Market Volatility a Necessary Windows for Financial Profit
In fact, market volatility, another term for shot-term instability, in the financial sector of the economy has become a major source of profit for financial institutions.Long-term investors are endangered species in the financial world; most market participants have become leveraged traders for short-term profit, even pension funds and university endowment funds. The only factor of production that maintains any semblance of stability is wages.
The recurring financial crises around the world shared similar characteristics. Each crisis was largely unanticipated by market analysts and central bank economists, with the forward markets providing no indication of the impending upheaval. Going into each crisis, complacent traders took on highly leveraged long positions in currencies, bonds, or spread products that soon came under heavy speculative counterattack.In each case, traders adopted trading models constructed from historical paradigms to guide their trading strategies. When a decisive majority of traders followed similar trading strategies, the market would overshoot from technical pressure and conventional wisdom became disconnected with reality. But once a crisis hit and conventional wisdom was discredited by facts, traders rushed to liquidate their highly leveraged positions en mass, hoping for timely exit before the crowd. In each instance, the rush to unwind highly-leveraged positions accentuated the magnitude of the currency or fixed-income crises.
Exchange Rates and Purchasing Power Parity
Theoretically, exchange rates adjust to achieve purchasing power parity (PPP) between two currencies. PPP is achieved when a unit of domestic currency can purchase the same quantity of goods in another economy when converted to foreign currency at the prevailing exchange rate, to conform to the law of one price. If PPP holds, then identical baskets of goods should sell for the same price in each economy after exchange rate conversion. If they do not, then opportunities for “risk-free profits” will exist through arbitrage in foreign exchange markets that translates into massive flows of funds across national borders. Eventually, price arbitrage will set a market exchange rate or the prices of goods in the two economies will change so that PPP between the two currencies is reestablished. With deregulated global capital markets, prices of assets also adjust towards convergence of PPP between two currencies to cause market crashes.
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