Richard Olsen’s Reactions on Critics

Why have we focused on studying the forex markets? Researching these markets is like doing research in a nuclear reactor, where basic processes can be studied in states of high energy. In such an environment it is easier to identify the forces that drive financial markets and distinguish them from random market effects.

People fail to realize the importance of forex markets to support the globalization of the "investment business." Relative to trade flows, investments across borders have increased much more dramatically. The forex markets have to be able to accommodate the demands of these international investors, who want to sell their foreign holdings at a moment's notice. Even though the forex markets have grown, the growth has been insufficient to support the requirements of an international investment community.

The introduction of electronic transaction systems has speeded up transactions in forex dramatically during the past six years. There is a side effect that has been neglected by many of the commentators. Similar to the money multiplier, there is a market liquidity multiplier. If the efficiency of the transaction system increases, then transactions are settled much more quickly. This has the effect that liquidity dries up much more rapidly than in the past.

My inference is that today's forex markets are far too small to support our globalized financial community. The effect will be erratic price movements, as we saw on 7 October 1998 with the 20% shift in the dollaryen exchange rate.

The introduction of the euro will make things worse. I think that we have to look at the euro as a merger of the European countries. Europe will thus become like one big football stadium with a strong US counterpart. The world will thus have two big football stadia. The stadia need wide roads, that is, highly liquid forex markets. Unfortunately, the new dollar euro exchange rate will not be sufficiently liquid to absorb the large shifts of capital that will occur between the dollar and the euro.

Professor Amartya Sen, who received the 1998 Nobel Prize for Economics, explained in great detail that starvation is not a problem of a lack of food, but deficiencies in the distribution system. We face a similar situation with the financial markets, where the fundamental economy is in satisfactory shape, but the allocation system, that is, the financial markets and in particular the forex markets and the balance sheets of the banks, are in deep trouble.

Critics on Richard Olsen

Smart as it is, there are times when the approach of Olsen and his colleagues has failed to work. Like other more simple data mining and historically based methods, it works in periods when currency movements are following a trend but gets whipsawed with penaliz-ing transaction costs in trendless markets. And during a change in the trend, O&A might identify a turn but not know the difference between a minor and a major turn.

Yet this group comes closer to modeling how the foreign exchange world really works than others. When there are new academic insights, they are likely to note them early.

A broader social counterpoint to today's forex markets is that with this daily volume of electronic, invisible money flowing throughout the world, a single nimble trader can drive a monetary institution to the wall. A trader is often compensated by a share of the trading profit, which can put tens of millions into his or her pocket. The trading institution takes the risk and the trader takes the profit: a true asymmetrical payoff scheme operates to pyramid risks. A central bank seeking to dampen its currency swings may come forward with a few billion but this is typically something that a single trader could command. In these circumstances, a central bank attempting to influence a currency is like sending a bicycle onto a superhighway.

The size of forex trade has played its part in the series of currency crises in emerging nations during the 1990s. The capacity for massive daily foreign currency flows to take place made possible the almost overnight collapses of the currencies of Thailand, Indonesia and Russia in 1997-8. As confidence in the economies of these countries fell away, demand for their currencies dried up as investors took their capital out or stopped bringing it in. Governments had tried to buy their own currencies to underpin their value but could not keep up with the sellers. When they stopped their own forex activity, the forces of demand and supply saw the baht, rupiah and ruble in turn crash in value, deepening the crisis of confidence and economic slowdown.

Some commentators are now recommending a tax on forex dealings: for example, Nobel Laureate James Tobin has warned that free capital markets with flexible exchange rates encourage short-term speculation that can have a ''devastating impact on specific industries and whole economies." To avoid this real economic havoc, he advocates a 0.5% tax on all foreign exchange transactions in order to deter speculators, a remedy dubbed the Tobin tax.

There are three rationales for the proposed Tobin tax: the first is that the volume of foreign exchange transactions is excessive fifty to a hundred times greater than that required to finance international trade; the second is related to the first reducing volatility offers more independence to national economic policy-makers; and the third is simply the tax-raising abilities of such a tax, which is linked with the view that the financial sector is relatively undertaxed.

Foreign exchange guru: Richard Olsen

In the pre-radio and telephony days, information about markets moved by post, horses and even by carrier pigeons. Investors with information in one market would send their instructions to other markets and success was often an outcome of the speed of transferring the messages.

Today's global environment also puts a premium on speed, but it is not measured in days or hours but nanoseconds. Currency-trading departments are decentralized so that individuals, usually young, nimble and quick, can make massive decisions on their own. The trading rooms of major institutions trading currencies for their own accounts often contain no one over the age of 35, none with bonus possibilities less than multiple millions and all eager to take risks to achieve personal gain.

It is perhaps not surprising that currency markets trading in hundreds of billion dollars a day, open 24 hours and with information moving so fast that there is always the chance of an information advantage, would attract speculative attention. And not surprising either that the value of speed and ability to grasp all the markets' information at once would attract academics building new models. One of these, and one of the best, is Richard Olsen of Olsen and Associates (O&A), a high-frequency data processing firm in Zurich in which Dean LeBaron has personally invested.

A visit to O&A, in a refurbished flour mill alongside Zurichsee is like a visit to Silicon Valley. Attire is California casual, tee shirts and jeans, though Olsen does wear a tie to see clients. Dogs and bikes sit outside offices while their owners are huddled over computer keyboards. Conversation is usually in English though it is hardly the first language for the majority. Academic disciplines are mathematics, economics or almost anything else. The common characteristic of the people is smart, very smart.

Olsen and his colleagues are the best at acquiring and analyzing high-frequency data, using very advanced mathematical techniques to forecast currency movements. By high frequency, they mean second by second, and forecasting might be for an hour or so ahead, perhaps even a week if long-term the value of high-frequency forecasts decay rapidly as the information that produced it is disseminated.