Foreign exchange markets

30 June 2008

Foreign exchange market volatility picked up sharply in the latter half of 2007 and has remained at elevated levels since. This was associated with a faster rate of decline of the US dollar as well as a substantial appreciation of the euro, yen and Swiss franc. As carry trades became less attractive, expected growth differentials became more of a focal point for market sentiment than prevailing levels of interest rates. While exchange rate policies continued to shape the behaviour of some emerging market currencies, developments in commodity prices and specific trends in capital flows also exerted a considerable influence on exchange rates.

Notwithstanding some significant exchange rate movements and tensions in certain foreign exchange swap and cross-currency swap markets, foreign exchange spot markets generally continued to function smoothly throughout the period of higher volatility. From a longer-term perspective, there have been a number of notable developments that could potentially have a bearing on the resilience of foreign exchange markets. These include higher turnover, greater diversity in foreign exchange market activity and improvements in the risk management infrastructure. While generally positive, it is possible that the full implications of these developments for market dynamics at times of stress have not yet become apparent. It is important, therefore, to sustain the impetus for better risk management practices in foreign exchange markets going forward.