6-minute read
The Foreign Exchange (FX) market is the world's largest and most liquid market, with a daily trading volume last measured at $6.6 trillion (in the triennial BIS survey, 2019) – and it's growing!
The basic purpose of the market is, of course, to facilitate currency conversion, but there are many reasons why one currency would need to be converted into another, and there are vast numbers of participants in the FX market, each with their agenda.
Who's Trading?
The FX market is classified as "Over The Counter" (OTC), meaning it exists through a series of decentralised networks and relationships as opposed to a formal 'exchange'. Some of the most significant market participants are:
- Dealers: including banks and non-bank firms that act as a counterparty to buyers and sellers, providing liquidity to the market. Inter-dealer FX trading accounts for nearly half of all trade flows
- Brokers: less common in the traditional sense, whereby a broker would bring together buyers and sellers, but increasingly common in the form of Prime Brokerage through an e-FX service, whereby the Broker allows its clients to transact using its trading lines with a range of executing dealers
- Commercial Companies: that have an underlying need to trade generated through the course of their business operations. This is typically through import or export activities or via assets or liabilities in foreign currencies, such as loans or group undertakings
- Speculators: traders in the market without an underlying need to transact; rather they aim to generate profit through buying and selling currencies. Retail trading, that is individual traders, makes up a minuscule proportion of total FX volume (perhaps less than 1%), but is becoming increasingly popular
- Central Banks: a critical part of the market, central banks operate to manage foreign currency reserves, intervene to control the value of their currency, and to transact between other central banks
- Money Remittance Firms: non-bank financial institutions that process payments and currency conversions on behalf of individuals and companies
Within the above list of participants, we can also add arbitrageurs, hedge funds, sovereign wealth funds, investment firms, and many others. But you get the idea that it's a big market with lots of players with varying motives...
Supply and Demand?
There are numerous natural and inherent reasons why one country's currency will appreciate or depreciate over time. Short-term changes in FX prices are mostly due to speculative or opportunistic trading activity, largely in response to developments in the economy or other financial markets.
Let's first consider some of the underlying factors that will naturally change the demand for a currency over the medium and long term:
- Interest Rates: simply, higher interest rates attract investment and therefore creates demand for the currency
- Central Bank Intervention: exchange rates can be manipulated by central banks in order that a target rate or band is maintained. They do this to stabilise prices and ensure favourable conditions for trade
- Inflation: higher inflation weakens the currency as it reduces its purchasing power, moreover exports are less competitive which reduces demand and further weakens the currency
- Trade Balance: when a country has higher exports than imports it has a positive trade balance, meaning it generates foreign exchange reserves and there is greater buying demand for its currency
- Public Debt: Governments finance public sector spending through debt. High debt levels can lead to inflation, and in a worst-case outcome may trigger a default.
- Economic Performance: Investors will favour a country with stable and strong economic performance, leading to foreign investment
- Political Stability: A stable and accommodating political regime will be attractive to overseas investors, leading to demand for the currency
As we can see, the primary, long-term, intrinsic reasons for a currency to change in value relate to the naturally shifting demand to buy or sell the currency. High inflation or public debt doesn't happen overnight, but confidence, market sentiment, and speculative trading can be triggered in a moment. An economic data release might be the trigger for a currency to gain or lose value based on the potential future economic performance of the country. These second-by-second reactionary price changes might seem fickle, but consider a picture being built over time.
Additionally, there are technical reasons for a currency to change in value. These include trading around specific "fixing" times, the expiry of currency options contracts, and month-end currency flows.
The Narrative, Randomness, and Efficiency
Humans are preconditioned to look for the story, the reason something happened – the narrative! Sometimes there are obvious triggers, such as a central bank decision or a major economic data release, but other times it seems that prices have moved almost randomly.
That's an interesting idea, randomness, and it's central to the random walk theory which suggests that financial asset prices cannot be predicted, that prices move randomly, and that technical analysis (the use of chart patterns and other indicators) is undependable.
Within the FX market, because of its size and interconnectedness with all other global financial markets, there is certainly an element of randomness that comes into play on occasion.
Harry Mills, Founder & CEO, Oku Markets
Accurately ascribing a price change to one individual event or factor can be difficult or impossible, especially when the market is influenced by a nearly endless number of factors and actors! One of our favourite responses to a question as to why the price has changed is simply "more buyers than sellers."
Another widely adopted theory is that financial prices fully demonstrate all available information and expectations. This is known as the efficient market hypothesis, and it suggests that prices always trade at fair value and that outperformance is therefore impossible.
Currencies can be valued in many ways, and it's not uncommon for a currency to be under- or over-valued according to, for example, Purchasing Power Parity (PPP) measurement, for long periods due to other factors. Take the British pound which fell by around 10% against the US dollar immediately following the EU referendum in June 2016 (it ultimately dropped by 20% over the subsequent few months). This price change was in anticipation of what was to come in terms of political instability, disruptions to UK-EU trading, reduced output, falling spending, unemployment etc., and not necessarily due to a fundamental change in the current "value" of the pound from literally one day to the next.
The Bottom Line
There are many influences driving FX prices in the long term, and they rightly relate to the underlying performance of the economy (of the currency, and the world). In the short term, currencies move in real-time with events, data releases, and market sentiment. Often these immediate price movements contribute to the building long-term picture of the currency's value, and other times short-term fluctuations are erased and minimised by long-term trends.
The best advice we can give to a business attempting to manage its currency risk is to think first about your company objectives, the sources of currency exposure, and the quantification and impact of the FX risk being faced. For most businesses, it pays to have a long-term plan in place and to mostly ignore the day-to-day fluctuations that can be distracting. These intraday movements can be considered and possibly exploited at the point of execution of any hedging trades.
Need our help?
At Oku Markets, we specialise in formulating bespoke currency management strategies for businesses. We're proud to work transparently with our clients, offering fixed and fair pricing, and always empowering them to make better decisions by sharing information and providing education on the complexities of financial markets.
You can contact us for a review of your currency processes and for our guidance and suggestions at [email protected] or 0203 838 0250.
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