Trading in the Global Currency Markets: Foreign Exchange Markets Handbookby Cornelius Luca, Tom Gorman (With)
-Ira Kawaller, Vice President, Director Chicago Mercantile Exchange
The foreign currency exchange market is the world's largest and fastest growing financial market, generating a staggering $1 trillion per day in
"Comprehensive...This book covers all the bases reflecting the voice of an experienced practitioner in the foreign exchange marketplace."
-Ira Kawaller, Vice President, Director Chicago Mercantile Exchange
The foreign currency exchange market is the world's largest and fastest growing financial market, generating a staggering $1 trillion per day in volume. Open 24 hours a day, it produces awe-inspiring gains and losses, takes no holidays, and has no boundaries. And, because only a tiny fraction of its transactions are conducted on regulated exchanges, it's the least understood of markets.
Now beginner and expert traders alike can gain unique insights into this immensely lucrative market with this comprehensive and up-to-the-minute guide. Foreign currency market expert Cornelius Luca brings the complex machinations of the foreign currency markets vibrantly to life, concisely and clearly analyzing the various currencies, market forces and emerging technologies, and illuminating them all with plenty of real-world examples and graphics.
Whether you're a foreign exchange trader in a commercial or investment bank, financial information service, trading corporation, or insurance company, you can turn to this book for a better understanding of market characteristics, mechanics, trading techniques, forecasting methods and much more.
Open Trading in the Global Currency Markets and arm yourself with an arsenal of trading weapons you can use to prosper in the world's most fascinating and profitable market!
- Prentice Hall Press
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Read an Excerpt
Foreign exchange took off in earnest as recently as 1973, when currencies were finally allowed to float freely. Ostensibly a new industry, its origins can actually be traced to ancient times, when foreign coins started to be exchanged. Since stocks and bonds took several more millennia to come into existence, foreign exchange is, in fact, the oldest financial market.
Few financial instruments generate as much excitement and profitability. Traders from around the world enter positions for weeks, days, hours or only split seconds. The market can have explosive moves or steady flows. Money changes hands quickly, for a staggering daily average of $1 trillion. The foreign exchange profitability is legendary. George Soros' Quantum fund realized a profit in excess of U.S. $1 billion for a couple of days' work in September 1992. And Hans U. Hufschmid of Salomon Brothers, Inc. netted an income package of $28 million for 1993. Even by Wall Street standards, these numbers are heart stoppers.
It is impossible to envision a world without foreign exchange. Even the smallest transaction across borders triggers a currency exchange at one point or another. Whether importing or exporting raw materials, labor, manufactured goods or services, foreign exchange is an integral part of the transaction.
In addition to the corporate demand, currency trading provides a leading source of income for most financial institutions. In terms of profitability, commercial banks have steadily switched their focus from lending to foreign exchange. Along with investment banks, they set up sophisticated individual dealing rooms, somewhat resembling the NASA mission control rooms.
The latest newcomer to the markets, the hedge funds, rose to prominence in the early 1990s. Extremely aggressive, the hedge fund is able to concentrate billions of dollars into a single position, betting not only on the capacity of "reading" the market correctly, but also on its capability of "making" the market due to its sheer trade size.
Despite its high trading volume and its fundamental role, the foreign exchange market is rarely in the limelight. Since only a tiny fraction of the transactions are conducted on regulated exchanges, the currency markets are generally less visible and receive less media coverage.
There are no geographic, temporal or man-made boundaries to foreign exchange. This is a vibrant 24-hour market open to all eligible players. There are no official openings or closings, with the exception of the currency futures and the options on currency futures. Should the trading session not provide enough satisfaction, traders can deal after normal hours. And if there is a national holiday, players are generally able to find other markets open.
This book introduces you to all the significant aspects of foreign exchange in a practical manner, to best answer your typical questions, such as:
· Why do we trade currencies?
· Who are the players?
· What currencies do we trade?
· What makes them move?
· What instruments can we trade?
· How can we use them?
· How can we forecast currency behavior?
· How do we access the pertinent information?
The book is divided into six parts:
Part 1: Presents the basis of foreign exchange and the factors that contributed to the growth of the industry, from market developments to technological breakthroughs.
Part 2: Presents the historical developments in the market and how these elements have shaped the contemporary environment.
Part 3: Focuses on the mechanics of the market, the major players and markets, the risks pertinent to foreign exchange, corporate trading, methods of trading execution and dealing settlements.
Part 4: Analyzes foreign exchange instruments and provides comprehensive coverage of the major option strategies.
Part 5: Focuses on fundamental analysis, the economic indicators vital to the financial markets that may be disregarded in the currency markets, and the mind of the trader, for a point of view different at times from the typical theoretical expectation.
Part 6: Provides an exhaustive view on technical analysis, including an in-depth chart analysis comparing the major chart types, chart formations and oscillators, and a comprehensive discussion of candlestick and point and figure charts as they apply to foreign currencies only.
Leading experts in these fields have courteously contributed their significant knowledge and experience to this book. In addition to taking advantage of their level of sophistication, you will have the opportunity to learn and compare their financial services for your own use.
There are no miracle answers, of course--at least not in this book. In fact, I generally shy away from rules of thumb. The only solid answer I favor is, "It depends." What you will learn is what makes the market move and the traders tick.
You are presented with a comprehensive arsenal of trading weapons, many of them on the cutting edge of technology. You will answer yourself "on what it all depends." Based on these elements, you will be able to make your own choices, test them and ultimately use them for your own benefit.
What Is Foreign Exchange?
Foreign exchange is simultaneously a simple and complex notion, depending on the end-user. Despite the wide ranging points of view, they all have a common element. Foreign exchange is simply the mechanism which values foreign currencies in terms of another currency. An exchange rate is therefore the price of one currency in terms of another.
Why Foreign Exchange Occurs
Tourists around the world generate substantial foreign exchange flow. Whether the American tourists abroad in 1985 or the foreign tourists in the United States in the early 1990s, they all must convert their currencies to the local currencies to pay for traveling expenses. These small individual transactions generate important cash flow when compounded.
Investors around the world, large and small, are continuously hunting for investment opportunities. Whether in the equity markets, or real estate, or bank deposits, any international investment must, at one point or another, go through foreign exchange.
An American shopper may buy an American-made silk tie in an American boutique. Chances are that the silk was produced abroad. Even if an American buys an American car from an American dealer, if the car was assembled in Canada or Mexico, foreign exchange was executed.
The presence of foreign exchange in one or more stages of production is deeply ingrained, albeit not always obvious.
Global markets have become so competitive that corporations must continuously search the world for new markets and cheaper sources of raw materials and labor.
The degree of international integration generates interest rates adjustments, which in turn affect the foreign exchange rates.
Political changes are also major factors in foreign exchange. For instance, the fall of the Soviet Empire, despite its historic proportions, did not itself directly affect the foreign exchange market. However, a consequence of the fall, the German unification, generated a long term rally in the Deutsche mark, based on expectations of future economic might and short term high interest rates geared against inflation.
In terms of political or economic uncertainty, local currencies are quickly discarded in favor of safe-haven currencies, such as US dollars or Swiss francs. For instance, in the war-torn former Yugoslavia, where inflation rampages at incredulous rates of tens of million percent per year, the currencies of choice are US dollars and Deutsche marks.
In future chapters we will discuss in detail the major factors affecting the foreign exchange markets. For the time being, we must remember several of their general characteristics. The foreign exchange markets are:
1. sensitive to a large and continuously changing number of factors,
2. open to all players in the major currencies,
3. large and liquid in the major currencies,
4. concentrated on several currencies, and
5. extremely efficient relative to other financial markets.
Factors That Have Contributed to Foreign Exchange Volume Growth
The volume in foreign exchange has experienced a spectacular growth ever since currencies were allowed to float freely against each other. While the daily turnover in 1977 was US $5 billion, it increased to US $600 billion in 1987, to reach the US $1 trillion mark in September 1992 (see Figure 1.1).
Volume in foreign exchange cannot be measured directly the way it is done in the stock market. Foreign exchange is generally conducted in a decentralized manner, with the notable exceptions of the currency futures and the options on currency futures. What is behind this spectacular growth?
Exchange Rates Volatility
During the last days of the fixed exchange rates system, few envisioned the volatility potential of the currency markets. People generally assumed that economic forces just needed occasional self adjustment in an otherwise quiet activity. Were they wrong. The unchecked increase of the US dollar in the 1980s had a destructive effect on the American exporters' international trade competitiveness. The US dollar's record highs were capped in September 1985 and the currency was sent into a two year nosedive, which trimmed 50 percent of its value (see Figure 1.2). The impact of the exchange rate activity on the international economy and trade is difficult to gauge.
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 instrument which may be profitable under conditions of low volatility is currency options.
Interest Rates Volatility
Economic internationalization generated a significant impact on the interest rates as well. Willingly or not, economies became much more interrelated, a factor which 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 (see Figure 1.3) have a substantial impact on exchange rates. However, the correlation between the two is not mechanical. This will be discussed in Part 5, which deals with fundamental analysis.
In the past decades we have witnessed an unprecedented internationalization in 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 since 1989, due to the fall of Communism in Europe and the economic and financial growth in both Southeast Asia and South America. These changes have been positive toward foreign exchange since more transactional layers were added.
The New York, or London or Tokyo markets' clear boundaries are being blurred by the 24-hour trading and brokerage desks.
Increased Corporate Interest
Foreign exchange has been perceived by many corporations as a transaction cost, albeit a rather volatile one. This passive approach proved costly for many corporations, large and small. A successful performance of a product or service overseas may be pulled down from the profit point of view by adverse foreign exchange conditions. However, the opposite is true as well.
The overall international performance of a product or service may be enhanced by an accurate handling of the foreign exchange. Experience has proven over and over again that it is worth focusing not on what you pay for foreign exchange, but on what foreign exchange can pay to you. Proper handling of foreign exchange generally adds substantially to the rate of return. Therefore, the interest in foreign exchange has increased dramatically in the past decade, although the full potential has not yet been reached. Many corporations are using currencies not only for hedging, but also for capitalizing on opportunities solely in the currency markets.
Increased Players' Sophistication
Advances in computers, computer software, telecommunications and the increased experience have sharpened the players' sophistication. This enhanced the trader's confidence in their ability to both generate profits and properly handle the exchange risks. Therefore, trading sophistication lead toward volume increase.
Developments in Telecommunications
In the 1970s and early 1980s, foreign exchange was mostly conducted via telephone, and to a much lesser extent on the telex machine. Both mediums are slow and error-prone. The introduction of automated dealing systems in the second half of the 1980s completely altered the way foreign exchange was conducted. The dealing systems are on-line computer systems which link market players on one-on-one basis. They are reliable and much faster, allowing traders to conduct four simultaneous trades, rather than one, or a maximum of two on the phone. They are also safer, as players are able to see the deals which they execute. Finally, the dealing systems have many other features which facilitate trading which will be presented in detail in Chapter 3. The dealing systems had a major role in expanding the foreign exchange business due to their reliability, speed and safety. Although it may be difficult to recall the days before the fax machines were introduced, it is only fair to mention their share into helping foreign exchange. In an industry where the speed of transfer of accurate information is paramount, faxes are currently commonplace.
Computer (Hardware and Software) Development
Computers have a significant role at many stages of conducting foreign exchange. In addition to the dealing systems, matching systems simultaneously connect all players around the world, electronically duplicating the brokers market.
The new front end-back office systems provide full accounting coverage, ticket writing, back office processing and risk management implementation at a fraction of the cost.
Unlike the limited technical analysis of the early 1980s, advanced software now makes it possible to generate all types of charts, augment them with sophisticated technical studies and put them at the traders' fingertips on a continuous basis at a rather limited cost.
Also, currency options can hardly be traded professionally without the aid of computers, because complex strategies require the help of advanced software for pricing.
New FX Instruments
Among the first new foreign exchange instruments were the currency futures, which were developed on the Chicago International Monetary Market about two decades ago. Foreign exchange is continuously enriched by new products in the currency options area. The gamut of options strategies has expanded significantly, as a result of the more sophisticated approach of corporations to foreign exchange trading. Options generally allow for customized strategies for hedging and speculation.
One of the biggest fears among the equity players is the bear market. There is no such thing in the foreign exchange markets. Whether the US dollar reaches record highs or record lows, the market is active and liquid. The foreign exchange market is concentrated in four major currencies-Deutsche mark, Japanese yen, British pound and Swiss franc--which are quoted against the US dollar, ensuring a high degree of efficiency. Other financial markets tend to be fragmented among different issues and instruments, with much less liquidity available.
Meet the Author
Cornelius Luca is a foreign currency market expert with more than twenty years of experience in international finance. He is the author of Technical Analysis Applications in the Global Currency Markets, and teaches classes and seminars at the New York Institute of Finance and New York University.
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