International monetary system and foreign exchange
Functions of Currency
- medium of exchange
- unit of account
- store of value
International monetary system and foreign
Foreign exchange is money denominated in other currency of
another country or group of countries.
Done at OTC over the counter or ETM (Exchange traded
OTC done at commercial banks like BOA or investment banks
like Merryll lynch or other financial
ETM done at securities exchanges like Chicago mercantile
exchange or Philadelphia stock exchange where certain types of
forex instruments are used like exchange traded futures and
Traditional instruments traded on OTC:
Others traded on exchange
Currency swaps of interest bearing financial instruments
Options the right but not obligations to trade forex in future.
Investment currency in many capital markets
Reserve currency held in many banks
Transaction currency in many commodity markets
Intervention currency monetary authorities in many market
operation to influence their own exchange rates.
Most frequently traded in currency pairs 4 of 7. Euro and yen
Bank for international settlements a Switzerland based central
bank (owned and controlled by 50 central banks conducts
survey for forex market activity the records.
Biggest market for forex is london followed by NY and Japan
The spot market
Bid and offer are buying and selling price for a currency.
The difference is called spread or trader margin.
Direct or indirect quotes.
Rate quoted today for future delivery.
On forward discount or forward premium.
Fee or cost of option is called premium.
For specific amount and specific maturation date.
Not done by bankers but by exchange brokers.
Hard currencies are those that are relatively
stable, are fully convertible
Currencies that are not fully convertible are
soft currencies or weak currencies.
How some govts conserve forex
Import licensing: fixed exchange rate at which
exporter must render forex and then it is rendered to
importers of essential goods at rates fixed by govt.
Multiple exchange rates: govt defines which kind of
transaction are to be conducted at what exchange
Import deposit: deposit entire amount of import
transaction with central bank for a specified time
period – interest free.
Exchange rate mechanism
1944 the Bretton Woods : meeting to discuss what was needed to bring
economic stability and growth in post world war period.
As a result IMF was born in1945 and started financial operation in 1947. to
Promote international monetary co-operation
Facilitate growth of international trade.
Promote exchange rate stability
Establish multilateral system of payments
Make resources available to members who experience BOP difficulties
The chief features of the Bretton Woods system were an obligation for each
country to adopt a monetary policy that maintained the exchange rate by tying its
currency to the U.S. dollar and the ability of the IMF to bridge temporary
imbalances of payments.
US dollar was a standard against gold $35 to an ounce of gold.(28 grams app.).
This was established as par value whether gold or dollar was used as basis for
par value. It became the benchmark by which each currency was valued against
Exchange rate mechanism
1947: US held 70% of world’s official gold
reserves. The dollar was strong so
governments bought and sold dollars instead
of gold thinking US would redeem dollar for
The IMF system was thus that of a fixed
exchange rate with dollar value remaining
fixed. Other countries could change the value
of their currencies against $ or gold.
Exchange rate mechanism
1971: Nixon pressed for restructuring of
international monetary system if US were still
to trade $ for gold. The smithsonian system
came to place:
8% devaluation in $
Revaluation of other currencies i.e increase in
Widening of Exchange rate flexibility from 1% to
Exchange rate mechanism
1972 : the smithsonian arrangement did not last.
World currency markets remained unsteady. $
devalued by 10%. Currencies began to float (market
dependent to determine values)against other
currencies instead of relying on smithsonian
The Jamaica agreement came into place which
amended original rules to eliminate concept of par
value in order to permit greater exchange rate
Role of IMF
Permitted countries to select and maintain
exchange rate arrangements.
Had a surveillance program which allows it to
monitor economic policies that would affect
Consults annually to see if they are acting
openly and responsibly in their exchange rate
The IMF currency the SDR
Members contribute on joining. Called quota,
it is based on national income, BOP,
monetary reserves, and other economic
SDR: Special drawing rights.
SDR composed of 5 currencies: Dollar, Euro,
Japanese yen, Pound, and is found by
weighted average as per the holdings
Holdings are decided after every 5 years.
Exchange rate mechanism regimes
Exchange agreements with no separate legal tender: currency of another
country is the sole legal tender or member belongs to currency union, eg EU
Currency board arrangements: implicit legislative commitment to exchange
domestic currency with a specified foreign currency at a fixed exchange rate.
Pegged exchange rates: currency is pegged to another major currency or basket
of currencies with minor fluctuation of 1/21 %. China to USD
Pegged exchange rates within horizontal bars: same as above but the deviation
may be more than 1/21%. Denmark
Crawling peg: pegged and periodically adjusted at preannounced rates. Costa
Managed Float with no pronounced path for exchange rates: monetary authority
influences the movement of exchange rate by actively intervening in exchange
markets. Eg India
Independent float: Market driven with intervention aimed only to moderate the
change of rates or to thwart any undue fluctuations.Eg US
Central banks role
Limited these day cos forex is traded to the
tune of $ 3-4 trillion each day.
Managing exchange rates not possible over a
long period of time.
However to limit huge fluctuations and undue
one the central bank play a role by buying
and selling currencies.
Also fiscal policies can play a role.
Theory that seeks to define relationships among
States that relative rates of inflation must cause
changes in exchange rates to keep the prices of
goods in two countries similar.
The Economist which used the price of ‘Big Mac’ to
estimate the exchange rates since 1986. ‘Big Mac’
is sold in over 120 countries. ‘McParity’
PPP assumes that there are no barriers to trade and
that transportation costs are nil.
The fischer theory and the international fischer
The theory states that if interest rates in US are
more than in Japan the dollar will depreciate. This
will be so because the higher interest rates exist to
counter higher inflation.
The fischer theory
(1+r) = (1+R) (1+i)
r= nominal monetary interest rate
R= Real interest rate
I = Inflation
Uses trends in economic variables to predict
Uses past trends to spot future trends in rates
Factors to understand or early warning
Managed or floating: if managed how credible or
sustainable it is?
Does it appear ok in terms of PPP
What is the cyclic situation in employment growth,
savings, investments, inflation
Credibility of government and central bank and
National or international events in terms of crisis or
emergencies. Are there any meeting scheduled eg
Foreign Exchange Rate
Effect of Devaluation
- Exports and Employment
- Imports & Consumer
Leading and Lagging: It refers to the adjustment of the times of payments that are made
in foreign currencies. Leading is the payment of an obligation before due date while
lagging is delaying the payment of an obligation past due date. The purpose of these
techniques is for the company to take advantage of expected devaluation or revaluation of
the appropriate currencies. Lead and lag payments are particularly useful when forward
contracts are not possible.
Pass-Through Costs :Formally the exchange rate pass-through (ERPT) is the
percentage change in local currency import prices resulting from a one percent change in
the exchange rate between the exporting and importing countries. Inevitably the change in
the import prices find their way to retail and consumer prices. Inflation pass through occurs
when the change in the currency changes prices and therefore inflation