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How To Profit From Interventions In The Forex Market
How would you like to make $1,287 in 10 minutes? Well, if you had purchased a $100,000 lot of U.S. dollar/Japanese yen on Dec. 10, 2003, at 107.40 and sold 10 minutes later at 108.80, you could have. It would have worked like this:
1. Bought $100,000 and sold 10,740,000 yen (100,000*107.40)
2. Ten minutes later, the USD/JPY increases to 108.80
3. Sell $100,000 to buy 10,880,000 yen, to realize a gain of 140,000 yen
4. In dollar terms, the gain would be 140,000/108.8 = $1,286.76 USD
Tutorial: Top 10 Forex Trading Rules
There becomes a problem, however, when there is a sudden, rapid and sustainable movement in a currency's valuation, which makes it impractical, or even impossible, for a central bank to immediately respond via interest rates, used to quickly correct the movement. These are times in which interventions take place.
A Brief Economics Lesson
The entire foreign-exchange market (forex) revolves around currencies and their valuations relative to one another. These valuations play a large role in domestic and global economics. They determine many things, but most notably the prices of imports and exports.
Instability and Intervention
Since currencies always trade in pairs relative to one another, a significant movement in one, directly impacts the other. When a country's currency becomes unstable for any reason, speculation, growing deficits, or national tragedy, for example, other countries experience the aftereffects. Normally, this occurs over a long period of time, which allows for the market and/or central banks to effectively deal with any revaluation needs.
Valuation and the Central Banks
In order to understand why interventions occur, we must first establish how currencies are valuated. This can happen in two ways: by the market, through supply and demand, or by governments (i.e., central banks). Subjecting a currency to valuation by the markets is known as floating the currency. Conversely, currency rates set by governments is known as fixing the currency, meaning a country's currency is pegged to a major world currency, usually the U.S. dollar.
Thus, in order for a central bank to maintain or stabilize the local exchange rate, it will implement monetary policy by adjusting interest rates or by buying and selling its own currency on the foreign-exchange market, in return for the currency to which it is pegged. This is called intervention. (To learn more about a central bank's role read: How do central banks inject money into the economy?)
Take the USD/JPY currency pair, for example. Between 2000 and 2003, the Bank of Japan intervened several times to keep the yen valued lower than the dollar, as they were afraid of an increase in the value of the yen making exports relatively more expensive than imports, and hindering an economic recovery at that time. In 2001, Japan intervened and spent more than $28 billion to halt the yen from appreciating and in 2002, they spent a record $33 billion to keep the yen down.
