Foreign Exchange Trading Is Growing:
Foreign exchange (forex) trading is growing. According to the latest survey, there was $3.2 trillion worth traded per day in 2007, up 30% from $2 trillion traded in 2004. The increase is a result of more hedging by corporations, currency trading by hedge funds and other investment companies, and an increase in trading in emerging market currencies. (Source: Bureau for International Settlements,
Trienniel Central Bank Survey of Foreign Exchange and Derivatives Markets, December 2007)
One Reason Is a Decline in Volatility and Risk:
In addition, forex
volatility is declining. This includes historical volatility (how much prices actually went up and down) and implied volatility (how much future prices are expected to vary, as measured by futures options).
In the late ‘90’s, volatility was usually in the teens, sometimes as high as 20% (U.S. dollar vs yen). Today, volatility, especially with the Euro and the yen, is below 10%.
Why Is Volatility Lower?:
One reason volatility has been lower is that, until the current recession, GDP growth has been more moderate. Only Japan experienced a severe downturn in the last decade.
Second, inflation has been low and stable in most economies. Central banks have learned how to measure, anticipate, and adjust for inflation.
Third, central bank policies are more transparent, meaning they signal more clearly what they intend to do, so markets are less likely to overreact.
Fourth,many countries have also built up large foreign currency reserves, which discourages speculation in their currency. Speculation creates volatility.
Flexible Exchange Rates Also Reduces Volatility:
Flexible exchange rates allow for natural, and gradual movements of exchange rates. More countries are adopting flexible exchange rates. Fixed exchange rates are more likely to let pressure build up, so that market forces overwhelm them and cause huge swings in exchange rates until they stabilize at a new, natural level.
Better Technology Allows Easier Forex Trading:
Better technology allows for faster response on the part of forex traders, which allows for more natural currency adjustments. It allows more traders, and more trades, which allows for additional smoothing in the market. It also allows more expertise in the currency markets, which reduces the risk that a few players can control the markets and cause large swings.
How Forex Affects the U.S. Economy:
Lower volatility in forex trading means less risk in the global economy than it in past decades. Why? - central banks have become smarter, while the forex markets are now more sophisticated, and therefore less likely to be manipulated. This means that dramatic losses based on currency fluctuations, like we saw in Asia in 1998, are less likely to happen.
However, the global recession means fewer opportunities for trading and profitability in other areas, such as the stock market, commodities futures and real estate. This means traders may start speculating more in the forex market. This could create a bubble that could be as damaging as the ones in those other sectors. Because of the trillions traded in forex, even larger losses could be incurred.
Furthermore, forex trading affects the value of the U.S. dollar, and other currencies. If traders bid the dollar up, as happened in the last quarter of 2008, the U.S. exports become less competitive, slowing GDP growth. If they bid the dollar down, then oil-producing countries will raise the price of oil, since oil is sold in dollars. The impact of expanding forex trading needs to be watched, and perhaps regulated, to avoid potential bubbles and busts.
