Special drawing rights

Several nations peg their currency's exchange rate to a basket of currencies assembled by the international monetary fund, known as the special drawing right (SDR). The SDR is an official international monetary reserve unit designed to settle international claims arising from transactions between the IMF, governments of member nations, central banks, and various international agencies. SDRs are really "book entries" on the ledgers of the IMF and are sometimes referred to as "paper gold" periodically, that organization will issue new SDRs and credit them to the international reserve accounts of member nations. To spend its SDRs, a nation simply requests the IMF to transfer some amount of SDRs from its own reserve account to the reserve account of another nation, usually one whose currency is widely accepted in the international markets. In return, the country asking for the transfer gets deposit balances denominated in the currency of the nation receiving the SDRs. These deposit balances may then be used to make international payments.
The value of SDRs today is based upon a basket of currencies representing the five IMF member nations with the largest volume of exports during the 1975-79 periods. These five countries are the United Stated, The Federal Republic of Germany, France, Japan, and the United Kingdom. In determining the current value of SDRs the currency of each of these five nations is weighted according to the value of their exports and currency holdings. In 1981 the weights applied to these five currencies in the SDR basket were: U.S. dollars, 42 percent; German marks, 19 percent: French francs, 13 percent; Japanese yen, 13 percent; and British pound sterling, 13 percent. Countries that peg their currency's value to the value of SDR basket include Burma, Guinea, Kenya, Vietnam, Zaire, and Zambia.

The gold standard

The problem of trading in different monetary units whose prices changes frequently is one of the world‘s oldest financial problems. It has been dealt with in a wide variety of ways over the centuries. One of the most successful solutions prior to the modern era centered upon gold as an international standard of value. During the 17th and 18th centuries-a period which gave birth to the Industrial Revolution and the rapid expansion of world trade-major trading nations in Western Europe made their currencies freely convertible into gold. Gold bullion and gold coins could be exported and imported from one country to another without significant restriction, and each unit of currency was defined in terms of so many grains of fine gold. Nations adopting the gold standard agreed to exchange paper money or gold coins for gold bullion in unlimited amounts at fixed, predetermined prices.
one advantage of the gold standard was that it imposed a common standard of value upon all national currencies. This brought a measure of security to international trade and investment, dampened exchange rate fluctuations, and stimulated the expansion of commerce and long-term investment abroad. A second advantage of the gold standard was economic discipline. Tying national currencies to gold regulated the growth and stability of national economies. A nation experiencing severe inflation or excessively rapid growth in consumption of imported goods and services soon found itself losing gold reserves. Exports declined, unemployment rose, and domestic prices soon began to fall. As a result, the volume of imports was curtailed, and the outflow of gold reduced. Eventually, export industries would recover and the country would begin to rebuild its gold reserves, providing a basis for further expansion of its international trade.
These advantages of security and economic discipline were offset by a number of limitations inherent in the gold standard. For one thing, the gold standard depended crucially upon free trade. Nations desiring to protect their industry and jobs from foreign competition through export or import restrictions could not do so. Moreover, the growth of a nation‘s money supply was limited by the size of its gold stock. Problems of rising unemployment or lagging economic growth might call for a stimulative monetary policy, leading to lower interest rates and rapid expansion of the domestic money supply. However, such a policy required a suspension of gold convertibility, taking the nation off the gold standard. Thus, the gold standard often conflicted with national economic goals and drastically limited the policy alternatives open to governmental authorities.

Buying and selling foreign exchange by international banks

Major multinational banks, as we saw in the preceding topics, have dealer departments which specialize in trading foreign currencies. The largest multinational hold inventories of selected currencies for themselves and for the convenience of their customers, they may also negotiate forward contracts for the future delivery of foreign exchange and speculate on future currency price movements in hopes of turning a profit. Smaller banks usually hold very small currency inventories and concentrate mainly on buying and selling foreign exchange for their customers rather than for speculative purposes. They frequently purchase whatever currency is needed for immediate or future delivery to a customer from larger international banks that maintain active currency position.

Spot,Forward,and Contracts

Earlier in this blog we distinguished between the spot market, or market for immediate delivery of a currency, and the forward market, where contracts are made for future currency delivery. Trading in the spot market results in spot contracts, which are agreements to deliver a specified amount of foreign currency at an agreed-upon price, usually within one or two business days and sometimes on the same day. In contrast, a forward contact is an agreement to deliver a specified amount of foreign currency at a set price on some future date (usually within 30, 90, or 120 days).
In the forward market, therefore, the currency is purchased or sold now at a price agreed upon today, but delivery and payment are made in the future. The actual delivery date is referred to by traders as the value date. In the event customers do not know when they will receive or will need foreign currency, then an option forward contract frequently is used

Central Bank intervention affect on exchange rates

Overhanging the currency markets today is the ever present possibility that central banks will become active participants. Major central banks around the world, including the Federal Reserve System, the Deutschbank in West Germany, and the Bank of England, may decide on a given day that their national currency is declining too rapidly in value relative to one or more other key currencies. Thus, if the dollar falls precipitously against the mark, support operations by Federal Reserve in cooperation with the Deutschbank may be employed to stabilize the currency markets. Usually, central bank intervention is temporary, designed to promote a smooth adjustment in currency values toward a new equilibrium level rather than to permanently "prop up" a week currency. We will have more to say about central bank intervention in the currency markets.

Domestic Economic and political conditions affect on exchange rates

the market for a national currency is of course influenced by domestic conditions. Wars, revolutions,the death of a major political leader, inflation, recession, and labor strikes have all been observed to have adverse effects on the currency of a nation experiencing these problems. On the other hand, signs of rapid economic growth,industrial development, improving government finances, rising stock and bond prices, and successful economic policies to control inflation and unemployment usually lead to a stronger currency in the exchange markets.

speculation affect on exchange rates

exchange rates also are profoundly affected by speculation over future currency values. Brokers, dealers,and investors in foreign exchange monitor the currency markets daily, looking for profitable trading opportunities. A currency viewed as temporarily undervalued will quickly bring forth numerous buy orders, driving its price higher vis-a-vis other currencies. A currency considered to be overvalued will soon be greeted by a rash of sell orders,depressing its price. Today the international financial system is so efficient and finely tuned that billion of dollars can flow across national boundaries in a matter of hours in response to speculative fever. As we saw earlier in our review of the Eurodollar market, these massive unregulated flows can wreak havoc with the plans of economic policymakers because currency trading affects interest rates and the money supply.

Factors affecting foreign exchange rates

the exchange rate for any foreign currency depends on a multitude of factors reflecting economic and financial conditions in the country issuing the currency. one of the most important factors is the status of a nation‘s balance-of-payments position. when a country experiences a deficit in its balance of payments, it becomes a net demanded of foreign currencies and may be forced to sell substantial amounts of its own currency to pay for imports of goods and services. therefore, balance-of-payments deficits often lead to depreciation of a nation‘s currency relative to other currencies. During the 1970s, when the United States was experiencing deep balance-of-payments deficits and owed substantial amounts abroad for imported oil, the value of the dollar sagged dramatically.Both the Federal Reserve System and the Treasury were forced to enter the foreign exchange markets with heavy purchases of dollars and offering of dollar-denominated government securities to create a demand for dollars and prop up the dollar‘s exchange value.

The principle of interest-rate parity(2)

To illustrate the principal of interest-rate parity, suppose interest rates in a foreign country are 3 percent above those in the United States. Then the currency of that foreign nation will, in equilibrium, sell at a 3 percent discount in the forward exchange market. Similarly, if interest rates are 1 percent lower abroad than in the United States, in equilibrium the foreign currency of the nations involved should sell at a 1 percent premium against the dollar. When such an equilibrium position is reached, movements of funds between nations even with currency risks covered do not generate excess returns relative to domestic investments of comparable risk. Capital funds tend to stay in the domestic market rather than flowing abroad.
It is when interest parity does not exist that capital tends to flow across national boundaries in response to differences in domestic and foreign interest rates. For example, suppose interest rates in a foreign nation are 3 percent above U.S. interest rates on securities of comparable quality and the foreign currency involved is selling at 1 percent discount against the dollar in the forward-exchange market. In this case, investing abroad with exchange risks covered will yield the investor a net return of 2 percent per year. Clearly, there is appositive incentive to invest overseas. In the absence of exchange controls, capital will flow abroad.
Is this situation likely to persist for a long period of time? No, because the movement of funds into a country offering higher interest rates tends to increase the forward discount on its currency and lowers the net interest returns to the investor. Other factors held constant, the flow of funds abroad eventually will subside, and capital funds will tend to stay at home until further changes in currency prices and interest rates take place.

The principle of interest-rate parity(1)

The foregoing example suggests an important rule regarding international capital flows and foreign-exchange rates: the rate of return to the investor from any foreign investment is equal to the interest earned plus or minus the premium or discount on the price of the foreign currency involved in the transaction. The theory of forward exchange states that, under normal conditions, the forward discount or premium on one currency relative to another is directly related to the difference in interest rates between the two countries involved. More specifically, the currency of the nation experiencing higher interest rates normally will sell at a forward discount in terms of the currency issued by the nation with lower interest rates. And the currency of the nation with relatively low interest rates normally will sell at a premium forward relative to that of the high-rate country. A condition Known as interest-rate parity exists when the interest-rate differential between two nations is exactly equal to the forward discount or premium on their two currencies.
When parity exists, the currency markets are in equilibrium, and capital funds will not flow from one country to another. This is due to the fact that the gain from investing abroad at higher interest rates is fully offset by the cost of covering currency risk in the forward exchange market.

The forward market for currencies(2)

The need for hedging against the risk of fluctuating currency-exchange rates was recognized as early as the 14th century, when forward-market trading first appeared. However, the market developed slowly due to numerous political upheavals, war, and a poorly developed communications network. Following a burst of forward-exchange trading during the 1920s, the forward market almost disappeared during the depression years and World War II. It revived during the 1950s, however, and grew dramatically during the 1970s as currency prices became extremely volatile. Thousands of corporations, foreign governments, and central banks have entered the market during the past decade, responding to problems created by the wide ranges over which national currencies float today.

The forward market for currencies(1)

Knowledge of how the foreign-exchange markets works and the ways in which currency risk can be reduced is indispensable for business managers today. Changes in the relative values of various currencies can wreak havoc with planning by firms engaged in the export or import business. Of Course, the problem of fluctuating currency values is not so serious if payment for goods, services, or securities must be made right away. Spot-market prices of foreign currencies normally change very little from day to day. However, if payment must be made weeks or months in the future, there is considerable uncertainly as to what the spot rate will be for any currency on any given future date. When substantial sums of money are involved, the rational investor or commercial trader will try to guarantee the future price at which currency can be purchased. This is the function of the forward exchange market-to reduce the risk associated with the future purchase and delivery of foreign currency by agreeing upon a price in advance.

The Managed Floating Currency Standard

In the 1978 a new international payments system-often called a managed floating currency standard- was formally adopted by member nations of the IMF. known as the Second Amendment to the International Monetary Fund‘s Article of Agreement, the official rules under which today‘s international money system is supposed to operate allow each nation to choose its own exchange-rate policy, consistent with the structure of its economy and its economic goals. There are, however, three principles which each member country must follow in establishing its exchange-rate policy:
1- when a nation intervenes in the foreign-exchange markets to protect its own currency, it must take into account the interests and welfare of other IMF member countries.
2- Government intervention in the foreign-exchange markets should be carried out to correct disorderly conditions in those markets which are short term in nature.
3- No member nation should intervene in the exchange markets in order to gain an unfair competitive advantage over other IMF members or to prevent effective adjustments in a nation‘s balance-of-payments position.

Abandonment of the Bretton Woods System

Continuing inflation and other economic weaknesses forced the abandonment of the Bretton System early in the 1970s. The first and most-important step in the dismantling of the old system was taken by the Nixon administration in August 1971, When the dollar was devalued and the convertibility of foreign official holdings of dollars into gold suspended. Gold ceased to be an international monetary medium;it is traded today only as a commodity.
A second step toward a new monetary system was taken in March 1973, when IMF member nations agreed to allow their currencies to float over a wider range, intervening only when currency-exchange rates varied from their par values by more than 2.25 percent.however,volatile economic conditions continued to generate massive speculative flows of capital across national boundaries. Using improved communications and funds-transfer techniques, speculators anticipating changes in official currency exchange rates could now move huge amounts of funds from one nation to another both cheaply and quickly. Central banks, including the Federal Reserve System, soon found themselves compelled to intervene in the currency markets almost daily and to use up huge amounts of foreign exchange reserves.soon, the largest IMF member countries were allowing their currencies to float in value, responding more actively to demand and supply forces in the marketplace.

The Gold Exchange Standard(2)

Despite the problems inherent in the gold exchange standards, there is currently a great deal of interest in the United States in returning to some type of gold standard. Congress created a 17-member Gold Commission in 1980 to "study and make recommendations concerning the role of gold in the domestic and international monetary systems." Chaired by the Secretary of the Treasury, the Gold Commission is charged with the responsibility of reviewing systems for linking the dollar‘s value to gold as a way of controlling monetary growth and stabilizing or eliminating inflation. At least two problems appear to stand in the way of a return to even a modified gold standard .first, while a dollar-gold link may stabilize prices in the long run; a gold standard is likely to produce substantial short-run swings in prices and domestic employment, some of which would be politically dangerous. Second, world production of gold is expected to be essentially flat or possibly even downward over at least the next two decades. The result, in all probability, would be a sharply inflated gold price and significant instability in the international payments system

The Gold Exchange Standard(1)

While government policy makers were mainly concerned about the effects of the gold standard on domestic economics, investors and commercial traders found that gold bullion was not a particularly convenient medium of exchange. Gold is bulky, expensive to transport, and risky to handle. Moreover, the world‘s gold supply was limited relative to the rapidly expanding volume of international trade. These problems gave rise in the 19th century to the gold exchange standard. Central banks, governments, major commercial banks, and other institutions actively engaged in international commerce began to hold stocks of convertible currencies. Each currency was freely convertible into gold at a fixed rate but also was freely convertible into other currencies at relatively stable prices. In practice, virtually all transactions took place in convertible currencies, while gold faded into the background as an international medium of exchange.
Without question, the gold exchange standard provided greater convenience for international traders and investors. However, that monetary standard possessed the same inherent limitations as the original gold standard. National currencies were still tied to gold, and growth in world trade depended crucially upon growth of the international gold stock. The gold exchange standard collapsed during the economic chaos of the Great Depression of the 1930s.

Instruments of foreign exchange market: mail transfer

When speed is not a critical factor, a mail transfer of foreign exchange may be used. Such transfers are simply written orders from a holder of a foreign exchange deposit to a bank to pay a designated individual, firm, or institution upon presentation of draft. A mail transfer may, of course, require days to execute, depending upon the speed of mail deliveries.

Foreign currency and coin itself (as opposed to bank deposits) is an important instrument for payment in the foreign exchange markets. This is especi

Foreign currency and coin itself (as opposed to bank deposits) is an important instrument for payment in the foreign exchange markets. This is especially true for tourists, who require pocket money to pay for lodging, meals, transactions, etc. usually this money winds up in the hands of merchants accept it in payment for purchases and is deposits in domestic banks. For example, many U.S. banks operating along the Canadian and Mexican borders receive a substantial volume of Canadian dollars and Mexican pesos each day. These funds are normally routed through the banking system back to banks in the country of issue, and the U.S. banks receive credit in the form of a deposit denominated in a foreign currency. This deposit may then be loaned to a customer or another bank that needs foreign currency. Some dealers in the New York money market buy and sell foreign bank notes and coins.

Instruments of foreign exchange market: bills of exchange

One of the oldest and most important of all international financial instruments is the bill of exchange. Frequently today the word draft is used instead of bill. Either way a draft or bill of exchange is a written order requiring a person, business firm, or bank to pay a specified sum of money to the bearer of the bill.
We may distinguish between sight bills, which are payable on demand (presentation), or time bills, which mature at a future date and are payable only at that time. There are also documentary bills, which typically accompany the international shipment of goods. A documentary bill must be accompanied by shipping papers (such as bills of lading), allowing importers of goods to pick up their merchandise. In contrast, a clean bill has no accompanying documents and is simply an order to a bank to pay a certain sum. The most-common example arises when an importer requests its bank to send a letter of credit to an exporter in another country. The letter authorizes the exporter to draw bills for payment, either against the importer‘s bank or against one of its correspondent banks. Most bills of exchange drawn in connection with U.S. imports and exports are payable in U.S. dollars

Instruments of foreign exchange market:cable transfers

There are several financial instruments which are used to facilitate foreign-exchange trading. one of the most important is the cable transfer-an execute order sent by cable to a foreign bank holding a currency seller‘s account. the seller directs the bank to debit the seller‘s account and credit the account of a buyer or someone the buyer designates (such as a commercial bank).
For example, suppose a U.S. export firm has just received payment from one of its overseas customer in francs. The U.S. firm is paid in the form of a deposit denominated in francs residing currently in a bank in Paris. The U.S. exporter cables the Paris bank to transfer the francs to the account of a New York bank, receiving a dollar deposit from the New York bank at the current dollar-franc exchange rate. The export firm now has dollars which can be spent in the United States for raw materials, to meet payrolls, pay taxes, etc., while it's New York bank now owns a deposit in francs which can be loaned out or used for other purposes.
The essential advantage of the cable transfer is speed since the transaction can be carried out the same day or within one or two business days. Business firms selling their goods in international markets can avoid tying up substantial sums of money in foreign exchange by using cable transfers.