Volatility and Interconnectedness of Foreign Exchange Market

The Foreign Exchange Market in short also called the forex market is a global marketplace for exchanging national currencies. This market determines foreign exchange rates for every currency. It includes all aspects of buying, selling, and exchanging currencies at current or determined prices.

Foreign exchange trading uses currency pairs, priced in terms of one versus the other such as USD/IRS (U.S. dollar versus Indian Rupees), EUR/USD (euro (EUR) versus the USD) or USD/JPY U.S. dollar versus Japanese Yen, USD/GBP, (US Dollar versus Great Britton Pounds), etc.

Reasons for volatility in the forex market:

Generally, oil exports, forex regimes, and monetary policies, the financial and political environment of interconnected countries are major factors driving volatility transmission in global forex markets. Political turmoil, natural disasters, and war are some of the other events that can have a deep effect on the currency markets.

The interconnectedness of foreign currencies:

The US dollar (USD) and Euro are major volatility transmitters in the forex market while other currencies including the Japanese yen and the British pound are net volatility receivers. In volatility connectedness, network currencies of 65 major global currencies, tend to be bunched according to geographical distributions. While a direct relationship may not be apparent, it’s the ripple effects from a small market disruption can have an immediate effect on exchange rates and currency values due to the global and inter-connectedness of the forex marketplace.

Devaluation of a currency:

In macroeconomics and modern monetary policy, devaluation is an official lowering of the value of a country’s currency within a fixed-exchange-rate system. Countries use devaluation to boost exports due to the lowered value in currency perceived by countries that import the goods, reduce trade deficits, and lower the cost of interest payments on government debt. The negative implications of devaluation include fostering uncertainty within the global markets and creating tension between other competing countries. On July 1, 1997, the central bank of Thailand devalued their currency Baht. This caused a chain reaction of falling stock markets and asset price devaluations as private debt exploded throughout Asian markets from South Korea, Philippines, Laos, and Malaysia to Singapore, Taiwan, Vietnam, Indonesia to Japan, Hong Kong, and even mainland China and eventually leading to a U.S. market crash four months later.

Change of Government due to election or coup:

Change of any government either due to elections or due to a coup where a lawful government is overthrown through illegal means can cause potential political instability and uncertainty. Forex traders don’t like the uncertainty. Political instability tends to outweigh any positive outcomes from a new government in the short run, and related currencies will usually suffer losses.

Impact on unplanned elections:

Unplanned elections due to no-confidence motions, corruption scandals, or any major revolt against the government can wreak havoc on the currency of the country. This is because a change in government can mean a change in the monetary or fiscal policy of the new government, which is typically associated with greater volatility in the value of a country’s currency.

The fallout of natural disaster:

The fallout from a natural disaster can be catastrophic for a country. Natural disasters like Earthquakes, floods, tornadoes, and hurricanes harm a country’s citizens, morale, and infrastructure. Extensive damage to infrastructure which is the backbone of any economy results in drainage of funds for repairs and for the affected areas to function properly. Natural disasters unexpectedly disturb the normal inflow of foreign reserves, thus, they prevent an economy from purchasing the required quantity of foreign goods. Natural disasters also lead to the outflow of capital due to uncertainty. The loss of life, and widespread damage coupled with the uncertainty that inevitably accompanies natural disasters can lead to a decline in currency value.

War between countries:

The war between Russia and Ukraine posed a threat to the world supply chain system. Russia supplies oil and gas to countries such as Europe. Ukraine is a supplier of agricultural resources, etc. to many parts of the world. Due to war problems, these resources were cut off. There was also the threatened energy supply issue. The increase in oil prices leads to the increase of related products together. Trading in international currency markets was also affected by the war. Due to the war, the euro currency fell more than 4% against the dollar.

Related Posts:

1. EXPLAINED: INTERCONNECTEDNESS OF CREDIT MARKET

2. BENEFITS AND RISKS OF INTERCONNECTEDNESS OF BANKS

3.. INTERCONNECTEDNESS OF THE MONEY MARKET

4. INTERCONNECTEDNESS OF THE CAPITAL MARKET

5. THE INTERCONNECTEDNESS OF FINANCIAL MARKETS