Unit-2IFM

The Monetary System

Bimetallism: Before 1875Free coinage was maintained for both gold and silverGresham’s Law: Only the abundant metal was used as money, diving more

scarce metals out of circulation Classic gold standard: 1875-1914

Great Britain introduced full-fledged gold standard in 1821, France (effectively) in the 1850s, Germany in 1875, the US in 1879, Russia and Japan in 1897.

Gold alone is assured of unrestricted coinageThere is a two-way convertibility between gold and national currencies at a

stable ratioGold may be freely exported and importedCross-border flow of gold will help correct misalignment of exchange rates and

will also regulate balance of payments.The gold standard provided a 40 year period of unprecedented stability of

exchange rates which served to promote international trade.

Interwar period: 1915-1944World War I ended the classical gold standard in 1914Trade in gold broke down After the war, many countries suffered hyper inflationCountries started to “cheat” (sterilization of gold)Predatory devaluations (recovery through exports!)The US, Great Britain, Switzerland, France and the Scandinavian countries

restored the gold standard in the 1920s.After the great depression, and ensuing banking crises, most countries

abandoned the gold standard. Bretton Woods system: 1945-1972

U.S. dollar was pegged to gold at $35.00/oz.Other major currencies established par values against the dollar. Deviations

of ±1% were allowed, and devaluations could be negotiated.

Jamaica Agreement (1976)Central banks were allowed to intervene in the foreign exchange markets to

iron out unwarranted volatilities.Gold was officially abandoned as an international reserve asset. Half of the

IMF’s gold holdings were returned to the members and the other half were sold, with proceeds used to help poor nations.

Non-oil exporting countries and less-developed countries were given greater access to IMF funds.

Plaza Accord (1985)G-5 countries (France, Japan, Germany, the U.K., and the U.S.) agreed that it

would be desirable for the U.S. dollar to depreciate. Louvre Accord (1987)

G-7 countries (Canada and Italy were added) would cooperate to achieve greater exchange rate stability.

G-7 countries agreed to more closely consult and coordinate their macroeconomic policies.

Current Exchange Rate Arrangements

36 major currencies, such as the U.S. dollar, the Japanese yen, the Euro, and the British pound are determined largely by market forces.

50 countries, including the China, India, Russia, and Singapore, adopt some forms of “Managed Floating” system.

41 countries do not have their own national currencies!40 countries, including many islands in the Caribbean, many African

nations, UAE and Venezuela, do have their own currencies, but they maintain a peg to another currency such as the U.S. dollar.

The remaining countries have some mixture of fixed and floating exchange-rate regimes.

The Euro

Product of the desire to create a more integrated European economy.

Eleven European countries adopted the Euro on January 1, 1999: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg,

Netherlands, Portugal, and Spain.The following countries opted out initially:

Denmark, Greece, Sweden, and the U.K.Euro notes and coins were introduced in 2002Greece adopted the Euro in 2001Slovenia adopted the Euro in 2007

UK & Sweden join euro

The Mini-Case can be found in E&R, p. 57.Please read E&R pp. 35-46 in preparation for the

discussion next time.Think about:

Potential benefits and costs of adopting the euro.Economic and political constraints facing the

country.The potential impact of British adoption of the

euro on the international financial system, including the role of the U.S. dollar.

The implications for the value of the euro of expanding the EU to include, e.g., Eastern European countries.

The Foreign Exchange Market

The FX market is a two-tiered market:Interbank Market (Wholesale)

Accounts for about 83% of FX trading volume—mostly speculative or arbitrage transactions

About 100-200 international banks worldwide stand ready to make a market in foreign exchange

FX brokers match buy and sell orders but do not carry inventory and FX specialistsClient Market (Retail)

Accounts for about 17% of FX trading volumeMarket participants include international banks, their customers, non-

bank dealers, FX brokers, and central banks

Fx market

Exchange Rate Theories

Factors affecting exchange rates:Rate of inflationrate of interestBalance of payments

2 theories explain fluctuations in exchange rate i.e. Purchasing Power Parity (PPP) and Interest Rate Parity theory (IRP)

Purchasing Power Parity theory

Enunciated by Swedish Economist Gustav Cassel.Purchasing power of a currency is determined by the amount of goods and services that can be purchased with one unit of that currency.Exchange rate between countries providing same purchasing power for each currency

Purchasing power parity

It is ideal if Exchange Rate is in tune with PPOtherwise there is disequilibrium.Floating exchange rate should vary according to the rate of inflation.

Country A inflation is higher than country B

Imports of country A increases and exports decreases

Deficit in trade

balance of country

A

Depreciation of country

A’s currency

formulae

P0A = S0A/B X P0B

A = quoted currencyB=base currencyS0 = Spot Exchange Rate

P0 = Purchasing Power

S1A/B = S0A/B X (1+rA/1+rB)

S1 = Future Exchange Rate

rA = Interest rate of country A

rB = Interest rate of country B

Criticisms

Government interventionRestrictions in exchange marketsSpeculation in exchange marketStructural changes in the economyContinuation of long term flowsRate of inflation not well defined(sample and weights)It considers only goods and not capital

Interest Rate Parity Theory

Premium /discount of one currency against another should reflect the interest differential between the 2 currencies. It a perfect market situation, no restriction of flow of money One should able to gain real value of one’s monetary assets irrespective of the country where they are held.

formulae

Ct = Co X (1+Id/1+If)n

Ct = forward rate

Co = spot rate

n=no of yearsId=interest Rate in country d

If=interest Rate in country f

If the Exchange rate between USD and FFR is FFr 5.0150/$ and interest for one year are 7% ($) and 8.5% (FFr) respectively. Determine the Exchange rate after one year.

Dollar depreciates, franc appreciates as interest rates are higher in franceCt= 5.0150 X (1+0.07/1+0.085) (quoted currency/base currency)4.94FFr/$Criticisms: capital flows, arbitrage, indirect restrictions, speculation activities.

Fisher Effect (FE)

IRP theory is explained with nominal interest rates.

It does not represent the real increase in the wealth.

It does not consider inflation rateThe real increase is reflected by the real interest

rate.The concept made popular by Irving Fisher.The normal interest rate is a combination of the

real interest rate and the expected rate of inflation.

INTERNATIONAL FISHER EFFECT (IFE)

It is the combination of Fisher effect and PPP theoryInterest rates are significantly correlated with inflation rates.The relationship between the % change in the spot exchange rate over timeUses interest rate differential to explain changes in exchange rateStates that the interest rate differential shall be equal to inflation rate differential.

IFE is derived from PPP and IRP theory.If there are no differences in capital flows, the investment the real rate of interest will be in equilibrium. Fisher explains more about the interaction between real sector, monetary sector and foreign exchange market

PPP % CHANGE IN SPOT EXCHANGE RATEINFLATION RATE DIFFERENTIAL

SPOT RATE INFLUENCED BY DIFFERENTIAL IN INFLATION RATES. PP WILL BE EQUAL FOR DOMESTIC AND IMPORTED GOODS

IRP FORWARD RATE PREMIUM/DISCOUNT INTEREST DIFFERENTIAL

FR OF ONE CURRENCY IN RELATION TO ANOTHER WILL CONTAIN A PREMIUM DETERMINED BY THE IRD BETWEEN 2 COUNTRIES.

IFE % CHANGE IN SPOT EXCHANGE RATE. IRD

SPOT RATE DETERMINED BY INTEREST RATE DIFFERENTIAL

comparison

law of one prices

The law of one price (LOP) is an economic concept which posits that "a good must sell for the same price in all locations“ (wilkipedia.com).The law of one price constitutes the basis of the theory of purchasing power parity and is derived from the no arbitrage assumption.

Depreciation and appreciation

Depreciation is a decrease in the value of a currency relative to another currency.

A depreciated currency is less valuable (less expensive) and therefore can be exchanged for (can buy) a smaller amount of foreign currency.

$1/€1 to $1.20/€1 means that the dollar has depreciated relative to the euro. It now takes $1.20 to buy one euro, so that the dollar is less valuable.

The euro has appreciated relative to the dollar: it is now more valuable.

Appreciation

Appreciation is an increase in the value of a currency relative to another currency.

An appreciated currency is more valuable (more expensive) and therefore can be exchanged for (can buy) a larger amount of foreign currency.

$1/€1 ! $0.90/€1 means that the dollar has appreciated relative to the euro. It now takes only $0.90 to buy one euro, so that the dollar is more valuable.

The euro has depreciated relative to the dollar: it is now less valuable.

arbitragers:they want to earn a profit without taking any kind of risk (usually commercial banks):

try to make profit from simultaneous exchange rate differences in different marketsmaking use of the interest rate differences that exist in national financial markets of two countries along with transactions on spot and forward foreign exchange market at the same time (covered interest parity)

hedgers and speculators: hedgers do not want to take risk while participating in the market, they want to

insure themselves against the exchange rate changes speculators think they know what the future exchange rate of a particular currency

will be, and they are willing to accept exchange rate risk with the goal of making profit

every foreign exchange market participant can behave either as a hedger or as a speculator in the context of a particular transaction

Types of Foreign Exchange Market Transactions

Spot Foreign Exchange Transactions: almost immediate delivery of foreign exchange Outright Forward Transactions

buyer and seller establish the exchange rate at the time of the agreement, payment and delivery are not required until maturity

forward exchange rates: 1, 3, 6, 9 months, one year

Swap Transactions:

Swap Transactions:simultaneous purchase and sale of a

given amount of foreign exchange for two different value dates:

“spot against forward” swaps:

Foreign exchange markets

Currency conversion in the foreign exchange market

Is necessary to complete private and commercial transactions across bordersA tourist needs to pay expenses on the road in local currencyA firm

• Buys/sells goods and services in the other country’s local currency• Uses the foreign exchange market to invest excess funds

Is used to speculate on currency movements foreign exchange markets are markets on which

individuals, firms and banks buy and sell foreign currencies

Spot & forward rates

Spot rates are exchange rates for currency exchanges “on the spot”, or when trading is executed in the present.

Forward rates are exchange rates for currency exchanges that will occur at a future (“forward”) date.

forward dates are typically 30, 90, 180 or 360 days in the future.

rates are negotiated between individual institutions in the present, but the exchange occurs in the future.

Other methods of currency exchange

Foreign exchange swaps: a combination of a spot sale with a forward repurchase, both negotiated between individual institutions.

Swap of cash flows in one currency for another.swaps often result in lower fees or transactions costs because they combine two transactions.

Futures contracts: a contract designed by a third party for a standard amount of foreign currency delivered/received on a standard date.

contracts can be bought and sold in markets, and only the current owner is obliged to fulfill the contract.

Options contracts: a contract designed by a third party for a standard amount of foreign currency delivered/received on or before a standard date.

contracts can be bought and sold in markets.

a contract gives the owner the option, but not obligation, of buying or selling currency if the need arises.

Quotations

• Direct quote American Quotation:• One foreign currency unit and number of home

currency units• e.g., 1 USD = 62 INR

• Indirect quote/ European Quotation:• One home currency unit and number of foreign

currency units• e.g., 1 INR = 0.0162 USD

Transaction cost

Bid-Ask Spreadused to calculate the feecharged by the bank

• Bid = the price at which the bank is willing to buy

• Ask = the price it will sellthe currency

Cross rate

The exchange rate between 2 non - US$

currencies.

Exchange rate between two currencies derived

from the exchange rates of currencies with third

currency

E.g., EUR/JPY is derived from EUR/USD &

USD/JPY

SPOT MARKET

Refers to the current exchange rateImmediate exchange of currenciesImmediate deliveryCash settlement is made after 2 working days, excluding holidays.

Forward rate

Exchange of foreign currencies at a future date.Agreed amount, rate and delivery date.30, 90 of 180 days.Useful for exporters and importersFR higher than existing spot rate – forward premiumFR lower than the existing spot rate – forward discount

formulae

CALCULATING THE FORWARD PREMIUM OR DISCOUNT

= FR-SR x 12 x 100 SR n

where FR = the forward rate of exchange SR = the spot rate of exchange n = the number of months in the

forward contract

Spot transaction

Settlement Date Value Date:

1. Date when money is due

2. 2nd Working day after date of original transaction.

BID/ASK =SPREADDealers bid at one price and offer at a slightly higher price, profit is called spread.Spread is for managing risks through strategies that require numerous foreign transactionsThe dealer ready to buy $ - Bid priceThe dealer ready to sell $ - Ask prices% spread = Ask price – Bid price/Ask price x100

Pip is a part of spread, which is the smallest amount a price can move in any currency quote

covered interest Arbitrage

International flow of short term liquid capital to earn a higher returnSpot purchase of foreign currency to make the investment and offsetting the simultaneous forward sale to cover the foreign exchange risk.

NETTING Definition: Consolidating the value of two or more transactions, payments or positions in order to

create a single value. Netting entails offsetting the value of multiple positions, and can be used to determine which party is owed remuneration in a multiparty agreement.

Netting is a general concept that has a number of more specific uses. In a case in which a company is filing for bankruptcy, parties that do business with the defaulting company will offset any money owed to the defaulting company with any money owed by the defaulting company. The remainder represents the total amount owed to the defaulting company or money owed by it, and can be used in bankruptcy proceedings.

Companies can also use netting to simplify third-party invoices, ultimately reducing multiple invoices into a single one. For example, several divisions in a large transport corporation purchase paper supplies from a single supplier, but the paper supplier also uses the same transport company to ship its products to others. By netting how much each party owes the other, a single invoice can be created for the company that has the outstanding bill. This technique can also be used when transferring funds between subsidiaries.

Netting is also used in trading. An investor can offset a position in one security or currency with another position either in the same security or another one. The goal in netting is to offset gains in one position with losses in another.

Exchange rate system Fixed Exchange rate: when government of country fixes rate of exchange it is called fixed

exchange rate. This is also called official exchange rate and it is revised from time to time. Fixed rates are those that have direct convertibility towards another currency. In case of a separate currency, also known as a currency board arrangement, the domestic currency is backed one to one by foreign reserves. A pegged currency with very small bands (< 1%) and countries that have adopted another country's currency and abandoned its own also fall under this category.

Floating Exchange rate: Floating rates are the most common exchange rate regime today. For example, the dollar, euro, yen, and British pound all are floating currencies. However, since central banks frequently intervene to avoid excessive appreciation or depreciation, these regimes are often called managed float or a dirty float.

Pegged floating currencies are pegged to some band or value, either fixed or periodically adjusted. Pegged floats are:

Crawling bands: the rate is allowed to fluctuate in a band around a central value, which is adjusted periodically. This is done at a preannounced rate or in a controlled way following economic indicators.Crawling pegs: the rate itself is fixed, and adjusted as above.Pegged with horizontal bandsthe rate is allowed to fluctuate in a fixed band (bigger than 1%) around a central rate.

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