The Dollar-Pound Exchange Rate - Research Paper Example

The Dollar-Pound Exchange Rate Introduction The dollar pound exchange rates have been pretty mobile and have affected the investors and the traders drastically since the pre-second world war years. During the major shake up in the 1930s, a number of traders lost their money when there was a sudden market depression which led to a crashing pound against dollar. In today's market scenario, there is a tendency to control the forex market by both the current traders of the currency in addition to those who are trading in the futures market. Looking back at the 1931 devaluation of the pound, there is a large scale market pressure based on the fundamentals of the pound sterling against the dollar's market fundamentals (Marsh & Hallwood, Aug 2003). This coupled with the devaluation of the pound sterling, in a bid to reduce the domestic credit in UK, brought down the exchange rates against pound sterling. But there was always an opinion and not wrongly, that the market was predominantly controlled during those days by speculators which was possibly the single largest reason to work against the interests of pound sterling. Though this was the scene in September 1931, the scene has not undergone drastic changes in terms of operational methods. The number of players in the market, speculators, traders and the countries interacting with one another has all increased. But then the basic working of the market remains more or less similar to the pre-war condition in the case that it is controlled by the speculators of the market to a great degree. The market has been set aside as Futures for the speculators. But then the futures carry a very special impact on the over all exchange rates of the currencies on the bourse. The aim of this research is to study the impact of the futures market on the currency exchange rate across the counter. Objectives of the Research The objective of the research is to identify a relationship either empirical or otherwise between the futures market and that of the spot business after passage of a specific time. It is quite possible that the current futures price on a specific contract at a specific period could determine the price of the currency, in our case, the pound against the dollar, for that period in time. The projections and the relationships if could be explained and established then it would be easy to predict the future price of the currency at a specified contract period based on the current futures rate as well as on the spot price if relevant. This objective comes out of the hypothesis that there will be a clear impact of the futures rate of the market on the spot price of the currency. The exchange rate would therefore, is expected to vary with the futures price or rate as much as with the spot rate at the given point in time. Research material that is supporting this hypothesis as well as contra to this are studied and these are researched to spot the relationship between them in order to predict the future path that the spot prices might take. Literary Review There have been a number of theories and models that have been set to explain the exchange rate dynamics. Jeffrey Frankel (Sep 1981) writes about the empirical exchange rate model. In a typical exchange rate equation for the empirical nature of the behaviour o the exchange rates, most of the proponents accepts a 'semi-reduced' form of the formula. The equation consisted of the nominal exchange rate on the left hand side of the equation and the right hand side consisted of the variables to the issue, specifically, money supplies, relative Outputs, interest rates and wealth positions normally dictated by the cumulated current account positions. All this would make up the empirical relationships that make up the exchange rate for the currency. Peter Hooper and John Morton (1980) introduced the current account in the equation in the eighties. However, the empirical system of explanation for the exchange rates failed to stand the test of the time. The main purpose to study the changes in the pound-dollar relationships is to predict the changes in the price and if possible bring in a relationship that would help in understanding their variations more clearly. In order to understand the variation of any foreign exchange rate, it is important to have clear metrics designed for the economic factors. Christopher Sims (1980) brought in the much acclaimed Econometrica which spoke of the measuring techniques that could be adopted. He introduced the VAR approach to simulating the effect of the changes and the exchange model. The methodologies to evaluate VAR itself were undergoing changes to take care of the inaccuracies and the variation was also noted in the way real GDP was being evaluated. However, these factors tended to influence the way the market was behaving towards the exchange rates. Still, the attempt to define an empirical relationship bringing in additional parameters was thought to be possible. But as the relationships were getting more and more defined, it was found that none of the models could really fit into the requirements of the exchange as it started evolving. Instead the random walk model was used to explain the behaviour of the forex institutions. The way the exchange rates behaved and the money flow itself was set to rest with the help of random walk model (Kenneth Rogoff, 2001). Paul Krugman (1991) proposed the target zones after analysing the reasons behind the changes in the exchange rates between pound and dollar. Instead of pegging or fixing the values of one currency against the other, the target zones created the band. The band will be maintained by the central bank intervention. If there is specifically variation or fluctuation of the rates beyond the band then the intervention will be more pronounced and the rate will be tried and brought back within the band. The most celebrated banding of the exchange rates was done by the European Monetary System that maintained the exchange rates of member countries within the +/- 2.25% band created around a grid of central parities. This ensured that when the currencies merged there was no uneven merger taking place (Giovazzi & Giovanni, 1989). The target zone indeed helps to stabilise the exchange rate market (Steven Durlauf & Lawrence Blume (eds), forthcoming 2007). Futures The interest futures are being gainfully employed for the purpose of controlling the exchange rate behaviours in the market by the central banks of various countries (John Driffill, et al, 29 Mar 2005). The futures on the exchange rates which is becoming more pronounced of late is having a larger influence on the exchange rates than the interest futures. Whereas in the case of commodity futures, the market is decided more by the political, environmental, industrial, economic and competitive factors, in the case of currency, the future rates are becoming more and more speculative with large banking on the political and economic status of the country. This speculative trading and the effect of such speculative trading on the currencies were very clear during the 1997 Asian currency crisis (Stanley Fischer, 22 Jan 1998). Though the effect of the futures was minimal in the crisis, the effect has become more pronounced in the new millennium. It has been found that 'the amount of information contained in currency futures prices is much greater than one would expect based on relative market size' says Joshua Rosenberg and Leah Traub. The futures is increasing in its volume trade done compared to the spot business and the impact is gradually getting noticed in the business. The effect of futures on the business is therefore, felt by the researchers and presented in a number of reports that have come forth. However, there is no study that indicates the comprehensive or an empirical relationship that exists between the volume traded in the futures market and their price levels with the spot market price levels either on the current counter or in the future point of time. This impact is yet to be fully studied or analyzed by researchers. Methodology This will be using a detailed literary review coupled with data collection made using a survey and from existing archived data. This information is then analysed using SPSS or other software tools based on the quantitative results. For the qualitative results, analysis is done using the existing information. Methods Approach This research will be carried out both quantitatively and qualitatively. On a broader scale, the research will comprise of the following steps: 1. Detailed Literary Review: the current study of the literature in the connected sphere will be expanded and a comprehensive review of both the points for and against the hypothesis will be gathered. This information will be analysed and then specific opinion will be formed based on this information. This might be in line with the hypothesis or may not be. This would then be presented in the report. 2. Survey: A qualitative and a quantitative survey will be carried out. In order to execute this, a questionnaire will be decided to gather relevant information that would help in identifying whether the traders in the business saw any specific relationship between the factors. The questionnaire will comprise of both qualitative open ended questions, so that the ideas in the minds of the respondents can be taken out. The questionnaire will also have specific quantitative questions that would help in organising and identifying a quantitative response to the issue under question (Neumann WL, 20 Sep 2005). This would enable in further statistical analysis of the data that is collected. The questionnaire will be prepared based on these principles and will be circulated among the respondents as detailed in the data collection section. 3. Data collection will be done based on the information so far gathered and from the survey that will be done using the questionnaire framed. Data collection will also be collected on the market fluctuations and facts of the market. Data for this is available with a number of sources. This will be collected and used for in analysis further (Coxon APM, Jan 1999). 4. Data analysis: Now the data collected will be under three categories: 1. Qualitative data 2. Quantitative Data 3. Data from the other sources. The qualitative data is not analysable and is of the nature that can be used for the purpose of clarifying and identifying specific results that are either in line with our perception or against. The qualitative data will only help in forming opinions and not in any other way. Whereas, the quantitative data can be used along with the data from the other sources to identify and find the nature of relationship that exists between the factors considered. Analysis can be carried out using any of the statistical tools like SPSS and others. The analysis can also be done using Microsoft Excel if needed. This would help in bringing out a graphical and empirical relationship between the factors identified and presented. A model will not be complete if the factors are not related and if their behaviour is not predictable. 5. Based on this analysis, conclusions are drawn for the entire project. All the points for and against the hypothesis are lined up to bring about a clearer understanding of the project. These are then tabulated and presented. Data Collection Once the questionnaires are framed, data collection will be done from willing respondents who are in line with our plan of respondents. These have to be a select list of people from various walks of life and are directly or indirectly linked to the foreign exchange market. A stratified random sampling is done of the respondents that would ensure randomness of the sampled respondents as well as provide the research with enough data for grouping the responses and ensure proper analysis of such responses (William G Cochran, July 1997). The respondents are also categorised based on the level of involvement in the foreign exchange market. The major classifications will be trader, broker, bank, financial institution and others. This would help in establishing the nature of interest that the respondent might have and might also be able to segregate his or her motive in such responses (Statistics Canada, 2006). Data collection is also done from the market. This will be the macro and micro economic data that pertains to the traded currencies, viz., Pound Sterling and the US Dollar. Both the currencies and their data for the period under reckoning will be collected. The traded volumes in the currencies in the futures market and their price levels will also be collected. For the same period, the spot prices will also be taken into consideration and the same will be compared with the future prices decided during the earlier period until the end of the contract. The variations of the data with reference to both the futures as well as with the spot prices are taken to ascertain the quantum of loss sustained or profits made during this period by the traders is marked out. This will help in judging the nature of movement of pricing and its relationship with the futures. Time Scale This work will require time to collect relevant information from the respondents and from various locations for the exchange. This would take six months to execute the job to its completion from the commencement of the research. It is also important to note that the work would require travelling if needed to ensure that the right kind of data is collected. Conclusion Many models have been made and they have succeeded in predicting the behaviour of the foreign currency exchanges to some extent. There are a number of factors that make the foreign exchange rates still unpredictable and the empirical formulas have failed to that extent. There are new factors that get added to the empirical formula depending on the nature of work that has to be carried out on the exchanges. Factors like the interest futures, political and economical issues also affect the price of the currency. It was also suggested that the futures market for the currencies also play an important role in determining the rates of the currencies at the given point in time. But then, the futures price themselves are not determined by any scientific reasoning but by speculation. However, the relationship between the futures rates on the currency prices have significant impact on the same period pricing of the currency has been taken as the hypothesis for the current research work. All documents and literature in support of and against the hypothesis will be collected and the needed survey will be carried out to collect the relevant data. This data will be used and analysed to either prove or counter the hypothesis thus drawn. References 1. Coxon APM (Jan 1999) Sorting Data: Collection and Analysis, Sage Publications. 2. Giavazzi & Giovanni (1989) Limiting Exchange Rate flexibility: The European Monetary System, Cambridge MA: MIT Press. 3. Ian Marsh & Paul Hallwood (Aug 2003) Exchange Market Pressure on the Pound-Dollar Exchange Rates: 1925-1931, University of Connecticut, Department of Economics Working Paper Series. 4. John Driffill, et al, (2006) Monetary Policy and Financial Stability: What role for the Futures Market School of Economics Mathematics and Statistics, Birkbeck College, University of London, available at: http://www.ems.bbk.ac.uk/faculty/driffill/Finstability_22March05_JD.pdf 5. Kenneth Rogoff (2001) The failure of empirical exchange rate models: no longer new but still true, Economic Policy: Web Essay, Harvard University, available at: http://www.economics.harvard.edu/faculty/rogoff/papers/EP_Web2001.pdf 6. Neumann WL (20 Sep 2005) Social Research Methods: Qualitative and Quantitative Approaches - Sixth edition, Allyn & Bacon: University of Wisconsin at Whitewater. 7. Paul Krugman (1991) Target Zones and Exchange Rate Dynamics, Quarterly Journal of Economics, 106, pp 669-682. 8. Peter Hooper & John Morton (1980) Fluctuations in the dollar: a model of nominal and real exchange rate determination, International Finance Discussion Papers, No. 168, Board of Governors of the Federal Reserve System (U.S.). 9. Stanley Fischer (22 Jan 1998) The Asian Crisis: A view from the IMF, Address at the Midwinter conference of the Banker's Association for Foreign Trade, Washington DC, available at: http://www.imf.org/external/np/speeches/1998/012298.htm 10. Statistics Canada (2006) Data Collection Methods, Canada's National Statistical Agency, available at: http://www.statcan.ca/english/edu/power/ch2/methods/methods.htm 11. Steven Durlauf & Lawrence Blume (eds) (2007 forthcoming), Exchange Rate Target Zones, Palgrave-MacMillan. 12. William G Cochran (Jul 1997) Sampling Techniques 3rd Edition, Wiley. Read More