Three Factors that Determine Foreign Exchanges Rates in the Short Run

While the three main determinants of long-run exchange rates are purchasing power parity, productivity trends, and the savings/investment balance trends, short-term determinates (within a year) are:

  1. Trend-Following /Bandwagon Effect: This investment ichimoku trading strategy is based on the technical analysis of market prices, or in other words, where traders look for patterns in the market. While many economists have questioned this strategy’s effectiveness (many believe that trading based on trends does not work), traders have had an annual average return of 5.6%, a standard deviation (volatility) of 10 and a Sharpe Ratio (return adjusted for riskiness) of 0.54 across the seven most traded currencies from 1986-2002. Many economists speculate the reason for these positive, but highly volatile, returns is because of the bandwagon effect. (The bandwagon effect is the psychological phenomenon in which people do something because others are doing it.) Thus, the bandwagon effect is a determinant of short-term foreign exchange rates because traders are following each other when they are trading. If one were to “identify” a specific trend, they could in theory earn a profit.
  2. FX Options and Market Positioning: The options market provides information regarding the market’s expectation of the probability distribution of future interest rates and exchange rates. Since the options market reveals the implied volatility of different traded currency pairs, if the forward implied volatility curve were steeply upward sloping, the market would be pricing in the expectation of a future jump in currency volatility. On the other hand, if the forward implied volatility curve were flat, the marketplace would be pricing in no change in the level of currency volatility. Thus, traders could make a profit based of the predicted future jumps in volatility. However, during the 80s, the Bank of England examined the implied forward volatility curves and concluded that “Forward volatility curves…. did not expect the increase in volatilities (that occurred) in October 1998. Although (historical) volatility had increased throughout the summer, the forward volatility curve suggested that it would fall back towards previous levels”. In spite of this, traders still use this method as a way of predicting foreign exchange rates in the short-run.
  3. Order-Flow Analysis: Order flow analysis refers to analyzing the orders of foreign exchange traders. When there are an abundance of order flows, a possible explanation is that many traders think a particular currency pair is either over- or under-traded. Thus, foreign exchange traders can use this information to make a trade corresponding to the direction they think the currency pair is headed.

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