Intro: Foreign Exchange
Foreign Exchange
Foreign Exchange (updated 22 Feb 99)
Foreign exchange (forex) markets form the core of the global financial market, a seamless twenty-four hour structure dominated by sophisticated professional players - commercial banks, central banks, hedge funds and forex brokers - and often extremely volatile. Many investors, particularly American ones, tend to ignore currency movements, and few financial analysts are trained to analyze the details of forex markets. But this is a mistake. As the 1997 Asian crisis and its aftermath vividly reveal, foreign exchange these days tends to lead economic activity. And the foreign exchange markets are huge, growing and increasingly powerful.
According to the Bank for International Settlements, the central bank for central banks, average daily turnover on the world's foreign exchange markets reached almost $1,500 billion in April 1998, 26% higher than when it last measured forex flows in 43 different countries three years earlier. Transactions involving dollars on one side of the trade accounted for 87% of that forex business. Almost a third of all forex trading takes place in London, by far the world's largest center, with New York and Tokyo second and third. Although London forex trading grew more slowly than New York over the three years to 1998, its average daily turnover remains greater than New York and Tokyo combined, having risen from $464 billion to $637 billion.
To put these figures in perspective, daily trading volume on the New York Stock Exchange (NYSE) is only about $20 billion; activity in short-term US government securities is around ten times that at $200 billion; and so at $1,500 billion, foreign exchange trading is seven and a half times the volume of trading in short-term US government securities and seventy-five times NYSE trading. This volume is far greater than the size of foreign currency reserves held by any single country. The forex markets cannot be ignored: for their size and forecasting ability; and for the potential that developments in these markets have for the future of the dollar as the world's dominant currency.
In the past, trading in the real economy controlled relative currency relationships. Since most currency flows were to settle trading patterns, there was a balance as goods and capital moved at about the same speed. But now the leads and lags are the other way around. While in name forex markets exist to facilitate international trade, in practice, the bulk of turnover in these markets is attributable to speculation. Because financial flows are many times the size of trade flows and because financial flows are nearly instantaneous, currency market levels now tend to set trade: if a country's currency becomes low relative to others, domestic producers find it easier to export. The market sets the economy.
Foreign exchange guru: Richard Olsen
In the pre-radio and telephony days, information about markets moved by post, horses and even by carrier pigeons. Investors with information in one market would send their instructions to other markets and success was often an outcome of the speed of transferring the messages.
Today's global environment also puts a premium on speed, but it is not measured in days or hours but nanoseconds. Currency trading departments are decentralized so that individuals, usually young, nimble and quick, can make massive decisions on their own. The trading rooms of major institutions trading currencies for their own accounts often contain no one over the age of thirty-five, none with bonus possibilities less than multiple millions and all eager to take risks to achieve personal gain.
It is perhaps not surprising that currency markets trading in hundreds of billion dollars a day, open twenty-four hours and with information moving so fast that there is always the chance of an information advantage would attract speculative attention. And not surprising either that the value of speed and ability to grasp all the markets' information at once would attract academics building new models. One of these, and one of the best, is Richard Olsen of Olsen and Associates (O&A), a high-frequency data processing firm in Zurich.
A visit to O&A, in a refurbished flour mill alongside Zuriichsee is like a visit to Silicon Valley. Attire is California casual, tee shirts and jeans, though Olsen does wear a tie to see clients. Dogs and bikes sit outside offices while their owners are huddled over computer keyboards. Conversation is usually in English though it is hardly the first language for the majority. Academic disciplines are mathematics, economics or almost anything else. The common characteristic of the people is smart, very smart.
Olsen and his colleagues are the best at acquiring and analyzing high-frequency data, using very advanced mathematical techniques to forecast currency movements. By high frequency, they mean second by second, and forecasting might be for an hour or so ahead, perhaps even a week if long-term - the value of high-frequency forecasts decay rapidly as the information that produced it is disseminated.
Counterpoint
Smart as it is, there are times when the approach of Olsen and his colleagues has failed to work. Like other more simple 'data mining' and historically based methods, it works in periods when currency movements are following a trend but gets 'whipsawed' with penalizing transaction costs in trendless markets. And during a change in the trend, O&A might identify a turn but not know the difference between a minor and a major turn.
Yet this group comes closer to modeling how the foreign exchange world really works than others. When there are new academic insights, they are likely to note them early.
A broader social counterpoint to today's forex markets is that with this daily volume of electronic, invisible money flowing throughout the world, a single nimble trader can drive a monetary institution to the wall. A trader is often compensated by a share of the trading profit, which can put tens of millions into his or her pocket. The trading institution takes the risk and the trader takes the profit: a true asymmetrical payoff scheme operates to pyramid risks. A central bank seeking to dampen its currency swings may come forward with a few billion but this is typically something that a single trader could command. In these circumstances, a central bank attempting to influence a currency is like sending a bicycle onto a superhighway.
The size of forex trade has played its part in the series of currency crises in emerging nations during the 1990s. The capacity for massive daily foreign currency flows to take place made possible the almost overnight collapses of the currencies of Thailand, Indonesia and Russia in 1997-8. As confidence in the economies of these countries fell away, demand for their currencies dried up as investors took their capital out or stopped bringing it in. Governments had tried to buy their own currencies to underpin their value but could not keep up with the sellers. When they stopped their own forex activity, the forces of demand and supply saw the baht, rupiah and ruble in turn crash in value, deepening the crisis of confidence and economic slowdown.
Some commentators are now recommending a tax on forex dealings: for example, Nobel Laureate James Tobin has warned that free capital markets with flexible exchange rates encourage short-term speculation that can have a 'devastating impact on specific industries and whole economies'. To avoid this real economic havoc, he advocates a 0.5% tax on all foreign exchange transactions in order to deter speculators, a remedy dubbed the 'Tobin tax'.
There are three rationales for the proposed Tobin tax: the first is that the volume of foreign exchange transactions is excessive - fifty to a hundred times greater than that required to finance international trade; the second is related to the first - reducing volatility offers more independence to national economic policy-makers; and the third is simply the tax-raising abilities of such a tax, which is linked with the view that the financial sector is relatively undertaxed.
Guru response
Richard Olsen comments: 'People fail to realize the importance of forex markets to support the globalization of the 'investment business'. Relative to trade flows, investments across borders have increased much more dramatically. The forex markets have to be able to accommodate the demands of these international investors, who want to sell their foreign holding at a moment's notice. Even though the forex markets have grown, the growth has been insufficient to support the requirements of an international investment community.'
'The introduction of electronic transaction systems has speeded up transactions in forex dramatically during the past six years. There is a side effect that has been neglected by many of the commentators. Similar to the money multiplier, there is a 'market liquidity multiplier'. If the efficiency of the transaction system increases, then transactions are settled much more quickly. This has the effect that liquidity dries up much more rapidly than in the past.'
'My inference is that today's forex markets are far too small to support our globalized financial community. The effect will be erratic price movements, as we saw on 7 October 1998 with the 20% shift in the dollar-yen exchange rate.'
'The introduction of the euro will make things worse. I think that we have to look at the euro as a merger of the European countries. Europe will thus become like one big football stadium with a strong US counterpart. The world will thus have two big football stadia. The stadia need wide roads, that is, highly liquid forex markets. Unfortunately, the new dollar-euro exchange rate will not be sufficiently liquid to absorb the large shifts of capital that will occur between the dollar and the euro.'
'Professor Amartya Sen, who received the 1998 Nobel prize for economics, explained in great detail that starvation is not a problem of a lack of food, but deficiencies in the distribution system. We face a similar situation with the financial markets, where the fundamental economy is in satisfactory shape, but the 'allocation system', that is, the financial markets and in particular the forex markets and the balance sheets of the banks, are in deep trouble.'
Where next?
Currency attacks are becoming a depressingly common feature of the global economy. But the exact timing of the onset of an attack is notoriously difficult to predict. Richard Olsen has developed a global financial early-warning system, which tries to do the same thing as a gadget that tells someone when they are getting their next heart attack.
He comments: 'We have been looking at the data now for many years and we have learned a lot about what really makes a market function successfully. And, most importantly, how the components within the market - that is, the market makers, the medium and long-term investors - interact, and what is required to build a healthy market or, in reverse, what leads to a negative market with large-scale shocks.' For obvious reasons, such a system would be of immense interest to regulators and speculators.
The core determining factor of a currency's value is the health of the real national economy, especially the balance of payments current account. If there is a surplus on the current account, that is, a country sells more goods than it buys, then buyers have to acquire that currency to purchase goods. This adds to foreign reserves and bids up the price of that currency. Conversely, a current account deficit implies the need to sell the local currency in order to acquire foreign goods. Persistent current account deficits, particularly if allied with relatively low foreign reserves, indicate a problem.
A currency's value is also affected by levels of inflation and the domestic rate of interest. High rates of interest and low inflation make a currency attractive for those holding assets denominated in it . So typically one country raising interest rates while others remain the same will raise the value of its currency as money flows into the country. This will have a limited effect if the 'fundamentals' are wrong.
Comparative inflation rates, interest rates and balances of payments will all give clues to likely medium term movements of a currency. But a key factor determining short- term currency values is market sentiment. There can be a self-fueling process in which enthusiasm for a currency, or the lack of it, drives the exchange rate. Speculators might decide, as they did during the European Monetary System debacle of 1992-3 and the Asian and Russian crises of 1997-8, that a currency is overvalued or simply that there are speculative gains to be made by selling it.
Currency attacks are triggered when a small shock to the fundamentals of the economy is combined with systemic weaknesses in the corporate and banking sectors. One facet of such systemic weaknesses is the effect of belated hedging activity by some economic actors in the economy whose currency is under attack. The more these actors try to hedge, the greater is the incentive for others to follow suit. This unleashes a whiplash effect, which turns a potentially orderly depreciation into a collapse of the currency. In other words, if speculators believe a currency will come under attack, their actions will precipitate the crisis; while if they believe the currency is not in danger, their inaction will spare it from attack - attacks are self-fulfilling.
The magnitude of the shock necessary to trigger an attack need not be large, which makes predictions very difficult. Nevertheless, it is possible to draw some broad conclusions on the vulnerability of currencies to attack. In particular, there must be a pre-existing weakness, which will prevent the authorities from conducting a full-fledged defense of the currency by raising interest rates. The weakness may not be lethal in itself (though it can become lethal once the situation deteriorates) so it is a necessary condition but not a sufficient condition for a speculative attack.
Self-fulfilling attacks may affect any country - with a fixed exchange rate and high capital mobility - that is in the gray area between 'fully safe' and 'sure to be attacked'. Recent research suggests that countries with strong trade links with a country that has recently experienced a currency crisis is highly likely to face an attack itself - the growing phenomenon of contagion in foreign exchange markets.
Read on
Online
www.forex.co.uk - a website called Forex Watch, which has a mass of charts and technical analysis of currency movements
www.olsen.ch and www.oanda.com - the websites of Olsen and Associates
Foreign Exchange (updated 22 Feb 99)
Foreign exchange (forex) markets form the core of the global financial market, a seamless twenty-four hour structure dominated by sophisticated professional players - commercial banks, central banks, hedge funds and forex brokers - and often extremely volatile. Many investors, particularly American ones, tend to ignore currency movements, and few financial analysts are trained to analyze the details of forex markets. But this is a mistake. As the 1997 Asian crisis and its aftermath vividly reveal, foreign exchange these days tends to lead economic activity. And the foreign exchange markets are huge, growing and increasingly powerful.
According to the Bank for International Settlements, the central bank for central banks, average daily turnover on the world's foreign exchange markets reached almost $1,500 billion in April 1998, 26% higher than when it last measured forex flows in 43 different countries three years earlier. Transactions involving dollars on one side of the trade accounted for 87% of that forex business. Almost a third of all forex trading takes place in London, by far the world's largest center, with New York and Tokyo second and third. Although London forex trading grew more slowly than New York over the three years to 1998, its average daily turnover remains greater than New York and Tokyo combined, having risen from $464 billion to $637 billion.
To put these figures in perspective, daily trading volume on the New York Stock Exchange (NYSE) is only about $20 billion; activity in short-term US government securities is around ten times that at $200 billion; and so at $1,500 billion, foreign exchange trading is seven and a half times the volume of trading in short-term US government securities and seventy-five times NYSE trading. This volume is far greater than the size of foreign currency reserves held by any single country. The forex markets cannot be ignored: for their size and forecasting ability; and for the potential that developments in these markets have for the future of the dollar as the world's dominant currency.
In the past, trading in the real economy controlled relative currency relationships. Since most currency flows were to settle trading patterns, there was a balance as goods and capital moved at about the same speed. But now the leads and lags are the other way around. While in name forex markets exist to facilitate international trade, in practice, the bulk of turnover in these markets is attributable to speculation. Because financial flows are many times the size of trade flows and because financial flows are nearly instantaneous, currency market levels now tend to set trade: if a country's currency becomes low relative to others, domestic producers find it easier to export. The market sets the economy.
Foreign exchange guru: Richard Olsen
In the pre-radio and telephony days, information about markets moved by post, horses and even by carrier pigeons. Investors with information in one market would send their instructions to other markets and success was often an outcome of the speed of transferring the messages.
Today's global environment also puts a premium on speed, but it is not measured in days or hours but nanoseconds. Currency trading departments are decentralized so that individuals, usually young, nimble and quick, can make massive decisions on their own. The trading rooms of major institutions trading currencies for their own accounts often contain no one over the age of thirty-five, none with bonus possibilities less than multiple millions and all eager to take risks to achieve personal gain.
It is perhaps not surprising that currency markets trading in hundreds of billion dollars a day, open twenty-four hours and with information moving so fast that there is always the chance of an information advantage would attract speculative attention. And not surprising either that the value of speed and ability to grasp all the markets' information at once would attract academics building new models. One of these, and one of the best, is Richard Olsen of Olsen and Associates (O&A), a high-frequency data processing firm in Zurich.
A visit to O&A, in a refurbished flour mill alongside Zuriichsee is like a visit to Silicon Valley. Attire is California casual, tee shirts and jeans, though Olsen does wear a tie to see clients. Dogs and bikes sit outside offices while their owners are huddled over computer keyboards. Conversation is usually in English though it is hardly the first language for the majority. Academic disciplines are mathematics, economics or almost anything else. The common characteristic of the people is smart, very smart.
Olsen and his colleagues are the best at acquiring and analyzing high-frequency data, using very advanced mathematical techniques to forecast currency movements. By high frequency, they mean second by second, and forecasting might be for an hour or so ahead, perhaps even a week if long-term - the value of high-frequency forecasts decay rapidly as the information that produced it is disseminated.
Counterpoint
Smart as it is, there are times when the approach of Olsen and his colleagues has failed to work. Like other more simple 'data mining' and historically based methods, it works in periods when currency movements are following a trend but gets 'whipsawed' with penalizing transaction costs in trendless markets. And during a change in the trend, O&A might identify a turn but not know the difference between a minor and a major turn.
Yet this group comes closer to modeling how the foreign exchange world really works than others. When there are new academic insights, they are likely to note them early.
A broader social counterpoint to today's forex markets is that with this daily volume of electronic, invisible money flowing throughout the world, a single nimble trader can drive a monetary institution to the wall. A trader is often compensated by a share of the trading profit, which can put tens of millions into his or her pocket. The trading institution takes the risk and the trader takes the profit: a true asymmetrical payoff scheme operates to pyramid risks. A central bank seeking to dampen its currency swings may come forward with a few billion but this is typically something that a single trader could command. In these circumstances, a central bank attempting to influence a currency is like sending a bicycle onto a superhighway.
The size of forex trade has played its part in the series of currency crises in emerging nations during the 1990s. The capacity for massive daily foreign currency flows to take place made possible the almost overnight collapses of the currencies of Thailand, Indonesia and Russia in 1997-8. As confidence in the economies of these countries fell away, demand for their currencies dried up as investors took their capital out or stopped bringing it in. Governments had tried to buy their own currencies to underpin their value but could not keep up with the sellers. When they stopped their own forex activity, the forces of demand and supply saw the baht, rupiah and ruble in turn crash in value, deepening the crisis of confidence and economic slowdown.
Some commentators are now recommending a tax on forex dealings: for example, Nobel Laureate James Tobin has warned that free capital markets with flexible exchange rates encourage short-term speculation that can have a 'devastating impact on specific industries and whole economies'. To avoid this real economic havoc, he advocates a 0.5% tax on all foreign exchange transactions in order to deter speculators, a remedy dubbed the 'Tobin tax'.
There are three rationales for the proposed Tobin tax: the first is that the volume of foreign exchange transactions is excessive - fifty to a hundred times greater than that required to finance international trade; the second is related to the first - reducing volatility offers more independence to national economic policy-makers; and the third is simply the tax-raising abilities of such a tax, which is linked with the view that the financial sector is relatively undertaxed.
Guru response
Richard Olsen comments: 'People fail to realize the importance of forex markets to support the globalization of the 'investment business'. Relative to trade flows, investments across borders have increased much more dramatically. The forex markets have to be able to accommodate the demands of these international investors, who want to sell their foreign holding at a moment's notice. Even though the forex markets have grown, the growth has been insufficient to support the requirements of an international investment community.'
'The introduction of electronic transaction systems has speeded up transactions in forex dramatically during the past six years. There is a side effect that has been neglected by many of the commentators. Similar to the money multiplier, there is a 'market liquidity multiplier'. If the efficiency of the transaction system increases, then transactions are settled much more quickly. This has the effect that liquidity dries up much more rapidly than in the past.'
'My inference is that today's forex markets are far too small to support our globalized financial community. The effect will be erratic price movements, as we saw on 7 October 1998 with the 20% shift in the dollar-yen exchange rate.'
'The introduction of the euro will make things worse. I think that we have to look at the euro as a merger of the European countries. Europe will thus become like one big football stadium with a strong US counterpart. The world will thus have two big football stadia. The stadia need wide roads, that is, highly liquid forex markets. Unfortunately, the new dollar-euro exchange rate will not be sufficiently liquid to absorb the large shifts of capital that will occur between the dollar and the euro.'
'Professor Amartya Sen, who received the 1998 Nobel prize for economics, explained in great detail that starvation is not a problem of a lack of food, but deficiencies in the distribution system. We face a similar situation with the financial markets, where the fundamental economy is in satisfactory shape, but the 'allocation system', that is, the financial markets and in particular the forex markets and the balance sheets of the banks, are in deep trouble.'
Where next?
Currency attacks are becoming a depressingly common feature of the global economy. But the exact timing of the onset of an attack is notoriously difficult to predict. Richard Olsen has developed a global financial early-warning system, which tries to do the same thing as a gadget that tells someone when they are getting their next heart attack.
He comments: 'We have been looking at the data now for many years and we have learned a lot about what really makes a market function successfully. And, most importantly, how the components within the market - that is, the market makers, the medium and long-term investors - interact, and what is required to build a healthy market or, in reverse, what leads to a negative market with large-scale shocks.' For obvious reasons, such a system would be of immense interest to regulators and speculators.
The core determining factor of a currency's value is the health of the real national economy, especially the balance of payments current account. If there is a surplus on the current account, that is, a country sells more goods than it buys, then buyers have to acquire that currency to purchase goods. This adds to foreign reserves and bids up the price of that currency. Conversely, a current account deficit implies the need to sell the local currency in order to acquire foreign goods. Persistent current account deficits, particularly if allied with relatively low foreign reserves, indicate a problem.
A currency's value is also affected by levels of inflation and the domestic rate of interest. High rates of interest and low inflation make a currency attractive for those holding assets denominated in it . So typically one country raising interest rates while others remain the same will raise the value of its currency as money flows into the country. This will have a limited effect if the 'fundamentals' are wrong.
Comparative inflation rates, interest rates and balances of payments will all give clues to likely medium term movements of a currency. But a key factor determining short- term currency values is market sentiment. There can be a self-fueling process in which enthusiasm for a currency, or the lack of it, drives the exchange rate. Speculators might decide, as they did during the European Monetary System debacle of 1992-3 and the Asian and Russian crises of 1997-8, that a currency is overvalued or simply that there are speculative gains to be made by selling it.
Currency attacks are triggered when a small shock to the fundamentals of the economy is combined with systemic weaknesses in the corporate and banking sectors. One facet of such systemic weaknesses is the effect of belated hedging activity by some economic actors in the economy whose currency is under attack. The more these actors try to hedge, the greater is the incentive for others to follow suit. This unleashes a whiplash effect, which turns a potentially orderly depreciation into a collapse of the currency. In other words, if speculators believe a currency will come under attack, their actions will precipitate the crisis; while if they believe the currency is not in danger, their inaction will spare it from attack - attacks are self-fulfilling.
The magnitude of the shock necessary to trigger an attack need not be large, which makes predictions very difficult. Nevertheless, it is possible to draw some broad conclusions on the vulnerability of currencies to attack. In particular, there must be a pre-existing weakness, which will prevent the authorities from conducting a full-fledged defense of the currency by raising interest rates. The weakness may not be lethal in itself (though it can become lethal once the situation deteriorates) so it is a necessary condition but not a sufficient condition for a speculative attack.
Self-fulfilling attacks may affect any country - with a fixed exchange rate and high capital mobility - that is in the gray area between 'fully safe' and 'sure to be attacked'. Recent research suggests that countries with strong trade links with a country that has recently experienced a currency crisis is highly likely to face an attack itself - the growing phenomenon of contagion in foreign exchange markets.
Read on
Online
www.forex.co.uk - a website called Forex Watch, which has a mass of charts and technical analysis of currency movements
www.olsen.ch and www.oanda.com - the websites of Olsen and Associates
posted by Eastlaw at Friday, April 22, 2005
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