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Exchange Rates and Gold's Zero Discount Value

Exchange Rates and Gold's Zero Discount Value

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Published by michael s rozeff
A balance sheet approach demystifies currency exchange rates. The greater the discount at which gold sells from its zero discount value in a currency, the more overvalued is that currency as compared with other currencies whose gold prices are closer to their ZDVs.
A balance sheet approach demystifies currency exchange rates. The greater the discount at which gold sells from its zero discount value in a currency, the more overvalued is that currency as compared with other currencies whose gold prices are closer to their ZDVs.

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Categories:Business/Law, Finance
Published by: michael s rozeff on Nov 13, 2009
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07/16/2010

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Exchange Rates and Gold’s Zero Discount Value
 by Michael S. Rozeff This note provides a simple
 financial 
model of exchange rates – very simple. If it has merit, it is probably as a rough or long-term guide to their tendencies. I make no empirical attempt toexplain the market’s ups and downs, with all the attendant noise, leads, lags, and manifoldinfluences.The usual
economics
models look at such things as purchasing power parity, data on moneysupplies, prices, rates of price inflation, interest rates, and output. I focus on gold and themonetary base for precision of thought, but I recognize that in application, one probably has touse some measures of interest rates and other monetary aggregates to make sense of exchangerates. My approach is a
balance sheet 
approach.In earlier articles, I introduced the notion of a Zero Discount Value (ZDV) for gold when thereare bank notes issued against gold. The ZDV is the value of the notes in terms of their weight ingold.Here I relate the ZDV to exchange rates in three different cases. Case1 is the free and fullconvertibility of notes into gold. In this case, the ZDV is the market price of gold. It follows thatthe exchange rate between two different bank notes relates directly to the two ZDVs. In case 2, Iassume that there is inconvertibility of notes and that the prices of gold are both discounted fromthe ZDVs by the same proportion. In this case, the exchange rate is the same as in the convertiblecase. In case 3, I assume inconvertibility but that the gold prices represent different discountsfrom the ZDVs. The exchange rate in this case is such that each note is worth the same marketamount of gold after applying the exchange rate. However, both the exchange rate itself and thegold that backs each note diverge from the convertible case. A disequilibrium results. This produces pressure on the exchange rate that tends to move it toward the value that holds in theconvertible case.If all central bank notes were freely convertible into gold, then they would all have to have thesame gold-equivalent backing that is consistent with their exchange rates. If they did not, therewould be arbitrage opportunities. Non-convertibility of bank notes into a common medium of redemption like gold abates or interrupts arbitrage. It allows disequilibria to persist. Other kinds of exchange restrictions do thesame. But although arbitrage by individuals may not be possible, a tendency to achieveequilibrium still pressures exchange rates in a direction consistent with convertibility. That is the point argued in this note.Case 1. Suppose there are two bank notes D and E. There are 1000 D issued and 750 E issued.Let bank D hold 0.2 grains of gold per D, and bank E hold 0.33 grains of gold per E. Then 1D isequivalent to 0.6E. The arbitrage-free exchange rate between D and E is 1D = 0.6E.
 
Consider the totals. Bank D has issued 1000D bank notes worth the 200 grains of gold it carriesas an asset, and bank E has issued 750E bank notes worth the 250 grains of gold it carries. ZeroDiscount Value (ZDV) is defined as the price of the bank notes in terms of the quantity of goldheld by the bank. D’s ZDV is 5D per grain and E’s ZDV is 3E per grain. These values areconsistent with 5D = 3E or an exchange rate of 1D = 0.6E. The
market 
 prices of gold in terms of D and E have to be the same as the ZDV values when there is convertibility. A grain of goldcosts 5D and also 3E; 5D have to exchange for 3E to prevent arbitrage profits.Thus, if there is convertibility of bank notes into gold, the ratio of the Zero Discount Values of two different bank notes also gives the arbitrage-free exchange rate.Case 2. In a non-convertible system of banking, gold can sell at less than its ZDV. Suppose agrain of gold sells for 0.15 of D’s ZDV, i.e., at 0.75D per grain. Suppose that the discount of E’snotes to its ZDV is the same. That is, gold is 0.15 of E’s ZDV, i.e., 0.45E per grain. In this case,where the discounts are identical, the exchange rate is 1D = 0.6E, since 0.6 x 0.75 = 0.45. Either 1D or 0.6E buy the same number of grains of gold in the market, namely, 1.3333 grains.Furthermore, the backing of the notes at this exchange rate is the same. Both 1D and 0.6E havethe same backing of 0.2 grains.The exchange rate in this non-convertible case remains the same as in the convertible case if andonly if both bank notes sell at the same discount from their respective ZDVs. If they sell atdifferent discounts to their ZDVs, then their exchange rate will no longer be at the rate indicated by the freely convertible benchmark.Case 3. Suppose now that gold priced in D and E notes sells at
different 
discounts to ZDV.Suppose gold sells at 0.15 of its ZDV in D, and it sells at 0.30 of its ZDV in E. Gold is 5D per grain. At 0.15 of its ZDV, it is 0.75D per grain. If gold sells for 0.30 of E’s ZDV of 3E per grain,its price is 0.9E per grain. At the exchange rate of 0.75D to 0.9E, or 1D to1.2E, the same
market 
amounts of gold are exchanged.This means that if we attempt an arbitrage at the observed exchange rates, it will not be profitable. Let us borrow 1D and exchange it for 1.2E. Sell 1.2E and get 1.3333 grains. Exchangethat for 1D and repay the D loan. There is no profit using market rates. Gold prices are consistentwith the exchange rates.It is the exchange rates that are out of equilibrium. This is because the notes are selling atdifferent discounts to ZDV. This shows up in that the
backing 
of the notes at this exchange rate isno longer the same. 1D has a backing of 0.2 grains, and 1.2E has a backing of 0.4 grains.If D and E are inconvertible and D sells at a larger discount to ZPV, D’s exchange rate moveshigher compared to the convertible case. If the price of gold in D notes is relatively lower thanthe price of gold in E notes as reflected in the larger discount from ZDV, then the value of Dnotes is relatively larger as compared with the convertible case and the equal discount case. Thismeans that the D notes appear overvalued and the E notes undervalued. This coincides with thelower gold backing of the D notes at the new exchange rate.
 
We uncover a relation that allows us to detect overvalued and undervalued currencies in a verysimple way. Calculate a currency’s ZDV. Obtain the price of gold in that currency. Calculate thediscount of gold’s market price from its ZDV. The larger is this discount, the greater is thiscurrency overvalued relative to other currencies. All of them may be overvalued relative to gold, but that is a separate matter.Although 1D and 1.2E exchange for the same amount of gold in the market, the 1D has less gold behind it than the 1.2E. If a trader wanted gold and held both D and E, he might consider it better to sell his Ds rather than his Es to buy it. He could sell 1D and buy 1.333 grains, and he’d give upa backing of 0.2 grains. If he sold 1.2E and bought 1.333 grains, he’d give up a backing of 0.4grains. He’d gain 0.2 grains backing by selling D rather than E.This can be seen in another way. The holders of 
both
D and E notes have an incentive to sellthem in order to get gold, since both notes are at a discount to ZDV. If a buyer can be found whowill buy 1000 D notes and give up gold, he’d give up 1,333 grains at the price of 0.75D per grain.He’d get 1000 notes with a backing of 200 grains. This is obviously a very bad (unprofitable)deal for buyers, but that is what it means to say that arbitrage is possible. The same goes for the Enotes. Someone who bought 600E notes would also have 200 grains of gold behind them, buthe’d have given up 666.67 grains of gold at the price of 0.9E per grain to get them. A seller whohad the choice of selling D or E notes does better to sell the D notes because he gets more actualgold as compared with the gold-equivalent in the notes he disposes of. There should be atendency for those who want gold to hold on to the E notes and sell the D notes to get the gold.This should tend to lower the price of D in terms of E and move the exchange rate closer to theconvertible benchmark.With this framework, we can now think about a sequence of events that changes exchange rates.1. Assume a money system with central banks. It is not a free market system. It is a fiat moneysystem in which the notes of the central banks receive partial backing from gold.2. Assume that banks D and E have 1000 notes issued against 200 gold grains and 750 notesissued against 250 gold grains, and that both have gold prices that are at 30 percent of ZDV.Then D’s gold price is 1.5D per grain and E’s gold price is 0.9E per grain. The exchange rate of their notes is 1D to 0.6E.3. The D central bank doubles its notes without adding any gold. This means that the ZDV risesto 10D per grain. If gold remains at 30 percent of its ZDV, its price becomes 3D per grain. Theequilibrium exchange rate is 3D to 0.9E or 1D to 0.3E, showing the 50 percent devaluation. Sodoes the doubling in the price of gold.4. Assume that market reactions are not instantaneous or that expectations are slow to adjust, for which there are any number of possible reasons. Then when D’s ZDV rises to 10D, assume thatgold in that currency stays temporarily at a price that is 1.5D per grain. Gold sells at 15 percent of ZDV rather than 30 percent.

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