Currency market possesses a certain dynamics that no other financial markets have. Unlike in the case of equity or fixed income markets, the mainstream of forex market traders is speculators in one way or another.

Global merchandise trade going through the forex market makes up around 1–2% of total volume. Allowing foreign direct investment, we increase the volume contribution to about 5%.

Asset market volumes have risen sharply over the past 20 years as barriers to capital have fallen. Having made up only a small proportion of currency market volume before the end of the Bretton Woods exchange rate system, they probably now make up as much as 35% of total currency market volume on a daily basis.

That being said, there is still 60% of daily currency market volume, which has to be assigned to “speculation”. Despite the fact that the figures presented here are very approximate, the idea of proportions is pretty clear.

With these numbers, does it still surprising that many of the traditional exchange rate models based on the current account and therefore on trade flows are humble forecasters of exchange rates over the short term?! This also gives some ideas as to why the portfolio balance approach to exchange rates gives unsatisfactory results.

Economic theory tackles the issue of exchange rates by trying to discover a theoretical equilibrium level, against which one can measure over, or undervaluation relative to the actual exchange rate. Such theory relies on a number of significant grounds which may influence the exchange rates:

Exchange rates replicate all existing information at any one time

There is perfect information distribution (meaning, no-one has an advantage)

While it is still unclear whether these factors occur in other financial markets, they are clearly presented in the forex trading market.

Some refer to fx market as a “perfect” market, with tones of available information and perfect efficiency to motivation.

Unfortunately, currency market is hardly perfect. Information is not perfect as some market participants are able to gain more knowledge than others. Why does this happen?

· There is just too much information to comprehend. No trader can possibly absorb it all.

· The information is not perfect and some traders do have an advantage over others. For example, the clue about specific flows that may happen, a bank’s personal “order book” and the ability to trade larger currency transactions than other traders.

Knowledge in forex is power. And since this power is not distributed in an equal manner, forex trading has an element of competition.

The more information is available to us, the less we actually have the time to read. If the good news is that we are closer to perfect knowledge than we have ever been, then the bad news is that we are never likely to get there!

Information costs money to deliver and therefore there is not “perfect” information delivery

because not everyone gets it, either at all or at the same time. Even if it were free, “information

overload” still means that not everyone reads and uses it at the same time.

To summarize, there is neither perfect information nor perfect information dispersal—and there never will be. In response, an economist might argue that we have “good” information, if not perfect information. It would be tough to argue with this, but then “good” is not “perfect” and “perfect” is a necessary aspect of the equilibrium concept.

Furthermore, this supposed equilibrium level is rarely ever reached. Real life is surely a

constant state of flux and imbalance, so why should financial markets be any different?

In turn, if one assumes that the economic fundamentals that can affect exchange rates are themselves in a constant state of flux, one must equally assume that the equilibrium itself is in a constant state of flux—which to an extent calls into question the idea of it being an “equilibrium” in the first place.

In truth, it is a signpost on a road. It points you in the right direction, but it gives

you no idea of when you will get there or where you might have to turn off along the way.

Articles - Forex Analysis