Theoretical Review of Exchange Rates

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Theoretical Review of Exchange Rates

Activity in the foreign exchange market transactions include trading, hedging, and speculation arbitrage. Activities such transactions may affect whether or not the exchange rate movements is highly dependent on the strength of demand and supply in currency markets. However, speculative transactions in the Forex market is the transaction to benefit from expectations of future exchange rate movements that differ from the forward premium in the market is often a dominant cause exchange rate volatility.

There are several approaches developed so far in understanding exchange rate movements in short-term period. The first approach based on technical approach which refers to the graph of exchange rate movements and not based on fundamental macro-economic developments. This approach is basically based on the behavior of market participants (Allen and Taylor, 1990, Cheung and Chinn 1999). Another approach is, as was done by Evans and Lyons (2002), where it is stated exchange rate movements driven by the demand to make a purchase or a request to make sales as a result of market information. Information markets are not necessarily related to the information about macro economic fundamentals.

Chartist argued that exchange rate movements are influenced by the trend. Market participants who based on the chart will make a purchase currency when the exchange began to move up and sell currencies when the exchange rate of return has decreased. While the fundamentalists took the position to buy currency when they think the value of currency has been in the position of "under price" compared with the fundamental value, and make sales if the currency exchange rate has experienced overprice. Problems arise when the heterogeneous expectation of the fundamentalists, this will cause volatility in the short term and the strategy of the Chartist would cause long-term volatility (Helinä Laakkonen, 2004). Next.

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