FOREIGN EXCHANGE: DEALING SYSTEM, SETTLEMENT, EFFECT ON GDP & LIQUIDITY

Submitted by:Sushil Kumar (85)

FUNCTIONS OF FOREIGN EXCHANGE MARKET

It is the market where currencies are bought and sold against each other. It is the largest market in the world.

The daily volumes in the UK, USA, Japan were reported to be as follows -: UK:

$ 1359 b USA: $ 664  b                         Japan:   $ 238 b

UK is contributed maximum liquidity in the forex  market.

THE FUNCTIONS OF THE FOREIGN EXCHANGE MARKET

enables the conversion of the currency of one country into the currency of another 2. It performs the hedging function converting the risk on foreign exchange transactions 3. Transfer purchasing power between countries

4. TO PROVIDE CREDIT TO

IMPORTER DEBTOR

INTERNATIONAL Monetary System

EVOLUTION OF THE INTERNATIONAL MONETARY SYSTEM

Bimetallism: Before 1875 Classical Gold Standard: 1875-1914 Interwar Period: 1915-1944 Bretton Woods System: 1945-1972 The Flexible Exchange Rate Regime: 1973-Present

BIMETALLISM: BEFORE 1875

A “double standard” in the sense that both gold and silver were used as money. Some countries were on the gold standard, some on the silver standard, some on both. Both gold and silver were used as international means of payment and the exchange rates among currencies were determined by either their gold or silver contents. Gresham’s Law implied that it would be the least valuable metal that would tend to circulate.

CLASSICAL GOLD STANDARD: 1875-1914

During this period in most major countries:
 Gold

alone was assured of unrestricted coinage  There was two-way convertibility between gold and national currencies at a stable ratio.  Gold could be freely exported or imported.

The exchange rate between two country’s currencies would be determined by their relative gold contents.

CLASSICAL GOLD STANDARD: 1875-1914
For example, if the dollar is pegged to gold at U.S. $30 = 1 ounce of gold, and the British pound is pegged to gold at £6 = 1 ounce of gold, it must be the case that the exchange rate is determined by the relative gold contents:

$30 = £6 $5 = £1

CLASSICAL GOLD STANDARD: 1875-1914

Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment. Misalignment of exchange rates and international imbalances of payment were automatically corrected by the price-specie-flow mechanism.

CLASSICAL GOLD STANDARD: 1875-1914

There are shortcomings:
 The

supply of newly minted gold is so restricted that the growth of world trade and investment can be hampered for the lack of sufficient monetary reserves. Even if the world returned to a gold standard, any national government could abandon the standard.

INTERWAR PERIOD: 1915-1944

Exchange rates fluctuated as countries widely used “predatory” depreciations of their currencies as a means of gaining advantage in the world export market. Attempts were made to restore the gold standard, but participants lacked the political will to “follow the rules of the game”. The result for international trade and investment was profoundly detrimental.

BRETTON WOODS SYSTEM: 1945-1972

Named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire. The purpose was to design a postwar international monetary system. The goal was exchange rate stability without the gold standard. The result was the creation of the IMF and the World Bank.

BRETTON WOODS SYSTEM: 1945-1972

Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar. Each country was responsible for maintaining its exchange rate within ±1% of the adopted par value by buying or selling foreign reserves as necessary. The Bretton Woods system was a dollar-based gold exchange standard.

COLLAPSE OF BRETTON WOODS (1971)
  

U.S. high inflation rate

U.S.$ depreciated sharply. Smithsonian Agreement (1971) US$ devalued to 1/38 oz. of gold. 1973 The US dollar is under heavy pressure, European and Japanese currencies are allowed to float 1976 Jamaica Agreement Flexible exchange rates declared acceptable Gold abandoned as an international reserve

  

BRETTON WOODS SYSTEM: 1945-1972
German mark

British pound

French franc

ar u P l Va e

Par Valu e
U.S. dollar

Pa Va r lu e

Gold

Pegged at $35/oz.

THE FLEXIBLE EXCHANGE RATE REGIME: 1973-PRESENT.

Flexible exchange rates were declared acceptable to the IMF members.

Central banks were allowed to intervene in the exchange rate markets to iron out unwarranted volatilities.

Gold was abandoned as an international reserve asset. Non-oil-exporting countries and less-developed countries were given greater access to IMF funds.

CURRENT EXCHANGE RATE ARRANGEMENTS

Free Float

The largest number of countries, about 48, allow market forces to determine their currency’s value.

Managed Float

About 25 countries combine government intervention with market forces to set exchange rates.

Pegged to another currency

Such as the U.S. dollar or euro (through franc or mark).

No national currency

Some countries do not bother printing their own, they just use the U.S. dollar. For example, Ecuador, Panama, and El Salvador have dollarized.

EUROPEAN MONETARY SYSTEM

Eleven European countries maintain exchange rates among their currencies within narrow bands, and jointly float against outside currencies. Objectives:
 To

establish a zone of monetary stability in Europe.  To coordinate exchange rate policies vis-à-vis nonEuropean currencies.  To pave the way for the European Monetary Union.

WHAT IS THE EURO?

The euro is the single currency of the European Monetary Union which was adopted by 11 Member States on 1 January 1999. These original member states were: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands.

countries using different exchange rate systems

FOREIGN EXCHANGE RATES
The foreign exchange rates between two currencies specifies how much one currency is worth in terms of other currency in term of the home nation’s currency.

QUOTATIONS: 

Direct :In a direct quotation, the exchange rate is expressed as the number of units of the home or domestic currency per unit of the foreign currency

Indirect :An indirect quotation is one that the exchange rate is expressed as the number of the foreign currency units per domestic currency unit.

THE DETERMINATION OF EXCHANGE RATES
The important theories which helps in determining exchange are as: 1. Purchasing power parity (PPP). 2. Balance of payment approach. 3. Monetary and portfolio approach.

PURCHASING POWER PARITY (PPP)
It states that identical goods should be sold at identical prices.  Exchange rate should adjust for price differential.  p (domestic price)=P (foreign price)/e (exchange rate).  Exchange rate will also compensate inflation rate.  It hold in long run.

BALANCE OF PAYMENT APPROACH
It determines exchange rate at which both the internal and external economy are in equilibrium.  Internal equilibrium reflects a state of full employment.  External equilibrium reflects equilibrium in BOP.  It is difficult to determine exact rate of unemployment nor exchange rate consistent with an equilibrium in the external account.  It holds good in long term.

MONETARY AND PORTFOLIO APPROACH
It assumes that economic agents can choose from a portfolio of domestic and foreign assets.  Assets can be in a form of money or bonds having expected return.  Arbitrage opportunity determines the exchange rate.

INTERNATIONAL PARITY CONDITIONS

It exists a definite relationship between interest rates, inflation rates and exchange rates.

INTEREST RATE PARITY

The difference between the current exchange rate and the forward rate results from the difference in the interest rate of two countries. This is referred to as the interest rate parity.

Interest differential = Exchange rate (Forward and spot differential)

INFLATION RATES : -(PPP)

The expected future spot rate deviates fro the current spot rate because of the difference in the expected inflation rates in two countries. This notion is based on the law of one price. The price of similar goods should be same in foreign currency equivalent. This is known as purchase power parity. Nominal interest rates reflect the inflation rates.

EXCHANGE RATES :

A forward exchange rate should rate should be what the foreign exchange market participants expect the future spot rate to be. This is expectation theory of exchange rates.

FOREIGN CURRENCY OPTIONS

CURRENCY OPTIONS
Meaning of a Currency Option  Types of Options  Status of Options  Option pricing and valuation  Strategies using Options  When to use currency options  Market structure

CURRENCY OPTIONS

“A foreign currency option contract is a financial instrument from a writer (the seller) that gives the holder (the buyer) the right but not the obligation to sell or buy currencies at a set price either on a specific date or before some expiration date.” First offered on Philadelphia Exchange (PHLX). Fastest growing segment of the hedge markets.

 Call

Option: An option that gives the owner the right to buy a currency. Option: An option that gives the owner the right to sell a currency.

 Put

TYPES OF OPTIONS

American Style: An option that can be exercised any time before or on the expiration date. European Style: An option that can only be exercised on the expiration date.

CURRENCY OPTIONS

Exercise or Strike Price: The price (spot exchange rate) at which the option may be exercised. Option Premium: The amount that must be paid to purchase the option contract. Break-Even: The point at which exercising the option exactly matches the premium paid.

STATUS OF OPTIONS

Out-of-Money Option : The spot rate has not reached the exercise price, the option cannot be exercised. At-the-Money Option : The spot rate equals the exercise prices and would lead to zero cash flow. In-the-Money Option : The spot rate has surpassed the exercise price and would lead to positive cash flows.

In-Money Calls and Puts
 Call  Put

is in the money if ST > E is in the money if E > ST

Out of Money Calls and Puts
 Call  Put

is out of money if ST < E is out of money if E < ST

OPTION PRICING AND VALUATION
1) Value of an option equals a. Intrinsic value: the amount in-the-money b. Time value: the amount the option is in excess of its intrinsic value.

2) Other factors affecting the value of an option : a. value rises with longer time to expiration. b. value rises when greater volatility in the exchange rates.

STRATEGIES USING CURRENCY OPTIONS

Long a Call Option/Buy a Call Option
 Buy

a right to purchase a foreign currency at a predetermined exchange rate

Long a Put Option
 Buy

a right to sell a foreign currency at a predetermined exchange rate

CALL OPTION

The holder of a call option expects the underlying currency to appreciate in value. Consider 4 call options on the euro, with a strike of 92 ($/€) and a premium of 0.94 (both cents per unit). The face amount of a euro option is €62,500. The total premium is: $0.0094·4·€62,500=$2,350.

Call Option: Hypothetical Pay-Off Profit $1,400
Break-Even

Payoff Profile

0 --$1,100 --$2,350

92 92.5 88.15

92.94 Spot Rate 93.5

Out-ofLoss the-money At

In-the-money

PUT OPTION

The holder of a put option expects the underlying currency to depreciate in value. Consider 8 put options on the euro with a strike of 90 ($/€) and a premium of 1.95 (both cents per unit). The face amount of a euro option is €62,500. The total premium is: $0.0195·8·€62,500=$9,750.

Profit

Put Option: Hypothetical payoff at a spot rate of 88.15 Payoff Profile
Break-Even

0 -$500

88.05 88.15

90

Spot Rate

--$9,750 Loss In-the-money At Out-of-the-money

WHEN TO USE CURRENCY OPTIONS
A)

For Hedging Foreign Exchange Risk :

Foreign Currency Cash Outflows  Risk: Foreign currency may increase in value against domestic currency  Strategy: Buy a call option on the foreign currency

Foreign Currency Cash Inflows  Risk: Foreign currency may decrease in value against domestic currency  Strategy: Buy a put option on the foreign currency B) For Speculators : - profit from favorable exchange rate changes.

MARKET STRUCTURE
Location : a. Organized Exchanges b. Over-the-counter - Two levels: retail and wholesale.

FOREIGN CURRENCY SWAPS

Currency swaps originally were developed by banks in the UK to help large clients circumvent UK exchange controls in the 1970s. An agreement to make a currency exchange between two foreign parties. The agreement consists of swapping principal and interest payments on a loan made in one currency for principal and interest payments of a loan of equal value in another currency. The World Bank first introduced currency swaps in 1981 in an effort to obtain German marks and Swiss francs. This type of swap can be done on loans with maturities as long as 10 years. It differ from interest rate swaps because it also involve principal. fixed-floating currency swap is equivalent to a strip of currency forwards.

COMPARATIVE ADVANTAGE FOR CURRENCY SWAPS

Two firms can enter into a currency swap to exploit their comparative advantages regarding borrowing in different countries. That is, suppose:  Firm B can borrow in $ at 8.0%, or in € at 6.0%.  Firm A can borrow in $ at 6.5% or in € at 5.2%. If A wants to borrow €, and B wants to borrow $, then they may be able to save on their borrowing costs if each borrows in the market in which they have a comparative advantage, and then swapping into their preferred currencies for their liabilities.

Exploiting comparative advantages
A domestic company has comparative advantage in domestic loan but it wants to raise foreign capital. The situation for a foreign company happens to be reversed.
domestic bank domestic principal Pd domestic company foreign company lend out foreign principal Pf foreign bank

Pd = F0 Pf

domestic company

enter into a currency swap

foreign company

Goal :- To exploit the comparative advantages in borrowing

rates for both companies in their domestic currencies.

Cash flows between the two currency swap counter parties (assuming no inter temporal default)
domestic principal Pd (initiation) periodic foreign coupon payments cf Pf foreign principal Pf (maturity) foreign principal Pf (initiation) periodic domestic coupon payments cd Pd domestic principal Pd (maturity)

domestic company

foreign company

domestic company

foreign company

Settlement rules:Under the full (limited) two-way payment clause, the nondefaulting counter party is required (not required) to pay if the final net amount is favorable to the defaulting party.

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