Exchange rate movements as explained by dealers

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

Excessive speculation has been one of several trading strategies adopted by a recently developed type of investment vehicle known as hedge funds. Hedge funds are typically made up of a group of wealthy investors who employ a manager to achieve the maximum return in particular asset classes. As managers are generously rewarded for their achievements, they can choose to adopt aggressive trading strategies (Chicago Mercantile Exchange, 1995). In foreign exchange markets hedge funds have been known to gradually build up very large positions in particular currencies and then reverse these positions rapidly. If their reversal generates excessive exchange rate movements they are able to earn large profits. By building up the positions gradually their impact on exchange rates is only really felt when they reverse their positions. However, only a small number of hedge funds are large enough to create market positions sizeable enough to generate such movements (Reserve Bank of Australia, 1999).

The survey respondents would have recently experienced the destabilising impact of hedge funds on the Australian dollar in mid 1998. Between December 1997 and March 1998 hedge funds were said to have built up large short positions in the Australian dollar using borrowed funds (Rankin, 1999). During this period the Australian dollar was already experiencing a downward trend following the unfavorable impact of the Asian crisis on Australia's trade and capital flows. Consequently, the effect of hedge funds selling the Australian dollar went largely unnoticed. However, as the Australian dollar approached US60 cents, hedge funds began to sell more aggressively and generated uncertainty among other currency traders about what exchange rate the Australian dollar should trade at (Rankin, 1999). Significant Reserve Bank intervention was required in early June 1998 to stop this aggressive selling from continuing (Reserve Bank Bulletin, 1998).

While the respondents do not unanimously support speculation as a stabilising force, most of them felt it increased exchange rate volatility and improved market efficiency and liquidity (see Table 3). The increased volatility can be partly explained by speculators adopting trading strategies differing from those of other market participants. That is they could be buying or selling currencies at a time when other market participants are trading in the opposite direction or not trading very actively. The ability for speculation to improve market efficiency can be accounted for by the tendency for speculators to commence trading when they perceive that current and expected market fundamentals have not been correctly priced into the existing exchange rates (Blundall-Wignall et al., 1993). They will then trade in a manner that forces a currency's value to change until it reaches its true value. This increase in efficiency could also be accompanied by increased market liquidity as previously inactive dealers and dealers who normally trade for other reasons will enter the market to profit from the impact of speculative trading on the exchange rate.