The Currency Market Information Edge

The global foreign exchange (forex) market is the largest financial market in the world, and its size and liquidity ensure that new information or news is disseminated within minutes. The forex market has some unique characteristics, however, that distinguish it from other markets. These unique features may give some participants an "information edge" in some situations, resulting in new information being absorbed over a longer period of time. 

Unique Characteristics of the Forex Market Unlike stocks, which trade on a centralized exchange such as the New York Stock Exchange, currency trades are generally settled over the counter (OTC). The OTC nature of the global foreign exchange market means that, rather than a single, centralized exchange (as is the case for stocks and commodities), currencies trade in a number of different geographical locations, most of which are linked to each other by state-of-the-art communications technology. OTC trading also means that at any point in time, there are likely to be a number of marginally different price quotations for a particular currency; a stock, on the other hand, only has one price quoted on an exchange at a particular instant. 

The global forex market is also the only financial market to be open virtually around the clock, except for weekends. Another key distinguishing feature of the currency markets is the differing levels of price access enjoyed by market participants. This is unlike the stock and commodity markets, where all participants have access to a uniform price. 

Market ParticipantsCurrency markets have numerous participants in multiple time zones, ranging from very large banks and financial institutions on one end of the spectrum, to small retail brokers and individuals on the other. Central banks are among the largest and most influential participants in the forex market. On a daily basis, however, large commercial banks are the dominant players in the forex market, on account of their corporate customers and currency trading desks. Large corporations also account for a significant proportion of foreign exchange volume, especially companies that have substantial trade or capital flows. Investment managers and hedge funds are also major participants.

Differing Prices Banks' currency trading desks trade in the interbank market, which is characterized by large deal size, huge volumes and tight bid/ask spreads. These currency trading desks take foreign exchange positions either to cover commercial demand (for example, if a large customer needs a currency such as the euro to pay for a sizable import), or for speculative purposes. Large commercial customers get prices, with a markup embedded in them. from these banks; the markup or margin depends on the size of the customer and the size of the forex transaction. Retail customers who need foreign currency have to contend with bid/ask spreads that are much wider than those in the interbank market. 

Speculative Positions Vs. Commercial TransactionsIn the global foreign exchange market, speculative positions outnumber commercial foreign exchange transactions, which arise due to trade or capital flows, by a huge margin, although the exact extent is difficult to quantify. This makes the forex market very sensitive to new information, since an unexpected development will cause speculators to reassess their original trades and adjust these trades to reflect the new information. For example, if a company has to remit a payment to a foreign supplier, it has a finite window in which to do so. The company may try to time the purchase of the currency so as to obtain a favorable rate, or it may use a hedging strategy to cover its exchange risk; however, the transaction has to occur by a definite date, regardless of conditions in the foreign exchange market. 

On the other hand, a trader with a speculative currency position seeks to maximize his or her trading profit or minimize loss at all times; as such, the trader can choose to retain the position or close it at any point. In the event of new information, the adjustment process for such speculative positions is likely to be almost instantaneous. The proliferation of instant communications technology has caused reaction times to shorten dramatically in all financial markets, not just in the forex market. This knee jerk reaction, however, is generally followed by a more gradual adjustment process, as market participants digest the new information and analyze it in greater depth. 

Information EdgeWhile there are numerous factors that affect exchange rates, from economic and political variables tosupply/demand fundamentals and capital market conditions, the hierarchical structure of the forex market gives the biggest players a slight information edge over the smallest ones. In some situations, therefore, exchange rates take a little longer to adjust to new information. 

For example, consider a case where the central bank of a major nation with a widely-traded currencydecides to support it in the foreign exchange markets, a process known as "intervention." If this intervention is unexpected and covert, the major banks from which the central bank buys the currency have an information edge over other participants, because they know the identity and the intention of the buyer. Other participants, especially those with short positions in the currency, may be surprised to see the currency suddenly strengthen. While they may or may not cover their short positions right away, the fact that the central bank is now intervening to support the currency may cause these participants to reassess the viability and implications of their short strategy. 

Example – Forex Market Reaction to News All financial markets react strongly to unexpected news or developments, and the foreign exchange market is no exception. Consider a situation in which the U.S. economy is weakening, and there is widespread expectation that the Federal Reserve will reduce the benchmark federal funds rate by 25 basis points (0.25%) at its next meeting. Currency exchange rates will factor in this rate reduction in the period leading up to the expected policy announcement. If, however, the Federal Reserve decides at its meeting to leave rates unchanged, the U.S. dollar will in all likelihood react dramatically to this unexpected development. If the Federal Reserve implies in its policy announcement that the U.S. economy\'s prospects are improving, the U.S. dollar may also strengthen against major currencies.

The Bottom LineWhile the massive size and liquidity of the foreign exchange market ensures that new information or news is generally absorbed within minutes, its unique features may result in new information being absorbed over a longer period in some situations. In addition, the hierarchical structure of the forex market can give the biggest players a slight information edge.

Ways You Can Short Europe

It's well known that the European Economic and Monetary Union (EMU) is in dire straits. Insolvency plagues the region, with countries like Portugal, Ireland, Italy, Greece and Spain (colloquially called the PIIGS) facing massive budget deficits relative to theirGross Domestic Products (GDP) and rising unemployment. Furthermore,impotent monetary policy as well as a prolonged lack of unified fiscal policy have dampened growth prospects and exacerbated the EMU's problems.

Before considering a specific investment, an experienced investor will make it a point to thoroughly understand the macroeconomic panorama at hand. Solutions addressing the woes of the eurozone are varied. Proposed reforms to the Maastricht Treaty include banking and fiscal union; all the while, eurozone leaders debate the effectiveness of economic stimulus programs. To a certain extent, any legislation to bolster confidence in the EMU would be healthy for the global economy. Inaction is the eurozone's greatest enemy.

Financials and the Euro
From a traditional standpoint, the Financial Services industry is typically a bull-market sector, suffering most when Mr. Market experiences a downturn. Accordingly, European banks have struggled to remain solvent throughout the euro crisis, as their loans have had difficulty performing and their assets have depreciated in value. These symptoms are most evident in the nations hit the hardest by the euro crisis, namely the PIIGS nations. Within the economies of Ireland and Spain, where housing bubbles popped in 2008, the banking system has had an especially hard time getting back on its feet.

Shorting banks in these in high debt-to-GDP ratio countries is an interesting move - if you can do it. While the P/E multiples of European financial stocks, such as Banco Santander or Deutsche Bank, are currently low, the exit of any PIIGS nations from the EMU would trigger a massive sell-off within the industry across Europe. Other industries would surely suffer as well, but a devalued currency would challenge banks with eroding balance sheets and cash flows. More specifically, the inevitable devaluation of an exited nation's instituted currency would result in the further lowering of equity multiples for domestic Financial Services firms. 

Exchange traded funds can make capitalizing on this bearish outlook on European financials easier, such as the iShares MSCI EMU Index. For individuals predicting further decline in the euro against the greenback, leveraged ETNs like Market Vectors Double Short Euro ETN are an option.

Shorting Government Bonds 
Generally, it's difficult to short a bond, especially one in a continent beyond your borders. Moreover, bond-land is not customarily as volatile as the stock market, making it harder for a short to perform well. In Europe, bond auctions in PIIGS nations are seeing all-time low prices and all-time high yields. Throughout the euro crisis, the results of these bond auctions have been an indicator of investor confidence. Even a cursory examination of the yields in PIIGS nations shows that investors are wary of the risks associated with the eurozone's worst economies. Clearly, the time to short debt offerings in these nations has come and gone.

However, in a more economically robust country, such as Germany, the exit of any PIIGS nation from the EMU would render a short play wildly profitable. If any nation left the eurozone, German national debt offerings might suffer disastrous consequences. Germany's treasury bonds have already been propped up by a "flight to quality." Furthermore, if a PIIGS nation split ways with the euro, confidence in the system as a whole would waver and German bonds would conceivably plummet in price, while yields would skyrocket. A flight from quality, so to speak, can be significantly more rampant and contagious than its inverse. Shorting ETFs, such as WisdomTree Euro Debt Fund, with holdings in German and French bonds might make for one way to profit from this ordeal.

The Bottom LineAs European leaders flounder to reach a consensus on fiscal, monetary and economic stimulus policies, investors can capitalize on the EMU's systemic weakness. While the economic turmoil in Europe opens opportunities for short selling, be advised that some European nations have temporarily imposed bans on short selling individual securities.

Knowing which precise stocks, bonds and other structured products to short is difficult; an understanding of the macroeconomic issues at stake is of the utmost importance. Only when equipped with this knowledge can an investor confidently make investments, especially during tumultuous financial times.