American Terms/European Terms
American Terms
When the USD is the numerator
European Terms
When the USD is the denominator.
→ NOTE:
In a ratio, the numerator number before the backslash, and the denominator is the number after
the backslash, i.e. numerator/denominator.
→ EXAMPLE:
USD/CHF (American terms)
EUR/USD (European terms
Base/Quote/Terms/Secondary Currency
Base Currency
In Forex markets, the base currency is the first currency in a currency pair (a quotation of two different
currencies, depicting how many units of the counter currency are needed to buy one unit of the base
currency).
Quote Currency
The quote currency is the second currency quoted in a currency pair. In a direct quote, the quote
currency is the domestic currency. In an indirect quote, the quote currency is the domestic currency.
Terms Currency
Terms currency is another way to refer to a quote currency—a currency quotation shows how many
units of the terms currency will equal 1 unit of the base currency.
Secondary Currency
Also known as ‘variable currency’ or ‘counter currency’, the secondary currency is the currency that the
investor trades the base currency against (i.e. USD in EUR/USD).
→ EXAMPLES:
(1)
Australian Dollar (AUD) against United States Dollar (USD): AUD/USD 0.6660
Australian Dollars is the base currency, and US Dollars is the terms currency. One Australian Dollar is
equal to 0.666 US Dollar (66.6 US cents).
(2)
EUR/USD = 1.35
EUR = Base Currency
USD = Counter Currency
Price = to buy one Euro you will need to spend $1.35US
If a quotation goes up then it means that the base currency is getting stronger vis-à-vis the counter
currency.
(3)
EUR/USD = 1.6
Now, one euro is exchanges for $1.6US.
If a quotation goes down then it means that the base currency is getting weaker vis-à-vis the counter
currency.
(4)
EUR/USD = 1.2
Now, one euro is exchanges for $1.2US.
Bid/Ask Spread
Bid/Ask Spread
Like in the securities markets, the forex markets have a bid price (the price at which a broker is willing to
buy the base currency) and an ask price (the price at which a broker is willing to sell the base
currency). When you enter into a forex transaction you buy at the ask and you sell at the bid. The
difference between the bid price and the ask price is the spread. Spreads are usually quoted in pips.
→ EXAMPLE:
EUR/USD = 1.2345/1.2349
Bid= 1.2345; Ask = 1.2349; Spread = 0.0004 (4 pips)
May also be quoted in the following manner:
EUR/USD = 1.2345/49 /USD = 45/49
→ Why does bid/ask spread matter?
The spread matters because this effectively indicates how much a currency pair must move before the
position becomes profitable for the trader. If there is a large spread then the currency pair will need to
move further in order to make a profit. It the spread is small (as in many of the “major” currencies) then
the movement needed for a position to become profitable is much smaller.
Collateral/Security Deposit/Margin
Collateral/Security Deposit/Margin
Margin, also called collateral or security deposit, is the amount that must be deposited in a trading
account in order to control a lot of a currency. If the leverage in the account is 100:1, then the margin
required will be 1% of the value of the lot. If the leverage in the account is 200:1, then the margin
required will be 0.5% of the value of the lot.
Forex Counterparty & Regulated Entities
Forex Counterparty & Regulated Entities
Counterparties or dealers act as counterparties to off-exchange retail forex transactions.
Examples of counterparties are Futures Commission Merchants (FCMs), Retail Foreign
Exchange Dealer (RFEDs), and other regulated entities listed in the Commodity Exchange Act
Futures Commission Merchant (FCM)
The term “futures commission merchant” means an individual, association, partnership,
corporation, or trust that:
(A) is engaged in soliciting or in accepting orders for the purchase or sale of any commodity for
future delivery on or subject to the rules of any contract market or derivatives transaction
execution facility;
and
(B) is in or in connection with such solicitation or acceptance of orders, accepts any money,
securities, or property (or extends credit in lieu thereof) to margin, guarantee, or secure any
trades or contracts that result or may result there from.
Retail Forex Exchange Dealer (RFED)
A retail forex exchange dealer is a firm acting only as the counterparty to retail off-exchange
foreign exchange contracts. These firms will be required to register as Retail Foreign Exchange
Dealers (RFEDs).
→ NOTE:
An RFED or an FCM that is substantially engaged in on-exchange activities and acts as a retail
forex counterparty will be designated under NFA rules as an approved forex dealer member
(FDM) of NFA.
Forex Dealer Member
The term “forex dealer member” is not defined in the Commodities Exchange Act (CEA) and is
not a specific CFTC registration category. The term “forex dealer member” was simply created
by the NFA. In general, forex dealer members are NFA Members who act as counterparties to
forex transactions. This is a self-executing requirement, which means that any NFA Member
who qualifies is automatically a forex dealer member. There is no application form and no
approval requirement.
Commodity Pool Operator (CPO)
A CPO is a person engaged in a business similar to an investment trust or a syndicate and who
solicits or accepts funds, securities, or property for the purpose of trading commodity futures
contracts or commodity options. The commodity pool operator either itself makes trading
decisions on behalf of the pool or engages a commodity trading advisor (CTA) to do so.
Commodity Trading Advisor (CTA)
A CTA is a person who, for pay, regularly engages in the business of advising others as to the
value of commodity futures or options or the advisability of trading in commodity futures or
options, or issues analyses or reports concerning commodity futures or options.
Associated Person (AP)
An AP is an individual who solicits or accepts (other than in a clerical capacity) orders,
discretionary accounts, or participation in a commodity pool, or supervises any individual so
engaged, on behalf of a futures commission merchant, an introducing broker, a commodity
trading advisor, a commodity pool operator, or an agricultural trade option merchant.
Principal
A principal of a firm is:
a sole proprietor of a sole proprietorship or a general partner of a partnership;
a director, president, CEO, COO, CFO, or a person in charge of a business unit, division
or function subject to regulation by CFTC of a corporation, limited liability company or
limited partnership; or
a manager, managing member, or a member vested with the management authority for a limited
liability company or limited liability partnership; or an individual who directly or indirectly,
through agreement, holding companies, nominees, trusts or otherwise:
is the owner of 10% or more of the outstanding shares of any class of an entity’s stock;
is entitled to vote 10% or more of any class of an entity’s voting securities;
has the power to sell or direct the sale of 10% or more of any class of an entity’s voting
securities;
has contributed 10% or more of an applicant or registrant’s capital;
is entitled to receive 10% or more of an applicant or registrant’s net profits; or
has the power to exercise a controlling influence over an applicant or registrant’s
activities that are subject to regulation by the Commission; or
an entity that
is a general partner of a partnership;
is the direct owner of 10% or more of any class of an entity’s securities; or
has directly contributed 10% or more of an applicant or registrant’s capital unless such
capital contribution consists of subordinated debt contributed by:
an unaffiliated bank insured by the Federal Deposit Insurance Corporation;
a United States branch or agency of an unaffiliated foreign bank that is licensed under the
laws of the United States and regulated, supervised and examined by United States
government authorities having regulatory responsibility for such financial institutions; or
an insurance company subject to regulation by any State.
Introducing Broker (IB)
An IB is a firm or individual that solicits and accepts futures orders from customers but does not
accept money, securities or property from the customer. An IB must be registered with the CFTC
and must carry all of its accounts through an FCM on a fully disclosed basis. The new CFTC
rules have made it a requirement for all introducing broker to be guaranteed by an FCM. This
type of IB has no minimum capital or financial reporting requirements. All of the accounts of a
guaranteed IB must be carried by the guaranteeing FCM.
Cross Rates
Cross Rates
These are basically the exchange rate of two currencies when the USD is not involved. There are
times when a person may want to trade a currency against another currency but the currency pair
is not offered through the FDM. In these instances, a trader wishing to execute such a trade will
need to do so by making a trade in the middle. This practice is called a cross trade (the exchange
rate on a cross trade is referred to as cross rates). Cross trades take place automatically through
your FCM/FDM, and some are quoted automatically.
Common Crosses are:
CHF/JPY
EUR/GBP
EUR/JPY
EUR/CHF
→ EXAMPLE:
If someone in the US wants to make a EUR/JPY trade and it is not available at the FDM the
trader will need to:
Buy USD/JPY
Then buy EUR/USD
Currency Crosses
Currency Crosses
Currency pairs which do not involve the USD. Currency crosses that use the Euro are called
“Euro crosses.” Currency crosses are less liquid than the major crosses and trading hours may
be restricted. They represent a smaller portion of the foreign exchange markets.
→ EXAMPLE: GBP/JPY
Currency Pair
Currency Pair
This is the individual product being bought by and sold to the customer. It is a quotation of two
different currencies. The base currency (first currency also called the transaction currency) is
traded against the secondary currency (also known as the counter currency, quote currency or
payment currency). The currency pair is priced in terms of the base currency expressed in the
secondary currency.
Direct Quote & Indirect Quote
Direct Quote
This is the amount of one currency (the local currency) needed to purchase one unit of a foreign
currency. Domestic currency is the base currency and is in the terms of one unit.
Indirect Quote
This is the amount of one currency (the local currency) you get when you sell one unit of a
foreign currency. Domestic currency is the counter currency and is in the terms of one unit.
→ EXAMPLE:
For US person a direct quote would be USD/EUR.
For US person an indirect quote would be EUR/USD.
Direct quotation: 1 foreign currency unit = x home currency units
Indirect quotation: 1 home currency unit = x foreign currency units
For more information see: http://en.wikipedia.org/wiki/Exchange_rate
Exchange Rate
Exchange Rate
This is the rate at which one currency can be converted into another.
→ EXAMPLE:
An exchange rate of 102 Japanese yen (JPY, ¥) to the United States dollar (USD, $)
This can also be expressed as: JPY 102 = USD 1.
Forex Forward Rate
Forex Forward Rate
The exchange rate of which a currency can be exchanged for another currency for settlement on
a predetermined future date (the maturity date). The rate is the forward rate as of the time of the
trade. The rate is determined with regard to the current spot exchange rate and then forward
points or added or subtracted.
Forward Point
Forward Point
With regard to a specific currency, the difference between the spot price and the futures
price. The forwards point may be at a premium or a discount.
→ EXAMPLE:
Spot Rate: EUR/USD = 1.2655
Forward Rate: EUR/USD = 1.2661
This means there is 6 forward basis point premium.
Interest Rate Differential (IRD)
Interest Rate Differential (IRD)
The difference between the interest rates of two similar assets and will vary based on the cross being
traded; in forex the IRD may positively or negatively affect your account balance if positions are held
overnight/for a long time. In the NOK/JPY trade you will get 7% (annual) interest and will pay 0% for
borrowing the JPY. This is a positive IRD. Usually this will not matter for most traders.
The IRD is a key component of the carry trade. For example, say an investor borrows US $1,000 and
converts the funds into British pounds, allowing the investor to purchase a British bond. If the purchased
bond yields 7% while the equivalent U.S. bond yields 3%, then the IRD equals 4% (7-3%). The IRD is the
amount the investor can expect to profit using a carry trade. This profit is ensured only if the exchange
rate between dollars and pounds remains constant.
Interest Rate Parity
Interest Rate Parity
An economic concept which basically states that there should be no arbitrage opportunity through use
of a foreign currency and interest rate vis-à-vis another.
The relationship can be seen when you follow the two methods an investor may take to convert
foreign currency into U.S. dollars. Option A would be to invest the foreign currency locally at
the foreign risk-free rate for a specific time period. The investor would then simultaneously enter
into a forward rate agreement to convert the proceeds from the investment into U.S. dollars,
using a forward exchange rate, at the end of the investing period. Option B would be to convert
the foreign currency to U.S. dollars at the spot exchange rate, then invest the dollars for the same
amount of time as in option A, at the local (U.S.) risk-free rate. When no arbitrage opportunities
exist, the cash flows from both options are equal.
→ EXAMPLE:
Interest rate parity is a non-arbitrage condition which says that the returns from borrowing in one
currency, exchanging that currency for another currency and investing in interest-bearing
instruments of the second currency, while simultaneously purchasing futures contracts to convert
the currency back at the end of the holding period, should be equal to the returns from
purchasing and holding similar interest-bearing instruments of the first currency. If the returns
are different, an arbitrage transaction could, in theory, produce a risk-free return.
Source: http://en.wikipedia.org/wiki/Interest_rate_parity
Mark-Ups & Mark-Downs
Mark-Ups
The difference between what the market maker/broker bought the currency for on the market and
what it sold the currency to the buyer. Can be done on both the bid and ask to make more money.
→ NOTE:
A broker receives commission and a dealer receives a mark up or mark down. Can be done on both the
bid and ask to make more money.
→ EXAMPLE:
A dealer may decide that a markup on a security issue held in inventory is appropriate because of a
rising stock market
Mark-Downs
The broker offers a lower price to try to stimulate trading in hopes that they will the money back on the
extra commissions.
→ EXAMPLE:
A bond trader may take a markdown in long-term bonds held in inventory when market interest rates
rise.
→ NOTE:
A markdown is the amount subtracted from the selling price, when a customer sells securities to a
dealer in the over-the-counter (OTC) market. Had the securities been purchased from the dealer, the
customer would have paid a markup, or an amount added to the purchase price. When broker/dealers
charge a markup or markdown on a securities transaction, they are acting as principals (dealers). If
broker/dealers act as agents, they charge a commission. A broker/dealer cannot charge a markup and a
commission or a markdown and a commission on the same transaction.
The National Association of Securities Dealers (NASD) Rules of Fair Practice established 5% as a
reasonable guideline in markups and markdowns, though many factors enter into the question of
fairness, and exceptions are common. However, this is more of a guide than a rule. If a broker/dealer
charges a markup in excess of 5%, s/he will have to be able to justify it based on all relevant
circumstances concerning the transaction.
Forex PIPs
Forex PIPs
Shorthand for “percentage in point.” In forex trading, a pip is the smallest incremental
movement available in any currency pair. Most pips are calculated to the fourth place after the
decimal point.
→ NOTE:
Pip value can be either fixed or variable depending on the currency pair.
→ EXAMPLE:
The pip value for EUR/USD is always $10 for standard lots, $1 for mini lots, and $0.10 for micro lots.
A lot is a standard unit size of a transaction. Typically, one standard lot is equal to 100,000 units of the
base currency, 10,000 units if it’s a mini lot, or 1,000 units if it’s a micro lot. Some dealers offer the
ability to trade in any unit size, down to as little as 1 unit.
→ HOW TO CALCULATE:
To express the value in the terms currency, multiply 1 pip with the lot value:
EURUSD pip = 0.0001 X 100,000 = $10.00
EURUSD pip = 0.0001 X 10,000 = $1.00
USDCHF pip = 0.0001 X 100,000 = SFr 10.00
USDCHF pip = 0.0001 X 10,000 = SFr 1.00
Forex Rollovers
Forex Rollovers
In a forex transaction, you are basically long the base currency and short the quote currency. While
settlement of the spot transaction is supposed to take place within two days, this does not happen
because accounts are never fully funded and delivery is never actually contemplated. Accordingly,
accounts are “rolled over” every night (usually at 4pm EST) which means that positions are closed and
then re-initiated (if not closed out during the day). Some traders will offset their positions at 3:50pm EST
to avoid this. Because you have one currency in an account (and are “borrowing” the currency that is
sold), you should also receive interest on the currency in the account (and pay interest on the borrowed
currency). The difference between the two interest rates (the interest rate differential) is deposited in
the account and can affect performance.
As mentioned above, a spot transaction is generally due for settlement within two business days (the
value date). The cost of rolling over a transaction, or the rollover fee, is calculated by the difference in
the interest rates that apply to the two currencies in the currency pair that you’re trading. If you buy a
currency pair where the base currency has a higher interest rate, then you’ll receive interest, and vice
versa. Most brokers will automatically roll over your open positions allowing you to hold your position
indefinitely.
→ EXAMPLE:
For a short position in 3 standard contracts ($300 000) in the EUR/USD:
14th June 2006 6:18 am : Buy: Rate 1.2542 : Counter amount 376 260 DB
14th June 2006 6:18 am : Sell: Rate 1.25425: Counter amount 376 275 CR
In this situation, the rollover fee as you can see is 0.5 pips, which is $5 per contract. Because we’re in 3
contracts, this is 1.5 pips or $15 for that day. Currently the trade is 31 pips in profit per contract (profit
of $930).
Source: www.theforextrader.net
Tomorrow Next Day & Spot Next
Tomorrow Next Day (Tom Next)
The act of rolling over the currency is known as “tom next”, which stands for tomorrow next day, and is
basically part of the forex rollover process. Off-exchange foreign currency trades typically settle two
days after the transaction is initiated. However, traders typically do not want to do this (avoiding actual
delivery of the currency).
Spot Next
This is currency to be delivered the day after the delivery date (also known as the spot date or value
date). Spot means “immediately”. One could said, “He overnight swapped from the spot date to the
next business day.“
In Spot forex, the majority of the time the end of the business day is 21:59 (London time). Any positions
still open at this time are automatically rolled over to the next business day, which again finishes at
21:59.
Spot Rate/Spot Price
Spot Rate/Spot Price
This is basically the current exchange rate of the currency pair. The spot price is different from
the price of a futures or forward contract on the currency pair.
Trade Date & Settlement Date
Trade Date (Entry Date)
The day that a currency trade is initiated; the day on which you “buy” a currency pair.
Settlement Date
The business day which the base currency in a transaction is to be delivered. For spot
transactions, the settlement date is two business days from the trade date (T+2).
→ NOTE:
For USD/CDN trades, the settlement date is one business day (T+1). Because positions are rolled over,
the settlement date is always being pushed back.
The trade date is the on which a transaction occurs, especially the trade of a security or derivative. It is
important to note that the trade date differs from the settlement date, which can range from one to five
days following the trade date, depending on the type of security being traded. On the trade date,
ownership of the securities being traded transfers from the seller to the buyer, but the seller does not
receive payment until the settlement date.
Forex Swaps
Forex Swaps
A forex swap consists of two legs: (i) current spot transaction and (ii) a forward contract. The
effect of this is to exchange your currency and then get the currency back in the future. Spot and
forward trades are rolled into one. This is generally done for businesses for various reasons.
Swap is a forex trading term and it means a real-time purchase and sale of the same amount of a
selected currency for two different dates for the sale and purchase of another selected currency.
Thus, a forex swap is in a way a borrowing mechanism. You basically borrow one currency while lending
another for a selected period of time. In other words, swap is interest rates for the currency pairs you
sell or buy. Depending on the pair, you may either earn or pay swap interests. By utilizing a forex swap,
you can buy/sell a base currency today and sell/buy that currency sometime in the future.
→ NOTE:
Regular forwards are referred to as “outright forwards” because they are more often used.
→ EXAMPLE:
Swapping the US Dollar for a Euro:
Forex trader enters a swap and buys $100,000 with exchange rate of $0.1 per euro. At the same time,
another trader agrees to sell in 3 month the same $100,000 dollars to buy Euros at the exchange rate of
$0.09. During this trade the trader makes up to 50,000 euro profit because the value of dollar changed.
Balance of Payments (BOP)
Balance of Payments (BOP)
An economic indicator that takes the following factors into account over a certain time period: (i)
trade balance (balance of trade), (ii) foreign investments and (iii) investments by foreigners. If
there is a positive BOP then money is flowing into the country; if there is a negative BOP then
then money is flowing out of the country. Some traders use this to determine currency prices.
Bank for International Settlements (BIS)
Bank for International Settlements (BIS)
International organization which fosters international monetary and financial cooperation and
serves as a bank for central banks. Importantly, it acts as a prime counterparty for central banks
in their financial transactions and also acts as an agent or trustee in connection with international
financial operations. The BIS is involved with the Basel Committee and Basel Accords. Its goal
is to act as a financial safety net through strong regulation and supervision.
Capital Account
Capital Account
Increase in foreign ownership of domestic assets – increase in domestic ownership of foreign assets +
portfolio investment (stocks, bongs) + other investment (loans, bank accounts). This measures money
flowing into and out of a country because of capital flows. If a country is doing well, then money will
flow into that country, and these flows are reflected in the capital account. When there are strong
inflows or outflows of capital, the currency will be affected.
→ EXAMPLE:
Large inflows = currency value will go up.
Large outflows = currency value will go down.
→ NOTE:
http://www.informedtrades.com/24711-capital-account-measuring-capital-flows.html
Current Account
Current Account
Current account measures money flowing into and out of a country as a result of trade flows. It
can be measured through the following formula:
→ FORMULA:
[Exports – Imports = BOT] + Net Factor Income From Abroad (interest, dividends) + Net
Transfer Payments (aid to other countries)
Surplus: generally strengthens currency
Deficit: generally weakens currency
The value of currency theoretically should increase or decrease depending on whether there is a
surplus or a deficit.
→ NOTE:
http://www.informedtrades.com/24555-measuring-trade-flows-move-currencies-current
account.html
Clearing House Interbank Payment System (CHIPS)
Clearing House Interbank Payment System (CHIPS)
The aggregated (netted) transactions between counterparties are settled at the end of the trading
day and then debited/credited through Fedwire. The netting allows banks to hold onto their
capital during the day (instead of being debited instantly through Fedwire) allowing the
transferring bank to earn interest. CHIPS is run by a private New York clearing house
system. Often used to settle EURO transactions. Usually higher value payments than for
Fedwire.
→ NOTE:
http://en.wikipedia.org/wiki/Clearing_House_Interbank_Payments_System
Discount Rate
Discount Rate
The rate set by the Federal Reserve Bank for short term lending to eligible depository
institutions. This interest rate is used to determine the present value of futures cash flows. The
discount rate can influence currency exchange rates. Most lending is not done through this
system and it seems to be more of a symbolic rate as it will imply policy decisions.
Lower discount rate: Federal Government trying to stimulate economy (increase amount of
money in system)
Increase discount rate: Federal Government trying to reign in the threat of inflation (decrease
amount of money in system)
→ NOTE:
http://www.investopedia.com/terms/d/discountrate.asp
http://www.forextradingfloor.com/index.php?page=articles&gparent_id=15&parent_id=15&type
=view&cat_id=20
http://www.ibtimes.com/articles/20081021/the-monetary-policy-tools-of-the-federal-reserve.htm
Exchange Rate Elasticity
Exchange Rate Elasticity
Price transmission elasticity and exchange rate elasticity define the mechanism of international export
market and changing market positions of exporting countries.
Exchange Rate Intervention
Exchange Rate Intervention
The monetary authority of a country (usually the country’s central bank) will intervene in the
forex markets in order to counter disorderly market conditions. The authority will buy or sell its
currency in order to bring the exchange rates up or down. Interventions can be coordinated with
the central banks of other countries. In the US, the Federal Government will do this on through
spot transactions instead of forward transactions.
→ NOTE: http://www.ny.frb.org/aboutthefed/fedpoint/fed44.html
Exchange Rate Volatility
Exchange Rate Volatility
Probably the most important characteristic of alternative exchange rate systems is the feature used to
describe them, namely fixed or floating. Fixed exchange rates, by definition, are not supposed to
change. They are meant to remain fixed for, ideally, a permanent period of time. Floating rates do just
that—they float up and down, down and up, from year to year, week to week, and minute by minute.
What a floating exchange rate will be a year from now, or even a week from now, is often very difficult
to predict.
Volatility represents the degree to which a variable changes over time. The larger the magnitude of a
variable change, or the more quickly it changes over time, the more volatile it is.
Since fixed exchange rates are not supposed to change, by definition, they have no volatility. A floating
exchange rate may or may not be volatile depending on how much it changes over time. However, since
floating exchange rates are free to change, they are generally expected to be more volatile. Volatile
exchange rates make international trade and investment decisions more difficult because volatility
increases exchange rate risk. Exchange rate risk refers to the potential to lose money because of a
change in the exchange rate.
Source: “International Finance Theory and Policy”, by Steven M. Suranovic:
www.internationalecon.com/Finance/F-toc.php
→ NOTE: http://internationalecon.com/Finance/Fch110/F110-1.php
Fiscal Policy
Fiscal Policy
A government’s decisions regarding spending and revenue collection (taxation). Fiscal policy
influences the economy. It is to be contrasted with monetary polcy which focuses centrally on
the supply of money. the following are types of fiscal policy:
Neutral: spending equals taxation
Expansionary: spending is greater than tax revenue; usually associated with budget deficit
Contractionary: tax revenue is greater than spending; usually associated with a budget surplus
Fisher Effect
Fisher Effect
The effect proposes that if the real interest rate is equal to the nominal interest rate minus the
expected inflation rate, and if the real interest rate were to be held constant, that the nominal rate
and the inflation rate have to be adjusted on a one-for-one basis.
→ NOTE: Real interest rate = nominal interest rate - inflation rate
→ EXAMPLE: In simple terms: an increase in inflation will result in an increase in the nominal
interest rate. For example, if the real interest rate is held at a constant 5.5% and inflation
increased from 2% to 3%, the Fisher Effect indicates that the nominal interest rate would have to
increase from 7.5% (5.5% real rate + 2% inflation rate) to 8.5% (5.5% real rate + 3% inflation
rate).
Source: http://www.investorwords.com/6519/Fisher_effect.htm
Gross Domestic Product (GDP)
Gross Domestic Product (GDP)
The market value of goods and services produced in the US by US residents or non residents
over a period of time (typically a year). Increasing GDP is better than decreasing GDP.
Inflation
Inflation
The rise in level of prices of goods and services in an economy over time (the decline in the real
value of money over time). The supply of money and inflation are linked. Inflation has a large
effect on interest rates, which in turn effect exchange rates. Over the long term inflation means
that the value of a currency will drop.
Inflation numbers influenced by GDP numbers, PPI (produce price index), CPI (consumer price
index)
→ NOTE:
http://en.wikipedia.org/wiki/Inflation
http://www.forexfloor.com/inflation-indicators.html
Theory of Purchasing Power Parity (PPP)
Theory of Purchasing Power Parity (PPP)
Also called the law of one price, the theory that the price of a currency (as defined by the
exchange rate with another currency) is determined by the relative level of prices of the two
countries. Basically the theory says that the price of a basket of goods should be the same in two
countries. If 10 HC buys 15 FC then PPP says that the same basket of goods which cost 10HC
should also cost 15FC. Essentially, the prices of currencies tend to move toward equilibrium.
The problem with the theory is that it does not accurately predict variations in exchange
rates. PPP cannot be used along as a decision making tool with regard to forex
transactions. PPP often does not take into account issues such as transportation costs, demand
within the country, etc.
→ EXAMPLE:
Big Mac Index, see http://www.actionforex.com/financial-glossary/financial-glossary/big-mac-
index-20041204335/
Forex Trading Calculations
Forex Trading Calculations:
Cross rate transactions
Effects of leverage calculations
Netting of positions
Open trade variation
Profit & loss calculations
Pip values, price after pips
Option and exotic option profit & loss calculations
Return on collateral, security deposit, margin
Transaction costs
Cross Rate Transactions
Cross Rate Transactions
Cross-rate transactions occur when two currencies are equal which follows from their forex currency
exchange rate according to a forex rate of the third currency. There are a couple of ways that cross rate
transactions can be executed. First, some FDMs will actually offer these pairs. Second you can buy
EUR/USD and then USD/JPY to affect a EUR/JPY cross.
Currency pairs that do not involve the USD are referred to as cross rates. Even though the USD is not
represented in the quote, the USD rate is usually used in the quote calculation. An example of a cross
rate is the EUR/GBP.
→ EXAMPLE: Assume that the following major exchange rates are known:
EUR/USD = 1.0060/65
GBP/USD = 1.5847/52
USD/JPY = 120.25/30
USD/CHF = 1.4554/59
→ CALCULATE GBP/CHF:
GBP/USD: Bid: 1.5847 Offer: 1.5852
USD/CHF: 1.4554 1.4559
GBP/USD X USD/CHF = 1.5847 X 1.4554 1.5852 X 1.4559
Effects of Leverage Calculations
Effects of Leverage Calculations
Leverage calculations allow you to see basically how much equity is in your account so you will not be
subject to a margin call. Most forex brokers allow a very high leverage ratio, or, to put it differently,
have very low margin requirements. The margin in a forex account is a performance bond, the amount
of equity needed to ensure that you can cover your losses.
If you have 100:1 leverage, then the margin in your account must be at least 1% of the contract value. If
you have 200:1 leverage, then the margin in your account must be at least 0.5% of the contract value.
To calculate margin, you take the price of the currency X the number of units X the margin requirement.
→ EXAMPLE: EUR/USD = 1.35
1.35 x 100,000 x 1% = 1,350 USD that must be used as margin to control the 100,000 units of EUR
Netting of Positions
Netting of Positions
At the end of the day institutions will net their long and short positions between one another so
that they do not have to settle every single transaction – only the net positions are settled. This
can save on fees and commissions.
Open Trade Variation
Open Trade Variation
Profit and Loss Calculations
Profit and Loss calculations – []
Example:
USD is base currency
Profit = Price Change in Pips x Units Traded
USD is secondary currency
Profit = Price Change in Pips x Units Traded / Exit Price
Good Websites:
http://www.forex.com/calculating_forex_pl.html
http://www.streetdirectory.com/travel_guide/148460/foreign_exchange/forex_trading___profit_a
nd_loss_calculations.html
Pip Values & Price After Pips
Pip Values
Forex pip value refers to the amount of money gained/lost for each pip that is gained/lost in currency
trading. The easiest way to find out pip value of a currency pair is by observing how much money you
gain/lose for each pip you gain/lose when you are in-trading. To do the manual calculation, you need to
know what ‘1 pip’ is for the related currency pair. The pip value for each currency pair is different and
the value can be determined according to the following formula:
→ FORMULA: Pip Value = 1 pip x Trade Size
Price After Pips
I am not sure what they are trying to get at…maybe the fact that there are spreads and that when you
initiate a position you are automatically starting with a loss the size of the spread….
Example:
USD/JPY at an exchange rate of 119.90
(.01 / 119.80) x $100,000 = $8.34 per pip
USD/CHF at an exchange rate of 1.4555
(.0001 / 1.4555) x $100,000 = $6.87 per pip
In cases where the US Dollar is not quoted first, the formula is slightly different.
EUR/USD at an exchange rate of 1.1930
(.0001 / 1.1930) X EUR 100,000 = EUR 8.38 x 1.1930 = $9.99734 rounded up will be $10 per
pip
GBP/USD at an exchange rate or 1.8040
(.0001 / 1.8040) x GBP 100,000 = 5.54 x 1.8040 = 9.99416 rounded up will be $10 per pip.
Good Website:
http://www.babypips.com/school/know_your_ps_and_ls.html
Option & Exotic Option P&L Calculation
Option & Exotic Option P&L Calculation
Buying an Option
You pay the premium (quoted in pips). If at expiration the option is in the money then the profit
equals the difference between the strike price and the current market price (closing spot price)
less the amount of the premium paid. Profit potential is unlimited and the potential loss is
limited to the amount paid for the premium
Exotic Option P&L Calculation - [Need to include]
→ NOTE:
Using options: http://www.forexcapital.com/options.htm
Exotic options: http://www.elitetrading.de/forum/forex/exotic_forex_options_1865.html
Return on Collateral/Security Deposit/Margin
Return on Collateral/Security Deposit/Margin
Leverage allows the trader to increase the possible ROI on an investment. The amount of the
ROI is expressed as a percentage of the margin amount. For instance, if you gain $200 on a
trade which was initiated with $1,000 on margin, your return on margin is 20%.
Example:
The Trader buys 100,000 GBP at 1.9505 USD (using US$1000 as the margin amount).
The Trader calculates a potential profit and places a limit order of 1.9620 (Potential profit of US$1,115.00)
The Trader calculates a potential loss and places a stop at 1.9475 (Potential loss of US$300) Within the next hour the GBP rallies to 1.9592, stalls and begins to reverse. The Trader decides the limit will not be reached, so he closes his position by selling the GBP at
1.9558 and locks in a profit of US$530.00 The Trader made a profit of US$530 on a margin amount of $1000 = 53% return on margin in an
hour.
Source:
http://209.85.173.132/search?q=cache:F1AKfPCKJVEJ:www.silversandcapital.com/investinginf
orex.aspx+forex+return+on+margin&cd=7&hl=en&ct=clnk&gl=us&client=firefox-a
Transaction Costs
Transaction Costs
Most FDMs do not have separate commissions or other fees per transaction, but this will be
decided at each FDM. Instead FDMs make money through the spread that they make on each
side of the transaction (i.e. they buy the currency for less than they sell it to you). The pip spread
actually works as a kind of transaction cost, for more on this see
http://www.babypips.com/school/how_leverage_affects_transacti.html.
Transaction costs vary from FDM to FDM. You should consider:
1. Commissions. If there is a commission, add it to the spread to determine total cost. Also, you need to determine whether the commission is calculated on a per side or round trip basis.
2. Spread on currency pairs. This is the value of the pip multiplied by the spread (pip X spread). The spread may fluctuate throughout day, based on the FDM.
3. Rollover rates. These are important for longer term strategies (and are not necessarily important for day traders).
4. Quality of execution, including slippage and the consistency of rates versus other platforms.
→ NOTE:
http://www.aboutcurrency.com/university/fxvideocourse/how_to_evaluate_forex_transaction_co
sts.shtml
Country Risk/Sovereign Risk
Country Risk/Sovereign Risk
Some countries still interfere (i.e. limit supply of currency available) with the natural market
mechanisms of the forex markets. Such interference could affect a currency in a number of
different ways including the liquidity of the currency. If significant enough the trader may not
be able to receive a rightful payment. Country risk is most acute with the so called “exotics.”
Credit Risk
Credit Risk
The risk that the counterparty defaults. The counterparty to an off-exchange transaction may not,
for a variety of reasons, be able to complete a transaction. Such non completion of any portion
of a transaction may be to the detriment to the other party. In such cases, the other party will be
subject to all or partial loss.
In the event of bankruptcy of the counterparty the trader may be unable to recover assets held at
the counterparty (for example, the Refco scandal). Generally there is no segregated customer
protection in the event of a bankruptcy. However, in many cases, credit risk for many forex
transactions is restricted because of the short term contract execution.
Exchange Rate Risk
Exchange Rate Risk
Exchange rate risk is the currency fluctuations on the worldwide currency market, fluctuation of
demand and supply for a particular currency. The most effective way to control the risk of
exchange rate is to get rid of the positions that lose too much, and to increase the number of
those who keeps the lose limits taken into account; essentially, limit the position and the limit
loss. Maintaining a limit position allowed for a particular investor’s currency, in each
transaction, during the transaction will be determined by it. The loss limit is also an instrument of
the investor that may set the limit to which it is admitted to lose in the foreign exchange
transactions, the limit above which the loss will be automatically stopped.
The exchange rates between currencies can change quickly and by a significant amount. These
changes could produce large losses for the trader. Some traders utilize stop losses or limit orders
in order to mitigate this risk.
Interest Rate Risk
Interest Rate Risk
The value of a foreign currency investment can be affected negatively by a number of factors
related to the interest rate or one or other of the currencies traded.
Liquidity Risk
Liquidity Risk
There is a risk that it may be impossible to liquidate a position. This can happen when a
currency is deregulated or fixed trading bands are widened. Some potential currencies include
(but are not limited to): Thai Baht, South Korean Won, Malaysian Ringitt, Brazilian Real, Hong
Kong Dollar.
Forex Exotic Options
Forex Options and Exotic Options
Options are a great tool for traders during anticipated periods of market volatility. During these
periods of volatility it is expected that huge drawdowns could occur. It is also during this time
that prices can gap up or down so slippage during these times is expected to increase.
Forex options are not traded on an exchange so they are usually privately negotiated contracts
between the FDM and the trader.
→ NOTE:
Managers who utilize these types of instruments may be subject to regulation under state
investment advisory laws. Many state securities laws are written broadly so as to include
“investment contacts” in the definition of “security.” While I have not personally heard of a
state making a claim like this, it is not hard to see a state making such a claim.]
Barrier Forex Option
In its most basic form, the barrier option is an option which is triggered upon the happening of an
event (the barrier) (i.e. a currency pair reaching a previously determined exchange rate). A
double barrier option has a barrier both above and below the current market price. There are two
central ways to play barrier options: knock-in or knock out.
These pay off if an asset reaches a certain price. Knock-in options are created with predetermined
characteristics when the underlying reaches a certain price. Knock-out options are options that
terminate if the underlying reaches a certain price. Since the option ceases to exist, there is no payoff
even if the price moves back within the knock-out barrier before the original expiration. Thus, an option
with a knock-out barrier has a maximum specified value and payoff.
Because the option may either not come into existence or pass out of existence, barrier options are
generally cheaper the standard options, with the double-barrier option being cheapest. Most exotic FX
options are barrier options.
Knock-in Barrier Option
The knock-in triggers an option contract upon a certain price which is hit by the currency
pair. This means that there is no option contract in existence until a barrier is hit. [What does
this mean for long and short?] The knock in can be structured so it is triggered upon a price
increase (the up and in option) or upon a price decrease (the down and in option).
Knock-out Barrier Option
The knock-out cancels an existing option contract which will be effective unless a certain price is
hit by the currency pair. Unlike a knock-in option, the knock-out option is currently in existence;
it will cease to be once the barrier is hit. [What does this mean for long and short?] Like the
knock-in, the knock-out can be structured to be triggered upon a price increase (the up and out)
or upon a price decrease (the down and out).
Single-Barrier Options
These have a single trigger price that is either above or below the strike price, and double-barrier
options have trigger prices that are above and below the strike price.
Double Barrier Options
[Need to include]
Compound Options
This is an option to purchase an existing option. This has two potential premiums: the first to
purchase the compound option and the second to purchase the underlying option. Because there
are two premiums compound options are more expensive than vanilla options. Advantage is that
they provide the opportunity for large amounts of leverage and that they are cheaper (initially)
than vanilla options.
A compound option or “split fee option” is an option on an option. It gives the holder the right to buy or
sell another option, and are generally used for currency or fixed income markets where insecurity exists
regarding the option’s risk protection. The exercise payoff of a compound option involves the value of
another option. Compound options thus have two strike prices and two exercise dates. There are four
types of compound options:
call on a call put on a put call on a put put on a call
→ NOTE:
http://en.wikipedia.org/wiki/Barrier_option
http://www.financial-spread-betting.com/exotic-options.html
http://www.traderslog.com/forex-options.htm
http://www.forexdirectory.net/exover.html
Market Risk
Market Risk
Risk that the general forex market may cause the value of a position to change.
Operational Risk
Operational risk
Risk inherent in the trader’s operational structure. For instance if a trader’s decision making
skills are spread out and decisions are dependant on a number of different systems, any thing that
happens to one part of the system could affect the whole. This may affect the trader’s ability to
enter and exit trades as it would normally do.
Additionally, forex dealers typically have operational risk related to their quoting and execution
systems.
Settlement Risk/Herstaat Risk
Settlement Risk/Herstaat Risk
Because of the time differences involved in the forex trading markets, there was the possibility
that there would be differences in the time of the settlement of the forex contracts. This meant
that it was possible that the counter party would not pay the trader (i.e. you would send them
your currency and they would not send you their currency). This has been mitigated through the
CLS system. Herstatt risk refers to a situation in 1974 when a German bank called Herstatt was
shut down by German banking regulators prior to paying off its counterparties; this left the
counterparties with substantial losses.
CFTC Jurisdiction and Jurisdictional limitations
CFTC Jurisdiction and Jurisdictional Limitations
CFTC:
The Commodities Futures Trading Commission (CFTC) is a government agency which is
charged with enforcing the laws under the Commodities Exchange Act, as amended (CEA). The
CFTC, with regard to the CEA, is functionally equivalent to the SEC. With regard to off-
exchange foreign currency transactions, Congress has provided a mandate to the CFTC to
propose rules which will require the registration of forex managers and solicitors. Once a
registration structure is enacted the CFTC will ultimately be in charge of making sure that these
maangers and solicitors are operating pursuant to the regulations promulgated by the CFTC. The
CFTC will provide the NFA with the authority to monitor these managers and solicitors and
oversee the registration process.
CFTC Jurisdiction:
On May 22, 2008, the Congress passed H.R. 6124, the Food, Conservation, and Energy Act of
2008 (also known as “the Farm Bill”) which contains several amendments to the Commodity
Exchange Act (“CEA”). In particular, Title XIII of the FarmBill (1) clarifies that the CFTC’s
anti-fraud authority applies to certain retail off-exchange foreign currency transactions, (2)
creates a new registration category for retail foreign exchange dealers, (3) requires registration
for those who solicit orders, exercise discretionary trading authority and operate pools with
respect to retail off-exchange foreign currency transactions, and (4) imposes minimum capital
requirements for futures commission merchants and retail foreign exchange dealers that act as
counterparties to such transactions. Parts of the legislation, particularly those confirming the
Commission’s anti-fraud authority, were effective upon passage. Other parts of the legislation,
such as those requiring the registration of parties engaged in these transactions and minimum
capital requirements, will only be effective upon the Commission’s issuance of final
regulations. Any such changes to the information below will be accomplished through notice
and comment rulemaking and will be made available in the Federal Register section of
CFTC.gov.
A complete description of the amendments to the CEA effected by Title XIII of the Farm Bill
can be found in the Joint Statement of Managers, pp. 291-299, which can be accessed through
the House Agriculture Committee’s Farm Bill Homepage. Interested parties should monitor the
Commission’s website as well as the National Futures Association’s website, for developments.
The CFTC has witnessed increasing numbers, and a growing complexity, of financial investment
opportunities in recent years, including a sharp rise in foreign currency (forex) trading scams.
The Commodity Futures Modernization Act of 2000 (CFMA) made clear that the CFTC has
jurisdiction and authority to investigate and take legal action to close down a wide assortment of
unregulated firms offering or selling foreign currency futures and options contracts to the general
public. The CFTC also has jurisdiction to investigate and prosecute foreign currency fraud
occuring in its registered firms and their affiliates. The CFTC issued an advisory in 2001 that
discussed these CFMA amendments to the Commodity Exchange Act (CEA), 7 USC 1, et seq.
The Division of Trading and Markets (now Division of Clearing and Intermediary Oversight, or
DCIO) issued an advisory in 2002 concerning foreign currency trading by retail customers
(PDF). The advisory affirms that off-exchange trading of foreign currency futures and options
contracts with retail customers by a counterparty that is not a regulated financial entity as set
forth in the CFMA is unlawful. The advisory further states that, if there is a lawful counterparty
to the transaction, such as a person registered as a futures commission merchant, the persons
acting as intermediaries to such a transaction, that is, in the manner of an introducing broker,
commodity trading advisor or commodity pool operator, would not need to register under the
CEA if that is their only involvement in futures or option transactions.
DCIO issued an additional advisory in 2007 concerning foreign currency trading by retail
customers (PDF). The DCIO Advisory addresses the following issues: (1) registration
requirements for associated persons of firms registered as introducing brokers (IBs), commodity
trading advisors, and commodity pool operators that are involved in forex transactions; (2) the
permissibility of certain unregistered affiliates of a futures commission merchant (FCM) to act as
proper counterparties in forex transactions; (3) claims that forex customer funds are segregated;
(4) introducing entities acting as FCMs; (5) the applicability of the IB guarantee agreement to
forex transactions and prohibiting guaranteed IBs from introducing forex transactions to an FCM
that is not its guarantor FCM; (6) prohibiting forex account statements of an FCM’s unregistered
affiliate from being included in the FCM’s account statements to its customers; and (7)
prohibiting retail customers from acting as counterparties to each other in forex transactions.
CFTC Jurisdictional Limitations:
CFTC Chairman Gary Gensler addressed the following limitations to the authority of the CFTC in his
address to the U.S. Senate:
Retail Fraud: In the 2008 Farm Bill the Congress clarified the CFTC’s jurisdiction over fraud in retail
foreign currency transactions. Since the passage of the Farm Bill, unscrupulous firms have been offering
the same type of fraudulent “rolling spot” commodity contracts that were prohibited in the Farm Bill,
but in other commodities that were not covered by the bill. Since the enactment of the Farm Bill, the
CFTC has received more than 50 complaints from the public relating to potential fraud from such
contracts. The regulatory reform package should include a provision to expand the CFTC’s jurisdiction
over this type of retail fraud to all types of commodities.
Foreign Boards of Trade: As part of regulatory reform legislation, the Congress should also
provide the CFTC with clear statutory authority to ensure that traders that are trading on a
foreign board of trade through trading terminals in the U.S. comply with the same U.S. position
limits and reporting requirements when trading a foreign contract that settles against any price of
a contract traded on a U.S. exchange.
Source: CFTC Chairman Gary Gensler Address to the US Senate
http://www.cftc.gov/customerprotection/fraudawarenessandprevention/forex/index.htm
Conflicts of Interest
Conflicts of Interest
I am not sure what they are getting at here. In general, all conflicts of interest would need to be
disclosed. The interpretive notices to Rule 2-29 and Rule 2-9 give us some insight into this
general principal.
Interpretive notice to Rule 2-29: Disclosing conflicts of interest for securities futures products.
Firms must make sure they:
disclose all conflicts of interest
review promotional material; firms must make sure that promotional material is accurate
and does not gloss over any conflicts of interest
Interpretive notice to Rule 2-9: Ethics training.
Ethics program should address: avoidance of conflicts of interest and proper disclosure and
handling of conflicts of interest.
Disclosures to Customers
Disclosures to Customers
[Need to include] See NFA Interpretive Notice on Rule 2-36(e).
NFA Interpretive Notice Compliance Rule 2-36(e):
Supervision of the use of Electronic Trading Systems
NFA Interpretive Notice Compliance Rule 2-36(e): Supervision of the use of Electronic
Trading Systems
General: this part of the rule applies generally to FDMs and, inc certain instances, the APs of the
FDM. It will also apply to Members which solicit, introduce, or manage customer accounts
(those parts applicable to FDMs will also apply to these members if the customer deals with a
counterparty that is not a FDM).
Issues for white labelers: if the firm providing the white label product is a FDM, the member
may rely on the FDM. If the firm providing the product is not a FDM then the Member is
ultimately liable. In the former situation the Member must (i) Provide required notifications and
disclosures to customers; (ii) Maintain records; and (iii) Respond to situations where it has
reason to believe the white labeler is not complying with the Notice.
Focus on the following areas: the security, capacity, credit and risk-management controls, and
records provided by the firm’s electronic trading systems.
Rule 2-36(e) provides:
Supervision. Each Forex Dealer Member shall diligently supervise its employees and agents in
the conduct of their forex activities for or on behalf of the Forex Dealer Member. Each Associate
of a Forex Dealer Member who has supervisory duties shall diligently exercise such duties in the
conduct of that Associate’s forex activities for or on behalf of the Forex Dealer Member.
Specific Items Discussed in Interpretive Notice
Security
Authentication & Encryption. User should be authenticated when logging on (passwords,
secured, digital certificates, etc) and this information should be appropriately encrypted;
firewalls should be used when and if appropriate
Customers should be able to tell the Member about access issues
Periodic testing. Annual independent internal audit or qualified outside audit; report
docemented and provided to senior management; if any deficiency there should be follow
up
Electronic trading system should be monitored by appropriate personnel; procedures in
place for updating the system as needed
Capacity
Adopt and enforce written procedures to evaluate capacity of ETS
ETS should go through initial stress test; subject to periodic reviews thereafter by
independent inside pary or qualified outside party; audits documented and reviewed by
management
ETS should be tested for both capacity and performance; system should be designed to
provide adequate capacity to meet estimated peak volume needs
Firm should also have procedures for following up on customer compliancts regarding
these issues
Disaster recovery. Contingency plan should be in place should the system go down or
abnormal volume; backup systems can include telephone
If operational issues, these should be relayed to the customers through the website, email,
im, or through the phone
Firm should disclose that there may be system issues in advance and what customers can
do. This can be in the customer agreement
Credit and risk-management controls
Procedures should be in place to make sure there is not undue financial risk on the firm or
the other customers from a customer trade
ETS should be designed to allow the firm to limit the customers trading; ETS should
block order the exceed pre-set limits
ETS should be designed so that if stop-losses are exceeded positions will be closed out
prior to a position becoming a deficit; there is a greater duty to make sure this is the case
if the fdm states that the customer cannot lose more than they invest
If ETS does not automatically liquidate a position, the ETS should generate an aler to the
customer
Periodic review of the system to make sure proper credit and risk management
Recordkeeping
Written procedures to record and maintain essential information re: customer order and
account activity
Records should include: Date and time the order is received by the system; Price (or
premium for an option) at which the order is placed; Price (or premium for an option)
quoted on the trading platform when the order was placed (if the system is a trading
platform); Account identification; Currency pair; Size; Buy or sell; Type of order (if not a
straight market order); Date and time the order is transmitted to the trading platform (if
the system is an AORS); Date and time of execution (if the system is a trading platform);
Size and price (or premium) at which the order is executed; Date and time the execution
information is received (if the system is an AORS); andDate and time the execution
information is reported by the system.
Options also need: Put or call; Strike price; and Expiration date.
Time recorded to nearest second
Rollover information should include: Account identification; Currency pair; Size; Long
or short; Date and time of the rollover; Price of the position after the rollover; Bid and
ask prices quoted on the platform when the rollover occurred; Amount of interest credited
or debited to the account, if any; Any other fees charged for the rollover.
ETS should be designed so that it is searchable for any one of a number of different items
Daily account records should include the following items: Account identification; Funds
in the account (net of any commissions and fees); Open trade equity (the net profits and
losses on open trades); and Account balance (funds in the account plus or minus open
trade equity). Options should also include: Long option value; Short option value; and
Net option value.
ETS must have dynamic information on price changes, to the nearest second.
Daily exception reports. Those trades which fill outside the price range at the time order
was entered into; these reports should be reviewed by management on a daily basis for
suspicious or unjustifiable activity
Month end assessment fee reports – number and size of forex transactions for the month
Record retention. 5 years, first 2 in an accessable place
Trade Integrity
Written procedures to maintain integreity of the ETS
ETS should be designed to provide bids and officers related to current market activity
If firm advertises a particular spread (x pip) then the ETS should be able to handle this
ETS designed for minimal slippage, and only then based on market conditions
Price adjustments should be done pursuant to objective criteria identified in written
procedures; otherwise management approval needed for an adjustment
APs should be prohibited from adjustinc prices for any reason once the order hits the ETS
If automatic rollover, the ETS should be designed to follow the procedures detailed in the
written agreement
Annual Certification
By all FDMs
AP who is also a principal, filed with the NFA
Also members who are involved with counterparties which are not FDMs
Futures requirements:
Know Your Customer
Know Your Customer
Members and Associates have a duty to acquaint themselves sufficiently with the personal and
financial circumstances of each forex customer to determine what further facts, explanations and
disclosures are needed in order for the customer to make an informed decision on whether to
enter into forex transactions.
Every Member should determine what information it will obtain from a prospective forex
customer. At a minimum, the Member soliciting the customer to engage in forex transactions
should obtain the customer’s name, address, principal occupation or business, current estimated
annual income and net worth, approximate age, and an indication of the customer’s previous
investment and trading experience. Members and their Associates need to ensure that each
customer they solicit has received adequate information concerning the risks of forex
transactions so that the customer can make an informed decision as to whether forex transactions
are appropriate for the customer. These obligations fall on the Forex Dealer Member when a
non-Member solicits the customer.
Members and APs have a duty to make sure customer makes informed decision with regard to
forex transactions (FDMs have this duty if non-member solicits customer):
Should consider personal and financial circumstances
Should provide additional facts, explanations, disclosures if necessary
Members must decide what information to request from a customer
Minimumum information – customer’s name, address, principal occupation or business,
current estimated annual income and net worth, approximate age, and an indication of the
customer’s previous investment and trading experience
Minimum information: customer’s name, address, principal occupation or business,
current estimated annual income and net worth, approximate age, and an indication of the
customer’s previous investment and trading experience.
Registration Requirements
Registration Requirements
Forex managers and solicitors generally will need to make sure that both the firm and the
individual (associated person or AP) are registered with the CFTC. The firm will also need to be
a member of the NFA.
Firms must complete and submit Form 7R through the NFA’s online registration system. The
cost for firm registration is likely to be $200 for Forex CPOs, Forex CTAs, and Forex
IBs. These firms will also need to become members of the NFA which costs $750 on an annual
basis. These firms will also need to become members of the NFA which costs $750 on an annual
basis. Guaranteed forex IBs need a guarantee form signed by the FDM [Form 1-FR-IB (Part B)].
Individuals must complete and submit Form 8-R through the NFA’s online registration system. Each
individual (whether a principal or an AP) will need to have passed both the Series 3 exam and the Series
34 exam. Individuals will need to submit a fingerprint card as well.
→ NOTE: Individuals who were APs of a registered firm as of May 22, 2008 may be “grandfathered” in
and may not need to take the Series 34 exam.
Forex CPOs and forex CTAs will need to have their disclosure documents reviewed by the NFA prior to
soliciting clients with those documents.
Security of Customer Funds, No Segregation
Security of Customer Funds, No Segregation
Generally customer funds are not held in segregated customer accounts separate from the
FDM. Accordingly, in the event of a bankruptcy at a FDM, the customer funds would be
administered by a trustee according to the US bankruptcy laws (if based in the US). Customers
would be entitled to a pro rate distribution of available assets. There is no guarantee they would
be able to recover all of the customer funds.
Security Deposit Rules
Security Deposit Rules
The following is the text of Section 12 of NFA’s Financial Requirements from NFA’s Rules
Manual:
[Adopted Effective December 1, 2003. Effective dates of amendments: June 6, 2004; September
15, 2005; February 13, 2007; May 14, 2008; October 31, 2008; and November 30, 2009.]
(a) Each Forex Dealer Member shall collect and maintain the following minimum security
deposit for each forex transaction between the Forex Dealer Member and a person that is not an
eligible contract participant as defined in Section 1a(12) of the Act:
(i) 1% of the notional value of transactions in the British pound, the Swiss franc, the Canadian
dollar, the Japanese yen, the Euro, the Australian dollar, the New Zealand dollar, the Swedish
krona, the Norwegian krone, and the Danish krone;
(ii) 4% of the notional value of other transactions;
(iii) for short options, the above amount plus the premium received; and
(iv) for long options, the entire premium.
(b) The Executive Committee may temporarily increase these requirements under extraordinary
market conditions.
(c) For purposes of this rule:
(1) “Forex” has the same meaning as in Bylaw 1507(b); and
(2) “Forex Dealer Member” has the same meaning as in Bylaw 306.
(d) In addition to cash, a Forex Dealer Member may accept those instruments described in CFTC
Rule 1.25 as collateral for customers’ security deposit obligations. The collateral must be in the
FDM’s Possession and control and is subject to the haircuts in CFTC Rule 1.17.
Two general security deposit requirements are 1% or 4%. Between the FDM and customer (who
is not an Eligible Contract Participant (ECP):
1% (British pound, the Swiss franc, the Canadian dollar, the Japanese yen, the Euro, the
Australian dollar, the New Zealand dollar, the Swedish krona, the Norwegian krone, and
the Danish krone);
4% (All other currencies);
For short options, the above amount plus the premium received; and
For long options, the entire premium.
FDMs complying with the 150% rule (pursuant to Section 11(a)(i) or (ii)), can have
lower security deposits
Acceptable Collateral – cash and other items pursuant to CFTC Rule 1.25, subject to
haircuts
Reports to Customers/Confirmations/Monthly Summaries
Reports to Customers/Confirmations/Monthly Summaries
See generally Rule 2-44 Forex Customer statements
here: www.nfa.futures.org/nfamanual/NFAManual.aspx?RuleID=RULE%202-44&Section=4.
Written confirmation provided to customers within one business day of activity.
Written confirmation must include the following information:
1. Date; 2. Transaction type (e.g., new position, offsetting position, rollover, adjustment); 3. Currency pair; 4. Buy or sell (if a new or offsetting position); 5. Size; 6. Price or premium (for new or offsetting positions or price adjustments); 7. Price or premium change (for price adjustments); 8. Monetary adjustments (debit or credit); 9. Net profit or loss for offsetting positions; and 10. Charges for each transaction (e.g., rollover interest and/or fees).
Daily statements must be provided to customers on a daily basis and must show account equity
as of the end of the previous day. They can be provided electronically and can be combined with
confirmations and provided electronically with the customers consents
Monthly statements are required for all accounts that have open positions at the end of the
month or changes in the account balance or equity since the prior statement. Quarterly
statements are required for all other open accounts. The monthly or quarterly statements must
contain the following information regarding the transactions during the reporting period and the
funds in the account:
The account equity at the beginning of the reporting period; All initiating or offsetting transactions, deliveries, option exercises, or option expirations that
occurred during the reporting period, with the following information for each: date, currency pair, buy or sell, size, and price or premium (with any price or premium adjustment noted);
All open positions in the account, with the following information for each position: date initiated, currency pair, long or short, size, price or premium at which it was initiated (with any price or premium adjustment noted), and the unrealized profit or loss;
All deposits and withdrawals during the reporting period; All other monetary adjustments (debits and credits) to the account; The amount of cash in the account (excluding non-cash collateral and unrealized profits and
losses); A breakdown by type of all fees and charges during the period, including commissions and
interest expense or rollover fees; and The account equity at the end of the reporting period.
Promotional Material & Solicitation
Promotional Material
This is quite a nebulous topic which is explored in greater depth elsewhere in the materials. I
provide an overview below.
See generally NFA rule 2-36(h) Filing Promotional Materials with NFA:
The Compliance Director may require any Forex Dealer Member for any specified period to file
copies of all promotional material with NFA for its review and approval at least 10 days prior to
its first use or such shorter period as NFA may allow. The Compliance Director may also require
a Forex Dealer Member to file for review and approval copies of promotional material prepared
or used by some or all of the non-Members it is responsible for under Section (d).
The Forex Transactions Guide states:
Communications with the Public and Promotional Material - No Member or Associate shall
make any communication with potential or current customers that operates as a fraud or deceit;
uses a high-pressure approach; or implies that forex transactions are appropriate for all persons.
Promotional material used by the Member or Associate shall not:
Deceive the public or contain any material misstatement of fact or omit a fact that makes the promotional material misleading;
Include any statements of opinion unless they are clearly identified as such and have a reasonable basis in fact;
Mention the possibility of profit unless accompanied by an equally prominent statement of the risk of loss;
Include any reference to actual past trading profits without mentioning that past results are not necessarily indicative of future results;
Include any statistical or numerical information about past performance of actual accounts unless the Member can demonstrate that the performance is representative of actual performance of all reasonably comparable accounts for the same period (calculated in accordance with the formula in CFTC Regulation 4.35(a)(6) and NFA Compliance Rule 2-34); or
Include testimonials unless they are representative of all reasonably comparable accounts, the material prominently states that the testimonial is not indicative of future performance or success, and the material prominently states that they are paid testimonials (if applicable).
No Member or Associate may represent that forex funds deposited with a Forex Dealer Member
are given special protection under the bankruptcy laws. No Member or Associate may represent
or imply that any assets necessary to satisfy its obligations to customers are more secure because
the Member keeps some or all of those assets at a regulated entity in the United States or a
money center country.
No Member or Associate may represent that its services are commission free without
prominently disclosing how it is compensated in near proximity to that representation.
No Member or Associate may represent that it offers trading with “no-slippage” or that it
guarantees the price at which a transaction will be executed or filled, unless:
It can demonstrate that all orders for all customers have been executed and fulfilled at the price initially quoted on the trading platform when the order was placed;9 and
No authority exists, pursuant to a contract, agreement, or otherwise, to adjust customer accounts in a manner that would have the direct or indirect effect of changing the price at which an order was executed.
Members and Associates may not solicit customers based on the leverage available unless they
balance any discussion regarding the advantages of leverage with an equally prominent
contemporaneous disclosure that increasing leverage increases risk.
No Member shall use or directly benefit from any radio or television advertisement that
recommends specific forex transactions or describes the extent of any profit obtained in the past
or that can be obtained in the future unless the member submits the advertisement to NFA’s
Promotional Material Review Team for its review and approval at least 10 days prior to its first
use or such shorter period as NFA may allow.
Every Member should adopt and enforce written procedures to supervise communications with
potential and current customers and promotional material. A supervisory employee that is, or is
under the ultimate supervision of, a listed principal who is also an NFA Associate should review
and approve all promotional material and make a written record of such review and approval.12
All promotional material should be maintained by each Member and be available for
examination for the periods specified in the recordkeeping section of this notice, measured from
the date of last use.
See also Notice I-08-15:
(i) Hypothetical Results
Any Member who uses promotional material that includes a measurement or description or
makes any reference to hypothetical forex transaction performance results that could have been
achieved had a particular trading system of the Member or Associate been employed in the past
must comply with Compliance Rule 2-29(c) and the related Interpretive Notice as if the
performance results were for transactions in on-exchange futures contracts.
Solicitation
See NFA Rule 2-39 at www.nfa.futures.org/nfamanual/NFAManual.aspx?RuleID=RULE%202-
39&Section=4
NFA Interpretive Notice Regarding Forex Transactions
NFA Interpretive Notice Regarding Forex Transactions
→ See NFA Bylaw 306
at: www.nfa.futures.org/nfamanual/NFAManual.aspx?RuleID=BYLAW%20306&Section=3
Forex Dealer Member (FDM) is an NFA member who acts a counterparty to forex transaction. It is a self-
executing title, meaning that an NFA member is an FDM solely by nature of acting as a counterparty to
forex transactions. No applications or approvals are required to be considered an FDM. If you do not act
as a counterparty to a forex transaction (IB, CTA, or CPO), then you are not considered an FDM, but you
may be subject to parts of NFA Rule 2-36 pursuant to NFA Rule 2-39.
The following are not FDMs and not subject to NFA Rule 2-36:
financial institutions (e.g., banks and savings associations); certain insurance companies and their regulated subsidiaries or affiliates; financial holding companies; investment bank holding companies; registered broker-dealers that are members of FINRA; and Material Associated Persons of registered broker-dealers that are members of FINRA.
→ General Disclosures:
Disclosure of characteristics and risks of forex transactions (members and associates should know what information has been provided to the customer)
→ Specific Disclosures:
disclaimer regarding non-protection under the Bankruptcy Code manner in which member will be compensated for services 2 paragraph uppercase disclaimer re: trading not conducted on exchange, conflict of interest,
trading exposure disclose bid and offer when customer enters an order duty to update information if a material change would make prior information misleading
(member)
Reporting: NFA is concerned that the customer receives timely and accurate notice of account status:
Confirmations: Written confirmation must be submitted within one business day of any account activity (including offsetting transactions, rollovers, deliveries, etc.). Information should include all costs, fees, commission, third party fees, etc.
Monthly/Quarterly Summaries: If (1) there has been activity in an account during the month or (2) there are any open positions in the account at the end of the month, the FDM will need to provide a monthly summary of all forex transactions and other account activity to the customer. For customer accounts not fitting within the above, summaries should be provided quarterly.
Delivery: both confirmation and summaries may be transmitted by electronic means.
Supervision:
NFA Notice to Members: Supervision of Forex Promotional
Materials
NFANotice to Members – Supervision of Forex Promotional Materials (Notice I-08-15;
March 27, 2008) - there are three main parts to this notice.
Supervisory employee responsible for reviewing FDM promotional materials must be under the
ultimate supervision of a principal of the FDM who is also an AP (means that an individual
principal of a FDM will ultimately be held liable for fraudulent or midleading promotional
materials)
FDM must have policies on reviewing the activities of non-Members with which they do
business, including:
Regular review of trading
Procedures for customer complaints
Review of promotional materials
Review of activites of non-Members must also be done by an AP under the ultimate
supervision of an FDM principal/AP
Gross National Product (GNP)
Gross National Product (GNP)
The market value of all goods and services produced by US residents in the US or abroad (i.e. regardless
of where they were produced) over a period of time (typically a year).
World Trade Organization
World Trade Organization
The World Trade Organization (WTO) is an international organization designed by its founders
to supervise and liberalize international trade. The organization officially commenced on January
1, 1995 under the Marrakesh Agreement, succeeding the 1947 General Agreement on Tariffs and
Trade (GATT).
The World Trade Organization deals with regulation of trade between participating countries; it
provides a framework for negotiating and formalizing trade agreements, and a dispute resolution
process aimed at enforcing participants’ adherence to WTO agreements which are signed by
representatives of member governments and ratified by their parliaments.
Among the various functions of the WTO, these are regarded by analysts as the most important:
It oversees the implementation, administration and operation of the covered agreements.
It provides a forum for negotiations and for settling disputes.
Additionally, it is the WTO’s duty to review and propagate the national trade policies,
and to ensure the coherence and transparency of trade policies through surveillance in
global economic policy-making.
Another priority of the WTO is the assistance of developing, least-developed and low-
income countries in transition to adjust to WTO rules and disciplines through technical
cooperation and training.
The WTO is also a center of economic research and analysis: regular assessments of the
global trade picture in its annual publications and research reports on specific topics are
produced by the organization.
Finally, the WTO cooperates closely with the two other components of the Bretton
Woods system, the IMF and the World Bank.
Theory of Elasticities
Theory of Elasticities
The theory of elasticities holds that the exchange rate is simply the price of foreign exchange that
maintains the balance of payments in equilibrium. In other words, the degree to which the exchange
rate responds to a change in the trade balance depends entirely on the elasticity of demand to a change
in price.
For instance, if the imports of country A are strong, then the trade balance is weak. Consequently, the
exchange rate rises, leading to the growth of country A’s exports, and triggers in turn a rise in its
domestic income, along with a decrease in its foreign income.
Whereas a rise in the domestic income (in country A) will trigger an increase in the domestic
consumption of both domestic and foreign goods and, therefore, more demand for foreign
currencies, a decrease in the foreign income (in country B) will trigger a decrease in the domestic
consumption of both country B’s domestic and foreign goods, and therefore less demand for its
own currency. The elasticities approach is not problem-free because in the short term the
exchange rate is more inelastic than it is in the long term and additional forex rate variables arise
continuously, changing the rules of the game.
Source: http://www.iforex.org
Central Bank Activities
Central Bank Activities
A central bank, reserve bank, or monetary authority is the entity responsible for the monetary policy of
a country or of a group of member states. It is a bank that can lend money to other banks in times of
need. Its primary responsibility is to maintain the stability of the national currency and money supply,
but more active duties include controlling subsidized-loan interest rates, and acting as a lender of last
resort to the banking sector during times of financial crisis (private banks often being integral to the
national financial system). It may also have supervisory powers, to ensure that banks and other financial
institutions do not behave recklessly or fraudulently.
Intervention
Official intervention in the foreign exchange market means that the central bank or other agent of the
government buys or sells foreign currency in an attempt to influence the exchange rate value. Purchases
of foreign exchange usually are intended to push down the home currency value of the exchange rate,
and sales usually are intended to push it up.
Sterilized Intervention
In a sterilized intervention, the central bank offsets the purchase or sale of foreign exchange by selling
or purchasing domestic securities so as to keep the domestic interest rate at its target. Since the
domestic interest rate usually is considered the main determinant of the value of the domestic currency,
many argue, it must change in order to influence the exchange rate. Sterilized intervention may be
especially useful when the exchange rate is under speculative attack (that is, when a change in the
exchange rate is not justified by fundamentals) or to help coordinate private sector expectations
Role of Central Banks
Role of Central Banks
The role of central banks in microfinance is related to their broader role in the financial system
and in the economy more generally.
Central banks have a number of objectives:
tactical or macroeconomic objectives (relating primarily to the domestic price level and
the exchange rate);
long-term strategic objectives of financial sector development (including the
development of an effective payments system and other forms of financial infrastructure);
and
sectoral or microeconomic objectives (such as prudential supervision and deposit
insurance).
Portfolio Balance
Portfolio Balance
One of the problems stock investors have is losing their balance in an investment portfolio spread. This
balancing problem can occur in a rising market or in a falling market. The balance is the ratio in your
portfolio of stocks, bonds and cash. Investors should have a ratio in mind (some leave out cash) of how
they want their investments to be in proportion to their total portfolio.
International Monetary Fund (IMF)
International Monetary Fund (IMF)
The IMF promotes international monetary cooperation and exchange rate stability, facilitates the
balanced growth of international trade, and provides resources to help members in balance of
payments difficulties or to assist with poverty reduction.
Through its economic surveillance, the IMF keeps track of the economic health of its member
countries, alerting them to risks on the horizon and providing policy advice. It also lends to
countries in difficulty, and provides technical assistance and training to help countries improve
economic management. This work is backed by IMF research and statistics.
The IMF supports its membership by providing:
policy advice to governments and central banks based on analysis of economic trends and
cross-country experiences;
research, statistics, forecasts, and analysis based on tracking of global, regional, and
individual economies and markets;
loans to help countries overcome economic difficulties;
concessional loans to fight poverty in developing countries; and
technical assistance and training to help countries improve the management of their
economies.
International Fisher Effect (IFE)
International Fisher Effect (IFE)
An economic theory that states that an expected change in the current exchange rate between any two
currencies is approximately equivalent to the difference between the two countries’ nominal interest
rates for that time.
→ CALCULATE:
% change in the exchange rate =
(country A’s interest rate - country B’s interest rate)/(1 + country B’s interest rate)
≈ (country A’s interest rate - country B’s interest rate)
→ EXAMPLE:
If country A’s interest rate is 10% and country B’s interest rate is 5%, country B’s currency
should appreciate roughly 5% compared to country A’s currency.
The rational for the IFE is that a country with a higher interest rate will also tend to have a higher
inflation rate. This increased amount of inflation should cause the currency in the country with the high
interest rate to depreciate against a country with lower interest rates.
Interbank Funds Transfers & Settlement System
Interbank Funds Transfers & Settlement System
In the United States, payment and securities settlement systems consist of numerous financial
intermediaries, financial services firms, and non-bank businesses that create, distribute, and process
large-value payments. The bulk of the dollar value of these payments are processed electronically and
are generally used to purchase, sell, or finance securities transactions; disburse or repay loans; settle
real estate transactions; and make large-value, time-critical payments, such as payments for the
settlement of interbank purchases and sales of federal funds, settlement of foreign exchange
transactions, or other financial market transactions.
There are two primary networks for interbank, or large-value, domestic, funds transfer payment orders.
The first, Fedwire® Funds Service, is operated by the Federal Reserve Banks and is an important
participant in providing interbank payment services, as well as safekeeping and transfer services for U.S.
government and agency securities and mortgage-backed securities. In addition, Fedwire Funds Service
and the Federal Reserve’s National Settlement Service (NSS) are critical components used in other
payment systems’ settlement processes. The Clearing House Interbank Payments Company L.L.C. (CHIP
Co.) operates the second, the Clearing House Interbank Payments System (CHIPS).
Processing large-value funds transfers involves two key elements: clearing and settlement. Clearing is
the transfer and confirmation of information between the payer (sending financial institution) and
payee (receiving financial institution). Settlement is the actual transfer of funds between the payer’s
financial institution and the payee’s financial institution. Settlement discharges the obligation of the
payer financial institution to the payee financial institution with respect to the payment order. Final
settlement is irrevocable and unconditional. The finality of the payment is determined by that system’s
rules and applicable law.
In general, payment messages may be credit transfers or debit transfers. Most large-value funds transfer
systems are credit transfer systems in which both payment messages and funds move from the payer
financial institution to the payee financial institution. An institution initiates a funds transfer by
transmitting a payment order (a message that requests the transfer of funds to the payee). Payment
order processing follows the predefined rules and operating procedures of the large-value payment
system used. Typically, large-value payment system operating procedures include identification,
reconciliation, and confirmation procedures necessary to process the payment orders. In some systems,
financial institutions may contract with one or more third parties to help perform clearing and
settlement activities on behalf of the institution.
The legal framework governing payment activity and the regulatory structure for financial
institutions that provide payment services is complex. There are rules for large-value payments
that are distinct from retail payments. Large-value funds transfer systems differ from retail
electronic funds transfer (EFT) systems, which generally handle a large volume of low value
payments including automated clearinghouse (ACH) and debit and credit card transactions at the
point of sale.
Source: www.ffiec.gov
Balance of Trade
Balance of Trade
The value of a country’s exports minus its imports. A nation’s balance of trade is favorable when the
exports of goods exceed imports, and is said to be unfavorable if imports exceed exports.
Economic Indicators
Economic Indicators
Employment
Consumer Spending
Income
Industrial and Inflation Indicators
Foreign Investment Indicators
Foreign Investment Indicators
The forex market is sensitive to changes in the economy and will react accordingly. As the
economy is affected by investment performance, the expected returns may change due to the
influence of inflation or deflation. Thus, it’s important to consider foreign economy trends while
planning investment strategies.
→ EXAMPLE:
Foreign Investment Indicators
The Business Cycle has 4 stages: 1) recovery (also known as expansion); 2) peak; 3) contraction (also
known as recession); and 4) trough. The growth of business activity, increase of demand and production,
as well as expansion of employment should also be observed.
Gross National Product (GNP) is one of the key indicators of the economic activity. All the services
provided and the goods produced within the US economy form the GNP. There are 4 components
included in the GNP. They are: 1) consumer spending; 2) government spending; 3) investments; and 4)
net exports.
Jurisdictional & Regulatory Framework
Jurisdictional & Regulatory Framework
[Need to include]
NFA Membership & Associate Membership Requirements
NFA Membership & Associate Membership Requirements
Membership in NFA and CFTC registration are mandatory for futures commission merchants (FCMs),
commodity trading advisors (CTAs), commodity pool operators (CPOs), floor brokers, and introducing
brokers (IBs) working with customer accounts, as well as floor traders. The CFTC also requires associate
membership in NFA and CFTC registration for most associated persons (APs). APs solicit orders,
customers, or customer funds for FCMs, IBs, CTAs, or CPOs. Membership is voluntary for futures
exchanges.