1. HOW DOES FOREIGN EXCHANGE TRADING WORK?

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1 XV. Important additional information on forex transactions / risks associated with foreign exchange transactions (also in the context of forward exchange transactions) The following information is given in addition to the general risks associated with forward transactions. Please read the following information attentively. Foreign exchange and Foreign spot transactions are associated with a high risk of loss. Before getting involved as market participants on the international foreign exchange markets, you should read the following information attentively, in particular the risk information stated in item 6 of this section. The term "FOREX is made up of the contractions for (= foreign) and ex (= exchange). FOREX trading or FX trading describes the international foreign exchange trading, that is the purchase and sale of currencies. 1. HOW DOES FOREIGN EXCHANGE TRADING WORK? Foreign exchange trading is based on a worldwide decentralised trading system (no fixed stock exchange, but OTC (over the counter) trading) which can be accessed directly by all participants. However, there is no fixed market place or stock market, therefore the market for foreign exchange trading is called an OTC market (over the counter). This trading system is called interbank FX market; the trading between the market participants is called interbank trading. The heart of this system is the interbank matching system that determines current rates during trading times (market making). Private foreign exchange traders are directly connected to the worldwide trading system through a foreign exchange broker and thus benefit from all advantages offered by this system. The most important benefit is a fully automated trading system providing all services from price determination to the execution of the trade. Manipulations are virtually impossible. In second place, a transparent real-time price system is available. The broker trades at the rate that he / she sees like the other market participants and executes the trade completely within fractions of a second. The foreign exchange market is one of the biggest and most liquid markets in the world. Trading takes place 24 hours a day, 5 days a week. Basically, we distinguish between spot exchange transactions and forward exchange transactions (forward exchange contracts). As the following explanations will illustrate in more detail, the value date of spot transactions normally is two working days after conclusion. Forward exchange transactions are valued at a particular date in the future agreed by contract and at a rate agreed in advance. Foreign exchange can be purchased at a current rate with immediate delivery and settlement on the spot market. The determination of the rate is based on supply and demand of those market participants who need foreign exchange with immediate delivery. This determination of price is called rate on the spot market. The exchange rates on the spot market are highly sensitive to economic changes. They are the basis of the international cash flows since foreign exchange transactions can be settled only within a few minutes. Spot markets are the most liquid foreign exchange markets. New buy and sell orders continuously influence the rates. 2. DEFINITION OF EXCHANGE RATE The exchange rate always refers to two currencies and describes their exchange ratio. The currency that is rated is called base currency. It is the currency stated first in the pair of currencies. The currency that expresses the rate is called quoted currency. The rate expressed by the quoted currency refers to a unit of the base currency. The exchange rate for the pair of currencies EUR/USD shows the value of one euro in US dollars, so it expresses the quantity of the quoted currency that is required for exchanging into or from the base currency. When a broker states a quotation for the sale of EUR/USD, he / she will be selling euros and buying US dollars. Therefore, he / she is exchanging euros into US dollars. When selecting the base currency for any pair of main currencies, the market adheres to an established hierarchy. For example, for a trade involving US and Australian dollars, the market will quote AUD/USD. For exchanges between Australian dollars and British pounds, the market will quote GBP/AUD. The euro is used as base currency in any pair of currencies. 3. HANDLING OF SPOT EXCHANGE AND FORWARD EXCHANGE TRANSACTIONS As a general rule, spot exchange transactions are fulfilled by the mutual physical delivery of currency amounts. However, in practice, it may also be fulfilled by offsetting against a concluded opposite transaction. 60

2 The relevant exchange rates in spot transactions are defined by the bid price and the ask price. In international foreign exchange trading, he bid price is the price at which the customer can sell a base currency, while the ask price is the price at which the customer can buy a base currency. The difference between bid price and ask price is called market difference (spread). On the spot market, the exchange rate is agreed at the trading date; the actual transaction is then carried out as quickly as possible. The standard time for immediate settlement is two business days after the trading day (d+2). This date is called value date or spot date. USD/CAD transactions are the only exception and are settled within a business day (d+1). This procedure reduces the settlement risk and allows time for doing the formalities such as confirmations of transactions including the payment orders of the two parties. If such a spot transaction has not been settled on the second business day (2 days after the trading day), interest will be charged to the party in default. The development of Intraday (real-time gross settlement RTGS) in the 1990s, i.e. possibility to settle purchase and sell within a day, made it possible to settle transactions as of today (d+0) and over night as of tomorrow (d+1). As already explained above, spot exchange transactions are generally fulfilled by paying a corresponding currency amount. The contracting party may request the customer to deposit a security ( margin ) for covering the risk of non-performance. The margin covers a corresponding amount of the customer s traded currency volume. In general, the amount of the margin payment depends on the development of the exchange rates. A forward exchange contract is a transaction to exchange currencies, i.e. the purchase or sale of a certain currency on a future date at a rate agreed today. This rate is called forward rate. Banks will provide forward exchange quotes for most of the tradable currencies. Forward value dates are calculated out of spot value dates, which are in turn calculated out of the transaction date. As already mentioned, the spot date is two business days after the transaction date. So for a 1-month forward contract concluded on Wednesday, 11 August 2004, the spot value date will be Friday, 13 August, and the forward value date will be Monday, 13 September. The term of forward exchange contracts is between 3 days and approximately 2 years. Both types of contracts show the expected development of the future foreign exchange rates by means of the positions held. 4. SPECULATION AND HEDGING USING CURRENCY FUTURES CONTRACTS Forward exchange contracts are mainly used for hedging open positions and for speculating. Pure speculators express a specific opinion regarding the expected development of the exchange rates by means of currency futures contracts. Futures traded on a stock exchange often present a very large leverage effect. Standard contracts (price, volume, maturity) create liquidity which allows speculators to trade contracts before their expiry date. The limited number of available currency pairs as well as the standard volume and the limited settlement dates are factors that contribute to the liquidity of futures contracts. 5. OTC FORWARD EXCHANGE TRADING OTC forward exchange trading is the preferred instrument to hedge currency risks or to speculate. We distinguish between four main categories: 5.1 Hedging of opposite positions Risk-averse hedge customers with underlying foreign exchange transactions. They wish to hedge the future value of a fixed income. If, for example, a UK corporation receives an amount in euro in 30 days, the value of the euro compared to the GBP can be fixed today by concluding a forward exchange contract with a bank to sell euro for GBP in 30 days at an agreed fixed rate. 5.2 Hedging of future income Portfolio managers use forward exchange contracts for hedging the risk of exchange rate movements. They wish to secure the value of an investment or of future investment returns (e.g. interest coupon payments for fixed-interest securities denominated in a foreign currency). 5.3 Liquidity management Banks use forward exchange contracts mainly for liquidity management. They combine a forward exchange transaction with a spot exchange transaction to create a two-leg transaction, the so-called foreign exchange swap. 61

3 5.4 Speculation Portfolio managers take positions with the sole objective of making a favourable independent transaction. This transaction is not based on any positions to be hedged. They only aim at making use of (probable) opportunities. 6. RISKS IN FOREIGN EXCHANGE TRADING This risk information cannot cover all possible risks associated with foreign exchange trading. The following information refers to the typical risks associated with foreign exchange trading. On account of the associated risks, trading in foreign exchanges requires special knowledge, abilities and experience and therefore is not suitable for many investors. This is why you would consider very carefully whether trading in foreign exchange is a suitable type of investment for you in view of your experience, investment goals, financial possibilities and other investment-related personal circumstances. If you are not sure as to this necessary assessment, you should ask your legal, economic or other adviser for help. The following information is given in addition to the general information on risks associated with forward transactions. You will find further information on risks there as well. Therefore, please read those documents thoroughly before trading! 6.1 Risks based on extreme price fluctuations As illustrated above, the foreign exchange market is the most liquid financial market in the world. Today, the extremely short reaction times and the large number of market operations sometimes result in large price fluctuations on a single day that were possible in the past over rather large periods of time only. It is this fact that, on the one hand, makes the forex trade interesting, but, on the other hand, also is responsible for its extraordinarily high risk. 6.2 Risks resulting from margin transactions - leverage effect It is true that the handling of a foreign exchange transaction based on the provision of a margin reduces the capital employed so that a relatively large trading volume can be achieved by employing a relatively small amount of capital, but the risk of loss increases as well. This correlation is called leverage effect. The leverage effect results in the fact that even small price fluctuations may have a strong effect on the capital employed by you. This may result in the loss of your entire capital employed. Example: You have an available margin amounting to 20,000 USD on your trading account and buy 100,000 EUR. In case of a current EUR/USD rate of this transaction has an equivalent value of 125,000 USD that you have to pay. However, you only have to make a security deposit, the so-called margin for this transaction. The margin amounts to a fraction of the value of the concluded transaction only, in this example it is 10% of the value of the transaction, i.e. 12,500.- USD. The investment condition in the form of the fixed margin that is relatively low compared to the overall value of the transaction creates a leverage effect: In the example above, this leverage amounts to 1:10. The deposited margin amounts to a tenth of the traded volume of 125,000 USD. If the EUR/USD rate falls from to (minus 4% = 0.05 USD), this will result in a loss of 5,000 USD (125,000 USD had to be paid for 100,000 EUR, but now you will only get back 120,000 USD for 100,000 EUR). The loss for the overall account increases to 25% on account of the leverage used. After deducting the trading loss of 5,000 USD, only 15,000 USD remain of the margin of 20,000 USD initially paid in. This leverage effect results in the fact that already small variations in the rate of the currency pair have large effects on the account capital. (In the example, a change in the exchange rate by 4 per cent resulted in a loss of 25% (5,000 USD) in the trading account). This may cause to the total loss of the capital paid in as margin. Example: A fixed margin of 12,500 USD is deducted from the available margin of 20,000 USD for purchasing 100,000 EUR. The available margin now amounts to 7,500 USD. If the EUR/USD rate falls from to (minus 12% = 0.15 USD), this will result in a loss of 15,000 USD (125,000 had to be paid for 100,000 EUR, but now you will only get back 110,000 USD for 100,000 EUR). The available margin of 7,500 USD would not be enough to settle this loss. In this case, the bank would call for a further margin (capital) for balancing the account and initiate the forced closing of the transaction, unless not already carried out by a trading system on account of its risk management criteria. In case of closing of the transaction, the deposited margin can be used to settle the losses. In this case, the payment of a further margin would not be necessary. 5,000 USD would remain as new freely available capital for other transactions. The larger the leverage is in a spot transaction, the higher is the risk of loss in case of small market fluctuations. Supposing that the fixed margin is 10% of the trading volume, that is 12,500 USD, in the example above. This results in a leverage of 1:10 since a change in the EUR/USD exchange rate by 10 per cent results in a loss of 12,500 USD). You have to realise that, when concluding a transaction, a portion of your capital paid in (available margin) will be fixed as margin as soon as you open positions in the FOREX market. Losses sustained in the context of transactions may exceed the remaining capital by far and use up the fixed margin. You can lose your entire paid-up capital (total loss). If losses result in the fact that your entire margin no longer is enough for the open transactions, you will have to provide a further margin for restoring a balanced account. The time limit fixed for that may be extremely short. If you fail to provide the 62

4 required capital within the fixed time limit, the open transactions will be closed by the bank. Most of the electronic trading systems are already fully developed to automatically liquidate the customer's open positions at defined limits of loss or if certain risk management criteria are met. 6.3 Currency and price risk Profits and losses arising from foreign exchange transactions occur for buyer and seller like a mirror image. The seller of a foreign exchange transaction undertakes to deliver the foreign exchange at a future exchange rate. The exchange rate at the date of execution might be significantly higher than the rate at the date of conclusion. If, in this case, the seller does not own the foreign exchange to be delivered, the seller might, under certain circumstances, be obliged to conclude a closing transaction. The seller s risk arises from the price difference. This risk of loss cannot be determined in advance and can account for your entire paid-up capital. For example, this is the case when the seller does not own the foreign exchange, but has to procure it at maturity only. In this case, significant losses might result as the seller might be required to buy at a clearly higher rate, depending on the market situation. If the seller is unable to procure the foreign exchange, he /she will have to make corresponding settlement payments. The same will apply to the buyer of a foreign exchange transaction, if the exchange rate at the execution date is lower than the rate at the date of conclusion. It depends on the customer s respective contracting partner or on the agreement entered into with that person to what extent he / she will close out transactions of the customer prematurely by concluding an opposite transaction of by settlement in case of losses. These risks cannot be excluded by means of careful analyses of rates either. Please read that information. When trading currencies on the spot market / interbank market, the exchange of currencies will take place immediately. In this case, an exchange of two currencies takes place immediately upon the conclusion of the transaction at the current market rate. 6.4 Risk of counterparty default The risk of counterparty default (also called credit risk or counterparty risk ) is the risk that a contracting party does not meet their obligations and is in default. This results in a financial damage to the other contracting party since they have to conclude replacement transactions at unfavourable prices. Reasons for the default of a counterparty include the credit standing of the business partner or country risks at the partner s place of business. Such a counterparty default may occur at any time and does not depend on market activity. A participant may be in default, for example, when he / she becomes insolvable, files for insolvency / bankruptcy or a moratorium is introduced. The potential loss resulting from the default of a counterparty amounts to the expenses incurred for the replacement through the substitute transaction. Therefore, the risk of counterparty default is also called replacement risk or substitution risk. The risk that the counterparty does not meet their obligations and thus a loss is sustained carries particular weight in foreign exchange transactions. The execution of foreign exchange transactions generally takes place at different places. This is why, when placing their payment orders, no party can be sure that the other party meets their obligations under the contract. This (time zone) risk is particularly high when, due to time zone differences between the two places of payment, one of the parties is obliged to make a payment before the other party does. 6.5 Ineffectiveness of risk limitations It might happen that transactions to exclude or limit risks associated with concluded transactions (closing transactions) cannot be concluded at all or at a losing market price only. These transactions include limit or stop order or combined if-then limit or stop orders. The application of limit or stop orders (orders to limit trading profits or trading losses in case of certain market fluctuations by automatically initiating the closing of a transactions) cannot always limit losses to the defined amounts. It is possible that, on account of a certain market situation, the orders cannot be executed timely, not at the fixed price or not at all, which may result in the total loss of your margin capital as well as further losses exceeding the latter. In particular in very volatile market phases, unforeseeable price changes may result in the fact that the closing of the position falls under the defined risk limit. This may result in the fact that a rather large loss or even a total loss is sustained. Thus, the risk limitation intended by these orders may completely fail and a total loss or even larger losses may occur. 6.6 Risks associated with online trading 63

5 Further risks may result from characteristic features of online trading, in particular, orders of any kind, also stop limit orders and / or stop loss orders may be transmitted or executed only in part, not at all or not timely on account of system errors, system failures, transmission errors, other errors of hardware or software or the interruption of the connection. These errors and failures may result in losses up to total loss of the entire margin capital paid in. 6.7 Other risks Additional risks might result if the conclusion and / or execution of foreign exchange transactions are subject to a low other than German law. This might result in the fact that the assertion and enforcement of claims arising from the conclusion and / or execution of foreign exchange transactions is associated with actual or legal difficulties. Risks might also result from the absence of regulatory regulations or the presence of inadequate regulatory regulations. Additional risks might result if the contracting party speaks another language when concluding and / or executing foreign exchange transactions. This might result in communication difficulties or translation errors. 6.8 Risk associated with day trading Same-day foreign exchange transactions in the same currency pair might result in immediate losses. Contracting parties might lose their entire capital. In case of day trading transactions with borrowed funds, customers will always be obliged to repay the credit irrespective of their success in day trading. When attempting to make profits in day trading, the customer will also compete with professional and well-financed market participants. Day trading requires the customer s in-depth knowledge with respect to exchange markets, exchange trading methods and strategies. 64

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