THE RISKS OF TRADING IN THE FOREX MARKET

Although every investment involves some risk, the risk of loss in
trading off-exchange forex contracts can be substantial. Therefore,
if you are considering participating in this market, you should
understand some of the risks associated with this product so you
can make an informed decision before investing.

As stated in the introduction to this booklet, off-exchange foreign
currency trading carries a high level of risk and may not be suitable
for all customers. The only funds that should ever be used to speculate
in foreign currency trading, or any type of highly speculative
investment, are funds that represent risk capital – i.e., funds you
can afford to lose without affecting your financial situation. There
are other reasons why forex trading may or may not be an appropriate
investment for you, and they are highlighted below.

The market could move against you

No one can predict with certainty which way exchange rates will
go, and the forex market is volatile. Fluctuations in the foreign
exchange rate between the time you place the trade and the time
you close it out will affect the price of your forex contract and the
potential profit and losses relating to it.

You could lose your entire investment

You will be required to deposit an amount of money (often referred
to as a “security deposit” or “margin”) with your forex dealer in
order to buy or sell an off-exchange forex contract. As discussed
earlier, a relatively small amount of money can enable you to hold a
forex position worth many times the account value. This is referred
to as leverage or gearing. The smaller the deposit in relation to the
underlying value of the contract, the greater the leverage.

If the price moves in an unfavorable direction, high leverage can
produce large losses in relation to your initial deposit. In fact, even
a small move against your position may result in a large loss, including
the loss of your entire deposit. Depending on your agreement
with your dealer, you may also be required to pay additional losses.
You are relying on the dealer’s

creditworthiness and reputation

Retail off-exchange forex trades are not guaranteed by a clearing
organization. Furthermore, funds that you have deposited to
trade forex contracts are not insured and do not receive a priority
in bankruptcy. Even customer funds deposited by a dealer in
an FDIC-insured bank account are not protected if the dealer
goes bankrupt.

There is no central marketplace

Unlike regulated futures exchanges, in the retail off-exchange
forex market there is no central marketplace with many buyers
and sellers. The forex dealer determines the execution price, so
you are relying on the dealer’s integrity for a fair price.
The trading system could break down

If you are using an Internet-based or other electronic system to place
trades, some part of the system could fail. In the event of a system
failure, it is possible that, for a certain time period, you may not be
able to enter new orders, execute existing orders, or modify or
cancel orders that were previously entered. A system failure may also
result in loss of orders or order priority.

You could be a victim of fraud

As with any investment, you should protect yourself from fraud.
Beware of investment schemes that promise significant returns
with little risk. You should take a close and cautious look at the
investment offer itself and continue to monitor any investment
you do make.

What are foreign currency exchange rates?

Foreign currency exchange rates are what it costs to exchange one
country’s currency for another country’s currency. For example, if
you go to England on vacation, you will have to pay for your hotel,
meals, admissions fees, souvenirs and other expenses in British
pounds. Since your money is all in US dollars, you will have to use
(sell) some of your dollars to buy British pounds.

Assume you go to your bank before you leave and buy $1,000
worth of British pounds. If you get 565.83 British pounds
(£565.83) for your $1,000, each dollar is worth .56583 British
pounds. This is the exchange rate for converting dollars to pounds.
If £565.83 isn’t enough cash for your trip, you will have to
exchange more US dollars for pounds while in England. Assume
you buy another $1,000 worth of British pounds from a bank in
England and get only £557.02 for your $1,000. The exchange rate
for converting dollars to pounds has dropped from .56583 to
.55702. This means that US dollars are worth less compared to the
British pound than they were before you left on vacation.

Assume that you have £100 left when you return home. You go to
your bank and use the pounds to buy US dollars. If the bank gives
you $179.31, each British pound is worth 1.7931 dollars. This is
the exchange rate for converting pounds to dollars.
Theoretically, you can convert the exchange rate for buying a currency
to the exchange rate for selling a currency, and vice versa, by
dividing 1 by the known rate. For example, if the exchange rate for
buying British pounds with US dollars is .56011, the exchange rate
for buying US dollars with British pounds is 1.78536 (1 ÷ .56011
= 1.78536). Similarly, if the exchange rate for buying US dollars
with British pounds is 1.78536, the exchange rate for buying
British pounds with US dollars is .56011 (1÷ 1.78536 = .56011).
This is how newspapers often report currency exchange rates.

As a practical matter, however, you will not be able to buy and sell
the currency at the same price, and you will not receive the price
quoted in the newspaper. This is because banks and other market
participants make money by selling the currency to customers for
more than they paid to buy it and by buying the currency from
customers for less than they will receive when they sell it. The
difference is called a spread and is discussed later in this booklet.
How can I trade foreign currency exchange rates?

As you can see from the example, currency exchange rates fluctuate.
As the value of one currency rises or falls relative to another,
traders decide to buy or sell currencies to make profits. Retail
customers also participate in the forex market, generally as speculators
who are hoping to profit from changes in currency rates.
Foreign currency exchange rates may be traded
in one of three ways:

1. On an exchange that is regulated by the Commodity
Futures Trading Commission (CFTC). For example, the
Chicago Mercantile Exchange offers forex futures and
options on futures products. Exchange-traded forex futures
and options provide their users with a liquid, secondary
market for contracts with a set unit size, a fixed expiration
date and centralized clearing.

2. On an exchange that is regulated by the Securities and
Exchange Commission (SEC). For example, the
Philadelphia Stock Exchange offers options on currencies
(i.e., the right but not the obligation to buy or sell a
currency at a specific rate within a specified time).
Exchange-traded options on currencies have characteristics
similar to exchange-traded futures and options (e.g., a
liquid, secondary market with a set size, a fixed expiration
date and centralized clearing).

3. In the off-exchange, also called the over-the-counter
(OTC), market. A retail customer trades directly with a
counterparty and there is no exchange or central clearing
house to support the transaction. Off-exchange trading is
subject to limited regulatory oversight.
This brochure focuses on the off-exchange foreign currency market.