Exchange rate movements as explained by dealers

Economic Papers (Economic Society of Australia), Sept, 2003 by Tiffany Hutcheson

1 Introduction

Theoretically, the value of a currency is determined by the economic fundamentals of its country, such as interest rates, inflation rates and national income. These fundamentals have an effect on trade and capital flows and hence the demand and supply of the currency. However, there have been many well-known episodes when real exchange rates have moved contrary to these fundamentals for lengthy periods of time (Krugman, 1989). Attempts using empirical models to test economic fundamentals as a basis for predicting exchange rate movements have not been very successful especially over the short run (Taylor, 1995). Furthermore, market practitioners have successfully developed and implemented profitable trading strategies, which do not rely on economic fundamentals. One reason for the poor performance of trading activities based on fundamental analysis could be the behaviour of practitioners trading in the foreign exchange market (Krugman, 1989). For example, some practitioners may trade tactically in a way that forces an exchange rate to move away from its fundamental value. These practitioners would then establish a currency position that becomes profitable once general market trading moves the exchange rate back towards its true value (Rankin, 1999).

To gather information on the factors influencing traders, dealers in the Australian foreign exchange market were asked to complete a questionnaire survey. Their responses can be used to gauge the degree to which economic fundamentals influence the trading behaviour of dealers and hence exchange rates. As the majority of currency trading occurs through dealers, they are an ideal group to survey (Carew and Slayter, 1994). In order for their trading to be profitable they need to pay attention to any factor or event they consider will influence exchange rates. Consequently their responses can be used to obtain information on the relative importance dealers place on various factors considered to influence exchange rates. This information will contribute to the continuing debate on exchange rate determination. It may identify areas other than those previously studied, such as purchasing power parity, which could be researched in order to provide additional explanations for exchange rate movements.

The survey also included questions on the market's trading environment, such as the use of electronic broking, bid-ask spread size and the degree of competition in the market. The dealers' responses to these questions were analysed in an earlier paper (Hutcheson, 2001).

The paper is organised as follows. The preparation of the survey questions and the collection of the survey data are discussed in part two. The impact of changing economic fundamentals on exchange rates is investigated in part three while the influence of non-fundamental factors, impact of economic announcements and predictability of exchange rate movements are analysed in parts four, five and six respectively. Part seven contains some concluding observations about the survey responses.

2 The Survey Data

Each of the institutions licensed by the Reserve Bank of Australia, as at 12th July 1999, to deal in foreign exchange received a copy of the survey. A high response rate was achieved with 39 of the 59 surveys mailed out being completed and returned (1). Consequently, the survey responses should be representative of the views of the majority of dealers trading in the market. As explained in an earlier paper on this survey, most of the survey respondents held senior positions in the foreign exchange section of their institution's treasury department (Hutcheson, 2001). The comprehensive knowledge and market experience of these respondents should ensure the survey responses are a fairly accurate description of events in the market.

Survey data has been used in the past to obtain feedback from foreign exchange dealers (2). Some of the questions used in this survey are based on questions included in surveys undertaken by Cheung, Chinn and Marsh (1999), Cheung and Wong (2000) and Cheung and Chinn (2001). However, the questions are asked in a different way to the other surveys. Consequently, it is difficult to directly compare the responses to all the similar questions across the surveys.

3 Fundamental Movements in Exchange Rate

Market participants known as fundamental analysts adopt the notion that exchange rate movements are determined by the economic fundamentals of the countries represented by the exchange rate. They argue that the market regards a currency, as being under or over valued if it does not reflect these fundamentals thus creating a profitable arbitrage opportunity. In a floating exchange rate regime, where central banks do not intervene, arbitrageurs would buy undervalued currencies and sell overvalued currencies. This trading would force the currency's value to move quickly back towards its true value (Neely, 1997). According to fundamentalists if all currently available information on economic fundamentals is correctly priced into an exchange rate it will only change when new information becomes available.