The document discusses the history and evolution of international monetary systems from bimetallism to the present day. It covers major historical systems like the gold standard and Bretton Woods system. It also explains key concepts in international finance like exchange rate theories, foreign exchange markets, and currency quotations. Major developments covered include the establishment of the Euro and current mixed exchange rate arrangements used globally.

1. Unit-2
IFM

2. The Monetary System
 Bimetallism: Before 1875
 Free coinage was maintained for both gold and silver
 Gresham’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 coinage
 There is a two-way convertibility between gold and national currencies at a stable ratio
 Gold may be freely exported and imported
 Cross-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.

3.  Interwar period: 1915-1944
 World War I ended the classical gold standard in 1914
 Trade in gold broke down
 After the war, many countries suffered hyper inflation
 Countries 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.

4.  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.

5. 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.

6. 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 2002
 Greece adopted the Euro in 2001
 Slovenia adopted the Euro in 2007

7. 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.

8. 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 specialists
 Client Market (Retail)
 Accounts for about 17% of FX trading volume
 Market participants include international banks, their customers, non-bank
dealers, FX brokers, and central banks

9. Fx market

10. Exchange Rate Theories
Factors affecting exchange rates:
Rate of inflation
rate of interest
Balance of payments
 2 theories explain fluctuations in exchange rate
i.e. Purchasing Power Parity (PPP) and Interest
Rate Parity theory (IRP)

11. 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

12. Purchasing power parity
It is ideal if Exchange Rate is in tune with PP
Otherwise there is disequilibrium.
Floating exchange rate should vary
according to the rate of inflation.

13. 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

14. formulae
P0A = S0A/B X P0B
A = quoted currency
B=base currency
S0 = 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

15. Criticisms
Government intervention
Restrictions in exchange markets
Speculation in exchange market
Structural changes in the economy
Continuation of long term flows
Rate of inflation not well defined(sample and
weights)
It considers only goods and not capital

16. 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.

17. formulae
Ct = Co X (1+Id/1+If)n
Ct = forward rate
Co = spot rate
n=no of years
Id=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.

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

19. 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 rate
The 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.

20. INTERNATIONAL FISHER EFFECT
(IFE)
It is the combination of Fisher effect and PPP
theory
Interest rates are significantly correlated with
inflation rates.
The relationship between the % change in the spot
exchange rate over time
Uses interest rate differential to explain changes in
exchange rate
States that the interest rate differential shall be
equal to inflation rate differential.

21. 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

22. PPP % CHANGE IN SPOT EXCHANGE RATE
INFLATION
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

23. 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.

24. 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.

25. 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.

26. 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
markets
making 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

27. 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

28. Swap Transactions:
Swap Transactions:
simultaneous purchase and sale of a given
amount of foreign exchange for two
different value dates:
“spot against forward” swaps:

29. Foreign exchange markets
 Currency conversion in the foreign exchange
market
Is necessary to complete private and commercial
transactions across borders
A tourist needs to pay expenses on the road in local
currency
A 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

30. 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.

31. 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.

32. 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.

33. 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

34. Transaction cost
Bid-Ask Spread
used to calculate the fee
charged by the bank
• Bid = the price at which
the bank is willing to buy
• Ask = the price it will sell
the currency

35. 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

36. SPOT MARKET
Refers to the current exchange rate
Immediate exchange of currencies
Immediate delivery
Cash settlement is made after 2 working
days, excluding holidays.

37. 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 importers
FR higher than existing spot rate – forward
premium
FR lower than the existing spot rate – forward
discount

38. 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

39. Spot transaction
Settlement Date Value Date:
1. Date when money is due
2. 2nd Working day after date of
original transaction.

40. BID/ASK =SPREAD
Dealers 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 transactions
The dealer ready to buy $ - Bid price
The 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

41. covered interest Arbitrage
International flow of short term liquid capital
to earn a higher return
Spot purchase of foreign currency to make
the investment and offsetting the
simultaneous forward sale to cover the
foreign exchange risk.

42. 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.

43. 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 bands
the rate is allowed to fluctuate in a fixed band (bigger than 1%) around a central rate.

44. THE END