Milton Friedman, the Nobel Prize-winning economist and father of Monetarism, argued that many of the fears of trade deficits are unfair criticisms in an attempt to push macroeconomic policies favorable to exporting industries. He stated that these deficits are not harmful to the country as the currency always comes back to the country of origin in some form or another (country A sells to country B, country B sells to country C who buys from country A, but the trade deficit only includes A and B). In fact, in his view, the "worst case scenario" of the currency never returning to the country of origin was actually the best possible outcome: the country actually purchased its goods by exchanging them for pieces of cheaply-made paper. As Friedman put it, this would be the same result as if the exporting country burned the dollars it earned, never returning it to market circulation.
Critics claim that Friedman's argument is equivalent to saying that it doesn't matter if you get indebted, because eventually you will have to pay the money back. The obvious counterargument is that once a significant debt has been accumulated, paying it back may be painful. Friedman's supporters retort that when the money returns, the demand for foreign currency will make the exchange rate better for trade deficit country.
Friedman's view is seen by many as ignoring the intergenerational or long run consequences of deficits, low savings, and borrowing to fund consumption. If country A has a trade deficit because of large imports of consumer goods, other countries accumulate cash from country A. That money can be used to purchase existing investment assets and government bonds within country A. As a result, the return from those assets will accrue not to citizens of country A but to foreigners. The consumption standard of future generations in country A may therefore potentially decline as a result of the deficit. In particular, Americans are increasingly paying taxes to finance the interest on federal bonds held by foreigners. However, a criticism of this argument notes that all transactions are win-win. In the case of foreign investment in American assets, it helps fuel American economic growth and keeps US interest rates low. This argument is more appealing in the case of foreign direct investment, and less obvious when foreigners simply purchase the existing stock of assets.
Friedman also believed that deficits would be corrected by free markets as floating currency rates rise or fall with time to encourage or discourage imports in favor of the exports, reversing again in favor of imports as the currency gains strength. A potential difficulty however is that currency markets in the real world are far from completely free, with government and central banks being major players, and this is unlikely to change within the foreseeable future.
Friedman and other economists have also pointed out that a large trade deficit (importation of goods) signals that the country's currency is strong and desirable. To Friedman, a trade deficit simply meant that consumers had opportunity to purchase and enjoy more goods at lower prices; conversely, a trade surplus implied that a country was exporting goods its own citizens did not get to consume or enjoy, while paying high prices for the goods they actually received.
Perhaps most significantly, Friedman contended strongly that the current structure of the balance of payments is misleading. In an interview with Charlie Rose, he stated that "on the books" the US is a net borrower of funds, using those funds to pay for goods and services. He pointed to the income receipts and payments showing that the US pays almost the same amount as it receives: thus, U.S. citizens are paying lower prices than foreigners for capital assets to exchange roughly the same amount of income. The reasons why the U.S. (and UK) appear to earn a higher rate of return on their foreign assets than they pay on their foreign liabilities are not clearly understood. An important contributing factor is that the U.S. has investment primarily in stocks abroad, while foreigners have invested heavily in debt instruments, such as U.S. government bonds More recently, U.S. net foreign income has deteriorated, and appears set to stay in deficit in the future
Friedman presented his analysis of the balance of trade in Free to Choose, widely considered his most significant popular work.
Tuesday, September 4, 2007
Milton Friedman on trade deficits
Economic impact
Modern economists are split on the economic impact of the trade deficit with some viewing it as a loss in a fixed volume of trade and more radical Neoliberal voices who claim it is a sign of economic strength.
The traditional view opposes long run trade deficits and outsourcing for the sake of labor arbitrage to obtain cheap labor as an example of absolute advantage which does not produce mutual gain, and not an example of comparative advantage which does.
Neoliberal economists claim that trade deficits are beneficial, noting the correlation between increasing trade deficits and increasing GDP and employment ([1]). An expanding economy means increased demand for domestic and foreign products. This rising demand promotes domestic investment as both foreign and domestic businesses seek to capitalize on the growth in demand. As the rate of growth accelerates foreign credit sources have greater incentives to invest in a growing nation's capital. The greater net inflows from abroad, the greater the trade deficit. Thus, GDP growth can be correlated with a trade deficit. However, these economists seem to ignore the fact the excessive borrowing may artificially inflate GDP.
Strong GDP growth economies such as the United Kingdom, Australia, Hong Kong and the United States run consistent trade deficits.
On the other hand, GDP growth may be due to excess borrowing to fund consumption and not an expansion of the base of an economy.[4] Developed nations such as Canada, Japan, and Germany typically run trade surpluses. China also has a trade surplus. A higher savings rate generally corresponds with a trade surplus. In 2006, the United States has its lowest savings rate since 1933.[5] Correspondingly, the United States has high trade deficits. The general decline of Great Britain is another example of the deleterious effects of long term trade deficits.
Some contend long term effects of the trade deficits are deleterious. Since the stagflation of the 1970's, the U.S. economy has been characterized by somewhat slower growth. In 1985, the U.S. began its growing trade deficit with China. In 2006, the primary economic concerns have centered around: high national debt ($9 trillion), high corporate debt ($9 trillion), high mortgage debt ($9 trillion), high unfunded Medicare liability ($30 trillion), high unfunded Social Security liability ($12 trillion), high external debt (amount owed to foreign lenders) and a serious deterioration in the United States net international investment position (NIIP) (-24% of GDP),[6] high trade deficits, and a rise in illegal immigration. These issues have raised concerns among economists and unfunded liabilites were mentioned as a serious problem facing the United States in the President's 2006 State of the Union address.
Large imbalances may sometimes be a sign of underlying economic problems or rigidities. An example would be a situation where exchange rates have been fixed or pegged for political reasons at levels impeding a correction of a trade imbalance.
The trade deficit must be "financed" by foreign income or transfers, or by a capital account surplus. This includes inward foreign investment and capital purchases (stocks, bonds ect). An increase in net foreign liabilities tends to lead to an increase in the net outflow of income on international investments.
Those in favor of the trade deficit point to this financing as the source of the benefit. Instead of buying goods back, buyers in the receiving country send the money back in the form of capital. A firm in America sends dollars for Chinese toys, and the Chinese receivers use the money to buy stock in an American firm. Although this is a form of financing, it is not a debt on any party in America.
Such payments to foreigners have intergenerational effects: by shifting consumption over time, some generations may gain at the expense of others . However, a trade deficit may lead to higher consumption in the future if, for example, it is used to finance profitable domestic investment, which generates returns in excess of that paid on the net foreign liabilities (a situation that might arise if a country experiences an unexpected gain in productivity). Similarly, a surplus on the current account implies an increase in the net international investment position and the shifting of consumption to future rather than current generations.
However, trade imbalances are not always indicative of the smooth operation of the market given differences in international productivity and intertemporal consumption preferences. Trade deficits have often been associated with a loss of international competitiveness, or unsustainable 'booms' in domestic demand. Similarly, trade surpluses have been associated with policies that inefficiently bias a country's economic activity towards external demand, resulting in lower living standards. An example of an economy which has had a positive balance of payments was Japan in the 1990s. The positive balance was partly the result of protectionist measures that brought excessive profits to Japanese exporters.
The traditional view opposes long run trade deficits and outsourcing for the sake of labor arbitrage to obtain cheap labor as an example of absolute advantage which does not produce mutual gain, and not an example of comparative advantage which does.
Neoliberal economists claim that trade deficits are beneficial, noting the correlation between increasing trade deficits and increasing GDP and employment ([1]). An expanding economy means increased demand for domestic and foreign products. This rising demand promotes domestic investment as both foreign and domestic businesses seek to capitalize on the growth in demand. As the rate of growth accelerates foreign credit sources have greater incentives to invest in a growing nation's capital. The greater net inflows from abroad, the greater the trade deficit. Thus, GDP growth can be correlated with a trade deficit. However, these economists seem to ignore the fact the excessive borrowing may artificially inflate GDP.
Strong GDP growth economies such as the United Kingdom, Australia, Hong Kong and the United States run consistent trade deficits.
On the other hand, GDP growth may be due to excess borrowing to fund consumption and not an expansion of the base of an economy.[4] Developed nations such as Canada, Japan, and Germany typically run trade surpluses. China also has a trade surplus. A higher savings rate generally corresponds with a trade surplus. In 2006, the United States has its lowest savings rate since 1933.[5] Correspondingly, the United States has high trade deficits. The general decline of Great Britain is another example of the deleterious effects of long term trade deficits.
Some contend long term effects of the trade deficits are deleterious. Since the stagflation of the 1970's, the U.S. economy has been characterized by somewhat slower growth. In 1985, the U.S. began its growing trade deficit with China. In 2006, the primary economic concerns have centered around: high national debt ($9 trillion), high corporate debt ($9 trillion), high mortgage debt ($9 trillion), high unfunded Medicare liability ($30 trillion), high unfunded Social Security liability ($12 trillion), high external debt (amount owed to foreign lenders) and a serious deterioration in the United States net international investment position (NIIP) (-24% of GDP),[6] high trade deficits, and a rise in illegal immigration. These issues have raised concerns among economists and unfunded liabilites were mentioned as a serious problem facing the United States in the President's 2006 State of the Union address.
Large imbalances may sometimes be a sign of underlying economic problems or rigidities. An example would be a situation where exchange rates have been fixed or pegged for political reasons at levels impeding a correction of a trade imbalance.
The trade deficit must be "financed" by foreign income or transfers, or by a capital account surplus. This includes inward foreign investment and capital purchases (stocks, bonds ect). An increase in net foreign liabilities tends to lead to an increase in the net outflow of income on international investments.
Those in favor of the trade deficit point to this financing as the source of the benefit. Instead of buying goods back, buyers in the receiving country send the money back in the form of capital. A firm in America sends dollars for Chinese toys, and the Chinese receivers use the money to buy stock in an American firm. Although this is a form of financing, it is not a debt on any party in America.
Such payments to foreigners have intergenerational effects: by shifting consumption over time, some generations may gain at the expense of others . However, a trade deficit may lead to higher consumption in the future if, for example, it is used to finance profitable domestic investment, which generates returns in excess of that paid on the net foreign liabilities (a situation that might arise if a country experiences an unexpected gain in productivity). Similarly, a surplus on the current account implies an increase in the net international investment position and the shifting of consumption to future rather than current generations.
However, trade imbalances are not always indicative of the smooth operation of the market given differences in international productivity and intertemporal consumption preferences. Trade deficits have often been associated with a loss of international competitiveness, or unsustainable 'booms' in domestic demand. Similarly, trade surpluses have been associated with policies that inefficiently bias a country's economic activity towards external demand, resulting in lower living standards. An example of an economy which has had a positive balance of payments was Japan in the 1990s. The positive balance was partly the result of protectionist measures that brought excessive profits to Japanese exporters.
Balance of trade
The balance of trade forms part of the current account, which also includes other transactions such as income from the international investment position as well as international aid. If the current account is in surplus, the country's net international asset position increases correspondingly. Equally, a deficit decreases the net international asset position.
The trade balance is identical to the difference between a country's output and its domestic demand (the difference between what goods a country produces and how many goods it buys from abroad; this does not include money re-spent on foreign stocks, nor does it factor the concept of importing goods to produce for the domestic market).
Measuring the balance of payments can be problematic because of problems with recording and collecting data. As an illustration of this problem, when official data for all the world's countries are added up, exports exceed imports by a few percent; it appears the world is running a positive balance of trade with itself. This cannot be true, because all transactions involve an equal credit or debit in the account of each nation. The discrepancy is widely believed to be explained by transactions intended to launder money or evade taxes, smuggling and other visibility problems. However, especially for developed countries, accuracy is likely to be good.
Factors that can affect the balance of trade figures include:
Prices of goods manufactured at home (influenced by the responsiveness of supply)
Exchange rates
Trade agreements or barriers
Other tax, tariff and trade measures
Business cycle at home or abroad.
The balance of trade is likely to differ across the business cycle. In export led growth (such as oil and early industrial goods), the balance of trade will improve during an economic expansion. However, with domestic demand led growth (as in the United States and Australia) the trade balance will worsen at the same stage in the business cycle.
The trade balance is identical to the difference between a country's output and its domestic demand (the difference between what goods a country produces and how many goods it buys from abroad; this does not include money re-spent on foreign stocks, nor does it factor the concept of importing goods to produce for the domestic market).
Measuring the balance of payments can be problematic because of problems with recording and collecting data. As an illustration of this problem, when official data for all the world's countries are added up, exports exceed imports by a few percent; it appears the world is running a positive balance of trade with itself. This cannot be true, because all transactions involve an equal credit or debit in the account of each nation. The discrepancy is widely believed to be explained by transactions intended to launder money or evade taxes, smuggling and other visibility problems. However, especially for developed countries, accuracy is likely to be good.
Factors that can affect the balance of trade figures include:
Prices of goods manufactured at home (influenced by the responsiveness of supply)
Exchange rates
Trade agreements or barriers
Other tax, tariff and trade measures
Business cycle at home or abroad.
The balance of trade is likely to differ across the business cycle. In export led growth (such as oil and early industrial goods), the balance of trade will improve during an economic expansion. However, with domestic demand led growth (as in the United States and Australia) the trade balance will worsen at the same stage in the business cycle.
The Difference between Spot and Futures in Forex
Before a description of retail trading, it is important to understand the difference between the Spot and Futures markets. Futures are generally based on contracts, with typical durations of 3 months. Spot, on the other hand, is a two-day cash delivery. While the Futures markets was created to hedge out risks and speculate on future market conditions, Spot was created to allow actual cash deliveries. Spot developed a two-day delivery date in order to give those transporting the actual cash a window of time to receive it. While in theory there still is a two-day delivery date imposed after a Forex transaction, this is effectively no longer used. Every day, at 5 pm EST (the predetermined end of the trading day) Spot positions are closed and then reopened. This is done in order to guarantee an unlimited timeline for delivery. For example, if a Spot transaction occurs on a Monday, the delivery date is Wednesday. At 5 pm on Monday, the position is closed and then immediately re-opened; now this is a new position with the close date of Thursday. This daily process allows an investor to hold open a position indefinitely.
Another important difference between Futures and Spot is how interest is credited. Each currency in a Forex transaction has an inherent interest rate attached to it. In the case of the US dollar, this is the Federal Funds Rate. This interest is added every single day whether the market is trading or not. Interest cannot take a vacation; money and its loaning value are still important even if the financial world has stopped dealing. In Futures, the interest is built into the price of the contract. In Spot, however, interest is not taken into account in the offering price because the Spot market is a cash market, not a contract market. There must be some mechanism for crediting interest, and various institutions have developed ways to do it. The most common method is to credit that day’s worth of interest at the same time they “flip” the position, or carry it over to the next day. This is important for later discussions and analysis because the transactions examined in this study had interest credited at the end of the business day at exactly 5 pm EST. If a position was held from 5:01 pm on Tuesday and closed at 4:59 pm on Wednesday, no interest would be credited for that day. If, on the other hand, a position was opened Tuesday at 4:59 pm and closed Tuesday 5:01 pm, a full day’s interest would be credited. This has interesting ramifications; traders who work intra-day, or “day traders,” often do not use interest for either gain or loss.
Another important difference between Futures and Spot is how interest is credited. Each currency in a Forex transaction has an inherent interest rate attached to it. In the case of the US dollar, this is the Federal Funds Rate. This interest is added every single day whether the market is trading or not. Interest cannot take a vacation; money and its loaning value are still important even if the financial world has stopped dealing. In Futures, the interest is built into the price of the contract. In Spot, however, interest is not taken into account in the offering price because the Spot market is a cash market, not a contract market. There must be some mechanism for crediting interest, and various institutions have developed ways to do it. The most common method is to credit that day’s worth of interest at the same time they “flip” the position, or carry it over to the next day. This is important for later discussions and analysis because the transactions examined in this study had interest credited at the end of the business day at exactly 5 pm EST. If a position was held from 5:01 pm on Tuesday and closed at 4:59 pm on Wednesday, no interest would be credited for that day. If, on the other hand, a position was opened Tuesday at 4:59 pm and closed Tuesday 5:01 pm, a full day’s interest would be credited. This has interesting ramifications; traders who work intra-day, or “day traders,” often do not use interest for either gain or loss.
Financial Instruments
There are several types of financial instruments commonly used.
Forwards: One way to deal with the Forex risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a few days, months or years.
Futures: Foreign currency futures are forward transactions with standard contract sizes and maturity dates — for example, 500,000 British pounds for next November at an agreed rate. Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.
Swaps: The most common type of forward transaction is the currency swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not contracts and are not traded through an exchange.
Spot: A spot transaction is a two-day delivery transaction, as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction. The data for this study come from the Spot market.
Forwards: One way to deal with the Forex risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a few days, months or years.
Futures: Foreign currency futures are forward transactions with standard contract sizes and maturity dates — for example, 500,000 British pounds for next November at an agreed rate. Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.
Swaps: The most common type of forward transaction is the currency swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not contracts and are not traded through an exchange.
Spot: A spot transaction is a two-day delivery transaction, as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction. The data for this study come from the Spot market.
Transaction costs and market makers
Market makers are well compensated for allowing retail clients to enter the Forex market. They take part or all of the spread in all currency pairs traded. In a common example, EUR/USD, the spread is typically 3 pips (3/100 of a percent). Thus prices are quoted with both a Buy and Sell price (e.g., Buy Eur/USD 1.2000, Sell Eur/USD 1.2003). That difference of 3 pips is the spread and can amount to a significant amount of money. (Note: the spread is only taken out at the beginning of the trade; this transaction cost is subtracted only upon entering the trade, not leaving it) Because the typical standard lot is 100,000 units of the base currency, those 3 pips on EUR/USD translate to $30 paid by the client to the market maker. However, a pip is not always $10. A pip is 1/100th of a percent, and the currency pairs are always purchased by buying 100,000 of the base currency, which is also known as the counter currency. For the pair EUR/USD, the base currency is USD; thus, 1/100th of a percent on a pair with USD as the base currency will always have a pip of $10. If, on the other hand, your currency has Swiss Frank (CHF) as a base instead of USD, then 1/100th of a percent is now worth around $8, because you are buying 100,000 worth of Swiss Franks.
If a trader with a $10,000 account on 100:1 leverage felt, after reading reports on the economy, that the USD was going to go up in value against the EUR and the CHF, he would Sell EUR/USD (thus selling EUR and buying USD) and Buy USD/CHF (buying USD and selling CHF). The transaction is all electronic, so the trader doesn’t need to have Euros in his account. On a large scale, the market maker can sell Euros on behalf of the trader, knowing that the position will eventually be closed and converted back to USD. Assume that the client sold 100,000 EUR/USD at 1.2000 and bought 100,000 USD/CHF at 1.2500. Seconds after this transaction, his account would read: Balance: $10,000, Equity $9,946. The loss of $54 is due to the transaction cost taken only at the entry of a position of 3 pips, which translates to $30 for the EUR/USD pair and $24 for the USD/CHF pair. With equity of $9,946 on 100:1 leverage with 2 positions opened, $2,000 is now held in margin, leaving the trader $7,946 in usable margin. Suppose the EUR/USD (sold at 1.2003) starts to move against the trader and goes up in value to 1.2013, while the USD/CHF (bought at 1.2500) starts moving for the client and also goes up in value to 1.2515. His account information will have changed but his balance and margin will remain unchanged at $10,000 and $2,000 respectively. His equity and his usable margin, however, will change to reflect the new market conditions. While for the trader, the platform will calculate this all automatically, it is important to see it step by step.
Beginning Summary
Client Account: XXX
Balance $10,000
Equity: $ 10,000
Usable Margin: $10,000
Used Margin: $0
Step 1: Client XXX places two trades.
Sells 1 standard lot EUR/USD (100,000 worth of the base currency -- USD)
Buys 1 standard lot of USD/CHF (100,000 worth of the base currency – CHF)
Balance remains: $10,000
Equity: $9,946 (roughly, due to transaction costs of 3 pips each. $30 – EUR/USD transaction cost $24 USD/CHF transaction cost---the difference is due to difference in pip value)
Usable Margin: $7,946
Used Margin $2,000
Step 2: Market Conditions Change, with EUR/USD going up 10 pips (a 10 pip decrease in value to the client, since he is short EUR/USD), while the USD/CHF has increased in value by 15 pips.
EUR/USD pair has lost 10 pips, with each pip $10 so it has lost $100
USD/CHF has gained 15 pips, with each pip around $8 so it gained $120
The difference is now +$20
Balance: $10,000
Equity: $9,966
Usable Margin: $7966
Used Margin: $2000
Step 3: Client closes both positions (by performing the opposite trade – Buying EUR/USD and Selling USD/CHF). He now has no positions in the market, and his money is no longer fluctuating with the market.
Balance: $9,966
Equity: $9,966
Usable Margin: $9,966
Used Margin: $0
If a trader with a $10,000 account on 100:1 leverage felt, after reading reports on the economy, that the USD was going to go up in value against the EUR and the CHF, he would Sell EUR/USD (thus selling EUR and buying USD) and Buy USD/CHF (buying USD and selling CHF). The transaction is all electronic, so the trader doesn’t need to have Euros in his account. On a large scale, the market maker can sell Euros on behalf of the trader, knowing that the position will eventually be closed and converted back to USD. Assume that the client sold 100,000 EUR/USD at 1.2000 and bought 100,000 USD/CHF at 1.2500. Seconds after this transaction, his account would read: Balance: $10,000, Equity $9,946. The loss of $54 is due to the transaction cost taken only at the entry of a position of 3 pips, which translates to $30 for the EUR/USD pair and $24 for the USD/CHF pair. With equity of $9,946 on 100:1 leverage with 2 positions opened, $2,000 is now held in margin, leaving the trader $7,946 in usable margin. Suppose the EUR/USD (sold at 1.2003) starts to move against the trader and goes up in value to 1.2013, while the USD/CHF (bought at 1.2500) starts moving for the client and also goes up in value to 1.2515. His account information will have changed but his balance and margin will remain unchanged at $10,000 and $2,000 respectively. His equity and his usable margin, however, will change to reflect the new market conditions. While for the trader, the platform will calculate this all automatically, it is important to see it step by step.
Beginning Summary
Client Account: XXX
Balance $10,000
Equity: $ 10,000
Usable Margin: $10,000
Used Margin: $0
Step 1: Client XXX places two trades.
Sells 1 standard lot EUR/USD (100,000 worth of the base currency -- USD)
Buys 1 standard lot of USD/CHF (100,000 worth of the base currency – CHF)
Balance remains: $10,000
Equity: $9,946 (roughly, due to transaction costs of 3 pips each. $30 – EUR/USD transaction cost $24 USD/CHF transaction cost---the difference is due to difference in pip value)
Usable Margin: $7,946
Used Margin $2,000
Step 2: Market Conditions Change, with EUR/USD going up 10 pips (a 10 pip decrease in value to the client, since he is short EUR/USD), while the USD/CHF has increased in value by 15 pips.
EUR/USD pair has lost 10 pips, with each pip $10 so it has lost $100
USD/CHF has gained 15 pips, with each pip around $8 so it gained $120
The difference is now +$20
Balance: $10,000
Equity: $9,966
Usable Margin: $7966
Used Margin: $2000
Step 3: Client closes both positions (by performing the opposite trade – Buying EUR/USD and Selling USD/CHF). He now has no positions in the market, and his money is no longer fluctuating with the market.
Balance: $9,966
Equity: $9,966
Usable Margin: $9,966
Used Margin: $0
Retail Forex is usually highly leveraged
The idea of margin (leverage) and floating loss is another important trading concept and is perhaps best understood using an example. Most retail Forex market makers permit 100:1 leverage, but also, crucially, require you to have a certain amount of money in your account to protect against a critical loss point. For example, if a $100,000 position is held in Eur/USD on 100:1 leverage, the trader has to put up $1,000 to control the position. However, in the event of a declining value of your positions, Forex market makers, mindful of the fast nature of Forex price swings and the amplifying effect of leverage, typically do not allow their traders to go negative and make up the difference at a later date. In order to make sure the trader does not lose more money than is held in the account, Forex market makers typically employ automatic systems to close out positions when clients run out of margin (the amount of money in their account not tied to a position). If the trader has $2,000 in his account, and he is buying a $100,000 lot of EUR/USD, he has $1,000 of his $2,000 tied up in margin, with $1,000 left to allow his position to fluctuate downward without being closed out.
Typically a trader's trading platform will show him three important numbers associated with his account: his balance, his equity, and his margin remaining. If trader X has two positions: $100,000 long (buy) in EUR/USD, and $100,000 short (sell) in GBP/USD, and he has $10,000 in his account, his positions would look as follows: Because of the 100:1 leverage, it took him $1,000 to control each position. This means that he has used up $2,000 in his margin, out of a $10,000 account, and thus he has $8,000 of margin still available. With this margin, he can either take more positions or keep the margin relatively high to allow his current positions to be maintained in the event of downturns. If the client chooses to open a new position of $100,000, this will again take another $1,000 of his margin, leaving $7,000. He will have used up $3,000 in margin among the three positions. The other way margin will decrease is if the positions he currently has open lose money. If his 3 positions of $100,000 decrease by $5,000 in value (not at all an unusual swing), he now has, of his original $7,000 in margin, only $2,000 left. As discussed above, if you have a $10,000 account and only open one $100,000 position, this has committed only $1,000 of your money plus you must maintain $1,000 in margin. While this leaves $9,000 free in your account, it is possible to lose almost all of it if the position dives. On the other hand, if you have 5 positions open in a $10,000 account, you can lose only $5,000 because the other $5,000 is held in margin. However, this does not make it safer to hold more positions. The Forex market fluctuates so rapidly, that with shallow margins, you are much more likely to be closed out of your position and lose it entirely when it might have recovered from a temporary fluctuation if you had had sufficient margin to cover the variation. The more positions open at one time, the more risk the trader is exposed to.
Typically a trader's trading platform will show him three important numbers associated with his account: his balance, his equity, and his margin remaining. If trader X has two positions: $100,000 long (buy) in EUR/USD, and $100,000 short (sell) in GBP/USD, and he has $10,000 in his account, his positions would look as follows: Because of the 100:1 leverage, it took him $1,000 to control each position. This means that he has used up $2,000 in his margin, out of a $10,000 account, and thus he has $8,000 of margin still available. With this margin, he can either take more positions or keep the margin relatively high to allow his current positions to be maintained in the event of downturns. If the client chooses to open a new position of $100,000, this will again take another $1,000 of his margin, leaving $7,000. He will have used up $3,000 in margin among the three positions. The other way margin will decrease is if the positions he currently has open lose money. If his 3 positions of $100,000 decrease by $5,000 in value (not at all an unusual swing), he now has, of his original $7,000 in margin, only $2,000 left. As discussed above, if you have a $10,000 account and only open one $100,000 position, this has committed only $1,000 of your money plus you must maintain $1,000 in margin. While this leaves $9,000 free in your account, it is possible to lose almost all of it if the position dives. On the other hand, if you have 5 positions open in a $10,000 account, you can lose only $5,000 because the other $5,000 is held in margin. However, this does not make it safer to hold more positions. The Forex market fluctuates so rapidly, that with shallow margins, you are much more likely to be closed out of your position and lose it entirely when it might have recovered from a temporary fluctuation if you had had sufficient margin to cover the variation. The more positions open at one time, the more risk the trader is exposed to.
Retail Forex Trading
As previously mentioned, currencies fluctuate relative to other currencies. Take two of the most common currency pairs, the EUR/USD (the price for Euros in US dollars) and the GBP/USD (the price for The Great British Pound in US dollars). If there is positive economic news in the Euro zone and negative economic news in the United Kingdom, it is very conceivable that the EUR/USD would go up in value, meaning it is now more expensive in US dollars to purchase one EUR, and that the GBP/USD would go down in value, meaning it is now cheaper to buy Great British Pounds with US dollars. In this scenario, the US dollar went up in value against one currency and down in relation to another. It is important to understand this idea that currency pairs move mostly independently from one another. Currency pairs with similar currencies on one side (like the USD in the previous example) can be similarly affected by news regarding the common currency, but the crucial concept is that they don’t have to be.
History
Retail trading, is more structured than the forex market as a whole.[citation needed] While forex has been traded since the beginning of financial markets, modern retail trading has only been around since about 1996 . Prior to this time, retail investors were limited in their options for entering the forex market. They could create multiple bank accounts, each one denominated in a different currency, and transfer funds from one account to another in order to profit from fluctuating exchange rate. This was troublesome, however, because the transaction costs incurred were large due to the small quantity of funds being converted relative to the size of the market. This transaction type was at the very bottom of the forex pyramid.
By 1996, new market makers took advantage of developments in web-based technology that made retail forex trading practical. These internet-based market makers would take the other side of retail trader’s trades. The new companies felt that there was enough liquidity in the forex market, and eventually within their own customer base, to guarantee markets under all but the most unusual market conditions. These companies also created online trading platforms that provided a quick and easy way for individuals to buy and sell on the Forex Spot market. In addition, the companies realized that by pooling many retail traders together, they had the size to enter the upper echelons of the forex market, which reduced the size of the spread. As the business grew, the market makers were given better prices, which they then passed on to the customer.
Market makers got around this issue by allowing customers to inflate all movements many times over. In the world of online currency exchange, no transaction actually leads to physical delivery to the client; all positions will eventually be closed. The market makers are therefore able to offer high amounts of leverage. While up to 4:1 leverage is available in equities and 20:1 in Futures, it is common to have 100:1 leverage in currencies; some forex market makers offer up to 400:1. In the typical 100:1 scenario, the client absorbs all risks associated with controlling a position 100 times the capital they are putting up, and, given that the money is only being used for currency exchange and on the market makers’ books, the transaction can proceed.
Current spreads for the most common currency pair, EUR/USD, is typically 3 pips (3/100th of a percent). An equivalent trade using a bank account would most likely be between 200 and 500 pips, while an equivalent trade using cash at an exchange institution would be around 750 – 2500 pips.
Currencies are quoted in pairs i.e. EUR/USD (Euro vs. United States Dollar). Out of convention, the currency quoted first was the stronger currency at the time of inception
By 1996, new market makers took advantage of developments in web-based technology that made retail forex trading practical. These internet-based market makers would take the other side of retail trader’s trades. The new companies felt that there was enough liquidity in the forex market, and eventually within their own customer base, to guarantee markets under all but the most unusual market conditions. These companies also created online trading platforms that provided a quick and easy way for individuals to buy and sell on the Forex Spot market. In addition, the companies realized that by pooling many retail traders together, they had the size to enter the upper echelons of the forex market, which reduced the size of the spread. As the business grew, the market makers were given better prices, which they then passed on to the customer.
Market makers got around this issue by allowing customers to inflate all movements many times over. In the world of online currency exchange, no transaction actually leads to physical delivery to the client; all positions will eventually be closed. The market makers are therefore able to offer high amounts of leverage. While up to 4:1 leverage is available in equities and 20:1 in Futures, it is common to have 100:1 leverage in currencies; some forex market makers offer up to 400:1. In the typical 100:1 scenario, the client absorbs all risks associated with controlling a position 100 times the capital they are putting up, and, given that the money is only being used for currency exchange and on the market makers’ books, the transaction can proceed.
Current spreads for the most common currency pair, EUR/USD, is typically 3 pips (3/100th of a percent). An equivalent trade using a bank account would most likely be between 200 and 500 pips, while an equivalent trade using cash at an exchange institution would be around 750 – 2500 pips.
Currencies are quoted in pairs i.e. EUR/USD (Euro vs. United States Dollar). Out of convention, the currency quoted first was the stronger currency at the time of inception
The use of high leverage
By offering high leverage, the market maker encourages traders to trade extremely large positions. This increases the trading volume cleared by the market maker and increases his profits, but increases the risk that the trader will receive a margin call. While professional currency dealers (banks, hedge funds) never use more than 10:1 leverage, retail clients are generally offered leverage between 50:1 and 200:1, and even up to 400:1
Why retail speculators shouldn't be able to beat the market
The foreign exchange market is a zero sum game in which there are many experienced well-capitalized professional traders (e.g. working for banks) who can devote their attentions full time to trading. An inexperienced retail trader will have a significant information disadvantage compared to these traders.
Retail traders are - almost by definition - undercapitalized. Thus they are subject to the problem of Gambler's Ruin. In a fair game (one with no information advantages) between two players that continues until one trader goes bankrupt, the player with the lower amount of capital has a higher probability of going bankrupt first. Since the retail speculator is effectively playing against the market as a whole - which has nearly infinite capital - he will almost certainly go bankrupt.
The retail trader always pays the bid/ask spread which makes his odds of winning less than those of a fair game. Additional costs may include margin interest, or if a spot position is kept open for more than one day the trade must be "resettled" each day, each time costing the full bid/ask spread.
According to the Wall Street Journal (Currency Markets Draw Speculation, Fraud July 26, 2005) "Even people running the trading shops warn clients against trying to time the market. 'If 15% of day traders are profitable,' says Drew Niv, chief executive of FXCM, 'I'd be surprised.' "
Retail traders are - almost by definition - undercapitalized. Thus they are subject to the problem of Gambler's Ruin. In a fair game (one with no information advantages) between two players that continues until one trader goes bankrupt, the player with the lower amount of capital has a higher probability of going bankrupt first. Since the retail speculator is effectively playing against the market as a whole - which has nearly infinite capital - he will almost certainly go bankrupt.
The retail trader always pays the bid/ask spread which makes his odds of winning less than those of a fair game. Additional costs may include margin interest, or if a spot position is kept open for more than one day the trade must be "resettled" each day, each time costing the full bid/ask spread.
According to the Wall Street Journal (Currency Markets Draw Speculation, Fraud July 26, 2005) "Even people running the trading shops warn clients against trying to time the market. 'If 15% of day traders are profitable,' says Drew Niv, chief executive of FXCM, 'I'd be surprised.' "
CFTC warnings
The CFTC lists 9 warning signs for foreign exchange trading fraud:
1. Stay away from opportunities that seem too good to be true
Always remember that there is no such thing as a "free lunch." Be especially cautious if you have acquired a large sum of cash recently and are looking for a safe investment vehicle. In particular, retirees with access to their retirement funds may be attractive targets for fraudulent operators. Getting your money back once it is gone can be difficult or impossible.
2. Avoid any company that predicts or guarantees large profits
Be extremely wary of companies that guarantee profits, or that tout extremely high performance. In many cases, those claims are false.
The following are examples of statements that either are or most likely are fraudulent:
"Whether the market moves up or down, in the currency market you will make a profit."
"Make $1000 per week, every week"
"We are out-performing domestic investments."
"The main advantage of the forex markets is that there is no bear market."
"We guarantee you will make at least a 30-40% rate of return within two months."
3. Stay Away From Companies That Promise Little or No Financial Risk
Be suspicious of companies that downplay risks or state that written risk disclosure statements are routine formalities imposed by the government.
The currency futures and options markets are volatile and contain substantial risks for unsophisticated customers. The currency futures and options markets are not the place to put any funds that you cannot afford to lose. For example, retirement funds should not be used for currency trading.
g. You can lose most or all of those funds very quickly trading foreign currency futures or options contracts. Therefore, beware of companies that make the following types of statements:
"With a $10,000 deposit, the maximum you can lose is $200 to $250 per day."
"We promise to recover any losses you have."
"Your investment is secure."
4. Don't Trade on Margin Unless You Understand What It Means
Margin trading can make you responsible for losses that greatly exceed the dollar amount you deposited.
Many currency traders ask customers to give them money, which they sometimes refer to as "margin," often sums in the range of $1,000 to $5,000. However, those amounts, which are relatively small in the currency markets, actually control far larger dollar amounts of trading, a fact that often is poorly explained to customers.
Don't trade on margin unless you fully understand what you are doing and are prepared to accept losses that exceed the margin amounts you paid.
5. Question Firms That Claim To Trade in the "Interbank Market"
Be wary of firms that claim that you can or should trade in the "interbank market," or that they will do so on your behalf.
Unregulated, fraudulent currency trading firms often tell retail customers that their funds are traded in the "interbank market," where good prices can be obtained. Firms that trade currencies in the interbank market, however, are most likely to be banks, investment banks and large corporations, since the term "interbank market" refers simply to a loose network of currency transactions negotiated between financial institutions and other large companies.
6. Be Wary of Sending or Transferring Cash on the Internet, By Mail or Otherwise
Be especially alert to the dangers of trading on-line; it is very easy to transfer funds on-line, but often can be impossible to get a refund.
It costs an Internet advertiser just pennies per day to reach a potential audience of millions of persons, and phony currency trading firms have seized upon the Internet as an inexpensive and effective way of reaching a large pool of potential customers.
Companies offering currency trading on-line will usually be located in different legal jurisdictions to you. Even if they display an address or any other information identifying their nationality on their Web site it may be false. Be aware that if you transfer funds to foreign firms it may be very difficult or impossible to recover your funds.
7. Currency Scams Often Target Members of Ethnic Minorities
Some currency trading scams target potential customers in ethnic communities, particularly persons in the Russian, Chinese and Indian immigrant communities, through advertisements in ethnic newspapers and television "infomercials."
Sometimes those advertisements offer so-called "job opportunities" for "account executives" to trade foreign currencies. Be aware that "account executives" that are hired might be expected to use their own money for currency trading, as well as to recruit their family and friends to do likewise. What appears to be a promising job opportunity often is another way many of these companies lure customers into parting with their cash.
8. Be Sure You Get the Company's Performance Track Record
Get as much information as possible about the firm's or individual's performance record on behalf of other clients. You should be aware, however, that It may be difficult or impossible to do so, or to verify the information you receive. While firms and individuals are not required to provide this information, you should be wary of any person who is not willing to do so or who provides you with incomplete information. However, keep in mind, even if you do receive a glossy brochure or sophisticated-looking charts, that the information they contain might be false.
9. Don't Deal With Anyone Who Won't Give You His Background
Plan to do a lot of checking of any information you receive to be sure that the company is and does exactly what it says.
Get the background of the persons running or promoting the company, if possible. Do not rely solely on oral statements or promises from the firm's employees. Ask for all information in written form.
If you cannot satisfy yourself that the persons with whom you are dealing are completely legitimate and above-board, the wisest course of action is to avoid trading foreign currencies through those companies
1. Stay away from opportunities that seem too good to be true
Always remember that there is no such thing as a "free lunch." Be especially cautious if you have acquired a large sum of cash recently and are looking for a safe investment vehicle. In particular, retirees with access to their retirement funds may be attractive targets for fraudulent operators. Getting your money back once it is gone can be difficult or impossible.
2. Avoid any company that predicts or guarantees large profits
Be extremely wary of companies that guarantee profits, or that tout extremely high performance. In many cases, those claims are false.
The following are examples of statements that either are or most likely are fraudulent:
"Whether the market moves up or down, in the currency market you will make a profit."
"Make $1000 per week, every week"
"We are out-performing domestic investments."
"The main advantage of the forex markets is that there is no bear market."
"We guarantee you will make at least a 30-40% rate of return within two months."
3. Stay Away From Companies That Promise Little or No Financial Risk
Be suspicious of companies that downplay risks or state that written risk disclosure statements are routine formalities imposed by the government.
The currency futures and options markets are volatile and contain substantial risks for unsophisticated customers. The currency futures and options markets are not the place to put any funds that you cannot afford to lose. For example, retirement funds should not be used for currency trading.
g. You can lose most or all of those funds very quickly trading foreign currency futures or options contracts. Therefore, beware of companies that make the following types of statements:
"With a $10,000 deposit, the maximum you can lose is $200 to $250 per day."
"We promise to recover any losses you have."
"Your investment is secure."
4. Don't Trade on Margin Unless You Understand What It Means
Margin trading can make you responsible for losses that greatly exceed the dollar amount you deposited.
Many currency traders ask customers to give them money, which they sometimes refer to as "margin," often sums in the range of $1,000 to $5,000. However, those amounts, which are relatively small in the currency markets, actually control far larger dollar amounts of trading, a fact that often is poorly explained to customers.
Don't trade on margin unless you fully understand what you are doing and are prepared to accept losses that exceed the margin amounts you paid.
5. Question Firms That Claim To Trade in the "Interbank Market"
Be wary of firms that claim that you can or should trade in the "interbank market," or that they will do so on your behalf.
Unregulated, fraudulent currency trading firms often tell retail customers that their funds are traded in the "interbank market," where good prices can be obtained. Firms that trade currencies in the interbank market, however, are most likely to be banks, investment banks and large corporations, since the term "interbank market" refers simply to a loose network of currency transactions negotiated between financial institutions and other large companies.
6. Be Wary of Sending or Transferring Cash on the Internet, By Mail or Otherwise
Be especially alert to the dangers of trading on-line; it is very easy to transfer funds on-line, but often can be impossible to get a refund.
It costs an Internet advertiser just pennies per day to reach a potential audience of millions of persons, and phony currency trading firms have seized upon the Internet as an inexpensive and effective way of reaching a large pool of potential customers.
Companies offering currency trading on-line will usually be located in different legal jurisdictions to you. Even if they display an address or any other information identifying their nationality on their Web site it may be false. Be aware that if you transfer funds to foreign firms it may be very difficult or impossible to recover your funds.
7. Currency Scams Often Target Members of Ethnic Minorities
Some currency trading scams target potential customers in ethnic communities, particularly persons in the Russian, Chinese and Indian immigrant communities, through advertisements in ethnic newspapers and television "infomercials."
Sometimes those advertisements offer so-called "job opportunities" for "account executives" to trade foreign currencies. Be aware that "account executives" that are hired might be expected to use their own money for currency trading, as well as to recruit their family and friends to do likewise. What appears to be a promising job opportunity often is another way many of these companies lure customers into parting with their cash.
8. Be Sure You Get the Company's Performance Track Record
Get as much information as possible about the firm's or individual's performance record on behalf of other clients. You should be aware, however, that It may be difficult or impossible to do so, or to verify the information you receive. While firms and individuals are not required to provide this information, you should be wary of any person who is not willing to do so or who provides you with incomplete information. However, keep in mind, even if you do receive a glossy brochure or sophisticated-looking charts, that the information they contain might be false.
9. Don't Deal With Anyone Who Won't Give You His Background
Plan to do a lot of checking of any information you receive to be sure that the company is and does exactly what it says.
Get the background of the persons running or promoting the company, if possible. Do not rely solely on oral statements or promises from the firm's employees. Ask for all information in written form.
If you cannot satisfy yourself that the persons with whom you are dealing are completely legitimate and above-board, the wisest course of action is to avoid trading foreign currencies through those companies
Forex scam
A forex scam is any trading scheme used to defraud individual traders by convincing them that they can expect to gain an unreasonably high profit by trading in the foreign exchange market, which would be a zero-sum game were it not for the fact that there are brokerage commissions, which technically make forex a "negative-sum" game.
These scams might include churning of customer accounts for the purpose of generating commissions, selling software that is supposed to guide the customer to large profits,[1] improperly managed "managed accounts",[2] false advertising,[3] Ponzi schemes and outright fraud.[4] It also refers to any retail forex broker who indicates that trading foreign exchange is a low risk, high profit investment.[5]
The U.S. Commodity Futures Trading Commission (CFTC), which loosely regulates the foreign exchange market in the United States, has noted an increase in the amount of unscrupulous activity in the non-bank foreign exchange industry.[6]
An official of the National Futures Association was quoted[7] as saying, "Retail forex trading has increased dramatically over the past few years. Unfortunately, the amount of forex fraud has also increased dramatically..." Between 2001 and 2006 the U.S. Commodity Futures Trading Commission has prosecuted more than 80 cases involving the defrauding of more than 23,000 customers who lost $300 million, mostly in managed accounts. CNN also quoted Godfried De Vidts, President of the Financial Markets Association, a European body, as saying, "Banks have a duty to protect their customers and they should make sure customers understand what they are doing. Now if people go online, on non-bank portals, how is this control being done?"
The highly technical nature of retail forex industry, the OTC nature of the market, and the loose regulation of the market, leaves retail speculators vulnerable. Defrauded traders and regulatory authorities, can find it very difficult to prove that market manipulation has occurred since there is no central currency market, but rather a number of more or less interconnected marketplaces provided by interbank market makers.
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