As we know from earlier posts, economic theory approaches the issue of exchange rates by trying to find a theoretical equilibrium level, against which one can measure over- or undervaluation relative to the actual exchange rate. Such theory relies on a number of important premises with regard to the information that might affect exchange rates:
Exchange rates reflect all available knowledge at any one time
There is perfect knowledge dispersal (such that no-one has an advantage)
While it is debatable whether or not these exist in other financial markets, we do know that these are not the reality in the currency market. Many people think of the currency or FX market as the “perfect market”, being that in which knowledge dispersal is optimum and which responds with perfect efficiency to stimulus. This simply isn’t the case. Information is not perfect and some market participants can indeed gain a knowledge advantage over their counterparts. Why is this so?
The sheer weight of information affecting exchange rates at any one time is so huge that all currency market practitioners cannot possibly absorb all of it all of the time.
Knowledge dispersal is not perfect and some do have an advantage over others. Such advantages may include knowledge about specific flows that may occur, a bank’s own “order book” and finally the ability to do larger currency market transactions than other market participants.
If knowledge is power, then such power in the currency market is not distributed equally. This is no accident. Indeed, it is the very intention of normal and healthy competition to try to gain advantage over other market participants. While news information has never been as freely available as now, at some point that very availability swamps the ability of the users of such information to absorb it all. To some, we appear closer to a state of perfect knowledge than we have ever been, yet I would liken this to the speed of transportation. In 1900, the average speed of the leading mode of transportation in the city of London (the horse) was 11 miles an hour. In 2000, the average speed of the now leading mode of transportation (the turbo fuel-injected car) was . . . 11 miles an hour. Progress begets more progress until you progress so far that you go nowhere. The more information that is available to us, the less we actually have the time (or the willingness) to read. If the good news is that we are closer to perfect knowledge than we have ever been, then the bad news is that we are never likely to get there!
Information costs money to deliver and therefore there is not “perfect” information delivery because not everyone gets it, either at all or at the same time. Even if it were free, “information overload” still means that not everyone reads and uses it at the same time. If you don’t believe me, just think of your e-mail inbox! In sum, there is neither perfect information nor perfect information dispersal — and there never will be. In response, an economist might argue that we have “good” information, if not perfect information. It would be tough to argue with this, but then “good” is not “perfect” and “perfect” is a necessary aspect of the equilibrium concept. Furthermore, this supposed equilibrium level is rarely ever reached. Real life is surely a constant state of flux and imbalance, so why should financial markets be any different? In turn, if one assumes that the economic fundamentals that can affect exchange rates are themselves in a constant state of flux, one must equally assume that the equilibrium itself is in a constant state of flux — which to an extent calls into question the idea of it being an “equilibrium” in the first place. In truth, it is a signpost on a road. It points you in the right direction, but it gives you no idea of when you will get there or where you might have to turn off along the way.