JLS: Theory of Central Bank's Target Zone-Based Trading
According to "equilibrium exchange rate theory" as the rule of thumb mutually agreed by the global economists and monetarists, the prices of the exchange rates move from "equilibrium exchange rate at economic fundamental" known as "disequilibrium" to the "equilibrium exchange rate at interest rate differential" known as "equilibrium". Thus, the prices of the exchange rates move from "disequilibrium" to "equilibrium".
The wide or width of the "disequilibrium" to "equilibrium" is the medium term exchange rate target zone by target zone theory. A long debated wide or width of the medium term exchange rate target zones with controversies between policy makers and the global economists and monetarists result the introduction of the Plaza Accord, Louvre Accord, EMS Treaty and monetarists consensus for the target zones set to 5 %, 10 %, 15 % and 15 % by the OECD and IMF.
The global central banks however face difficulties for measuring the target zones with over 300 currency pairs in the market place with mixed interest rate differentials by the mixed interest rate policies by the global central banks. This issue however to be resolved by the introduction of the currency band theory on time series currency band and the time series interest rate differential currency band as the tools for assessing and measuring the actual wide or width of the over 300 currency pairs in the market with mixed interest rate differentials by the mixed interest rate policies by the global central banks.
Time series currency band and the time series interest rate differential currency band is structured to accomodate the 5 %, 10 % and the 15 % on the wide or width of the target zones. It is "dynamic", "self-driven", "self-adjustment", "self-alignment", "self-realignment" to measure the "actual wide or width of the medium term exchange rate target zones". Selected emerging market and developing central banks however are allowed to manage their target zones wider than 15 % due to the limitation of their monetary tools and management.
At equilibrium or equilibrium exchange rate at interest rate differentials, the prices tend to move to out of the currency bands, then the global central banks, individually or collectvely undertake market sterilization to slower the strengthening/weakening of the currency pairs to central band/central parity as agreed by mutual consensus. This sterilization is the short term exchange rate target zone. However, very often the sterilization not necessary due to the fact that world largest capitalized market players regulated by the BIS and the global central banks already anticipate the lower and upper ceilings as well as the central band or central parity.
To the public and during press conference, the global central banks always stated "medium term price stability" which is actually the medium term exchange rate target zone, and short term price stability which is also actually the short term exchange rate target zone. Internal the global central banks recognized as "target zone" and to the "public" introduced as "price stability". Target zone popular interior the global monetarists and price stability popular interior the global economists.
As a result, the global economists fail to predict the FX prices in medium and short terms (Fed working technical paper), but still follow in long term by the economic-based theory of exchange rates, such as PPP, interest rate, balance of trade, balance of assets, as well as other economic-based exchange rate theories introduced by the global economists. However, longer and longer the economic-based exchange rate theories will be lesser uses due to global capital flow free mobility. Economy is creativity and the creativity can only to be established if capital is available - capital flow.
The wide or width of the "disequilibrium" to "equilibrium" is the medium term exchange rate target zone by target zone theory. A long debated wide or width of the medium term exchange rate target zones with controversies between policy makers and the global economists and monetarists result the introduction of the Plaza Accord, Louvre Accord, EMS Treaty and monetarists consensus for the target zones set to 5 %, 10 %, 15 % and 15 % by the OECD and IMF.
The global central banks however face difficulties for measuring the target zones with over 300 currency pairs in the market place with mixed interest rate differentials by the mixed interest rate policies by the global central banks. This issue however to be resolved by the introduction of the currency band theory on time series currency band and the time series interest rate differential currency band as the tools for assessing and measuring the actual wide or width of the over 300 currency pairs in the market with mixed interest rate differentials by the mixed interest rate policies by the global central banks.
Time series currency band and the time series interest rate differential currency band is structured to accomodate the 5 %, 10 % and the 15 % on the wide or width of the target zones. It is "dynamic", "self-driven", "self-adjustment", "self-alignment", "self-realignment" to measure the "actual wide or width of the medium term exchange rate target zones". Selected emerging market and developing central banks however are allowed to manage their target zones wider than 15 % due to the limitation of their monetary tools and management.
At equilibrium or equilibrium exchange rate at interest rate differentials, the prices tend to move to out of the currency bands, then the global central banks, individually or collectvely undertake market sterilization to slower the strengthening/weakening of the currency pairs to central band/central parity as agreed by mutual consensus. This sterilization is the short term exchange rate target zone. However, very often the sterilization not necessary due to the fact that world largest capitalized market players regulated by the BIS and the global central banks already anticipate the lower and upper ceilings as well as the central band or central parity.
To the public and during press conference, the global central banks always stated "medium term price stability" which is actually the medium term exchange rate target zone, and short term price stability which is also actually the short term exchange rate target zone. Internal the global central banks recognized as "target zone" and to the "public" introduced as "price stability". Target zone popular interior the global monetarists and price stability popular interior the global economists.
As a result, the global economists fail to predict the FX prices in medium and short terms (Fed working technical paper), but still follow in long term by the economic-based theory of exchange rates, such as PPP, interest rate, balance of trade, balance of assets, as well as other economic-based exchange rate theories introduced by the global economists. However, longer and longer the economic-based exchange rate theories will be lesser uses due to global capital flow free mobility. Economy is creativity and the creativity can only to be established if capital is available - capital flow.
Comment:
Cross Rates or Derivative Target Zones
The cross rates of derivatives' target zones represent the differential target zones of their major pairs' target zones with correction by the derivatives' interest rate differentials.
For example, the target zone of GBPJPY is the differential target zone of the GBPUSD and USDJPY with correction to "upward" by the current interest rate differential between GBPJPY (positive interest rate differential).
The cross rates of derivatives' target zones represent the differential target zones of their major pairs' target zones with correction by the derivatives' interest rate differentials.
For example, the target zone of GBPJPY is the differential target zone of the GBPUSD and USDJPY with correction to "upward" by the current interest rate differential between GBPJPY (positive interest rate differential).
Assuming the target zone is 10 % and the price already moved for 1 % then the balance to target 10%-1% equals to 9 %. The estimated average weekly price fluctuation about 1.5% to 2.00 % (150-200 PIPs) thus the balance of the trade could be targeted is 9% with initial assumed risk 2 %.
At 10x leverage ratio of portfolio management then the target of profit 10x9 % equals to 90 % and the initial risk assumed 10x2% equals to 20 %, thus reward to risk ratio 90/20= 4.5x
Assuming the weekly price fluctuation alignment about 20 PIPs daily and the average weekly price fluctuation 200 PIPs, then the initial risk assumed 20 % could be manageable to risk free in 200PIPs/20PIPs equals to 10 days. Or, the possibility for risk-free trading position management will be in 10-15 trading days and to hold the portofolio at risk free to target.