Questions On The Foreign Exchange Market Essay

Questions On The Foreign Exchange Market Essay

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INTRODUCTION

One of the fundamental topics in the foreign exchange market is to know how information is reflected in the determination of prices. This question is also true for any topics in financial economics but it is all the more important in the currencies market, which is the largest market in the world.

The first searches about the correlation between the releases of macroeconomic data and the foreign exchange rate between two currencies were made in the early 1980s. Meese and Rogoff (1983) first try to demonstrate that exchange rates could not be explained by fundamentals. Another study by Frankel and Rose (1995) shown that, at short horizons, a driftless random walk characterizes exchange rates better than standard models based on observable macroeconomic fundamentals. Several authors made that same conclusion. In the early stage of searches on the topic, studies were conducted by using semi-annual or monthly data, which can explain the results found and that economic releases could not determine the exchange rates in the short term. However, searches have shown that economic data provided support to determine exchange rates in the long-run (Taylor, 1995).

The apparition of computers gave the possibility to authors to analyze more data and to concentrate on the effects of macroeconomic releases on the exchange rates in the short run. By being able to collect high- frequency data, authors have been able to demonstrate the importance of various announcements to determine exchange rates. Technology allowed studies to be more precise because they gave the researchers the opportunity to analyze price movements in a short interval around the releases. It permitted to isolate the announcement’s effect on the exchange rate.

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... each country, and then compare the quantity of currencies needed to buy these goods and services.
However, empirical testing of purchasing power parity and the law of one price has been done, but these tests have not proved these theories to be accurate in predicting exchange rates. Another conclusion found is that the purchasing power parity holds up well over the very long run but poorly for shorter time periods. These conclusions meet the ones made by Meese and Rogoff (1983) and Frankel and Rose (1985) who found that fundamentals, like money differentials, inflation differentials and the trade balance couldn’t explain movements in exchange rates.
Authors then began to focus on the determinants that could affect the exchange rates in the short run, by studying shorter window of time in order to be able to see the impact of macro announcements on exchange rates.

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