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  • December 2013

    Volume 10, No. 12

    Strategies, analysis, and news for FX traders

    THE YENS YEAR-END POSITION P. 6

    Butterflies and option volatility in the FX majors p. 22

    FX systems: Single vs. multiple currencies p. 18

    2014: On the forex horizon p. 12

    Trading a head-and-shoulders pattern in the Euro p. 33

  • 2 December2013CURRENCY TRADER

    CONTENTS

    Contributors .................................................4

    Global MarketsIs dollar/yen gearing up for another run? .........................................6Istheyenreadytomakeanothersignificant

    move after its multi-month consolidation?By Currency Trader Staff

    On the MoneyWhat to worry about next year ..............12A look at some of the issues looming over the FX market as we head into a new year.By Barbara Rockefeller

    Trading StrategiesIs less more in forex? ..............................18Traders tend to favor systems that test well across multiple instruments, but should that be a goal for FX traders?By Daniel Fernandez

    Advanced ConceptsButterflies are free, and well worth it: The majors ................................................22 Dobutterfliesofferaneasyapproachtotrading

    option volatility on the major currencies?By Howard L. Simons

    Global Economic Calendar ........................28Important dates for currency traders.

    Events .......................................................28Conferences, seminars, and other events.

    Currency Futures Snapshot .................29

    BarclayHedge Rankings ........................29Top-ranked managed money programs

    International Markets ............................30 Numbers from the global forex, stock, and interest-rate markets.

    Forex Journal ...........................................33 Seeing if the Euro has a good head on its shoulders.

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    Questions or comments?Submit editorial queries or comments to

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  • CONTRIBUTORS

    4 December2013CURRENCY TRADER

    Editor-in-chief: Mark Etzkorn

    [email protected]

    Managing editor: Molly Goad

    [email protected]

    Contributing editor:

    Howard Simons

    Contributing writers:

    Barbara Rockefeller,

    Marc Chandler, Chris Peters

    Editorial assistant and

    webmaster: Kesha Green

    [email protected]

    President: Phil Dorman

    [email protected]

    Publisher, ad sales:

    Bob Dorman

    [email protected]

    Classified ad sales: Mark Seger

    [email protected]

    Volume 10, No. 12. Currency Trader is published monthly by TechInfo, Inc., PO Box 487, Lake Zurich, Illinois 60047. Copyright 2013 TechInfo, Inc. All rights reserved. Information in this publication may not be stored or reproduced in any form without written permission from the publisher.

    The information in Currency Trader magazine is intended for educational purposes only. It is not meant to recommend, promote or in any way imply the effectiveness of any trading system, strategy or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Trading and investing carry a high level of risk. Past perfor-mance does not guarantee future results.

    For all subscriber services: www.currencytradermag.com

    A publication of Active Trader

    CONTRIBUTORS

    qHoward Simons is president of Rosewood Trading Inc. and a strategist for Bianco Research. He writes and speaks fre-quently on a wide range of economic and financial market issues.

    qDaniel Fernandez is an active trader with a strong interest in calculus, statistics, and economics who has been focusing on the analysis of forex trading strategies, particularly algorithmic trading and the mathematical evaluation of long-term system profitability. For the past two years he has published his research and opinions on his blog Reviewing Everything Forex, which also in-cludes reviews of commercial and free trading systems and general interest articles on forex trading (http://mechani-calforex.com). Fernandez is a graduate of the National University of Colombia, where he majored in chemistry, concentrating in computational chemistry. He can be reached at [email protected].

    qBarbara Rockefeller (www.rts-forex.com) is an international economist with a focus on foreign exchange. She has worked as a forecaster, trader, and consultant at Citibank and other financial institutions, and currently publishes two daily reports on foreign exchange. Rockefel-ler is the author of Technical Analysis for Dummies, Second Edition (Wiley, 2011), 24/7 Trading Around the Clock, Around the World (John Wiley & Sons, 2000), The Global Trader (John Wiley & Sons, 2001), The Foreign Exchange Matrix (Harriman House, 2013), and How to Invest Internationally, published in Japan in 1999. A book tentatively titled How to Trade FX is in the works. Rockefeller is on the board of directors of a large European hedge fund.

    Once you know the true market support levels, you know where you stand. You know when to be cautious, and when to let go and let your profit run. If you had AbleTrend at your fingertips, you would always know exactly where the markets true support levels are. Then you could:

    a) Be able to sit tight and sustain your position during the market testing, and enjoy the market when it soars;

    b) Exit the market when it breaks the support levels (the small blue dots below the bars) and cut your losses short.

    If you do not know the true market support/resistance level then fear will drive you out of market when you should stay, or you will stay in the market too long with losing positions. Its as simple as that. If you can read the chart with support levels, you could do better than most fund managers and save a bundle in service fees.

    Do you know someone who has lost thousands of dollars in trading, but who was not willing to pay for time-tested trading signals? 15 years ago, people would say what an advantage it would be to have AbleTrend! Today one would say what a disadvantage it is not to have AbleTrend

    Test Drive AbleTrend 7.0 and Discover the True Market Support/Resistance Levels for the Markets You Trade

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    THESE RESULTS ARE BASED ON SIMULATED OR HYPOTHETICAL PERFORMANCE RESULTS THAT HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE THE RESULTS SHOWN IN AN ACTUAL PER-FORMANCE RECORD, THESE RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, BECAUSE THESE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THESE RESULTS MAY HAVE UNDER-OR OVER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED OR HYPOTHETICAL TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THESE BEING SHOWN. THE TESTIMONIAL MAY NOT BE REPRESENTATIVE OF THE EXPERIENCE OF OTHER CLIENTS AND THE TESTIMONIAL IS NO GUARANTEE OF FUTURE PERFORMANCE OR SUCCESS. TECHNICAL ANALYSIS OF STOCKS & COMMODITIES LOGO AND AWARD ARE TRADEMARKS OF TECHNICAL ANALYSIS, INC.

    AbleTrend 7.0

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    LINKS

    TRADERS 'RESOURC E

    Get Started Today! www.ablesys.com/ACTAblesys Corp. 20954 Corsair Blvd. Hayward, CA 94545 Tel: 510-265-1883 Fax: 510-265-1993

    How many times has fear made you exit the market too soon and miss the big move?

    SINCE 1995

    CTAREGISTERED

    WITH THE CFTC

    Scientific support levels help you to distinguish a retracement from a reversal

    Underwater on a trade? You need to know how far is too far, and whether the current

    pull back is just a retracement or if its a reversal.

    These pull backs tested the T2 support levels but did not break through, therefore they are only retracements

    Prices broke the T2 resistance level (small red dots above the bars) and remained beyond them. Its a reversal. The trend has changed its direction!

  • Once you know the true market support levels, you know where you stand. You know when to be cautious, and when to let go and let your profit run. If you had AbleTrend at your fingertips, you would always know exactly where the markets true support levels are. Then you could:

    a) Be able to sit tight and sustain your position during the market testing, and enjoy the market when it soars;

    b) Exit the market when it breaks the support levels (the small blue dots below the bars) and cut your losses short.

    If you do not know the true market support/resistance level then fear will drive you out of market when you should stay, or you will stay in the market too long with losing positions. Its as simple as that. If you can read the chart with support levels, you could do better than most fund managers and save a bundle in service fees.

    Do you know someone who has lost thousands of dollars in trading, but who was not willing to pay for time-tested trading signals? 15 years ago, people would say what an advantage it would be to have AbleTrend! Today one would say what a disadvantage it is not to have AbleTrend

    Test Drive AbleTrend 7.0 and Discover the True Market Support/Resistance Levels for the Markets You Trade

    www.ablesys.com/ACT

    30 DAY TRIAL START TODAY!

    $20 DISCOUNTCODE: ACT1113

    THESE RESULTS ARE BASED ON SIMULATED OR HYPOTHETICAL PERFORMANCE RESULTS THAT HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE THE RESULTS SHOWN IN AN ACTUAL PER-FORMANCE RECORD, THESE RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, BECAUSE THESE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THESE RESULTS MAY HAVE UNDER-OR OVER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED OR HYPOTHETICAL TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THESE BEING SHOWN. THE TESTIMONIAL MAY NOT BE REPRESENTATIVE OF THE EXPERIENCE OF OTHER CLIENTS AND THE TESTIMONIAL IS NO GUARANTEE OF FUTURE PERFORMANCE OR SUCCESS. TECHNICAL ANALYSIS OF STOCKS & COMMODITIES LOGO AND AWARD ARE TRADEMARKS OF TECHNICAL ANALYSIS, INC.

    AbleTrend 7.0

    AwardWinningTrading

    Software

    1997 - 2013

    For Stocks,Futures

    FOREX &Options

    CTA Firm

    Readers Choice Awards1997-2013 in Stock TradingSystem; Futures Trading System& Option Trading System

    LINKS

    TRADERS 'RESOURC E

    Get Started Today! www.ablesys.com/ACTAblesys Corp. 20954 Corsair Blvd. Hayward, CA 94545 Tel: 510-265-1883 Fax: 510-265-1993

    How many times has fear made you exit the market too soon and miss the big move?

    SINCE 1995

    CTAREGISTERED

    WITH THE CFTC

    Scientific support levels help you to distinguish a retracement from a reversal

    Underwater on a trade? You need to know how far is too far, and whether the current

    pull back is just a retracement or if its a reversal.

    These pull backs tested the T2 support levels but did not break through, therefore they are only retracements

    Prices broke the T2 resistance level (small red dots above the bars) and remained beyond them. Its a reversal. The trend has changed its direction!

  • 6 December2013CURRENCY TRADER

    GLOBAL MARKETS

    The Japanese yen has suffered dramatic losses this year, but yen weakness was an intentional policy move by Japanese authorities designed to stimulate domes-tic growth and inflation. As of Dec. 2, the yen had dropped more than 30% since October 2012 vs. the U.S. dollar in response to the implementation of Abenomics, the term given to the eco-nomic policies by current Japanese Prime Minister Shinzo Abe (Figure 1).

    The three prongs of Abes economic initiative include aggressive monetary policy, fiscal policy, and growth strate-gies aimed at lifting the Japanese econo-my out of the deflationary fog it has been in for two decades. In response, Japanese equities rocketed higher, with the Nikkei 225 gaining about 50% on the year in early December.

    Is dollar/yen gearing up for another run?

    Is the yen ready to make another significant move after its multi-month consolidation?

    BY CURRENCY TRADER STAFF

    FIGURE 1: WEEKLY YEN FUTURES

    The USD/JPY rate has rallied strongly over the past year or so, with the yen losing more than 30% vs. the dollar since fall 2012.Source: TradeStation

  • CURRENCY TRADERDecember2013 7

    After hitting a high of 103.73 on May 22, the dollar/yen rate (USD/JPY) consolidated, forming the triangle pat-tern the currency pair eventually penetrated to the upside in mid-November (Figure 2). By early December, the pair was trading at its highest level since the end of May.

    Economic upticksFor 2013, Moodys Analytics estimates 2013 Japanese gross domestic product (GDP) growth at 1.7%, while forecasting a 2% rate for 2014.

    Fourth-quarter 2012 GDP came in at +1.1%, but jumped to +4.1% in the first quarter of 2013 and +3.8% in Q2, according to seasonally adjusted, annualized data from Nomura. However, in Q3, GDP moderated to a 1.9% pace, which sparked some concerns.

    Wells Fargo economist Tim Quinlan contends Abenomics is working so far, despite the apparent Q3 economic con-traction. Abenomics has gotten the Japanese economy off to a pretty decent trajectory in terms of economic growth, he says. Some people point to the GDP slowdown in the third quarter as an indication its not working, but that was almost entirely a function of a drop-off in exports in that quarter. There was better domestic demand during that period.

    A pick-up in inflation is a key component of Japans economic strategy, and some progress has occurred on that front already. Japanese consumer prices declined 0.2% in the fourth quarter of 2012, 0.6% in the first quarter of 2013, and 0.3% in Q2, but in Q3 they jumped 0.9%.

    Quinlan notes that although imported fuel and energy costs contributed to the uptick, the biggest driver of inflation is inflation expectations. Bank of Japan (BOJ) Governor Haruhiko Kuroda has exceeded financial mar-ket expectations with his qualitative and quantitative monetary policies, he says. The BOJ is buying exchange-traded mutual funds and its buying real estate outright with Japanese REITS. After 15 years of deflation, it has put people in a mindset of, maybe this will work.

    However, the work on this front is still just beginning, Quinlan adds. To increase the rate of inflation, we will need to see an increase in wage growth, he says.

    Tax hike and other obstaclesWhile the Abenomics policies may have triggered an initial economic reaction, several challenges remain, including an increase in the consumption tax scheduled for April 2014. In an attempt to combat Japans high debt-to-GDP ratio, the sales tax will increase 3% to 8%.

    FIGURE 2: DAILY DOLLAR/YEN

    By early December the dollar/yen pair was in the process of challenging its May high.Source: TradeStation

  • 8 December2013CURRENCY TRADER

    GLOBAL MARKETS

    We are a little concerned, says Chris Rupkey, chief financial economist at Bank of Toyko-Mitsubishi. Its going to take a big chunk out of the economy it takes a lot out of consumer spending.

    Richard Cochinos, head of Americas G-10 FX Strategy at Citigroup, says the upcoming tax hike is weighing on consumer confidence. A 1997 sales tax hike, which had an immediate and negative impact on GDP, is still alive in the memories of many Japanese consumers. It knocked growth off the table, he says.

    I expect if we get past the consumer tax hike in the spring and growth does not plummet, we should begin to see confidence in Japanese households rise and that will become the trigger to look at aggressively selling yen, Cochinos adds. He also notes the potential for either addi-tional fiscal stimulus or additional quantitative easing (QE) to offset the negative impact of the sales tax hike on growth.

    The sales tax hike isnt the only potential hurdle. While describing the BOJs mon-etary policy actions as a good way of priming the pump, Quinlan notes it alone can-not reverse the Japanese economys course. It gives the economy a little bit of a boost, he says. But ulti-mately, if you want to have lasting economic growth, it has to come from other places besides expansive monetary policy.

    Quinlan says recommendations from the Organisation for Economic Co-operation and Development (OECD), which include efforts to encourage greater female partici-pation in the workforce, could help Japans shrinking labor pool. He says other options could be to liberalize trade or open the door to immigration.

    The winds from Abenomics are still blowing strong for the moment, Rupkey says. But its been about a year that weve been trading on it. We need some new factors. Maybe a pickup in world growth would be bullish, since Japanese corporations make a lot of sales in Europe.

    According to Glenn Levine, economist at Moodys Analytics, the big issue is whether Abe moves forward in a meaningful way on the third arm of his economic plan sweeping economic reform and whether this boosts private non-residential investment and the economys pro-

    ductive capacity. On this final point, the evidence so far is mixed, but as Abes tenure drags on without substantial policy progress, his political capital will erode and it will become increasingly likely that his overall plan will fall short, he says.

    The yen trendThus far, the strong depreciation trend in the yen vs. the dollar has largely resulted from the BOJs massive QE pro-gram.

    Ongoing monetary stimulus from the BOJ is the main factor driving the yen, Levine says. We expect this to continue, ensuring the yen will maintain a weakening bias. The other big issue globally is the Fed taper. Although it has little impact on the yen/dollar rate, it will drive the yen cross rates, particularly with emerging market curren-

    cies.Rupkey explains the con-

    nection to the yen and the economy: The secret to the Japanese economy is that it is very much trickle down, he says. If corporations are doing well and exporters are getting more dollars for their exports, thats good for the economy. Dollar/yen 120 is good, 75 is not so good. Abenomics was designed to push up the dollar vs. the yen because its good for the economy.

    Charles St-Arnaud, execu-tive director-Foreign Exchange Research and Economics at

    Nomura, says his firm continues to expect the yen to grad-ually depreciate. Nomura has a target of 110 for the end of 2014.

    BNP Paribas is also bearish on the yen, with a 118 dol-lar/yen forecast for the end of 2014. Our sense is most of the yen weakness this year was driven by Japanese events and aggressive easing by the BOJ, says Vassili Serebriakov, BNP Paribas currency strategist. But going forward, the U.S. side of the equation will be more impor-tant. We expect stronger U.S. growth, Fed tapering in March, and rising U.S. yields, which should support dol-lar/yen.

    Global FX flow patternsCochinos has been monitoring how global capital is mov-ing around the world. He analyzes FX order flow of Citis

  • CURRENCY TRADERDecember2013 9

    client base placing all FX trades executed with Citi in a database, which he breaks down into different categories, including client type.

    Selling yen has been predominantly a foreign trade, he says. Historically, weve seen selling by European clients and Americas clients, but there hasnt been a lot of domes-tic selling in the yen weakness story. Dollar/yen rallies in the Americas and European time zones, but its completely flat in the Asian time zone. This shows me it is predomi-nantly American and European accounts that are selling it.

    Cochinos says an additional client base will need to enter the market and aggressively sell yen to break the dol-lar/yen pair out of its wide range between roughly 103.75 and 93.75.

    He notes Japanese household savings accounts have approximately $8 trillion, or roughly 800 trillion Japanese yen.

    Japanese households have 54% of their assets sitting in cash, which compares to roughly 14% in the U.S. and 36% in Europe, he says. The reason Japanese accounts are sitting in cash is that the country has been mired in a disinflationary or deflationary environment for the better part of 15 years. If you buy into the story, which I do, that Kuroda and Abe will re-engineer the return of growth and inflation to Japan, then cash, which had been appreciat-ing on an annual basis, will begin to depreciate. As infla-tion begins to rise in Japan, households are likely to start investing their cash in order to retain its real purchasing power.

    Cochinos says an increase in Japanese consumer con-fidence will be needed to trigger a shift in these money flows.

    It has been predominantly foreign investors buying USD/JPY that has caused dollar/yen to rally, he says. For the next leg, were looking for Japanese households to get involved. Confidence is highly correlated to out-ward investment in securities. Ultimately, when consumer confidence rises, youll see the animal spirits rising within Japanese households, and they will invest some of their money.

    Cochinos notes consumer confidence numbers peaked in May, just after the BOJ began its asset purchase pro-gram. The confidence numbers have been falling since [outside of an unsustainable spike in September], which shows Japanese households havent bought into the pro-gram yet, he says. Were unlikely to see the dollar/yen meaningfully above 105 until we see greater outflows from Japanese money managers and household selling of yen, he says.

    If consumer confidence picks up and Japanese house-

    holds begin to reach for yield with overseas investments, Cochinos sees the 125 level as a potential dollar/yen objective. If you see broad portfolio flows out of Japan, it would be a believable target, he says. A 5% reduction in their savings used to purchase overseas assets would be a $400 billion JPY negative order flow. It would certainly take time, but thats the direction and magnitude consis-tent with the amount of capital were talking about.

    On the crossesLooking at the crosses, Cochinos says he expects the New Zealand dollar (NZD/JPY) and Aussie/yen (AUD/JPY) rates to weaken significantly. We are seeing weaker eco-nomic data across the APAC (Asia Pacific) region, which is very bearish for the Aussie dollar, he says. Im looking for the yen to weaken vs. the dollar, but regionally the yen still remains a defensive currency.

    Other market-watchers agree. We expect JPY to remain under pressure on crosses into 2014 as the Bank of Japan maintains its QE program at full pace until further notice, says Sean Callow, senior currency strategist at Westpac Institutional Bank. Indeed, as growth has decelerated and the rise in inflation and reduction of deflation might not prove durable, early in 2014 we could see increased discus-sion of the BOJ increasing the scale of its QE, adding to yen weakness.

    Looking ahead, however, Callow notes there will be pauses and pullbacks, given a speculative market that seems very long USD/JPY already. But he adds that USD/JPY may not be the best way to trade yen weakness. We do not expect the U.S. economy to be strong enough for the Fed to start reducing QE until at least Q3 2014, which will keep a lid on U.S. yields and limit upside on USD/JPY.

    Callow believes a better play is to go long the NZD/JPY pair. The Reserve Bank of New Zealand seems highly likely to raise interest rates in 2014, probably by 100 basis points, he says. This is broadly priced in, but once the date for the first hike draws near, the kiwi should draw fresh demand. The kiwi/yen is likely to be a buy on dips into 2014, targeting 87-88.

    Serebriakov also thinks the New Zealand currency has a bullish outlook in the near future (see Figure 3). We think the kiwi will be one of the strongest commodity-based cur-rencies, he says. The New Zealand dollar will do well against the yen. Looking at market expectations, we could have three to four rate hikes by the RBNZ totaling 75-100 basis points.

    Fed taperingOnce the U.S. Federal Reserve begins to taper its monthly

  • 10 December2013CURRENCY TRADER

    GLOBAL MARKETS

    purchases of Treasuries and mortgage-backed securities, the shift in monetary policy is expected to be dollar-bullish, and thus would further support a rise in the dollar/yen rate.

    Tapering is negative for U.S. bonds; it will push yields higher and interest rate differentials between U.S. bonds and Japanese bonds would favor a stronger dollar/yen, Cochinos says.

    Fed tapering could trigger some move-ment on the yen/emerging-market (EM)crosses, with the yen rising and EM FX falling (Figure 4). The Indian rupee and the Indonesian rupiah are particu-larly vulnerable within Asia. But all the emerging market currencies Turkish lira, Philippine peso, Thai baht, etc. are exposed to the Fed, Levine says.

    Safe havenLast but not least, its worth remem-bering the Japanese yen is viewed as a safe-haven currency during times of global economic turmoil or instability. If financial market conditions grow more turbulent in the future, the yen could rise again, Rupkey says.

    Rupkey says the Japanese banking systems strength and stability supports the yens safe-haven position. During the financial crisis in 2008, the banking system in Japan didnt get involved in mortgage-related products, he says. It is widely acknowledged the banking sys-tem is sound.

    Although U.S. equities have been on a tear this year, many analysts have warned of the potential for a correction, which would be another factor that could contribute to safe-haven yen buying. If the stock market were to lose 10%, the yen would probably appreciate on that, Rupkey says. y

    FIGURE 3: KIWI/YEN

    Some analysts see the potential for a long expect the New Zealand dollar/yen play.Source: TradeStation

    FIGURE 4: YEN/RUPEE

    Fed tapering could trigger yen strength vs. emerging currencies, including the Indian rupee.Source: www.advfn.com

  • CURRENCY TRADERDecember2013 1111-IB13-692

    Member - NYSE, FINRA, SIPC. Lower investment costs will increase your overall return on investment, but lower costs do not guarantee that your investment will be profitable Supporting documentation for any claims and statistical information will be provided upon request. The settlement date of foreign exchange trades can vary due to time zone differences and bank holidays. When trading across foreign exchange markets, this may neces-sitate borrowing funds to settle foreign exchange trades. The interest rate on borrowed funds must be considered when computing the cost of trades across multiple markets.

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    Forex.How profitable are you?

    Interactive Brokers

    Data provided by forexmagnates.com, includes the impact of any commissions

    % Profit % LossTotal

    AccountsSpread

    MarkupsQ3 2013

    Percentage of profitable and unprofitable accounts as reported to the NFA

    Interactive Brokers OANDA

    FXDD

    ILQ

    Gain Capital

    IBFX/TradeStation

    FXCM

    MB Trading

    44.0%

    35.1%

    29.1%

    22.3%

    31.0%

    32.0%

    28.0%

    27.2%

    56.0%

    64.9%

    70.9%

    77.7%

    69.0%

    68.0%

    72.0%

    72.8%

    23,759

    20,812

    5,118

    1,138

    11,425

    8,718

    22,055

    3,365

    NO

    YES

    YES

    YES

    YES

    YES

    YES

    YES

    Lower your costs to maximize your return

  • Big-picture forecasting is hardly ever a good idea. Mostly you end up eating crow. And yet we all want to get at least a broad outline of what to expect in the coming year, even if the whole thing goes out the window at the first really big shock.

    And shocks are by definition something we are very bad at predicting. We may know there will be a weather shock or a financial sector failure, but not the exact form it will take. For example, a large minority foresaw the housing crash but nobody knew about AIG. And nobody foresaw the Arab Spring, or that the Health Insurance Marketplace website rollout would be a train wreck.

    What are we missing this time? Heres a short list of events in 2014 that we do know about:

    Latvia joins the EMU. Greece takes over the rotating EU presidency in January, and Italy gets it in June. The European Central Bank (ECB) conducts capital adequacy and stress tests before taking over bank supervision.

    Russia hosts the G8 in June. China starts implementing its Third Plenum reforms,

    which include relaxing the one-child policy, getting rid of prison camps, opening up financial markets, and possibly letting the yuan float more widely.

    Janet Yellen takes over as Fed chairman and a slew of new Fed officials come into office and onto the Federal Open Market Committee (FOMC). We get the begin-ning of tapering in 2014, if not in December 2013. We may also start getting a press conference after every policy meeting, like all the other major central banks.

    In April Japan will raise the consumption tax from 5% to 8%, a threat to Abenomics unless we also get the third arrow structural reform, including putting more income in wage-earner pockets.

    We will get the outcome of the London fix investiga-tion.

    EuropeThe Euros resilience is an astonishing phenomenon in the history of foreign exchange. We saw another instance in November. On Nov. 7, the ECB cut the key refi rate by 25

    basis points to 0.25%, and the Euro already falling in anticipation bottomed the very same day (Figure 1). The Euro fell below the 20-day moving average (red) and the 50-day MA (turquoise), but didnt come close to the 200-day MA (green). The Euro did put in a downside breakout of the rising channel drawn off the July low, but for only a week, after which it closed a few times back inside the ris-ing channel.

    This is classic sell on the rumor, buy on the news, but when the news is authentically negative, and it is in this case, the upward bounce is shallow and short-lived, and sometimes a dead-cat bounce.

    The catalyst for the reversal was a combination of really good German data, including IFO, and fairly downbeat U.S. data that suggested further delay in tapering. Even so, the big picture on rates is the spread between the German Bund and the U.S. 10-year T-note is at a full 100 bp. The outlook is firmly Europe down, U.S. up. That the Euro shrugged off the rate cut implies the imagined delay in tapering was a more important factor than the actual rate cut.

    This has unhappy implications for the year ahead. Low growth and inflation data out of the Eurozone (with the exception of Germany) hints the ECB will be scraping the bottom of the barrel for additional boosts. One idea gain-ing widespread attention is a negative deposit rate for banks parking surplus cash at the ECB. Bank chief Mario Draghi took the unusual step of mentioning the negative rate rumor, saying it was just something discussed in the policy meeting and not likely to occur.

    All the same, as the ECB investigates banks for non-performing loans and other bad assets in the quest for better capital adequacy and stress resistance, observers are pretty sure some ugly stuff will be found under the rugs. A separate agency, the Securities and Markets Authority, has already discovered the big 39 banks in the region have huge divergences in the way they disclose critical data, including income itself, forbearance on non-performing loans, derivatives, and even liquidity.

    The Eurozone weathered the peripheral sovereign debt crisis, which seems to be back-burnered for the moment, but the banking sector could well turn out to be the 800-

    On the Money

    12 December2013CURRENCY TRADER

    ON THE MONEY

    What to worry about next year A look at some of the issues looming over the FX market as we head into a new year.

    BY BARBARA ROCKEFELLER

  • CURRENCY TRADERDecember2013 13

    pound gorilla in the room. This is not to say Europe will face a banking sector crisis like the U.S. did in 2008-2009, but the chance of fireworks is pretty high. Also the ECB cannot, literally, engage in troubled asset relief (TARP), although it can possibly do TALF (term asset-backed loan facility). But another thing the ECB cannot do is quantita-tive easing. At a guess, it will be expedient to sweep a lot of unhappy disclosures from the bank investigation back under the rug.

    Meanwhile, U.S. banks are cleaned up, or at least a lot cleaner than they were, and busily paying fat fines for past misbehavior. The dollar doesnt get any benefit from a rela-tively healthy banking sector, but it seems lopsided that the Euro doesnt get any drag from an unhealthy one. And if rate cuts in Europe are not terribly Euro-negative and its only the Fed that counts, the longer the Fed defers taper-ing, the longer the dollar stays weak.

    In fact, if the 10-year spread is already 100 points in favor of the dollar, the key question is, how much more premium does the U.S. have to pay to catch a break?

    The Fed and taperingIn practice, the number that counts is payrolls, with the November number due on December 6. If the U.S. econ-omy is indeed stagnating, as former Treasury Secretary Lawrence Summers asserts, we should expect a return to low-ish numbers after Octobers surprise rise of 204,000, which hardly anyone saw coming.

    TrimTabs, like ADP with its paycheck business, uses real data to make its estimates, the daily income tax deposits to the Treasury from all salaried employees (including the public sector). TrimTabs claims this data is live and real-time, better than the BLS surveys, and more accurate in the

    sense that once the BLS is finished revising (and revising again), the final number is close to the TrimTabs number.

    You cant get the TrimTabs forecast for November unless you subscribe, but all year TrimTabs has been saying aver-age monthly jobs gains are lower in 2013 than in 2012. For October, for example, TrimTabs had a forecast of 91,000, or half the published BLS number. If TrimTabs is right that the BLS data meets its own forecast after revisions, we need to expect a substantial revision to the October data, perhaps as early as the December 6 release of November data.

    If the November jobs data is disappointing and/or the October revision is a big cut, we will have a discrepancy between the market and the too-optimistic Fed. Speaking to the National Economics Club in New York, Fed chief Ben Bernanke was thought to say the Fed had not ruled out tapering as early as the December FOMC meeting on Dec. 17-18. The 10-year yield rose as he was speaking.

    Bernanke defended forward guidance. The Fed still expects improvement in employment and a gradual rise in inflation to its 2% target. But even when tapering begins, the Fed funds base-case rate will remain near zero for a very long time until perhaps well after unemployment drops below 6.5%. Markets are beginning to appreciate that they are separate tools and that the mix of those tools will change somewhat over time, Bernanke said. Its the most fundamental point I wanted to make.

    Yeah, but the market doesnt believe it works that way. One idea floated at an earlier FOMC was that lowering the unemployment benchmark would convince traders that the forward guidance of lower for longer was sincere. Some analysts, notably at Deutsche Bank, were convinced we would get the change, and of course its still possible.

    FIGURE 1: RESILIENCE OF THE EURO

    When the ECB cut its key refi rate 25 basis points on Nov. 7, the Euro sold off intraday but rebounded strongly.Source: Chart Metastock; data Reuters and eSignal

    Barbara RockefellerCurrency Trader May Dec 2013Figure 1. Resilience of the Euro

    ber9 16 23 30

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  • 14 December2013CURRENCY TRADER

    ON THE MONEY

    The obsession with how, exactly, tapering is going to be introduced is not misplaced. A story in the Financial Times uses the word anguish to describe the Fed decision-making process. The forward guidance process is weak. For one thing, decision-makers are using proxies (the unemployment rate) for overall economic performance. For another, central bankers hearts are not really in it the commitment to forward guidance is paper-thin. In a nutshell, central bankers are skating on thin ice and they know it.

    Janet Yellen used the word ultimately multiple times in her Senate Finance Committee confirmation hearing: Ultimately, the Federal Reserve will remove its extreme policies of monetary stimulus, because ultimately the U.S. economy will stage a recovery. Yellens use of the word ultimately was interpreted to mean she is in no hurry to taper, and the absence of hawkish words means dovish-ness by definition. Thus we go from uncertainty over cri-teria for tapering and the timing of tapering to that awful thing, forward guidance, which doesnt work well and is not really credible even in the minds of the very people using it for policy. What a pickle.

    Its probably too much to hope for, but theres a glimmer of a suggestion that tapering is not the only policy initia-tive. Talk of cutting the deposit rate for banks from 0.25% to zero has been around for a long time, but suddenly its on the table again and the Fed board thinks its worth considering at some stage. Yellen worried in her confir-mation testimony that lowering the rate would impair money market function, showing that once again the Feds clientele is the banks, not the borrowing public.

    Smart people disagree on the effect. Economist Alan Blinder and Minneapolis Fed President Narayana Kocherlakota say goosing lending is a good priority but others think the effect would be small, including New York Fed researchers. The researchers are likely looking at mechanical models that fail to account for squishy things like confidence.

    One reason for interest on deposits is to siphon funds out of the economy to manage inflation, so in the absence of inflation, maybe letting some of it loose is appropriate. Besides, it would save $199 million (2012) in interest pay-ments, not a lot of cost, but so what? The cost is not the point. If the ECB is considering a negative rate on bank deposits, for the Fed to keep 0.25% is doubly dumb.

    But the main event is tapering. St. Louis Fed President James Bullard said tapering is definitely on the table but data-dependent. A strong jobs report, I think, would increase the probability some for a December taper, he said. Not the best use of language increase the prob-ability some. An interesting point is the idea of lowering the unemployment threshold from 6.5%, to drive home the point that meeting the threshold does not imply rate hikes, was embraced by only a few.

    A replay of the May-September drama would be a very

    bad thing. Many thought the Fed-promised tapering would start in September but, at the last minute and with-out warning, the Fed retreated, saying the economy wasnt good enough. Now the market is pricing in tapering in December, and while we may deride traders for overre-acting, if the Fed doesnt mean it, it should know better than to poke a stick at a sleeping bear. The Fed can again decline to taper in December but it will do so with its cred-ibility intact only if it takes some other actions, like cutting the deposit rate and getting more specific about what data it needs to see (participation rate, etc.).

    As the only federal institution left standing these days with any authority and respect, the Fed cant afford to fumble. What the Fed does or doesnt do in December likely depends on the intelligence it gets about the budget. No deal, no taper (in December). The budget deadline is Jan. 15 and the FOMC meets Jan. 24-25. Therefore, January is a far more likely date than December.

    Nobody else is mentioning this timetable, but it seems logical. Budget gridlock and government shutdown cant be minor factors to the Fed. Surveys continue to show the majority believe tapering will not begin until the March meeting. Analysts note taper-date survey respondents tend to favor dates that include a press conference, like December and March, leading to the idea the Fed will take away this bias by holding a press conference at every meeting. Since the rest of the developed worlds central banks have a press conference after every meeting, this is not such a shocking change. In retrospect, the Fed was right to delay tapering at the September meeting because of the 16-day government shutdown and near default that ensued in October. Ending tapering as this was going on might have been disruptive in all kinds of pinball ways.

    Its possible the Fed will delay in December for the same reason. But if so, it really should say so out loud for its own credibility, although the Fed likes to stay as far away as possible from any comment that sounds remotely politi-cal.

    To summarize: We get both hawkish-seeming and dov-ish-seeming remarks from top Fed officials. The consensus is for tapering to start in March, but we could get some additional change in the environment at the December meeting, too, such as a cut to zero in the bank deposit rate, a lowering of the unemployment threshold, or the announcement of press conferences after every meeting.

    Bottom line, uncertainty remains high and volatile, roil-ing bond and FX markets in December, and Q1 cant be ruled out.

    ChinaInformation on the reforms agreed to at the Third Plenum is still a bit sketchy, but the reform agenda is reported to be wide and deep. The reform covers 15 sectors and runs to 20,000 words. Reforms will include opening the financial sector, relaxing restrictions on investment, and fixing the

  • CURRENCY TRADERDecember2013 15

    IPO system. Markets loved the whole idea, especially ending the one-child policy, and the Shanghai rose 5.28% in the seven days after the Plenum ended, as shown in Figure 2s chart of the Shanghai Composite index. An upside breakout could be forming.

    Two points that have emerged so far: According to Gov. Zhou Xiaochuan, the Peoples Bank of China (PBOC) will widen the yuans trading band in an orderly way and basically end nor-mal intervention, as well as phase out investment caps for both domestic and foreign investors. In addition, PBOC Deputy Gov. Yi Gang said Its no longer in Chinas favor to accumulate foreign-exchange reserves. The marginal cost of accumulating foreign-exchange reserves has exceeded the marginal gains.

    While other countries (India, Indonesia) saw outflows since June on the tapering story, China kept seeing inflows, with reserves rising from $3.5 trillion to $3.8 trillion. Yi also said the yuan appreciation benefits more people in China than it hurts. Yi is head of the State Administration of Foreign Exchange (SAFE), so he ought to know. But obviously the yuan will spike if the government stops intervening; besides where will they put the money if not into reserves? Commodity stockpiles are one idea they are not conventional monetary reserves but gold is a conventional reserve, so its presumably not an option. Maybe SAFE will give the money to the sovereign wealth fund, the Chinese Investment Corporation or spend it. What an idea.

    One area where spending would be useful is the social sector. The report contains this statement: More attention also needs to be paid to employment, income levels, social security and peoples health. Also: On economic matters, Chinese leaders said they would establish a system for insuring bank deposits, prepare a mechanism for finan-cial bankruptcy and ease controls on prices for energy, water, telecommunications and other services. They will also increase the amount of profits that Chinas vast state-owned enterprises pay to the government. It also said it would ease curbs on offshore securities investments and mergers and acquisitions, without providing detailsThe document set few firm deadlines. One of them raises the proportion of profits state companies must return to the

    treasury, increasing that rate to 30% by 2020, from a cur-rent range of 5% to 15%.

    There are some important currency-relevant tidbits here beyond just opening up the financial sector to higher foreign participation. Deposit insurance and proper bank-ruptcy rules are high on the list. While property rights are probably not going to reach the Anglo-American standard, elevating property rights puts China on a fully capitalist track.

    Investors are going to flock to China in even greater numbers.

    JapanWhen the yield on your 10-year note is 111 bp below Bunds and 211 bp below U.S. 10-year T-notes, you have to expect your currency to be unpopular. This is what is hap-pening to the Japanese yen, which made a four-year low against the Euro and a five-month low against the dollar in November. In recent months, the dollar/yen has been underpinned by rising U.S. yields and hit 101 for the first time since early July, above the magic 100 level.

    This is exactly what Abenomics was designed to deliver, but after reaching a high in May (103.73), the dollar/yen wobbled as low as 93.79. The causes were a combination of flight to safety by domestic traders, loss of confidence in imminent tapering, and discouragement over whether Abenomics can deliver the third arrow, structural reform. The market is willing to believe the first arrow (raising quantitative easing to astronomical heights) was good and the second arrow (infrastructure spending) was

    FIGURE 2: SSE COMPOSITE (SHANGHAI)

    News of Chinas Third Plenum reforms was greeted favorably by the markets. The Shanghai Composite index rose 5.28% in the seven days after the Plenum ended.

    Barbara RockefellerCurrency Trader May Dec 2013Figure 2. SSE Composite (Shanghai)

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  • 16 December2013CURRENCY TRADER

    ON THE MONEY

    pretty good, too. As a result, the Nikkei stock index rose a stunning 80% between November and May (Figure 3).

    Now, ahead of the hike in the consumption tax rate from 5% to 8% on April 1, we need to see and have faith in structural reform: lowering the corporate tax rate, remov-ing restrictions on employment practices, and goosing companies to find a better use for their hoard of 220 tril-lion (according to the BOJ as of June 2013). Other initia-tives already announced include payments to low-income wage earners, tax incentives for home purchases, and gov-ernment spending to boost health care and tourism.

    Not to be dismissed is the Trans-Pacific Partnership, which seeks to remove tariffs on many agricultural prod-ucts, like the amazing 778% tariff on foreign rice. Japanese rice is promoted as having magical properties; in that case, why does it need such a killer tariff?

    More details about the third arrow are due in early December. The yield differential is wide against the yen but if the third arrow is deemed weak or unworkable, or if a crisis drives money home to the yen, we could see the Nikkei and the dollar/yen pair sink.

    The London fixBig bank traders who participate in the London fix are under the microscope of no fewer than eight regulators from the U.S., UK, and Switzerland, plus a few transna-tional agencies.

    According to the Financial Times, there is a whistle blow-er who charges some of the traders with collusion, mean-ing they disclosed their buying or selling needs ahead of time (4 p.m. London or 11 a.m. New York time) in order to suit their own banks book and/or give them a head start on adjusting their book. Additional charges include disclosing the likely direction of FX prices at the fix to pals with private trading accounts to let them front-run the fix. Regulator are poring over not only official phone taps but also social network chats and tweets.

    What will they find? We guess probably the same amount of malfeasance and fraud as would be found in any investigation of any other business (say, stock trading), or roughly 5-10%. The problem is not that some people on trading floors are crooked, but that the regulators will throw the baby out with the bath water, never having actu-ally managed a trading book themselves.

    Heres the shocking truth banks have always front-run their FX customers. Its how that market works and is inherent to professional FX trading. To outlaw front-run-ning would be like telling the supermarket it cant stock up on turkey and cranberry sauce ahead of Thanksgiving. The traders need an inventory to meet customer needs and need to know when supply is going to be big so they can avoid a disruptive price crash. Market makers must always make a two-way price, of course, but nowhere is it written they must book massive and preventable losses.

    The dividing line between sharing inside information on pending supply and demand with professional counter-parts is an entirely different thing from sharing it with non-professional pals in order to front-run the fix for personal gain. The first can be justified and the second cannot. For the press to ramp this up into a FX scandal deserving of the regulatory hammer coming down hard on the industry is a bad thing. It can only increase volatility to no good purpose. Catching crooks is one thing, but tarring a whole industry with the same brush is overkill.

    By this time next year, the London FX fix scandal will presumably be over with. We may not like the outcome. y Barbara Rockefeller (www.rts-forex.com) is an international economist with a focus on foreign exchange, and the author of the new book The Foreign Exchange Matrix (Harriman House). For more information on the author, see p. 4.

    FIGURE 3: USD/JPY (GREEN) VS. NIKKEI (LEFT SCALE)

    Japans Nikkei stock index rallied 80% between November 2012 and May 2013 in response to Abenomics initiatives.

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    Barbara RockefellerCurrency Trader Mag Dec 2013Figure 3: USD/JPY (Green) vs. Nikkei (Left Scale)

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  • 18 October2010CURRENCY TRADER18 December2013CURRENCY TRADER

    The idea of creating trading strategies that work on mul-tiple instruments comes from the experience of trend-following traders in the 1970s and 1980s, but it remains a common piece of advice for algorithmic forex traders today. Its natural to believe a trading system that tests profitably on several currency pairs is robust, while a system that works on a single pair is possibly optimized and thus inherently vulnerable. A system that works on multiple pairs, the logic goes, must be exploiting some fundamental market characteristic.

    Well explore this assumption by evaluating whether trading systems that generate in-sample (IS) profits across multiple currency pairs are, in fact, more likely to generate positive returns on future, unseen price data.

    To conduct this experiment well use daily data for the Euro/U.S. dollar (EUR/USD), British pound/U.S. dollar (GBP/USD), and U.S. dollar/Japanese yen (USD/JPY) pairs from January 2000 to September 2013. This data will be split into an in-sample period span-ning January 2000 to January 2006

    and an out-of-sample (OS) period from January 2006 to September 2013.

    Generating systems Well use the in-sample data to develop sample trading systems to use in different test cases. First well create 1,000 in-sample profitable systems for each of the three currency pairs (criteria: R2 > 0.8, minimum 10 trades per year). Then well create an additional 1,000 systems for each pair that also generates in-sample profits in the other two pairs. This will allow us to compare the out-of-sample results of strategies designed with the prerequisite of mul-

    TRADING STRATEGIES

    Is less more in forex?Traders tend to favor systems that test well across multiple

    instruments, but should that be a goal for FX traders?

    BY DANIEL FERNANDEZ

    TABLE 1: IN-SAMPLE VS. OUT-OF-SAMPLE PERFORMANCEProfitable OS OS better than IS Mean OS P/L IS vs. OS (R)

    EU 77.1% 12.6% 17.2% 0.34GU 40.1% 3.3% -5.8% -0.12

    UJ 66.5% 17.2% 8.5% -0.04EU MPP 50.1% 4.6% 0.99% 0.057GU MPP 33.6% 3.4% -12.32% -0.15UJ MPP 61.1% 9.9% 5.31% -0.02all MPP 48.2% 6% -2% -0.057Systems developed for multiple-pair profitability (MPP) across all three symbols performed much worse on out-of-sample data.

  • CURRENCY TRADERDecember2013 19

    tiple-pair profitability (MPP) to the out-of-sample results of those built only with the requirement of single-pair profitably. (All systems were generated using the Kantu Parameterless system generator with a starting balance of $100,000.)

    Similar to the results published in previous articles (see Related reading), in-sample system generation in the EUR/USD and the USD/JPY pairs leads to better-than-random odds of achieving positive results in the out-of-sample period, while the GBP/USD pair has a low prob-ability of success. Figure 1 maps in-sample profitability vs. out-of-sample profitability for the three currency pairs for the systems that were generated for single-pair profitabil-ity only.

    Also in agreement with previous tests, the EUR/USD pair has a positive correlation between in-sample prof-itability and out-of-sample profitability implying a reduced probability of data-dredging while the other pairs exhibited negative or only slightly positive correla-tions. Overall, the results suggest the 2000-2006 in-sample period had a good chance of generating some level of out-of-sample profitability in the 2006-2013 period only in the EUR/USD and the USD/JPY pairs.

    By comparison, the systems that were developed with in-sample profitability for all three currency pairs pro-duced conspicuously negative out-of-sample performance results. Table 1 shows the number of profitable out-of-sample results for all pairs drops considerably even for the GBP/USD pair, which already had low out-of-sample profitability. Figure 2 is the same as Figure 1 except it maps the results for the systems that were generated for multi-ple-pair profitability.

    FIGURE 1: SYSTEMS DEVELOPED FOR SINGLE-PAIR PROFITABILITY

    GBP/USD

    USD/JPY

    EUR/USD

  • These results are interesting because they suggest trad-ing only systems that were profitable across multiple currency pairs (Figure 2 and the bottom half of Table 1) would have performed worse in real trading on future, unseen data. This is further highlighted by the mean out-of-sample profits, which also dropped considerably when multiple pair profitability was required.

    Making sense of the resultsAlthough this might initially seem completely counterin-tuitive, there are, in fact, good reasons why trading a setup with in-sample profitability across multiple currency pairs will likely lead to worse results in out-of-sample trading.

    Imagine that each currency pair had 10 fundamental characteristics that could be used to create systems that would be profitable in out-of-sample market conditions but 100 characteristics that are spuriously correlated with in-sample profitability that would lead to random, negatively biased out-of-sample results. The success of multiple-pair trading is determined by the degree to which those 10 fundamental conditions overlap among the differ-ent currency pairs. If nine of the 10 conditions are shared while 50 of the spuriously correlated components are elim-inated between the pairs, the odds of building a system for multiple pairs that leads to more robust trading results increases substantially. But if only one of the 10 conditions is shared even if the same 50 spuriously correlated com-ponents are cancelled the odds of success are reduced considerably.

    Heres the problem: Currency pairs tend to share more spurious correlations than true fundamental correlations. As a result, trading systems that work (in-sample) across multiple pairs are not only less profitable, they are far less

    20 December2013CURRENCY TRADER

    TRADING STRATEGIES

    FIGURE 2: SYSTEMS DEVELOPED FOR MULTIPLE-PAIR PROFITABILITY

    EUR/USD

    GBP/USD

    USD/JPY

  • CURRENCY TRADERDecember2013 21

    likely to succeed in the future than a system developed for a single currency pair. This means that when generating strategies it makes more sense to attempt to exploit trad-ing opportunities in specific pairs rather than attempting to exploit a general market phenomenon across multiple pairs.

    The reason this is true in forex and not in other markets has a lot to do with the significant differences in currency pairs that are not as common in bonds, stocks, or com-modities. For example, in the stock market all instruments generally share a long-term positive bias; this makes creat-ing systems designed to work across multiple stocks by tackling fundamental market characteristics a good idea.

    In other words, such systems tend to exploit a strong underlying market bias not present in forex. A long-term forex bias, such as carry, can change significantly over time, as core characteristics (such as interest rates) change, while in stocks core characteristics are more likely to be permanent features of the market. The changing relation-ships between countries, interest rates, central bank inter-ventions, and so on, make different currency pairs behave more like different markets instead of different instruments within a market sharing fundamental characteristics.

    Better to go with single-pair strategiesIts worth noting this analysis doesnt mean that building systems that work across many currency pairs is not pos-sible. As the results show, a certain percentage of systems developed for the three different pairs worked historically. What these results indicate is that, historically, it was not a good idea to follow this path, at least during the in-sample period used here and using these specific currency pairs. Instead, it has been better to focus on generating systems

    that exploit the fundamental characteristics of a single pair this has led to better odds of achieving out-of-sample profitable results.

    Other questions to look into include whether this holds true for larger portfolios, or for portfolios comprised of different symbols (e.g., only JPY pairs) and much longer in-sample periods. y

    Daniel Fernandez is an active trader focusing on forex strategy analysis, particularly algorithmic trading and the mathematical evaluation of long-term system profitability. For more information on the author, see p. 4.

    Measuring system quality with Ideal R Currency Trader, July 2013Calculating regressions on rolling time periods of an equity curve provides a more accurate understanding of a trading systems value.

    FX trading system development: Outperforming your tests by Daniel Fernandez, Currency Trader, August 2013When youre developing a forex trading strategy, how much price data should you use?

    System testing in dollar/yen and pound/dollar pairs by Daniel Fernandez, Currency Trader, September 2013Different currency pairs require different testing param-eters when developing trading systems.

    Avoiding data dredging in forex systems by Daniel Fernandez, Currency Trader, October 2013How do you know if your trading strategy is capitalizing on a genuine market dynamic or just lucking out?

    Related reading

  • 22 December2013CURRENCY TRADER

    TRADING STRATEGIESADVANCED CONCEPTS

    Certain words tend to turn certain traders off almost immediately. Very few futures traders are comfortable with swap terminology, even as the mandates of Dodd-Frank have pushed swap clearing closer into the world of futures. Non-option traders tend to react similarly to vari-ous option terms such as boxes, butterflies, and the topic of the past two months, risk reversals (see Going forward with reversals, October and November 2013).

    Both the October examination of risk reversals for major currencies and the November counterpart for minor cur-rencies concluded the relative anxiety between long and short positions expressed in the different volatilities for call and put options of similar delta was information-rich for future market direction. This should not have been sur-prising, as prices in any market are set by the willingness of the buyer or seller at the margin to pay more or accept less, respectively.

    What about symmetric anxiety as measured in a but-terfly trade? These trades consist of buying both the call and the put of a similar delta and selling two at-the-money options. We generally expect out-of-the-money volatility to be higher as a matter of course to reflect the greater risks involved in writing those options. In practice, however, the smile of volatility often is skewed in such a way that volatility in either the call or put wing is greater than the at-the-money volatility, while the other wings volatility is less than the at-the-money volatility.

    How do butterflies relate to the carry return from bor-

    Butterflies are free and well worth it:

    The majors

    Do butterflies offer an easy approach to trading option volatility on the major currencies?

    BY HOWARD L. SIMONS

    FIGURE 2: THE JAPANESE YEN AND THREE-MONTH BUTTERFLIES

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    FIGURE 1: THE EURO AND THREE-MONTH BUTTERFLIES

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    2.12

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    utterflies

    Log 1

    0 USD

    Car

    ry R

    etur

    n In

    to E

    UR

    , Jan

    . 4, 2

    006

    = 2.

    00

    Led

    Two

    Mon

    ths

    The Euro And Three-Month Butterflies

    Carry 3-Mo 25 3-Mo 35

  • CURRENCY TRADERDecember2013 23

    rowing the USD and lending into the target currency? First, lets map the butterfly values for both three-month 25- and 35-delta against the common logarithm of the total carry return from the U.S. dollar into those currencies, re-indexed to January 2006. This approach allows for the intuitively appealing rising line depicting a stronger currency.

    As in the case of risk reversals, if butterflies are to have any value in trading and market analysis, they should lead the return series. The same two-month lead-time on average as used previously will be used here. However, we should not expect the more symmetric risk measurement of the but-terfly to be as strong a directional indicator as risk reversals. Therefore, the second part of this discussion will focus on butterflies as a mean-reverting indicator for future absolute returns relative to recent absolute returns.

    Butterflies and the majorsThe Euro has lived in a near-permanent state of crisis since the sovereign-debt woes of its weaker members came to the fore in late 2009. However, no one should confuse tension with price action; the common currency has been confined in the upper half of the range it has occupied since its January 1999 inception. Given the number of stories about the bloc fragmenting, the demand for option protection at the wings was small, especially for the 35-delta butterfly, going into May 2013 (Figure 1). That started to change in May 2013 with speculation as to if and when the Federal Reserve would start tapering bond purchases under QE3.

    The yen, as is its wont, presents a very different picture (Figure 2). While the 25-delta butterfly spiked higher during the 2008 financial crisis, the 35-delta butterfly turned negative evidence of a large demand for protection against large moves combined with a lack of concern about small moves. Both butterflies rose during the 2011 U.S. debt ceiling and European sovereign credit situations and then fell as Japan started to become much more aggressive in its attempts to drive the JPY lower. Once taper-talk began in May 2013, the 25-delta butterfly rose.

    Prior to 2013, butterflies for the Canadian dollar were unusually active relative to the underlying moves in the cur-

    FIGURE 5: THE SWISS FRANC AND THREE-MONTH BUTTERFLIES

    0.0%

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    1.98

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    utterflies

    Log 1

    0 USD

    Car

    ry R

    etur

    n In

    to C

    HF,

    Jan

    . 4, 2

    006

    = 2.

    00

    Led

    Two

    Mon

    ths

    Carry 3-Mo 25 3-Mo 35

    FIGURE 4: THE AUSTRALIAN DOLLAR AND THREE-MONTH BUTTERFLIES

    0.0%

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    1.92 1.94 1.96 1.98 2.00 2.02 2.04 2.06 2.08 2.10 2.12 2.14 2.16 2.18 2.20 2.22 2.24 2.26 2.28

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    utterflies

    Log 1

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    ry R

    etur

    n In

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    UD

    , Jan

    . 4, 2

    006

    = 2.

    00

    Led

    Two

    Mon

    ths

    Carry 3-Mo 25 3-Mo 35

    FIGURE 3: THE CANADIAN DOLLAR AND THREE-MONTH BUTTERFLIES

    0.0%

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    1.92

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    utterflies

    Log 1

    0 USD

    Car

    ry R

    etur

    n In

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    AD

    , Jan

    . 4, 2

    006

    = 2.

    00

    Led

    Two

    Mon

    ths

    Carry 3-Mo 25 3-Mo 35

  • ON THE MONEY

    24 December2013CURRENCY TRADER

    ADVANCED CONCEPTS

    rency (Figure 3). The large spike in the 25-delta butterfly during the 2008 financial crisis was to be expected, but the spikes associated with the first rescue of Greece in May 2010 and yet another European debt crisis in October 2011 were almost as large. They were not associated with large moves in the currency itself. Once the CAD settled into a weak downtrend in 2013, the butterflies stopped flapping about.

    Butterflies for the Australian dollar exhibited a series of spikes corresponding to periods of high tension in global financial markets (Figure 4). With the exception of the 2008 financial crisis, these were unrelated to movements in the AUDs carry return. As in the case of the Euro, butterfly levels declined sharply following the November 2011 expansion of global currency swaps. The 25-delta butter-fly rose during the first five months of 2013 as the AUD turned lower and then declined once taper-talk began, even as the AUD remained under pressure.

    The Swiss francs butterfly history has been sedate given the currencys volatility and imposed rate ceilings since the financial crisis (Figure 5). It has the usual spikes during the financial crisis, along with one following the imposi-tion of the 1.20 CHF per EUR ceiling in September 2011, but has been remarkably stable since that event.

    The Swedish krona has not been as much of a repository of flight capital from the Eurozone as the CHF has been, but its butterfly history has been quite similar (Figure 6). Its 25-delta butterfly declined steadily between the expan-sion of currency swap lines in November 2011 and the beginning of taper-talk in May 2013. Both butterflies have been rising since then.

    Finally, the British pounds butterfly history has declined steadily since the 2008 financial crisis, with the two excep-tions of the first rescue of Greece in May 2010 and the European sovereign credit crisis of late 2011 (Figure 7). The Bank of Englands aggressive monetary easing has kept the GBP out of the spotlight and, most critically, within fairly steady trading ranges against both the USD and the EUR. The low butterfly levels reflected this narrative into May 2013; the 25-delta butterfly then began to expand like the Euros.

    FIGURE 8: THREE MONTH-AHEAD RETURN SHIFTS FOR THE EURO

    FIGURE 7: THE BRITISH POUND AND THREE-MONTH BUTTERFLIES

    0.0%

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    1.90

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    utterflies

    Log 1

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    ry R

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    n In

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    BP,

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    . 4, 2

    006

    = 2.

    00

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    Two

    Mon

    ths

    The British Pound And Three-Month Butterflies

    Carry 3-Mo 25 3-Mo 35

    FIGURE 6: THE SWEDISH KRONA AND THREE-MONTH BUTTERFLIES

    -0.1%

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    utterflies

    Log 1

    0 USD

    Car

    ry R

    etur

    n In

    to S

    EK, J

    an. 4

    , 200

    6 =

    2.00

    Le

    d Tw

    o M

    onth

    s

    Carry 3-Mo 25 3-Mo 35

  • CURRENCY TRADERDecember2013 25

    Prospective returnsNow lets see whether absolute three month-ahead return shifts appear to be a function of these butterflies and of the forward rate ratio between six and nine months (FRR6,9) for the major currencies (see Major currencies and The Great LIBOR Kerfuffle, June 2013). The FRR6,9 is the rate at which borrowing can be locked in for three months starting six months from now, divided by the nine-month rate itself. The steeper the yield curve, the more this ratio exceeds 1.00; an inverted yield curve has an FRR6,9 less than 1.00.

    Prospective return shifts will be defined as the abso-lute average daily return for the next three months minus the average absolute daily return for the previous three months. The goal here is to see whether 25-delta butterflies, which measure the difference between out-of-the-money and at-the-money volatility, lead changes in absolute return levels. If so, traders can use them to place trading strate-gies such as straddles or strangles, both of which are bets on large or small absolute movement in either direction, respectively.

    In the remaining charts, positive absolute return shifts are depicted with green bubbles, negative with red bub-bles; the diameter of the bubble corresponds to the absolute magnitude of the return. The last datum used, from the beginning of June 2013, is highlighted and the end-August 2013 sample-end is marked with a crosshair.

    In the case of the Euro, the results are indeterminate (Figure 8). The steepening of the EUR FRR6,9 combined with the rising 25-delta butterfly in the taper-talk era has placed prospective returns into a zone of mixed indica-tions.

    The yen, on the other hand, has moved into a zone of negative prospective returns (Figure 9). It would take a steeper JPY FRR6,9 with a material shift either higher or lower in the 25-delta butterfly to place the yen in a zone of positive prospective returns.

    The Canadian dollars map is poised to move into a zone of positive prospective returns if the CAD FRR6,9 and the 25-delta butterfly both decline (Figure 10). Moves toward steeper yield curves and higher 25-delta butterfly levels would put the CAD into a zone of negative prospective returns.

    FIGURE 10: THREE MONTH-AHEAD RETURN SHIFTS FOR THE CANADIAN DOLLAR

    FIGURE 9: THREE MONTH-AHEAD RETURN SHIFTS FOR THE JAPANESE YEN

    FIGURE 11: THREE MONTH-AHEAD RETURN SHIFTS FOR AUSTRALIAN DOLLAR

  • ON THE MONEY

    26 December2013CURRENCY TRADER

    ADVANCED CONCEPTS

    The collapse in 25-delta butterflies for the Australian dollar has pushed the map into an unpopulated zone, a sort of terra incognita similar to European maps before the Age of Discovery (Figure 11). On a purely contrarian basis if nothing else, the present configuration lies much closer to zones from which positive returns on the AUD have emerged.

    The Swiss francs map has a very large and defined zone of negative return shifts with 25-delta butterfly levels greater than 0.40% and an FRR6,9 less than 1.20 (Figure 12). It also has a cluster of positive prospective returns with 25-delta butterflies near 0.30 and with CHF FRR6,9 levels greater than 2.50. However, trading the CHF has been nothing other than an exercise in political intelligence since the first large-scale interventions by the Swiss National Bank at the end of 2009; no one should assume either the option or money-market indicators are related to free-market assessments.

    The rising butterfly levels for the krona along with its flatter SEK FRR6,9 are keeping the SEK on a path of prospective negative returns (Figure 13). The history of this market has been very clear: Movements toward the lower-right corner are associated with a weaker SEK.

    Finally, the map for the British pound is moving in a direction of positive prospective returns (Figure 14). A reversal of conditions prevailing since May 2013 would be required to push the outlook for the GBP in a negative direction.

    All mean-reverting strategies involving volatility involve the problem of parameterization: The terms high and low are meaningless by themselves; they need to be placed into some reference of absolute real-ized volatility, time-adjusted price proximity to a last new high or low, or broader measure of intermarket volatility.

    It would be nice to think the butterfly market could provide us with an easy mechanical approach to trad-ing option volatility on the major currencies, but this does not appear to be the case. We will see next month whether this conclusion holds for the minor currencies as well. y

    Howard Simons is president of Rosewood Trading Inc. and a strategist for Bianco Research. For more information on the author, see p. 4.

    FIGURE 13: THREE MONTH-AHEAD RETURN SHIFTS FOR THE SWEDISH KRONA

    FIGURE 12: THREE MONTH-AHEAD RETURN SHIFTS FOR THE SWISS FRANC

    FIGURE 14: THREE MONTH-AHEAD RETURN SHIFTS FOR THE BRITISH POUND

  • CURRENCY TRADERDecember2013 27

  • 28 December2013CURRENCY TRADER

    CPI: Consumer price indexECB: European Central BankFDD(firstdeliveryday):Thefirstday on which delivery of a com-modityinfulfillmentofafuturescontract can take place.FND(firstnoticeday):Alsoknownasfirstintentday,thisisthefirstdayonwhichaclear-inghouse can give notice to a buyer of a futures contract that it intends to deliver a commodity in fulfillmentofafuturescontract.The clearinghouse also informs the seller.FOMC: Federal Open Market CommitteeGDP: Gross domestic productISM: Institute for supply management LTD(lasttradingday):Thefinalday trading can take place in a futures or options contract.PMI: Purchasing managers indexPPI: Producer price index

    Economic Release release(U.S.) time(ET)GDP 8:30 a.m.CPI 8:30 a.m.ECI 8:30 a.m.PPI 8:30 a.m.ISM 10:00 a.m.Unemployment 8:30 a.m.Personal income 8:30 a.m.Durable goods 8:30 a.m.Retail sales 8:30 a.m.Trade balance 8:30 a.m.Leading indicators 10:00 a.m.

    GLOBAL ECONOMIC CALENDAR

    December1

    2 U.S.: November ISM manufacturing report3 Brazil: Q3 GDP

    4

    U.S.: October trade balance and fed beige bookAustralia: Q3 GDPCanada: Bank of Canada interest-rate announcement

    5

    France: Q3 employment reportUK: Bank of England interest-rate announcementECB: Governing council interest-rate announcement

    6

    U.S.: November employment reportBrazil: November CPI and PPICanada: November employment reportLTD: December forex options; December U.S. dollar index options (ICE)

    78

    9 Mexico: Nov. 30 CPI and November PPI10 South Africa: Q3 employment report

    11Germany: November CPIJapan: November PPISouth Africa: November CPI

    12

    U.S.: November retail salesAustralia: November employment reportFrance: November CPIHong Kong: Q3 PPISouth Africa: November PPI

    13 U.S.: November PPI1415

    16

    India: November PPILTD: December forex futures; December U.S. dollar index futures (ICE)

    17

    U.S.: November CPIHong Kong: September-November employment reportUK: November CPI and PPI

    18

    U.S.: November housing starts and FOMC interest-rate announcementUK: Aug.-Oct. employment reportFDD: December forex futures; December U.S. dollar index futures (ICE)

    19Brazil: November employment reportHong Kong: Q3 GDP

    20

    U.S.: Q3 GDPCanada: November CPIGermany: November PPIJapan: Bank of Japan interest-rate announcementMexico: November employment reportUK: Q3 GDP

    2122

    23U.S.: November personal incomeHong Kong: November CPIMexico: Dec. 15 CPI

    24 U.S.: November durable goodsFrance: Q3 GDP2526

    27France: November PPIJapan: November employment report and CPI

    28293031 India: November CPI

    The information on this page is sub-ject to change. Currency Trader is not responsible for the accuracy of calendar dates beyond press time.

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    EVENTS

  • CURRENCY TRADERDecember2013 29

    CURRENCY FUTURES SNAPSHOT as of Nov. 29

    The information does NOT constitute trade signals. It is intended only to provide a brief synopsis of each markets liquidity, direction, and levels of momentum and volatility. See the legend for explanations of the different fields. Note: Average volume and open interest data includes both pit and side-by-side electronic contracts (where applicable).

    LEGEND:Volume: 30-day average daily volume, in thousands.OI: 30-day open interest, in thousands.10-day move: The percentage price move from the close 10 days ago to todays close.20-day move: The percentage price move from the close 20 days ago to todays close.60-day move: The percentage price move from the close 60 days ago to todays close.The % rank fields for each time window (10-day moves, 20-day moves, etc.) show the percentile rank of the most recent move to a certain number of the previous moves of the same size and in the same direction. For example, the % rank for the 10-day move shows how the most recent 10-day move compares to the past twenty 10-day moves; for the 20-day move, it shows how the most recent 20-day move compares to the past sixty 20-day moves; for the 60-day move, it shows how the most recent 60-day move compares to the past one-hundred-twenty 60-day moves. A reading of 100% means the current reading is larger than all the past readings, while a reading of 0% means the current reading is smaller than the previous readings. Volatility ratio/% rank: The ratio is the short-term volatility (10-day standard deviation of prices) divided by the long-term volatility (100-day standard deviation of prices). The % rank is the percentile rank of the volatility ratio over the past 60 days.

    BarclayHedge Rankings: Top 10 currency traders managing more than $10 million

    (as of Oct. 31 ranked by October 2013 return)

    Trading advisor Octoberreturn 2013 YTD

    return$ Under mgmt.

    (millions)

    1 24FX Global Advisors 4.70% 26.24% 67.92 TMS(ArktosGCSII) 4.23% -1.42% 16.03 Gedamo(FXAlpha) 4.12% 14.24% 31.84 DynexCorp(Currency) 4.01% 4.61% 30.05 SwingCapital(FX) 3.26% 0.60% 48.06 CambridgeStrategy(AsianMrkts) 2.90% 2.71% 122.07 Gedamo(FXOne) 2.81% 8.41% 44.18 FDOPartners(EmergingMarkets) 2.65% 8.57% 2174.09 CambridgeStrategy(EmergingMkts) 2.24% -5.82% 57.0

    10 JCICapital(FXMacro) 1.97% 3.78% 23.8Top 10 currency traders managing less than $10M & more than $1M

    1 InvestmentCapitalAdv(ManagedActs) 11.50% 48.67% 4.02 FourCapital(FX) 10.02% 37.20% 1.13 MFG(BulpredUSD) 4.75% 6.07% 1.74 Vortex(FX) 2.91% 0.41% 1.05 HartswellCapitalMgmt(Apollo) 1.15% -7.61% 3.06 MDC Trading 0.80% 8.59% 1.57 MatadorFX(MFX1) 0.675 -11.56% 1.08 ROWAssetMgmt(Currency) 0.50% 3.44% 10.09 GloranisGmbH(ForexPrivate1) 0.39% 1.31% 2.4

    10 BlueFinCapital(ManagedFX) 0.15% -1.54% 3.0

    Based on estimates of the composite of all accounts or the fully funded subset method.Does not reflect the performance of any single account.PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE.

    Market Sym Exch Vol OI 10-day move / rank20-day

    move / rank60-day

    move / rankVolatility

    ratio / rank

    EUR/USD EC CME 193.7 248.7 0.98%/67% -0.04% / 4% 3.56% / 81% .29/45%

    JPY/USD JY CME 113.8 182.8 -2.35% / 85% -4.04% / 100% -2.26% / 65% .65 / 100%GBP/USD BP CME 91.0 180.4 1.91%/91% 1.94%/60% 4.94%/76% .24 / 52%AUD/USD AD CME 81.3 128.1 -2.22% / 80% -3.59%/71% -0.25% / 0% .61 / 100%CAD/USD CD CME 48.5 112.0 -1.30%/95% -1.86% / 100% -1.18% / 37% .71/97%CHF/USD SF CME 30.9 48.2 1.04% / 67% -0.17% / 7% 4.20%/79% .29/43%MXN/USD MP CME 30.0 114.6 -1.04% / 10% -0.65% / 31% 1.98%/58% .33 / 43%U.S. dollar index DX ICE 18.4 44.7 -0.30% / 50% -0.19%/0% -1.84% / 46% .20 / 27%NZD/USD NE CME 12.4 23.6 -1.67% / 71% -1.40% / 71% 3.10% / 20% .38 / 65%E-Mini EUR/USD ZE CME 3.7 4.9 0.98%/67% -0.04% / 4% 3.56% / 81% .29/45%

    Note:Averagevolumeandopeninterestdataincludesbothpitandside-by-sideelectroniccontracts(whereapplicable).Priceactivityisbased on pit-traded contracts.

  • INTERNATIONAL MARKETS

    30 December2013CURRENCY TRADER

    CURRENCIES (vs. U.S. DOLLAR)

    Rank CurrencyNov. 27

    price vs. U.S. dollar

    1-month gain/loss

    3-monthgain/loss

    6-monthgain/loss

    52-week high

    52-week low Previous

    1 Great Britain pound 1.617095 0.03% 3.83% 6.91% 1.6286 1.4877 162 Hong Kong dollar 0.12899 0.01% 0.03% 0.14% 0.129 0.1288 133 Chinese yuan 0.163125 -0.15% 0.47% 0.88% 0.16337 0.1583 124 New Zealand dollar 0.82142 -0.80% 4.87% 1.46% 0.8619 0.7704 155 Taiwan dollar 0.03377 -0.82% 1.09% 1.24% 0.0345 0.0326 106 Canadian dollar 0.948805 -0.87% -0.28% -2.08% 1.0166 0.9445 177 Singapore dollar 0.799 -1.27% 2.25% 1.02% 0.8207 0.7792 58 Indian rupee 0.016075 -1.71% 3.64% -10.35% 0.0188 0.0147 2

    9 Swiss franc 1.0993 -1.88% 1.42% 5.69% 1.1213 1.0274 8

    10 Euro 1.35429 -1.89% 1.24% 4.72% 1.3802 1.2798 411 South African rand 0.098904 -2.81% 1.51% -5.29% 0.118 0.0961 1412 Thai baht 0.031205 -3.2