The following are some of the most common types of foreign currency hedging vehicles used in today's markets as a foreign currency hedge. While retail forex traders typically use foreign currency options as a hedging vehicle. Banks and commercials are more likely to use options, swaps, swaptions and other more complex derivatives to meet their specific hedging needs.
Spot Contracts - A foreign currency contract to buy or sell at the current foreign currency rate, requiring settlement within two days.
As a foreign currency hedging vehicle, due to the short-term settlement date, spot contracts are not appropriate for many foreign currency hedging and trading strategies. Foreign currency spot contracts are more commonly used in combination with other types of foreign currency hedging vehicles when implementing a foreign currency hedging strategy.
For retail investors, in particular, the spot contract and its associated risk are often the underlying reason that a foreign currency hedge must be placed. The spot contract is more often a part of the reason to hedge foreign currency risk exposure rather than the foreign currency hedging solution.
Forward Contracts - A foreign currency contract to buy or sell a foreign currency at a fixed rate for delivery on a specified future date or period.
Foreign currency forward contracts are used as a foreign currency hedge when an investor has an obligation to either make or take a foreign currency payment at some point in the future. If the date of the foreign currency payment and the last trading date of the foreign currency forwards contract are matched up, the investor has in effect "locked in" the exchange rate payment amount.
* Important: Please note that forwards contracts are different than futures contracts. Foreign currency futures contracts have standard contract sizes, time periods, settlement procedures and are traded on regulated exchanges throughout the world. Foreign currency forwards contracts may have different contract sizes, time periods and settlement procedures than futures contracts. Foreign currency forwards contracts are considered over-the-counter (OTC) due to the fact that there is no centralized trading location and transactions are conducted directly between parties via telephone and online trading platforms at thousands of locations worldwide.
Foreign Currency Options - A financial foreign currency contract giving the buyer the right, but not the obligation, to purchase or sell a specific foreign currency contract (the underlying) at a specific price (the strike price) on or before a specific date (the expiration date). The amount the foreign currency option buyer pays to the foreign currency option seller for the foreign currency option contract rights is called the option "premium."
A foreign currency option can be used as a foreign currency hedge for an open position in the foreign currency spot market. Foreign currency options can also be used in combination with other foreign currency spot and options contracts to create more complex foreign currency hedging strategies. There are many different foreign currency option strategies available to both commercial and retail investors.
Interest Rate Options - A financial interest rate contract giving the buyer the right, but not the obligation, to purchase or sell a specific interest rate contract (the underlying) at a specific price (the strike price) on or before a specific date (the expiration date). The amount the interest rate option buyer pays to the interest rate option seller for the foreign currency option contract rights is called the option "premium." Interest rate option contracts are more often used by interest rate speculators, commercials and banks rather than by retail forex traders as a foreign currency hedging vehicle.
Foreign Currency Swaps - A financial foreign currency contract whereby the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate. The buyer and seller exchange fixed or floating rate interest payments in their respective swapped currencies over the term of the contract. At maturity, the principal amount is effectively re-swapped at a predetermined exchange rate so that the parties end up with their original currencies. Foreign currency swaps are more often used by commercials as a foreign currency hedging vehicle rather than by retail forex traders.
Interest Rate Swaps - A financial interest rate contracts whereby the buyer and seller swap interest rate exposure over the term of the contract. The most common swap contract is the fixed-to-float swap whereby the swap buyer receives a floating rate from the swap seller, and the swap seller receives a fixed rate from the swap buyer. Other types of swap include fixed-to-fixed and float-to-float. Interest rate swaps are more often utilized by commercials to re-allocate interest rate risk exposure.
John Nobile - Senior Account Executive
CFOS/FX - Online Forex Spot and Options Brokerage
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Wednesday, September 24, 2008
Tuesday, September 23, 2008
Forex Options Market Overview
The forex options market started as an over-the-counter (OTC) financial vehicle for large banks, financial institutions and large international corporations to hedge against foreign currency exposure. Like the forex spot market, the forex options market is considered an "interbank" market. However, with the plethora of real-time financial data and forex option trading software available to most investors through the internet, today's forex option market now includes an increasingly large number of individuals and corporations who are speculating and/or hedging foreign currency exposure via telephone or online forex trading platforms.
Forex option trading has emerged as an alternative investment vehicle for many traders and investors. As an investment tool, forex option trading provides both large and small investors with greater flexibility when determining the appropriate forex trading and hedging strategies to implement.
Most forex options trading is conducted via telephone as there are only a few forex brokers offering online forex option trading platforms.
Forex Option Defined - A forex option is a financial currency contract giving the forex option buyer the right, but not the obligation, to purchase or sell a specific forex spot contract (the underlying) at a specific price (the strike price) on or before a specific date (the expiration date). The amount the forex option buyer pays to the forex option seller for the forex option contract rights is called the forex option "premium."
The Forex Option Buyer - The buyer, or holder, of a foreign currency option has the choice to either sell the foreign currency option contract prior to expiration, or he or she can choose to hold the foreign currency options contract until expiration and exercise his or her right to take a position in the underlying spot foreign currency. The act of exercising the foreign currency option and taking the subsequent underlying position in the foreign currency spot market is known as "assignment" or being "assigned" a spot position.
The only initial financial obligation of the foreign currency option buyer is to pay the premium to the seller up front when the foreign currency option is initially purchased. Once the premium is paid, the foreign currency option holder has no other financial obligation (no margin is required) until the foreign currency option is either offset or expires.
On the expiration date, the call buyer can exercise his or her right to buy the underlying foreign currency spot position at the foreign currency option's strike price, and a put holder can exercise his or her right to sell the underlying foreign currency spot position at the foreign currency option's strike price. Most foreign currency options are not exercised by the buyer, but instead are offset in the market before expiration.
Foreign currency options expires worthless if, at the time the foreign currency option expires, the strike price is "out-of-the-money." In simplest terms, a foreign currency option is "out-of-the-money" if the underlying foreign currency spot price is lower than a foreign currency call option's strike price, or the underlying foreign currency spot price is higher than a put option's strike price. Once a foreign currency option has expired worthless, the foreign currency option contract itself expires and neither the buyer nor the seller have any further obligation to the other party.
The Forex Option Seller - The foreign currency option seller may also be called the "writer" or "grantor" of a foreign currency option contract. The seller of a foreign currency option is contractually obligated to take the opposite underlying foreign currency spot position if the buyer exercises his right. In return for the premium paid by the buyer, the seller assumes the risk of taking a possible adverse position at a later point in time in the foreign currency spot market.
Initially, the foreign currency option seller collects the premium paid by the foreign currency option buyer (the buyer's funds will immediately be transferred into the seller's foreign currency trading account). The foreign currency option seller must have the funds in his or her account to cover the initial margin requirement. If the markets move in a favorable direction for the seller, the seller will not have to post any more funds for his foreign currency options other than the initial margin requirement. However, if the markets move in an unfavorable direction for the foreign currency options seller, the seller may have to post additional funds to his or her foreign currency trading account to keep the balance in the foreign currency trading account above the maintenance margin requirement.
Just like the buyer, the foreign currency option seller has the choice to either offset (buy back) the foreign currency option contract in the options market prior to expiration, or the seller can choose to hold the foreign currency option contract until expiration. If the foreign currency options seller holds the contract until expiration, one of two scenarios will occur: (1) the seller will take the opposite underlying foreign currency spot position if the buyer exercises the option or (2) the seller will simply let the foreign currency option expire worthless (keeping the entire premium) if the strike price is out-of-the-money.
Please note that "puts" and "calls" are separate foreign currency options contracts and are NOT the opposite side of the same transaction. For every put buyer there is a put seller, and for every call buyer there is a call seller. The foreign currency options buyer pays a premium to the foreign currency options seller in every option transaction.
Forex Call Option - A foreign exchange call option gives the foreign exchange options buyer the right, but not the obligation, to purchase a specific foreign exchange spot contract (the underlying) at a specific price (the strike price) on or before a specific date (the expiration date). The amount the foreign exchange option buyer pays to the foreign exchange option seller for the foreign exchange option contract rights is called the option "premium."
Please note that "puts" and "calls" are separate foreign exchange options contracts and are NOT the opposite side of the same transaction. For every foreign exchange put buyer there is a foreign exchange put seller, and for every foreign exchange call buyer there is a foreign exchange call seller. The foreign exchange options buyer pays a premium to the foreign exchange options seller in every option transaction.
The Forex Put Option - A foreign exchange put option gives the foreign exchange options buyer the right, but not the obligation, to sell a specific foreign exchange spot contract (the underlying) at a specific price (the strike price) on or before a specific date (the expiration date). The amount the foreign exchange option buyer pays to the foreign exchange option seller for the foreign exchange option contract rights is called the option "premium."
Please note that "puts" and "calls" are separate foreign exchange options contracts and are NOT the opposite side of the same transaction. For every foreign exchange put buyer there is a foreign exchange put seller, and for every foreign exchange call buyer there is a foreign exchange call seller. The foreign exchange options buyer pays a premium to the foreign exchange options seller in every option transaction.
Plain Vanilla Forex Options - Plain vanilla options generally refer to standard put and call option contracts traded through an exchange (however, in the case of forex option trading, plain vanilla options would refer to the standard, generic forex option contracts that are traded through an over-the-counter (OTC) forex options dealer or clearinghouse). In simplest terms, vanilla forex options would be defined as the buying or selling of a standard forex call option contract or a forex put option contract.
Exotic Forex Options - To understand what makes an exotic forex option "exotic," you must first understand what makes a forex option "non-vanilla." Plain vanilla forex options have a definitive expiration structure, payout structure and payout amount. Exotic forex option contracts may have a change in one or all of the above features of a vanilla forex option. It is important to note that exotic options, since they are often tailored to a specific's investor's needs by an exotic forex options broker, are generally not very liquid, if at all.
Intrinsic & Extrinsic Value - The price of an FX option is calculated into two separate parts, the intrinsic value and the extrinsic (time) value.
The intrinsic value of an FX option is defined as the difference between the strike price and the underlying FX spot contract rate (American Style Options) or the FX forward rate (European Style Options). The intrinsic value represents the actual value of the FX option if exercised. Please note that the intrinsic value must be zero (0) or above - if an FX option has no intrinsic value, then the FX option is simply referred to as having no (or zero) intrinsic value (the intrinsic value is never represented as a negative number). An FX option with no intrinsic value is considered "out-of-the-money," an FX option having intrinsic value is considered "in-the-money," and an FX option with a strike price at, or very close to, the underlying FX spot rate is considered "at-the-money."
The extrinsic value of an FX option is commonly referred to as the "time" value and is defined as the value of an FX option beyond the intrinsic value. A number of factors contribute to the calculation of the extrinsic value including, but not limited to, the volatility of the two spot currencies involved, the time left until expiration, the riskless interest rate of both currencies, the spot price of both currencies and the strike price of the FX option. It is important to note that the extrinsic value of FX options erodes as its expiration nears. An FX option with 60 days left to expiration will be worth more than the same FX option that has only 30 days left to expiration. Because there is more time for the underlying FX spot price to possibly move in a favorable direction, FX options sellers demand (and FX options buyers are willing to pay) a larger premium for the extra amount of time.
Volatility - Volatility is considered the most important factor when pricing forex options and it measures movements in the price of the underlying. High volatility increases the probability that the forex option could expire in-the-money and increases the risk to the forex option seller who, in turn, can demand a larger premium. An increase in volatility causes an increase in the price of both call and put options.
Delta - The delta of a forex option is defined as the change in price of a forex option relative to a change in the underlying forex spot rate. A change in a forex option's delta can be influenced by a change in the underlying forex spot rate, a change in volatility, a change in the riskless interest rate of the underlying spot currencies or simply by the passage of time (nearing of the expiration date).
The delta must always be calculated in a range of zero to one (0-1.0). Generally, the delta of a deep out-of-the-money forex option will be closer to zero, the delta of an at-the-money forex option will be near .5 (the probability of exercise is near 50%) and the delta of deep in-the-money forex options will be closer to 1.0. In simplest terms, the closer a forex option's strike price is relative to the underlying spot forex rate, the higher the delta because it is more sensitive to a change in the underlying rate.
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Forex Option Defined - A forex option is a financial currency contract giving the forex option buyer the right, but not the obligation, to purchase or sell a specific forex spot contract (the underlying) at a specific price (the strike price) on or before a specific date (the expiration date). The amount the forex option buyer pays to the forex option seller for the forex option contract rights is called the forex option "premium."
The Forex Option Buyer - The buyer, or holder, of a foreign currency option has the choice to either sell the foreign currency option contract prior to expiration, or he or she can choose to hold the foreign currency options contract until expiration and exercise his or her right to take a position in the underlying spot foreign currency. The act of exercising the foreign currency option and taking the subsequent underlying position in the foreign currency spot market is known as "assignment" or being "assigned" a spot position.
The only initial financial obligation of the foreign currency option buyer is to pay the premium to the seller up front when the foreign currency option is initially purchased. Once the premium is paid, the foreign currency option holder has no other financial obligation (no margin is required) until the foreign currency option is either offset or expires.
On the expiration date, the call buyer can exercise his or her right to buy the underlying foreign currency spot position at the foreign currency option's strike price, and a put holder can exercise his or her right to sell the underlying foreign currency spot position at the foreign currency option's strike price. Most foreign currency options are not exercised by the buyer, but instead are offset in the market before expiration.
Foreign currency options expires worthless if, at the time the foreign currency option expires, the strike price is "out-of-the-money." In simplest terms, a foreign currency option is "out-of-the-money" if the underlying foreign currency spot price is lower than a foreign currency call option's strike price, or the underlying foreign currency spot price is higher than a put option's strike price. Once a foreign currency option has expired worthless, the foreign currency option contract itself expires and neither the buyer nor the seller have any further obligation to the other party.
The Forex Option Seller - The foreign currency option seller may also be called the "writer" or "grantor" of a foreign currency option contract. The seller of a foreign currency option is contractually obligated to take the opposite underlying foreign currency spot position if the buyer exercises his right. In return for the premium paid by the buyer, the seller assumes the risk of taking a possible adverse position at a later point in time in the foreign currency spot market.
Initially, the foreign currency option seller collects the premium paid by the foreign currency option buyer (the buyer's funds will immediately be transferred into the seller's foreign currency trading account). The foreign currency option seller must have the funds in his or her account to cover the initial margin requirement. If the markets move in a favorable direction for the seller, the seller will not have to post any more funds for his foreign currency options other than the initial margin requirement. However, if the markets move in an unfavorable direction for the foreign currency options seller, the seller may have to post additional funds to his or her foreign currency trading account to keep the balance in the foreign currency trading account above the maintenance margin requirement.
Just like the buyer, the foreign currency option seller has the choice to either offset (buy back) the foreign currency option contract in the options market prior to expiration, or the seller can choose to hold the foreign currency option contract until expiration. If the foreign currency options seller holds the contract until expiration, one of two scenarios will occur: (1) the seller will take the opposite underlying foreign currency spot position if the buyer exercises the option or (2) the seller will simply let the foreign currency option expire worthless (keeping the entire premium) if the strike price is out-of-the-money.
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Forex Call Option - A foreign exchange call option gives the foreign exchange options buyer the right, but not the obligation, to purchase a specific foreign exchange spot contract (the underlying) at a specific price (the strike price) on or before a specific date (the expiration date). The amount the foreign exchange option buyer pays to the foreign exchange option seller for the foreign exchange option contract rights is called the option "premium."
Please note that "puts" and "calls" are separate foreign exchange options contracts and are NOT the opposite side of the same transaction. For every foreign exchange put buyer there is a foreign exchange put seller, and for every foreign exchange call buyer there is a foreign exchange call seller. The foreign exchange options buyer pays a premium to the foreign exchange options seller in every option transaction.
The Forex Put Option - A foreign exchange put option gives the foreign exchange options buyer the right, but not the obligation, to sell a specific foreign exchange spot contract (the underlying) at a specific price (the strike price) on or before a specific date (the expiration date). The amount the foreign exchange option buyer pays to the foreign exchange option seller for the foreign exchange option contract rights is called the option "premium."
Please note that "puts" and "calls" are separate foreign exchange options contracts and are NOT the opposite side of the same transaction. For every foreign exchange put buyer there is a foreign exchange put seller, and for every foreign exchange call buyer there is a foreign exchange call seller. The foreign exchange options buyer pays a premium to the foreign exchange options seller in every option transaction.
Plain Vanilla Forex Options - Plain vanilla options generally refer to standard put and call option contracts traded through an exchange (however, in the case of forex option trading, plain vanilla options would refer to the standard, generic forex option contracts that are traded through an over-the-counter (OTC) forex options dealer or clearinghouse). In simplest terms, vanilla forex options would be defined as the buying or selling of a standard forex call option contract or a forex put option contract.
Exotic Forex Options - To understand what makes an exotic forex option "exotic," you must first understand what makes a forex option "non-vanilla." Plain vanilla forex options have a definitive expiration structure, payout structure and payout amount. Exotic forex option contracts may have a change in one or all of the above features of a vanilla forex option. It is important to note that exotic options, since they are often tailored to a specific's investor's needs by an exotic forex options broker, are generally not very liquid, if at all.
Intrinsic & Extrinsic Value - The price of an FX option is calculated into two separate parts, the intrinsic value and the extrinsic (time) value.
The intrinsic value of an FX option is defined as the difference between the strike price and the underlying FX spot contract rate (American Style Options) or the FX forward rate (European Style Options). The intrinsic value represents the actual value of the FX option if exercised. Please note that the intrinsic value must be zero (0) or above - if an FX option has no intrinsic value, then the FX option is simply referred to as having no (or zero) intrinsic value (the intrinsic value is never represented as a negative number). An FX option with no intrinsic value is considered "out-of-the-money," an FX option having intrinsic value is considered "in-the-money," and an FX option with a strike price at, or very close to, the underlying FX spot rate is considered "at-the-money."
The extrinsic value of an FX option is commonly referred to as the "time" value and is defined as the value of an FX option beyond the intrinsic value. A number of factors contribute to the calculation of the extrinsic value including, but not limited to, the volatility of the two spot currencies involved, the time left until expiration, the riskless interest rate of both currencies, the spot price of both currencies and the strike price of the FX option. It is important to note that the extrinsic value of FX options erodes as its expiration nears. An FX option with 60 days left to expiration will be worth more than the same FX option that has only 30 days left to expiration. Because there is more time for the underlying FX spot price to possibly move in a favorable direction, FX options sellers demand (and FX options buyers are willing to pay) a larger premium for the extra amount of time.
Volatility - Volatility is considered the most important factor when pricing forex options and it measures movements in the price of the underlying. High volatility increases the probability that the forex option could expire in-the-money and increases the risk to the forex option seller who, in turn, can demand a larger premium. An increase in volatility causes an increase in the price of both call and put options.
Delta - The delta of a forex option is defined as the change in price of a forex option relative to a change in the underlying forex spot rate. A change in a forex option's delta can be influenced by a change in the underlying forex spot rate, a change in volatility, a change in the riskless interest rate of the underlying spot currencies or simply by the passage of time (nearing of the expiration date).
The delta must always be calculated in a range of zero to one (0-1.0). Generally, the delta of a deep out-of-the-money forex option will be closer to zero, the delta of an at-the-money forex option will be near .5 (the probability of exercise is near 50%) and the delta of deep in-the-money forex options will be closer to 1.0. In simplest terms, the closer a forex option's strike price is relative to the underlying spot forex rate, the higher the delta because it is more sensitive to a change in the underlying rate.
John Nobile - Senior Account Executive
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Learn Forex Trading - a Guide for Beginners
One can learn forex trading as easily as one would like to learn other subjects or train in other professions. The criteria for learning forex trading is an analytical / logical bent of mind and some number crunching abilities.
Forex Trading Online - 7 Reasons Why You Should!
Forex trading online is a fast way to use your investment capital to it's fullest. The Forex markets offer distinct advantages to the small and large traders alike, making Forex currency trading in many ways preferable to other markets such as stocks, options or traditional futures.
Dont Deny Reality
If you want to be a successful trader, you must make sure you do not deny reality in any phase of your trading. You cannot deny losses, price direction, mistakes you make, being undercapitalized, or a whole host of things you would rather not think about.
Psychology Of Trading
The psychological aspect of trading is usually underestimated by those new to trading. The psychological problem for most traders is the fear of losing - ironically it is this fear that causes most traders to lose money in the long run.
Money Management, Part 1
There are some common mistakes I've seen traders make in the area of money management. First, let's understand what money management is all about.
The Margin Advantages of Trading FOREX.
There is one aspect that is considered as one of the best advantages of FOREX Trading. This is related to the amount of money you need to place a trade, this is known as "margin", and in short, this is all that can be lost in a the case you had a bad trade.
Day Trading - Moving Averages vs Support and Resistance
When day trading the SP and Nasdaq futures, do you rely on your moving averages more than your support & resistant areas?During the first hour of trading, the support and resistance zones on the SP and Nasdaq futures are the most important things to watch. The moving averages have not yet had a chance to come into play.
Online Stock Trading: Freedom of Trade
I remember the first time I started to trade online. It was just before the tech bubble of the late 1990's and the internet was still something new for most people.
Is The U.S. Dollar About To Reverse Course?
For the first time in several years the U.S.
The Meaning of FOREX Price Charts and How to Use Them
There is one very important factor that you should consider with great care if you are willing to become a successful, profitable Forex trader. This ever important factor that must be always present in the trader's portfolio, is the ability to read the charts.
Online Futures Trading - Advantages and Disadvantages
What Is Online Futures Trading?A futures contract is an agreement to buy or sell a commodity at a date in the future. Everything about a futures contract is standardized except its price.
Trade Entry Techniques
Most traders tend to concentrate on pinpointing the perfect entry for a trade. However, in reality the entry price is just one part of the equation.
Forex Trading - Advantages and Disadvantages
What is Forex Trading?Forex, or Foreign Exchange, is the simultaneous exchange of one country's currency for that of another. This market of exchange has more daily volume, both buyers and sellers, than any other in the world.
Forex Training: Follow Your Gut or Your Broker
Which way will the forex market move? Do you just follow your gut feeling? Or do you have Neo's sixth sense that would let you be one with the market and feel the underlying currents.Trading forex is a non stop action movie but a good one, where you really don't know who will win at the end.
Exploring the World of Day Trading
Are you looking into a career in day trading? In the past, the tools for day trading were available only to professionals. But thanks to the power of the Internet, everything you need to get started is now conveniently online.
FOREX Trading Philosophy
Keen on starting FOREX trading? Why would you not be? Many beginning FOREX traders are captivated by the allure of easy money. FOREX websites offer 'risk-free' trading, 'high returns' and 'low investment' - these claims have a grain of truth in them, but the reality of FOREX is a bit more complex.
Advantages of Trading FOREX Over Stocks and Commodities
There are many advantages to Trading FOREX as your main income generator. Let's start by something that may be worrying you already.
"Do I need a Diploma or some kind of Certification to trade FOREX?" The answer is this:
When attempting to make more profit than losses on the fluctuation of exchange rates between major currencies (i.e., Trading the FOREX), nobody is going to ask you for a diploma, a formal license or verify the amount of hours you've spent studying the Foreign exchange market and banking industry. All you need is the proper training.
But this is not the only advantage you get when trading FOREX, compared to other ways of investment and speculation; i.e. Stocks and Commodities. You have a whole bunch of advantages over these other options that will be enumerated in the following paragraphs.
The Main Benefits of Trading the FX Spot Market:
1): FOREX is the largest financial market in the world.
With a daily trading volume of over $1.5 trillion, the spot FOREX market can absorb trading sizes that dwarf the capacity of any other market. In fact, when compared with the $50 billion daily market for equities or the $30 billion futures market, it becomes quickly apparent this gives you, and millions of other FOREX traders, almost infinite trading liquidity and flexibility.
2): FOREX is a TRUE 24-hour market.
The FOREX Market never sleeps. Trading positions can be entered and exited at any moment - around the globe, around the clock, six days a week. There is no waiting for an opening bell as in the case of trading stocks. It is a 24- hour, continuous electronic (ONLINE) currency exchange that never closes. This is very desirable for you if you want to trade on a part-time basis, because you can choose when you want to trade: morning, noon or night.
3): There is never a Bear Market in FOREX.
You can have access to a seamless, mutually-inclusive (two- way) exchange of currencies. Meaning, because currencies trade in "pairs" (for example, US dollar vs. yen or US dollar vs. Swiss franc), one side of every currency pair (for example, USD/JPY - JPY = YEN) is constantly moving in relation to the other. Thus, when you buy a particular currency, you are actually simultaneously selling the other currency in that particular pair. As the market moves, one of the currencies will increase in value versus the other. Of course, it is up to you to choose the correct currency to be long or short. Since currency trading always involves buying one currency and selling another, there is no structural bias to the market. This means you have equal potential to profit in both a rising or falling market.
4): High Leverage - up to 200:1 Leverage.
You are permitted to trade foreign currencies on a highly leveraged basis - up to 200 times your investment with some brokers. This is primarily attributed to the higher levels of liquidity within the currency markets. Standard 100,000- unit currency lots can be traded with as little as 1% margin, or $1,000. Mini FX accounts are permitted to trade with just 0.5% margin -- in other words, just $50 allows you to control a 10,000-unit currency position. Futures traders, who are accustomed to margin requirements generally equal to 5%-8% of the contract value, will immediately recognize that the FOREX market provides much greater leverage, and for stock traders, who must post at least 50% margin, thereâ??s no comparison. If you are looking for an efficient use of trading capital, this is it!
5): Price Movements Are Highly Predictable.
Although currency prices in the FX market may be volatile, they generally repeat themselves in relatively predictable cycles, creating trends. The strong trends that foreign currencies develop are a significant advantage for traders who use the correct "technical" methods.
Unlike stocks, currencies rarely spend much time in tight trading ranges and have the tendency to develop strong trends. Over 80% of volume is speculative in nature and, as a result, the market frequently overshoots and then corrects itself. As a technically-trained trader, you can easily identify new trends and breakouts, which provide for multiple opportunities to enter and exit positions.
6:) Commission-free Trading and Low Transaction Cost
When you trade FOREX, through one of our recommended brokers (this info is in our private resources section), you'll do it totally commission-free! These brokers don't charge commissions to trade or to maintain an account, and that goes for all clients trading the FOREX through them, regardless of your account balance or trading volume. Even Mini FX traders can buy and sell currencies online, commission-free.
What about trading fees? There are none of the usual fees to which futures and equity traders are accustomed -- no exchange or clearing fees, no N_F_A or S_E_C fees. Because currencies trade over-the-counter (OTC), via a global electronic network -- in FOREX, what you see is what you get, allowing you to make quick decisions on your trades without having to worry or account for fees that may affect your profit/loss or slippage.
In the equities markets, you must pay both a commission and exchange fees. The over-the-counter structure of the FX market eliminates exchange and clearing fees, which in turn lowers transaction costs.
So, if FOREX broker don't charge commissions, how do they make money? Like all traded financial products, over-the- counter currency trading involves a bid/ask spread, which represents the prices at which your counterparty is willing to trade. Because the currency market offers round-the-clock liquidity, you receive tight, competitive spreads both intra-day and night. Stock traders can be more vulnerable to liquidity risk and typically receive wider trading spreads, especially during after-hours trading.
7): Instantaneous Order Execution and Market Transparency.
Market transparency is highly desired in any trading environment. The greater the market transparency, the more efficient the market becomes. Unlike other markets where transparency is compromised (like in the Enron scandal), FOREX markets are highly transparent (i.e., analyzing countries, and having access to real-time research / news, is easier than companies).
Because of this transparency, as an FX trader, you will be able to exercise risk management strategies in accordance to the fundamental and technical indicators we teach at RapidForex.com
The FX market offers the highest level of market transparency out of all the financial markets. Because of this, order execution and fill confirmation usually occur in just 1-2 seconds. Markets that do not offer executable prices and force traders to absorb slippage obviously compromise the trader's profit potential considerably.
In the forex world, order execution is all-electronic and because you'll be trading via an Internet-based platform, instantaneous execution is routine. There are no exchanges, no traditional open-outcry pits, no floor brokers, and consequently, no delays.
http://www.1-forex.com
Omar Vargas
Forex trader and freelance writer
http://www.1-forex.com
MORE RESOURCES:
RELATED ARTICLES
Forex Scams: How to Spot Them A Mile Away
In recent years, investors have witnessed increased number of investment opportunities and offerings. While the complexity and success of these investment products vary, technological innovation has made the Forex market one of the fastest growth areas.
Trading Profitably on the Foreign Exchange Market
You may be asking yourself "how does one begin to trade profitably as a currency trader?".First, it is important to closely monitor foreign equity markets to attempt to predict or model how their respective currencies will perform against other currencies, ideally, currencies that are not very closely related, nor proportional, to the former currency.
Getting a Forex Trading Education
Many Americans are interested in getting involved in forex trading. Before doing this, you should get a forex trading education.
E-currency Exchange Trading
If you are reading this article you are probably one of the many people who have spent countless hours searching for unique ways to make money on the internet. Very few people have gone on to succeed and most have failed miserably time and time again.
FOREX Trading Philosophy
Keen on starting FOREX trading? Why would you not be? Many beginning FOREX traders are captivated by the allure of easy money. FOREX websites offer 'risk-free' trading, 'high returns' and 'low investment' - these claims have a grain of truth in them, but the reality of FOREX is a bit more complex.
Trade Entry Techniques
Most traders tend to concentrate on pinpointing the perfect entry for a trade. However, in reality the entry price is just one part of the equation.
Where to Get Forex Training
For those of you who are interested in forex trading, you may want to start off by getting some good forex training. Forex training is a necessity for anyone with this interest.
How To Handle A String Of Losses
Everybody hates to lose and unfortunately no one is blessed with the ability of foresight, therefore losses are an unavoidable part of trading. When we enter a trade we will either be right, or wrong, and even if we broke-even we'd still be classed as being wrong - as nobody enters into a trade just to break-even! When unsuccessful traders encounter a string of losses they begin to engage in self-destructive patterns that help them escape the pain they are experiencing.
Choosing A Forex Broker
With currency trading becoming ever more popular, the number of brokers is growing at a rapid rate. What should one look at when deciding which broker to open an account with? These are the important points to consider.
A Look at Forex Market Makers
The investor in the currency market takes for granted that a pair of currencies can be bought or sold at a moment's notice. Once an order is placed with a broker, the trade is executed within seconds.
Exploring the World of Day Trading
Are you looking into a career in day trading? In the past, the tools for day trading were available only to professionals. But thanks to the power of the Internet, everything you need to get started is now conveniently online.
Stock Market Report: Day Trading or Swing Trading Online? Stock Investing Information
Profitable day traders recognize that momentum trading is among the fastest & most effective ways to harvest BIG piles of cash in the stock market.The problem is that if you don't know what stocks to look for and how to approach them while limiting your risk, you won't even get close to making some profits.
The Yin and the Yang of Markets
I am reading a fantastic book on trading, first published in 1924, by Richard D. Wyckoff, titled "How I Trade and Invest in Stocks & Bonds".
The Secrets of the Super-Traders
The first and perhaps most important "secret" is to realize that your methodology or approach (no matter how good) is only part of being a highly successful trader. This applies to any trading style including, day trading, swing trading or position trading.
Day Trading - Moving Averages vs Support and Resistance
When day trading the SP and Nasdaq futures, do you rely on your moving averages more than your support & resistant areas?During the first hour of trading, the support and resistance zones on the SP and Nasdaq futures are the most important things to watch. The moving averages have not yet had a chance to come into play.
Online Stock Trading: Freedom of Trade
I remember the first time I started to trade online. It was just before the tech bubble of the late 1990's and the internet was still something new for most people.
Financial Crises, Global Capital Flows and the International Financial Architecture
The recent upheavals in the world financial markets were quelled by the immediate intervention of both international financial institutions such as the IMF and of domestic ones in the developed countries, such as the Federal Reserve in the USA. The danger seems to have passed, though recent tremors in South Korea, Brazil and Taiwan do not augur well.
Forex Broker Involvement Optional
To trade on the forex market, the largest financial market on the planet, one must use a forex broker. Not unlike a stock broker, a forex broker can also makes suggestions about which moves to make when exchanging foreign currency.
Intrenet Marketing VS Forex Currency Trading
Have you noticed that when someone's trying to sell you something - such as a system for making money - they always make it look far easier than it is? Let's look at two Internet businesses, almost as diametrically opposed as it's possible to be - Internet Marketing and Forex Currency Trading.You've probably heard the old Internet adage - build a better website and they will come.
Online Futures Trading - Advantages and Disadvantages
What Is Online Futures Trading?A futures contract is an agreement to buy or sell a commodity at a date in the future. Everything about a futures contract is standardized except its price.
"Do I need a Diploma or some kind of Certification to trade FOREX?" The answer is this:
When attempting to make more profit than losses on the fluctuation of exchange rates between major currencies (i.e., Trading the FOREX), nobody is going to ask you for a diploma, a formal license or verify the amount of hours you've spent studying the Foreign exchange market and banking industry. All you need is the proper training.
But this is not the only advantage you get when trading FOREX, compared to other ways of investment and speculation; i.e. Stocks and Commodities. You have a whole bunch of advantages over these other options that will be enumerated in the following paragraphs.
The Main Benefits of Trading the FX Spot Market:
1): FOREX is the largest financial market in the world.
With a daily trading volume of over $1.5 trillion, the spot FOREX market can absorb trading sizes that dwarf the capacity of any other market. In fact, when compared with the $50 billion daily market for equities or the $30 billion futures market, it becomes quickly apparent this gives you, and millions of other FOREX traders, almost infinite trading liquidity and flexibility.
2): FOREX is a TRUE 24-hour market.
The FOREX Market never sleeps. Trading positions can be entered and exited at any moment - around the globe, around the clock, six days a week. There is no waiting for an opening bell as in the case of trading stocks. It is a 24- hour, continuous electronic (ONLINE) currency exchange that never closes. This is very desirable for you if you want to trade on a part-time basis, because you can choose when you want to trade: morning, noon or night.
3): There is never a Bear Market in FOREX.
You can have access to a seamless, mutually-inclusive (two- way) exchange of currencies. Meaning, because currencies trade in "pairs" (for example, US dollar vs. yen or US dollar vs. Swiss franc), one side of every currency pair (for example, USD/JPY - JPY = YEN) is constantly moving in relation to the other. Thus, when you buy a particular currency, you are actually simultaneously selling the other currency in that particular pair. As the market moves, one of the currencies will increase in value versus the other. Of course, it is up to you to choose the correct currency to be long or short. Since currency trading always involves buying one currency and selling another, there is no structural bias to the market. This means you have equal potential to profit in both a rising or falling market.
4): High Leverage - up to 200:1 Leverage.
You are permitted to trade foreign currencies on a highly leveraged basis - up to 200 times your investment with some brokers. This is primarily attributed to the higher levels of liquidity within the currency markets. Standard 100,000- unit currency lots can be traded with as little as 1% margin, or $1,000. Mini FX accounts are permitted to trade with just 0.5% margin -- in other words, just $50 allows you to control a 10,000-unit currency position. Futures traders, who are accustomed to margin requirements generally equal to 5%-8% of the contract value, will immediately recognize that the FOREX market provides much greater leverage, and for stock traders, who must post at least 50% margin, thereâ??s no comparison. If you are looking for an efficient use of trading capital, this is it!
5): Price Movements Are Highly Predictable.
Although currency prices in the FX market may be volatile, they generally repeat themselves in relatively predictable cycles, creating trends. The strong trends that foreign currencies develop are a significant advantage for traders who use the correct "technical" methods.
Unlike stocks, currencies rarely spend much time in tight trading ranges and have the tendency to develop strong trends. Over 80% of volume is speculative in nature and, as a result, the market frequently overshoots and then corrects itself. As a technically-trained trader, you can easily identify new trends and breakouts, which provide for multiple opportunities to enter and exit positions.
6:) Commission-free Trading and Low Transaction Cost
When you trade FOREX, through one of our recommended brokers (this info is in our private resources section), you'll do it totally commission-free! These brokers don't charge commissions to trade or to maintain an account, and that goes for all clients trading the FOREX through them, regardless of your account balance or trading volume. Even Mini FX traders can buy and sell currencies online, commission-free.
What about trading fees? There are none of the usual fees to which futures and equity traders are accustomed -- no exchange or clearing fees, no N_F_A or S_E_C fees. Because currencies trade over-the-counter (OTC), via a global electronic network -- in FOREX, what you see is what you get, allowing you to make quick decisions on your trades without having to worry or account for fees that may affect your profit/loss or slippage.
In the equities markets, you must pay both a commission and exchange fees. The over-the-counter structure of the FX market eliminates exchange and clearing fees, which in turn lowers transaction costs.
So, if FOREX broker don't charge commissions, how do they make money? Like all traded financial products, over-the- counter currency trading involves a bid/ask spread, which represents the prices at which your counterparty is willing to trade. Because the currency market offers round-the-clock liquidity, you receive tight, competitive spreads both intra-day and night. Stock traders can be more vulnerable to liquidity risk and typically receive wider trading spreads, especially during after-hours trading.
7): Instantaneous Order Execution and Market Transparency.
Market transparency is highly desired in any trading environment. The greater the market transparency, the more efficient the market becomes. Unlike other markets where transparency is compromised (like in the Enron scandal), FOREX markets are highly transparent (i.e., analyzing countries, and having access to real-time research / news, is easier than companies).
Because of this transparency, as an FX trader, you will be able to exercise risk management strategies in accordance to the fundamental and technical indicators we teach at RapidForex.com
The FX market offers the highest level of market transparency out of all the financial markets. Because of this, order execution and fill confirmation usually occur in just 1-2 seconds. Markets that do not offer executable prices and force traders to absorb slippage obviously compromise the trader's profit potential considerably.
In the forex world, order execution is all-electronic and because you'll be trading via an Internet-based platform, instantaneous execution is routine. There are no exchanges, no traditional open-outcry pits, no floor brokers, and consequently, no delays.
http://www.1-forex.com
Omar Vargas
Forex trader and freelance writer
http://www.1-forex.com
MORE RESOURCES:
RELATED ARTICLES
Forex Scams: How to Spot Them A Mile Away
In recent years, investors have witnessed increased number of investment opportunities and offerings. While the complexity and success of these investment products vary, technological innovation has made the Forex market one of the fastest growth areas.
Trading Profitably on the Foreign Exchange Market
You may be asking yourself "how does one begin to trade profitably as a currency trader?".First, it is important to closely monitor foreign equity markets to attempt to predict or model how their respective currencies will perform against other currencies, ideally, currencies that are not very closely related, nor proportional, to the former currency.
Getting a Forex Trading Education
Many Americans are interested in getting involved in forex trading. Before doing this, you should get a forex trading education.
E-currency Exchange Trading
If you are reading this article you are probably one of the many people who have spent countless hours searching for unique ways to make money on the internet. Very few people have gone on to succeed and most have failed miserably time and time again.
FOREX Trading Philosophy
Keen on starting FOREX trading? Why would you not be? Many beginning FOREX traders are captivated by the allure of easy money. FOREX websites offer 'risk-free' trading, 'high returns' and 'low investment' - these claims have a grain of truth in them, but the reality of FOREX is a bit more complex.
Trade Entry Techniques
Most traders tend to concentrate on pinpointing the perfect entry for a trade. However, in reality the entry price is just one part of the equation.
Where to Get Forex Training
For those of you who are interested in forex trading, you may want to start off by getting some good forex training. Forex training is a necessity for anyone with this interest.
How To Handle A String Of Losses
Everybody hates to lose and unfortunately no one is blessed with the ability of foresight, therefore losses are an unavoidable part of trading. When we enter a trade we will either be right, or wrong, and even if we broke-even we'd still be classed as being wrong - as nobody enters into a trade just to break-even! When unsuccessful traders encounter a string of losses they begin to engage in self-destructive patterns that help them escape the pain they are experiencing.
Choosing A Forex Broker
With currency trading becoming ever more popular, the number of brokers is growing at a rapid rate. What should one look at when deciding which broker to open an account with? These are the important points to consider.
A Look at Forex Market Makers
The investor in the currency market takes for granted that a pair of currencies can be bought or sold at a moment's notice. Once an order is placed with a broker, the trade is executed within seconds.
Exploring the World of Day Trading
Are you looking into a career in day trading? In the past, the tools for day trading were available only to professionals. But thanks to the power of the Internet, everything you need to get started is now conveniently online.
Stock Market Report: Day Trading or Swing Trading Online? Stock Investing Information
Profitable day traders recognize that momentum trading is among the fastest & most effective ways to harvest BIG piles of cash in the stock market.The problem is that if you don't know what stocks to look for and how to approach them while limiting your risk, you won't even get close to making some profits.
The Yin and the Yang of Markets
I am reading a fantastic book on trading, first published in 1924, by Richard D. Wyckoff, titled "How I Trade and Invest in Stocks & Bonds".
The Secrets of the Super-Traders
The first and perhaps most important "secret" is to realize that your methodology or approach (no matter how good) is only part of being a highly successful trader. This applies to any trading style including, day trading, swing trading or position trading.
Day Trading - Moving Averages vs Support and Resistance
When day trading the SP and Nasdaq futures, do you rely on your moving averages more than your support & resistant areas?During the first hour of trading, the support and resistance zones on the SP and Nasdaq futures are the most important things to watch. The moving averages have not yet had a chance to come into play.
Online Stock Trading: Freedom of Trade
I remember the first time I started to trade online. It was just before the tech bubble of the late 1990's and the internet was still something new for most people.
Financial Crises, Global Capital Flows and the International Financial Architecture
The recent upheavals in the world financial markets were quelled by the immediate intervention of both international financial institutions such as the IMF and of domestic ones in the developed countries, such as the Federal Reserve in the USA. The danger seems to have passed, though recent tremors in South Korea, Brazil and Taiwan do not augur well.
Forex Broker Involvement Optional
To trade on the forex market, the largest financial market on the planet, one must use a forex broker. Not unlike a stock broker, a forex broker can also makes suggestions about which moves to make when exchanging foreign currency.
Intrenet Marketing VS Forex Currency Trading
Have you noticed that when someone's trying to sell you something - such as a system for making money - they always make it look far easier than it is? Let's look at two Internet businesses, almost as diametrically opposed as it's possible to be - Internet Marketing and Forex Currency Trading.You've probably heard the old Internet adage - build a better website and they will come.
Online Futures Trading - Advantages and Disadvantages
What Is Online Futures Trading?A futures contract is an agreement to buy or sell a commodity at a date in the future. Everything about a futures contract is standardized except its price.
Hedging Foreign Exchange Risks
The exchange rate of the Macedonian Denar against the major hard currencies of the world has remained stable in the last few years. Because of the IMF restrictions, the local Narodna (Central) Bank does not print money and there are no physical Denars in the economy and in the local banks.
Thus, even if people want to buy Foreign Exchange in the black market, or directly from the banks - they do not have the Denars to do it with.
The total amount of Denars (M1, in professional financing lingo) in the economy is around 200,000,000 USD, according to official figures. This translates into 100 USD per capita. Thus, even if each and every citizen of Macedonia were to decide to convert ALL their Denars to Deutsch Marks - they would still be able to buy only 150 DM each, on average. These tiny amounts are not sufficient to raise the rate at which DMs are exchanged for Denars (=the price of DMs in Denars).
But will this situation last forever?
According to economic theory scarcity raises the price of the scarce commodity. If Denars are rare - their price will remain high in DM terms, i.e. they will not be devalued against the stronger currency. The longer the Central Bank does not print Denars - the longer the exchange rate will be preserved.
But a strong currency (the Denar, in this case) is not always a positive thing.
The Denar is not strong because Macedonia is rich. The country is in a problematic economic situation. The banking system is perilous and unstable. The reserves of foreign exchange are minimal - less than 30 million USD.
The currency is stable because of externally imposed constraints and an artificial manipulation of the money supply.
Moreover, a strong currency makes goods produced in Macedonia relatively expensive in outside, export markets. Thus, it is difficult for Macedonian growers and manufacturers to export. When they sell their goods in Germany, they get DM for them and when they convert these receipts into Denars - they get less then they should have if the Denar reflected the true relative strengths of the two economies: the German one and the Macedonian one.
They pay expenses (e.g.: salaries to their workers, rent, utilities) in Denars. These expenses grow all the time as true inflation grows (as opposed to the official rate of inflation which is suspiciously low) - but they keep getting the same amount of Denars for their produce and products when they convert the DMs which they got for them.
On the other hand, imports to Macedonia become relatively cheaper: it takes less Denars to buy goods in DM in Germany, for instance.
Thus, the end result is a growing preference for imports and a decline in exports. In the long term, this increases unemployment. Export is the biggest driving force in creating jobs in modern economies. In its absence, economies stagnate and dwindle and people lose their jobs.
But an unrealistic exchange rate has at least two additional adverse effects:
One - as a rule, various sectors of the economy borrow money to survive and to expand.
If they expect the local currency to be devalued - they will refrain from taking long term credits denominated in hard currencies. They will prefer credits in local currency or short term credits in hard currencies. They will be afraid of a sudden, massive devaluation (such as the one which happened in Mexico overnight).
Their lenders will also be afraid to lend them money, because these lenders cannot be sure that the borrowers will have the necessary additional Denars to pay back the credits in case of such a devaluation. Naturally, a devaluation increases the amounts of Denars needed to pay back a loan in foreign currency.
This is bad from both the macro-economic vantage point (that of the economy as a whole) - and from the micro-economic point of view (that of the single firm).
From the micro-economic point of view short term credits have to be returned long before the businesses which borrowed them have matured to the point of being able to pay them back. These short term obligations burden them, alter their financial statements for the worse and sometimes put their very viability at risk.
From the macro-economic point of view, it is always better to have longer debt maturities with less to pay every year. The longer the credits a country (single firms are part of a country) has to pay back - the better its credit standing with the financial community.
Another aspect: foreign credits are a competition to credits provided by the local banking system. If firms and individuals do not take credits from the outside because they fear a devaluation - they help to create a monopoly of the local banks. Monopolies have a way of fixing the highest possible prices (=interest rates) for their merchandise (=the money they lend).
Access to foreign credits reduces domestic interest rates through competition with the local credit providers (=banks).
It would be easy to conclude, therefore, that it is an important interest of a country to be open to foreign financial markets and to provide its firms and citizens with access to sources of foreign credits.
One important way of encouraging people (and firms are made of people) to do things - is to allay their fears. If people fear devaluation - a responsible government can never promise not to devalue its currency. Devaluation is a very important policy tool. But the government can INSURE against a devaluation.
In many countries of the West, one can buy and sell insurance contracts called forwards. They promise the buyer a given rate of exchange in a given date.
But many countries do not have access to these highly sophisticated markets.
Not all the currencies can be insured in these markets. The Macedonian Denar, for instance, is not freely convertible, because it is not liquid: there are not enough Denars to respond to the needs of a free marketplace. So, it cannot be insured using these contracts.
These less privileged countries establish special agencies which provide (mainly export) firms with insurance against changes in the exchange rates in a prescribed period of time.
Let us examine an example:
The firm MAK buys combines and tractors from Germany. It has to pay in DMs.
An international development bank offered to MAK a loan to be paid back in 7 years time in DM.
Today, MAK would be so afraid of devaluation, that it would rather pay the supplier of the equipment as soon as it has cash. This creates cash flow problems at MAK: salaries are not paid on time, raw materials cannot be bought, production stops, MAK loses its traditional markets - and all in order to avoid the risks of devaluation.
But - what if the right government agency existed?
If governmental insurance against devaluation existed - MAK would surely take the 7 year loan. It would take, let's say, 10 million DM.
MAK would apply to the governmental agency with its business.
It would pay the government agency a yearly insurance fee of 2.5% of the remaining balances of the loan (as it is amortized and reduced with each monthly payment). This would be considered a proper financing expenditure and the firm will be allowed to deduct it from its taxable income.
The government will provide MAK with an insurance policy. An exchange rate (let us say, 30 Denars to the DM) will be stated in the policy.
If - at the time that MAK had to make a payment - the rate has gone above 30 Denars to the DM - the government will pay the difference to MAK in DM. This will enable MAK to meet its obligations to its creditors.
MAK will be able to cancel this insurance at any time. If, for instance, it suddenly signs a major contract with a German buyer of its products - it will have income in DM which it will be able to use to pay the loan back. Then, the government insurance will no longer be needed.
This very simple government assistance will have the following effects:
It will encourage firms to obtain foreign credits.
It will create competition to the local banks, reduce interest rates and encourage a wider and better range of services offered to the public.
It will encourage foreign financial institutions to give loans to local firms once the risk of re-payment problems due to a devaluation is minimised.
It will place Macedonia in the ranks of the more developed and export oriented countries of the world.
It will facilitate activities with longer term credits (such as modernization of plants for which longer terms of payments are required).
As time goes by, the private sector may step in and supply its own insurance against devaluation .
Insurance firms the world over do it - why not in Macedonia which needs it more than many other countries?
About The Author
Sam Vaknin is the author of "Malignant Self Love - Narcissism Revisited" and "After the Rain - How the West Lost the East". He is a columnist in "Central Europe Review", United Press International (UPI) and ebookweb.org and the editor of mental health and Central East Europe categories in The Open Directory, Suite101 and searcheurope.com. Until recently, he served as the Economic Advisor to the Government of Macedonia.
His web site: http://samvak.tripod.com
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Thus, even if people want to buy Foreign Exchange in the black market, or directly from the banks - they do not have the Denars to do it with.
The total amount of Denars (M1, in professional financing lingo) in the economy is around 200,000,000 USD, according to official figures. This translates into 100 USD per capita. Thus, even if each and every citizen of Macedonia were to decide to convert ALL their Denars to Deutsch Marks - they would still be able to buy only 150 DM each, on average. These tiny amounts are not sufficient to raise the rate at which DMs are exchanged for Denars (=the price of DMs in Denars).
But will this situation last forever?
According to economic theory scarcity raises the price of the scarce commodity. If Denars are rare - their price will remain high in DM terms, i.e. they will not be devalued against the stronger currency. The longer the Central Bank does not print Denars - the longer the exchange rate will be preserved.
But a strong currency (the Denar, in this case) is not always a positive thing.
The Denar is not strong because Macedonia is rich. The country is in a problematic economic situation. The banking system is perilous and unstable. The reserves of foreign exchange are minimal - less than 30 million USD.
The currency is stable because of externally imposed constraints and an artificial manipulation of the money supply.
Moreover, a strong currency makes goods produced in Macedonia relatively expensive in outside, export markets. Thus, it is difficult for Macedonian growers and manufacturers to export. When they sell their goods in Germany, they get DM for them and when they convert these receipts into Denars - they get less then they should have if the Denar reflected the true relative strengths of the two economies: the German one and the Macedonian one.
They pay expenses (e.g.: salaries to their workers, rent, utilities) in Denars. These expenses grow all the time as true inflation grows (as opposed to the official rate of inflation which is suspiciously low) - but they keep getting the same amount of Denars for their produce and products when they convert the DMs which they got for them.
On the other hand, imports to Macedonia become relatively cheaper: it takes less Denars to buy goods in DM in Germany, for instance.
Thus, the end result is a growing preference for imports and a decline in exports. In the long term, this increases unemployment. Export is the biggest driving force in creating jobs in modern economies. In its absence, economies stagnate and dwindle and people lose their jobs.
But an unrealistic exchange rate has at least two additional adverse effects:
One - as a rule, various sectors of the economy borrow money to survive and to expand.
If they expect the local currency to be devalued - they will refrain from taking long term credits denominated in hard currencies. They will prefer credits in local currency or short term credits in hard currencies. They will be afraid of a sudden, massive devaluation (such as the one which happened in Mexico overnight).
Their lenders will also be afraid to lend them money, because these lenders cannot be sure that the borrowers will have the necessary additional Denars to pay back the credits in case of such a devaluation. Naturally, a devaluation increases the amounts of Denars needed to pay back a loan in foreign currency.
This is bad from both the macro-economic vantage point (that of the economy as a whole) - and from the micro-economic point of view (that of the single firm).
From the micro-economic point of view short term credits have to be returned long before the businesses which borrowed them have matured to the point of being able to pay them back. These short term obligations burden them, alter their financial statements for the worse and sometimes put their very viability at risk.
From the macro-economic point of view, it is always better to have longer debt maturities with less to pay every year. The longer the credits a country (single firms are part of a country) has to pay back - the better its credit standing with the financial community.
Another aspect: foreign credits are a competition to credits provided by the local banking system. If firms and individuals do not take credits from the outside because they fear a devaluation - they help to create a monopoly of the local banks. Monopolies have a way of fixing the highest possible prices (=interest rates) for their merchandise (=the money they lend).
Access to foreign credits reduces domestic interest rates through competition with the local credit providers (=banks).
It would be easy to conclude, therefore, that it is an important interest of a country to be open to foreign financial markets and to provide its firms and citizens with access to sources of foreign credits.
One important way of encouraging people (and firms are made of people) to do things - is to allay their fears. If people fear devaluation - a responsible government can never promise not to devalue its currency. Devaluation is a very important policy tool. But the government can INSURE against a devaluation.
In many countries of the West, one can buy and sell insurance contracts called forwards. They promise the buyer a given rate of exchange in a given date.
But many countries do not have access to these highly sophisticated markets.
Not all the currencies can be insured in these markets. The Macedonian Denar, for instance, is not freely convertible, because it is not liquid: there are not enough Denars to respond to the needs of a free marketplace. So, it cannot be insured using these contracts.
These less privileged countries establish special agencies which provide (mainly export) firms with insurance against changes in the exchange rates in a prescribed period of time.
Let us examine an example:
The firm MAK buys combines and tractors from Germany. It has to pay in DMs.
An international development bank offered to MAK a loan to be paid back in 7 years time in DM.
Today, MAK would be so afraid of devaluation, that it would rather pay the supplier of the equipment as soon as it has cash. This creates cash flow problems at MAK: salaries are not paid on time, raw materials cannot be bought, production stops, MAK loses its traditional markets - and all in order to avoid the risks of devaluation.
But - what if the right government agency existed?
If governmental insurance against devaluation existed - MAK would surely take the 7 year loan. It would take, let's say, 10 million DM.
MAK would apply to the governmental agency with its business.
It would pay the government agency a yearly insurance fee of 2.5% of the remaining balances of the loan (as it is amortized and reduced with each monthly payment). This would be considered a proper financing expenditure and the firm will be allowed to deduct it from its taxable income.
The government will provide MAK with an insurance policy. An exchange rate (let us say, 30 Denars to the DM) will be stated in the policy.
If - at the time that MAK had to make a payment - the rate has gone above 30 Denars to the DM - the government will pay the difference to MAK in DM. This will enable MAK to meet its obligations to its creditors.
MAK will be able to cancel this insurance at any time. If, for instance, it suddenly signs a major contract with a German buyer of its products - it will have income in DM which it will be able to use to pay the loan back. Then, the government insurance will no longer be needed.
This very simple government assistance will have the following effects:
It will encourage firms to obtain foreign credits.
It will create competition to the local banks, reduce interest rates and encourage a wider and better range of services offered to the public.
It will encourage foreign financial institutions to give loans to local firms once the risk of re-payment problems due to a devaluation is minimised.
It will place Macedonia in the ranks of the more developed and export oriented countries of the world.
It will facilitate activities with longer term credits (such as modernization of plants for which longer terms of payments are required).
As time goes by, the private sector may step in and supply its own insurance against devaluation .
Insurance firms the world over do it - why not in Macedonia which needs it more than many other countries?
About The Author
Sam Vaknin is the author of "Malignant Self Love - Narcissism Revisited" and "After the Rain - How the West Lost the East". He is a columnist in "Central Europe Review", United Press International (UPI) and ebookweb.org and the editor of mental health and Central East Europe categories in The Open Directory, Suite101 and searcheurope.com. Until recently, he served as the Economic Advisor to the Government of Macedonia.
His web site: http://samvak.tripod.com
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An Evaluation of the Devaluation
A Minister of Finance is morally right to lie about a forthcoming devaluation and a woman has the right to lie about her age. This is the common wisdom.
Rumours about a devaluation of the Macedonian Denar versus the major currencies were in the air during the last few weeks. Still, no government official had to lie. The market just did not believe it. The unofficial exchange rate stayed put at 27 MKD to the Deutschmark even as the devaluation was taking place.
This is strange. Devaluation rumours are usually reflected in the street exchange rates. The MKD has held its turf against other currencies in the last three years. A devaluation seemed like a reasonable proposition - or was it?
Why do governments devalue?
They do it mainly to improve the balance of trade. A devaluation means that more local currency is needed to purchase imports and exporters get more local currency when they convert the export proceeds (the foreign exchange that they get for their exports). In other words: imports become more expensive - and exporters earn more money. This is supposed to discourage imports - and to encourage exports and, in turn, to reduce trade deficits.
At least, this is the older, conventional thinking. A devaluation is supposed to improve the competitiveness of exporters in their foreign markets. They can even afford to reduce their prices in their export markets and to finance this reduction from the windfall profits that they get from the devaluation. In professional jargon we say that a devaluation "improves the terms of trade".
But before we examine the question whether all this is true in the case of Macedonia - let us study a numerical example.
Let us assume that we have a national economy with for types of products:
Imported, Exported, Locally Produced Import Substitutes, Locally consumed Exportable Products. In an economy in equilibrium all four will be identically priced, let us say at 2700 Denars (= 100 DEM) each.
When the exchange rate is 27 MKD/DM, the total consumption of these products will not be influenced by their price. Rather, considerations of quality, availability, customer service, market positioning, status symbols and so on will influence the consumption decision.
But this will all change when the exchange rate is 31 MKD/DM following a devaluation.
The Imported product will now be sold locally at 3100. The Importer will have to pay more MKD to get the same amount of DM that he needs to pay the foreign manufacturer of the product that he is importing.
The Exported products will now fetch the exporter the same amount of income in foreign exchange. Yet, when converted to MKD - he will receive 400 MKD more than before the devaluation. He could use this money to increase his profits - or to reduce the price of his product in the foreign markets and sell more (which will also increase his profits).
The Locally Produced Import Substitutes will benefit: they will still be priced at 2700 - while the competition (Imports) will have to increase the price to 3100 not to lose money!
The local consumption of products which can, in principle, be exported - will go down. The exporter will prefer to export them and get more MKD for his foreign exchange earnings.
These are the subtle mechanisms by which exports go up and imports go down following a devaluation.
In Macedonia, the situation is less clear. There is a great component of imported raw materials in the exported industrial products. The price of this component will increase. The price of capital assets (machinery, technology, intellectual property, software) will also increase and make it more difficult for local businesses to invest in their future. Still, it is safe to say that the overall effect of the devaluation will favour exporters and exports and reduce imports marginally.
Unfortunately, most of the imports are indispensable at any price (inelastic demand curve): raw materials, capital assets, credits, even cars. People buy cars not only to drive them - but also in order to preserve the value of their money. Cars in Macedonia are a commodity and a store of value and these functions are difficult to substitute.
But this is all in an idealized country which really exists nowhere. In reality, devaluation tends to increase inflation (=the general price level) and thus have an adverse macro-economic effect. Six mechanisms operate immediately following a devaluation:
The price of imported products goes up.
The price of goods and services, denominated in foreign exchange goes up. An example: prices of apartments and residential and commercial rentals is fixed in DEM. These prices increase (in terms of MKD) by the percentage of devaluation - immediately! The same goes for consumer goods, big (cars) and small (electronics).
Exporters get more MKD for their foreign exchange (and this has an inflationary effect).
People can convert money that they saved in foreign exchange - and get more MKD for it. A DEVALUATION IS A PRIZE GIVEN TO SPECULATORS AND TO BLACK MARKET OPERATORS.
Thus, the cost of living increases. People put pressure on their employees to increase their salaries. Unfortunately, there is yet no example in history in which governments and employers were completely successful in fending off such pressures. Usually, they give in, wholly or partially.
Certain countries tried to contain such wage pressures and the wage driven inflation which is a result of wage increases.
The government, employee trade unions and representatives of employers' unions - sign "economic pacts or package deals".
The government undertakes not to raise fees for public services, the employers agree not to fire people or not to reduce wages and employee trade unions agree not to demand wage hikes and not to strike.
Such economic pacts have been very successful in stabilizing inflation in many countries, from Israel to Argentina.
Still, some of the devaluation inevitably seeps into the wages. The government can effectively control only such employees as are in its direct employment. It cannot dictate to the private sector.
Inflation gradually erodes the competitive advantage awarded to the exporters by the devaluation which preceded it. So devaluations have a tendency to create a cancerous chain reaction: devaluation-inflation followed by more devaluation and yet by more inflation.
Arguably, the worst effect of a devaluation is the psychological one.
Macedonia has succeeded where many other countries failed: it created an atmosphere of macro-economic stability. It is a fact that the differential between the official and non-official exchange rates was very small (about 3.5%). This was a sign of trust in the macro-economic management. This devaluation had the effects of drugs: it could prove stimulating to the economic body in the short term - but it might be harmful to it in the longer term.
These risks are worth taking under two conditions:
That the devaluation is part of a comprehensive economic program intended to stimulate the economy and mainly the export sector.
That the devaluation is part of a long term macro-monetary plan with clear, OPENLY DECLARED, goals. In other words: the government and the Central Bank should have designed a multi-year plan, stating clearly their inflation objectives and by how much they are going to devalue the currency (MKD) over and above the inflation target. This is much preferable to "shock therapy": keeping the devaluation secret until the last minute and then declaring it overnight, taking everyone by surprise. The instinctive reaction is: "But if the government announces its intentions in advance - people and speculators will rush to take advantage of these plans. For instance, they will buy foreign exchange and put pressure on the government to devalue by dilapidating its foreign currency reserves".
If so, why didn't it happen in Israel, Argentina, Chile and tens of other countries? In all these countries, the government announced inflation and devaluation targets well in advance. Surprisingly, it had the following effects:
The business sector was able to plan its operations years in advance, to price its products properly, to protect itself by buying financial hedge contracts. Suddenly, the business environment became safe and predictable. This had an extremely favourable micro-economic effect.
The currency stabilized and displayed qualities normally associated with "hard currencies". For instance, the New Israeli Shekel, which no one wanted to touch and which was immediately converted to US dollars (to protect the value) - became a national hit. It appreciated by 50% (!) against the dollar, people sold their dollars and bought Shekels - and all this with an inflation of 18% per year! It became a truly convertible currency - because people could predict its value over time.
The consistency, endurance and resilience of the governments in implementing their macro-economoic agendas - made the populace regain their trust. Citizens began to believe their governments again. The openness of the government, the transparency of its operations and the fact that it kept its word - meant a lot in restoring the right, trusting relationship which should prevail between subjects and their administration.
That strict measures are taken to prevent the metamorphosis of the devaluation into inflation. The usual measures include a freeze on all wages, a reduction of the budget deficit, even temporary anti-import protective barriers to defend the local industries and to reduce inflationary pressures.
Granted, the government of Macedonia and its Central Bank are not entirely autonomous in setting the economic priorities and in deciding which measures to adopt and to what extent. They have to attune themselves to "advice" (not to say dictates or conditions) given by the likes of the IMF. If they fail to do so, the IMF and the World Bank will cut Macedonia off the bloodlines of international credits. The situation is, at times, very close to coercion.
Still, Macedonia could use successful examples in other countries to argue its case. It could have made this devaluation a turning point for the economy. It could have reached a nationwide consensus to work towards a better economic future within a national "Economic Agenda". It is still not to late to do so. A devaluation should be an essential part of any economic program. It could still be the cornerstone in an export driven, employment oriented, economy stimulating edifice.
About The Author
Sam Vaknin is the author of "Malignant Self Love - Narcissism Revisited" and "After the Rain - How the West Lost the East". He is a columnist in "Central Europe Review", United Press International (UPI) and ebookweb.org and the editor of mental health and Central East Europe categories in The Open Directory, Suite101 and searcheurope.com. Until recently, he served as the Economic Advisor to the Government of Macedonia.
His web site: http://samvak.tripod.com
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Rumours about a devaluation of the Macedonian Denar versus the major currencies were in the air during the last few weeks. Still, no government official had to lie. The market just did not believe it. The unofficial exchange rate stayed put at 27 MKD to the Deutschmark even as the devaluation was taking place.
This is strange. Devaluation rumours are usually reflected in the street exchange rates. The MKD has held its turf against other currencies in the last three years. A devaluation seemed like a reasonable proposition - or was it?
Why do governments devalue?
They do it mainly to improve the balance of trade. A devaluation means that more local currency is needed to purchase imports and exporters get more local currency when they convert the export proceeds (the foreign exchange that they get for their exports). In other words: imports become more expensive - and exporters earn more money. This is supposed to discourage imports - and to encourage exports and, in turn, to reduce trade deficits.
At least, this is the older, conventional thinking. A devaluation is supposed to improve the competitiveness of exporters in their foreign markets. They can even afford to reduce their prices in their export markets and to finance this reduction from the windfall profits that they get from the devaluation. In professional jargon we say that a devaluation "improves the terms of trade".
But before we examine the question whether all this is true in the case of Macedonia - let us study a numerical example.
Let us assume that we have a national economy with for types of products:
Imported, Exported, Locally Produced Import Substitutes, Locally consumed Exportable Products. In an economy in equilibrium all four will be identically priced, let us say at 2700 Denars (= 100 DEM) each.
When the exchange rate is 27 MKD/DM, the total consumption of these products will not be influenced by their price. Rather, considerations of quality, availability, customer service, market positioning, status symbols and so on will influence the consumption decision.
But this will all change when the exchange rate is 31 MKD/DM following a devaluation.
The Imported product will now be sold locally at 3100. The Importer will have to pay more MKD to get the same amount of DM that he needs to pay the foreign manufacturer of the product that he is importing.
The Exported products will now fetch the exporter the same amount of income in foreign exchange. Yet, when converted to MKD - he will receive 400 MKD more than before the devaluation. He could use this money to increase his profits - or to reduce the price of his product in the foreign markets and sell more (which will also increase his profits).
The Locally Produced Import Substitutes will benefit: they will still be priced at 2700 - while the competition (Imports) will have to increase the price to 3100 not to lose money!
The local consumption of products which can, in principle, be exported - will go down. The exporter will prefer to export them and get more MKD for his foreign exchange earnings.
These are the subtle mechanisms by which exports go up and imports go down following a devaluation.
In Macedonia, the situation is less clear. There is a great component of imported raw materials in the exported industrial products. The price of this component will increase. The price of capital assets (machinery, technology, intellectual property, software) will also increase and make it more difficult for local businesses to invest in their future. Still, it is safe to say that the overall effect of the devaluation will favour exporters and exports and reduce imports marginally.
Unfortunately, most of the imports are indispensable at any price (inelastic demand curve): raw materials, capital assets, credits, even cars. People buy cars not only to drive them - but also in order to preserve the value of their money. Cars in Macedonia are a commodity and a store of value and these functions are difficult to substitute.
But this is all in an idealized country which really exists nowhere. In reality, devaluation tends to increase inflation (=the general price level) and thus have an adverse macro-economic effect. Six mechanisms operate immediately following a devaluation:
The price of imported products goes up.
The price of goods and services, denominated in foreign exchange goes up. An example: prices of apartments and residential and commercial rentals is fixed in DEM. These prices increase (in terms of MKD) by the percentage of devaluation - immediately! The same goes for consumer goods, big (cars) and small (electronics).
Exporters get more MKD for their foreign exchange (and this has an inflationary effect).
People can convert money that they saved in foreign exchange - and get more MKD for it. A DEVALUATION IS A PRIZE GIVEN TO SPECULATORS AND TO BLACK MARKET OPERATORS.
Thus, the cost of living increases. People put pressure on their employees to increase their salaries. Unfortunately, there is yet no example in history in which governments and employers were completely successful in fending off such pressures. Usually, they give in, wholly or partially.
Certain countries tried to contain such wage pressures and the wage driven inflation which is a result of wage increases.
The government, employee trade unions and representatives of employers' unions - sign "economic pacts or package deals".
The government undertakes not to raise fees for public services, the employers agree not to fire people or not to reduce wages and employee trade unions agree not to demand wage hikes and not to strike.
Such economic pacts have been very successful in stabilizing inflation in many countries, from Israel to Argentina.
Still, some of the devaluation inevitably seeps into the wages. The government can effectively control only such employees as are in its direct employment. It cannot dictate to the private sector.
Inflation gradually erodes the competitive advantage awarded to the exporters by the devaluation which preceded it. So devaluations have a tendency to create a cancerous chain reaction: devaluation-inflation followed by more devaluation and yet by more inflation.
Arguably, the worst effect of a devaluation is the psychological one.
Macedonia has succeeded where many other countries failed: it created an atmosphere of macro-economic stability. It is a fact that the differential between the official and non-official exchange rates was very small (about 3.5%). This was a sign of trust in the macro-economic management. This devaluation had the effects of drugs: it could prove stimulating to the economic body in the short term - but it might be harmful to it in the longer term.
These risks are worth taking under two conditions:
That the devaluation is part of a comprehensive economic program intended to stimulate the economy and mainly the export sector.
That the devaluation is part of a long term macro-monetary plan with clear, OPENLY DECLARED, goals. In other words: the government and the Central Bank should have designed a multi-year plan, stating clearly their inflation objectives and by how much they are going to devalue the currency (MKD) over and above the inflation target. This is much preferable to "shock therapy": keeping the devaluation secret until the last minute and then declaring it overnight, taking everyone by surprise. The instinctive reaction is: "But if the government announces its intentions in advance - people and speculators will rush to take advantage of these plans. For instance, they will buy foreign exchange and put pressure on the government to devalue by dilapidating its foreign currency reserves".
If so, why didn't it happen in Israel, Argentina, Chile and tens of other countries? In all these countries, the government announced inflation and devaluation targets well in advance. Surprisingly, it had the following effects:
The business sector was able to plan its operations years in advance, to price its products properly, to protect itself by buying financial hedge contracts. Suddenly, the business environment became safe and predictable. This had an extremely favourable micro-economic effect.
The currency stabilized and displayed qualities normally associated with "hard currencies". For instance, the New Israeli Shekel, which no one wanted to touch and which was immediately converted to US dollars (to protect the value) - became a national hit. It appreciated by 50% (!) against the dollar, people sold their dollars and bought Shekels - and all this with an inflation of 18% per year! It became a truly convertible currency - because people could predict its value over time.
The consistency, endurance and resilience of the governments in implementing their macro-economoic agendas - made the populace regain their trust. Citizens began to believe their governments again. The openness of the government, the transparency of its operations and the fact that it kept its word - meant a lot in restoring the right, trusting relationship which should prevail between subjects and their administration.
That strict measures are taken to prevent the metamorphosis of the devaluation into inflation. The usual measures include a freeze on all wages, a reduction of the budget deficit, even temporary anti-import protective barriers to defend the local industries and to reduce inflationary pressures.
Granted, the government of Macedonia and its Central Bank are not entirely autonomous in setting the economic priorities and in deciding which measures to adopt and to what extent. They have to attune themselves to "advice" (not to say dictates or conditions) given by the likes of the IMF. If they fail to do so, the IMF and the World Bank will cut Macedonia off the bloodlines of international credits. The situation is, at times, very close to coercion.
Still, Macedonia could use successful examples in other countries to argue its case. It could have made this devaluation a turning point for the economy. It could have reached a nationwide consensus to work towards a better economic future within a national "Economic Agenda". It is still not to late to do so. A devaluation should be an essential part of any economic program. It could still be the cornerstone in an export driven, employment oriented, economy stimulating edifice.
About The Author
Sam Vaknin is the author of "Malignant Self Love - Narcissism Revisited" and "After the Rain - How the West Lost the East". He is a columnist in "Central Europe Review", United Press International (UPI) and ebookweb.org and the editor of mental health and Central East Europe categories in The Open Directory, Suite101 and searcheurope.com. Until recently, he served as the Economic Advisor to the Government of Macedonia.
His web site: http://samvak.tripod.com
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How Do Other Countries Devalue Their Currencies?
Countries devalue their currencies only when they have no other way to correct past economic mistakes - whether their own or mistakes committed by their predecessors.
The ills of a devaluation are still at least equal to its advantages.
True, it does encourage exports and discourage imports to some extents and for a limited period of time. As the devaluation is manifested in a higher inflation, even this temporary relief is eroded. In a previous article in this paper I described WHY governments resort to such a drastic measure. This article will deal with HOW they do it.
A government can be forced into a devaluation by an ominous trade deficit. Thailand, Mexico, the Czech Republic - all devalued strongly, willingly or unwillingly, after their trade deficits exceeded 8% of the GDP. It can decide to devalue as part of an economic package of measures which is likely to include a freeze on wages, on government expenses and on fees charged by the government for the provision of public services. This, partly, has been the case in Macedonia. In extreme cases and when the government refuses to respond to market signals of economic distress - it may be forced into devaluation. International and local speculators will buy foreign exchange from the government until its reserves are depleted and it has no money even to import basic staples and other necessities.
Thus coerced, the government has no choice but to devalue and buy back dearly the foreign exchange that it has sold to the speculators cheaply.
In general, there are two known exchange rate systems: the floating and the fixed.
In the floating system, the local currency is allowed to fluctuate freely against other currencies and its exchange rate is determined by market forces within a loosely regulated foreign exchange domestic (or international) market. Such currencies need not necessarily be fully convertible but some measure of free convertibility is a sine qua non.
In the fixed system, the rates are centrally determined (usually by the Central Bank or by the Currency Board where it supplants this function of the Central Bank). The rates are determined periodically (normally, daily) and revolve around a "peg" with very tiny variations.
Life being more complicated than any economic system, there are no "pure cases".
Even in floating rate systems, Central banks intervene to protect their currencies or to move them to an exchange rate deemed favourable (to the country's economy) or "fair". The market's invisible hand is often handcuffed by "We-Know-Better" Central Bankers. This usually leads to disastrous (and breathtakingly costly) consequences. Suffice it to mention the Pound Sterling debacle in 1992 and the billion dollars made overnight by the arbitrageur-speculator Soros - both a direct result of such misguided policy and hubris.
Floating rates are considered a protection against deteriorating terms of trade.
If export prices fall or import prices surge - the exchange rate will adjust itself to reflect the new flows of currencies. The resulting devaluation will restore the equilibrium.
Floating rates are also good as a protection against "hot" (speculative) foreign capital looking to make a quick killing and vanish. As they buy the currency, speculators will have to pay more expensively, due to an upward adjustment in the exchange rates. Conversely, when they will try to cash their profits, they will be penalized by a new exchange rate.
So, floating rates are ideal for countries with volatile export prices and speculative capital flows. This characterizes most of the emerging economies (also known as the Third World).
It looks surprising that only a very small minority of these states has them until one recalls their high rates of inflation. Nothing like a fixed rate (coupled with consistent and prudent economic policies) to quell inflationary expectations. Pegged rates also help maintain a constant level of foreign exchange reserves, at least as long as the government does not stray from sound macro-economic management. It is impossible to over-estimate the importance of the stability and predictability which are a result of fixed rates: investors, businessmen and traders can plan ahead, protect themselves by hedging and concentrate on long term growth.
It is not that a fixed exchange rate is forever. Currencies - in all types of rate determination systems - move against one another to reflect new economic realities or expectations regarding such realities. Only the pace of changing the exchange rates is different.
Countries have invented numerous mechanisms to deal with exchange rates fluctuations.
Many countries (Argentina, Bulgaria) have currency boards. This mechanism ensures that all the local currency in circulation is covered by foreign exchange reserves in the coffers of the Central bank. All, government, and Central Bank alike - cannot print money and must operate within the straitjacket.
Other countries peg their currency to a basket of currencies. The composition of this basket is supposed to reflect the composition of the country's international trade. Unfortunately, it rarely does and when it does, it is rarely updated (as is the case in Israel). Most countries peg their currencies to arbitrary baskets of currencies in which the dominant currency is a "hard, reputable" currency such as the US dollar. This is the case with the Thai baht.
In Slovakia the basket is made up of two currencies only (40% dollar and 60% DEM) and the Slovak crown is free to move 7% up and down, around the basket-peg.
Some countries have a "crawling peg". This is an exchange rate, linked to other currencies, which is fractionally changed daily. The currency is devalued at a rate set in advance and made known to the public (transparent). A close variant is the "crawling band" (used in Israel and in some countries in South America). The exchange rate is allowed to move within a band, above and below a central peg which, in itself depreciates daily at a preset rate.
This pre-determined rate reflects a planned real devaluation over and above the inflation rate.
It denotes the country's intention to encourage its exports without rocking the whole monetary boat. It also signals to the markets that the government is bent on taming inflation.
So, there is no agreement among economists. It is clear that fixed rate systems have cut down inflation almost miraculously. The example of Argentina is prominent: from 27% a month (1991) to 1% a year (1997)!!!
The problem is that this system creates a growing disparity between the stable exchange rate - and the level of inflation which goes down slowly. This, in effect, is the opposite of devaluation - the local currency appreciates, becomes stronger. Real exchange rates strengthen by 42% (the Czech Republic), 26% (Brazil), even 50% (Israel until lately, despite the fact that the exchange rate system there is hardly fixed). This has a disastrous effect on the trade deficit: it balloons and consumes 4-10% of the GDP.
This phenomenon does not happen in non-fixed systems. Especially benign are the crawling peg and the crawling band systems which keep apace with inflation and do not let the currency appreciate against the currencies of major trading partners. Even then, the important question is the composition of the pegging basket. If the exchange rate is linked to one major currency - the local currency will appreciate and depreciate together with that major currency. In a way the inflation of the major currency is thus imported through the foreign exchange mechanism. This is what happened in Thailand when the dollar got stronger in the world markets.
In other words, the design of the pegging and exchange rate system is the crucial element.
In a crawling band system - the wider the band, the less the volatility of the exchange rate. This European Monetary System (EMS - ERM), known as "The Snake", had to realign itself a few times during the 1990s and each time the solution was to widen the bands within which the exchange rates were allowed to fluctuate. Israel had to do it twice. On June 18th, the band was doubled and the Shekel can go up and down by 10% in each direction.
But fixed exchange rates offer other problems. The strengthening real exchange rate attracts foreign capital. This is not the kind of foreign capital that countries are looking for. It is not Foreign Direct Investment (FDI). It is speculative, hot money in pursuit of ever higher returns. It aims to benefit from the stability of the exchange rate - and from the high interest rates paid on deposits in local currency.
Let us study an example: if a foreign investor were to convert 100,000 DEM to Israeli Shekels last year and invest them in a liquid deposit with an Israeli bank - he will have ended up earning an interest rate of 12% annually. The exchange rate did not change appreciably - so he would have needed the same amount of Shekels to buy his DEM back. On his Shekel deposit he would have earned between 12-16%, all net, tax free profit.
No wonder that Israel's foreign exchange reserves doubled themselves in the preceding 18 months. This phenomenon happened all over the globe, from Mexico to Thailand.
This kind of foreign capital expands the money supply (it is converted to local currency) and - when it suddenly evaporates - prices and wages collapse. Thus it tends to exacerbate the natural inflationary-deflationary cycles in emerging economies. Measures like control on capital inflows, taxing them are useless in a global economy with global capital markets.
They also deter foreign investors and distort the allocation of economic resources.
The other option is "sterilization": selling government bonds and thus absorbing the monetary overflow or maintaining high interest rates to prevent a capital drain. Both measures have adverse economic effects, tend to corrupt and destroy the banking and financial infrastructure and are expensive while bringing only temporary relief.
Where floating rate systems are applied, wages and prices can move freely. The market mechanisms are trusted to adjust the exchange rates. In fixed rate systems, taxes move freely. The state, having voluntarily given up one of the tools used in fine tuning the economy (the exchange rate) - must resort to fiscal rigor, tightening fiscal policy (=collect more taxes) to absorb liquidity and rein in demand when foreign capital comes flowing in.
In the absence of fiscal discipline, a fixed exchange rate will explode in the face of the decision makers either in the form of forced devaluation or in the form of massive capital outflows.
After all, what is wrong with volatile exchange rates? Why must they be fixed, save for psychological reasons? The West has never prospered as it does nowadays, in the era of floating rates. Trade, investment - all the areas of economic activity which were supposed to be influenced by exchange rate volatility - are experiencing a continuous big bang. That daily small fluctuations (even in a devaluation trend) are better than a big one time devaluation in restoring investor and business confidence is an axiom. That there is no such thing as a pure floating rate system (Central Banks always intervene to limit what they regard as excessive fluctuations) - is also agreed on all economists.
That exchange rate management is no substitute for sound macro- and micro-economic practices and policies - is the most important lesson. After all, a currency is the reflection of the country in which it is legal tender. It stores all the data about that country and their appraisal. A currency is a unique package of past and future with serious implications on the present.
About The Author
Sam Vaknin is the author of "Malignant Self Love - Narcissism Revisited" and "After the Rain - How the West Lost the East". He is a columnist in "Central Europe Review", United Press International (UPI) and ebookweb.org and the editor of mental health and Central East Europe categories in The Open Directory, Suite101 and searcheurope.com. Until recently, he served as the Economic Advisor to the Government of Macedonia.
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The ills of a devaluation are still at least equal to its advantages.
True, it does encourage exports and discourage imports to some extents and for a limited period of time. As the devaluation is manifested in a higher inflation, even this temporary relief is eroded. In a previous article in this paper I described WHY governments resort to such a drastic measure. This article will deal with HOW they do it.
A government can be forced into a devaluation by an ominous trade deficit. Thailand, Mexico, the Czech Republic - all devalued strongly, willingly or unwillingly, after their trade deficits exceeded 8% of the GDP. It can decide to devalue as part of an economic package of measures which is likely to include a freeze on wages, on government expenses and on fees charged by the government for the provision of public services. This, partly, has been the case in Macedonia. In extreme cases and when the government refuses to respond to market signals of economic distress - it may be forced into devaluation. International and local speculators will buy foreign exchange from the government until its reserves are depleted and it has no money even to import basic staples and other necessities.
Thus coerced, the government has no choice but to devalue and buy back dearly the foreign exchange that it has sold to the speculators cheaply.
In general, there are two known exchange rate systems: the floating and the fixed.
In the floating system, the local currency is allowed to fluctuate freely against other currencies and its exchange rate is determined by market forces within a loosely regulated foreign exchange domestic (or international) market. Such currencies need not necessarily be fully convertible but some measure of free convertibility is a sine qua non.
In the fixed system, the rates are centrally determined (usually by the Central Bank or by the Currency Board where it supplants this function of the Central Bank). The rates are determined periodically (normally, daily) and revolve around a "peg" with very tiny variations.
Life being more complicated than any economic system, there are no "pure cases".
Even in floating rate systems, Central banks intervene to protect their currencies or to move them to an exchange rate deemed favourable (to the country's economy) or "fair". The market's invisible hand is often handcuffed by "We-Know-Better" Central Bankers. This usually leads to disastrous (and breathtakingly costly) consequences. Suffice it to mention the Pound Sterling debacle in 1992 and the billion dollars made overnight by the arbitrageur-speculator Soros - both a direct result of such misguided policy and hubris.
Floating rates are considered a protection against deteriorating terms of trade.
If export prices fall or import prices surge - the exchange rate will adjust itself to reflect the new flows of currencies. The resulting devaluation will restore the equilibrium.
Floating rates are also good as a protection against "hot" (speculative) foreign capital looking to make a quick killing and vanish. As they buy the currency, speculators will have to pay more expensively, due to an upward adjustment in the exchange rates. Conversely, when they will try to cash their profits, they will be penalized by a new exchange rate.
So, floating rates are ideal for countries with volatile export prices and speculative capital flows. This characterizes most of the emerging economies (also known as the Third World).
It looks surprising that only a very small minority of these states has them until one recalls their high rates of inflation. Nothing like a fixed rate (coupled with consistent and prudent economic policies) to quell inflationary expectations. Pegged rates also help maintain a constant level of foreign exchange reserves, at least as long as the government does not stray from sound macro-economic management. It is impossible to over-estimate the importance of the stability and predictability which are a result of fixed rates: investors, businessmen and traders can plan ahead, protect themselves by hedging and concentrate on long term growth.
It is not that a fixed exchange rate is forever. Currencies - in all types of rate determination systems - move against one another to reflect new economic realities or expectations regarding such realities. Only the pace of changing the exchange rates is different.
Countries have invented numerous mechanisms to deal with exchange rates fluctuations.
Many countries (Argentina, Bulgaria) have currency boards. This mechanism ensures that all the local currency in circulation is covered by foreign exchange reserves in the coffers of the Central bank. All, government, and Central Bank alike - cannot print money and must operate within the straitjacket.
Other countries peg their currency to a basket of currencies. The composition of this basket is supposed to reflect the composition of the country's international trade. Unfortunately, it rarely does and when it does, it is rarely updated (as is the case in Israel). Most countries peg their currencies to arbitrary baskets of currencies in which the dominant currency is a "hard, reputable" currency such as the US dollar. This is the case with the Thai baht.
In Slovakia the basket is made up of two currencies only (40% dollar and 60% DEM) and the Slovak crown is free to move 7% up and down, around the basket-peg.
Some countries have a "crawling peg". This is an exchange rate, linked to other currencies, which is fractionally changed daily. The currency is devalued at a rate set in advance and made known to the public (transparent). A close variant is the "crawling band" (used in Israel and in some countries in South America). The exchange rate is allowed to move within a band, above and below a central peg which, in itself depreciates daily at a preset rate.
This pre-determined rate reflects a planned real devaluation over and above the inflation rate.
It denotes the country's intention to encourage its exports without rocking the whole monetary boat. It also signals to the markets that the government is bent on taming inflation.
So, there is no agreement among economists. It is clear that fixed rate systems have cut down inflation almost miraculously. The example of Argentina is prominent: from 27% a month (1991) to 1% a year (1997)!!!
The problem is that this system creates a growing disparity between the stable exchange rate - and the level of inflation which goes down slowly. This, in effect, is the opposite of devaluation - the local currency appreciates, becomes stronger. Real exchange rates strengthen by 42% (the Czech Republic), 26% (Brazil), even 50% (Israel until lately, despite the fact that the exchange rate system there is hardly fixed). This has a disastrous effect on the trade deficit: it balloons and consumes 4-10% of the GDP.
This phenomenon does not happen in non-fixed systems. Especially benign are the crawling peg and the crawling band systems which keep apace with inflation and do not let the currency appreciate against the currencies of major trading partners. Even then, the important question is the composition of the pegging basket. If the exchange rate is linked to one major currency - the local currency will appreciate and depreciate together with that major currency. In a way the inflation of the major currency is thus imported through the foreign exchange mechanism. This is what happened in Thailand when the dollar got stronger in the world markets.
In other words, the design of the pegging and exchange rate system is the crucial element.
In a crawling band system - the wider the band, the less the volatility of the exchange rate. This European Monetary System (EMS - ERM), known as "The Snake", had to realign itself a few times during the 1990s and each time the solution was to widen the bands within which the exchange rates were allowed to fluctuate. Israel had to do it twice. On June 18th, the band was doubled and the Shekel can go up and down by 10% in each direction.
But fixed exchange rates offer other problems. The strengthening real exchange rate attracts foreign capital. This is not the kind of foreign capital that countries are looking for. It is not Foreign Direct Investment (FDI). It is speculative, hot money in pursuit of ever higher returns. It aims to benefit from the stability of the exchange rate - and from the high interest rates paid on deposits in local currency.
Let us study an example: if a foreign investor were to convert 100,000 DEM to Israeli Shekels last year and invest them in a liquid deposit with an Israeli bank - he will have ended up earning an interest rate of 12% annually. The exchange rate did not change appreciably - so he would have needed the same amount of Shekels to buy his DEM back. On his Shekel deposit he would have earned between 12-16%, all net, tax free profit.
No wonder that Israel's foreign exchange reserves doubled themselves in the preceding 18 months. This phenomenon happened all over the globe, from Mexico to Thailand.
This kind of foreign capital expands the money supply (it is converted to local currency) and - when it suddenly evaporates - prices and wages collapse. Thus it tends to exacerbate the natural inflationary-deflationary cycles in emerging economies. Measures like control on capital inflows, taxing them are useless in a global economy with global capital markets.
They also deter foreign investors and distort the allocation of economic resources.
The other option is "sterilization": selling government bonds and thus absorbing the monetary overflow or maintaining high interest rates to prevent a capital drain. Both measures have adverse economic effects, tend to corrupt and destroy the banking and financial infrastructure and are expensive while bringing only temporary relief.
Where floating rate systems are applied, wages and prices can move freely. The market mechanisms are trusted to adjust the exchange rates. In fixed rate systems, taxes move freely. The state, having voluntarily given up one of the tools used in fine tuning the economy (the exchange rate) - must resort to fiscal rigor, tightening fiscal policy (=collect more taxes) to absorb liquidity and rein in demand when foreign capital comes flowing in.
In the absence of fiscal discipline, a fixed exchange rate will explode in the face of the decision makers either in the form of forced devaluation or in the form of massive capital outflows.
After all, what is wrong with volatile exchange rates? Why must they be fixed, save for psychological reasons? The West has never prospered as it does nowadays, in the era of floating rates. Trade, investment - all the areas of economic activity which were supposed to be influenced by exchange rate volatility - are experiencing a continuous big bang. That daily small fluctuations (even in a devaluation trend) are better than a big one time devaluation in restoring investor and business confidence is an axiom. That there is no such thing as a pure floating rate system (Central Banks always intervene to limit what they regard as excessive fluctuations) - is also agreed on all economists.
That exchange rate management is no substitute for sound macro- and micro-economic practices and policies - is the most important lesson. After all, a currency is the reflection of the country in which it is legal tender. It stores all the data about that country and their appraisal. A currency is a unique package of past and future with serious implications on the present.
About The Author
Sam Vaknin is the author of "Malignant Self Love - Narcissism Revisited" and "After the Rain - How the West Lost the East". He is a columnist in "Central Europe Review", United Press International (UPI) and ebookweb.org and the editor of mental health and Central East Europe categories in The Open Directory, Suite101 and searcheurope.com. Until recently, he served as the Economic Advisor to the Government of Macedonia.
His web site: http://samvak.tripod.com
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Principle 1
Some currency traders find that it is useful to always trade a given currency pair at the very same time every day. The reasoning for this is that most of the other traders buying or selling that currency pair may also trade at the same time. Major trading pits may also be working the exact same shift every day. This technique may be especially useful for currency traders who exploit technical analysis. Again, the reasoning for this is that it may be possible to standardize the trading conditions if one trades during the same time frame every day, if only for a very little bit. However, that small bit of standardization may yield several pips worth of profit. Nevertheless, it is readily obvious that the foreign exchange market can be very volatile and random.
Principle 2
Certain currencies trade with a certain volatility at a certain time. Once you've finished practicing your trading skills on a demo account and you decide to test the waters using your own investment capital, you may want to minimize the amount of liquidity and volatility to hedge your risk. Alternatively, you may want to increase the risk involved, and potentially increase your profit potential. (It should be noted that very heavy risk is involved under any circumstances.)
The foreign exchange market follows the sun around the world moving from the United States to Australia and New Zealand to the Far East, to Europe and finally back to the United States. Overall foreign currency trading volume is determined by which markets are open and the overlap in the times that these markets are open. Currency trading volume is relatively high 24 hours a day, but there are considerable peaks in activity when the British, European, and US markets are open simultaneously, which is from 1 pm GMT to 4 pm GMT. Pacific Rim markets, such as Japan and Hong Kong, show a dip in their trading volume while there is extensive volume in the US market at the very same time. Nevertheless, it is still possible to perform technical analysis on Pacific Rim currencies. By trading during a certain time frame, one may be able to either minimize or maximize the level of volatility (and risk) for a given currency pair.
Principle 3
Although the above is a general statement about the activity volume for certain currencies, it may be a good idea to attempt to capture the level of volatility for given currency pairs. You can potentially use Bollinger bands, a tool used by technical analysts, to quantify volatility. Bollinger bands compare volatility and relative price levels over time. Some currency traders cannot trade a day in their life without using Bollinger bands, while others may not find any use for them; it is really up to you to decide whether Bollinger bands are of any use to your specific situation.
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The forex options market started as an over-the-counter (OTC) financial vehicle for large banks, financial institutions and large international corporations to hedge against foreign currency exposure. Like the forex spot market, the forex options market is considered an "interbank" market.
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