Exchange rate movements as explained by dealers

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

Regrettably daily and intra-day exchange rate movements are not well explained by fundamental analysis (Singleton, 1987). In fact there have been times when it has appeared as though dealers have simply disregarded economic fundamentals and are merely overreacting to news and rumours (Shleifer and Summers, 1990). As shown in table 1 the majority of respondents believe that intra-day exchange rate movements do not reflect changes in the fundamental value of an exchange rate. They feel that changing fundamental values are reflected a lot more in the movements that occur within a period of six months or greater. These responses reinforce the finding from other surveys that fundamental analysis became more important as the time horizon increased (Taylor and Allen, 1992; Cheung, Chinn and Marsh, 1999; Cheung and Wong, 2000; Cheung and Chinn, 2001).

4 Non-Fundamental Movements in Exchange Rate

The respondents indicate in Table 2 that excessive speculation and manipulation by hedge funds are the main factors preventing exchange rates from reflecting their fundamental value. Excessive intervention by central banks was the next most heavily supported factor while views taken by major trading banks and slowness of dealers to respond did not receive as much support. Whilst speculation has for some time been seen as a force that can potentially destabilise exchange rate movements, only in recent years have hedge funds been one of the factors held responsible for unpredicted swings in exchange rates.

Cheung and Wong's (2000) survey on dealers trading in Hong Kong, Tokyo and Singapore and Cheung and Chinn's (2001) survey on dealers trading in the United States also found that excessive speculation and hedge fund manipulation were regarded to be the major forces behind exchange rate movements.

4.1 Speculation

It has been argued that speculative forces can destabilise currencies and prevent them from reflecting a country's economic fundamentals (Neely, 1997). However, as shown in Table 3, the survey respondents do not unanimously support speculation as a destabilising force with 55.6% indicating that speculation mainly moves exchange rates towards their fundamental value while 44.4% indicate that it moves them away. This is consistent with the finding by Cheung and Wong (2000) for the Hong Kong, Tokyo and Singapore markets. On the other hand 70.67% of the respondents to Cheung and Chinn's (2001) survey of United States dealers considered speculation to be a force that moved exchange rates in the direction of their fundamental values.

The stabilising nature of speculation arises because speculators buy currencies whose value they expect to increase and sell currencies whose value they expect to decrease. When a currency's value moves in the expected direction the speculator will reverse their currency position and profit. As speculators reverse buying positions when exchange rates are increasing and reverse selling positions when exchange rates are decreasing, you would expect their trading to offset large upward and downward pressures on the value of a currency. However, there have been several speculative episodes since currencies began to be floated in the 1970s when excessive speculation has been blamed for driving exchange rates away from their true values. During these episodes exchange rates increased or decreased by more than was supported by economic fundamentals (Krugman, 1989). In particular the exchange rate movements did not support the relationships between exchange rates and changing relative inflation rates and interest rates between countries as explained by purchasing power parity and uncovered interest parity respectively. In other words it was the speculative trading that was causing the exchange rate to move rather than changing market fundamentals. Consequently, when speculators eventually reversed their position it was some time before exchange rates moved back towards their true value. Particularly if dealers who did not normally speculate started to imitate the trading behavior of speculators, a phenomenon known as herding behavior, without regard to whether or not their behavior is supported by economic fundamentals (Banerjee, 1992). It would take these dealers longer to reverse their positions than the large speculators and so exchange rates would continue to be driven away from their true value.