Money

Functions of Currency- medium of exchange- unit of account- store of value

International monetary system and foreign exchange Foreign exchange is money denominated in other currency of

another country or group of countries. Done at OTC over the counter or ETM (Exchange traded

market) OTC done at commercial banks like BOA or investment banks

like Merryll lynch or other financial ETM done at securities exchanges like Chicago mercantile

exchange or Philadelphia stock exchange where certain types of forex instruments are used like exchange traded futures and options.

Forex

Traditional instruments traded on OTC: Spot transactions Outright forwards FX Swaps

Others traded on exchange Currency swaps of interest bearing financial instruments

like bonds. Futures: Options the right but not obligations to trade forex in future.

The dollar

Popular because Investment currency in many capital markets Reserve currency held in many banks Transaction currency in many commodity markets Intervention currency monetary authorities in many market

operation to influence their own exchange rates. Most frequently traded in currency pairs 4 of 7. Euro and yen

come next. Bank for international settlements a Switzerland based central

bank (owned and controlled by 50 central banks conducts survey for forex market activity the records.

Biggest market for forex is london followed by NY and Japan

Forex

The spot market Bid and offer are buying and selling price for a currency.

The difference is called spread or trader margin. Direct or indirect quotes.

Forex

The futures Rate quoted today for future delivery. On forward discount or forward premium.

Forex

Options Strike price Fee or cost of option is called premium.

Forex

Futures For specific amount and specific maturation date. Not done by bankers but by exchange brokers.

Forex

Hard currencies are those that are relatively stable, are fully convertible

Currencies that are not fully convertible are soft currencies or weak currencies.

How some govts conserve forex Import licensing: fixed exchange rate at which

exporter must render forex and then it is rendered to importers of essential goods at rates fixed by govt.

Multiple exchange rates: govt defines which kind of transaction are to be conducted at what exchange rate.

Import deposit: deposit entire amount of import transaction with central bank for a specified time period – interest free.

Exchange rate mechanism

1944 the Bretton Woods : meeting to discuss what was needed to bring economic stability and growth in post world war period.

As a result IMF was born in1945 and started financial operation in 1947. to Promote international monetary co-operation Facilitate growth of international trade. Promote exchange rate stability Establish multilateral system of payments Make resources available to members who experience BOP difficulties

The chief features of the Bretton Woods system were an obligation for each country to adopt a monetary policy that maintained the exchange rate by tying its currency to the U.S. dollar and the ability of the IMF to bridge temporary imbalances of payments.

US dollar was a standard against gold $35 to an ounce of gold.(28 grams app.). This was established as par value whether gold or dollar was used as basis for par value. It became the benchmark by which each currency was valued against other currencies.

Exchange rate mechanism

1947: US held 70% of world’s official gold reserves. The dollar was strong so governments bought and sold dollars instead of gold thinking US would redeem dollar for gold.

The IMF system was thus that of a fixed exchange rate with dollar value remaining fixed. Other countries could change the value of their currencies against $ or gold.

Exchange rate mechanism

1971: Nixon pressed for restructuring of international monetary system if US were still to trade $ for gold. The smithsonian system came to place: 8% devaluation in $ Revaluation of other currencies i.e increase in

their value Widening of Exchange rate flexibility from 1% to

2.25 %

Exchange rate mechanism

1972 : the smithsonian arrangement did not last. World currency markets remained unsteady. $ devalued by 10%. Currencies began to float (market dependent to determine values)against other currencies instead of relying on smithsonian agreement.

The Jamaica agreement came into place which amended original rules to eliminate concept of par value in order to permit greater exchange rate flexibility.

Role of IMF

Permitted countries to select and maintain exchange rate arrangements.

Had a surveillance program which allows it to monitor economic policies that would affect exchange rates.

Consults annually to see if they are acting openly and responsibly in their exchange rate policies.

The IMF currency the SDR

Members contribute on joining. Called quota, it is based on national income, BOP, monetary reserves, and other economic indicators.

SDR: Special drawing rights. SDR composed of 5 currencies: Dollar, Euro,

Japanese yen, Pound, and is found by weighted average as per the holdings

Holdings are decided after every 5 years.

Exchange rate mechanism regimes Exchange agreements with no separate legal tender: currency of another

country is the sole legal tender or member belongs to currency union, eg EU Currency board arrangements: implicit legislative commitment to exchange

domestic currency with a specified foreign currency at a fixed exchange rate. Pegged exchange rates: currency is pegged to another major currency or basket

of currencies with minor fluctuation of 1/21 %. China to USD Pegged exchange rates within horizontal bars: same as above but the deviation

may be more than 1/21%. Denmark Crawling peg: pegged and periodically adjusted at preannounced rates. Costa

Rica, Chile Managed Float with no pronounced path for exchange rates: monetary authority

influences the movement of exchange rate by actively intervening in exchange markets. Eg India

Independent float: Market driven with intervention aimed only to moderate the change of rates or to thwart any undue fluctuations.Eg US

Central banks role

Limited these day cos forex is traded to the tune of $ 3-4 trillion each day.

Managing exchange rates not possible over a long period of time.

However to limit huge fluctuations and undue one the central bank play a role by buying and selling currencies.

Also fiscal policies can play a role.

PPP

Theory that seeks to define relationships among currencies.

States that relative rates of inflation must cause changes in exchange rates to keep the prices of goods in two countries similar.

The Economist which used the price of ‘Big Mac’ to estimate the exchange rates since 1986. ‘Big Mac’ is sold in over 120 countries. ‘McParity’

PPP assumes that there are no barriers to trade and that transportation costs are nil.

Interest rates

The fischer theory and the international fischer theory.

The theory states that if interest rates in US are more than in Japan the dollar will depreciate. This will be so because the higher interest rates exist to counter higher inflation.

The fischer theory (1+r) = (1+R) (1+i)

r= nominal monetary interest rate R= Real interest rate I = Inflation

forecasting

Fundamental Uses trends in economic variables to predict

future rates Technical

Uses past trends to spot future trends in rates

Factors to understand or early warning systems Managed or floating: if managed how credible or

sustainable it is? Does it appear ok in terms of PPP What is the cyclic situation in employment growth,

savings, investments, inflation Credibility of government and central bank and

political environment. National or international events in terms of crisis or

emergencies. Are there any meeting scheduled eg G7 etc.

Foreign Exchange Rate

Currency Equilibrium Effect of Devaluation- Exports and Employment- Imports & Consumer

Welfare

Foreign Exchange Market

Credit (Financing) Clearing Hedging Spot Market vs. Forward

Market

Financial Implications and Strategies Hedging: Leading and Lagging: It refers to the adjustment of the times of payments that are

made in foreign currencies. Leading is the payment of an obligation before due date while lagging is delaying the payment of an obligation past due date. The purpose of these techniques is for the company to take advantage of expected devaluation or revaluation of the appropriate currencies. Lead and lag payments are particularly useful when forward contracts are not possible.

Invoicing:

Pass-Through Costs :Formally the exchange rate pass-through (ERPT) is the percentage change in local currency import prices resulting from a one percent change in the exchange rate between the exporting and importing countries. Inevitably the change in the import prices find their way to retail and consumer prices. Inflation pass through occurs when the change in the currency changes prices and therefore inflation

Other Strategies