The Foreign Exchange Market
Even the casual stock market
observer is by now aware that many investors and traders
believe the foreign exchange market is playing a role in the
current unsettled conditions.
But what is the foreign exchange
market, and why should the value of the Yen or the Euro
vis-ý-vis the Dollar have any influence on the price of a
share of stock on U.S. stock exchanges?
Although we usually think of money
in terms of what we can buy with it, money too is actually a
commodity. People who have extra money lend it to others who
need it. The price for this money is what we refer to as
interest rates. In the international arena there is an added
dimension, namely, What is the value of one currency
relative to that of another country. This relationship is
what is referred to as the exchange rate.
If the Toyota Motor Company can
produce a car for export in Japan at a cost of 2,000,000
Yen, how much does that car cost in U.S. dollars? If the
exchange rate for Yen/U.S. Dollar is 200.00 yen to the
dollar, the car would have to cost $10,000 at the factory
for the Toyota company to realize its costs.
Assume the traders, bankers,
businessmen and speculators that comprise the foreign
exchange market, determine for some reason that they are
uncomfortable with the current Dollar/Yen exchange rate.
They believe the Yen is undervalued allowing the country to
export vast quantities of cars at very attractive prices. On
the other hand, foreign goods are unattractive to Japanese
consumers because they seem rather expensive in Yen terms.
As a result, Japanese ownership of dollars increases
rapidly. But with few outlets for these dollars an imbalance
develops and supply exceeds demand. Japanese become less
willing holders of the U.S. currency.
In effect, the market place should
now operate to try and find a level at which equilibrium
returns. The value of the dollar should begin to decline in
yen terms, thereby providing the owner of dollars with less
yen for each unit of currency. If the rate now adjusts to
100 yen per dollar, what in effect the market has
accomplished is that the price of the Toyota has suddenly
doubled to $20,000 which should reduce the number of cars
exported to the U.S. At the same time, the fact it now takes
only 100 yen to buy a dollar should also encourage the
Japanese to import more, cheaper goods from the U.S.
According to the textbook examples,
that is exactly what would be expected to happen. Americans
would cut down their purchases of suddenly expensive
Japanese cars and electronic equipment. For their part,
Japanese consumers would be greatly increasing their imports
of cheaper U.S. products. As a result, the currency will
find a new equilibrium point and a crisis is averted.
Of course nothing in life is that
simple, and there is also much human intervention in the
process which injects other considerations in the
determination of exchange rates. In actuality, one of the
major forces for smoothing imbalances in foreign exchange
markets is investments. Rather than seeking to balance
exports with imports, in the case of developed economies the
surplus will almost immediately be invested into securities
of the debtor country. Japan, which consistently enjoys
major trade surpluses with the United States, as a result
sits on dollar reserves in the billions. To realize some
return on these funds and also to recycle them in the
international market, Japan is a major investor in U.S. bond
and equity markets.
As long as there is relative
stability in the exchange rate environment, Japan or any
other country in its position, is relatively comfortable
with its investments. They earn a reasonable rate of return
and with stable foreign exchange rates, there is limited
However, in an unsettled
environment, such as currently exists, Japanese investors
suddenly have to fear losing not just capital gains
potential, but damage to their core investments resulting
from deteriorating foreign exchange values. Naturally, such
large shifts in currency valuations gives vent to anger,
frustration and of course the need to stem the losses and
This raises the specter of Japanese
selling of U.S. holdings or at least curbing any new
investments. For a market that has been enjoying a great
bull run, such as the U.S. equity market, the prospect a
major source of capital will be leaving the market and even
possibly begin selling, is a most unwelcome development. As
the dollar continued to wither in recent sessions, without
any firm Bank of Japan commitment to support the dollar, the
equity market reacted as if it were under direct attack and
was running for cover.
The system that presently governs
foreign exchange rate levels is known as a "floating
exchange rate system". In theory this means that the
relationships between different currencies is determined by
the interplay of the market place.
(It should be pointed out that the
currency market differs from the conventional investment
vehicles inasmuch as a currency rate can only exist in
relationship to another currency. An equity investment has a
self contained price based upon what its long-term value is
deemed to be. A bond carries a rate of interest that,
depending upon whether it is above or below current market
levels, will affect the value of the bond. However, a dollar
in the foreign market can only be valued in terms of how
many Yen or how many Euros it can buy.)
Today we take floating exchange
rates in stride. However, it was not always that simple. In
fact in historical terms, floating rates are a relatively
new phenomenon. Until the watershed changes in 1971 the
world operated with fixed-exchange rates. The world’s
central bankers would hold periodic meetings to review these
relationships and decide if any adjustments were needed. In
those days, gold ruled and in theory at least, nations that
ran trade deficits and were unable to support their currency
by buying them back, could be called upon by the creditor
country to cover the shortfall by a transfer of gold
Countries that wanted to improve
their international trade position or could not cover the
deficits with gold, would have to devalue their currency to
make it more attractive to prospective buyers. Of course
those that held the currency during devaluation, were the
With floating rates, such changes
in value can happen over a period of time and interested
parties have the opportunity to hedge against any expected
or unexpected changes in value. Convertibility into gold is
now but a fond memory.
Of course, as even a casual perusal
of financial news reports will quickly reveal, floating
exchange rates do not mean that countries do not exert, or
at least try to exert, some pressure on the movement of
rates. In fact central banks have an intricate web of swap
agreements with each other that is used when there is a need
for a concerted, coordinated effort to support a currency.
So perhaps it is best to classify the foreign market as a
qualified free floating system.
From a trading perspective, the
foreign exchange market is probably the largest
international trading arena, with daily activity in the
hundreds of billions of dollars. The heart of the market is
the international interbank network which consisted largely
of worldwide telephone trading between bankers and foreign
exchange dealers. Through vendors such as Reuters Ltd. much
of this global dealing has been automated and various
position keeping systems allows dealers to more efficiently
monitor their positions and profit and loss statements.
What adds to the complexity of the
market, but also to the efficiency of the global network, is
the arbitrage that is possible between currencies. As
mentioned earlier, a currency value can only be expressed in
terms of its relationship to another currency. Therefore,
there is a rate for dollar/yen and another rate for
dollar/euro. Separately there is a value for euro/yen. It is
possible in active market conditions for anomalies to occur
that offers the opportunity for profit by buying yen for
euro, then trading the euro for dollars and then covert the
dollars into Yen. It is the efficient arbitrage activity
that is key to keeping the market in equilibrium.
The major use of the foreign
markets is to facilitate international trade. Companies that
produce goods in one country but sell to another, have their
expenses in one currency but may receive payments for their
merchandise in another currency. Through the foreign
exchange market, the company can lock in an exchange rate at
a future date, corresponding to the time he expects payment.
In addition to the mammoth
international inter-bank market, there are very active
futures markets in a host of currencies that enable
companies and individuals to engage in all forms of hedging
strategies. There are also well established option exchanges
that lend even greater flexibility to the eliminating risk
in international transactions.
It is the ability of those engaged
in international trade to buy all this protection against
adverse currency movement that has facilitated the growth of
trade and also limits the negative impact that could affect
a country with a trade deficit.
As with any investment vehicle, its
worth is dictated by the valuation the market places on it.
This is of course a very empirical exercise in the case of a
currency since there are an untold number of variables that
one would need to consider.
However, there is a theory for rate
setting or rate relationships that is called "purchasing
power parity". This valuation method says that rate
relationships for currencies should be based on the ability
to purchase equal amounts of goods and services for fixed
amounts of currency. In simple terms, if a loaf of bread
cost $1 in the U.S. and 200 Yen in Japan, then the exchange
rate should not be 106 Yen to the dollar but closer to 200.
Whereas this theory does play some role, there are so may
political and special factors at play in this highly
sophisticated arena that all intrude on the pricing
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