This document provides an overview of international monetary systems and foreign exchange. It discusses the need to understand foreign exchange due to global trade involving multiple currencies. It describes hard and soft currencies and the functions of currency. It also outlines different exchange rate systems like the gold standard, Bretton Woods system, and classifications of exchange rate regimes including floating, pegged, and currency board arrangements. It concludes with descriptions of foreign exchange markets, hedging, and the difference between spot and forward markets.

1. International Monetary System and
Foreign Exchange
• Why the need to understand Foreign
Exchange?
The world is integrated today.
It is a fact of life that goods and services
produced in one country will be traded in
another.
The currency that one will receive/pay in
exchange for goods sold/bought will be other
than one’s home currency.

2. Foreign Exchange Management
Therefore, we need to understand how
currency fluctuations or volatility of currency
markets affects our decision-making ability as
a buyer/seller of goods/services.
Domestic and international transactions differ
in the use of more than one currency for
international trade. Thus international
business creates a need for buying, selling or
borrowing foreign currencies.

3. Foreign Exchange Management
It is important to understand how the
exchange rates are set and why the rates
change.
This would help the managers in making
decisions that are dependent on those
changes.
The price at which one currency is traded for
another is referred to as exchange rates.

4. Money
• Hard (International) Currencies vs. Soft
Currencies
Hard Currency – refers to a globally traded
currency that is expected to serve as a reliable
and stable store of value. Factors contributing
to a currency’s hard status might include the
long-term stability of its purchasing power, the
associated country’s political and fiscal
condition and outlook and the policy posture of
the issuing central bank.

5. Money
Soft Currency – indicates a currency which is
expected to fluctuate erratically or depreciate
against other currencies. Such softness is
typically the result of political or fiscal
instability within the associated country.

6. Money
• Functions of Currency
- medium of exchange
- unit of account
- store of value

7. Foreign Exchange Management
• Exchange-Rate Systems
- Gold Standard
- Par Value (Adjustable Peg)
– Crawling Peg :– a fixed exchange rate in
which regular (frequent?) periodic
adjustments
– Floating (Flexible) System: No Government
Interference, Market Forces dictate
equilibrium exchange rates, Value of a
nation’s currency allowed to “float” down
or up

8. Foreign Exchange Management
• Exchange-Rate Systems
- The exchange rate system we see today is
the latest stage in a world of continuing
change. The systems that have preceded
the present floating exchange rate system
have been varied.

9. Foreign Exchange Management
• Exchange-Rate Systems
Gold Standard – Till 1939, the world exchange
(monetary) system was based on ‘Gold
Standard’ which fixed exchange value between
gold and currency e.g. 1£ = 30 gm and 1Re = 2
gm.
Then 1£ = Rs. 15.

10. Foreign Exchange Management
• Exchange-Rate Systems
Gold Standard
There was no problem with this system as rate
of exchange remained more or less constant.
Gold Standard could work successfully if all
countries observed certain rules universally.

11. Foreign Exchange Management
For e.g. USA exports to UK were more than
the USA imports from UK. This meant that
the US trade balance was better than that of
UK. The balance will move from UK to USA in
the form of gold.
Rule: When gold moves out of UK, the supply of
money in UK goes down. In USA on the other
hand, price level will increase due to the
increased supply of money.

12. Foreign Exchange Management
This meant that in future the UK has more
scope to export as price levels in UK decline,
which is not the case in USA. Therefore, an
equilibrium established. Unfortunately, during
1930s, USA was constantly in surplus but did
not increase the level/supply of money. They
said “the extra gold was kept in cold storage
and not given to the monetary authority”.
Therefore, soon the European countries
refused to pay in gold as they could not get
back.

13. Foreign Exchange Management
The Bretton Woods System – The 1920s and
1930s were a dark period for world trade and
currency markets.
During the World Wars, many countries
suffered very badly. In order to correct the
BOP disequilibrium, many countries had to
resort to devaluation of their currencies.
International trade suffered a near death
blow.

14. Foreign Exchange Management
United States and Great Britain took the lead
and a conference was convened at Bretton
Woods in US in July 1944.
In accordance with the agreement reached at
the Conference, the International Monetary
Fund (IMF) was established in 1946.
The exchange rate system under the IMF came
to be known as Bretton Woods system and was
followed by member countries from 1946 to
1971.

15. Foreign Exchange Management
The Bretton Woods system required the IMF
member countries to fix the parities of their
currencies in terms of US dollars or gold.
The objective of stable exchange rates were
achieved as the countries were obliged to keep
the fluctuations within 1% of the declared
parity. It was agreed that no change in parity
could take place without the IMF’s approval.
The US fixed the parity of the US dollars in
terms of gold at $ 35 per ounce.

16. Foreign Exchange Management
Others were allowed to buy gold from USA at
this rate. This virtually fixed the notional gold
equivalent and also the price. In 1968 there
was a major crisis in USA. It suffered a
massive BOP deficit and accelerated inflation.
USA decided to devalue the dollar and said
that it was not interested in maintaining the
fixed value of gold. This led to increase in
international gold prices. The other major
countries issued a “floating rate of exchange”
wherein gold equivalent was rejected.

17. Official Classification of Exchange
Rate Regimes
• Floating Exchange Rate Regimes
- independently floating regimes
- managed floating regimes
• Intermediate Exchange Rate
Regimes
- soft pegs
- tightly managed floating regimes
• Hard Peg Regimes
- currency boards
- exchange rate regimes with no separate
legal tender

18. Official Classification of Exchange
Rate Regimes
• Floating Exchange Rate Regimes
- independently floating regimes
Pure Floating Rates (Free Float) – Under
the pure floating rate arrangement, the
exchange rate of the currency of a
country is determined entirely by market
considerations such as demand and supply.
The government or the Central Bank
makes no effort to fix the exchange rate.
Also referred to as a clean float.

19. Official Classification of Exchange
Rate Regimes
• Floating Exchange Rate Regimes
- managed floating regimes
Few countries have been able to long resist the
temptation to intervene actively in the foreign
exchange market in order to reduce the
economic uncertainty associated with a clean
float. The fear is that too abrupt a change in
the value of a nation’s currency could imperil its
export industries (if the currency appreciates)
or lead to a higher rate of inflation (if the
currency depreciates).

20. Official Classification of Exchange
Rate Regimes
• Floating Exchange Rate Regimes
- managed floating regimes
Most countries, with floating currencies have
attempted through central bank intervention to
smooth out exchange rate fluctuations. Such a
system of managed exchange rates, called a
managed float, is also known as a dirty float.

21. Official Classification of Exchange
Rate Regimes
• Intermediate Exchange Rate Regimes
- soft pegs
- tightly managed floating regimes
Pegging – under a pegging arrangement, a country
links the value of its currency to that of another
currency, usually that of its major trading partner.
Pegging to a particular currency implies that the
value of pegged currency moves along with the
currency to which it is pegged.

22. Official Classification of Exchange
Rate Regimes
• Intermediate Exchange Rate Regimes
- soft pegs
- tightly managed floating regimes
There are soft and hard pegs. Soft pegs generally
let their exchange rate fluctuate through a desired
bracket.
Crawling Pegs – the peg system is situated between
the fixed-rate and float-rate systems. The ‘crawling
peg’ is a system establishing a par value around which
the rate can vary up to a given percentage point.

23. Official Classification of Exchange
Rate Regimes
• Hard Peg Regimes
- currency boards
- exchange rate regimes with no separate legal
tender
Hard pegs follow the anchor currency more strictly.
Currency Board Arrangements – A monetary regime
based on an implicit legislative commitment to exchange
domestic currency for a specified foreign currency at a
fixed exchange rate.

24. Official Classification of Exchange
Rate Regimes
• Hard Peg Regimes
- currency boards
- exchange rate regimes with no separate legal
tender
Exchange Rate arrangements with No Separate Legal
tender - The currency of another country circulates as
the sole legal tender or the member belongs to a
monetary or currency union in which the same legal
tender is shared by the members of the union.

25. Foreign Exchange Market
• Credit (Financing)
• Clearing
• Hedging
• Spot Market vs. Forward
Market

26. Foreign Exchange Market
• Hedging – Exposures to currency risk can be
eliminated by hedging. The literary meaning if
the word is risk management. The aim is to
ensure that profits or costs are more
predictable. One commonly used instrument is
the forward contract.
• Spot Market vs. Forward Market

27. Foreign Exchange Market
• Spot Market vs. Forward Market
A spot transaction is a contract to buy or sell a
quantity of a foreign currency for immediate
settlement or value. The exchange rate for
such a transaction is known as spot rate.
‘Forward’ means any day beyond spot.