotel, the international leaders came to certain agreements regarding specific economies and the international economy as a
whole.
Across the world, inflation was at very low levels. In contrast to
the stagflation of the 1970s—where inflation was high and real economic
growth was low—the global economy in 1985 had done a complete 180degree turn, as inflation was now low but growth was strong.
While low inflation, even when coupled with robust economic growth,
still allowed for low interest rates—a circumstance developing countries
particularly enjoyed—there was an imminent danger of protectionist policies like tariffs entering the economy. The United States was experiencing
a large and growing current account deficit, while Japan and Germany were
facing large and growing surpluses. An imbalance so fundamental in nature
could create serious economic disequilibrium, which in turn would result
in a distortion of the foreign exchange markets and thus the international
economy.
The results of current account imbalances, and the protectionist policies that ensued, required action. Ultimately, it was believed that the rapid
acceleration in the value of the U.S. dollar, which appreciated more than
80 percent against the currencies of its major trading partners, was the primary culprit. The rising value of the U.S. dollar helped to create enormous
trade deficits. A dollar with a lower valuation, on the other hand, would be
more conducive to stabilizing the international economy, as it would naturally bring about a greater balance between the exporting and importing
capabilities of all countries.
At the meeting in the Plaza Hotel, the United States persuaded the
other attendees to coordinate a multilateral intervention, and on September 22, 1985, the Plaza Accord was implemented. This agreement was designed to allow for a controlled decline of the dollar and the appreciation
of the main antidollar currencies. Each country agreed to changes to its
economic policies and to intervene in currency markets as necessary to
get the dollar down. The United States agreed to cut its budget deficit and
to lower interest rates. France, the United Kingdom, Germany, and Japan
all agreed to raise interest rates. Germany also agreed to institute tax cuts
while Japan agreed to let the value of the yen “fully reflect the underlying

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strength of the Japanese economy.” However, the problem with the actual
implementation of the Plaza Accord was that not every country adhered
to its pledges. The United States in particular did not follow through with
its initial promise to cut the budget deficit. Japan was severely hurt by the
sharp rise in the yen, as its exporters were unable to remain competitive
overseas, and it is argued that this eventually triggered a 10-year recession
in Japan. The United States, in contrast, enjoyed considerable growth and
price stability as a result of the agreement.
The effects of the multilateral intervention were seen immediately, and
within two years the dollar had fallen 46 percent and 50 percent against the
deutsche mark (DEM) and the Japanese yen (JPY), respectively. Figure 2.1
shows this depreciation of the U.S. dollar against the DEM and the JPY. The
U.S. economy became far more export-oriented as a result, while other industrial countries like Germany and Japan assumed the role of importing.
This gradually resolved the current account deficits for the time being, and
also ensured that protectionist policies were minimal and nonthreatening.
But perhaps most importantly, the Plaza Accord cemented the role of the
central banks in regulating exchange rate movement: yes, the rates would
not be fixed, and hence would be determined primarily by supply and demand; but ultimately, such an invisible hand is insufficient, and it was the

FIGURE 2.1 Plaza Accord Price Action

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right and responsibility of the world’s central banks to intervene on behalf
of the international economy when necessary.

GEORGE SOROS—THE MAN WHO BROKE
THE BANK OF ENGLAND
When George Soros placed a $10 billion speculative bet against the U.K.
pound and won, he became universally known as “the man who broke the
Bank of England.” Whether you love him or hate him, Soros led the charge
in one of the most fascinating events in currency trading history.

The United Kingdom Joins the Exchange
Rate Mechanism
In 1979, a Franco-German initiative set up the European Monetary System
(EMS) in order to stabilize exchange rates, reduce inflation, and prepare
for monetary integration. The Exchange Rate Mechanism (ERM), one of
the EMS’s main components, gave each participatory currency a central
exchange rate against a basket of currencies, the European Currency Unit
(ECU). Participants (initially France, Germany, Italy, the Netherlands, Belgium, Denmark, Ireland, and Luxembourg) were then required to maintain
their exchange rates within a 2.25 percent fluctuation band above or below
each bilateral central rate. The ERM was an adjustable-peg system, and
nine realignments would occur between 1979 and 1987. While the United
Kingdom was not one of the original members, it would eventually join in
1990 at a rate of 2.95 deutsche marks to the pound and with a fluctuation
band of +/– 6 percent.
Until mid-1992, the ERM appeared to be a success, as a disciplinary effect had reduced inflation throughout Europe under the leadership of the
German Bundesbank. The stability wouldn’t last, however, as international
investors started worrying that the exchange rate values of several
currencies within the ERM were inappropriate. Following German reunification in 1989, the nation’s government spending surged, forcing the
Bundesbank to print more money. This led to higher inflation and left the
German central bank with little choice but to increase interest rates. But
the rate hike had additional repercussions—because it placed upward pressure on the German mark. This forced other central banks to raise their interest rates as well, so as to maintain the pegged currency exchange rates
(a direct application of Irving Fisher’s interest rate parity theory). Realizing that the United Kingdom’s weak economy and high unemployment rate

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would not permit the British government to maintain this policy for long,
George Soros stepped into action.

Soros Bets Against Success of U.K. Involvement
in ERM
The Quantum hedge fund manager essentially wanted to bet that the pound
would depreciate because the United Kingdom would either devalue the
pound or leave the ERM. Thanks to the progressive removal of capital controls during the EMS years, international investors at the time had more
freedom than ever to take advantage of perceived disequilibriums, so Soros
established short positions in pounds and long positions in marks by borrowing pounds and investing in mark-denominated assets. He also made
great use of options and futures. In all, his positions accounted for a gargantuan $10 billion. Soros was not the only one; many other investors soon followed suit. Everyone was selling pounds, placing tremendous downward
pressure on the currency.
At first, the Bank of England tried to defend the pegged rates by buying
15 billion pounds with its large reserve assets, but its sterilized interventions (whereby the monetary base is held constant thanks to open market
interventions) were limited in their effectiveness. The pound was trading
dangerously close to the lower levels of its fixed band. On September 16,
1992, a day that would later be known as Black Wednesday, the bank announced a 2 percent rise in interest rates (from 10 percent to 12 percent)
in an attempt to boost the pound’s appeal. A few hours later, it promised to
raise rates again, to 15 percent, but international investors such as Soros
could not be swayed, knowing that huge profits were right around the
corner. Traders kept selling pounds in huge volumes, and the Bank of
England kept buying them until, finally, at 7:00 p.m. that same day, Chancellor Norman Lamont announced Britain would leave the ERM and that
rates would return to their initial level of 10 percent. The chaotic Black
Wednesday marked the beginning of a steep depreciation in the pound’s
effective value.
Whether the return to a floating currency was due to the Soros-led attack on the pound or because of simple fundamental analysis is still debated today. What is certain, however, is that the pound’s depreciation of
almost 15 percent against the deutsche mark and 25 percent against the
dollar over the next five weeks (as seen in Figure 2.2 and Figure 2.3) resulted in tremendous profits for Soros and other traders. Within a month,
the Quantum Fund cashed in on approximately $2 billion by selling the now
more expensive deutsche marks and buying back the now cheaper pounds.
“The man who broke the Bank of England” showed how central banks can
still be vulnerable to speculative attacks.

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FIGURE 2.2 GBP/DEM After Soros

FIGURE 2.3 GBP/USD After Soros

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ASIAN FINANCIAL CRISIS (1997–1998)
Falling like a set of dominos on July 2, 1997, the relatively nascent Asian
tiger economies created a perfect example in showing the interdependence
of global capital markets and their subsequent effects throughout international currency forums. Based on several fundamental breakdowns, the
cause of the contagion stemmed largely from shrouded lending practices,
inflated trade deficits, and immature capital markets. Added together, the
factors contributed to a “perfect storm” that left major regional markets
incapacitated and once-prized currencies devalued to significantly lower
levels. With adverse effects easily seen in the equities markets, currency
market fluctuations were negatively impacted in much the same manner
during this time period.

The Bubble
Leading up to 1997, investors had become increasingly attracted to Asian
investment prospects, focusing on real estate development and domestic
equities. As a result, foreign investment capital flowed into the region as
economic growth rates climbed on improved production in countries like
Malaysia, the Philippines, Indonesia, and South Korea. Thailand, home of
the baht, experienced a 13 percent growth rate in 1988 (falling to 6.5 percent in 1996). Additional lending support for a stronger economy came
from the enactment of a fixed currency peg to the more formidable U.S.
dollar. With a fixed valuation to the greenback, countries like Thailand
could ensure financial stability in their own markets and a constant rate
for export trading purposes with the world’s largest economy. Ultimately,
the region’s national currencies appreciated as underlying fundamentals
were justified, and speculative positions in expectation of further climbs in
price mounted.

Ballooning Current Account Deficits and
Nonperforming Loans
However, in early 1997, a shift in sentiment had begun to occur as international account deficits became increasingly difficult for respective governments to handle and lending practices were revealed to be detrimental to the economic infrastructure. In particular, economists were alerted
to the fact that Thailand’s current account deficit had ballooned in 1996
to $14.7 billion (it had been climbing since 1992). Although comparatively
smaller than the U.S. deficit, the gap represented 8 percent of the country’s gross domestic product. Shrouded lending practices also contributed

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heavily to these breakdowns, as close personal relationships of borrowers
with high-ranking banking officials were well rewarded and surprisingly
common throughout the region. This aspect affected many of South Korea’s highly leveraged conglomerates as total nonperforming loan values
sky-rocketed to 7.5 percent of gross domestic product.
Additional evidence of these practices could be observed in financial
institutions throughout Japan. After announcing a $136 billion total in questionable and nonperforming loans in 1994, Japanese authorities admitted
to an alarming $400 billion total a year later. Coupled with a then crippled
stock market, cooling real estate values, and dramatic slowdowns in the
economy, investors saw opportunity in a depreciating yen, subsequently
adding selling pressure to neighbor currencies. When Japan’s asset bubble collapsed, asset prices fell by $10 trillion, with the fall in real estate
prices accounting for nearly 65 percent of the total decline, which was
worth two years of national output. This fall in asset prices sparked the
banking crisis in Japan. It began in the early 1990s and then developed into
a full-blown systemic crisis in 1997 following the failure of a number of
high-profile financial institutions. In response, Japanese monetary authorities warned of potentially increasing benchmark interest rates in hopes of
defending the domestic currency valuation. Unfortunately, these considerations never materialized and a shortfall ensued. Sparked mainly by an
announcement of a managed float of the Thai baht, the slide snowballed as
central bank reserves evaporated and currency price levels became unsustainable in light of downside selling pressure.

Currency Crisis
Following mass short speculation and attempted intervention, the aforementioned Asian economies were left ruined and momentarily incapacitated. The Thailand baht, once a prized possession, was devalued by as
much as 48 percent, even slumping closer to a 100 percent fall at the turn
of the New Year. The most adversely affected was the Indonesian rupiah.
Relatively stable prior to the onset of a “crawling peg” with the Thai baht,
the rupiah fell a whopping 228 percent from its previous high of 12,950 to
the fixed U.S. dollar. These particularly volatile price actions are reflected
in Figure 2.4. Among the majors, the Japanese yen fell approximately
23 percent from its high to its low against the U.S. dollar in 1997 and 1998,
as shown in Figure 2.5.
The financial crisis of 1997–1998 revealed the interconnectivity of
economies and their effects on the global currency markets. Additionally, it showed the inability of central banks to successfully intervene in
currency valuations when confronted with overwhelming market forces
along with the absence of secure economic fundamentals. Today, with the

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FIGURE 2.4 Asian Crisis Price Action

FIGURE 2.5 USD/JPY Asian Crisis Price Action

assistance of IMF reparation packages and the implementation of stricter
requirements, Asia’s four little dragons are churning away once again. With
inflationary benchmarks and a revived exporting market, Southeast Asia is
building back its once prominent stature among the world’s industrialized
economic regions. With the experience of evaporating currency reserves

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under their belts, the Asian tigers now take active initiatives to ensure that
they have a large pot of reserves on hand in case speculators attempt to
attack their currencies once again.

INTRODUCTION OF THE EURO (1999)
The introduction of the euro was a monumental achievement, marking the
largest monetary changeover ever. The euro was officially launched as an
electronic trading currency on January 1, 1999. The 11 initial member states
of the European Monetary Union (EMU) were: Belgium, Germany, Spain,
France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal, and
Finland. Greece joined two years later. Each country fixed its currency
to a specific conversion rate against the euro, and a common monetary
policy governed by the European Central Bank (ECB) was adopted. To
many economists, the system would ideally include all of the original 15
European Union (EU) nations, but the United Kingdom, Sweden, and Denmark decided to keep their own currencies for the time being. Euro notes
and coins did not begin circulation until the first two months of 2002. In
deciding whether to adopt the euro, EU members all had to weigh the pros
and cons of such an important decision.
While ease of traveling is perhaps the most salient issue to EMU citizens, the euro also brings about numerous other benefits:

r It eliminates exchange rate fluctuations, thereby providing a more stable environment to trade within the euro area.

r The purging of all exchange rate risk within the zone allows businesses
to plan investment decisions with greater certainty.

r Transaction costs diminish (mainly those relating to foreign exchange
operations, hedging operations, cross-border payments, and the management of several currency accounts).
r Prices become more transparent as consumers and businesses can
compare prices across countries more easily. This, in turn, increases
competition.
r The huge single currency market becomes more attractive for foreign
investors.
r The economy’s magnitude and stability allow the ECB to control inflation with lower interest rates thanks to increased credibility.
Yet the euro is not without its limitations. Leaving aside political
sovereignty issues, the main problem is that, by adopting the euro, a nation
essentially forfeits any independent monetary policy. Since each country’s
economy is not perfectly correlated to the EMU’s economy, a nation might

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find the ECB hiking interest rates during a domestic recession. This is especially true for many of the smaller nations. As a result, countries try to rely
more heavily on fiscal policy, but the efficiency of fiscal policy is limited
when it is not effectively combined with monetary policy. This inefficiency
is only further exacerbated by the 3 percent of GDP limit on budget deficits,
as stipulated by the Stability and Growth Pact.
Some concerns also exist regarding the ECB’s effectiveness as a central bank. While its target inflation is slightly below 2 percent, the euro
area’s inflation edged above the benchmark from 2000 to 2002, and has
of late continued to surpass the self-imposed objective. From 1999 to late
2002, a lack of confidence in the union’s currency (and in the union itself)
led to a 24 percent depreciation, from approximately $1.15 to the dollar in
January 1999 to $0.88 in May 2000, forcing the ECB to intervene in foreign
exchange markets in the last few months of 2000. Since then, however,
things have greatly changed; the euro now trades at a premium to the dollar, and many analysts claim that the euro will someday replace the dollar
as the world’s dominant international currency. (Figure 2.6 shows a chart
of the euro since it was launched in 1999.)

FIGURE 2.6 EUR/USD Since Inception

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There are 10 more members slated to adopt the euro over the next
few years. The enlargement, which will grow the EMU’s population by
one-fifth, is both a political and an economic landmark event: Of the new
entrants, all but two are former Soviet republics, joining the EU after 15
years of restructuring. Once assimilated, these countries will become part
of the world’s largest free trade zone, a bloc of 450 million people. Consequently, the three largest accession countries, Poland, Hungary, and the
Czech Republic—which comprise 79 percent of new member combined
GDP—are not likely to adopt the euro anytime soon. While euro members
are mandated to cap fiscal deficits at 3 percent of GDP, each of these three
countries currently runs a projected deficit at or near 6 percent. In a probable scenario, euro entry for Poland, Hungary, and the Czech Republic are
likely to be delayed until 2009 at the earliest. Even smaller states whose
economies at present meet EU requirements face a long process in replacing their national currencies. States that already maintain a fixed euro exchange rate—Estonia and Lithuania—could participate in the ERM earlier,
but even on this relatively fast track, they would not be able to adopt the
euro until 2007.
The 1993 the Maastricht Treaty set five main convergence criteria for
member states to join the EMU.
Maastricht Treaty: Convergence Criteria
1. The country’s government budget deficit could not be greater than

3 percent of GDP.
2. The country’s government debt could not be larger than 60 percent

of GDP.
3. The country’s exchange rate had to be maintained within ERM bands
without any realignment for two years prior to joining.
4. The country’s inflation rate could not be higher than 1.5 percent above
the average inflation rate of the three EU countries with the lowest
inflation rates.
5. The country’s long-term interest rate on government bonds could not
be higher than 2 percent above the average of the comparable rates in
the three countries with the lowest inflation.


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