Exchange rate movements as explained by dealers

Publisher:
Economic Society of Australia
Publication Type:
Journal Article
Citation:
Economic Papers, 2003, 22 (3), pp. 35 - 46
Issue Date:
2003-01
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Theoretically, the value of a currency is determined by the economic fundamentals of its country, such as interest rates, inflation rates and national income. These fundamentals have an effect on trade and capital flows and hence the demand and supply of the currency. However, there have been many well-known episodes when real exchange rates have moved contrary to these fundamentals for lengthy periods of time (Krugman, 1989). Attempts using empirical models to test economic fundamentals as a basis for predicting exchange rate movements have not been very successful especially over the short run (Taylor, 1995). Furthermore, market practitioners have successfully developed and implemented profitable trading strategies, which do not rely on economic fundamentals. One reason for the poor performance of trading activities based on fundamental analysis could be the behaviour of practitioners trading in the foreign exchange market (Krugman, 1989). For example, some practitioners may trade tactically in a way that forces an exchange rate to move away from its fundamental value. These practitioners would then establish a currency position that becomes profitable once general market trading moves the exchange rate back towards its true value
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