The Amateur Financier

(Today I have the pleasure of sharing a guest post from Michael Trinkle and his compatriots at Forex Traders.  I haven’t written very much about the forex markets (I haven’t had much opportunity to explore this particular type of investment), but it’s always nice to advance your knowledge.  Enjoy the knowledge, and be careful if you decide to invest in foreign exchange markets.)

The foreign exchange market has grown exponentially since exchange rates were allowed to float freely against each other back in the 1970s after the fall of the Bretton Woods treaty that effectively fixed exchange rates against the U.S. Dollar that was then on the gold standard.

This development is partly due to the international commodity market creating demand for global currencies and for growing international investment. In more recent years, growth in the forex market has also been boosted by the advent of electronic trading over the Internet.

Most forex news websites now offer forex broker reviews and links to online retail forex brokers that can help people who are interested in getting more involved in trading the forex market for their own retail accounts. Even though forex trading is not suited for everyone, it has grown a lot the past years.

Most Liquid Forex Currency Pairs and Trading Centers

The most active and liquid currencies traded in the global forex marketplace consist of the U.S Dollar, the EU’s Euro, the Japanese Yen, the British Pound Sterling and the Swiss Franc.

In addition to those major currencies, an important group of currencies exists which includes the Australian, Canadian and New Zealand Dollars. Due to their abundance of natural resources, these currencies are sometimes known as the Commodity Currencies or Com Dollars.

Along with the aforementioned majors, these make up the most liquid currencies traded worldwide.

The above currencies trade primarily in three main trading centers consisting of London, Tokyo and New York. These trading centers make up over sixty percent of global forex trading activity.

Forex Market Breakdown of Transactions

The average daily global turnover for the forex market in U.S. Dollars has been estimated to exceed $3 trillion. This makes the forex market the largest financial market on the planet and it contributes substantially to the global economy.

Daily forex trading volume is split among several forex trading products. These include:

• Forex Swaps – making up $1.7 trillion
• Spot Trades –  $1.0 trillion
• Forward Outrights – $400 billion
• Currency Options – $200 billion

Exponential Growth of the Forex Market

The forex market has seen astronomical growth in the past few years, which can be evidenced by the increase in trading volume as illustrated in the table below:

Year          Annual FX Trading Volume

The dramatic increase between 1977 and 2007 has been almost a thousandfold.

This impressive gain in forex market turnover is indicative of the increased global economic demand for foreign exchange, as well as the rising level of economic activity seen since the 1970s.

Elements of Growth for the Global Forex Market

Several important elements have contributed to the exponential growth of the forex market seen in recent years that reflect various developments in the global economy.

These include:

• Globalization – The amount of international trade since the 1970s has increased considerably, with the market for finished products and commodities being the fastest growing sectors which affect the forex market. As international trade increases, the need for foreign exchange transactions also increases.

• International Investment – Investment by companies and individuals has increased due to a search for better yielding investments, as well as opportunities for currency appreciation.

• Increased Data Processing Power – Advances in computer technology applied to electronic trade processing and automated trading systems have made it possible for the reliable execution of a larger number of forex transactions. In addition, the use of computers to manage risk and for technical analysis has greatly improved the trade analysis process.

• Risk Management – companies all over the world have become increasingly aware of how much adverse forex moves can affect their company’s profitability. This development has increased demand for forex hedging products such as currency futures and forward contracts and currency options.

• Volatility – the underlying volatility in the currency markets has increased with the increased volume, adding to the need for hedging and increasing opportunities for traders.

• Increased Access to Information – Market information has become increasingly accessible, allowing most people access to market information, timely news and other fundamental analysis tools.

Overall, the forex market has seen massive expansionary pressures as national economies become increasingly integrated into the global economy, as cross border investment has boomed, and as awareness of the impact of foreign exchange rates on the bottom line of international businesses has grown.

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Welcome to a special week-long series where we take a look at some prominent economic theories.  Don’t worry, it won’t be nearly as horrifyingly dull as it sounds; this is still the Amateur Financier, after all.  Plus, it’s always good to have a little background when you’re reading about things like ‘monetarism’ or ‘Austrian school economics’, or as in this case,

Keynesiansim

Founded By

John Maynard Keynes was a British economist whose most influential book, The General Theory of Employment, Interest, and Money was written as a response to the Great Depression.  He was involved in British politics before and during World War Two, and helped to create the International Monetary Fund and the World Bank before his death in 1946.  He was also married to a Russian ballerina, Lydia Lopokova, a fact I mention just in case you ever need to defend the sexiness of economists.

Just Look at That Sexy Mustache

The Theory

Keynes’ major insight was that the government could have a impact on the economy, working to stabilize it.  The results of private decisions and private enterprise could be inefficient, due in part to slow response of prices and wages to changes in supply and demand.   He also viewed recessions and depressions not as regular parts of the business cycle, but as problems that needed to be solved, most readily via government intervention.

One of the major parts of Keynes’ philosophy is the need for counter-cyclical economic policies, attempts by the government to counteract the excessive lows and the highs in the economic cycle.  During recessions, for example, he advocated government spending to help prop up businesses and give a boost to the economy, while during boom times, the government should rein in market extravagances by increasing interest rates or decreasing government spending.  In this way, the government would be a counterbalance to the business cycle, helping to stabilize it.

Two of the other ideas that Keynes helped to popularize are the multiplier and the paradox of thrift.  The multiplier argument maintained that spending could have a bigger effect than the initial amount spent. If the government provides for $10 million in payments, for example, the benefits to the broader economy can end up being much more than $10 million.  The initial recipients of the money will likely spend or invest it, with companies that will in turn spend or invest it, and so on.  The initial $10 million may lead to many times the economic benefit, as the money works its way through the system.

The paradox of thrift, on the other hand, maintains that while saving is good for the individual, if done in aggregate, it can be harmful to the economy as a whole.  Decreased spending leads to decreased demand, decreased demand can lead to lower economic growth and possible downsizing, potentially decreasing the total amount saved due to anemic growth and lower incomes.  The paradox is, while saving is good for the individual, saving too much can be bad for the economy.

Criticism of Keynesianism

One of the major philosophies opposed to Keynesian economics is Monetarism, another school of economic thought (which we’ll cover in more depth tomorrow).  Their major criticism has been that governments are, if anything, even worse at responding to fluctuations in the economy than the private sector.  By the time the government recognizes the problem, formulates a response, and puts the response into practice, the problem may have become greatly exacerbated, or it may have disappeared.  The monetarists lean towards a much less expansive role for government in economic policy, which is counter to the more interventionist Keynesian economic thought.

Keynesian policies also come under attack from Austrian School economists (again, more on them later this week), who denounce the Keynesian focus on the collective group rather than the individual.  They maintain that focusing on broad government action rather than micro-economic factors leads to collectivism and mis-spending of capital.  They also maintain that programs that start as temporary fixes to counterbalance an economic downturn can turn into permanent, expanding government programs that grow to consume larger and larger portions of government spending.

There’s also historical evidence (as noted below) that Keynesian approaches to boosting the economy are far from sure things.  In a deflationary environment, such as during the Great Depression, putting more money into the system (which Keynes recommends), can serve to counteract the forces of deflation and boost the economy.  However, in downturns with high inflation, such as the ‘Stagflation’ of the 1970′s, a further increase of money into the system will only aggravate the problem.

A Brief History

Keynes and his theories rose to prominence in the midst of the Great Depression, where the idea of the government ‘priming the pump’ to boost the economy was one already being taken up by Roosevelt, among others.  The success of government spending (either in the form of New Deal programs or military spending during World War II) at lifting the economy was considered to be proof of Keynes’ concepts, and they were put into practice in America and elsewhere through most of the forties, fifties, and sixties.

As mentioned, though, Keynesianism was unable to cope with the economic stagnation and inflationary climate of the 1970s.  From the Reagan administration (and its contemporaries in other countries) until 2008, Keynesian ideas and methods of dealing with the economy were pushed to the side, superceded by monetarism and supply-side ideals.  Attempts to use government as a cushion against the rises and drops of the economy were curtailed in favor of a philosophy of letting the economy run with as little government intervention as possible.

However, with the economic downturn of 2008, there’s been a resurgence of Keynes and his approach to economics in public life.  The great amount of spending by the US government over the past few years in an attempt to spur on growth is right in line with Keynesian monetary policy.  (We’ll have to see how if Keynes is still in fashion when the recession abates and Keynesian economics dictates that the government should cut spending to slow down the economy.)

Three Sentence Summary

Keynesianism stresses the need for government to serve as a counteracting force to the excesses of private economy.  The main thrust is that the government can counter the economic excesses of the private sector, spurring on growth when it’s slow and restraining over-zealous government expansion.  Recently, such interventionist ideas have become more common, in wake of the economic problems of 2008.

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Last year, Pennsylvania had a rather nasty budget impasse.  It made national news, and generally annoyed every Pennsylvanian who would rather be famous for our delightful groundhogs than the intractability of our leaders’ political fights.  One way the politicians finally were able to work out a solution that appeased everyone (or at least shut them up long enough to get the budget passed) was to increase the state tax on cigarettes.  Various commentators, from the papers to NPR, referred to the cigarette tax as a ‘sin tax’, which brings us to the obvious question: what is a sin tax?

Taxing Sin Done Right

Put simply, a sin tax is a tax on sin.  You probably guessed that, though, so let’s look a bit deeper.  The idea behind a sin tax is that there are some activities that we, as a society, consider undesirable.  Cigarette smoking is a common example, although things like using alcohol or even sugary foods and drinks have also been included or considered as possible subjects of a sin tax.  We could ban them outright, the way we with illegal drugs, but that costs a great deal of money to enforce and restricts people’s right to smoke, drink alcohol, or eat a Twinkie if they so desire (lump those rights all under ‘pursuit of happiness’).

What if there were an alternative, a way to keep something legal but discourage people from using it?  One way might be to make it more expensive; if the cost of a package of cigarettes goes up, a smoker is going to be less likely to purchase as many packs.  Adding a tax to cigarettes makes them more expensive, decreasing how many cigarettes get purchased and smoked (and generating income for the government, as well).

Sin, in convenient stick form

There are several advantages to sin taxes, particularly from the government’s standpoint:

-Politically Easy: Creating a (balanced) budget is hard, particularly when government spending is up and tax revenue is down (just look at the legislators in Pennsylvania).  No politician wants to be responsible for cutting a popular program, but no politician wants to raise taxes either, because raising taxes on a broad swath of the voting public is a good way to get unelected.  Sin taxes, which by nature only target a certain group of individuals, are a good way to raise taxes and keep your office, too.

-Profitable: Taxes do serve a purpose, of course; without them government wouldn’t be able to do everything that we ask of it.  (We can have a discussion of governmental effectiveness even with tax money to fuel it another day; today, let’s just focus on the sinning and the taxes.)  Sin taxes, as with any taxes, are able to provide the government with money, which of course means the government likes to have them as an option.

-Steer People Toward Good Behaviors: The difference between sin taxes and most other types of taxes is that sin taxes encourage better behavior from people.  By making the ‘sins’ more expensive, people should logically choose to avoid them, opting for something less expensive and more sin-free.  If the government imposes a sin tax on bowling, for example, miniature golf could see a rise in participants; in the same way, the government can ‘nudge’ people away from whatever activities are considered improper.

All this sounds pretty good; why not get rid of those pesky income and sales taxes and simply tax sins to meet all our governmental spending needs?  Well, there are some drawbacks, as well:

-Makes the Government Dependent on Sinners: One problem with making a sin tax a major (or even minor) source of income is that the government then has a perverse incentive to keep people sinning.  As mentioned, Pennsylvania only managed to solve its budget crisis in part due to more revenue from smokers and cigarette taxes; if all the smokers in PA suddenly quit (or started bumming cigs from out-of-state friends), we’d be facing another budget shortfall next year.  Whether they admit it or not, this means that PA lawmakers need smokers to keep smoking (and paying taxes on) cigarettes; with that in the back of their mind, how hard are they really going to try to stamp out smoking?

-Can be Regressive: Since the taxes are the same on each pack of cigarettes regardless of the income level of those purchasing the pack, lower income people will end up spending a higher percentage of their money on the taxes than higher income people.  Two different pack-a-day smokers will spend the same amount in taxes (let’s say $1000, just so we have a number), but that represents a much larger portion of a $20,000 a year income compared to earning $100,000 each year.  (That’s before we even get into the argument that poorer people are more likely to smoke, drink or otherwise ‘sin’ than richer people, making them more likely targets of this tax already.)

-Involves Government Regulation of Personal Behavior: Even ignoring the economic effects of the tax itself, there’s still the little matter that sin taxes involve the government deciding which behaviors are good and which are bad, and attempting to punish the bad ones.  Since these behaviors are personal and affect only the individual*, why should the government be able to dictate its preferences of how to act?  (*Alright, this is an oversimplification; something like smoking can impact people other than the smoker, through second hand smoke and the effects of smokers in health care plans, among other things.  There are alternatives that address those issues (rules about where smoking is permitted and higher premiums for smokers) without the need to resort to taxing all cigarettes sold, though.)

The Final Word on Sin (Taxes)

So where does all this leave us when it comes to sin taxes?  They’re probably here to stay.  Remember that first ‘pro’ point, ‘Politically Easy’?  That alone will ensure that some form of sin taxes stay around in some form for the foreseeable future.  Also, compared to some of the alternative methods of dealing with unwanted behaviors, such as banning them the way we do with illicit drugs, legalizing, taxing, and generating profit from ‘sinful’ activities seems downright sensible.  Compare cigarette use to marijuana use, for example; which generates more profit for the government in the form of taxes, and costs less to regulate and control?

If I had just one wish when it came to sin taxes, it would be that governments wouldn’t depend so highly on them for income.  If the behavior is so sinful that we need to stop it, why should the government be in a position of depending on it for revenue?  I’d like to see politicians opt instead for the politically harder but less moral-twisting approach of getting rid of sin taxes and relying on other taxes to generate income.  If they do opt to continue the taxes, though, I’d love to see the money be funneled back into programs designed to truly eliminate the sin; not only do you get the sin tax money out of the general public coffers, but you deliver a one-two punch to whatever behavior you’re attempting to eradicate.

I’ll bet you a carton of cigarettes that that never happens, though.

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I’ve discussed options briefly in the past, as part of my Investing 101 series.  While they can be useful as a way to profit from market movements without owning the underlying stocks, they can get a bit tricky.  To help you understand who profits from different option related situations, let’s go over a few examples.  (Don’t worry, there’ll be pictures soon!)

Calling in the Profits

As you hopefully remember from the aforementioned Investing 101 post, calls are options that enable you to purchase shares of stock at a particular value (the strike price) at some point in the future.  (Either at the expiration date, for European-style options, or at any time before or on the expiration date, for American-style options.)  You might be tempted to assume that after you have bought a call option, all you need to do is wait for the price of the underlying stock to go above the strike price, exercise the option (that is, buy the stock at the strike price), and bingo, instant profit by buying at a discount.

Well, that’s not quite the way it works.  In order to get someone to agree to sell you the stock at a particular, fixed value (which is known as writing a call), you have to give them an incentive (read: money).  This is called the option premium.  But that’s not the end; you also have to factor in the money you are paying to the brokerage in order to match you up with a call writer, the commission and other transaction costs.  All told, the price for you to break even on your option transaction (and make as much profit as if you simply bought the stock and held it while it rose in value) is found like this:

Break-Even Price (Calls) = Strike Price + Option Premium + Commission and Transaction Costs

If the price of the stock when you exercise the option is between the strike price and the break-even price, you (our option buyer) will be able to buy the underlying stock for less than the current market price, but the savings you get will not be enough to make the whole process (buying the option, then exercising it and buying the stock) profitable for you.  For a graphical representation, take a look at this (click the picture to expand it):

If we go from left to right across this chart (following the increase in stock prices) we see:

• Red: The call writer gets to pocket the option premium, and doesn’t have to part with his stocks.  Good for him, bad for the call buyer.
• Yellow: The call is exercised (it is ‘in the money’, meaning the strike price is less than the market value) but the savings on the buyer’s part don’t cover the cost of the option.  The call writer gets the strike price for the stocks, as well as some profit from writing the call, although not as much as if the stocks stayed below the strike price.  The call writer’s profit decreases the further to the right you do in the yellow area.  (Actually, because of the commissions charged by the brokerage, the far right area of the yellow section is one where neither the writer nor the buyer profit.  As a result it’s possible for opinions to be a lose-lose proposition (at least for everyone but the brokerage).)
• Green: The call is exercised, and the total cost to the option buyer is less than the cost of purchasing the stock at the new, higher price.  The buyer profits, and makes more profit the higher the stock price goes, while the call writer makes less profit than by holding and selling the stock outright.

Where are you Putting that?

Puts, in case you forgot, are essentially inverse calls; rather than allowing you to buy a stock at the strike price (regardless of the current market price), puts enable you to sell stock you own at a given price, regardless of the current market value.  Buying a put is a way to profit when your stock goes down in price, without having to sell the stock and buy it back later.  Of course, as with call options, puts have a premium and commission costs associated with them.  However, because you expect the price of your stock to go down (or are trying to insure against such a fate), when calculating the break-even price, we need to subtract these costs from the strike price:

Break-Even Price (Puts) = Strike Price – Option Premium – Commission and Transaction Costs

It might seem a bit odd, if you’re used to regular stock investing, but when buying puts, the more the stock price declines, the more profitable the put becomes (as it forces the writer to buy the stocks at a much higher than current price).  To see how this works in graphical form:

As you can see from this chart, the lower the stock price, the more profitable the put option.  If we go from right to left:

• Green: Below the break-even point, the put buyer can force the put writer to buy the underlying stock at the strike price for more than current market value, also netting enough profit to more than cover the cost of the option.  The buyer benefits, while the writer has to pay an overpriced amount for a declining stock.
• Yellow: The put is exercised and the put buyer can force the writer to buy the underlying stock for more than current market value, but not enough to cover the cost of the option.  The further to the right you go, the more profit from the option premium that the writer gets to keep.  (Again, the area right next to the green portion of the grid is one where, due to commissions, neither party will actually make a profit.)
• Red: Above the strike price, the put writer gets to both keep the premium and not have to buy the underlying stock.  The put writer benefits, while the put buyer is out the option premium and commission costs.

One final point about options before we call it a day.  You might be wondering why anyone would bother to buy options, when there are two areas of our graphs, the red and (most of) the yellow, where selling yields a profit.  Well, there are several reasons; first, no matter how the stock price moves, the only profit you can get from selling options is the option premium.  By way of contrast, when buying an option, you can get spectacular profits if the stock shoots into the stratosphere (with a call) or drops to nearly nothing (with a put).  Second, if you find yourself on the wrong on of one of the aforementioned greatly profitable deals (and did not buy back your option), you could end up selling a spectacular stock for a song or forced to buy a crummy one for much more than market value; whereas the option buyer will only be out the option premium and commission costs if the trade breaks badly for him or her.  Finally, if you are working with American-style options, all you need is one day when the option you sold goes into the green territory, and you can find yourself losing your profit.

What’s the moral here?  Don’t underestimate the risk with options, particularly when selling them; unlike buying options, you’re abdicating your ability to control when (or if) the option is exercised, leaving you to the mercy of the option buyer.  But don’t forget if you choose the buying path that you need to not only need to be concerned about the strike price, but also the break-even price.

Options aren’t for the lazy or weak of stomach; if you decide to invest in them, be sure you understand everything, including all the ways you could lose money (ESPECIALLY all the ways you could lose money) and only put a small portion of your portfolio at risk, at least until you become an options expert.  (And even then, only use options when needed.)  Good luck, and happy investing!

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