ABCs of Forex

Fundamentals
Kathy Lien & Boris Schlossberg
www.bkforex.com
Past performance is not indicative of future results. Trading forex carries a high level of risk, and may not be suitable for all
investors. The high degree of leverage can work against you as well as for you. Before deciding to trade any such leveraged
products you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists
that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you
cannot afford to lose. You should be aware of all the risks associated with trading on margin, and seek advice from an
independent financial advisor if you have any doubts.

The information, including Commentary and Trade Ideas, provided on bkforex.com should not be relied upon as a substitute
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their trading to their personal risk appetite.

BKForex LLC will not be responsible for any losses incurred on investments made by readers and clients as a result of any
information contained on BKForex LLC. BKForex LLC do not render investment, legal, accounting, tax, or other professional
advice. If investment, legal, tax, or other expert assistance is required, the services of a competent professional should be
sought.
FX – The Most Dynamic Market In The World

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What Makes the Forex
Market Unique?


Why ? Leverage
USD/JPY (each pip is worth approx $1.2) at 84

Cash on Cash 20x Leverage

Required Margin = $10,000 Required Margin = $500
100 pips move = +/- $120 (+/- 1.2%) 100 pips move = +/- $120 (+/- 24%)

2x Leverage 50x Leverage

Required Margin = $5,000
Required Margin = $200
100 pips move = +/- $120 (+/- 2.4%)
100 pips move = +/- $120 (+/- 60%)

2:1 5:1 10:1
No Leverage Leverage Leverage Leverage
Starting Value $10,000.00 $10,000.00 $10,000.00 $10,000.00
1% Loss $9,900.00 $9,800.00 $9,500.00 $9,000.00
1% Loss $9,801.00 $9,604.00 $9,025.00 $8,100.00
1% Loss $9,702.99 $9,411.92 $8,573.75 $7,290.00
1% Loss $9,605.96 $9,223.68 $8,145.06 $6,561.00
1% Loss $9,509.90 $9,039.21 $7,737.81 $5,904.90

5% To Recover 70% To Recover

$10,000 $10,000
Source: Technical Analysis of the Currency Market by Boris Schlossberg

Table of Doom
Amount of Equity Amount of Return Necessary to Restore to
Lost Original Equity Value
25% 33%
50% 100%
75% 400%
90% 1000%

Source: Technical Analysis of the Currency Market by Boris Schlossberg

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8 Major Currency Pairs
U.S. Dollar
Euro
British Pound
Japanese Yen
Australian Dollar
New Zealand Dollar
Canadian Dollar
Swiss Franc
Mexican Peso….
and many more…
Currency PIP Value

•  Euro Dollar (EUR/USD) $10.00/pip

British Pound (GBP/USD) $10.00/pip

•  Japanese Yen (JPY/USD) $10.20/pip (fluctuating)

•  Swiss Franc (CHF/USD) $8.70/pip (fluctuating)

•  Canadian Dollar (USD/CAD) $7.90/pip (fluctuating)

•  Australian Dollar (AUD/USD) $10.00/pip

•  New Zealand (NZD/USD) $10.00/pip

Currencies are
traded in pairs

Base vs. counter

currency
EUR vs. USD


Rollover

h1p://www.thedigeraSlife.com/blog/index.php/2008/10/13/high-yield-savings-account-interest-rate-changes-ahead/
 Trading
Forex vs. Stocks


What Moves Stocks?
ü  Corporate news and earnings
ü  Economic data
ü  Interest rates / comments by Central Banks
ü  Commodity prices
ü  Market sentiment
What Moves FX?
ü  Corporate news and earnings
ü  Economic data
ü  Interest rates / comments by Central Banks
ü  Commodity prices
ü  Market sentiment
Stock Trading
1.  Trade the Story - Valuation
2.  Trade the News – Corporate Announcements
3.  Trade the Charts – Technical Analysis
Forex Trading
1.  Trade the Story – economic outlook, interest rates
2.  Trade the News – economic data
3.  Trade the Charts – technical analysis
OR combination of
Technical & Fundamental Analysis

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Source: Babypips

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Currency trading can be more volatile > Each small
move is incrementally larger in FX

1.  Buy low, sell high > Can stop you out before it
rebounds
2. Practice good risk/reward - 2:1 ideal > May not
achieve the 2:1 risk/reward
3. Avoid getting in or out of the market too often > One of
the few ways to turn volatility into opportunity
 An Easy Guide
to
Understanding
the Global Economy

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 What is Economics
&
Why You Should Care

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 #1
GDP “IS” the Economy

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 GDP Formula

= C + I + G + NE

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GDP = C + I + G + NE

C = Consumer
Consumption (70%)

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GDP = C + I + G + NE

I = Investment (17%)

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GDP = C + I + G + NE

G = Government Spending
(19%)

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GDP = C + I + G + NE

NE = Net
Exports (-6%)

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GDP = C + I + G + NE
C = Consumer Consumption (70%)

I = Investment (17%)

G = Government Spending (19%)

NE = Net Exports (-6%)

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 Business
Cycles

Expansions & Recessions

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 Expansions = Growth, Upswings, Recoveries

Contractions = Recessions, Downturns, Negative

Growth

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Expansion = Consumer, Biz and Gvt Demand

Household Demand Rises

Businesses Increase Production

Workers Work More

Companies Eventually Hire!

Good for Stocks, Currencies, Risk Appetite

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Recession = 2 Quarters of Negative GDP Growth

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Recession = Consumer, Biz and Gvt Demand

Consumer Demand Declines

Businesses Cut Back Production

Workers Work Less

Companies Eventually Fire!

Bad for Stocks, Currencies, Risk Appetite

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How Recessions are Fought

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1. Fiscal Policy

2. Monetary Policy

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 Fiscal Responses

1. Tax Cuts
2. Increased Spending
3. Unemployment Insurance

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 Monetary Responses

1. Reduce Reserve Ratio

2. Cut Fed Funds Rate
3. Cut Discount Rate
4. Buy Government Bonds
5. Weaken Currency

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 Monetary Responses
Cut Federal Funds Rate

Lower Rates = Frees up Capital,

Helps Consumers

Raise Rates = Subtracts Capital,

Hurts Consumers
 Monetary Responses
Reduce Reserve Ratio

Reserve Requirements => Puts More

$$ into the financial system

Reserve Requirements => Takes $$

out of the financial system

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 Monetary Responses
Cut Discount Rate

Similar to Cutting Fed Funds Rate

but affects banks directly

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 Are Lower Rates
Positive or Negative for
a Currency?

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 Monetary Responses
Buy Government Bonds = QE

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 Monetary Responses
Weaken Currency

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 What is Quantitative Easing?
Quantitative = Specific Amount of $$ Created
Easing = Pressure on Banks

QE = Buying Financial Assets from Banks to

flood them with Reserves (think cash in their
hands)

GOAL? Get Banks to LEND

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LTRO

L = Long
T = Term
R = Refinancing
O = Operation

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How Does It Work?

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 ECB Lends 1%
Santander Invests at 5%
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Where do Central Banks get
the Money?

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What Happens in QE?
Fed adds a few zeros to their own account

Uses $$ to buy govt bonds & other assets

from financial firms

Firms use new $$ to lend or buy other assets

such as bonds

Bond yields fall, stock prices rise, FX reacts

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 Trade-Off

Inflation vs. Unemployment

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 INFLATION is VERY bad
because:
1.  Will Hit Struggling Consumers Really Hard
2.  Once Inflationary Spiral Gets Going, its Hard to Stop
3.  Inflation is a Hidden Tax on Everybody
4.  Threatens to Destabilize the Financial System

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Deflation can be TOXIC too!

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How to Unwind QE
Fed adds a few zeros to their own account

Uses $$ to buy govt bonds & other assets

from financial firms

Firms use new $$ to lend or buy other assets

such as bonds

Bond yields fall, stock prices rise, FX reacts

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 Bond Price and Yield
Relationship

Bond Price

Bond Yield

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 What Bond Yields and
Auctions Tell Us
Higher yields = BAD for struggling
nations
Bid to Cover Ratio
Yields Paid

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 Put Yourselves into the
Shoes of the Central Bank

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GDP = C + I + G + NE
C = Consumer Consumption (70%)

I = Investment (17%)

G = Government Spending (19%)

NE = Net Exports (-6%)

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Tying it all back to
Forex

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 3Ms
Macro
Micro
Monetary Policy
 Macro
ü  Political conflict
ü  Equities and risk appetite
ü  Oil and gold
Key Micro Data
ü Employment (Labour Data)
ü ISM (Manufacturing and Services Data)
ü Consumer Spending
ü Growth
ü Inflation
Monetary Policy
ü  Know the players
ü  Know the mandates
ü  Prepare properly
 #1 – Fair Values
DO NOT matter
What is
Purchasing Power Parity
(PPP)?

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10 Yr Historical PPP

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PPP based on CPI

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Big Mac Index

http://www.economist.com/content/big-mac-index
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The Fundamentals that
Matter in FX
 #1
Risk On / Risk Off

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 2 Key Phrases

#1 - High Beta Currencies

#2 - Safe Haven Currencies

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 What is a High Beta
Currency?
Beta = volatility of an asset compared to index
High Beta = Extra Volatile
High Beta Currency = Extra Volatile Currency

Mkts Go Up = High Beta FX Performs Better

Mkts Go Down = High Beta FX Performs Worse

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 What is a Safe Haven
Currency?
Safe Haven = Place to Escape Unpleasant /
Dangerous Things
Safe Haven Currency = Currencies that investors
park their $$ in during uncertain and dangerous times

Mkts Go Up = Safe Haven Currencies Weaken

Mkts Go Down = Safe Haven Currencies Strengthen

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 Risk On
-  Investors are optimistic
-  Willing to Take on Risk
-  Money Shifts from Bonds to Stocks
-  High Beta FX Rally
-  Safe Haven Currencies Sell Off

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 Risk Off
-  Investors are nervous, pessimistic
-  Shying away from ALL risky investments
-  Money Shifts from Stocks to Bonds
-  High Beta FX Sell Off
-  Safe Haven Currencies Rally

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 Risk On

EUR, GBP, AUD, NZD, CAD

Risk Off

USD, JPY, CHF

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K
Dollar Index

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 What Determines
Risk On / Risk Off?
“3 Ms”
Macro
Micro
Monetary Policy

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Central Bank Intervention

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 Source: eSignal
Past performance is not indicaSve of future results

Why Do We Care About

Central Bank Interven8on?

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 Source: eSignal
Past performance is not indicaSve of future results

Why Do We Care About

Central Bank Interven8on?

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 How Does Central Bank
Interven8on Work?

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h1p://www.artremis.com/arScle/pics/ubs_trading_floor08.jpg

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 How Does Central Bank
Interven8on Work?
SELL

Buy
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 Foreign Exchange Reserves

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of-cash.jpg
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 2 Choices for the Central Bank
1) Sterilize the Interven8on

- Sell Bonds Domes8cally > Soak Up the New Cash
Pros
Investor
Paying - Achieves
for psychological shock
Japanese Bonds of intervenSon
Government -  MiSgates prior
effects

Cons
- Rarely Lasts


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h1p://y.e-staSc.net/file-pic/handing-over-cash/handing-over-cash.jpg
 2 Choices for the Central Bank
2) Leave Interven8on Unsterilized

- No Addi8onal Ac8on to Change Monetary Base


Can Work if Problems are Domes8c in Origin and
Monetary in Nature

Japanese
Government

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How Do Carry Trades Work?

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 How Do Carry Trades Work?
Australian Dollar / Japanese Yen
2.50% 0.10%

h1p://swap.semanScweb.org/

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3 Conditions for Carry Trades

- Low Volatility
- Risk Appetite
- Bias to Tighten Monetary Policy

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What is Repatriation?

March Fiscal Yr End in Japan

December Window Dressing

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Macro Factors
InterMarket Correlations
The Relationships YOU MUST Know
•  Currencies Track Equities
•  Commodities are Priced in Dollars
•  The Dollar is King!
BUT Correlations are NOT always Causality and
do NOT hold 100% of the time

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Other Important Things to Know…
Fixings
Option Expirations
Real Money versus Smart Money
Seasonality
FX Reserves
How Does China’s Peg Work?

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Fixings
Some financial market contracts have a daily point
where the currency is fixed for reference purposes
Most Important Fixing Times
8:55am Tokyo Time (7:55pm NY Time)
4pm London Fix (11am NY Time)
Currencies can see unusual unexplained movements
leading up to and abruptly ending at the fixing time

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Option Expirations
Most Important Option Expiration Times
3pm Tokyo Expiry (2am NY Time)
10am NY Expiry***
Currencies can see unusual unexplained movements
leading up to and shortly after option expirations

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Macro Factors
REAL MONEY

VS
SMART MONEY

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Questions?