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analysis to forecast foreign exchange prices. Just when a strong, fundamentally-driven currency trend is unfolding, the local authorities are most likely step in to stop it. Market intervention by the Swiss National Bank several years ago to arrest the Swiss franc’s appreciation against the euro is a good example. Rather than it being driven by speculators, as suggested by SNB officials, it was largely due to the Swiss franc’s safe-haven status amidst crisis-ridden Europe. Once you have controlled for all of these variables, you need to acknowledge the size of the interbank market and the large amount of cash it is able to move on a speculative basis. Trading for short-term profit in foreign exchange makes fundamental analysis useful only in the longer term. As the authors of this book point out, technical analysis is an indispensable tool of the foreign exchange trader.

      The Foreign Exchange Matrix fills an important need in the market today regarding currency valuation and trading. With more than 50 years of foreign exchange market experience between them, Rockefeller and Schmelzer boldly go where few have dared. While they flatly admit to a lack of an elegantly simplistic theory to currency valuation, what they provide is a vigorous and comprehensive examination of the factors that weigh on foreign exchange markets. What the reader comes away with is not only a better understanding of what moves currency prices, but a better understanding of global markets and the interconnectedness of the world we live in. The historical anecdotes alone are worth the effort of reading this book, as the authors move effortlessly from the Asian Financial Crisis to the LTCM Crisis to the Lehman Crisis with deft and skill. While the reader may not decide to quit their day job to day trade foreign exchange spot, forward and option markets, they will have a greater understanding of what factors drive currency prices and a greater degree of comfort in managing foreign exchange exposure – whether that exposure is by default or design.

       Michael J. Woolfolk, PhD

       Managing Director and Senior Currency Strategist, Bank of New York Mellon, New York, NY, December 2012

      Introduction

      “There is no sphere of human thought in which it is easier to show superficial cleverness and the appearance of superior wisdom than in discussing questions of currency and exchange.”

      Winston Churchill, Speech to the House of Commons, 29 September 1949

      The FX market is a mystery to most people, including some of its participants. Pundits on other financial markets and legislators in most countries don’t fully understand it, either. Everyone notes how big the FX market is – bigger than all other global markets combined at $4 trillion per day – but no one ever asks “What is the purpose of all this trading volume?” There are other unanswered questions about FX too.

      We also want to know whether FX secretly drives all other markets, or whether it is the passive end-product of all the other markets. Neither assertion is wholly accurate, but knowing that doesn’t help us understand where FX does fit into the grand scheme of things. Further, why do exchange rates always overshoot any reasonable estimate of value, such as comparative purchasing power? Does this mean the FX market is inherently unstable, as financier George Soros has said?

      Most of all, FX is money, and money has many different roles. Money is not only how we pay the electric bill (medium of exchange), how we measure economic sustainability (unit of account), and how we measure wealth (store of value), it is also a symbol of a country.

      For example, the French were so attached to the now-defunct franc that they continued to hoard as much as €1 billion worth of them, or some 3% of the francs that were in circulation, when the euro was introduced in January 1999. In February 2012, the French government made a windfall gain of about €500 million when the franc finally hit its expiration date. Germany continues to allow the Deutsche Mark to serve as legal tender; the Bundesbank estimates that citizens hold as much as DM 13.2 billion as of end-June 2012. Then think of all the nicknames for the US dollar – such as greenback and buck – and most interesting, food names – including bread, clams and cabbage.

      How do the non-functional, reputational aspects of money affect FX trading and, while we’re on that theme, is it justified that the dollar is seemingly in perpetual crisis?

      It is possible to provide easy answers to these questions.

      Easy answers

      What is the purpose of FX trading volume?

      The FX market is so big because accounting convention allows it to be largely hidden. FX is a contingent asset/liability on the balance sheet of both banks and corporations, and is reported only in the footnotes of financial statements. Even then, FX is lumped together with “other securities.”

      Further, the FX market is so big also because FX is a market dominated almost entirely by private speculators, including banks and hedge funds, who are trading almost entirely on private credit. The positions are not reported, nor are the credit lines backing the trading. You will search in vain for a number representing the gross credit lines of any bank to other banks for the purpose of FX trading.

      FX trading outcomes are reported on the income statement, but do not have to be broken out from other securities trading. You will never discover how much profit Citibank, Deutsche Bank or Goldman Sachs made last quarter trading FX. And because FX traders are not burdened like equity and bond traders by having to meet a benchmark rate of return, relative performance among competitors is not in the public eye. FX traders have only cash profit targets and sometimes these are the bare minimum to justify the expense of the desk, quote terminal and telephone.

      Finally, FX traded by institutions is not directly regulated by governments, although retail trading by individuals is usually regulated. FX escapes new efforts at regulation, as in exemption of FX derivatives in the US during 2010 and 2011, because self-regulation actually works, and works with impressive efficiency. This is in part because FX is a market on the leading edge of technology advances. We have not had a global problem due to FX since the Herstatt Bank failure in 1974, which was even then actually a credit risk issue and not strictly an FX issue. In essence, Herstatt accepted FX payments due to it and then declared bankruptcy, avoiding paying out its side of the FX trades. Note that credit risk always starts with the character of the counterparty.

      Does the FX market drive other markets, or is it a passive end-product? Why do FX markets overshoot?

      FX is both the driver of economic conditions and the end-product of economic conditions, mainly through a single factor set – inflation and expected inflation, and its financial market manifestation, interest rates. The government entity most associated with inflation is the central bank and its interest rate policies. FX traders watch inflation and its evil cousin, deflation, tirelessly and obsessively, even when they are low and flat.

      It is true that exchange rates often overshoot reasonable estimates of their true value, but in the absence of any objective measurement of true value we count on market participants to judge when they have gone too far and to correct this themselves. If governments do not agree with the market’s valuation, and desire a correction to be forced, they may order their central banks to intervene directly in the FX market.

      The FX market is the only financial market in which governments intervene and such intervention is intermittent and fairly rare. Its rarity may suggest that governments dislike quarrelling with the market’s valuations because they actually do believe the best policy is to let the market decide, or alternatively they may be lily-livered in the face of such a behemoth. It would in fact be easier and cheaper to change the policies that led to a wrong currency valuation than to intervene.

      If the FX market is inherently unstable, it would be because governments engage in policies that lead to overshooting, including inadequate advance signalling of policy changes. So, if governments make bad decisions and manage policy poorly, it may be justified to say FX is inherently unstable.

      Exchange rates also overshoot because we misinterpret economic data and do not have a universally accepted theory of how exchange rates

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