INTERNATIONAL FINANCE

MBA(FT)

TOPIC 02
International Monetary System
International Monetary System
• Determination of exchange rate for currencies of various nations has
always been interesting.
• Over several centuries, the issue of how much is the worth of one
currency in terms of another has been the central thought for traders
and speculators.
• For several centuries, economists have struggled to find a mechanism
for settlement of trade within and outside a nation.
• This topic discusses the history of development in the monetary
systems that evolved over a period of time.
Old Barter System
• International trade has been going on from the primitive time, even
when there existed no currency or money.
• When there was no currency, the mode of settlement of trade had
been the barter system.
• In barter system, a certain quantity of goods was exchanged for other
goods as a trade settlement.
• Even in modern-day society, trade on barter takes place where
nations adopt exchange of oil for food grains, arms or medicines, etc.
• Along with logistics, the biggest problem in barter system was , lack
of common denominator.
Gold Specie Standard
• Inconvenience of barter system forced traders to find a common
denominator in which value of goods can be established.
• As a result, gold coins evolved as the medium of exchange for
settlement of trade
• Gold became popular medium of exchange because of the following
reasons
• Durability
• Storability
• Portability
• Divisibility
• Standardizability
Classical Gold Standard
• Britain started the gold standard
• Paper or coin currencies were convertible into gold, at a specified
fixed rate
• In 1873, most countries started following gold standard
• The currencies issued by different countries were convertible into
gold at fixed rates
• The determination of exchange rate was simple and straight forward.
• USD 20.67 = 1 ounce gold
• GBP 4.2474 = 1 ounce gold
• Implies, GBP 1 = USD 4.8665
• This continues till world was –I (1914)
 Classical Gold Standard
1704 The British West Indies 'de facto' following Queen Anne's proclamation.
Kingdom of Great Britain 'de facto' following Isaac Newton's revision of the mint ratio, at 1 guinea to 129.438 grains (8.38 g) of 22
1717 carat crown gold.
1821 United Kingdom 'de jure' at one sovereign to 123.27447 grains of 22 carat crown gold,
1818 Netherlands at 1 guilder to 0.60561 g gold.
Canada in conjunction with the American Gold Eagle coin equal to ten US dollars and also the British gold sovereign equal to four
1853 dollars eighty-six and two-thirds cents. The Canadian unit was made equal to the American unit in the year 1858.
1854 Portugal at 1000 réis to 1.62585 g gold.
1873 German Empire at 2790 Goldmarks to 1 kg gold.
1873 United States 'de facto' at USS20.67 to 1 troy oz (31.1 g) gold. Belgium, Italy, Switzerland, and France at 31 francs to 9.0 g gold.
1875 Denmark, Norway, and Sweden at 2480 kroner to 1 kg gold,
1876 France who founded Latin Monetary Union in 1865 fixed the value of franc at 0.2903 gm of gold,
1876 Spain at 31 pesetas to 9,0 g gold.
1878 Grand Duchy of Finland at 31 marks to 9.0 g gold.
1879 Austrian Empire.
1881 Argentina at 1 peso to 1.4516 g gold.
1885 Egypt fixed the value of its currency Egyptian pound to 7.4375 gm of gold.
1897 Russia at 31 roubles to 24.0 g gold.
1897 Japan at 1 yen devalued to 0.75 g gold.
1898 India when its silver rupee was pegged to pound sterling at I s 4d.
1903 The Philippines gold exchange/US dollar.
Variants of Gold Standard

• Gold Specie Standard

• Monetary unit is associated with circulating gold coins.
• Gold Bullion Standard
• The circulating currency is not gold but the monetary unit is convertible into
gold at a fixed rate.
• Gold Exchange Standard
• The countries issuing the currency undertakes to convert it into another
currency that is on gold bullion at a predetermined rate.
How Gold Standard Works
• The major advantage of gold standard was its feature of self-
correction and adjustment of international trade, which led to the
stability of prices and balanced trade.
• The gold standard would operate automatically and restore the
balance through price adjustment and flow of gold from one country
to another.
• Beyond the scope of fiscal and monetary policies that dominate and
guide the economic growth and development in modern days, no
such elaborate policy changes were required in the era of gold
standard.
Self Correcting Mechanism Under Gold Standard
Example
Increased productivity leads to
increased production and reduced price of goods and services
Export becomes competitive and import becomes less attractive
Increase in export and decrease in imports
Increase in flow of gold to the country
Increase in the money supply
Increase in prices of goods and services
Decrease in export and increase in imports
Balance of Payments corrected
Self Correcting Mechanism Under Gold Standard
Example
• Unlike modern time, under the gold standard, the aggregate amount
of currencies would remain same. (Except fresh mining of gold)
• The self correcting mechanism of gold standard rests on the following
principles;
• Free flow of gold across nations
• The currency circulation is proportional to the gold reserves of a country
• Quantity theory of money applies.
Prices under Gold Standard

• The greatest advantage of gold standard is its ability to keep inflation

at near zero level.
• The self correcting mechanism implies that while there would be
inflation in one part of the world, the other half will face deflation
• This kept the overall price level constant in the long run. Inflation and
deflation were short-run temporary phases.
• For about 200 years (1700s to 1914), the prices remained constant
Prices under Gold Standard

• Inflation has been a global phenomenon since abandonment of gold

standard
• At the same time, money expansion and economic growth were
limited to fresh mining of gold. (trade off between price stability and
economic growth)
• 1930 depression
• Inflation can be corrected in the short run but
• It takes time to increase consumption
The End of World War-I and Fiat Money
• Many saw gold standard as a constraining factor for development as it
did not allow for expansionary policies.
• Nations needed money for financing was and rehabilitation.
• Fiat Money:
• Issue of excess money without having the requisite gold.
• Issued by the governments on faith and not backed by tangible gold.
• After world war-I fiat money became widespread phenomenon for
the war-torn countries trying to rebuild nations.
1922 Genoa Conference
• After World War-II, countries tried to re-establish the gold standard
with the same gold parity that existed in the pre-world war period
• In 1922, gold standard was re-introduced as gold exchange standard
• Under the new gold exchange standard;
• US and England could hold gold as reserve whereas other countries could
have gold, dollar and pound as reserves.
• The international settlement could be done in gold, dollars and pounds
Collaps of Gold Standard
• There was accumulation of gold, dollars and pounds under the
managed gold standard.
• USA started accumulating large reserves of gold because of trade
surplus.
• Gold reserves across Europe depleted but money supply kept
increasing
• England devalued pound in 1930 and initiated competitive
devaluations across Europe. One country after another devalued its
currency to gain competitive edge over others to increase exports.
• This was virtual collapse of gold standard.
Bretton Woods System
• 1930 meeting in Bretton Woods, USA was a founding stone in
establishing a new mechanism of exchange rates
• It was called Bretton Woods System.
• An attempt was made to eliminate following problems;
• Hyperinflation in Germany
• Depression in USA
• Competitive Devaluations

• https://www.youtube.com/watch?v=RtFz9q26t5A
Bretton Woods System-FEATURES
The system was implemented in 1946. According to the system
• Each government was to fix the exchange rate of its currency in terms of US
dollars or gold, referred to as par value
• The US dollar was convertible into gold. The value of gold was fixed at $35
per oz.
• Monetary authorities in each country were obligated to defend the
exchange rate fixed in a band of +/- 1%. This was known as adjustable peg.
• The exchange rate within the band would be maintained by the central
banks with intervention of buying and selling of USD as the case may be.
Bretton Woods System-FEATURES
Bretton Woods System-FEATURES
• The US dollar required by the country would be provided by the IMF
(against the gold pledged by each nation)
• Temporary exchange rate instability would be overcome by central
bank intervention.
• In case the country is unable to defend the exchange rate within the
band due to fundamental disequilibrium. It could adjust the par value
by +/- 5% subject to approval from the IMF.
Bretton Woods System-Adjustment
Progress of Bretton Woods System
• At the time of introduction of BWS, USA was very sound with BoP
surplus and huge gold reserves. This was because of its exports to
Europe.
• European countries were running he deficits
• Due to this, in 1947, several countries (England, France, Scandinavian
countries) realized that their currencies were overvalued.
• As a result several devaluations of par value took place to make
export competitive.
Progress of Bretton Woods System
• Things changed rapidly and 1950 saw reversals of BoP.
• Trade Balance of USA started running negative whereas trade balance of
Japan and Europe started running to surplus.
• Capital controls across Europe started vanishing.
• Because of mounting prices of gold, there was loss of confidence in the
ability of dollar to convert the liabilities into gold.
• In 1962, system of gold pool was devised by the UK, France, Germany, Italy
to repose faith in gold and dollar.
• Vietnam was added to the loss of confidence.
• In 1967, british pound was devalued by 14.6% and FF by 11%
Progress of Bretton Woods System
• In 1971 USA made several announcement that made the system
collapse.
• 10% duty on imports.
• Dollar was no more convertible into gold.
• Price and wage control across US.
• USA didn’t want its currency to devalue but other currencies to
revalue.
• Other currencies preferred to float.
Progress of Bretton Woods System
• In 1971 USA owned $88 bn in short-term liabilities due to consistent BoP
deficit (against the gold worth $12bn)
• To save BWS, Several last minute measures were announced
• Dollar was devalued by 8.87% ($38.05 per oz of gold)
• Countries with surplus BoP were asked to revalue upward.
• Fluctuation margin of 2.25% was allowed.
• USA agreed to remove 10% duty.
• In spite of all these, by 1972, USAs trade deficit reached to a record level of
$9.80 bn on current account.
• It devalued USD further to USD 42.222 per oz of gold.
• In 1976, Jamaica agreement was signed to legalize the floating exchange
rate and demonetization of gold as the currency of reserve.
INTERNATIONAL FINANCE
MBA(FT)

TOPIC 06
Currency Futures
Introduction
• In terms of PRICING, FUNDAMENTALS and APPLICATIONS, Futures are
identical to Forwards.
• Futures differ substantially from Forwards in terms of their MARKET,
OPERATIONS and SETTLEMET.
• Currency Futures came into existence around 1970.
Introduction
• In terms of PRICING, FUNDAMENTALS and APPLICATIONS, Futures are
identical to Forwards.
• Futures differ substantially from Forwards in terms of their MARKET,
OPERATIONS and SETTLEMET.
• Currency Futures came into existence around 1970.
Limitation of Forward Contract
• Fairness of forward price.
• Negotiation of price in OTC contracts is always subject to the relative bargain power of
the counterparties involved.
• Forward exchange rate becomes the function of relative strength of the two parties
and it favours the stronger one.
• Free Flow of information
• Information on Price, Volume and trends in OTC market is not readily available which
makes price discovery less efficient
• Delivery based system
• Counterparty Risk
Forward Vs. Future
Forward Vs. Future
Future Contract Terminology
• Contract Size
• Contract Expiry
• Number of contracts available
• Price quotation
• Tick Size
• Settlement
• Mark to Market
• Margin
• Open Interest
Future Contract Specifications (NSE)

https://www1.nseindia.com/products/content/derivatives/curr_der/cd_contract_specifications.htm
Future Contract Specifications (NSE)
Future Contract Specifications (NSE)
Future Contracts at NSE

https://www.nseindia.com/market-data/currency-derivatives
Margin on Various Contract

https://zerodha.com/margin-calculator/Currency/
Pricing of Future Contract
(𝑟−𝑟𝑓 )×𝑇
•𝐹0 = 𝑆0 × 𝑒
• F0 = Theoretical futures price
S0 = Value of the underlying
r = Cost of financing (using continuously compounded interest rate)
rf = Foreign risk free interest rate
T = Time till expiration (in years)
e = 2.71828
Future SPREAD
• Spread in other markets involve two transactions; spot and
future in near month and far month.
• Currency Spot markets are not available for retail traders
• Hence, spread in currency markets involve both the
long/Short transactions in future contracts.
• There are two types of Spread transactions in Futures:
1. Future Bull Spread:-Buying NEAR month and selling
FAR month contract
2. Future Bear Spread:-Selling NEAR month and Buying
FAR month contract
https://zerodha.com/varsity/chapter/the-usd-inr-pair-part-
2/#:~:text=Well%2C%20this%20is%20fairly%20easy,as%20the%20'Calendar%20Spread'.&text=As%20of%20today%20the%20
USD,contract%20is%20trading%20at%2067.6900.
Calendar SPREAD Contracts at NSE
• Margins in Calendar Spread
Calendar SPREAD Contracts at NSE

https://www.nseindia.com/market-data/currency-derivatives
Calendar SPREAD-Example
1 st April 20th April
Contract LTP Current Spread LTP Expected Spread
28-Apr-21 72.9000 73.2000
27-May-21 73.5525 73.4525
Calendar SPREAD-Example
1 st April 20th April
Contract LTP Current Spread Expected Spread
28-Apr-21 72.9000 73.2000
0.6525 0.2525
27-May-21 73.5525 73.4525
Calendar SPREAD-Example
1 st April 20th April
Contract LTP Current Spread Expected Spread
28-Apr-21 72.9000 73.2000
0.6525 0.2525
27-May-21 73.5525 73.4525

Bull Spread Bear Spread

Buy 1000 USD in April Sell 1000 USD in April
Sell 1000 USD in May Buy 1000 USD in May
Difference Difference
Calendar SPREAD-Example
1 st April 20th April
Contract LTP Current Spread Expected Spread
28-Apr-21 72.9000 73.2000
0.6525 0.2525
27-May-21 73.5525 73.4525

Bull Spread Bear Spread

Buy 1000 USD in April -72,900.00 Sell 1000 USD in April -73,452.50
Sell 1000 USD in May 73,552.50 Buy 1000 USD in May 73,200.00
Difference Difference
Calendar SPREAD-Example
1 st April 20th April
Contract LTP Current Spread Expected Spread
28-Apr-21 72.9000 73.2000
0.6525 0.2525
27-May-21 73.5525 73.4525

Bull Spread Bear Spread

Buy 1000 USD in April -72,900.00 Sell 1000 USD in April -73,452.50
Sell 1000 USD in May 73,552.50 Buy 1000 USD in May 73,200.00
Difference 652.50 Difference -252.50
Calendar SPREAD-Example
1 st April 20th April
Contract LTP Current Spread Expected Spread
28-Apr-21 72.9000 73.2000
0.6525 0.2525
27-May-21 73.5525 73.4525

Bull Spread Bear Spread

Buy 1000 USD in April -72,900.00 Sell 1000 USD in April -73,452.50
Sell 1000 USD in May 73,552.50 Buy 1000 USD in May 73,200.00
Difference 652.50 Difference -252.50 400.00
Calendar SPREAD-Example
1 st April 20th April
Current Spread Expected Spread

0.6525 0.2525

Difference
Buy Spread Sell Spread
652.50 -252.50 400.00
Using Futures for Hedging Foreign Exchange Risk
• Short the receivable currency
• Long the payable currency