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03 - Foreign Exchange Trading

Without foreign exchange trading, international trade itself could not exist. In
former times trade was based on bartering goods were exchanged for other goods.
The introduction of precious metals (i, e., gold and silver) to pay for goods can be
considered the forerunner of the foreign exchange market.

The Greeks and Romans commonly used gold as a medium of exchange. Most
world trade continued to be based on gold until the nineteenth century. By then
industrialization in Western Europe and the United States had boosted world trade to
such an extent that gold reserves were no longer adequate to meet the requirements.
Governments introduced a par value of their respective local currencies in gold. Thus,
the currencies were related to one another through a system called the gold standard.
The United States joined this system in 1879. The gold standard system determined
the value of all currencies based on gold. This meant the values of different currencies
could be compared in terms of one another,

The system worked well until World War 1, when trade was interrupted. After the
war, currencies fluctuated widely in terms of gold and, thus, in relation to each other.
The value of currencies¡ was meant to be regulated by supply and demand (the market
mechanism), but speculators often interfered with this mechanism. So in an effort to
create more stable exchange markets, some countries, notably the United States,
England, and France, returned to the gold standard. Except for a brief period in the
early 1930s, the United States stayed on the gold standard. By 1971 it was the only
country whose currency remained convertible into gold, and so, by declaring the dollar
inconvertible, the gold standard was finally abolished. This meant that holders of United
States dollars could no longer exchange their dollars for gold at par value.

In 1944 toward the end of World War 11, the Western industrialized nations
realized that foreign trade would be necessary to quickly and effectively heal the
wounds of war. To create a calm and stable foreign exchange market, the United
States government called for a conference in the summer of 1944. It was held in Bret-
ton Woods, New Hampshire. At this conference, both the International Monetary Fund
(IMF) and the International Bank for Reconstruction and Development were
established.

The Bretton Woods Agreement stipulated that all member countries would express
the value of their currencies in gold. However, only the United States dollar was
convertible into gold, at the price of $35 an ounce.

Central banks of the member countries were required to intervene in the foreign
exchange markets to keep the value of their currencies within 1 percent of the par
value. This intervention was achieved by actively buying or selling foreign exchange or
gold. A given currency could, therefore, never rise above nor fall below fixed points,
which are called intervention points. These are the prices beyond which the central
bank intervenes. This is called the system of fixed exchange rates.

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“Año del Fortalecimiento de la Soberanía Nacional”

The system of fixed exchange rates worked well until the late 1960s and early
1970s. At that time a number of countries devalued their currencies. This meant that
their currencies were now worth less in terms of gold. England in 1967, France in
1969, and the United States in 1971 and 1973, devalued their currencies. This caused
an almost unprecedented turbulence in the foreign exchange: markets. In addition,
countries such as West Germany and Holland revalued their currencies (increased the
par value of their currencies in terms of gold). Intervention by central banks became
very I costly. Foreign currency and gold reserves were drained. Countries had to buy
their own currency with gold and foreign exchange in order to keep its value above the
minimum intervention point, as agreed at Bretton Woods.

It is not surprising, then, that the world saw a return to a floating exchange rate
system. Central banks were no longer required to support their own currencies.
England, France (only I temporarily), Italy, Japan, and the United States all floated their
currencies. Western Europe, united in the Common Market, moved to preserve the
fixed-rate system but allowed a widening of the intervention points to within 2.25
percent of the par value of the currencies. This system became known as the snake
since these currencies move up and down together against currencies outside the
snake. The British and the Italians, now members of the Common Market, are
expected to eventually join their currencies to the snake.

The foreign exchange market is the mechanism through which foreign currencies
are traded. It is not an actual marketplace but a system of telephone and telex
communications between banks, customers, and middlemen (foreign exchange
brokers, acting for a client vis-à-vis the bank).

Most banks have a special foreign exchange trading department, which consists of
foreign exchange dealers and an administrative staff. Customers trade with banks,
banks trade among themselves, and brokers often trade on behalf of banks or corpora-
tions. Active participants in the foreign exchange market include tourists, investors,
exporters and importers, and governments, whose central banks intervene in the
markets to minimize fluctuations in their currencies.

The market consists of spot and forward transactions. When a French father
transfers money to his son in New York, a typical spot transaction occurs. The French
father buys the dollars spot-for immediate delivery-although business practice allows
two days for actual delivery. This permits sufficient time to consummate the
transaction. The French father, of course, pays for the dollars with his own currency,
that is, French francs.

A forward transaction means that delivery of a currency is specified to take place

at a future date. Japanese exporters of Toyota cars to the United States know from
their sales contracts that they will receive a specified United States dollar amount in six
months. In order to protect themselves against fluctuating exchange sales, they can
sell the dollars forward six months to their bank in Japan in return for yen. Payment and
delivery are not required until six months later. The rate of exchange is fixed, however,
on the date of the contract. Forward rates are usually quoted on a 30-, 90-, or 180-day
basis, but major currencies can have any maturity up to a year and sometimes longer.
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Dealers, having concluded a forward contract, should always hedge with an

offsetting contract, so as not to leave their position open. For example, if they buy
forward thirty days, they should immediately sell forward thirty days for the same
amount. Obviously, traders try to realize a profit margin between the two transactions.
If dealers do not equalize their position, they are said to speculate. If they buy currency
forward without selling forward at the same time, this position is known as long; if they
sell a currency forward without buying forward at the same time, this is called short.
Such behavior can be disastrous if the exchange rates change rapidly. For instance,
suppose that a French company concludes a contract with an American importer,
promising to deliver a certain commodity in six months valued at 1,000,000 French
francs. At the exchange rate of 22 cents for one franc, the French company expects to
receive $220,000. If the franc rises to the dollar rate of 23 cents within six months, and
the French company does not sell dollars forward, only 956,521. 72 francs will be
obtained. Since it cost 1,000,000 francs to deliver the original commodities, the French
company would lose 43,478.28 francs.

Forward rates can be quoted either outright or in terms of a premium or discount

on the spot rate. The following table of British pounds on July 6, 1976, shows outright
quotations. A bid is the price dealers will pay to acquire pounds. An offer is the price
they will sell the pounds for.

July 6, 1976 Bid Offer

Spot $1.8020 $1. 8030

One month forward $1.7895 $1. 7915

Two months forward $1. 7795 $1. 7815

Three months forward $1.7695 $1.7715

Six months forward $1.7445 $1.7465

One year forward $1. 7010 $1.7030

Arbitrage is the practice of transferring funds from one currency to another to

benefit from rate differentials. For instance, local supply and demand factors may result
in a dollar spot rate in London that differs from the rate in New York. If the spot rate is
higher in London, an arbitrage dealer would quickly buy dollars with pounds in New
York and sell the dollars in London for pounds. Such arbitraging makes sense only if
transaction costs (cable, paper - work, etc.) are covered and a small profit is realized.
Opportunities to realize big profits do not exist in this type of arbitraging, since

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communication systems today make the price, and therefore profit opportunities,
available to everyone.

Another form of arbitrage is interest arbitrage. If interest rates in England are 2

percent higher than in the United States money market, a United States investor would
do well to change United States dollars into pounds sterling and then invest the sterling
at the English interest rate. However, the exchange rate discount of sterling is 1
percent. The investor will have to buy back dollars at a 1 percent premium, thus losing
1 percent. Still, the investor makes an overall gain of 1 percent. Of course, such
transactions can only be realized in the absence of foreign exchange regulations, such
as capital transfer limitations, which are sometimes imposed by governments. Such
restrictions serve to protect a country's foreign exchange and gold reserves and,
therefore, its balance of payments (as we have seen in U nit Two).

The foreign exchange market is an extremely valuable mechanism for world trade. Its
main function is to reduce the risk of fluctuating exchange rates or of a change in the
parity of currencies (devaluation or revaluation).

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