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 currency risk.

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 recoup.

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 reserves.

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 real losers.

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 models.