January, 2019

Types of Foreign Exchange Regimes

Flexible Versus Fixed Exchange Rates

A flexible exchange rate of a freely floating exchange rate is a system
under which the exchange rate is determined by the forces of demand
and supply. This phenomenon works similar to the market for goods
and services where excess demand exerts an upward pressure on price,
and where excess supply exerts a downward pressure on price, so that
equilibrium is ultimately reached through the interaction of demand
and supply.
A fixed exchange rate, on the other hand, is where governments (the
monetary authorities – the Federal Reserve Bank (Fed) as in the USA or
central banks in other places) determine exchange rates and make
necessary adjustments in their economies to maintain those rates. In
other words, the rate is predetermined.

Advocates of flexible exchange rates argue that:

1. The system of flexible exchange rates is more efficient than a
system of fixed exchange rates to correct balance – of – payments
disequilibria. In other words, a deficit or surplus in the nation’s
balance of payments is automatically corrected by a depreciation
or an appreciation of the nation’s currency, respectively, without
any government intervention and loss of accumulation of
international reserves by the nation,
 2. By allowing a nation to achieve external balance easily and
automatically (because it corrects the balance of payments
disequilibria as is stated above), flexible rates facilitate the
achievement of internal balance (i.e., full employment and price
stability) and other economic objectives of the nation.
Advocates of fixed exchange rates argue that:
1. Lower uncertainty: A fixed exchange rate system avoids the wild
day-to-day fluctuations that are likely to occur under flexible
rates. The fluctuation of exchange rates from day to day
discourages specialization in production and the flow of
international trade and investments. In other words, by
introducing a degree of uncertainty not present under fixed rates,
flexible exchange rates reduce the volume of international trade
and investment. That is, under the fixed exchange rates, the
economic agents will have a reasonably good idea of the exchange
rate since it is maintained within a relatively narrow band by the
operations of the monetary authorities. This means, under the
flexible exchange rate regime, the economic agents are less
certain,
2. Consequently, flexible exchange rates are more likely to lead to
destabilizing speculation and are inflationary. In other words,
speculation is more likely to be destabilizing under a flexible
exchange rate than under a fixed rate. With destabilizing
speculation, speculators purchase a foreign currency when the
exchange rate is rising, in the expectation that the exchange rate
will rise even more, and sell the foreign currency when the

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 exchange rate is falling, in the expectation that the exchange rates
will fall even more.
A careful review of the theoretical arguments raised by each side does
not lead to any clear-cut conclusions that one system is overwhelmingly
superior to the other. To be sure, at the time of the collapse of the fixed
exchange rate system in the early 1970s, the majority of economists
seemed to lean toward flexible exchange rates. However, as a result of
the great volatility in exchange rates experienced over the past decade,
the balance today seems to be toward fixed or more managed rates. In
the managed – floating exchange rate system, the exchange rate almost
floats while the monetary authorities intervene in the foreign exchange
market in order to smooth out short term fluctuations.
Managed Floating Exchange Rate System:
The nation’s monetary authorities are entrusted with the responsibility
to intervene in the foreign exchange markets to smooth out short-term
fluctuations without attempting to affect the long – run trend in
exchange rates.

Spot exchange rate versus forward exchange rate:

In a spot transaction the seller of exchange has to deliver the foreign
exchange he/she has sold “on the spot”, usually within two days.
Likewise, a buyer of exchange will immediately receive the foreign
exchange he/she has bought. On the other hand, in the case of forward
exchange market, when the contract is signed, the seller agrees to sell a
certain amount of foreign exchange to be delivered at a future date at a
price agreed upon in advance. Analogously, a buyer agrees to buy a
certain amount of foreign exchange at a future date and at a

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predetermined price. The most common forward contracts are for 1
month (30 days), 3 months (90 days), 6 months (180 days), 9 months
(270 days), and 1 year (360 days).
Examples:
Let the spot rate be: $2 = £1
Let the forward rate be: $2.03 = £1
That is, the forward rate is higher than the spot rate. Thus, there is a
premium on sterling. The premium is usually expressed as a percentage
of the spot rate.
Premium on £ (if forward rate is greater than spot rate)
Calculation:
rf - rs / rs = 2.03 – 2.00/2.00 = 0.03/2 = 0.015 =1.5%
Thus, the premium on the pound is 1.5 per cent.
On the other hand, if the spot rate is higher than the forward rate, we say
the pound sterling is at a discount.

Let:
Spot rate: $2 = £1
Forward rate: $1.96 = £1
Calculation:
rs - rf / rs = 2.00 – 1.96/ 2.00 = 0.04/2 =0.02 = 2 per cent
Thus, the discount on the pound is 2 per cent.

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Some Basic concepts:
1. Foreign exchange market: is a market (or framework) in which
individuals, firms, and banks buy and sell foreign currencies or
foreign exchange.
2. Arbitrage: The purchase of a currency in the monetary center
where it is cheaper for immediate resale in the monetary center
where it is more expensive in order to make a profit.
For example, in the case of two-point arbitrage (that is, two currencies
and two monetary centers), let $1.99 = £1 in New York, and $2.01 = £1
in London.
An arbitrageur (a foreign exchange dealer) would purchase pounds at
$1.99 in NY and immediately resell them in London for $2.01, realizing
a profit of $0.02 per pound.
On 1 million pound, a profit of: 0.02 X 1, 000,000, 000 = $20,000
As arbitrage takes place, the exchange rate between the two currencies
tends to be equalized in the two monetary centers.
That is, the demand for pounds increases in NY, exerting an upward
pressure on the dollar price of pounds. In London, the supply of pounds
increase, exerting a downward pressure on the dollar price of pounds.
This continues, until the dollar price of pound becomes equal in NY and
London, say at $2 = £1, thus eliminating the profitability of further
arbitrage.
There can also be three-point or triangular arbitrage involving three
currencies and three monetary centers, but this is not common.
3. Hedging: is the avoidance of a foreign exchange risk or the
covering of an open position. A hedger seeks to cover a foreign
exchange risk (risk – averse).

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4. Speculation: is the acceptance of a foreign exchange risk or open
position, in the hope of making a profit. A speculator accepts or
even seeks out a foreign exchange risk (risk – lover). The
speculator who expects the spot rate to increase in the future buys
forward; whereas the speculator who expects the spot rate to fall
sells forward.