The mystery of exchange rate determination solved

IMG_0136I remember many years ago a young trader telling me that he might as well close his eyes and throw a dart at a board and be guided by the number he hit through his trading day. The random approach, broke even, but as he gained experience and developed a trader`s nouse so he started to aim with eyes open and with more precision and this improved his odds of winning to 60/40. The only reason I am reminded of this is because you cannot beat experience and I will replace nouse with knowledge of economics. More recently a close friend and experienced trader asked me if my economics can explain what is happening on forex markets. Obviously I said it could and I would explain it on a blog. However before I do that let me illustrate how important economic theory is to understanding the real world, or in this example almost the real world.

In the 70`s and 80`s I was teaching theories of the firm and the on-going criticism was that they were idealised models using geometry and algebra and they had no relevance to the world of business. I explained that economics was very important to the success of a business and the response was “prove it” so I did.

I was not going to run my own business as I went into education for an easy life and I have the greatest respect for entrepreneurs who are the real source of economic growth in any economy. However I saw an opportunity to prove my point. The Institute of Chartered Accountants, ICL, IBM, The Times and Sunday Times were among a number of bodies who ran “Management Games” or “Business Games” and these attracted competitors from all the top companies. These games used computer simulations to create up a competitive industry. Each firm/competing team started in an identical situation with regard to production, pricing, marketing, finance and with identical balance sheets and profit and loss accounts. Over five or six trading periods each team would change its price, capacity, research and development budget, marketing, transport etc. At the end of the game the highest profit won and the team moved on to the next round and an eventual final.

With my students we created teams to challenge the best firms in the world with only our knowledge of economic theory. Over 17 years we won 14 national titles. In 1981 we played against 2000+ companies and at the final in London we won the Financial Times Rosebowl. The result was:-


Seevic (acronym for my college)               £2,881,941

Shell UK                                                         £1.631.080

IMI                                                                  £1,134,920

Reed Int                                                       -£1,299,160

In 1997 I was asked to play in a Champion of Champions competition for former winners where I played against my arch nemesis from Lombard North Central. I won and have never played again as I had proved my point that theories of the firm are very helpful in business.

On to exchange rates. Because the forex market is a free market the rules of supply and demand apply, but there is an important difference between long term trends and short term fluctuations. As I had applied the theories of the firm, so I decided to apply my knowledge to the forex markets. I decided I would learn more by trading miniscule amounts of currency on one of the trading sites. Relying on my knowledge of long term trends I was unsuccessful almost every time, but when I concentrated on short term fluctuations I was much more successful. The interesting thing was the extent to which short term perceptions drove the market irrespective of whether the ideas were right or wrong.

At this point it is necessary to understand the difference between the long term trend and short term fluctuations. To explain this I am going to look at the 1960`s when there was only long term factors determining prices and compare them with the situation now when there are many overriding short term factors, which may last only seconds, that disturb the market and create opportunities for traders. But remember that underneath it all there is still the long term trend.

In the 1960`s the exchange rate was fixed, but it was still determined in the market by supply and demand. It was just that the Bank of England would intervene by buying and selling the currency to maintain a par value of $2.40 with margins of fluctuation to $2.38 & $2.42. There were no opportunities to speculate except in the case I will explain below, so most of the time activity in the forex markets was driven by the real demand for imports and exports of goods and services.

To determine the long term stability of the currency it was necessary to look at the current account balance on the balance of payments. This was the difference in value between the total amount of goods and services sold abroad and the total amount of imports purchased from abroad. A continuing surplus showed that the currency was undervalued and was likely to be revalued if domestic corrective action was not taken by the government. A continuing deficit meant the currency was overvalued and was likely to be devalued. There was hardly any speculative activity as Central Banks were fairly adept at maintaining a fixed or par value for the currency.

If things went wrong, and they did towards the end of the 60`s when government tried to use Keynesian demand management policies and caused imbalance on the external account. A few people recognised that this was a “speculators paradise” as a series of current balance deficits signalled the likelihood of a devaluation and selling the pound was a money spinner. There was no risk of a rise in the value of the currency so if the currency was devalued they won and if it did not then they did not lose. In 1967 those shorting the currency made 14% on a decision to devalue sterling.

In the 70`s things changed when exchange rates floated, and to provide some stability for trade a number of new markets grew up. These included forward markets, futures markets, swaps and options. They opened up a whole new world for speculation as small changes in currency and large geared funds created a new career in trading.

So what has changed between the 1960`s and now is that in the 60`s almost 100% of business on forex markets was driven by a real demand for imports, which supplied currency to the market, and demand for exports which demanded currency from this market. Now however only about 5% of forex trade is driven by real factors and 95% is driven by speculative decisions that are based upon expectations, unexpected outcomes, new information, rumours, crackpot theories to mention but a few. Any forex site will gives dates for important decisions, the release of relevant statistics or important information. Looking at just one of these variables, interest rates, we can see that expectations of rate hikes cause significant changes in the currency value, even though, in the UK, rates have not changed for more than six years. Also the direction of change in the currency is often the opposite of the long term trend. Knowledge that one member of the MPC has voted for a rate rise will cause the value of the currency to rise while information that two members have voted for a change will have an even greater effect and so on.

Let us put all of this together. Large and continuing current balance deficits on the external accounts of the UK and USA mean that the currencies are currently overvalued and in the long term will fall against a basket of other currencies. In contrast a large current account surplus in China means the yuan is undervalued and will rise over the long term. However looking closer at the China situation we can see that recently the short term value has been bucking the trend and bringing down the value of the yuan. This is because of the power and influence of the Chinese government, who are concerned that a shrinking surplus will reduce their ability to buy favour around the world, and they are able to push against the trend and force the yuan lower. This however will not continue as the long term trend is up and it is the long term trend that has the final say in the market.

To recap: it is necessary to look at a country`s current account balance to determine the long term strength of its currency and then listen to the tittle tattle in the markets to determine any short term fluctuations; and if you act quickly enough, or are privileged to receive information first, then you can make money on the forex markets.

John Hearn 14/9/15



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