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Handbook of Exchange Rates by Lucio Sarno, Ian Marsh, Jessica James

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22.3 Foreign Exchange Investable Indices and Strategy-Based Products

22.3.1 Why Profit Opportunities Exist?

We showed in Section 22.1 how much FX market has grown over the years and how big it actually is compared to the bond and equity markets. If the market is so deep with tight spreads, should we not expect the inefficiencies to be traded away? How is it possible to make money from FX?

The efficient market hypothesis assumes that investors are rational and are all profit oriented. However, in the FX market, the majority of the players are not motivated by profits from FX. The trading volumes are dominated by players whose goal is not necessarily to make money from FX. Currencies are bought or sold by central banks driven by policy; by corporations for hedging purposes, to make payments for expenses, or to repatriate earnings; by funds to rebalance international equity or bond exposures; and, finally, by tourists. According to estimates, a substantial portion of the daily trading volume is not profit oriented and is instead based on a need to simply exchange currencies. This means that the pure profit-oriented volume does not dominate the total volume traded. Hence, the FX market economically is inefficient and returns can potentially be generated.

Note that the alpha seeking portion of the currency market is included in “other financial institutions” in Figure 22.2. The share of the daily turnover for this category has increased from 13% to 48% between 1992 and 2010. However, ...

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