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P. 1
Practitioner Guide to Forex Market-part 2

Practitioner Guide to Forex Market-part 2

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Published by acreddi
Practitioner Guide to Forex Market
Practitioner Guide to Forex Market

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Categories:Business/Law, Finance
Published by: acreddi on Aug 16, 2009
Copyright:Attribution Non-commercial

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05/11/2014

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Chapter 1
 
Forex is International Payments
 
There is no sphere of human influence in which it is easier to show superficialcleverness and the appearance of superior wisdom as in matters of currencyand exchange. (
WINSTON CHURCHILL
,
 
speech in House of Commons, 1946)As for foreign exchange, it is almost as romantic as young love, and quite asresistant to formulae (
H L MENCKEN
,
The Dismal Science 
)
 Foreign exchange (shortened to forex or FX) is the consequence of the coexis-tence between the nationalism of currencies and the internationalism of trade.While nations zealously keep their identity with their own flags and curren-cies, the comparative and competitive advantages compel them to tradeacross borders. No country can produce all that it consumes, nor can it con-sume all that it produces (comparative advantage). Even if they were, it will notbe effective and efficient (competitive advantage).We may say that what money does for goods and services within in acountry (i.e. medium of exchange, store of value), forex does the same for dif-
 
Chapter 1
 
2
ferent brands of money (see Exhibit 1-1). If the world has a single currency ortrade does not cross national borders, the forex disappears.
EXHIBIT
1-1:
 
Money versus Forex
Settlement of international trade requires two elements: international mon-ey and
an “adjustment” mechanism to correct trade imbalances among n
a-tions. Experience shows that the first is less important and that the second hasbeen the source of much trouble. The evolution and the timeline of internation-al payment systems are reviewed below.
1.1. Gold Standard: 1870
 –
1914
Under Gold Standard, central banks issued paper money and held gold (or sil-ver or both) in reserve to back the paper money. The international paymentssystem was built on the following features.
Export and import of gold was freely allowed
 
Currencies were valued in gold at a fixed rate (“mint par rate”)
 
Convertibility of currency to gold at mint par rate was guaranteed bycentral banksThe mint par rates of a national currency determined its value against othercurrencies. For example, if mint par rates of US dollar and Indian rupee were$100 and Rs 4,000 per unit amount of gold, respectively, then dollar-rupee fo-rex price would be: Rs 4,000 / $ 100 = Rs 40 per $. The forex price would be
fixed 
at this level, regardless of demand-supply for the currency. If it were not,there would be an opportunity for arbitrage profit by converting currencies intogold at mint par rates, and moving gold between the two countries. In practice,the arbitrage rate level would be slightly off the mint par rate because of trans-
CHINA
 
INDIA
 
noodles silk roti cotton
Analects Spring in a Small Town Arthashastra Mughal-e-Azam 
yuan rupeeforex
 
Forex as International Payments 
 
3
action costs in shipping gold. Instead of one mint par rate, there was a rangedefined by gold
export point 
and
import point 
.The theory of the adjustment mechanism for trade imbalance under GoldStandard involved the chain of events, including the movement of gold amongnations, shown in Exhibit 1-2.
EXHIBIT
1-2:
Adjustment Mechanism under Gold Standard
The adjustment process was symmetrical in the sense that the country withtrade surplus shared the burden of the country with trade deficit. The forexprices were fixed and stable, and the role of central bank was to freely buy andsell gold at the mint par rate. The domestic policies (e.g. economic growth, un-employment) were subordinate to external trade imbalances.In practice, the changes in price level or unemployment and the movementof gold was not to the extent warranted by the adjustment mechanism. Thiswas due to the skillful management of international clearing by the Bank ofEngland, which induced international capital flows in sterling pound by varyingthe interest rates. Interest rate rose in countries with trade deficit and fell incountries with trade surplus. The cornerstone of the Gold Standard remainedthe full convertibility of sterling pound to gold at
₤ 
1
17
10½ a troy ounce. TheGold shipped outLower money stockDeflation
TRADE SURPLUS
 
Less imports, more exportsMore imports, less exportsInflationHigher money stockGold shipped in
TRADE DEFICIT
 

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