Lion Asset Management

FX Trading

Most traded currencies^[1]
Currency distribution of reported FX market turnover

Rank	Currency	ISO 4217 code (Symbol)	% daily share (April 2007)
1	United States dollar	USD ($)	86.3%
2	Euro	EUR (€)	37.0%
3	Japanese yen	JPY (¥)	16.5%
4	Pound sterling	GBP (£)	15.0%
5	Swiss franc	CHF (Fr)	6.8%
6	Australian dollar	AUD ($)	6.7%
7	Canadian dollar	CAD ($)	4.2%
8-9	Swedish krona	SEK (kr)	2.8%
8-9	Hong Kong dollar	HKD ($)	2.8%
10	Norwegian krone	NOK (kr)	2.2%
11	New Zealand dollar	NZD ($)	1.9%
12	Mexican peso	MXN ($)	1.3%
Other			16.8%
Total			20

There is no unified or centrally cleared market for the majority of FX trades, and there is very little cross-border regulation. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currencies instruments are traded. This implies that there is not a single exchange rate but rather a number of different rates (prices), depending on what bank or market maker is trading, and where it is. In practice the rates are often very close, otherwise they could be exploited by arbitrageurs instantaneously. Due to London’s dominance in the market, a particular currency’s quoted price is usually the London market price. A joint venture of the Chicago Mercantile Exchange and Reuters, called Fxmarketspace opened in 2007 and aspired but failed to the role of a central market clearing mechanism.

The main trading center is London, but New York, Tokyo, Hong Kong and Singapore are all important centers as well. Banks throughout the world participate. Currency trading happens continuously throughout the day; as the Asian trading session ends, the European session begins, followed by the North American session and then back to the Asian session, excluding weekends.

Fluctuations in exchange rates are usually caused by actual monetary flows as well as by expectations of changes in monetary flows caused by changes in GDP growth, inflation (purchasing power parity theory), interest rates (Interest rate parity,Domestic Fisher effect, International Fisher effect), budget and trade deficits or surpluses, large cross-border M&A deals and other macroeconomic conditions. Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time. However, the large banks have an important advantage; they can see their customers’ order flow.

Currencies are traded against one another. Each pair of currencies thus constitutes an individual product and is traditionally noted XXX/YYY, where YYY is the ISO 4217 international three-letter code of the currency into which the price of one unit of XXX is expressed (called base currency). For instance, EUR/USD is the price of the euro expressed in US dollars, as in 1 euro = 1.5465 dollar. Out of convention, the first currency in the pair, the base currency, was the stronger currency at the creation of the pair. The second currency, counter currency, was the weaker currency at the creation of the pair.

The factors affecting XXX will affect both XXX/YYY and XXX/ZZZ. This causes positive currency correlation between XXX/YYY and XXX/ZZZ.

On the spot market, according to the BIS study, the most heavily traded products were:

• EUR/USD: 27 %
• USD/JPY: 13 %
• GBP/USD (also called sterling or cable): 12 %

and the US currency was involved in 86.3% of transactions, followed by the euro (37.0%), the yen (16.5%), and sterling (15.0%) (see table). Note that volume percentages should add up to 200%: 100% for all the sellers and 100% for all the buyers.

Trading in the euro has grown considerably since the currency’s creation in January 1999, and how long the foreign exchange market will remain dollar-centered is open to debate. Until recently, trading the euro versus a non-European currency ZZZ would have usually involved two trades: EUR/USD and USD/ZZZ. The exception to this is EUR/JPY, which is an established traded currency pair in the interbank spot market. As the dollar’s value has eroded during 2008, interest in using the euro as reference currency for prices in commodities (such as oil), as well as a larger component of foreign reserves by banks, has increased dramatically. Transactions in the currencies of commodity-producing countries, such as AUD, NZD, CAD, have also increased.

Determinants of FX Rates

The following theories explain the fluctuations in FX rates in a floating exchange rate regime (In a fixed exchange rate regime, FX rates are decided by its government):

(a) International parity conditions viz; Purchasing power parity, Interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world.

(b) Balance of payments model. This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous appreciation of dollar during 1980s and most part of 1990s in face of soaring US current account deficit.

(c) Asset market model. Views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by people’s willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that “the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.”

None of the models developed so far succeed to explain FX rates levels and volatility in the longer time frames. For shorter time frames (less than a few days) algorithm can be devised to predict prices. Large and small institutions and professional individual traders have made consistent profits from it. It is understood from above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces of demand and supply. The world’s currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange.

Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology.

Economic factors

These include: (a)economic policy, disseminated by government agencies and central banks, (b)economic conditions, generally revealed through economic reports, and other economic indicators.

(a)Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government’s central bank influences the supply and “cost” of money, which is reflected by the level of interest rates).

(b)Economic conditions include:

Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country’s currency.

Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country’s currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation’s economy. For example, trade deficits may have a negative impact on a nation’s currency.

Inflation levels and trends: Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising [. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.

Economic growth and health: Reports such as gross domestic product (GDP), employment levels, retail sales, capacity utilization and others, detail the levels of a country’s economic growth and health. Generally, the more healthy and robust a country’s economy, the better its currency will perform, and the more demand for it there will be.

Productivity of an economy: Increasing productivity in an economy should positively influence the value of its currency. It affects are more prominent if the increase is in the traded sector.

Political conditions

Internal, regional, and international political conditions and events can have a profound effect on currency markets. Expectations of war between India and Pakistan can negatively influence the value of currencies of two nations.

All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation’s economy. For example, destabilization of coalition governments in India, Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive or negative interest in a neighboring country and, in the process, affect its currency.

Market psychology

Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:

Flights to quality: Unsettling international events can lead to a “flight to quality,” with investors seeking a “safe haven“. There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The Swiss franc has been a traditional safe haven during times of political or economic uncertainty.

Long-term trends: Currency markets often move in visible long-term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends.

“Buy the rumor, sell the fact:” This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being “oversold” or “overbought”. To buy the rumor or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices.

Economic numbers: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. “What to watch” can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight.

Technical trading considerations: As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns.

Forex Investor Alert

NATIONAL FUTURES ASSOCIATION
FOREX INVESTOR ALERT
FEBRUARY 2007

In August 2003 NFA issued an Investor Alert discussing the risks of trading in the retail off-exchange foreign currency (forex) market. Since that time, participation in forex trading by retail investors has increased dramatically. There are current 37 active Forex Dealer Members registered with NFA. These 37 firms hold over $800 million in customer funds.

Unfortunately, the amount of forex fraud has also increased dramatically. Since 2001, the Commodity Futures Trading Commission (CFTC) has filed 93 enforcement actions in federal court against hundreds of firms, owners and employees for defrauding over 25,000 customers who lost over $395 million in forex schemes. In addition, NFA has taken enforcement actions against a number of its Forex Dealer Members.

It is critical, therefore, that individuals who are considering participating in the forex market understand the risks associated with this product and conduct due diligence before making any investment decisions.

* Although forex dealers must be regulated, firms and individuals can solicit retail accounts for forex dealers and manage those accounts without being subject to any regulatory requirements. There are currently more than 2,000 such firms and individuals. If you are contacted by one of them, either through a telephone call, an e-mail message or a Web site, find out if they are regulated. If they are not, you may be exposed to additional risks.

* Be aware of investment schemes that promise significant returns with little risk. Be very cautious and closely monitor any investment you do make.

* Because the forex market is volatile, fluctuations in the foreign exchange rate between the time you place the trade and the time you attempt to liquidate it will affect the price of your forex contract and the potential profit and losses relating to it.

* Only a relatively small amount of money can enable you to hold a forex position for much more than the account value. This is referred to as leverage or gearing. If the price moves in an unfavorable direction, high leverage can produce large losses in relation to your initial deposit. In fact, even a small move against your position may result in a large loss, including the loss of your entire initial deposit and the liability for additional losses.

* Forex transactions are not traded on an exchange. Therefore, under the U.S. Bankruptcy Code, your funds may not receive the same protections as funds used to margin or guarantee exchange-traded futures and options contracts, which receive a priority in bankruptcy.

For additional information on retail forex trading, you should consult NFA’s brochure, “Trading in the Retail Off-Exchange Foreign Currency Market: What Investors Need to Know.” NFA has also developed a Forex Online Learning Program, an interactive self-directed program explaining how retail forex contracts are traded, the risks inherent in forex trading and steps individuals should take before opening a forex account. Both the brochure and the online learning program are available at no charge to the public in the Investor Learning Center section of NFA’s Web site (www.nfa.futures.org).

As mentioned above, retail off-exchange forex trading carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose all of your initial investment and be liable for additional losses. Therefore, you should not invest money that you cannot afford to lose. Be aware of all the risks associated with forex trading and make an informed decision after consulting with your financial advisor and considering your own financial situation and objectives.

NFA and the CFTC encourage members of the public to bring to our attention any suspicious activities involving foreign currency investments or suspicious Internet Web sites. Contact NFA’s Information Center at 1-8… or file a complaint through NFA’s Web site (http://www.nfa.futures.org/basicnet/Complaint.aspx). Contact the CFTC at 1-866-366-2382, visit the CFTC’s Customer Protection Web page (www.cftc.gov/cftc/cftccustomer.htm) or fill out the CFTC’s Internet Report Form (www.cftc.gov/enf/enfform.htm).

NFA is a self-regulatory organization subject to oversight by the CFTC. NFA’s primary mission is to protect investors and maintain market integrity.