International finance has been increasingly confusing for academics, policy-makers, and traders. Just when you think currency markets will be well-behaved and follow theory, they will move in ways that are totally unexpected. We have always known that currencies are hard to predict given they are expectational markets. Even with perfect foresight about underlying fundamentals, our ability to explain currency is suspect. The research continues to show that currencies are hard to predict and fundamental models can only explain a small percentage of the price variation. There needs to be a deeper framework for understanding foreign exchange behavior.
The researchers at the Bank of International Settlements recently provided an interesting framework (Conceptual Challenges in International Finance) that should be helpful for all those who try to understand the moves in currencies. They have coined the name “triple coincidence problem” in international finance. We fall into a certain traps when we make three simple assumptions concerning currencies. There is a potential for significant confusion on currency behavior when we assume or think about balance with respect to country borders.
The coincidence is based on three assumptions: GDP area, currency area, and decision-maker. The normal currency market assumption is that the GDP area and currency area overlap and there is only one representative agent that plays in the currency markets. In reality, if these assumption occurs, it is more of a coincidence and not what is seen in reality. So what doe this mean for traders and investors?
- Assuming that all investors are profit-maximizers is dangerous. In the simplest arrangement beyond a representative agent, there are speculators, hedgers, central banks, information traders, informationless traders, and noise traders. Markets will not be immediately well-behaved or follows standard arbitrage arrnagements if there are non-profit maximizers dominating the market.
- Currency markets are not just defined by GDP borders. The size of trading and flows may be much greater than the GDP of a country and be unrelated to trade flows. If a trader looks at net flows for a country, he will miss the gross behavior associated with a currency. A current account may be balanced but the gross behavior of markets may generate significant risks.
- A currency can be traded or used by more than just market participants involved with a GDP area. A currency area can be wide-ranging. For example, the dollar as a funding currency will be disconnected with the economics of the US. The same can be the case for the Swiss franc and Japanese yen.
Making the simple assumptions learned in textbook models is dangerous for trading currencies. Traders have to think outside limiting assumptions.