The Eurozone Crisis and AAA Ratings

Europe is in trouble. This is nothing new, of course, as headlines have constantly reminded us of the threats facing the euro, of the profligacy of many European governments and of the forces trying to tear the euro-zone apart, battling those trying to keep it together. Europe is in trouble because so many economic and political factors seem to be on an unavoidable collision course, like a ship bearing down on a giant iceberg. No one is quite sure how bad it could get.

While pundits and politicians fret over the future, one group cannot afford to sit idly by: ratings agencies. The outlooks that they provide investors with help shape the amounts that sovereign countries have to pay for debt - in short, their creditworthiness. Just as a corporation's debt may receive a rating ranging from AAA to junk, nations also receive marks.

Investors typically focus their attention on two ratings agencies: Standard & Poor's and Moody's. While both have come under fire in recent years for their ratings of corporate debt and some of the more infamous financial instruments (remember all of those well-rated mortgages found in CDS?), there seems to be less concern when it comes to their approach to the health of euro-zone economies.
According to Standard & Poor's, 13 of 17 euro-zone countries have negative outlooks, including three of four countries currently given AAA ratings. Five countries - Cyprus, Ireland, Italy, Portugal and Spain - have adequate funding in the near term (BB or BBB+ ratings), but face greater threats to their financial stability in the long term. Greece, considered to be the precipitating cause of the current crisis, has the lowest rating, CCC. Germany, the country considered the last bastion of stability, was given a stable outlook and an AAA rating.

Moody's Starts the Frenzy

On Sept. 4, Moody's issued its own set of ratings, and its results have caused significant global consternation. Nine of the 16 countries it rated were downgraded since last year, with Cyprus, Italy, Slovenia and Spain falling the furthest. Moody's has five euro-zone countries with AAA ratings listed: Austria, Finland, France, Germany and the Netherlands. This is a higher count than Standard and Poor's four top-rated economies (Moody's did not cover Luxembourg), and the two differed on France and Austria.

One of the debt instruments Moody's looked at was the one-year credit default swap (CDS)-implied EDF (Expected Default Frequency). The higher this rate, the more likely a country is to default on its debt, a bad sign for countries looking for funding in the credit market. The rate has improved for several countries over the course of the year, with Cyprus, Ireland and Portugal falling the furthest. But Europe is not out of the woods yet. From Aug. 17 to Aug. 31, Italy's CDS-implied EDF (one-year) has increased from 0.48% to 0.57% and Spain's from 0.62% to 0.70%.

And Then Things Get Complicated

Since the beginning of the crisis, the healthier euro-zone countries have insisted that the countries with the biggest debt problems adhere to austerity measures and cut public sector spending; but it is not that simple. What makes assessing the risk of euro-zone countries difficult is how many interlocking gears there are in the entire euro machine. While public sector spending has been a problem, so have other factors:

•    The labor competitiveness gap between euro-zone countries has widened. Because of labor mobility laws, production has shifted to more competitive countries and helped keep unemployment rates high in countries with high debt.
•    Trade between euro-zone members has become increasingly unbalanced, with countries such as Germany, the Netherlands and Luxembourg sporting current account surpluses approaching the 6% threshold set by the European Commission. Countries facing the worst debt problems have the worst current account problems. Remember, having a common currency means governments cannot toy with exchange rates.

Part of the Moody's report also hinted at more unexpected exposures; specifically, that some of the more stable countries are supporting the European Financial Stability Facility (EFSF). The EFSF is designed to prop up faltering eurozone economies, some of which may continue to need support in the coming years. By acting as guarantors to a large amount of EFSF funding, Germany, Luxembourg and the Netherlands were all put on notice by Moody's. Germany provides nearly 30% of the funding.

Fixit Before Grexit

Finland has managed to come out of the Moody's report relatively unscathed, despite also being an EFSF guarantor. In recent weeks there has been talk of a "Fixit" within Finland's government, meaning that the country is considering dropping the euro altogether. Unlike Germany and Luxembourg, Finnish banks have less exposure to the debts of countries such as Italy, Spain, Portugal and Greece. Finland also exports more of its goods and services to countries outside of the euro-zone, while Germany's exports are heavily focused on euro-zone members.

Much of the euro debacle has been a crisis of expectations that has morphed into a battle of words between northern and southern European countries. Southern Europe has been plagued by government debt, high unemployment and low competitiveness. Northern European debts have trended lower, and several governments there are looking to hold referendums about exiting the euro. After all, why would you want to pay for someone else's bad behavior? The problem is that while the execution of the euro was sloppy, many economies are simply too intertwined for a clean break. The ratings agencies know this, as do politicians. Prepare for a cold winter, with frosty glares between politicians rivaling temperatures outside.

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Canada's Commodity Currency: Oil and The Loonie

For whatever reason, when Americans think of major crude oil exporters, they think of Saudi Arabia, Kuwait and other nations in the Middle East as the primary sources of oil consumed in the U.S. That assumption is wrong. The bulk of the imported oil consumed in the U.S. comes from Canada. In March 2009, the U.S. was consuming nearly 2.5 million barrels of Canadian crude per day, far more than the 1.9 million daily barrels the U.S. purchased from Mexico, the second biggest supplier of crude oil to the States.

Canada is one of the 10 largest producers in the world and has been rated as the one of the most energy-secure nations in the world by Energy Security News. Crude oil is Canada's most exported product to its southern neighbor and is tens of billions of dollars ahead of the next largest category - automobiles. The U.S. isn't the only loyal buyer of Canadian oil, either. Japan imports nearly all of its crude oil from Canada, and is another important buyer of Canadian crude.

Commodity Currency

Canada's deep ties to the oil business make the Canadian dollar, or loonie, a favorite of currency traders to play on oil prices. They're right to do so, because the historic correlation between the loonie and crude is intimate to say the least. If you've ever heard the term "commodity currency," the Canadian dollar is the embodiment of that term. It's a great example of a correlation between commodity prices and currency movements.

Conventional wisdom says that if the price of oil is rising, the Canadian dollar will follow suit, especially against the greenback because oil prices are denominated in U.S. dollars. Likewise, currency traders are apt to buy the buck against its northern rival when crude prices tumble. Now this strategy doesn't work 100% of the time, no strategy does, but it works enough of the time to be extremely profitable for forex traders. So let's take a further look at crude oil prices and their impact on the Canadian dollar.

A Loyal Customer

Canada's role as a chief oil exporter is bolstered by a friendly customer that is close by with a voracious appetite for crude. While the appetite for crude oil in the U.S. does fluctuate, American demand for oil has been on a steady upswing, historically speaking. Canadian oil producers benefit by not having exorbitant shipping costs to the U.S., and this keeps more dollars in Canada, benefiting the economy as a whole.

Of course, it's not cheap to get oil from Canada to Japan, but the market is still lucrative for Canadian producers. Overall, having two politically stable countries among your top customers for any export is a plus, and it certainly doesn't hurt the loonie's value that the U.S. and Japan are two of the largest economies in the world, and among the top 8 most tradable currencies.

Plenty in the Tank

Another potential source of strength for the Canadian dollar, assuming worldwide oil demand flourishes in the future, is the fact that not only did Canada surpass Saudi Arabia as the top supplier of crude to the U.S., Canada has the second-largest proven reserves of crude, behind its rival from the Middle East.

Although Canada is a long way from Saudi Arabia in terms of proven reserves, new discoveries in the Kingdom have not been impressive in recent years, leading some industry observers to ponder if Saudi Arabia's reserves are as high as the royal family says they are. On the other hand, thanks to the booming tar sands, Canada is actually moving up the list of oil exporters. As new discoveries of note become harder to come by, Canada and its currency are poised to benefit by being able to meet demand for crude from the world's hungriest customers.

And we can't forget that among the nations expected to crave more and more crude in the future is China, which has already taken note of Canada's vast reserves, so it's not unreasonable to expect that Chinese demand for Canadian crude will grow as the Chinese economy grows. Chalk up another point in favor of the loonie.

How to Play This Profitable Pair

Looking at a chart that compares crude oil and the performance of the Canadian dollar is like watching a pair of professional dancers. Oil is the leader and where it goes, its partner, the loonie, usually follows; at least about 80% of the time, according to the exact correlation figures. Therefore, a move in oil is a leading indicator that can be a tip-off for the astute investor to buy or sell short Canadian dollars.

Obviously, forex trading isn't for every investor, but there are other ways to play the crude/loonie pair and exchange-traded funds (ETFs) focused on the Canadian might be the best way. The CurrencyShares Canadian Dollar Trust (NYSE:FXC) tracks the loonie's daily performance, so it gives investors direct exposure to the currency without risk of investing in the forex market. Another ETF to consider may be the iShares MSCI Canada Index (NYSE:EWC), which tracks a basket of some of the largest stocks that trade on the Toronto Stock Exchange (TSX).

Investors should note that the EWC tracks Canadian companies from a wide swath of industries, not just the oil patch. For those that prefer direct equity investments, Suncor Energy (NYSE:SU) is one of Canada's largest oil firms, a dominant presence in the oil sands of western Canada, and its stock is sure to pop as oil demand surges.

Next time the price of oil heads up, don't get angry and worry about how much your next trip to the gas station is going to cost. Get even by making a play on the Canadian dollar. After all, revenge on rising oil prices may be a dish best served Canadian.


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Forex Leverage: A Double-Edged Sword

One of the reasons why so many people are attracted to trading forex compared to other financial instruments is that with forex, you can usually get much higher leverage than you would with stocks. While many traders have heard of the word "leverage," few have a clue about what leverage is, how leverage works and how leverage can directly impact their bottom line.

What Is leverage?

Leverage involves borrowing a certain amount of the money needed to invest in something. In the case of forex, that money is usually borrowed from a broker. Forex trading does offer high leverage in the sense that for an initial margin requirement, a trader can build up - and control - a huge amount of money.

To calculate margin-based leverage, divide the total transaction value by the amount of margin you are required to put up.

Margin-Based Leverage =    Total Value of Transaction
    Margin Required

For example, if you are required to deposit 1% of the total transaction value as margin and you intend to trade one standard lot of USD/CHF, which is equivalent to US$100,000, the margin required would be US$1,000. Thus, your margin-based leverage will be 100:1 (100,000/1,000). For a margin requirement of just 0.25%, the margin-based leverage will be 400:1, using the same formula.

Margin-Based Leverage Expressed as Ratio	Margin Required of Total Transaction Value
400:1	0.25%
200:1	0.50%
100:1	1.00%
50:1	2.00%

However, margin-based leverage does not necessarily affect one's risks. Whether a trader is required to put up 1 or 2% of the transaction value as margin may not influence his or her profits or losses. This is because the investor can always attribute more than the required margin for any position. What you need to look at is the real leverage, not margin-based leverage.

To calculate the real leverage you are currently using, simply divide the total face value of your open positions by your trading capital.

Real Leverage =    Total Value of Transaction
    Total Trading Capital

For example, if you have $10,000 in your account, and you open a $100,000 position (which is equivalent to one standard lot), you will be trading with a 10 times leverage on your account (100,000/10,000). If you trade two standard lots, which is worth $200,000 in face value with $10,000 in your account, then your leverage on the account is 20 times (200,000/10,000).

This also means that the margin-based leverage is equal to the maximum real leverage a trader can use. And since most traders do not use their entire accounts as margin for each of their trades, their real leverage tends to differ from their margin-based leverage.

Leverage in Forex Trading

In trading, we monitor the currency movements in pips, which is the smallest change in currency price, and that could be in the second or fourth decimal place of a price, depending on the currency pair. However, these movements are really just fractions of a cent. For example, when a currency pair like the GBP/USD moves 100 pips from 1.9500 to 1.9600, that is just a one cent move of the exchange rate.

This is why currency transactions must be carried out in big amounts, allowing these minute price movements to be translated into decent profits when magnified through the use of leverage. When you deal with a large amount like $100,000, small changes in the price of the currency can result in significant profits or losses.

When trading forex, you are given the freedom and flexibility to select your real leverage amount based on your trading style, personality and money management preferences.

Risk of Excessive Real Leverage

Real leverage has the potential to enlarge your profits or losses by the same magnitude. The greater the amount of leverage on capital you apply, the higher the risk that you will assume. Note that this risk is not necessarily related to margin-based leverage although it can influence if a trader is not careful.

Let's illustrate this point with an example (Figure 1).

Both Trader A and Trader B have a trading capital of US$10,000, and they trade with a broker that requires a 1% margin deposit. After doing some analysis, both of them agree that USD/JPY is hitting a top and should fall in value. Therefore, both of them short the USD/JPY at 120.

Trader A chooses to apply 50 times real leverage on this trade by shorting US$500,000 worth of USD/JPY (50 x $10,000) based on his $10,000 trading capital. Because USD/JPY stands at 120, one pip of USD/JPY for one standard lot is worth approximately US$8.30, so one pip of USD/JPY for five standard lots is worth approximately US$41.50. If USD/JPY rises to 121, Trader A will lose 100 pips on this trade, which is equivalent to a loss of US$4,150. This single loss will represent a whopping 41.5% of his total trading capital.

Trader B is a more careful trader and decides to apply five times real leverage on this trade by shorting US$50,000 worth of USD/JPY (5 x $10,000) based on his $10,000 trading capital. That $50,000 worth of USD/JPY equals to just one-half of one standard lot. If USD/JPY rises to 121, Trader B will lose 100 pips on this trade, which is equivalent to a loss of $415. This single loss represents 4.15% of his total trading capital.

Refer to the chart below to see how the trading accounts of these two traders compare after the 100-pip loss.

Trader A	Trader B
Trading Capital	$10,000	$10,000
Real Leverage Used	50 times	5 times
Total Value of Transaction	$500,000	$50,000
In the Case of a 100-Pip Loss	-$4,150	-$415
% Loss of Trading Capital	41.5%	4.15%
% of Trading Capital Remaining	58.5%	95.8%
Figure 1: All figures in U.S. dollars

With a smaller amount of real leverage applied on each trade, you can afford to give your trade more breathing room by setting a wider but reasonable stop and avoiding risking too much of your money. A highly leveraged trade can quickly deplete your trading account if it goes against you, as you will rack up greater losses due to bigger lot sizes. Keep in mind that leverage is totally flexible and customizable to each trader's needs. Having an aim of trading profitably is not about making your millions by the end of this month or this year.



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Calculating Profits and Losses of Your Currency Trades

Currency trading offers a challenging and profitable opportunity for well-educated investors. However, it is also a risky market, and traders must always remain alert to their trade positions. The success or failure of a trader is measured in terms of the profits and losses (P&L) on his or her trades. It is important for traders to have a clear understanding of their P&L, because it directly affects the margin balance they have in their trading account. If prices move against you, your margin balance reduces, and you will have less money available for trading.

Realized and Unrealized Profit and Loss

All your foreign exchange trades will be marked to market in real-time. The mark-to-market calculation shows the unrealized P&L in your trades. The term "unrealized," here, means that the trades are still open and can be closed by you any time. The mark-to-market value is the value at which you can close your trade at that moment. If you have a long position, the mark-to-market calculation typically is the price at which you can sell. In case of a short position, it is the price at which you can buy to close the position.

Until a position is closed, the P&L will remain unrealized. The profit or loss is realized (realized P&L) when you close out a trade position. When you close a position, the profit or loss is realized. In case of a profit, the margin balance is increased, and in case of a loss, it is decreased.

The total margin balance in your account will always be equal to the sum of initial margin deposit, realized P&L and unrealized P&L. Since the unrealized P&L is marked to market, it keeps fluctuating, as the prices of your trades change constantly. Due to this, the margin balance also keeps changing constantly.

Calculating Profit and Loss

The actual calculation of profit and loss in a position is quite straightforward. To calculate the P&L of a position, what you need is the position size and by how many pips the price has moved. The actual profit or loss will be equal to the position size multiplied by the pip movement.

Let's look at an example:

Assume that you have a 100,000 GBP/USD position currently trading at 1.6240. If the prices move from GBP/USD 1.6240 to 1.6255, then the prices have move up by 15 pips. For a 100,000 GBP/USD position, the 15 pips movement equates to USD 150 (100,000 x 15).

To determine if it's a profit or loss, we need to know whether we were long or short for each trade.

Long position: In case of a long position, if the prices move up, it will be a profit, and if the prices move down it will be a loss. In our earlier example, if the position is long GBP/USD, then it would be a USD 150 profit. Alternatively, if the prices had moved down from GBP/USD 1.6240 to 1.6220, then it will be a USD 200 loss (100,000 x -0.0020).

Short position: In case of a short position, if the prices move up, it will be a loss, and if the prices move down it will be a profit. In the same example, if we had a short GBP/USD position and the prices moved up by 15 pips, it would be a loss of USD 150. If the prices moved down by 20 pips, it would be a USD 200 profit.

The following table summarizes the calculation of P&L:

100,000 GBP/USD	Long position	Short position
Prices up 15 pips	Profit $150	Loss $150
Prices down 20 pips	Loss $200	Profit $200

Another aspect of the P&L is the currency in which it is denominated. In our example the P&L was denominated in dollars. However, this may not always be the case.

In our example, the GBP/USD is quoted in terms of the number of USD per GBP. GBP is the base currency and USD is the quote currency. At a rate of GBP/USD 1.6240, it costs USD 1.6240 to buy one GBP. So, if the price fluctuates, it will be a change in the dollar value. For a standard lot, each pip will be worth USD 10, and the profit and loss will be in USD. As a general rule, the P&L will be denominated in the quote currency, so if it's not in USD, you will have to convert it into USD for margin calculations.

Consider you have a 100,000 short position on USD/CHF. In this case your P&L will be denominated in Swiss francs. The current rate is roughly 0.9129. For a standard lot, each pip will be worth CHF 10. If the price has moved down by 10 pips to 0.9119, it will be a profit of CHF 100. To convert this P&L into USD, you will have to divide the P&L by the USD/CHF rate, i.e., CHF 100 / 0.9119, which will be USD 109.6611.

Once we have the P&L values, these can easily be used to calculate the margin balance available in the trading account. Margin calculations are typically in USD.

You will not have to perform these calculations manually because all brokerage accounts automatically calculate the P&L for all your trades. However, it is important that you understand these calculations as you will have to calculate your P&L and margin requirements while structuring your trade even before you actually enter the trade. Depending on how much leverage your trading account offers, you can calculate the margin required to hold a position. For example, if your have a leverage of 100:1, you will require a margin of $1,000 to open a standard lot position of 100,000 USD/CHF.

Having a clear understanding of how much money is at stake in each trade will help you manage your risk effectively.




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