Foreign Exchange Market Intervention
As we recently stated, about the only way that interest rates will not equalize for any of the previously outlined economic relationship is if the government steps in and interferes. Governments pay very close attention to exchange rates since that is the price that links their country’s competitiveness with the rest of the world. We just learned how purchasing power parity tends to equalize the prices of all goods across countries. Next, you must understand that any appreciation or depreciation beyond what is necessary to equalize prices is called the real or the inflation-adjusted exchange rate.
For example, if the U.S. inflation rate is 5% and is 3% for Japan then the Japanese Yen is expected to appreciate by about 2% relative to the dollar. However, if it appreciates 3% against the dollar, it is overvalued by 1% in real terms or inflation-adjusted terms. There are pros and cons to a currency that has a real appreciation (over and above the differences in inflation). On the plus side for example, if the Japanese Yen is stronger in real terms against the dollar then the yen can buy more goods. Remember from the beginning of this course that yen appreciates against the dollar because it can buy more dollars. This is certainly good for a country because they now enjoy more imports. Japanese products that compete with these imports are now likely to have price stabilizations, which can reduce inflationary pressures.
The negative aspect for a country with a strong currency is that their exports are now more expensive and people will buy fewer goods. If the yen has appreciated in real terms against the dollar then people will buy fewer Japanese goods because the yen are so expensive. Remember that people don’t want money for the sake of money but rather for what it can buy. If the price of money is high, so is the price of that country’s goods. The law of demand tells us that as the price rises, people will buyer fewer goods and therefore less currency. The strong currency can actually create unemployment in certain sectors.
What about the country with the weak currency? There are pros and cons here as well. In fact they are the mirror-image of the advantages and disadvantages for the country with the strong currency. In this example, if the U.S. Dollar is relative weak against the yen then U.S. corporations are more competitive because their goods are now cheaper. The law of demand tells us that people buy more goods when the price is low and therefore must buy more currency. The negative side is that there are Americans who depend on foreign products and services to survive and those products are becoming very expensive.
Depending on the business cycle and political goals, governments may prefer to have overvalued or undervalued currencies. Some governments feel they can judge the value of their currency better than the market so are willing to intervene and either increase or decrease their currency’s value as they see fit. This is very much the same idea as when corporations buy their own stock back in the open market. If Microsoft feels their stock is too cheap they can buy up shares and sell it later at a profit if they are correct. And who better to judge the value of its shares than the corporation? They often know a lot more about the upcoming products and business plans than the analysts and investors who buy shares on the open market. This is the same idea for governments that buy their own currency in the open market. They feel it is too cheap so will buy it up through the open market.
For example, assume that the U.S. feels its currency is too cheap against the yen. The government can buy U.S. Dollars by selling yen thus driving up the price of the dollar against the yen. The Japanese government could also do the same thing if they felt the yen was overvalued relative to the dollar. They could sell yen and buy dollars, which would lead to the same effect in that the U.S. Dollar would rise against the yen.
Sterilized and Unsterilized Intervention
If the government just buys and sells its currency in the open market it is called unsterilized intervention. The definition of an unsterilized intervention is that the government has not insulated its money supplies from the foreign exchange transactions. Understanding this definition is much easier by considering the previous example where we assumed the U.S. government felt that the dollar was undervalued against the yen. To prop up the dollar’s price, the government bought dollars and sold yen. However, these actions directly affect the money supply. When the government buys dollars, it pulls dollars out of circulation and reduces the supply of dollars. At the same time, it is increasing the supply of yen in the open market. When the supply of money changes so do the inflation rates and the interest rates and both of these have effects on the exchange rate. This makes the task of increasing or decreasing the exchange rate to a given level a daunting task because the government is trying to hit a moving target from a moving platform. It’s much easier if only the target moves and everything else stays stationary.
To do so, governments often use sterilized intervention. A sterilized intervention is done when the government neutralizes the impact of the open market currency purchases and sales by offsetting them with open market operations through the central bank. Let’s go back to the example where the U.S. government wanted to increase the dollar’s exchange rate against the yen by purchasing dollars and selling yen. This would decrease the number of dollars in the hands of the U.S. economy. Fewer dollars in the banking system tends to increase the interest rate with other factors constant. To offset this, the Federal Reserve Bank could buy Treasury Bills (T-Bills) in the open market, which is does by giving cash to the banks. This cash infusion offsets the cash taken out by the system through the outright buying and selling of currencies (unsterilized intervention).
If the Fed adds the proper amount of cash then there is no net difference in the amount of dollars in the economy and only the exchange rate will change. Another way to understand this effect is by considering the effect on interest rates. We said that when dollars are pulled out of the system that interest rates tend to rise. When the Fed buys T-Bills, they put buying pressure on them, which increases their price. And what happens when the price of a bond rises? The interest rate falls. So whether we look at the open market operations in terms of money supply or interest rates, you can see that they will offset each other. That’s the whole idea behind sterilized interventions.
The Value of Money Determines Exchange Rates
The previous sections discussed the major reasons for exchange rate fluctuations. But in order to understand all the reasons why currency rates fluctuate, it’s best to understand the very basic motive for currency. From an economic standpoint, money serves four main purposes:
Medium of Exchange Unit of Account
Store of Value
Standard of Deferred Payment
Any increase or decrease in the exchange rate can usually be attributed to one of these four categories so let’s take a look at each in detail.
Medium of Exchange
The reason money is important for any nation to advance is that it reduces transaction costs by having a single medium of exchange. Lower costs benefit buyers and sellers and results in more trade. Under a barter system, the nation must create numerous exchange rates, which can get complicated quickly! Without money, you’d have to resort to a barter system where you’d trade goods in exchange for other goods. Imagine a simple island economy with only three commodities: fish, pineapples, and cloth. If you have one of the three goods, you can exchange it for some quantity of the others.
For example, assume you can exchange four pineapples for one fish and one yard of cloth for two pineapples. Quick – how many yards of cloth does it takes to purchase a fish? You can see that it takes a lot of time and energy (and algebra) to expand an economy under a barter system. The time spent trying to exchange goods and services adds to transaction costs, which makes things more expensive and results in less economic growth.
Transaction costs are also high under a barter system because people must find someone who wants their goods in exchange for the goods they want, which in economics is called a double coincidence of wants. If you have four pineapples and want a fish, you need to find a fisherman who wants four pineapples. If the fisherman wants two yards of cloth instead of pineapples, you will need to take your four pineapples and exchange them for two yards of cloth and then take the two yards of cloth back to the fisherman and get your fish. The barter system is truly an inefficient way of doing business. One of the functions of money is to avoid this nonsense and provide an efficient medium of exchange.
Unit of Account
To get around these inefficiencies, it would be nice to have all commodities quoted in a single unit; in the case for the U.S. we’d like to see them quoted in dollars. And that’s exactly what the second function of money does. It creates a standardized unit of account so that we can make easier comparisons. Think how much easier our island transactions would be if these commodities were quoted in dollars. If we knew the dollar prices of, fish, pineapples, and cloth we would not need to find other traders to conduct transactions. We could go straight to the one who produced the goods we want and pay with cash. Whether that person buys pineapples, fish, or cloth is irrelevant as the dollars received in exchange represent all other goods to them as well.
If one pineapple costs one dollar, then a fish costs $4 and cloth costs $2 per yard. Now if you want a fish, you can just pay the fisherman $4. If that fisherman wants pineapples, he can just buy four pineapples with that money. If he wants cloth, he can buy two yards of cloth. Much easier now, isn’t it?
Further, in this simple economy with only three goods, it takes three prices in order to conduct transactions. We need the prices of pineapples to fish, pineapples to cloth, and cloth to fish. With four products, we need six prices. If this simple economy grows to just a meager 100 goods, it is a mathematical fact that we would need 4,950 different prices to conduct transactions! Imagine the difficulty of running an economy with hundreds of thousands of products and services with each requiring its own exchange rate against all other products.
It should now be apparent that it is far more efficient to have everything quoted in a standard unit such as dollars. If you know how much something costs in dollars, you immediately know the exchange rates for all the other goods. A standard currency makes markets more efficient.
Store of Value
Money adds another dimension to efficiency in that it provides a store of value. This just means that it allows us to store our accumulation of goods (value) until a later date. In the island economy, if you exchange four pineapples for one fish, the fisherman may lose some or all of those pineapples if not consumed in a relatively short time. If he is in the business of selling fish, he may be overloaded on pineapples and end up losing all that he worked for. Money avoids this problem too. If the fisherman, instead, collects four dollars for the fish, he can choose to buy pineapples right then or he can defer that consumption to a later date. This also allows him to smooth out his consumption and buy pineapples as needed rather than having to accept all at once in exchange for fish. Money allows us to store our wealth for use at a later time.
Think in Terms of the Functions of Money
As we said earlier, if you want to understand why exchange rates fluctuate and all the ways that they can be affected, it helps to think in terms of the functions of money previously discussed, namely the “medium of exchange” “a store of value” functions (the “unit of account” function merely tells us why we have money and not why we would demand a specific currency.) The demand for any currency depends on that currency’s ability to provide these important functions.
As an example, a country experiencing high economic growth (GDP) will have increased demands placed on their currency. The increased demands will cause the high-growth country’s currency to rise. Other countries need that currency as a medium of exchange to buy the highly demanded products.
As another example, any news that affects the interest rates of that country will affect that currency’s usefulness as a store of value and therefore affect the demand. All things being equal, investors prefer higher interest rates to lower ones so if a country offers higher interest rates than another then capital should flow to that country to capture the higher yields. As capital flows to that country the price of their currency will rise as well. But interest rates are a tricky concept because what investors are really after is the inflation-adjusted return, or the real return on their money.
If inflation is expected to be lower, it will be able to maintain a better store of value and will therefore increase the demand for that currency. High inflation offsets the store of value function. For example, if inflation is expected to be 5% and turns out to be 6% then there is a net loss to the person who stored money for future use. Here’s why: Imagine that you have $100 today. You can either buy something for $100 today or you can save that money. If interest rates are 5%, you will have $105 in one year.
If the inflation rate turns out to be exactly 5% as predicted, then that good will now cost $105. You are no better or worse off by having stored the money. However, if inflation turns out to be 6% you will have $105 in your account but the item now costs $106 and you are worse off from storing the money. The reverse is also true. If inflation is expected to be 5% and is later announced that it is expected to be lower than expected then there will be an increased demand for that currency. The important point to understand is that the increased or decreased demand for money is all based on expectations of future inflation.
If the value of a currency fluctuates too much or is subject to great inflationary risks, the transaction costs become unclear and it is difficult, and far less efficient, for businesses to raise capital. Inflation distorts the value of money. As inflation becomes more unpredictable, consumers spend more time trying to protect their wealth, rather than investing and producing. If expectations for inflation are high, investors move their capital into more speculative investments such as gold, art or other hard assets that act as a store of wealth. With fewer funds available for investment, the interest rate is driven higher and fewer firms are able to invest and produce, which adds further declines in the economy, which can have negative effects on the exchange rate.
Closely related to this topic is the government’s stability and their ability to fully back their currency’s value. The more political unrest, the lower the demand for that currency and the exchange rate will fall. High inflation also challenges the credibility of the government. A government that continuously dilutes the currency so as to create high inflation will lose the confidence of investors. High nominal (stated) interest rates will not even attract investor capital under erratic inflationary environments. For example, around 1992, the country of Nigeria offered an investment with a seemingly high 36% annual interest rate that could be rolled over for a five-year period.
Remember, though, that is the nominal rate and includes a premium to "cover" the expected inflation. The U.S. exchange rate at that time was roughly 10 Naira per dollar. A U.S. investor could have taken $10,000, converted it to 100,000 Naira and invested it for a five-year span at 36% interest per year. At the end of the five years, the investor would have indeed collected many Naira but would they be better off? To be exact, the account would have grown from 100,000 to over 465,000 Naira, which would make the $10,000 investment worth $46,500 – assuming the exchange rate stayed the same. However, during that five-year period, runaway inflation took the exchange rate from 10:1 to over 920:1 making the initial $10,000 investment worth less than $500 after five years. High interest rates will certainly make for a big pile of currency at maturity but high inflation will eat away the value. Would you have invested the following five years even with a sizeable inflation premium?
A similar situation happened in Turkey. In the middle of 1995, one U.S. dollar would buy about 50,000 Turkish Lira; in October 2001, it would buy nearly 1.6 million Turkish Lira. As a consequence, the Turkish government paid nearly 70% interest on a 3-month treasury. So why aren't investors flocking for this nice high rate of return? That's because they don't have the confidence that the currency value is stable. Part of Turkey's problem at the time was due to the government's abandonment of currency "support" on the open market.
As discussed earlier, many countries buy and sell their currency in the open market to keep it in a specific, narrow range of exchange rates, which is something the Turkish government did until 2001. Regardless of the cause, once the people lose faith in the government's ability to stabilize their currency, inflation rates can run rampant. Figure 4-12 shows the exchange rate of Turkish Lira per U.S. dollar (USD/TRL) over a one-year period starting in October 2000. It is quite evident at which point the Turkish government announced their decision to no longer support their currency in the open market.
Figure 4-12: Can you spot the day when the Turkish government announced it will no longer support the Lira?
If you understand how the functions of money affect the demand then you can also figure out what will happen with the supply since they are two sides of the same coin. Figure 4-13 is a Yugoslavian note for 500 billion dinara that is absolutely worthless. That’s what happens with runaway inflation!
Figure 4-13
The Bid-Ask Spread Revisited
Now that you understand how supply and demand curves relate to currencies, let’s revisit the prior topic of bid-ask spreads to understand why they depend on volume, volatility, and transaction size. When we talked about exchange rate equilibrium before, we assumed that currencies could be bought and sold for the same price in which case the equilibrium price for that example was JPY/USD = 0.8535. In the presence of bid-ask spreads though, we find that the equilibrium price is not a single price. Instead, retail traders must buy at the asking price and sell at the bid price, which cause three immediate market inefficiencies. First, less quantity (volume) is transacted as can be seen from Figure 4-14.
Figure 4-14
Second, retail buyers must pay the asking price, which is a little bit more than the equilibrium price of 0.8535 in this example. Third, retail sellers will receive the bid, which is a little less than 0.8535. The key point to notice is that if the quantity were reduced further that the bid-ask spread would widen. This is a direct result from the asking price moving further up the demand line while the bid price is moved further down the supply line. Any factor that causes a reduction in volume will increase the bid-ask spread. Volatility is one of the main factors that cause such a reduction.
If the volatility (uncertainty) of a particular currency increases then it becomes harder to hedge the risk and fewer people will only trade the currency if there is a “risk premium” on the currency. This risk premium is captured in the form of being able to sell the currency for a little bit more or buy it for a little bit less than the true equilibrium price in the absence of spreads. In other words, the spread must widen and that causes the volume to decrease.
Size of transactions is another factor. If traders are trading large lot sizes then competition will increase for the orders and dealers will narrow the spreads thus promoting volume. If, on the other hand, you are trading small lot sizes then you should expect to see wider bid-ask spreads since there is less incentive to compete for that business. The bid-ask spread is purely a function of the volume (quantity) of currency that is being traded. Any factor that affects the volume must also affect the bid-ask spread.
Making Money with Currency Trading
It is often said that currency trading is “easy” due to the fact that there are only so many factors that affect their values. In other words, currencies, unlike stocks, are never subjected to surprise announcements about “accounting irregularities” or that the CEO absconded with company funds. Currency values move for distinct economic reasons. And those price changes can be quite large, as shown with the Turkish Lira in Figure 4-12 above, providing for substantial returns.
However, predicting those changes, no matter how mechanical they may be, is difficult. But if you understand the economic principles outlined in this section, you will at least be aware of potential opportunities. The number of currency pairs is quite small and the reasons for their changing values are quite known which is a nice feature of currency trading. But as we always teach, you’re better off hedging your bets in case you’re outlook is incorrect – especially considering the leverage involved with currency trading. And for that reason, many currency traders are turning to currency options. The principles and strategies involved with currency options are exactly the same as for equity options. Options are options; it’s only the underlying instruments that differ.
If you understand options along with the principles and mechanics outlined in this course, you will be in a better position to capitalize on changing currency values – a luxury that Milton Friedman was denied.