Forex dealers' perspectives on exchange rate determination in Korea

Economic Papers (Economic Society of Australia), June, 2004 by Changmo Ahn, George Fane, Euy-Hoon Suh

Empirical evidence for the self-fulfilling nature of technical trading in various foreign exchange markets is given by Frankel and Froot (1990) and by Taylor and Allen (1992). 'Herding', defined as doing something because others are doing it, can make the use of technical analysis self-fulfilling. Ahn et al. (2002) argue that excess demand or supply that is not cleared within the market can easily cause herding behaviour in a thin market like the one in Korea. Another explanation for herding behavior is following the advice of opinion leaders, that is persons or organizations that are believed to have better information about future price developments than other market participants. It is well known that in the US stock market many investors follow the advice of opinion leaders such as Merill Lynch, or of individuals like Joe Granville (Shleifer and Summers, 1990, p. 24).

There have been several surveys of forex markets to examine their microstructure, or dealers' views on how they behave. However, these surveys are mainly for highly developed markets such as UK (Taylor and Allen, 1992), USA (Cheung and Chinn, 1999), Germany (Menkhoff, 1998) and Australia (Hutcheson, 2001). Our survey was designed to provide a better understanding of the trading strategies of dealers, and the information that they rely on, in the relatively underdeveloped Korean forex market. (1) In particular, it examines:

* the relative importance of fundamentals, defined as a list of variables (see Section 3 and Table 3) found in mainstream macroeconomic models of exchange rate determination, and of apparently non-fundamental factors such as technical analysis, market sentiment and dealers' established positions;

* the limits to arbitrage and the unpredictability of the exchange rate when expectations are not fully rational; and

* the role of speculation and central bank intervention.

2 Overview of the Sample of Dealers Surveyed

A survey containing 24 questions was mailed to all active forex dealers in the Korea Forex Club to collect their views. The questions asked were similar to those asked by Shiller (1989), Taylor and Allen (1992), Cheung and Chinn (1999) and Menkhoff (1997, 1998). As a first step, we checked the relevance of the questionnaire to the Korean forex market after consultation with experienced foreign exchange dealers at the Bank of Korea and at the Korea Exchange Bank.

Most of the professional foreign exchange dealers that participate actively in the market are the members of the Korea Forex Club, which was established as a means for exchanging information and promoting friendly relationships among participants in the forex market. Although there are some forex dealers who are not the members of this club, their trading volume, trading frequency and influence on the market are reliably reported to be negligible. Consequently, the coverage of dealers for the survey was restricted to club members. As of August 2001, the Korea Forex Club consisted of 166 members from 46 banks. However, the questionnaire was sent only to the 136 members that are active dealers; of these active dealers, 71 work for domestic banks and 65 for foreign banks. Of the 30 members omitted from our survey, 24 are high-ranking executives who do not themselves participate in currency trading and 6 are employees of the two brokerage firms. Of the 136 questionnaires sent out, 69 were completed and returned. This constitues a relatively high response rate of 53.1 per cent.