MONEY, CURRENCY, ANDFOREIGN EXCHANGE (FOREX)

The most basic questions and concepts we must address involvethe differences between money, currency, and foreign exchange(FOREX). All too often these terms are interchanged. With equalfrequency, the differences are blurred and misconceptions aredeveloped. Aren’t the three terms one and the same? The answeris no.The Barter Process and the Evolution of MoneyMoney is the primal evolution of barter. It was developed as aconvenient means for exchanging goods and services. If my edu-cation correctly serves me, the first recorded book entries dateback 5,000 years ago to the Sumerians who were defined as thefirst society. Book entries could only become a reality as numericsystems were developed. This is how money allegedly originated.Certainly, there were methods to exchange goods and serv-ices before the Sumerians. The barter process appears in cavewall drawings and remains widely used today. However, barterlacks efficiency because it inevitably involves considerable nego-tiation to consummate a transaction. Value must be determinedthrough a process of bidding and offering. Sound familiar? Forexample, suppose an ancient tribesman trapped a few beaverswhile a fellow tribesman caught several fish. Not needing all the beavers or all the fish, the two may decide to exchange beaver forfish. Depending on the perceived value of beaver pelts in themind of the fisherman versus the relative hunger of the trapper,some ratio of beaver to fish would be agreed upon.Understandably, perceived values will change. The first inklingof seasonality can be deduced from the previous example by over-laying the need for warmth during the winter onto the nonseasonalrequirement for food. Logically, pelts should fetch more fish astemperatures cool. The trapper is likely to fatten up during winter,but go hungry in the summer. This suggests that the trapper willexpand his product line to include meat as well as pelts. This over-comes seasonal problems. Both the trapper and fisherman mustspend the better part of their day accumulating their bounties.Perhaps neither has time to build or maintain shelter. However,another tribesman discovers that his lack of skills as hunter or fish-erman is offset by his ability to construct sturdy huts.The hut builder introduces the concept of cyclical supply anddemand as well as an underlying seasonal influence. He mustbuild huts when the weather is mild and there is easy access tothe ground. His unique challenge derives from his product’s dura-bility coupled with seasonal supply. He develops a prolongedbarter whereby he swaps a hut for a year’s supply of fish or meat.Thus, the hut builder’s commitment to exchange today is carriedforward in payments. Heavens! Was this the first mortgage?The model grows more complex when the hut builder dis-covers that the value of his trade exceeds his requirements forfish and meat. Since he cannot consume all he has bartered for,he decides to use his excess to acquire a wagon from the wagonmaker to transport his building materials and increase his effi-ciency. Perhaps he also exchanges fish and meat for tools. Theincreased efficiency only brings the hut builder more fish andmeat. He decides to train other hut builders with the under-standing that they will work for him and receive a portion of hismeat and fish. The first real-estate tycoon is made. In all likeli-hood, he doesn’t even pay for the land!We see an economic system emerging from barter. All thewhile, however, transactions and relative values must be negoti-ated. Eventually, the hut builder’s tradesmen may decide to gooff on their own. Suddenly, there is competition in the real-estatemarket. With equal certainty, the tribe will have many fishermen, hunters, wagon builders, toolmakers, and other tradesmen.If competition becomes heated, arguments can develop, and,alas, we see the makings of war.This is not necessarily a historically correct portrayal. Themetaphor simply illustrates how a barter economy develops andfunctions. Reviewing and understanding this fundamental eco-nomic system is important when we seek to determine FOREXtrading strategies based upon relative values for global goods andservices. With the decline of colonization, nations have becomeregional. Since global resources are highly regional, nationalwealth becomes a function of location, population, and sophisti-cation. In turn, national wealth determines a currency’s relativestrength or weakness.Although this concept will be covered in later chapters, Iwon’t hold you in total suspense. Some basic examples can beillustrated by Middle East oil or South African gold and plat-inum. These natural and valuable resources provide foundationsfor national economic security. They also fuel currencyexchange. Japan relies upon ingenuity to efficiently convert rawmaterials into finished goods. The yen’s value rises and falls rel-ative to Japan’s innovation and related exports. Each nation reliesupon particular resources to derive wealth. As we will see, thiswealth is a driving force behind fluctuating currency values.However, it is not the only driving force.Returning to our barter example, we can identify a need for amore efficient method of exchange. A toolmaker observes thatsome metal materials have a mysterious attraction. A shiny yel-low metal is far heavier than the harder bronze he uses for an axor hammer. His neighbor takes a fancy to the yellow metal andoffers to exchange his skills as an artisan for a portion of theshiny yellow metal. Incredibly, the entire tribe, as well as othertribes, finds this yellow metal universally attractive. Of course,this metal is gold. After a sufficient quantity of gold becomesavailable, tribal members decide to mold it into uniform piecescalled coins. They examine a fundamental product like fish andsee that one fish fetches two beaver pelts. If they set the value ofone fish equal to one gold coin, then one gold coin buys twobeaver pelts. Thus, the value of a gold coin is established as aratio to a common barter product with a relatively stable per-ceived value.Money, Currency, and Foreign Exchange This example of converting gold into money does not takeseasonal or cyclical values into consideration. It is only a way toexplain the probable transition from barter to money. You areprobably saying, “Tell me something I don’t know.” I emphasizethat basic concepts translate into a more precise understandingof how FOREX works.In reality, gold is a convenient example rather than a histori-cally accurate account of how money emerged. Gold and even sil-ver were too scarce to be effective forms of money. This is why thePhoenicians resorted to shells, while other cultures minted cop-per, tin, and iron or used glass, beads, and stones. This does notimply that gold and silver were not used for exchange. However,gold and silver’s widespread use for day-to-day transactions wasnot common until far more sophisticated economies evolved.As we will see, gold and silver were symbols of wealth andstores of value. These metals were used for more substantialtransactions often involving exchange between kings or noble-men. These metals represented the first significant form ofFOREX. Equally important, gold and silver were used to measureoverall and relative wealth. You may say, “Wealth is wealth.”This truism stands; however, there is a concept of relative wealththat plays an important role in determining modern interna-tional currency trends.The Family Tree of Money, Currency, and FOREXMost of us are familiar with trading cards. Whether trading base-ball or Pokémon cards, children probably develop their first senseof value and negotiating skills by swapping trading cards. Indeed,some of us learned through this same primal exercise in FOREX.We can analyze card swapping in three ways. We can assumeeach card represents a form of currency whereby a specific cardis likened to the yen while another symbolizes the dollar. Weimmediately comprehend that the card’s value is directly associ-ated with its scarcity relative to demand. Children instinctivelyknow that the more rare the card, the more valuable it becomesrelative to other cards or simply for outright purchase.By the same token, children grasp the concept of storingvalue when they refuse to relinquish extremely valuable cards regardless of the offer. Of course, this is where children mayappear irrational. After all, every card should have a price, right?Interestingly, adults and, more significantly, entire societies canenter periods of irrational savings. The concept of storing value,regardless of alternatives, can be seen as a confidence crisis. Inthe child’s case, he or she lacks confidence that he or she willsecure a replacement card. Suddenly, this card is the only suchcard in the child’s mind—a must have or must keep. Whensocioeconomic panic sets in, history suggests we fall back on pri-mal wealth symbolism like gold, property, or essential assets.Today, we call this a flight to quality.Experienced currency traders might legitimately disagreewith equating each unique card with a unique currency. It is notnecessarily the case that the scarcest currency fetches the high-est price or attains the greatest perceived value. In fact, the mostabundant currency, like the dollar, is frequently viewed as themost valuable. Therefore, another viewpoint is that each playingcard represents a unit of currency similar to the $1, $5, $10, and$20 bills going up to the highest denomination. In this example,the trading card becomes money rather than currency. What’sthe difference?Simply put, money represents the means of exchange withinits country of origin. When we think of money, we immediatelyresort to the bills and coins in our pockets or purses. We rarelyconjure up an image of equalizing values between our pocketcash and the money of western Europe or the Pacific Rim. Thedifference is subtle, but consider that money has a fixed valuewithin its place of origin. If baseball cards had a fixed value, theywould not be negotiated. You would simply trade a known Xnumber of cards for a known Y quantity of cards. In turn, theratio of cards to each other permits different mixes of cards tobuy goods and services. Observation tells us this is not the case.Trading cards change value in accordance with the inventories ofthose making the bids and offers.Today, money, currency, and FOREX are like a family tree.Currency is money once removed. They are similar, yet theyoperate in different forums for different purposes. Another wayto view trading cards expounds upon the market concept of thebid and offer. At any given moment, groups of children sportingdifferent card inventories gather in separate markets to set theirMoney, Currency, and Foreign Exchange relative card values. Depending upon the inventories availablewithin each market, the same cards will take on different values.Given the sophistication and indulgence of our newest genera-tions, kids might plan to be in different markets at the same timeby communicating bids and offers via cell phone or email.Behold, children participating in arbitrage!When card values are exchanged in broad markets, we see ametaphoric example of FOREX. Taking this forward anotherstep, money is used to buy local goods and services. Assume abushel of soybeans is worth $6. We know that a $1 bill and $5bill will purchase a bushel of beans. If we use a $10 bill, wereceive $4 in change. A drought may drive soybeans higher,whereas good weather may lower prices. If the price is stable at$6, what is the same bushel worth in pounds (£)? The answer liesin the relative value of pounds to dollars. Consider that if thepound loses value against the dollar, U.S. soybeans become moreexpensive in the United Kingdom, but remain the same price indollars. This is another way to differentiate money from cur-rency. Recognize that this example uses a single commoditypriced in two currencies. When soybeans are sold in the UnitedKingdom, local influences may make the price in pounds higheror lower. Thus, local supply and demand prevails to set localprices.It does not take a great deal of perception to know where theexample culminates. If we remove the soybeans and simply tradepounds against dollars, we are dealing in FOREX. In the FOREXmarket, the supply and demand for different currencies at anygiven moment establishes an exchange value—hence the expres-sion foreign exchange. When you trade FOREX, you attempt toanticipate fluctuations in relative currency values. More oftenthan not, you are not concerned with the price of local goods andservices in local monies. There is an obvious link between localcurrency strength and weakness that is associated with inflationand deflation. If the dollar is inflating while the pound is not,there is a very good chance the pound will appreciate against thedollar. Unfortunately, FOREX relationships have become highlyanticipatory. This means that today’s inflation might be dis-counted by tomorrow’s anticipated price correction. The subtleaspects of forecasting will be explained in later chapters. For now,keep this concept in the back of your mind as we move forward. The Mechanisms of Money, Currency, and FOREXWith a modest understanding of money, currency, and FOREX,the next step in building a trading strategy involves breakingeach component down into its mechanism. Here, distinctionsbetween money and currency tend to blur. With concentration,we can maintain differentiation to develop more profound inter-pretations of intermarket events. Today’s money consists of cashand book entries. Both use common denominations or units.U.S. money begins with the unit of currency called the dollar.This is fractionalized or multiplied as required to refine purchaseprices. The fractions are on a base-10 system beginning with1/100thof $1 called the cent (¢). The physical representation of1¢ cent is the penny. Cent is the unit, whereas penny is the coin.Five cents is coined as the nickel. We are still dealing with thecent, but our physical money can be either 5 pennies or 1 nickel.Of course, 10¢ is a dime, 25¢ is a quarter, and, oddly, 50¢ is a 50-cent piece.I indulge in this elementary-level exercise because it is exceed-ingly important to make the leap from fractional units to currencyunits. The entire process of FOREX trading is based upon commonfractional values known as pips. A pip is the common denomina-tor between currencies much like the cent is the denominator forthe dollar. While writing this text, I could only identify one U.S.product where domestic prices were quoted in fractions of apenny. Perhaps you can identify more. What is it? For somestrange reason, U.S. retail gasoline is priced ending in nine-tenthsof a cent. I’ve always wondered why this is always rounded up tothe nearest cent. Who is keeping all those one-tenths?Those familiar with Charles Dickens’ novel Great Expecta-tions might associate the word pip with that book’s central char-acter. We less-literary folk must direct our attention to the lastsignificant decimal of a quoted currency. Again, this seeminglysimple definition takes on monumental importance because pipsdetermine the most common intraday and interday spreads andare also used to price transactions. The spread in pips can be themarket maker’s commission and, thus, your trading cost. As wewill discuss in further detail, the pip is used when currencies arequoted against each other in the cash, Interbank, or electronicspot FOREX markets. When the reciprocal is correlated to theMoney, Currency, and Foreign Exchange dollar in U.S. futures and options, the pip disappears. Each mar-ketplace has its own language and structure. Once you under-stand each market’s operations, including its advantages anddisadvantages, you can make an educated decision about howand where to participate.When conducting seminars on FOREX trading, I often drawthe parallel between components like money or currency andquantum physics versus cosmetology. Admittedly, this correla-tion is a scientific stretch and is not intended to infringe uponthe territorial imperative of our most brilliant academicians.FOREX trading does not require the CERN particle acceleratorto identify its inner most workings. However, the perspectivesare similar to emphasize a FOREX trader’s required multiplicity.The tiniest particles within our universe were born out of thegreatest cosmological event presumed to be the Big Bang.Money is derived from the most fundamental human prem-ise—faith. This faith that money is, in fact, valuable must begoverned by multiple facilities that include government treasur-ies, central banks, commercial banks, consumer banks, specialtybanks (savings and loans, credit unions, government lendinginstitutions like Fannie Mae and Freddie Mac, and so on), theInternational Monetary Fund, and international currency mar-kets. In addition, each sovereign’s taxing authority plays a role inthe amount of money citizens have available to spend and theamount governments have to spend or waste as they see fit. Eachlink in money’s governing chain plays a role in determiningvalue. Relationships between money institutions such as banks,coupled with the monetary policy of the governing institutionslike the Federal Reserve or Treasury, determine the money sup-ply. When correlated with demand, money establishes its valuerelative to domestic goods and services as well as its value asinternational currency.The Regulation of Money SupplyAs you can see, our very simple explanations of money, currency,and FOREX begin to become more complex. The amount ofmoney we have is primarily regulated by interest rates and trans-actions commonly called open market operations. In the UnitedStates and many other nations, money supply is also a function of reserve requirements. The focus on money and related bank-ing mechanisms alone can fill a book. Indeed, many texts havebeen written on the subject. A basic understanding of howmoney supply is regulated is another essential piece of theFOREX trader’s strategic puzzle. This is because money becomesa commodity for FOREX trading. Money translates into curren-cies that can be exchanged at rapidly fluctuating values to gen-erate a profit or, heaven forbid, a loss.Three Expressions of Money Supply in the United StatesIn the United States, money supply is expressed as three num-bers referenced as M1, M2, and M3. These three expressionshave different presumed transaction velocities. M1 is cash incirculation plus primary bank deposits called demand deposits.M2 takes savings deposits into consideration. Following theU.S. Savings and Loan Crisis, many analysts discounted M2 asa relic because banking structurally changed to give savingsdeposits more flexibility. With check-drawing privileges, savingaccounts are almost the same as demand deposits with theexception that they pay nominal interest. The advent of moneymarket accounts required a third category encompassed in M3.Together, these three measures of supply comprise the totalamount of local currency capable of circulating within theUnited States.During the 1970s through the 1980s, FOREX traders keenlyfocused on money supply. It was a Friday ritual to bet on thechange in M1 and M2, and therefore the change in U.S. currencyvalue relative to other currencies. The premise was simple. If M1and M2 grew appreciably, the dollar should weaken against othercurrencies —all things being equal. If the supply of U.S. currencyshrank while demand remained stable, the dollar’s value shouldincrease. Also, flooding the money supply implied increasinginflation. Inflation meant devaluation.The Facilities and Principles for Regulating FluctuationThe classic formula for determining domestic price levelspostulates that the price level is equal to the velocity of moneyMoney, Currency, and Foreign Exchange multiplied by the money supply. Referencing college texts suchas the famous 1948 book Economics by Paul Samuelson:P MVPrice Money Supply Transaction VelocityMore money in circulation chasing the same number ofgoods at an increasing velocity leads to inflation (a rising pricelevel). Of course, this is a market truism, too! The price of anycommodity is a function of how much money we throw at it andhow fast we throw it. This is easy to understand if we imaginean auction. If the room is crowded with people holding fists fullof cash, it’s a good assumption the value of auctioned items willbe high. If a small crowd with lousy credit shows up, it isunlikely auctioned items will reach their upset prices.As FOREX trading became more popular and sophisticated,pricing models grew more anticipatory. In other words, traderswanted to get the jump on money supply by examining theunderlying elements driving M1 and M2. Interest rates are firstin line. Central banks have the authority to change lending ratesbetween themselves and commercial banks as well as the loanrates between commercial banks. Lower rates permit more bor-rowing that, in turn, increases cash in circulation. The more cashthere is circulating, the greater the demand for goods and serv-ices. As demand grows, the economy grows.Of course, too much cash creates excessive demand. Whentoo much cash chases a static supply of goods and services, pricesare forced higher. This is the most fundamental market dynamic.The relationship between price and money supply has a role indetermining relative currency value. Money in circulation rep-resents currency.The Federal Reserve’s ability to increase money supply iscomplemented by tools to limit money supply. The most obvi-ous tool is the capacity to raise interest rates to discourage bor-rowing. This drains cash in circulation with the objective oflimiting demand for goods and services.It is essential to understand that these actions and their asso-ciated results are generalizations that have subtle or even bluntharmonics. For example, increasing interest rates also entice sav-ings. Saving money removes it from circulation. Our central bank has a solution to this potential problem. In addition to set-ting interest rates, the Federal Reserve can change the ratio ofdeposits to loans through an adjustment in the reserve require-ment. The reserve requirement is the amount of cash that a bankmust hold to cover immediate withdrawal demands.The mixture of reserves and interest rates becomes a complexeconomic elixir as we examine the theoretical and actual effectsof altering reserves and interest rates. If a bank is permitted to loana portion of its deposits, the amount of money expands by thereserve ratio. This is called the multiplier because the reserverequirement actually multiplies the amount of cash in circulation.Although this book is not intended to be a text on money andbanking, the subject is inseparable from understanding whatmakes FOREX fluctuate. If you learn anything about modernFOREX, it should be that it is part of a regulatory mechanism.For all practical purposes, money as it is created today is a fic-tion. Assets backing much of the world’s currency do not actu-ally exist, although government authorities will beg to differ!Whether we examine operations of the U.S. Federal Reserve(affectionately called the FED),or look at western European cen-tral banks operating under the Maastricht Treaty, the principlesand facilities are designed to achieve the same results—regulatemoney in circulation.Efficient Economic Theory in Modern Currency TradingRecall our first discussion of barter and the evolution of money.We know monetary value is associated with the ratio of a unit ofcurrency such as $1 and the amount it can buy. What is theamount it can buy? Obviously, we must know the referencecommodity. Is it an amount of gold or sugar? Assume it is sugar.Suppose $1 can buy 10 pounds of white sugar. Assume £1 canbuy 20 pounds of sugar. It stands to reason that £1 will have avalue of $2. It is simple algebra.This simplistic algebraic relationship was expressed byNavarro Martin de Azpilcueta who lived during the time ofChristopher Columbus (1492—1586). He postulated that the val-ues of the same goods in different countries created a ratio for theMoney, Currency, and Foreign Exchange relative value of different currencies. In its original expression,the theory was simple and suggested the relationship wasabsolute. The concept of purchasing power parity was remark-able for Azpilcueta’s time since it came at the leading edge of theAge of Mercantilism. Of course, his assumption lacked economicsophistication because it presumed that goods within each coun-try were the same. As mercantilism evolved into internationalcommerce, it became clear that divergent goods exclusivelyavailable from certain countries drove currency parity. Similargoods might be used to define an approximate currency relation-ship. Thus, an ounce of gold could be used as a standard to deter-mine the relative value between currencies. However, the forcesthat determined the gold ratio were independent.Silk and spices came from the Orient. Weapons, ships, andmechanical devices came from Europe. How can these dissimi-lar goods be reconciled? History students know that mercantil-ism was a primary catalyst for colonialism. Nations simply tookover resources in foreign lands. Thus, foreign products could bevalued in local currencies.How does this apply to modern currency trading? The foun-dation of any nation’s wealth was previously established by itsnatural resources. Thus, if silk were an exclusive product ofChina, then China’s wealth would be defined by demand for silkfrom nonproducing nations. A nation rich in gold would be richif other nations relied upon a gold standard. This empiric con-clusion was challenged during the 1980s and 1990s. A phenom-enon labeled Japan Inc. suggested that a nation could becomewealthy based upon its ability to convert another nation’s rawmaterials into finished products.This will be covered in greater detail later. However, the evo-lution of efficient economic theory actually altered the way cur-rencies fluctuated. Most notably, post World War II Germanytook full advantage of a consumer economy to build wealth anddrain gold reserves from other nations. Japan also capitalized onbeing prohibited from building or maintaining a war machine.Radios, TVs, and cars became the measure of the yen anddeutsche mark. Explosive economic growth followed both WorldWars. By the 1960s, Western economies were becoming morediversified and complex. Growth was being restricted by mone-tary standards, primarily gold. Learning from the Great Depression, U.S. and European mon-etary policy looked for an alternative to asset-backed currency.Eventually, gold was abandoned as a standard. Floating curren-cies took gold’s place. Some proponents of asset-backed currencyinsist we must return to a gold standard. Although gold appearsto be demonetized, it continues to play a role in cross-parity cal-culations. As we will see, gold remains a hidden reserve asset andpotential monetary measuring stick.The Ongoing Evolution of FOREXIt is often said that the more things change, the more theyremain the same. Currency markets demonstrate that this is par-tially true. Although the concept of money has evolved toinclude paper bills, coins, checks, credit and debits cards, andelectronic book entries, the essential function remains the same.Although international currencies have progressed from asset-backed valuation to floating parities, currency is still distin-guishable from region to region. However, FOREX has changedits methods and philosophies many times over the past fewdecades. Indeed, by the time you finish this book, there are likelyto be a dozen new twists to FOREX. From strategies to tradingforums, FOREX is a moving target with massive profit possibili-ties. That is why FOREX is emerging as the most exciting andfastest moving market in the world!Money, Currency, and Foreign Exchange .