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Economists seeking to understand what drives short-term changes in the demand for foreign currencies have been little helped by macroeconomic models. While these models can explain exchange rate changes over longer horizons, they do a poor job of tracking rate changes on a daily, weekly, or monthly basis.
This article argues that a potentially useful tool for understanding the short-term dynamics of exchange rates is the net foreign currency position of speculators in the futures market. The net position—calculated as contracts to buy a foreign currency at a future date minus contracts to sell the same currency—is carefully watched by currency market analysts, who interpret its movements as a good proxy for speculators’ changing views of the short-term direction of exchange rates.
Authors Klitgaard and Weir use data from the Chicago Mercantile Exchange to conduct statistical tests of the relationship between speculators’ net positions and exchange rates during the 1993-2003 period. They find a strong correlation between changes in speculators’ net positions in a given week and exchange rate moves over the same period. More specifically, they observe that
knowing the direction of the change in the net position in a particular currency would give observers a 75 percent chance of guessing the exchange rate’s direction correctly, and that
weekly changes in speculators’ net positions can track 30 to 45 percent of exchange rate movements of the major currencies over the same week.
The authors conclude, however, that position data do not predict exchange rate changes over the following week.
The authors’ findings suggest that net position data may be useful to policymakers. Because these data shed light on how some exposures in the currency market are evolving, they can be a timely supplemental source of information for those charged with ensuring the orderly functioning of markets. In addition, the data provide quantitative evidence that may help policymakers reach more informed assessments of the causes of currency price movements.
About the Authors
Thomas Klitgaard is a research officer and Laura Weir a vice president at the Federal Reserve Bank of New York.
The views expressed in this summary are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System.