Posted by talkingforex September 28, 2011 1 Comment

Valuing currencies

The forex market revolves around the value of currencies in relation to the values of other currencies. These values play a large economic role, especially in the prices of imports and exports.

Currencies are either valuated by the market, or by governments. In the market, the value of assets is determined by supply and demand; i.e. when there are more buyers than sellers of a currency, the demand is higher and so is the value of a currency. When there are more sellers than buyers, the lower the demand (or the higher the supply) the lower the value of a currency. A currency that is subject to market valuation is known as a floating currency.

Conversely, currency values can be set by governments, known as fixing a currency. The value of such currencies is pegged to another major world currency (usually the USD), or a basket of currencies.

Most currencies are on a managed float, meaning that the market usually determines their value, but governments also try to keep that value within a certain range by manipulating interest rates and trading their own currencies on the forex market.

Intervening in currencies

As currencies always are traded in pairs, a significant movement in one will directly impact the other. So in the AUD/USD pair, if the US releases some disappointing economic results, the forex pair is likely to rise (or the AUD is likely to rise against the USD).

If there is a sudden, sustainable movement in a currency’s value, this can make it impossible for a central bank to respond via adjusting interest rates, meaning that it will use other methods to intervene, such as selling its currency and buying the opposing currency.

One example would be the Japanese yen from 2000 to 2003, when the Bank of Japan intervened several times to keep the JPY lower than the USD. As a higher JPY would result in more expensive exports, the BoJ was worried about hindering economic recovery by allowing the currency to appreciate. Consequently, the BoJ spent over USD28 billion and USD33 billion buying the USD in 2001 and 2002 respectively to keep the value of the yen down in comparison.

Using interventions in your forex trading

Interventions can be good short-term trading opportunities.

In the case of a significant negative catalyst (such as poor economic results), a currency should be valued lower, meaning that the currencies with which it is paired will rise. If there is incentive for one of the paired currencies to remain below a certain price, traders can speculate on the probability of an intervention, which would result in sharp price movements. Traders can then make a profit by taking a position before the intervention and closing that position after the effects of the intervention have taken place.

If we look at The USD/JPY chart from July 27 to August 7, 2011, we can see that the yen was strengthening against the USD over the end of July and beginning of August (as this is a USD/JPY chart, the price moves down as the JPY strengthens due to the USD being weaker in comparison).

As in 2001, it is still important to the BoJ to keep the yen below a certain level against the USD, and on August 4 it intervened by selling off its currency, the third time it has done so since September 2010.

As we can see, the USD rose strongly in response, hitting a high of 80.238 before starting to fall again. Traders wanting to trade the intervention could have opened a long position on one contract of the currency pair at its August 3 low of 76.783 and setting a trailing stop to close the position automatically once the initial reaction to the intervention had ceased. A trailing stop at 20 pips would have closed the trade when the pair fell to 80.038 following its 80.238 high, securing a profit of JPY325,500

One contract is worth USD100,000, so if 1USD is trading for 80.238 yen, USD100,000 will be worth JPY8,023,800. To determine the profit of a long trade, you simply subtract your opening position from the value of your closing position and multiply it by 100,000. So 80.038 – 76.783 = 3.255 x 100,000 = JPY325,000. At an exchange rate of 1USD for JPY80.038, this equates to USD4,060.57 (325,000/80.038).

Principles for trading interventions

As government interventions aren’t always made public, here are some principles to follow that may help you cash in on them:

1. Interventions are usually made around the same level as previous interventions. The last JPY intervention was made on March 18, 2011, following the March 16 USD/JPY low of 76.431. On August 1, 2011, the pair hit a low of 76.302, an indication of the possibility of an impending intervention.
2. Sometimes there are statements hinting that an intervention may take place, with numerous reports in the news writing about an intervention in the days leading up to August 4.
3. Analysts can also give good estimates of intervention levels, so it is a good idea to keep an eye on forex analysts from popular banks and investment firms.
4. Always set a trailing stop when opening a position, as you can never be sure about just how much a currency pair will move (though previous intervention levels can provide a guide if you prefer to just set stop-losses and profit-limits).

As you can see, the potential profits of using government interventions in your forex trading can be high. However, if the expected intervention does not take place, you may lose more than your initial investment. Consequently, it is essential that traders research the fundamentals behind possible interventions, and using stops and limits to manage their risk.