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.
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.
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.
4.2 Intervention by the Reserve Bank
Central banks intervene in foreign exchange markets if they consider volatility to be excessive or currencies to be under or overvalued. In Australia the timing and size of the intervention undertaken by the Reserve Bank has varied across several periods since the Australian dollar was floated in December 1983 (Andrew and Broadbent, 1994). This variation has been due to a wide range of factors such as the severity of exchange rate volatility being experienced and how the intervention will affect other government policies. However, whatever the reason for the intervention most of the respondents feel that the Reserve Bank normally intervenes at the appropriate moment with only 14.3% feeling that its timing has been inappropriate (see Table 4). In recent years the Reserve Bank has seen the need to intervene several times. However, prior to 1997 the Reserve Bank had not intervened since November 1993.
72.7% of the respondents feel that Reserve Bank intervention has been successful in moving exchange rates towards their fundamental values. In fact, 76.55% of the respondents believe that Reserve Bank intervention achieves its goals. These responses support a study undertaken by Andrew and Broadbent (1994) on the effectiveness of Reserve Bank intervention. They argue that intervention will be successful if the Reserve Bank makes a profit from supporting a depreciating Australian dollar by buying at low exchange rate levels and an appreciating Australian dollar by selling at high exchange rates. Their study found that the Reserve Bank's foreign exchange operations had been profitable over most of the periods when intervention was taking place. While the Reserve Bank's trading on behalf of its clients, principally the Commonwealth Government, may have generated some of this profit, the continued finding of profitability over long periods does lend some support for judging intervention to be successful.
The respondents are equally divided on the impact of Reserve Bank intervention on volatility with 50% feeling it decreases volatility and 50% feeling it increases volatility. This appears to be contradictory to the notion that successful intervention should be stabilising. However, volatility is more likely to decrease over the long term, as successful intervention begins to calm down market behavior (Andrew and Broadbent, 1994). On the other hand intra-day volatility would increase when dealers did not correctly anticipate the intervention undertaken by the Reserve Bank, as they would now need to trade out of their current market positions.
5 Impact of Economic Announcements
Whilst the survey respondents maintain that changing economic fundamentals mainly have an impact on long-term exchange rate movements. Unexpected economic announcements made by governments can influence intra-day exchange rate movements. When determining a currency's value market participants will take into consideration the existing and expected economic fundamentals of the currency's country. So when government announcements of the actual fundamentals differ from market expectations, dealers will trade in a way that causes exchange rates to change, if dealers do not react before or at the same time as other dealers any profitable opportunity that exists will be traded away. Several studies using intra-day data have concluded that new economic announcements take only a few minutes to have an impact (Almeida et al., 1998; Kim, 1998). Table 5 reveals that dealers tend to react within less than a minute when announcements from the major developed countries on domestic inflation, unemployment, trade deficit, current account, interest rates, retail sales and gross domestic product differ from what was expected.
Several respondents claimed that in Australia the Australian dollar/United States dollar spot market reacted instantaneously to announcements by the Australian government whilst the reaction time in other spot market currency pairings was more delayed. The market also did not react as quickly to announcements made by countries other than Australia. This may be partly because the overseas announcements, such as announcements from the United States of America, are made while Australian financial markets, other than the market for foreign exchange, are closed. Consequently, foreign exchange dealers may not fully adjust their trading position until they see the response to the announcements from other Australian financial markets when they open the following day (Kim, 1998). For example, dealers may wait to see how the domestic market for interest rate securities responds to changes in overseas interest rates.
Respondents are asked to select the economic announcement from Australia and the United States of America that they consider has the biggest impact on the Australian foreign exchange market. Table 6 shows that five years ago respondents regarded interest rate announcements made by the Reserve Bank of Australia had the biggest impact followed by announcements on the current account, inflation and then trade balance. Today interest rate announcements still have the biggest impact but inflation and unemployment and then the current account and trade deficit now follow it. The strong support for interest rates announcements is expected as the direction and magnitude of international capital flows is affected by changes to relative interest rates between countries. A reason for dealers providing greater support for inflation announcements today than they did five years ago could be due to their growing concern about the ease in which the direction of international capital flows can change. The sudden capital reversals experienced by several Asian countries in the late 1990s made dealers aware of the speed in which the direction of these flows can change. As the Reserve Bank of Australia will place upward pressure on interest rates when inflation increases
above a target range, changing inflation can be seen as a factor influencing capital flows (Reserve Bank of Australia, 1996). Consequently, dealers expect international capital flows will be fairly responsive to announcements of higher inflation. There is still a close link between the current account and trade balance and the Australian dollar, as the majority of Australian exports are commodities priced in foreign currencies (Gruen and Kortian, 1996). Consequently, changes to world commodity prices affect export revenue and hence exchange rates.
Of the announcements covering economic conditions in the United States, the announcements that have the biggest impact on the Australian foreign exchange market today as well as five years ago are those for interest rates and employment. Current account and trade deficit announcements from the United States have very little impact, as they are not seen to be strong indicators of economic and financial conditions in the United States.
6 Predictability
The ability to successfully predict exchange rate movements has been questioned by both academics and dealers. In Table 7 the respondents give very little support for exchange rate movements being either always predictable or never being predictable. The majority of respondents felt that if anything they were more likely to be sometimes predictable. They give slightly more support for intra-day exchange rate movements being sometimes predictable than they do for periods of less than six months and periods longer than six months.
Although the respondents do not regard exchange rate movements as being very predictable, they do believe that several factors can be identified as having a major influence on exchange rates depending on the time horizon in question. In Table 8 respondents maintain that intra-day exchange rate movements are mainly determined by order placements followed by over-reaction to news, speculative forces, bandwagon effects and technical trading. The confidential nature of inter-dealer trades makes it very difficult to obtain data on the volume and price of individual trades. Consequently, the disclosure by respondents that order placements have a major influence on intra-day exchange rate movements indicates that studies of order flows should be able to reveal information on trading behavior.
However, as the time horizon increases the respondents indicate that economic fundamentals have a growing impact on exchange rate movements while the other factors become less significant, particularly over periods greater than six months. Order placements and over-reaction to news only seem to have an impact on intra-day exchange rate movements. Speculative forces and bandwagon effects, where dealers adopt the trading trends of other dealers, have the same degree of impact intra-day and over the medium run. Technical trading, which involves historical exchange rates being used to forecast future trends in exchange rate movements, has its greatest influence on medium run exchange rate movements. However, unlike economic fundamentals, technical trading has little impact on long-run exchange rate movements.
7 Conclusion
This paper analyses the responses provided by Australian foreign exchange dealers to a questionnaire survey on the factors influencing exchange rate movements and hence trading behavior. Dealers will have experienced periods when exchange rates movements were regarded as being normal as well as circumstances deemed to be irregular. Consequently, their responses to the survey questions should be able to provide information on the factors generating movements in exchange rates. While the dealers do differ in their responses to several of the survey questions, a majority response was recorded for most of the questions.
The survey respondents do agree with the theoretical argument that exchange rate movements can be explained by changing economic fundamentals. However, they believe this explanation holds mainly over the longer term. Although when announcements of Australian economic fundamentals are different from what the market expected, dealers are seen to react within less than a minute to correctly price the anomaly into current exchange rates. The economic announcement having the biggest impact both today and five years ago is interest rates.
Speculative behaviour is regarded to be the main factor that prevents exchange rates from reflecting their fundamental value. However, there was no unanimity among the respondents on whether or not speculation was a stabilising force. In fact speculation was seen to both increase exchange rate volatility and improve market efficiency. Excessive intervention by central banks also received considerable support as a factor behind non-fundamental exchange rate movements. Intervention by the Reserve Bank of Australia tends to successfully move exchange rates towards their fundamental value and is conducted at the most appropriate time, according to most respondents.
The respondents did not feel that speculative forces fully explained intra-day exchange rate movements. Factors considered to have a greater influence on moment-to-moment movements in exchange rates were order placements by clients and overreaction of market participants to events. Technical trading was considered to make an impression on medium term exchange movements.
Whilst this survey has been able to identify factors respondents believe influence exchange rate movements, it also found that most of the respondents do not feel that exchange rates can be accurately predicted. In fact they see exchange rate movements as being only sometimes predictable over all time horizons.
No comments:
Post a Comment