Overview and Terminology
LEGAL TENDER
Money created by a govt. that must (by law) be accepted as payment of debt
Legal tender
- $100 bill
Not legal tender
- $100 check (issued by bank and not govt.)
Great Seal of United States
Reverse side:
American Eagle and Number
13: whole country and original
13 states
Identification mark of Fed Reserve Bank that issued
Bill: B is for New York
Front of Great Seal:
Annuit Cerptis: “he has favored our undertaking” –
Reference to all seeing deity whose eye is at the
apex of pyramid
Overview and Terminology
GOLD STANDARD: 1876 until 1913 (World War I)
1.
Relative value of currencies was measured against precious metals like gold or silver
2.
Each country set the rate at which its currency could be converted to gold
3.
Must maintain adequate reserves of gold (Fort Nox) for redemption
4.
Gold standard implied a fixed exchange rate
5. Implicitly limited the rate at which any individual country could expand its money supply
(had to have adequate gold on hand)
6.
Worked very well until 1913 when WWI interrupted free movement of gold for reserves
1879-1971: U.S. stopped redeeming its paper currency with gold.
.
Example:
US$ gold rate was $20.67/oz,
British pound was pegged at
£4.2474/oz
US$/£ rate calculation is
$20.67/£4.2472 = $4.8665/£
WWI to 1971
1945-1973: Fixed Exchange Rates
• Dollar main reserve currency held by central bankskey to web of exchange rate value
• US running persistent + growing deficits – heavy
outflow of dollars required to finance deficit + meet
growing demand for dollars from business/investors
• Lack of confidence of US to meet its commitment to
convert dollars to gold forced President Nixon to
suspend official purchases or sales of gold on Aug. 15,
1971
• Exchange rates of most leading countries were
allowed to float in relation to the US dollar
• By the end of 1971, most of the major trading
currencies had appreciated vis-à-vis the US dollar; i.e.
the dollar depreciated
• A year and a half later, the dollar came under attack
again and lost 10% of its value
• By early 1973 a fixed rate system no longer seemed
feasible and the dollar, along with the other major
currencies was allowed to float
• By June 1973, the dollar had lost another 10% in
value
1971 forward
1971: gold standard abandoned
1971 + : currencies ‘FLOAT’
influenced by :
supply and demand
greater demand for nation’s product = greater demand for currency
greater demand for nation’s stocks/bonds = greater demand for currency
low inflation rate
stable government and governmental policies
government intervention regarding currency management
governmental intervention to defend value of its currency
agreements to lower interest rates
deliberate devaluation of a currency (make exports more competitive)
Govt. Intervention: Group of 5 effort to depreciate the dollar by 35% in 10 months: Sept 1985 – selling
billions of dollars to drive down the value of dollar.
Fed Reserve System
FEDERAL RESERVE SYSTEM- founded in 1913
• Guardian of the Nation’s money
• 12 separate distinct banks, 25 regional branches
• System run by 7-member Board of Governors (appointed by President, confirmed by Congress)
• Open Market Committee- responsible for guiding day to day money decisions
• discount rate
Euro and Monetary Unification


The euro, €, was launched on Jan. 4, 1999
Effects for countries using the euro currency include
• Cheaper transaction costs,
• Currency risks and costs related to exchange rate uncertainty are
reduced,
• All consumers and businesses, both inside and outside of the euro zone
enjoy price transparency and increased price-based competition
Euro and Monetary Unification
Convergence criteria called for countries’ monetary and fiscal
policies to be integrated and coordinated
– Nominal inflation should be no more than 1.5% above average for
the three members of the EU with lowest inflation rates during
previous year
– Long-term interest rates should be no more than 2% above average
for the three members of the EU with lowest interest rates
– Fiscal deficit should be no more than 3% of GDP
– Government debt should be no more than 60% of GDP
European Central Bank (ECB) was established to promote price
stability within the EU
Emerging Markets and Currency Regime Choices
Emerging Market
Country
Free-Floating Regime
•Currency value is free to float
up and down with
international market forces
•Independent monetary policy
and free movement of capital
allowed, but at the loss of
stability
•Increased volatility may be
more than what a small
financial market can
withstand
High capital mobility is forcing emerging market
nations to choose between two extremes
Currency Board or
Dollarization
•Currency Board fixes the
value of the local currency or
basket; Dollarization replaces
currency with the US dollar
•Independent monetary policy
is lost; political influence on
monetary policy is eliminated
•Seignorage, the benefits
accruing to a government
from the ability to print its
own money, is lost
Overview and Terminology
Foreign Exchange Markets


The FOREX market provides the physical and institutional structure
through which the money of one country is exchanged for that of another
country
A foreign exchange transaction is an agreement between a buyer and a
seller that a fixed amount of one currency will be delivered for some other
currency at a specified rate
Geographics




Geographically, the FOREX market spans the globe with prices moving
and currencies trading on a 24 hour basis
Major exchanges are located in Singapore, Hong Kong and Tokyo in the
East
Then it moves to Bahrain, and London for the European area
And on to New York, San Francisco and Sydney
Geographics
Measuring FOREX Market Activity: Average Electronic Conversations Per Hour
25,000
20,000
15,000
10,000
5,000
Greenwich Mean Time
0
1
2
3
4
5
6
10 AM
Lunch Europe
In Tokyo In Tokyo opening
7
8
9
Asia
closing
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
Americas London
open
closing
Afternoon
in America
6 pm Tokyo
In NY opens
Market Size
Global Foreign Exchange Market Turnover
(daily averages in April, billions of US dollars)
800
Spot
Forwards
Swaps
700
600
500
400
300
200
100
0
1989
1992
1995
1998
2001
Source: Bank for International Settlements, “Central Bank Survey of Foreign Exchange and
Derivatives Market Activity in April 2001,” October 2001, www.bis.org.
Market Size
Geographic Distribution of Foreign Exchange Market Turnover
(daily averages in April, billions of US dollars)
700
United States
United Kingdom
Japan
Singapore
Germany
600
500
400
300
200
100
0
1989
1992
1995
1998
2001
Source: Bank for International Settlements, “Central Bank Survey of Foreign Exchange and Derivatives
Market Activity in April 2001,” October 2001, www.bis.org.
Market Size
Currency Distribution of Global Foreign Exchange Market Turnover
(percentage shares of average daily turnover in April)
90
80
70
60
50
40
US dollar
euro
Deutshemark
French franc
EMS currencies
Japanese yen
Pound sterling
Swiss franc
30
20
10
0
1989
1992
1995
1998
2001
Source: Bank for International Settlements, “Central Bank Survey of Foreign Exchange and Derivatives
Market Activity in April 2001,” October 2001, www.bis.org.
Functions




The FOREX market is the mechanism by which participants transfer:
• purchasing power between countries
• obtains or provides credit for international trade
• minimizes exposure to exchange rate risk
FOREX: each party wants to transact in its own currency
FOREX market provides credit (letters of credit)
FOREX market provides ‘hedging’ facilities
Market Participants

The FOREX market consists of two tiers
– Interbank
– Client or retail market

Five broad categories of participants operate within these two
tiers
• Bank and non bank foreign exchange dealers
• Individuals and firms conducting commercial or investment
•
•
•
transactions
Speculators and arbitragers
Central banks and treasuries
Foreign exchange brokers
Bank and Non-Bank Dealers






These participants profit from buying currencies at a bid price and then reselling
them at an offer or ask price
Competition among dealers
– Narrows the spread between the bid and offer rate
– Promotes the market’s efficiency
Dealers on behalf of large international banks often act as market makers, often
willing to stand in and buy or sell these currencies without having a counterpart
with which to unload the “inventory”
They trade amongst other banks and dealers in order to keep their inventory levels
at manageable levels
Currency trading is profitable and often contributes between 10% - 20% of a banks’
average net income
Small- to medium-sized banks rarely act as market makers yet still participate in the
interbank market
Individuals/Firms Conducting Commercial/Investment Transactions
 Importers, exporters, portfolio investors, MNEs,

tourists and others use the FOREX market to
facilitate execution of commercial or investment
transactions
Some of these participants use the market to hedge
foreign exchange rate risk
Speculators and Arbitragers





Speculators and arbitragers seek to profit from
trading in the market itself
They operate for their own interest, without need or
obligation to serve clients or ensure a continuous
market
Speculators seek all their profit from exchange rate
changes
Arbitragers try to profit from simultaneous
differences in exchange rates in different markets
A large proportion of speculation and arbitrage is
conducted on behalf of major banks by traders
employed by those banks
Central Banks and Treasuries




Acquire/spend their country’s currency reserves
Influence the price at which their own currency trades
Support the value of their currency
Motive is not to profit but rather influence the foreign exchange value of their
currency in a manner that will benefit their interests
Foreign Exchange Brokers



Foreign exchange brokers are agents who facilitate trading between dealers without
themselves becoming principals in the transaction
For this service they charge a small commission
They maintain instant access to hundreds of dealers worldwide via open lines and at
times may maintain such lines with several banks, with separate lines for differing
currencies, spot and forward rates
Spot Transactions
A spot transaction in the interbank market is the purchase of
foreign exchange, with delivery and payment between banks to
take place, normally, on the second following business day
• The settlement date is often referred to as the value date
• This is the date when most dollar transactions are settled
through the computerized Clearing House Interbank
Payment Systems (CHIPS) in New York
MONEY: Currency Cross Rates
Foreign Exchange Quotes:
1.
Direct: quote is the price of a foreign currency unit in terms of the home currency (dollar
denominated)
2.
Indirect: quote is the price of a unit of home currency measured in the foreign currency.
Indirect = USD/EUR = 0.79 is the same as .79 Euro will buy $1 dollar
Direct = EUR/USD = 1.26 is the same as $1.26 buys 1 euro (this is how the markets quotes the Euro
(how many dollars to buy 1 Euro). This is NOT a FRACTION but as “Euros in dollar prices”.
USD
GBP
CHF
JPY
CAD
AUD
EUR
NZD
DKK
SEK
SEK 9.2331 14.39 6.2109 7.5255 5.8967 5.1419 9.0936 4.4905 1.2238
DKK 7.5448 11.76 5.0752 6.1495 4.8185 4.2017 7.4309 3.6694
Indirect
NZD 2.0561 3.2047 1.3831 1.6759 1.3132 1.1451 2.0251
EUR 1.0153 1.5825 0.6830 0.8276 0.6484 0.5654
AUD 1.7957 2.7987 1.2079 1.4636 1.1468
CAD 1.5658 2.4405 1.0533 1.2762
JPY 122.69 191.23 82.53
CHF 1.4866 2.3170
GBP 0.6416
USD
0.8172
0.2725 0.2227
0.4938 0.1346 0.1100
1.7685 0.8733 0.2380 0.1945
0.8720 1.5422 0.7615 0.2075 0.1696
78.36
68.33 120.84 59.67
16.26
13.29
Convention:
• quote’s definition depends on country of
reference
• NY bankers established European Terms
Convention, which uses the US Dollar as the
common denominator.
• Traders in US, Switzerland, etc would quote
CHF as 1.4866 / $1 dollar. (1.4866 Swisse to buy
$1) INDIRECT
• Exceptions: British Pound Sterling, Australia,
New Zealand and Euro-quoted DIRECT
1.2117 0.9494 0.8279 1.4642 0.7230 0.1970 0.1610
0.4316 0.5230 0.4098 0.3573 0.6319 0.3120 0.0850 0.0695
1.5586 0.6727 0.8151 0.6387 0.5569 0.9849 0.4864 0.1325 0.1083
Direct
Quoting Foreign Exchange (FX)-Spot Pricing
10/29/02: Live FX Spot Market as Offered by IFX LONDON
Notice the conventions:
• Euro quoted as direct (EUR/USD)
The Spot Market: Conventions
• Swiss Franc quoted as indirect (USD/CHF)
• Pound Sterling quoted as direct (GBP/USD)
Spot Transaction Trading: Retail Trading
SPOT EXCHANGE RATE MARKET
•
FX trading is normally undertaken on the basis of margin trading (‘gearing’).
•
Small deposit needed to control a much larger position in market-possible because one buys one
currency and simultaneously sell another
•
Margins are set by dealer
•
To swing $1,000,000, one must deposit $20,000 in account – margins are 2%
Commercial Banks normally trade in $1M lots
IFX allows trading in partial lots
Notice, trade is .2 lots (margin is 2 x $2,000= $4K)
Hypothetical Account
Initial Deposit
$20,000.00
Trade Size
0.50
Initial Margin
$10,000.00
Play
$10,000.00