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12 September 2017 Financial Analysts Journal Book Review

Foreign Exchange: A Practical Guide to the FX Markets (a review)

  1. Mark S. Rzepczynski

This short, practical book written in a refreshing and charming prose style constitutes a fine introduction to the foreign exchange market. It describes the basic market rules and supplies guidelines for determining value and managing risk; it does not fully close the gap between the theoretical world and practical aspects of investing in the FX market.

Even though foreign exchange (FX) is a vast market and possibly the most liquid in the world, it remains an area in which a well-written guide for practitioners is hard to find. The shortage of good books on the subject probably arises from the multiple challenges inherent in satisfying an audience with a wide range of knowledge and beliefs. Many investors still perceive FX as a “foreign” asset class with an arcane structure and Byzantine rules. Some do not consider it an asset class at all. Others think the volatility of foreign exchange exceeds any associated diversification benefits. Numerous institutions view exchange rates as an afterthought in generating returns and are further put off by the currency market’s uncertain valuation rules.

To benefit practitioners with diverse levels of sophistication, an FX primer must describe the basic market rules effectively and supply guidelines for determining value and managing risk. Furthermore, it must do all this in language comprehensible to readers who are more familiar with the equity and fixed-income markets.  Foreign Exchange: A Practical Guide to the FX Markets  fills this tall order. Using a refreshing and charming prose style, author Tim Weithers excels in making the esoteric FX world accessible. His book is filled with lively asides that convey useful information not often found in works on the subject.

The book appears to be an extension of Weithers’ training sessions for UBS employees and clients. His teaching experience has led him to focus on pricing conventions, the most formidable hurdle for newcomers to the world of exchange rates. He furnishes a solid introduction to the major markets—spot, forwards and futures, and options—as well as to the major market participants. His explanation of relative pricing conventions for all market instruments is the best available treatment of the subject. In addition, Weithers’ use of well-chosen examples and his focus on market segments prone to pricing mistakes are quite helpful.

FX options, a major focus of the book, are discussed with clarity and in considerable detail. The author’s strategy of presenting relative prices as the foundation of exchange rates is an effective means of outlining the relationship between calls and puts. In addition, Weithers points out similarities between FX option valuation and option valuation in other contexts, thereby demonstrating that FX models are simple extensions of well-known equity models. Progressing from elementary to more exotic models, Weithers gives the reader a good intuitive feel for the dynamics of these instruments.

Notwithstanding its excellent didactic methods,  Foreign Exchange  is written from a trading perspective, not from the investor’s viewpoint. For example, it contains no discussion of hedging FX risk. Readers hoping to gain insight into methods of controlling exchange rate risk will be disappointed. Those seeking to learn what makes the FX markets move will derive limited value from this book.

Investors who already have a working knowledge of the currency markets will not find much of the subtle detail that lies beneath the basic conventions. Furthermore, the book offers only a limited discussion of market microstructure, an increasingly important area of financial analysis. Not addressed, for example, are the dramatic changes from decentralized dealer markets to the use of electronic platforms. A firm grasp of market trading dynamics is essential to understanding the FX market.

Additionally,  Foreign Exchange  does not fully close the gap between the theoretical world and practical aspects of investing in the FX market. For instance, the author explains uncovered interest rate parity but does not explore the reasons why carry trades are so effective. In theory, the parity condition should not allow carry to persist. The puzzle of forward rate bias has spurred extensive academic research and vast flows of investor capital. Rarely does a discussion of exchange rates fail to turn to the dynamics of carry.

The author also declines to tackle the critical issue of the large slippage between theory and empirical reality in pricing. Lack of clarity on valuation may be the single biggest reason more investors do not trade foreign exchange. The fact that exchange rate models explain so little of the variation in prices is an ongoing riddle. With the market drivers still incompletely described, it is no wonder that practitioners continue to debate whether FX markets are too volatile. The most recent area of focus on valuation, flow dynamics, is a natural topic for a practitioner’s book, but it is not addressed except for a discussion of the key market participants.

Weithers devotes significant space to currency crises, which have been an important component of volatility in the past two decades. Unfortunately, the book’s review of the events may actually cause many investors to shy away from the FX markets. Why would anyone want to trade or invest in a market susceptible to regular, although seemingly unexpected, crises? Further undermining the case for FX investment is the book’s lack of discussion of techniques for protecting investors from crises through effective risk management.

The author provides a short review of technical analysis but does not address the two most important questions related to these techniques:

  1. Does technical trading work in practice?
  2. Why would technical trading be more likely to work in foreign exchange than in other asset classes?

To the first question, the answer is mixed. Technical trading was successful through the mid-1990s, but the performance of technical models, especially those based on relatively simple decision rules, has clearly deteriorated since then. Nevertheless, surveys indicate that technical tools are still one of the most important components of FX trading decisions.

An answer to the second question is complex. The mix of players, which includes central banks, may contribute significantly to the success of technical trading. Many non-profit-maximizing participants, such as hedgers, operate alongside central banks that have policy objectives to “lean against the wind.” Moreover, the market is decentralized and opaque. Given these dynamics, the speed of adjustment of prices may be slower than in other markets. Consequently, following the price action can represent a superior trading strategy. It would have been helpful if Weithers had provided theories of this sort.

To summarize,  Foreign Exchange  is a short, practical book that constitutes a fine introduction to the FX market. It is especially useful to readers who have been frustrated by the lack of specifics in other texts. Unfortunately, the author does not provide readers a firm foundation in the economics of exchange rates. 1

A significant body of academic research on exchange rates remains to be translated for practitioners. Unfortunately, investors will have to wait a bit longer for a work that truly bridges the gulf between theory and reality. In the interim,  Foreign Exchange: A Practical Guide to the FX Markets  will fill some of the gap. Without the benefit of greater understanding of market dynamics than this book provides, however, a new FX investor could be trading under hazardous conditions.


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