Currency Realignment and the Evolution of Currency Trading Theory

Multiple currency valuation is actually the basis for certain global monetary theory. As described earlier, Navarro Martin de Azpilcueta expressed his theory that commodities determine relative currency values. Obviously, today's currency markets are extraordinarily massive compared with simple mercantilism during the fifteenth century. Still, the ebb and flow of raw and finished commodities provides a basis for determining which currencies may be more coveted.

As FOREX trading evolved during the 1970s, the focus was, indeed, on balance of trade. The relationships seemed simple. Countries whose goods were in the greatest demand had the highest currency parity. Ah, life was easy. However, the global economy grew far faster than most had envisioned. In fact, money and currency transformed from exchange mediums to commodities, but with a twist. Once the gold standard was removed, money supply could expand and contract more freely. This set the stage for various revaluations that provided spectacular profit opportunities.

When a country suffered from too much expansion, its central bank usually intervened by raising interest rates. This raised a red flag that the brakes were being applied to avoid inflation. FOREX traders postulated that rising interest rates represented an exit or sell signal. Few wanted to hold a currency that was likely to inflate against other more stable currencies. For a brief time, traders followed this theory. However, the advent of interest rate futures and related options along with derivative transactions altered this logic.

Suddenly, traders realized that they could obtain higher yields by moving into the currency offering better interest rates. The obvious risk was that deteriorating currency value, that is, inflation, would offset the better yield. Of course, ingenuity found a solution. Using currency hedges, a trader could lock in parity while enjoying the better returns. This became extremely popular during the 1980s when countries like Australia issued bonds with rates as high as 20 percent. The transaction involved buying Australian bonds while selling short Australian dollars (AUD). If the AUD lost value against the U.S. dollar, the hedge made up the difference. Thus, the trader could achieve a pure Australian rate of return without currency parity risk.

While this apparent lock on parity appears to make perfect sense, it demonstrates the one cardinal rule in currency trading and, more specifically, currency parity. There are no rules! By the 1990s, traders had adopted a completely contradictory logic. Since the demand for higher interest drove traders toward the currency of greatest yield, there was noticeable selling pressure on the low-yield currency and associated buying pressure on the high-yield currency. Thus, a sell hedge on the currency exhibiting higher demand was abandoned. It was an entirely new ball game! This gave rise to the Currency Portfolio Theory. By viewing currencies as investment vehicles, the objective is to create a portfolio with the highest yield. The sheer volume of international currency trading obfuscated trade balances. Daily currency transactions dwarfed virtually every other import and export.

The evolution of currency trading theory is vitally important to keep in mind. You must be prepared to change your thinking to track the prevailing cash flow. Regardless of logic or the lack thereof, the rule is always, "Go with the flow." Tremendously sophisticated currency trading models have been developed at great time and expense by universities and financial institutions —not to mention governments. In the final analysis, a simple moving average has been known to beat out the most complicated neural network.

Philosophers have said two paths exist to knowledge. One is fast but long, while the other is slow but short. Both get you to an eventual answer. As investors, we have a propensity to want knowledge fast. However, if we leap into trading before developing a honed skill, the road to riches can be long. If we take our time and prepare for all contingencies with a comprehensive and educated plan, the preparation may be slow, yet the road to riches will be short. A generalization about national wealth is important because our world spins rapidly. Enormous fundamental change can be seen in less than a decade. From technology to political regimes, the world is rapidly changing and currency relationships hinge on this change.

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