An Analysis of the Information Content of Foreign Exchange Rate Movements

Abstract

Few of us fail to realize foreign exchange rates are ratios rather than prices, but we almost universally use them as if they were in fact the prices of currencies. This paper converts FX rates into prices by defining the value of each currency as its spending power in its home country: the place where it can be spent. Each FX rate becomes the ratio of two such values. The value of the absolute spending power of one currency in relation to another is not considered. Instead, the changes in the spending power of each currency relative to its counterpart contained in daily FX movements are examined. To make this observable, a synthetic exchange rate series is generated from the ten floating currencies most frequently traded against the US dollar. In this series the change in spending power (value) of each currency each day is known. The spending power changes derived from these synthetic FX rates are compared with the information which can be derived from actual exchange rates. The results show changes in FX rates contain almost no useable information on changes in currency values and are in fact unintuitive and highly misleading. If market participants act on the assumption that, in the absence of price sensitive information, yesterday’s FX rate is the best estimate of today’s rate, they will trade in a manner that leads to FX volatility rather than mean reversion. A solution to this problem is proposed. All changes in the value of individual currencies can be made completely transparent by introducing a global benchmark currency to replace the US dollar as the vehicle currency in FX trades.