INSIDE THE CURRENCY MARKET Since 1996, Bloomberg Press has published books for fi nancial profession- als on investing, economics, and policy affecting investors. Titles are written by leading practitioners and authorities, and have been translated into more than 20 languages. The Bloomberg Financial Series provides both core reference knowl- edge and actionable information for fi nancial professionals. The books are written by experts familiar with the work fl ows, challenges, and demands of investment professionals who trade the markets, manage money, and analyze investments in their capacity of growing and protecting wealth, hedging risk, and generating revenue. For a list of available titles, please visit our web site at www.wiley.com/ go/bloombergpress. INSIDE THE CURRENCY MARKET Mechanics, Valuation, and Strategies Brian Twomey John Wiley & Sons, Inc. Copyright © 2012 by Brian Twomey. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. 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For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: Twomey, Brian, 1961- Inside the currency market: mechanics, valuation and strategies / Brian Twomey.—1 p. cm.—(Bloomberg fi nancial series) Includes bibliographical references and index. ISBN 978-0-470-95275-7 (hardback); ISBN 978-1-118-14933-1 (ebk); ISBN 978-1-118-14934-8 (ebk); ISBN 978-1-118-14935-5 (ebk) 1. Foreign exchange market. 2. Interest rates. I. Title. HG3851.T88 2011 332.4'5—dc23 2011021444 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 To the memory of my grandfather, Richard Francis Schmidt, the greatest stock trader I’ve ever known and a man who taught me not only valuable lessons of life but foundations of the markets at a young age. Contents Foreword ix Preface xi Acknowledgments xv CHAPTER 1 Foreign Exchange Reports 1 CHAPTER 2 Currency Trading Beyond the Basics 15 CHAPTER 3 Exchange Rates and Trade Weight Indices 39 CHAPTER 4 Short-Term Interest Rates and Money Market Instruments 73 CHAPTER 5 LIBOR 103 CHAPTER 6 Government Bonds, Yields, Yield Curves, and Currency Prices 147 CHAPTER 7 Swaps and Forwards 197 CHAPTER 8 Stock and Bond Markets 221 vii viii Contents CHAPTER 9 Currency Cycles, Currency Futures, Options, and Volatility 269 CHAPTER 10 Technical Analysis 283 Bibliography 299 About the Author 303 Index 305 Foreword I met Brian Twomey about fi ve years ago when he came to my offi ce here in North Carolina for a day visit. What immediately struck me about Brian was his “fi re-in-the-belly” spirit and go-getter attitude. Brian impressed me with his knowledge of the markets as well as his outstanding analytical prow- ess. We’ve kept in touch over the years and I was honored to be contacted by Brian’s publisher for the purpose of writing this foreword. For anybody interested in trading or studying the Forex markets, I would consider this book required reading. I was astounded at the level of detail, especially in terms of the nation-by-nation analyses that is provided. Detailed methodologies, trade strategies, a terrifi c chapter devoted exclusively to the Libor, and an extensive analysis of currency pairs are also discussed. At the book’s conclusion, Brian explains “My purpose for this book was to address all the various issues involved that comprise a currency pair not only from a strict trading perspective but to bring an understanding from a whole host of perspectives.” I believe that Brian has achieved this objective tenfold. I predict that this book will serve as an important reference resource for all those interested in the inner workings of world currencies. I hope you enjoy this book as much as I did. John R. Hill President Futures Truth Co. ix Preface This book answers the question what are the components, the constituent factors that comprise the second side of a currency-pair equation and how should those factors be considered in terms of a trade strategy. A currency pair comprises two sides, a two-nation perspective. In order to understand a currency-pair combination, both sides of the pair must be considered from the two-nation perspective. The two-nation perspective was fully outlined in this text with not only the trader in mind but researchers, market professionals, and present and future students of the markets. The genesis of the book framework was derived from the many biases I saw over the years from the academic journals, trader publications, or years of prior books. Each book, each article, and each journal publication offered a point, an insight that would help the reader further his or her knowledge. But each publication taught a perspective, an insight that would eventually lead to the overall understanding of the two-nation operational framework. Yet years may pass before the full learned concepts could actually become operational in a trade strategy and understanding of the market due to the proper knowledge never advanced in one publication. Publications had biases, toward the U.S. dollar side of the currency-pair equation, with no consideration of the second part of the pair. Spot-currency prices move in the markets based on factors of interest rates but interest rates between two nations rather than one side of a currency pair. The question must then be asked: How does the second nation calcu- late and factor interest, and what market instruments are available to track the various rates that trade every day in the markets in order to track a trade throughout the various markets? To trade Australian dollar/Japanese yen, one must understand Japanese TIBOR and Euroyen rates in terms of bank bills and Overnight Cash Rates in Australia. To trade U.S. dollar/Canadian dollar, one must know the U.S. Fed funds rates in relation to Canada’s CORRA and OMMFR interest rates. xi xii Preface How those specifi c interest rates trade and direction of their movements can have profound effects on currency-pair prices. This book sets out to outline the two-sided currency-pair trade from a whole host of perspectives as it relates nation to nation. It addresses currency pairs from the eight major nations because that is where the vast majority of trade occurs. Chapter One is an outline of the Triennial Survey released every three years by the Bank of International Settlements (BIS). While that is not new to any publication, the historical surveys are addressed and analyzed so readers can understand the historical composition of the market in its proper context as well as the rise of many varied currency pairs and fi nancial instruments associated with the historical rise of the markets. Beside the Triennial surveys, the BIS offers annual and quarterly reviews of the currency markets and each is addressed in terms of the specifi cs of the markets, types of topics addressed, and factors for consideration to under- stand and evaluate the market. Foreign-exchange committees formed in the late 1970s and mimic the work of the BIS. Each nation has an FX Committee, but that commit- tee is specifi c to the nation of trade. Each nation’s FX Committee is fully highlighted. Chapter Two offers foundation and theories of money and interest. It begins with a historical perspective and answers such questions as supply and demand of money from an operational framework, always highlighted nation by nation. Historically, the demand and supply of money begins with the classical theorist, moves into Keynes, Von Hayek, and Milton Friedman. Theories and perspectives of Purchasing Power Parity are explored in fi ne detail. Chapter Three explores trade weight indices from a whole host of per- spectives: historical, methodological, index composition, and theories of composition from an economic perspective. Each nation is addressed specifi - cally in terms of formulas, calculations, currency composition, and economic framework, and trade strategies are explained in detail. Chapter Four begins the open-market valuation and knowledge of inter- est rates and currency-pair prices from the perspective of repurchase agree- ments. Each nation is addressed specifi cally due to the many factors nations consider as they approach their open-market operations. Repo rates establish a fl oor for interest, yet interest rates rise and fall with markets and economic conditions. Each nation is addressed in all its minute detail to fully under- stand the operational framework of repurchase-agreement markets.