The Asset Market Approach

This particular approach is one in which people say that the exchange rate is not actually determined by things like the flow in the balance of payments.

So if that's not the case in the financial markets then what is, you might reasonably start to wonder?

Well, under the asset market approach, the answer to that question is that currencies are nothing more than a type of asset that is traded within the market.

And therefore the exchange rate will be set based on anticipated future positions rather than the actual current position and capital flows.

So when trade flows have happened it should not be thought that they will actually set the curent exchange rate.

As a simple way of understanding how this could work, all you need to do is look at share prices, where the future is built in very much to the share price which is why good news can actually send a share price down and bad news send it up, depending on the expectations that had already been 'built into' the share price.

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