Fundamental Analysis#2

Economic Indicators 2

Economic indicators occur in a steady stream, at certain times, and a
little more often than changes in interest rates, governments, or natural
activity such as earthquakes etc. Economic data is generally (except of the
Gross Domestic Product and the Employment Cost Index, which are released
quarterly) released on a monthly basis.
All economic indicators are released in pairs. The first number reflects
the latest period. The second number is the revised figure for the month prior
to the latest period. For instance, in July, economic data is released for the
month of June, the latest period. In addition, the release includes the revision
of the same economic indicator figure for the month of May. The reason for
the revision is that the department in charge of the economic statistics
compilation is in a better position to gather more information in a month's
time. This feature is important for traders. If the figure for an economic
indicator is better than expected by 0.4 percent for the past month, but the
previous month's number is revised lower by 0.4 percent, then traders are
likely to ignore the overall release of that specific economic data.
Economic indicators are released at different times. In the United
States, economic data is generally released at 8:30 and 10 am ET. It is
important to remember that the most significant data for foreign exchange is
released at 8:30 am ET. In order to allow time for last-minute adjustments,
the United States currency futures markets open at 8:20 am ET.
Information on upcoming economic indicators is published in all leading
newspapers, such as the Wall Street Journal, the Financial Times, and the
New York Times; and business magazines, such as Business Week. More
often than not, traders use the monitor sources—Bridge Information Systems,
Reuters, or Bloomberg—to gather information both from news publications
and from the sources' own up-to-date information.

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

The Gross Domestic Product (GDP)
The Gross Domestic Product (GDP) refers to the sum of all goods and
services produced in the United States, either by domestic or foreign
companies. The differences between the two are nominal in the case of the
economy of the United States. GDP figures are more popular outside the

United States. In order to make it easier to compare the performances of
different economies, the United States also releases GDP figures.

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

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

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

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

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

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

exchange market is that the central bank will raise interest rates in order to
avoid or fight inflation.

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

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

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

Construction Indicators
Construction indicators constitute significant economic indicators that
are included in the calculation of the GDP of the United States. Moreover,
housing has traditionally been the engine that pulled the U.S. economy out of
recessions after World War II. These indicators are classified into three major
categories:
1. housing starts and permits;
2. new and existing one-family home sales and
3. construction spending.
Private housing is monitored closely at all the major stages. (See Figure
4.1.) Private housing is classified based on the number of units (one, two,
three, four, five, or more); region (Northeast, West, Midwest, and South);
and inside or outside metropolitan statistical areas.

Construction indicators are cyclical and very sensitive to the level of
interest rates (and consequently mortgage rates) and the level of disposable
income. Low interest rates alone may not be able to generate a high demand
for housing, though. As the situation in the early 1990s demonstrated, despite
historically low mortgage rates in the United States, housing increased only
marginally, as a result of the lack of job security in a weak economy.
Housing starts between one and a half and two million units reflect a
strong economy, whereas a figure of approximately one million units suggests
that the economy is in recession.

Inflation Indicators
The rate of inflation is the widespread rise in prices. Therefore, gauging
inflation is a vital macroeconomic task. Traders watch the development of
inflation closely, because the method of choice for fighting inflation is raising
the interest rates, and higher interest rates tend to support the local currency.
Moreover, the inflation rate is used to "deflate" nominal interest rates and the
GNP or GDP to their real values in order to achieve a more accurate measure
of the data.
The values of the real interest rates or real GNP and GDP are of the
utmost importance to the money managers and traders of international
financial instruments, allowing them to accurately compare opportunities
worldwide.
To measure inflation traders use following economic tools:
• Producer Price Index (PPI);
• Consumer Price Index (CPI);
• GNP Deflator;
• GDP Deflator;
• Employment Cost Index (ECI);
• Commodity Research Bureau's Index (CRB Index);
• Journal of Commerce Industrial Price Index (JoC).

The first four are strictly economic indicators; they are released at
specific intervals. The commodity indexes provide information on inflation
quickly and continuously.
Other economic data that measure inflation are unemployment,
consumer prices, and capacity utilization.

Producer Price Index (PPI)
Producer price index is compiled from most sectors of the economy,
such as manufacturing, mining, and agriculture. The sample used to calculate
the index contains about 3400 commodities. The weights used for the
calculation of the index for some of the most important groups are: food - 24
percent; fuel - 7 percent; autos - 7 percent; and clothing - 6 percent. Unlike
the CPI, the PPI does not include imported goods, services, or taxes.

Consumer Price Index (CPI)
Consumer price index reflects the average change in retail prices for a
fixed market basket of goods and services. The CPI data is compiled from a
sample of prices for food, shelter, clothing, fuel, transportation, and medical
services that people purchase on daily basis. The weights attached for the
calculation of the index to the most important groups are: housing - 38
percent; food - 19 percent; fuel - 8 percent; and autos - 7 percent.
The two indexes, PPI and CPI, are instrumental in helping traders
measure inflationary activity, although the Federal Reserve takes the position
that the indexes overstate the strength of inflation.

Gross National Product Implicit Deflator
Gross national product implicit deflator is calculated by dividing the
current dollar GNP figure by the constant dollar GNP figure.

Gross Domestic Product Implicit
Gross domestic product implicit deflator is calculated by dividing the
current dollar GDP figure by the constant dollar GDP figure.
Both the GNP and GDP implicit deflators are released quarterly, along
with the respective GNP and GDP figures. The implicit deflators are generally
regarded as the most significant measure of inflation.

Commodity Research Bureau's Futures Index (CRB index)
The Commodity Research Bureau's Futures Index makes watching for
inflationary trends easier. The CRB Index consists of the equally weighted
futures prices of 21 commodities. The components of the CRB Index are:
• precious metals: gold, silver, platinum;
• industrials: crude oil, heating oil, unleaded gas, lumber, copper,
and cotton;
• grains: corn, wheat, soybeans, soy meal, soy oil;
• livestock and meat: cattle, hogs, and pork bellies;
• imports: coffee, cocoa, sugar;
• miscellaneous: orange juice.
The preponderance of food commodities makes the CRB Index less
reliable in terms of general inflation. Nevertheless, the index is a popular tool
that has proved quite reliable since the late 1980s.

The "Journal of commerce" Industrial Price Index (JoC)

The "Journal of commerce" industrial price index consists of the prices
of 18 industrial materials and supplies processed in the initial stages of
manufacturing, building, and energy production. It is more sensitive than
other indexes, as it was designed to signal changes in inflation prior to the
other price indexes.

Merchandise Trade Balance
is one of the most important economic indicators. Its value may trigger
long-lasting changes in monetary and foreign policies. The trade balance
consists of the net difference between the exports and imports of a certain
economy. The data includes six categories:
1. food;
2. raw materials and industrial supplies;
3. consumer goods;
4. autos;
5. capital goods;
6. other merchandise.

Employment Indicators
The employment rate is an economic indicator with significance in
multiple areas. The rate of employment, naturally, measures the soundness of
an economy. (See Figure 4.2.) The unemployment rate is a lagging economic
indicator. It is an important feature to remember, especially in times of
economic recession. Whereas people focus on the health and recovery of the
job sector, employment is the last economic indicator to rebound. When
economic contraction causes jobs to be cut, it takes time to generate
psychological confidence in economic recovery at the managerial level before
new positions are added. At individual levels, the improvement of the job
outlook may be clouded when new positions are added in small companies
and thus not fully reflected in the data. The employment reports are
significant to the financial markets in general and to foreign exchange in
particular. In foreign exchange, the data is truly affective in periods of
economic transition—recovery and contraction. The reason for the indicators'
importance in extreme economic situations lies in the picture they paint of the
health of the economy and in the degree of maturity of a business cycle. A
decreasing unemployment figure signals a maturing cycle, whereas the
opposite is true for an increasing unemployment indicator.

Employment Cost Index (ECI)
Employment cost index measures wages and inflation and provides the
most comprehensive analysis of worker compensation, including wages,
salaries, and fringe benefits. The ECI is one of the Fed's favorite quarterly
economic statistics.

Consumer Spending Indicators
Retail sales is a significant consumer spending indicator for foreign
exchange traders, as it shows the strength of consumer demand as well as
consumer confidence. component in the calculation of other economic
indicators, such as GNP and GDP.
Generally, the most commonly used employment figure is not the
monthly unemployment rate, which is released as a percentage, but the
nonfarm payroll rate. The rate figure is calculated as the ratio of the
difference between the total labor force and the employed labor force, divided
by the total labor force. The data is more complex, though, and it generates
more information. In foreign exchange, the standard indicators monitored by
traders are the unemployment rate, manufacturing payrolls, nonfarm payrolls,
average earnings, and average workweek. Generally, the most significant
employment data are manufacturing and nonfarm payrolls, followed by the
unemployment rate.

Auto Sales
Despite the importance of the auto industry in terms of both production
and sales, the level of auto sales is not an economic indicator widely followed
by foreign exchange traders. The American automakers experienced a long,

steady market share loss, only to start rebounding in the early 1990s. But car
manufacturing has become increasingly internationalized, with American cars
being assembled outside the United States and Japanese and German cars
assembled within the United States. Because of their confusing nature, auto
sales figures cannot easily be used in foreign exchange analysis.

Leading Indicators
The leading indicators consist of the following economic indicators:
• average workweek of production workers in manufacturing;
• average weekly claims for state unemployment;
• new orders for consumer goods and materials (adjusted for
inflation);
• vendor performance (companies receiving slower deliveries from
suppliers);
• contracts and orders for plant and equipment (adjusted for
inflation);
• new building permits issued;
• change in manufacturers' unfilled orders, durable goods;
• change in sensitive materials prices.

Personal Income
is the income received by individuals, nonprofit institutions, and private
trust funds. Components of this indicator include wages and salaries, rental
income, dividends, interest earnings, and transfer payments (Social Security,
state unemployment insurance, and veterans' benefits). The wages and
salaries reflect the underlying economic conditions.
This indicator is vital for the sales sector. Without an adequate personal
income and a propensity to purchase, consumer purchases of durable and
nondurable goods are limited.
For the Forex traders, personal income is not significant.

Fundamental Analysis 1

Fundamental Analysis


Two types of analysis are used for the market movements forecasting:
fundamental, and technical (the chart study of past behavior of commodity
prices). The fundamental one focuses on the theoretical models of exchange
rate determination and on the major economic factors and their likelihood of
affecting the foreign exchange rates.

Economic Fundamentals#1

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

Purchasing Power Parity
Purchasing power parity states that the price of a good in one country
should equal the price of the same good in another country, exchanged at the
current rate—the law of one price. There are two versions of the purchasing
power parity theory: the absolute version and the relative version. Under the
absolute version, the exchange rate simply equals the ratio of the two
countries' general price levels, which is the weighted average of all goods
produced in a country. However, this version works only if it is possible to find
two countries, which produce or consume the same goods. Moreover, the
absolute version assumes that transportation costs and trade barriers are
insignificant. In reality, transportation costs are significant and dissimilar
around the world.
Trade barriers are still alive and well, sometimes obvious and
sometimes hidden, and they influence costs and goods distribution.
Finally, this version disregards the importance of brand names. For
example, cars are chosen not only based on the best price for the same type
of car, but also on the basis of the name ("You are what you drive").

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

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

Modern Monetary Theories on Short-Term Exchange Rate Volatility
The modern monetary theories on short-term exchange rate volatility
take into consideration the short-term capital markets' role and the long-term
impact of the commodity markets on foreign exchange. These theories hold
that the divergence between the exchange rate and the purchasing power
parity is due to the supply and demand for financial assets and the
international capability.
One of the modern monetary theories states that exchange rate
volatility is triggered by a one-time domestic money supply increase, because
this is assumed to raise expectations of higher future monetary growth.
The purchasing power parity theory is extended to include the capital
markets. If, in both countries whose currencies are exchanged, the demand

for money is determined by the level of domestic income and domestic
interest rates, then a higher income increases demand for transactions
balances while a higher interest rate increases the opportunity cost of holding
money, reducing the demand for money.
Under a second approach, the exchange rate adjusts instantaneously to
maintain continuous interest rate parity, but only in the long run to maintain
PPP.
Volatility occurs because the commodity markets adjust more slowly
than the financial markets. This version is known as the dynamic monetary
approach.

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

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

Spot Market'

Spot Market

Currency spot trading is the most popular foreign currency instrument
around the world, making up 37 percent of the total activity (See Figure 3.1).

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

The name "spot" does not mean that the currency exchange occurs the
same business day the deal is executed. Currency transactions that require
same-day delivery are called cash transactions. The two-day spot delivery for
currencies was developed long before technological breakthroughs in
information processing.
This time period was necessary to check out all transactions' details
among counterparties. Although technologically feasible, the contemporary
markets did not find it necessary to reduce the time to make payments.
Human errors still occur and they need to be fixed before delivery. When
currency deliveries are made to the wrong party, fines are imposed.
In terms of volume, currencies around the world are traded mostly
against the U.S. dollar, because the U.S. dollar is the currency of reference.
The other major currencies are the euro, followed by the Japanese yen, the
British pound, and the Swiss franc. Other currencies with significant spot
market shares are the Canadian dollar and the Australian dollar.
In addition, a significant share of trading takes place in the currencies
crosses, a non-dollar instrument whereby foreign currencies are quoted
against other foreign currencies, such as euro against Japanese yen.
There are several reasons for the popularity of currency spot trading.
Profits (or losses) are realized quickly in the spot market, due to market
volatility. In addition, since spot deals mature in only two business days, the
time exposure to credit risk is limited. Turnover in the spot market has been
increasing dramatically, thanks to the combination of inherent profitability and
reduced credit risk. The spot market is characterized by high liquidity and
high volatility. Volatility is the degree to which the price of currency tends to
fluctuate within a certain period of time. Free-floating currencies, such as the
euro or the Japanese yen, tend to be volatile against the U.S. dollar.
In an active global trading day (24 hours), the euro/dollar exchange
rate may change its value 18,000 times. An exchange rate may "fly" 200 pips
in a matter of seconds if the market gets wind of a significant event. On the
other hand, the exchange rate may remain quite static for extended periods
of time, even in excess of an hour, when one market is almost finished
trading and waiting for the next market to take over. This is a common
occurrence toward the end of the New York trading day. Since California
failed in the late 1980s to provide the link between the New York and Tokyo
markets, there is a technical trading gap between around 4:30 pm and 6 pm
EDT. In the United States spot market, the majority of deals are executed
between 8 am and noon, when the New York and European markets overlap
(See Figure 3.2). The activity drops sharply in the afternoon, over 50 percent
in fact, when New York loses the international trading support. Overnight
trading is limited, as very few banks have overnight desks. Most of the banks

send their overnight orders to branches or other banks that operate in the
active time zones.

The major traders in the spot market are the commercial banks and the
investment banks, followed by hedge funds and corporate customers. In the
interbank market, the majority of the deals are international, reflecting
worldwide exchange rate competition and advanced telecommunication
systems. However, corporate customers tend to focus their foreign exchange
activity domestically, or to trade through foreign banks operating in the same
time zone. Although the hedge funds' and corporate customers' business in
foreign exchange has been growing, banks remain the predominant trading
force.
The bottom line is important in all financial markets, but in currency
spot trading the antes always seem to be higher as a result of the demand
from all around the world.
The profit and loss can be either realized or unrealized. The realized
profit and loss is a certain amount of money netted when a position is closed.
The unrealized profit and loss consists of an uncertain amount of money that
an outstanding position would roughly generate if it were closed at the
current rate. The unrealized profit and loss changes continuously in tandem
with the exchange rate.

The Federal Reserve System of the USA

Like the other central banks, the Federal Reserve of the USA affects the
foreign exchange markets in three general areas:
• the discount rate;
• the money market instruments;
• foreign exchange operations.
For the foreign exchange operations most significant are repurchase
agreements to sell the same security back at the same price at a predetermined
date in the future (usually within 15 days), and at a specific rate of interest. This
arrangement amounts to a temporary injection of reserves into the banking
system. The impact on the foreign exchange market is that the dollar should
weaken. The repurchase agreements may be either customer repos or system
repos.
Matched sale-purchase agreements are just the opposite of repurchase
agreements. When executing a matched sale-purchase agreement, the Fed sells
a security for immediate delivery to a dealer or a foreign central bank, with the
agreement to buy back the same security at the same price at a predetermined
time in the future (generally within 7 days). This arrangement amounts to a
temporary drain of reserves. The impact on the foreign exchange market is that
the dollar should strengthen.
The major central banks are involved in foreign exchange operations in
more ways than intervening in the open market. Their operations include payments
among central banks or to international agencies. In addition, the Federal Reserve
has entered a series of currency swap arrangements with other central banks since
1962. For instance, to help the allied war effort against Iraq's invasion of Kuwait in
1990-1991, payments were executed by the Bundesbank and Bank of Japan to the
Federal Reserve. Also, payments to the World bank or the United Nations are executed
through central banks.
Intervention in the United States foreign exchange markets by the U.S.
Treasury and the Federal Reserve is geared toward restoring orderly conditions
in the market or influencing the exchange rates. It is not geared toward
affecting the reserves.
There are two types of foreign exchange interventions: naked intervention
and sterilized intervention.
Naked intervention, or unsterilized intervention, refers to the sole foreign
exchange activity. All that takes place is the intervention itself, in which the

Federal Reserve either buys or sells U.S. dollars against a foreign currency. In
addition to the impact on the foreign exchange market, there is also a monetary
effect on the money supply. If the money supply is impacted, then consequent
adjustments must be made in interest rates, in prices, and at all levels of the
economy. Therefore, a naked foreign exchange intervention has a long-term
effect.
Sterilized intervention neutralizes its impact on the money supply. As there
are rather few central banks that want the impact of their intervention in the
foreign exchange markets to affect all corners of their economy, sterilized
interventions have been the tool of choice. This holds true for the Federal
Reserve as well.
The sterilized intervention involves an additional step to the original
currency transaction. This step consists of a sale of government securities that
offsets the reserve addition that occurs due to the intervention. It may be easier
to visualize it if you think that the central bank will finance the sale of a currency
through the sale of a number of government securities.
Because a sterilized intervention only generates an impact on the supply
and demand of a certain currency, its impact will tend to have a short-to
medium-term effect.

The Central Banks of the Other G-7 Countries

In the wake of World War II, both Germany and Japan were helped to
develop new financial systems. Both countries created central banks that were
fundamentally similar to the Federal Reserve. Along the line, their scope was
customized to their domestic needs and they diverged from their model.
The European Central Bank was set up on June 1, 1998 to oversee the
ascent of the euro. During the transition to the third stage of economic and
monetary union (introduction of the single currency on January 1, 1999), it was
responsible for carrying out the Community's monetary policy. The ECB, which
is an independent entity, supervises the activity of individual member European
central banks, such as Deutsche Bundesbank, Banque de France, and Ufficio
Italiano dei Cambi. The ECB's decision-making bodies run a European System of
Central Banks whose task is to manage the money in circulation, conduct
foreign exchange operations, hold and manage the Member States' official foreign
reserves, and promote the smooth operation of payment systems. The ECB is
the successor to the European Monetary Institute (EMI).
The German central bank, widely known as the Bundesbank, was the
model for the ECB. The Bundesbank was a very independent entity, dedicated to
a stable currency, low inflation, and a controlled money supply. The
hyperinflation that developed in Germany after World War I created a fertile
economic and political scenario for the rise of an extremist political party and for
the start of World War II. The Bundesbank's chapter obligated it to avoid any such
economic chaos.
The Bank of Japan has deviated from the Federal Reserve model in terms
of independence. Although its Policy Board is still fully in charge of monetary
policy, changes are still subject to the approval of the Ministry of Finance
(MOF). The BOJ targets the M2 aggregate. On a quarterly basis, the BOJ
releases its Tankan economic survey. Tankan is the Japanese equivalent of the
American tan book, which presents the state of the economy. The Tankan's
findings are not automatic triggers of monetary policy changes. Generally, the
lack of independence of a central bank signals inflation. This is not the case in
Japan, and it is yet another example of how different fiscal or economic policies
can have opposite effects in separate environments.
The Bank of England may be characterized as a less independent central
bank, because the government may overrule its decision. The BOE has not had an
easy tenure. Despite the fact that British inflation was high through 1991, reaching
double-digit rates in the late 1980s, the Bank of England did a marvelous job of
proving to the world that it was able to maneuver the pound into mirroring the
Exchange Rate Mechanism.
After joining the ERM late in 1990, the BOE was instrumental in keeping
the pound within its 6 percent allowed range against the deutsche mark, but the
pound had a short stay in the Exchange Rate Mechanism. The divergence
between the artificially high interest rates linked to ERM commitments and
Britain's weak domestic economy triggered a massive sell-off of the pound in
September 1992.
The Bank of France has joint responsibility, with the Ministry of Finance, to
conduct domestic monetary policy. Their main goals are non-inflationary growth
and external account equilibrium. France has become a major player in the
foreign exchange markets since the ravages of the ERM crisis of July 1993, when
the French franc fell victim to the foreign exchange markets.
The Bank of Italy is in charge of the monetary policy, financial
intermediaries, and foreign exchange. Like the other former European
Monetary System central banks, BOI's responsibilities shifted domestically
following the ERM crisis. Along with the Bundesbank and Bank of France, the Bank
of Italy is now part of the European System of Central Banks (ESCB).
The Bank of Canada is an independent central bank that has a tight rein on
its currency. Due to its complex economic relations with the United States, the
Canadian dollar has a strong connection to the U.S. dollar. The BOC intervenes
more frequently than the other G7 central banks to shore up the fluctuations of
its Canadian dollar. The central bank changed its intervention policy in 1999 after
admitting that its previous mechanical policy, of intervening in increments of
only $50 million at a set price based on the previous closing, was not working.

Broker

Trading with Brokers

Foreign exchange brokers, unlike equity brokers, do not take positions for
themselves; they only service banks. Their roles are:
• bringing together buyers and sellers in the market;
• optimizing the price they show to their customers;
• quickly, accurately, and faithfully executing the traders' orders.
The majority of the foreign exchange brokers execute business via phone.
The phone lines between brokers and banks are dedicated, or direct, and are
usually in-stalled free of charge by the broker. A foreign exchange brokerage
firm has direct lines to banks around the world. Most foreign exchange is
executed through an open box system—a microphone in front of the broker that
continuously transmits everything he or she says on the direct phone lines to the
speaker boxes in the banks. This way, all banks can hear all the deals being
executed. Because of the open box system used by brokers, a trader is able to
hear all prices quoted; whether the bid was hit or the offer taken; and the
following price. What the trader will not be able to hear is the amounts of
particular bids and offers and the names of the banks showing the prices. Prices
are anonymous the anonymity of the banks that are trading in the market ensures
the market's efficiency, as all banks have a fair chance to trade.
Brokers charge a commission that is paid equally by the buyer and the
seller. The fees are negotiated on an individual basis by the bank and the
brokerage firm.
Brokers show their customers the prices made by other customers either
two-way (bid and offer) prices or one way (bid or offer) prices from his or her
customers. Traders show different prices because they "read" the market
differently; they have different expectations and different interests. A broker who
has more than one price on one or both sides will automatically optimize the
price. In other words, the broker will always show the highest bid and the
lowest offer. Therefore, the market has access to the narrowest spread possible.
Fundamental and technical analyses are used for forecasting the future direction
of the currency. A trader might test the market by hitting a bid for a small
amount to see if there is any reaction.
Brokers cannot be forced into taking a principal's role if the name switch
takes longer than anticipated.
Another advantage of the brokers' market is that brokers might provide a
broader selection of banks to their customers. Some European and Asian banks
have overnight desks so their orders are usually placed with brokers who can deal
with the American banks, adding to the liquidity of the market.

Direct Dealing
Direct dealing is based on trading reciprocity. A market maker—the bank
making or quoting a price—expects the bank that is calling to reciprocate with
respect to making a price when called upon. Direct dealing provides more trading
discretion, as compared to dealing in the brokers' market. Sometimes traders take
advantage of this characteristic.
Direct dealing used to be conducted mostly on the phone. Dealing errors
were difficult to prove and even more difficult to settle. In order to increase
dealing safety, most banks tapped the phone lines on which trading was
conducted. This measure was helpful in recording all the transaction details and
enabling the dealers to allocate the responsibility for errors fairly. But tape
recorders were unable to prevent trading errors. Direct dealing was forever
changed in the mid - 1980s, by the introduction of dealing systems.

Dealing Systems
Dealing systems are on-line computers that link the contributing banks
around the world on a one-on-one basis. The performance of dealing systems is
characterized by speed, reliability, and safety. Accessing a bank through a dealing
system is much faster than making a phone call. Dealing systems are
continuously being improved in order to offer maximum support to the dealer's
main function: trading. The software is very reliable in picking up the big figure of
the exchange rates and the standard value dates. In addition, it is extremely
precise and fast in contacting other parties, switching among conversations, and
accessing the database. The trader is in continuous visual contact with the
information exchanged on the monitor. It is easier to see than hear this
information, especially when switching among conversations.
Most banks use a combination of brokers and direct dealing systems. Both
approaches reach the same banks, but not the same parties, because
corporations, for instance, cannot deal in the brokers' market. Traders develop
personal relationships with both brokers and traders in the markets, but select
their trading medium based on price quality, not on personal feelings. The market
share between dealing systems and brokers fluctuates based on market
conditions. Fast market conditions are beneficial to dealing systems, whereas
regular market conditions are more beneficial to brokers.

Matching Systems
Unlike dealing systems, on which trading is not anonymous and is
conducted on a one-on-one basis, matching systems are anonymous and
individual traders deal against the rest of the market, similar to dealing in the
brokers' market. However, unlike the brokers' market, there are no individuals
to bring the prices to the market, and liquidity may be limited at times. Matching
systems are well-suited for trading smaller amounts as well.
The dealing systems characteristics of speed, reliability, and safety are
replicated in the matching systems. In addition, credit lines are automatically
managed by the systems. Traders input the total credit line for each counter
party. When the credit line has been reached, the system automatically disallows
dealing with the particular party by displaying credit restrictions, or shows the
trader only the price made by banks that have open lines of credit. As soon as
the credit line is restored, the system allows the bank to deal again. In the
interbank market, traders deal directly with dealing systems, matching systems,
and brokers in a complementary fashion.

Major Currencies

Major Currencies

The U.S. Dollar
The United States dollar is the world's main currency. All currencies aregenerally quoted in U.S. dollar terms. Under conditions of international economicand political unrest, the U.S. dollar is the main safe-haven currency which wasproven particularly well during the Southeast Asian crisis of 1997-1998.The U.S. dollar became the leading currency toward the end of theSecond World War and was at the center of the Bretton Woods Accord, as theother currencies were virtually pegged against it. The introduction of the euro in1999 reduced the dollar's importance only marginally.The major currencies traded against the U.S. dollar are the euro,Japanese yen, British pound, and Swiss franc.

The Euro
The euro was designed to become the premier currency in trading bysimply being quoted in American terms. Like the U.S. dollar, the euro has astrong international presence stemming from members of the EuropeanMonetary Union. The currency remains plagued by unequal growth, highunemployment, and government resistance to structural changes. The pair wasalso weighed in 1999 and 2000 by outflows from foreign investors, particularlyJapanese, who were forced to liquidate their losing investments in eurodenominatedassets. Moreover, European money managers rebalanced theirportfolios and reduced their euro exposure as their needs for hedging currencyrisk in Europe declined.

The Japanese Yen
The Japanese yen is the third most traded currency in the world; it has amuch smaller international presence than the U.S. dollar or the euro. The yen isvery liquid around the world, practically around the clock. The natural demand totrade the yen concentrated mostly among the Japanese keiretsu, the economicand financial conglomerates.The yen is much more sensitive to the fortunes of the Nikkei index, theJapanese stock market, and the real estate market. The attempt of the Bank ofJapan to deflate the double bubble in these two markets had a negative effecton the Japanese yen, although the impact was short-lived

The British Pound
Until the end of World War II, the pound was the currency of reference. Itsnickname, cable, is derived from the telex machine, which was used to trade itin its heyday. The currency is heavily traded against the euro and the U.S.dollar, but has a spotty presence against other currencies. The two-year boutwith the Exchange Rate Mechanism, between 1990 and 1992, had a soothingeffect on the British pound, as it generally had to follow the deutsche mark'sfluctuations, but the crisis conditions that precipitated the pound's withdrawal fromthe ERM had a psychological effect on the currency.Prior to the introduction of the euro, both the pound benefited from anydoubts about the currency convergence. After the introduction of the euro, Bankof England is attempting to bring the high U.K. rates closer to the lower rates inthe euro zone. The pound could join the euro in the early 2000s, provided thatthe U.K. referendum is positive.

The Swiss Franc
The Swiss franc is the only currency of a major European country thatbelongs neither to the European Monetary Union nor to the G-7 countries.Although the Swiss economy is relatively small, the Swiss franc is one of thefour major currencies, closely resembling the strength and quality of the Swisseconomy and finance. Switzerland has a very close economic relationship withGermany, and thus to the euro zone. Therefore, in terms of political uncertaintyin the East, the Swiss franc is favored generally over the euro.Typically, it is believed that the Swiss franc is a stable currency.Actually, from a foreign exchange point of view, the Swiss franc closelyresembles the patterns of the euro, but lacks its liquidity. As the demand for itexceeds supply, the Swiss franc can be more volatile than the euro.

Factors Caused Foreign Exchange Volume Growth

Foreign exchange trading is generally conducted in a decentralized manner,
with the exceptions of currency futures and options. Foreign exchange has
experienced spectacular growth in volume ever since currencies were allowed to
float freely against each other. While the daily turnover in 1977 was U.S. $5
billion, it increased to U.S. $600 billion in 1987, reached the U.S. $1 trillion mark
in September 1992, and stabilized at around $1,5 trillion by the year 2000.
Main factors influence on this spectacular growth in volume are indicated
below.
For foreign exchange, currency volatility is a prime factor in the growth
of volume. In fact, volatility is a sine qua non condition for trading. The only
instruments that may be profitable under conditions of low volatility are
currency options.

Interest Rate Volatility

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

Business Internationalization

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

Increasing of Corporate Interest

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

Increasing of Traders Sophistication

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

Developments in Telecommunications

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

Computer and Programming development

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

Money management

Basic Money Management for Forex Trading

There can be and are whole books written on the topic of money management, but I like to keep things simple so I will just give you a few simple rules that you can follow to implement successful money management in your forex trading. Actually, to make it even simpler, I believe that money management when it comes to the currency markets can really be summed up in a nice way with just one sentence: ......(wait for it)...... Make sure that you always trade the same number of lots on every trade that you make! Ok, that's it, end of article. Just kidding, but if you were to walk away and remember just that one sentence you would probably end up making your trading more profitable on the whole. I will let you in on a few some other aspects of good money management, but CONSISTENCY is a very important part that you should never neglect. First off, forex traders are able to take advantage of large amounts of leverage, which greatly magnifies any profits or losses. Because of this, doubling your trading account balance is just as easy as completely wiping out your account. The first simple rule of proper forex money management is to always fund your live trading account with RISK CAPITAL. Simply put, risk capital is just money that you do not need to survive or pay the bills. When you only fund your account with risk capital, you will feel much more emotionally detached from that money and it will be easier for you to adhere to the rules of your trading strategy. Something else that many novice forex traders fall victim to is over-trading their account. This will usually happen in a rage after a losing series of trades, and it is very reminiscent of a losing gambler trying to double his bets to recoup his losses, but only ends up losing more. The second simple rule of money management is not to over-trade your account, and only enter the market when you have SUFFICIENT REASON or justification for entering. Also realize that it is pretty unrealistic to believe that you can have winning trades 100% of the time. Losing trades just happen sometimes, so deal with it! Because even the best forex traders will still have losing trades occasially, it is wise to make sure that you always trade with a stop loss in order to minimize your losses (that is rule #3). But more than anything else, it is important to be consistent in the amount of money that you place on each trade. Do not trade 1 lot, and then later that day trade 8 lots, as this is a sure-fire indication that you are not confident in the rate of success of your trading system. So remember, be consistent and trade the same number of lots each time!
Article Source : http://www.superfeature.com
My name is Marcus Masters, and I have gathered a large collection of free forex ebooks and reports at TheForexSurfer.com/reports . You can also learn about my personal profitable forex trading strategy called Forex Surfing. Just go to TheForexSurfer.com