ForexInvestment & Trading

Forex Made Simple – A Beginner’s Guide to Foreign Exchange Success

Forex Made Simple - A Beginner's Guide to Foreign Exchange Success

In this Forex Beginner’s Guide

 

Chapter 1: History of foreign exchange

  • Introduction of the gold standard
  • Major influences on foreign exchange since World War II
    • The Bretton Woods Accord
    • The Nixon Shock
    • The Smithsonian Agreement
    • Free-floating currencies
    • Currency reserves
    • The European Community and the introduction of the euro
  • Recent growth of foreign exchange markets
    • Interest rate volatility
    • International business operations
    • Increased international trade and the use of currency hedging
    • Automated dealing systems
    • The internet and retail traders
  • Chapter summary

Chapter 2: Major currencies, economies and central banks

  • Major world currencies
    • The United States dollar
    • The euro
    • The Japanese yen
    • The British pound
    • The Australian dollar
    • The Swiss franc
    • The Canadian dollar
  • Central banks
    • Monetary policy
    • Interest rates
    • Open market operations
    • Reserve requirements
  • Central banks and the foreign exchange market
    • Repurchase agreements
    • Foreign exchange intervention
    • The rise of central banks
    • US Federal Reserve System
    • European Central Bank
    • Bank of Japan
    • Bank of England
    • Reserve Bank of Australia
    • Swiss National Bank
    • Bank of Canada
  • Chapter summary

Chapter 3: The foreign exchange markets and major participants

  • Forex market participants
    • The inter-bank market
    • Companies and businesses
    • Hedge funds
    • Investment management firms
    • Retail foreign exchange brokers and traders
  • Various currency markets
    • The forwards and swap market
    • Swaps
    • Currency futures
  • The spot market
  • Chapter summary

Chapter 4: Retail forex dealers and market makers

  • Forex market structure
  • Retail forex dealers
    • Market makers or dealing desks
    • Retail forex dealers or non-dealing desks
  • Choosing a retail forex dealer that suits you
    • Are they regulated? If so, in which country?
    • What is their capitalisation?
    • How user-friendly and reliable is their trading platform?
    • What customer support do they provide?
    • What types of accounts do they offer?
    • What leverage is offered and what is their margin call policy?
  • Chapter summary

Chapter 5: The mechanics of trading forex

  • Trading forex is trading money
  • The mechanics of forex trading
  • Base and quote (or counter) currencies
  • Currency pairs
  • Long or short?
  • Understanding pips
  • Lot sizes
    • Example 1
    • Example 2
    • Example 3
  • The bid/offer spread
  • How the trader and the dealer can both make a profit
  • Fractional pips
  • Margin and leverage
  • When to trade forex
  • Chapter summary

Chapter 6: How to place a forex trade

  • Placing a trade
    • Opening a trade at market
    • Using stop and limit orders to enter a trade
  • Rollover
  • The carry trade
  • Chapter summary

Chapter 7: Currency futures

  • The mechanics of trading currency futures
  • Long or short?
  • Novation
  • Standardised contracts and specifications
    • Delivery (or maturity) date
    • Settlement
    • Contract size
    • Understanding tick values
  • E-micro currency futures
  • Bid/ask spread
  • Margin and leverage
  • Spot forex and currency futures compared
    • OTC versus regulated exchange
    • Lot sizes and specifications
    • Pips and ticks
    • Brokers, dealers and market makers
    • Liquidity and transparency
    • Leverage and margin
    • It’s all about choice
  • Chapter summary

Chapter 8: Macro economics and how it affects forex

  • Economic theory
    • Purchasing power parity theory
    • Balance of payments theory
    • Real interest rate differential theory
  • Economic data and indicators that affect foreign exchange values
  • Economic indicators
    • Gross domestic product
    • Balance of trade
    • Industrial production
    • Durable goods orders
    • Construction indicators
    • Retail sales
    • Consumer confidence index
    • Institute for Supply Management Index
    • Conference Board Leading Economic Index®
  • Inflation indicators
    • Consumer price index
    • Producer price index
    • Commodity Research Bureau Futures Index
  • Employment indicators
    • Non-farm payrolls
    • Employment Cost Index
  • Important economic indicators for the major global economies
    • Important economic indicators for the Eurozone Important economic indicators for Japan
    • Important economic indicators for the United Kingdom Important economic indicators for Australia
    • Important economic indicators for Switzerland
    • Important economic indicators for Canada
  • Chapter summary

Chapter 9: Money management for forex

  • Swinging for the fences
  • Defining losses
    • Setting stop-loss levels
    • How much capital can you afford to lose?
    • Using leverage and position sizing
  • Leverage and small accounts
  • Chapter summary

 

Chapter 1 summary

⇒ The roots of modern-day currency trading can be traced back to the Middle Ages, when trade between countries with different currencies began.
⇒ The main aim of the implementation of the gold standard was to guarantee the value of any currency against that of another.
⇒ The stability that results from the use of the gold standard is also one of its biggest drawbacks, as it prevents exchange rates from responding freely to changing circumstances in different countries. A gold standard also limits the monetary policies that a country’s central bank can use to stabilise prices and other economic variables, which can cause severe economic shocks.
⇒ The real growth of the foreign exchange market place has taken place as a result of events occurring after World War II.
⇒ The Bretton Woods Accord established the US dollar as the global currency.
⇒ The death of the Bretton Woods system and the collapse of the Smithsonian Agreement ultimately led to the system of free-floating currencies that exists today. By 1978 the free floating of currencies was mandated by the International Monetary Fund (IMF).
⇒ The creation of the European Monetary Union was the result of a long series of post–World War II efforts aimed at creating closer economic cooperation among the capitalist European countries
⇒ In 1999, more than 40 years after the idea was first proposed, the euro was introduced as an all-European currency by 11 of the then 15 member states.
⇒ Average daily turnover in the foreign exchange market is now approaching the US$4 trillion level — a number that dwarfs the value of trades in all other financial markets.
⇒ Thanks to the advent of the internet and technological advancements in relation to trading platforms and dealing systems, the foreign exchange market can now be traded by a much wider community of traders around the globe and around the clock.

 

Chapter 2: Major currencies, economies and central banks

While you may be itching to start trading, if you are to become a competent and confident forex trader you will need an understanding of the underlying concepts of foreign exchange to give you a solid foundation on which to build your trading business. Understanding the roles and uses of the major (and some of the minor) currencies, the workings of the global economy, and the many interrelationships that exist will help your decision-making processes and the development of your trading system or strategy.

 

Major world currencies

Although all countries have their own currency, foreign exchange trading is limited to the currencies that have a global presence through their use in international trade and investment. In this chapter, we will look at the seven most actively traded global currencies: the US dollar, the euro, the Japanese yen, the British pound, the Australian dollar, the Swiss franc and the Canadian dollar.

 

Central banks

A country’s central or reserve bank is the financial institution that oversees the operation of the country’s banking and monetary system. A central bank will usually have several areas of responsibility, including:
⇒ issuing the national currency
⇒ regulating the money supply
⇒ implementing monetary policy and controlling interest rates
⇒ controlling inflation and price stability
⇒ maintaining currency values
⇒ ensuring stability of the financial system including regulating and supervising the commercial banks
⇒ acting as lender of last resort to commercial banks
⇒ acting as the government’s banker
⇒ managing foreign exchange reserves.
An independent central bank will ensure there is no political influence over the central bank’s policies and that the policies of the central bank will be neutral in regard to the governing political regime. This is particularly important during times of rising inflation or rising interest rates, which are politically sensitive issues.

Tip
As foreign exchange traders, we are most interested in the role of the central banks in using monetary policy to achieve a central bank’s objectives in terms of controlling inflation and unemployment levels; its intervention in the financial securities markets to attempt to control and manipulate interest rates and the money supply (often referred to as open market operations); and its management of foreign exchange reserve levels, and the impact these actions have on currency values.

 

Monetary policy

Monetary policy is the management of money supply to achieve the goals of stable prices, low unemployment, low inflation and sustainable levels of economic growth. Monetary policy is handled by a country’s central bank, and is in sharp contrast to fiscal policy, which refers to government spending, borrowing and taxation. The monetary policy tools available to a central bank to achieve these objectives and to influence the level of economic activity include:
⇒ interest rates
⇒ open market operations
⇒ reserve requirements.
All three have the effect of either expanding or contracting the money supply within an economy. Monetary policy is referred to as being either expansionary or contractionary. Expansionary monetary policy rapidly increases the supply of money in the economy and is used to encourage employment and economic growth by lowering interest rates. Contractionary policy is used to control rising inflation or combat inflationary pressures by decreasing, or slowly increasing, the money supply by raising interest rates.

Tip
Monetary policies exist and can be implemented by central banks because all the reserve currencies are fiat money. Fiat money has no intrinsic value, as it is not legally convertible to anything, nor is it fixed to any standard value. It can be created from nothing at any time by the simple act of printing more money.

 

Interest rates

Influencing market interest rates is perhaps the most visible of the monetary policy tools available to a central bank. Raising interest rates impacts directly on households through its effect on mortgage payments, and interest payments on other loans and consumer debt. This in turn serves to reduce consumer spending, because less money is then available to consumers.

Higher interest rates also discourage new borrowing, which decreases the amount of new money created through loans. Raising interest rates is a contractionary policy designed to slow down spending and the economy, and to reduce inflationary pressures. Conversely, a cut in interest rates means more money is available for consumer spending, which encourages more borrowing and has an expansionary effect and a positive impact on economic growth.

Tip
The effect of changing interest rates on the currency markets is generally an increase in the value of a currency in line with interest rate rises, and a decrease in the value of a currency when interest rates are cut.

A contributing factor to the strength of the Australian dollar since the global financial crisis has been the relatively high level of interest rates in Australia compared with those available in the rest of the world. Higher interest rates lead to an increase in the demand for the currency by investors and speculators. It is also an important component of the carry trade, which is discussed in detail in chapter 6.

 

Open market operations

Open market operations involve the central bank buying and selling government securities (mainly bonds) in the open market. This is a policy measure used to control the amount of money circulating in a country’s economy. When a central bank buys government securities, the effect is to expand the money supply and reduce interest rates.

When a central bank sells bonds, its action takes money out of the economy, so the money supply is reduced and interest rates rise. The effect on the currency is similar to that of direct interest rate changes where, generally speaking, lower rates lead to a fall in the currency, and higher interest rates will cause the value of the currency to rise.

For the central bank to buy government securities or foreign currency in the open market, it needs new money to be available to pay for its purchases, which requires the bank to print or create this new money. This is only possible because of the fiat money system under which the global economy now operates.

As most transactions are conducted electronically and money is held as electronic records, these open market operations are conducted by electronically debiting or crediting accounts, rather than the printing or destruction of actual cash money.

If the central bank is buying in the open market, the seller’s account is credited electronically, thus increasing the amount of money in that account and in the economy through the creation of new money. If the central bank is selling in the open market, the buyer’s account is debited electronically, which decreases the amount of money in the account, effectively destroying that money by removing it from circulation within the economy.

 

Reserve requirements

In many countries the commercial banks and other financial institutions that hold customer cash deposits are required to hold a percentage of these deposits and account balances on deposit at the central bank. This is known as the reserve requirement or cash reserve ratio.

In the Eurozone, for example, this reserve requirement is currently 2 per cent. This percentage amount generally remains stable and is seldom varied, though it can be used by the central bank to affect the money supply. If the reserve requirement percentage is increased, the supply of money in the economy is reduced, and interest rates will rise in response to less money being available.

A rise in interest rates will generally result in an increase in the value of the country’s currency. Altering reserve requirements causes a major long-term shift in the money supply, and so this method of influencing the economy is rarely used.

 

Central banks and the foreign exchange market

It’s useful for foreign exchange traders to have some insight into the operations of central banks in the foreign exchange markets. While this knowledge may not have a direct impact on your trading, it will certainly help you understand how the actions of the central banks can affect and move the markets.

 

Chapter 2 summary

⇒ Although all countries have their own currency, foreign exchange trading is limited to the currencies that have a global presence through their use in international trade and investment.
⇒ The United States dollar (USD, $) effectively became the world’s reserve currency under the Bretton Woods Accord. As a result the US dollar remains the world’s main currency with most global trade outside of Europe still being quoted in US dollars.
⇒ Of major interest in the future will be whether the Chinese yuan becomes a free-floating currency and can be freely traded on forex markets like other open market currencies.
⇒ Since the introduction of the euro in 1999, the importance of the US dollar as an international reserve currency has declined. The US dollar is still the most-held reserve currency, with holdings still more than double that of the euro, but the importance of the euro is steadily increasing.
⇒ Despite a much smaller international presence than either the US dollar or the euro, the Japanese yen is the third most traded currency in the world.
⇒ The British pound was subject to one of the most aggressive attacks on the value of a currency in September 1992 by a large hedge fund, which was convinced that the pound was overvalued.
⇒ Both the Australian dollar and Canadian dollar are referred to as commodity currencies because of the reliance of these two economies on raw materials.
⇒ The Swiss franc is still backed by a 20 per cent gold reserve.
⇒ A central or reserve bank is the financial institution that oversees the
operation of the banking and monetary system within a country.
⇒ Monetary policy is the main tool central banks use to control interest rates and currency values.
⇒ The mandate of all the central banks is very similar, with a focus on low inflation, currency stability, economic growth and prosperity within an economy.

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