Loans and money issues » currency

SWAPS

admin — Wed, 17 Nov 2010 11:01:02 +0000

A swap is an agreement whereby two parties (called counterparties) agree to exchange periodic payments. The dollar amount of the payments exchanged is based on some predetermined dollar principal, which is called the notional principal amount or notional amount. The dollar amount each counterparty pays to the other is the agreed-upon periodic rate times the notional principal amount. The only dollars that are exchanged between the parties are the agreed-upon payments, not the notional principal amount. In a swap, there is the risk that one of the parties will fail to meet its obligation to make payments (default). This is referred to as counterparty risk.
Swaps are classified based on the characteristics of the swap payments. There are four types of swaps: interest rate swaps, interest rate-equity swaps, equity swaps, and currency swaps. In an interest rate swap, the counterparties swap payments in the same currency based on an interest rate. For example, one of the counterparties can pay a fixed-interest rate and the other party a floating interest rate. The floating-interest rate is commonly referred to as the reference rate. In an interest rate-equity swap, one party is exchanging a payment based on an interest rate and the other party based on the return of some equity index. The payments are made in the same currency. In an equity swap, both parties exchange payments in the same currency based on some equity index. Finally, in a currency swap, two parties agree to swap payments based on different currencies.
A swap is not a new derivative instrument. Rather, it can be decomposed into a package of forward contracts. While a swap may be nothing more than a package of forward contracts, it is not a redundant contract for several reasons. First, in many markets where there are forward and futures contracts, the longest maturity does not extend out as far as that of a typical swap. Second, a swap is a more transactionally efficient instrument. By this we mean that in one transaction an entity can effectively establish a payoff equivalent to a package of forward contracts. The forward contracts would each have to be negotiated separately. Third, the liquidity of some swap markets is now better than many forward contracts, particularly long-dated (i.e., long-term) forward contracts.

TECHNICAL ANALYSIS AND CURRENCY MARKET PRACTITIONERS

admin — Thu, 02 Jul 2009 10:47:55 +0000

The various techniques of technical analysis, which we have only brieﬂy touched on here, have been widely practiced by traders for a very long time — centuries rather than years. The ﬁrst futures market was created in Japan in the early 1800s and the Japanese candlestick charting theory is seen as having emerged on the back of this. The very fact that we can chart US Treasuries back to the American Civil War conﬁrms that the art of charting is also hardly a new phenomenon in the US either. While currency, equity and ﬁxed income traders have long followed technical signals, corporations and asset managers have on the whole been somewhat more reticent to do so, either because of scepticism as to the merits of technical analysis or a lack of knowledge of how it works — or both. The best advance of any type of analytical discipline is that it actually works in practice; that it is capable of predicting exchange rates in this case and therefore using it one can generate excess returns. As Osler shows in her piece “Support for resistance: technical analysis and intraday exchange rates”,3 empirical evidence demonstrates that technical analysis can help in exchange rate prediction over and above the results available by simply using a random walk theory. Simply put, there is something to this. Looking at a slightly longer time frame, can a corporate Treasurer or an investor use technical analysis as part of their currency risk decision? The answer in this case is also, yes they can. While the primary focus of technical analysis is short term, it is fully capable of predicting multi-month of even multi-year moves. As an example, at the end of 1999, when the dollar–rand exchange rate was trading at around 6, the CitiFX Technicals team put out a buy signal, based on a combination of Elliott Wave Theory and the “golden cross” between the 55- and 200-day moving averages, with a multi-year target of 9.4 The exchange rate hit 9.00 on September 27, 2001. Again, the sceptical may see this as coincidence. However the fact is that skilful application of technical analysis principles correctly forecasts a move in the exchange rate that no interpretation of the “fundamentals” would have provided. At the very least, technical analysis should be a consideration for all types of currency market practitioner. Short-term traders are likely to use it as their primary analytical tool ahead of fundamental analysis because it is better suited to predicting short-term exchange rate moves than the traditional fundamental exchange rate models. Corporations and asset managers can use it as a cross-check of their fundamental views and also in terms of timing their hedging activity. The fact that traders watch technical levels and that traders make up the majority of currency market participants automatically makes those levels important.
What we have attempted in these few posts is to look at the basic principles and schools of thought within technical analysis, along with how and why it works. Having looked at pricing patterns, it is also important to look at the structural dynamics that determine that price. That is to say, one can look at a chart of an exchange rate, but it is also important to know how that price has been created and under what circumstances. Indeed, the type of exchange rate regime can render virtually worthless for periods of time most types of analysis, distorting both the fundamental and the technical signals that might otherwise be read. Thus, in the series of posts we take a look at the types of exchange rate regime and how each type might impact the exchange rate itself.

SCHOOLS OF (TECHNICAL) THOUGHT 1

admin — Tue, 30 Jun 2009 10:43:51 +0000

Having gone through the basic building blocks of technical analysis and the technical indicators that are used, we will now look at the major technical schools of thought that have dominated the way technical analysts and traders look at price patterns. The ﬁrst one to focus on is the Fibonacci school of thought, named after Leonardo Fibonacci, an Italian mathematician born in 1170. Fibonacci discovered a series of numbers such that each number is the sum of the two previous numbers:
1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233 and so on . . . To some, these numbers may seem more or less random. In fact, they are actually far from random, containing important interrelationships, and they are found in a surprising number of real-life examples. Indeed, it is not too much of an exaggeration to suggest that these numbers represent the mathematical building blocks of life. For a start, note that any given number is roughly 1.618 times the previous one. Equally, any number is 0.618 times the following number. As it stands, this does not answer the question of how Fibonacci happened to found, albeit inadvertently, a type of technical analysis. For this, we have to look ﬁrst at Fibonacci’s so-called “rabbit problem”, which relates to his attempt to demonstrate the application of Hindu–Arabic numerals through the example of rabbits. The mathematical problem that Fibonacci posed is that if two rabbits were put in an isolated place, how many pairs of rabbits could be produced from that pair in a year if every month each pair produces a new pair, which itself from the second month also becomes reproductive? At the start of the ﬁrst month, there would only be the ﬁrst pair. By the start of the second month, there would be the original pair plus one new pair, resulting in two pairs of rabbits. However, during that second month, the original pair will again produce another pair while the second pair is maturing. Thus, at the start of the third month, there should be three pairs, which brings us back to the Fibonacci number series. In terms of a mathematical formula, this can be expressed as: X n +1 = X n + X n−1 where X n is the number of pairs of rabbits after n months.
This became known as the Fibonacci sequence, as coined by the French mathematician Edouard Lucas (1842–1891). As the Fibonacci sequence progresses, a clear relationship between the numbers becomes apparent, as reﬂected by the 0.618 and 1.618 ratios mentioned above. The very fact that there can be a consistent ratio between numbers is itself “statistically signiﬁcant”, conﬁrming that there is more in this than just a random series of numbers. Note also that if you take any number and divide it by the number two higher in the sequence the ratio comes to 0.382. Not coincidentally, 38.2% and 61.8% are major Fibonacci retracement levels within the Fibonacci school of technical analysis.
While we look to Fibonacci and Lucas as the founders of modern-day Fibonacci analysis, it appears that long before them the importance of this sequence of numbers and ratios was well known and appreciated. Indeed, these ratios appear to have been used in the construction of both the Great Pyramid of Giza in Egypt and the Parthenon in Greece. The 0.618 or 1.618 ratio, also known as the Golden ratio, is commonly viewed in mathematics as one of the building blocks of natural growth patterns — in geometry as in life. Even the human body can be shown to contain elements of the Golden ratio, measuring the distance from the feet to the navel and in turn from the navel to the top of the head as a ratio. The basic building blocks of human beings, the DNA double helix, also contains the Golden ratio.