Currency swap

A currency swap is a foreign-exchange agreement between two parties to exchange aspects

(namely the principal and/or interest payments) of a loan in one currency for equivalent aspects
of an equal in net present value loan in another currency; see Foreign exchange derivative.
Currency swaps are motivated by comparative advantage.[1] A currency swap should be
distinguished from a central bank liquidity swap.

Contents
[hide]
• 1 Structure
• 2 Uses
○ 2.1 Hedging Example
• 3 History
• 4 References

[edit] Structure
Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps.
However, unlike interest rate swaps, currency swaps can involve the exchange of the principal.[1]
There are three different ways in which currency swaps can exchange loans:
The most simple currency swap structure is to exchange the principal only with the counterparty,
at a rate agreed now, at some specified point in the future. Such an agreement performs a
function equivalent to a forward contract or futures. The cost of finding a counterparty (either
directly or through an intermediary), and drawing up an agreement with them, makes swaps
more expensive than alternative derivatives (and thus rarely used) as a method to fix shorter term
forward exchange rates. However for the longer term future, commonly up to 10 years, where
spreads are wider for alternative derivatives, principal-only currency swaps are often used as a
cost-effective way to fix forward rates. This type of currency swap is also known as an FX-swap.
[2]

Another currency swap structure is to combine the exchange of loan principal, as above, with an
interest rate swap. In such a swap, interest cash flows are not netted before they are paid to the
counterparty (as they would be in a vanilla interest rate swap) because they are denominated in
different currencies. As each party effectively borrows on the other's behalf, this type of swap is
also known as a back-to-back loan.[2]
Last here, but certainly not least important, is to swap only interest payment cash flows on loans
of the same size and term. Again, as this is a currency swap, the exchanged cash flows are in
different denominations and so are not netted. An example of such a swap is the exchange of
fixed-rate US Dollar interest payments for floating-rate interest payments in Euro. This type of
swap is also known as a cross-currency interest rate swap, or cross-currency swap.[3]
Uses
Currency swaps have two main uses:
 • To secure cheaper debt (by borrowing at the best available rate regardless of currency and
then swapping for debt in desired currency using a back-to-back-loan).[2]
• To hedge against (reduce exposure to) exchange rate fluctuations.[2]
Hedging Example
For instance, a US-based company needing to borrow Swiss Francs, and a Swiss-based company
needing to borrow a similar present value in US Dollars, could both reduce their exposure to
exchange rate fluctuations by arranging any one of the following:
• If the companies have already borrowed in the currencies each needs the principal in,
then exposure is reduced by swapping cash flows only, so that each company's finance
cost is in that company's domestic currency.
• Alternatively, the companies could borrow in their own domestic currencies (and may
well each have comparative advantage when doing so), and then get the principal in the
currency they desire with a principal-only swap.
History
Currency swaps were originally conceived in the 1970s to circumvent foreign exchange controls
in the United Kingdom. At that time, UK companies had to pay a premium to borrow in US
Dollars. To avoid this, UK companies set up back-to-back loan agreements with US companies
wishing to borrow Sterling.[4] While such restrictions on currency exchange have since become
rare, savings are still available from back-to-back loans due to comparative advantage.
Cross-currency interest rate swaps were introduced by the World Bank in 1981 to obtain Swiss
francs and German marks by exchanging cash flows with IBM. This deal was brokered by
Salomon Brothers with a notional amount of $210 million dollars and a term of over ten years.[5]
During the global financial crisis of 2008, the currency swap transaction structure was used by
the United States Federal Reserve System to establish central bank liquidity swaps. In these, the
Federal Reserve and the central bank of a developed[6] or stable emerging[7] economy agree to
exchange domestic currencies at the current prevailing market exchange rate & agree to reverse
the swap at the same exchange rate at a fixed future date. The aim of central bank liquidity swaps
is "to provide liquidity in U.S. dollars to overseas markets."[8] While central bank liquidity swaps
and currency swaps are structurally the same, currency swaps are commercial transactions driven
by comparative advantage, while central bank liquidity swaps are emergency loans of US Dollars
to overseas markets, and it is currently unknown whether or not they will be beneficial for the
Dollar or the US in the long-term.[9]
The People's Republic of China has multiple year currency swap agreements of the Renminbi
with Argentina, Belarus, Hong Kong, Iceland, Indonesia, Malaysia, Singapore, and South Korea
that perform a similar function to central bank liquidity swaps.[10]

Foreign exchange derivative

From Wikipedia, the free encyclopedia

Jump to: navigation, search

A Foreign exchange derivative is a financial derivative where the underlying is a particular
currency and/or its exchange rate. These instruments are used either for currency speculation and
arbitrage or for hedging foreign exchange risk. For detail see:
• Foreign exchange option
• Forex swap
• Currency future
• Currency swap
• Foreign exchange hedge
• Binary option: Foreign exchange
This economics or finance-related article is a stub. You can help
Wikipedia by expanding it.
v • d • e

[hide]
v • d • e

Derivatives market

Derivative (finance)

Options
Terms Credit spread · Debit spread · Exercise · Expiration · Moneyness · Open
interest · Pin risk · Risk-free rate · Strike price · The Greeks · Volatility

Vanilla
Bond option · Call · Employee stock option · Fixed income · FX · Option
options styles · Put · Warrants

Exotic Asian · Barrier · Binary · Cliquet · Compound option · Forward start

options option · Interest rate option · Lookback · Mountain range · Rainbow
option · Swaption

Combinati
Collar · Fence · Iron butterfly · Iron condor · Straddle · Strangle · Covered
ons call · Protective put · Risk reversal
 Options Backspread · Bear spread · Bull spread · Butterfly spread · Calendar
spreads spread · Diagonal spread · Ratio spread · Vertical spread · Intermarket
Spread

Valuation
Binomial · Black · Black–Scholes · Finite difference · Put–call parity ·
of options Simulation · Trinomial

Basis swap · Constant maturity swap · Credit default swap · Currency swap · Equity
Swaps swap · Forex swap · Inflation swap · Interest rate swap · Total return swap · Variance
swap · Volatility swap · Correlation swap · Conditional variance swap

Forward
Backwardation · Commodity futures · Contango · Currency future · Financial future ·
s and Forward market · Forward price · Forward rate · Interest rate future · Margin · Pricing
Futures of Forwards · Pricing of Futures · Single-stock futures · Slippage

Other
Credit default option · CLN · Contract for difference · CPPI · Credit derivative · ELN ·
derivativ Equity derivative · Foreign exchange derivative · Fund derivative · Inflation
es derivatives · Interest rate derivative · PRDC · Real estate derivatives · Real options

Market
issues Tax policy · Consumer debt · Corporate debt · Government debt · Late 2000s recession

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Categories: Economics and finance stubs | Foreign exchange market | Derivatives

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Foreign exchange derivative
From Wikipedia, the free encyclopedia

Jump to: navigation, search

A Foreign exchange derivative is a financial derivative where the underlying is a particular

currency and/or its exchange rate. These instruments are used either for currency speculation and
arbitrage or for hedging foreign exchange risk. For detail see:
• Foreign exchange option
• Forex swap
• Currency future
• Currency swap
• Foreign exchange hedge
• Binary option: Foreign exchange
This economics or finance-related article is a stub. You can help
Wikipedia by expanding it.
v • d • e

[hide]
v • d • e

Derivatives market

Derivative (finance)

Options
Terms Credit spread · Debit spread · Exercise · Expiration · Moneyness · Open
interest · Pin risk · Risk-free rate · Strike price · The Greeks · Volatility

Vanilla
Bond option · Call · Employee stock option · Fixed income · FX · Option
options styles · Put · Warrants

Exotic Asian · Barrier · Binary · Cliquet · Compound option · Forward start

options option · Interest rate option · Lookback · Mountain range · Rainbow
option · Swaption
 Combinati
Collar · Fence · Iron butterfly · Iron condor · Straddle · Strangle · Covered
ons call · Protective put · Risk reversal

Options Backspread · Bear spread · Bull spread · Butterfly spread · Calendar

spreads spread · Diagonal spread · Ratio spread · Vertical spread · Intermarket
Spread

Valuation
Binomial · Black · Black–Scholes · Finite difference · Put–call parity ·
of options Simulation · Trinomial

Basis swap · Constant maturity swap · Credit default swap · Currency swap · Equity
Swaps swap · Forex swap · Inflation swap · Interest rate swap · Total return swap · Variance
swap · Volatility swap · Correlation swap · Conditional variance swap

Forward
Backwardation · Commodity futures · Contango · Currency future · Financial future ·
s and Forward market · Forward price · Forward rate · Interest rate future · Margin · Pricing
Futures of Forwards · Pricing of Futures · Single-stock futures · Slippage

Other
Credit default option · CLN · Contract for difference · CPPI · Credit derivative · ELN ·
derivativ Equity derivative · Foreign exchange derivative · Fund derivative · Inflation
es derivatives · Interest rate derivative · PRDC · Real estate derivatives · Real options

Market
issues Tax policy · Consumer debt · Corporate debt · Government debt · Late 2000s recession

Retrieved from "http://en.wikipedia.org/wiki/Foreign_exchange_derivative"

Categories: Economics and finance stubs | Foreign exchange market | Derivatives

Personal tools
• New features
• Log in / create account

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• Article
• Discussion
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Views
• Read
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Forex swap
From Wikipedia, the free encyclopedia
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In finance, a forex swap (or FX swap) is a simultaneous purchase and sale of identical amounts
of one currency for another with two different value dates (normally spot to forward).[1]; see
Foreign exchange derivative.
Contents
[hide]
• 1 Structure
• 2 Uses
• 3 Pricing
• 4 Related instruments
• 5 See also
• 6 References

Structure
A forex swap consists of two legs:
• a spot foreign exchange transaction, and
• a forward foreign exchange transaction.
These two legs are executed simultaneously for the same quantity, and therefore offset each
other.
It is also common to trade forward-forward, where both transactions are for (different) forward
dates.
Uses
By far and away the most common use of FX swaps is for institutions to fund their foreign
exchange balances.
Once a foreign exchange transaction settles, the holder is left with a positive (or long) position in
one currency, and a negative (or short) position in another. In order to collect or pay any
overnight interest due on these foreign balances, at the end of every day institutions will close
out any foreign balances and re-institute them for the following day. To do this they typically use
tom-next swaps, buying (selling) a foreign amount settling tomorrow, and selling (buying) it
back settling the day after.
The interest collected or paid every night is referred to as the cost of carry. As currency traders
know roughly how much holding a currency position will make or cost on a daily basis, specific
trades are put on based on this; these are referred to as carry trades.
Pricing
The relationship between spot and forward is as follows:

where:
• F = forward rate
• S = spot rate
 • r1 = simple interest rate of the term currency
• r2 = simple interest rate of the base currency
• T = tenor (calculated according to the appropriate day count convention)
The forward points or swap points are quoted as the difference between forward and spot, F - S,
and is expressed as the following:

where r1 and r2 are small. Thus, the absolute value of the swap points increases when the interest
rate differential gets larger, and vice versa.
Related instruments
A forex swap should not be confused with a currency swap, which is a much rarer, long term
transaction, governed by a slightly different set of rules

Comparative advantage
From Wikipedia, the free encyclopedia
Jump to: navigation, search
In economics, the law of comparative advantage refers to the ability of a party (an individual, a
firm, or a country) to produce a particular good or service at a lower opportunity cost than
another party. It is the ability to produce a product with the highest relative efficiency given all
the other products that could be produced.[1][2] It can be contrasted with absolute advantage which
refers to the ability of a party to produce a particular good at a lower absolute cost than another.
Comparative advantage explains how trade can create value for both parties even when one can
produce all goods with fewer resources than the other. The net benefits of such an outcome are
called gains from trade. It is the main concept of the pure theory of international trade.

Origins of the theory

Comparative advantage was first described by Robert Torrens in 1815 in an essay on the Corn
Laws. He concluded it was to England's advantage to trade with Portugal in return for grain,
even though it might be possible to produce that grain more cheaply in England than Portugal.
However, the concept is usually attributed to David Ricardo who explained it in his 1817 book
On the Principles of Political Economy and Taxation in an example involving England and
Portugal.[3] In Portugal it is possible to produce both wine and cloth with less labor than it would
take to produce the same quantities in England. However the relative costs of producing those
two goods are different in the two countries. In England it is very hard to produce wine, and only
moderately difficult to produce cloth. In Portugal both are easy to produce. Therefore while it is
cheaper to produce cloth in Portugal than England, it is cheaper still for Portugal to produce
excess wine, and trade that for English cloth. Conversely England benefits from this trade
because its cost for producing cloth has not changed but it can now get wine at a lower price,
closer to the cost of cloth. The conclusion drawn is that each country can gain by specializing in
the good where it has comparative advantage, and trading that good for the other.
Examples
The following hypothetical examples explain the reasoning behind the theory. In Example 2 all
assumptions are italicized for easy reference, and some are explained at the end of the example.
Example 1
Two men live alone on an isolated island. To survive they must undertake a few basic economic
activities like water carrying, fishing, cooking and shelter construction and maintenance. The
first man is young, strong, and educated. He is also faster, better, and more productive at
everything. He has an absolute advantage in all activities. The second man is old, weak, and
uneducated. He has an absolute disadvantage in all economic activities. In some activities the
difference between the two is great; in others it is small.
Despite the fact that the younger man has absolute advantage in all activities, it is not in the
interest of either of them to work in isolation since they both can benefit from specialization and
exchange. If the two men divide the work according to comparative advantage then the young
man will specialize in tasks at which he is most productive, while the older man will concentrate
on tasks where his productivity is only a little less than that of the young man. Such an
arrangement will increase total production for a given amount of labor supplied by both men and
it will benefit both of them.
Example 2
Suppose there are two countries of equal size, Northland and Southland, that both produce and
consume two goods, food and clothes. The productive capacities and efficiencies of the countries
are such that if both countries devoted all their resources to food production, output would be as
follows:
• Northland: 100 tonnes
• Southland: 400 tonnes
If all the resources of the countries were allocated to the production of clothes, output would be:
• Northland: 100 tonnes
• Southland: 200 tonnes
Assuming each has constant opportunity costs of production between the two products and both
economies have full employment at all times. All factors of production are mobile within the
countries between clothes and food industries, but are immobile between the countries. The price
mechanism must be working to provide perfect competition.
Southland has an absolute advantage over Northland in the production of food and clothes. There
seems to be no mutual benefit in trade between the economies, as Southland is more efficient at
producing both products. The opportunity costs shows otherwise. Northland's opportunity cost of
producing one tonne of food is one tonne of clothes and vice versa. Southland's opportunity cost
of one tonne of food is 0.5 tonne of clothes, and its opportunity cost of one tonne of clothes is 2
tonnes of food. Southland has a comparative advantage in food production, because of its lower
opportunity cost of production with respect to Northland, while Northland has a comparative
advantage in clothes production, because of its lower opportunity cost of production with respect
to Southland.
To show these different opportunity costs lead to mutual benefit if the countries specialize
production and trade, consider the countries produce and consume only domestically. The
volumes are:
Production and consumption before trade
Country Food Clothes
Northland 50 50
Southland 200 100
TOTAL 250 150
This example includes no formulation of the preferences of consumers in the two economies
which would allow the determination of the international exchange rate of clothes and food.
Given the production capabilities of each country, in order for trade to be worthwhile Northland
requires a price of at least one tonne of food in exchange for one tonne of clothes; and Southland
requires at least one tonne of clothes for two tonnes of food. The exchange price will be
somewhere between the two. The remainder of the example works with an international trading
price of one tonne of food for 2/3 tonne of clothes.
If both specialize in the goods in which they have comparative advantage, their outputs will be:
Production after trade
Country Food Clothes
Northland 0 100
Southland 300 50
TOTAL 300 150
World production of food increased. clothes production remained the same. Using the exchange
rate of one tonne of food for 2/3 tonne of clothes, Northland and Southland are able to trade to
yield the following level of consumption:
Consumption after trade
Country Food Clothes
Northland 75 50
Southland 225 100
World total 300 150
Northland traded 50 tonnes of clothes for 75 tonnes of food. Both benefited, and now consume at
points outside their production possibility frontiers.
Assumptions in Example 2:
• Two countries, two goods - the theory is no different for larger numbers of countries and
goods, but the principles are clearer and the argument easier to follow in this simpler
case.
• Equal size economies - again, this is a simplification to produce a clearer example.
• Full employment - if one or other of the economies has less than full employment of
factors of production, then this excess capacity must usually be used up before the
comparative advantage reasoning can be applied.
• Constant opportunity costs - a more realistic treatment of opportunity costs the reasoning
is broadly the same, but specialization of production can only be taken to the point at
 which the opportunity costs in the two countries become equal. This does not invalidate
the principles of comparative advantage, but it does limit the magnitude of the benefit.
• Perfect mobility of factors of production within countries - this is necessary to allow
production to be switched without cost. In real economies this cost will be incurred:
capital will be tied up in plant (sewing machines are not sowing machines) and labour
will need to be retrained and relocated. This is why it is sometimes argued that 'nascent
industries' should be protected from fully liberalised international trade during the period
in which a high cost of entry into the market (capital equipment, training) is being paid
for.
• Immobility of factors of production between countries - why are there different rates of
productivity? The modern version of comparative advantage (developed in the early
twentieth century by the Swedish economists Eli Heckscher and Bertil Ohlin) attributes
these differences to differences in nations' factor endowments. A nation will have
comparative advantage in producing the good that uses intensively the factor it produces
abundantly. For example: suppose the US has a relative abundance of capital and India
has a relative abundance of labor. Suppose further that cars are capital intensive to
produce, while cloth is labor intensive. Then the US will have a comparative advantage in
making cars, and India will have a comparative advantage in making cloth. If there is
international factor mobility this can change nations' relative factor abundance. The
principle of comparative advantage still applies, but who has the advantage in what can
change.
• Negligible transport cost - Cost is not a cause of concern when countries decided to trade.
It is ignored and not factored in.
• Before specialization, half of each country's available resources are used to produce each
good.
• Perfect competition - this is a standard assumption that allows perfectly efficient
allocation of productive resources in an idealized free market.
[edit] Example 3
The economist Paul Samuelson provided another well known example in his Economics.
Suppose that in a particular city the best lawyer happens also to be the best secretary, that is he
would be the most productive lawyer and he would also be the best secretary in town. However,
if this lawyer focused on the task of being a lawyer and, instead of pursuing both occupations at
once, employed a secretary, both the output of the lawyer and the secretary would increase, as it
is more difficult to be a lawyer than a secretary.[citation needed]
[edit] Effect of trade costs
Trade costs, particularly transportation, reduce and may eliminate the benefits from trade,
including comparative advantage. Paul Krugman gives the following example.[4]
Using Ricardo's classic example:
Unit labor costs
Cloth Wine
Britain 100 110
Portugal 90 80
In the absence of transportation costs, it is efficient for Britain to produce cloth, and Portugal to
produce wine, as, assuming that these trade at equal price (1 unit of cloth for 1 unit of wine)
Britain can then obtain wine at a cost of 100 labor units by producing cloth and trading, rather
than 110 units by producing the wine itself, and Portugal can obtain cloth at a cost of 80 units by
trade rather than 90 by production.
However, in the presence of trade costs of 15 units of labor to import a good (alternatively a mix
of export labor costs and import labor costs, such as 5 units to export and 10 units to import), it
then costs Britain 115 units of labor to obtain wine by trade – 100 units for producing the cloth,
15 units for importing the wine, which is more expensive than producing the wine locally, and
likewise for Portugal. Thus, if trade costs exceed the production advantage, it is not
advantageous to trade.
Krugman proceeds to argue more speculatively that changes in the cost of trade (particularly
transportation) relative to the cost of production may be a factor in changes in global patterns of
trade: if trade costs decrease, such as on the advent of steam-powered shipping, trade should be
expected to increase, as more comparative advantages in production can be realized. Conversely,
if trade costs increase, or if production costs decrease faster than trade costs (such as via
electrification of factories), then trade should be expected to decrease, as trade costs become a
more significant barrier.
[edit] Effects on the economy
Conditions that maximize comparative advantage do not automatically resolve trade deficits. In
fact, many real world examples where comparative advantage is attainable may require a trade
deficit. For example, the amount of goods produced can be maximized, yet it may involve a net
transfer of wealth from one country to the other, often because economic agents have widely
different rates of saving.
As the markets change over time, the ratio of goods produced by one country versus another
variously changes while maintaining the benefits of comparative advantage. This can cause
national currencies to accumulate into bank deposits in foreign countries where a separate
currency is used.
Macroeconomic monetary policy is often adapted to address the depletion of a nation's currency
from domestic hands by the issuance of more money, leading to a wide range of historical
successes and failures.
[edit] Considerations
[edit] Development economics
The theory of comparative advantage, and the corollary that nations should specialize, is
criticized on pragmatic grounds within the import substitution industrialization theory of
development economics, on empirical grounds by the Singer–Prebisch thesis which states that
terms of trade between primary producers and manufactured goods deteriorate over time, and on
theoretical grounds of infant industry and Keynesian economics. In older economic terms,
comparative advantage has been opposed by mercantilism and economic nationalism. These
argue instead that while a country may initially be comparatively disadvantaged in a given
industry (such as Japanese cars in the 1950s), countries should shelter and invest in industries
until they become globally competitive. Further, they argue that comparative advantage, as
stated, is a static theory – it does not account for the possibility of advantage changing through
investment or economic development, and thus does not provide guidance for long-term
economic development.
[edit] Free mobility of capital in a globalized world
Ricardo explicitly bases his argument on an assumed immobility of capital:
" ... if capital freely flowed towards those countries where it could be most profitably
employed, there could be no difference in the rate of profit, and no other difference in the
real or labour price of commodities, than the additional quantity of labour required to
convey them to the various markets where they were to be sold."[5]
He explains why, from his point of view, (anno 1817) this is a reasonable assumption:
"Experience, however, shows, that the fancied or real insecurity of capital, when not under the
immediate control of its owner, together with the natural disinclination which every man has to
quit the country of his birth and connexions, and entrust himself with all his habits fixed, to a
strange government and new laws, checks the emigration of capital."[5]
Some scholars, notably Herman Daly, an American ecological economist and professor at the
School of Public Policy of the University of Maryland, have voiced concern over the
applicability of Ricardo's theory of comparative advantage in light of a perceived increase in the
mobility of capital: "International trade (governed by comparative advantage) becomes, with the
introduction of free capital mobility, interregional trade (governed by Absolute advantage)."[6]
Adam Smith developed the principle of absolute advantage. The economist Paul Craig Roberts
notes that the comparative advantage principles developed by David Ricardo do not hold where
the factors of production are internationally mobile.[7][8] Limitations to the theory may exist if
there is a single kind of utility. Yet the human need for food and shelter already indicates that
multiple utilities are present in human desire. The moment the model expands from one good to
multiple goods, the absolute may turn to a comparative advantage. The opportunity cost of a
forgone tax base may outweigh perceived gains, especially where the presence of artificial
currency pegs and manipulations distort trade.[9] Global labor arbitrage, where one country
exploits the cheap labor of another, would be a case of absolute advantage that is not mutually
beneficial.[10][11][12]
Economist Ha-Joon Chang criticized the comparative advantage principle, contending that it may
have helped developed countries maintain relatively advanced technology and industry compared
to developing countries. In his book Kicking Away the Ladder, Chang argued that all major
developed countries, including the United States and United Kingdom, used interventionist,
protectionist economic policies in order to get rich and then tried to forbid other countries from
doing the same. For example, according to the comparative advantage principle, developing
countries with a comparative advantage in agriculture should continue to specialize in agriculture
and import high-technology widgits from developed countries with a comparative advantage in
high technology. In the long run, developing countries would lag behind developed countries,
and polarization of wealth would set in. Chang asserts that premature free trade has been one of
the fundamental obstacles to the alleviation of poverty in the developing world. Recently, Asian
countries such as South Korea, Japan and China have utilized protectionist economic policies in
their economic development.[13]

Exchange rate
From Wikipedia, the free encyclopedia
Jump to: navigation, search

This article does not cite any references or sources.

Please help improve this article by adding citations to reliable sources. Unsourced
material may be challenged and removed. (March 2008)

Foreign exchange

Exchange rates
Currency band
Exchange rate
Exchange rate regime
Fixed exchange rate
Floating exchange rate
Linked exchange rate

Markets
Foreign exchange market
Futures exchange
Retail forex

Products
Currency
Currency future
Non-deliverable forward
Forex swap
Currency swap
Foreign exchange option

Historical agreements
Bretton Woods Conference
Smithsonian Agreement
Plaza Accord
Louvre Accord

See also
Bureau de change /
currency exchange (office)

In finance, the exchange rates (also known as the foreign-exchange rate, forex rate or FX
rate) between two currencies specify how much one currency is worth in terms of the other. It is
the value of a foreign nation’s currency in terms of the home nation’s currency.[1] For example an
exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (USD, $) means that JPY
91 is worth the same as USD 1. The foreign exchange market is one of the largest markets in the
world. By some estimates, about 3.2 trillion USD worth of currency changes hands every day.
The spot exchange rate refers to the current exchange rate. The forward exchange rate refers
to an exchange rate that is quoted and traded today but for delivery and payment on a specific
future date.

Contents
[hide]
• 1 Quotations
• 2 Free or pegged
• 3 Bilateral vs. effective exchange
rate
• 4 Uncovered interest rate parity
• 5 Balance of payments model
• 6 Asset market model
• 7 Fluctuations in exchange rates
• 8 Manipulation of exchange rates
• 9 See also
• 10 References
• 11 External links

[edit] Quotations
An exchange system quotation is given by stating the number of units of "quote currency" (price
currency, payment currency) that can be exchanged for one unit of "base currency" (unit
currency, transaction currency). For example, in a quotation that says the EUR/USD exchange
rate is 1.2290 (1.2290 USD per EUR, also known as EUR/USD; see foreign exchange market),
the quote currency is USD and the base currency is EUR.
There is a market convention that determines which is the base currency and which is the term
currency. In most parts of the world, the order is: EUR – GBP – AUD – NZD – USD – others.
Thus if you are doing a conversion from EUR into AUD, EUR is the base currency, AUD is the
term currency and the exchange rate tells you how many Australian dollars you would pay or
receive for 1 euro. Cyprus and Malta which were quoted as the base to the USD and others were
recently removed from this list when they joined the euro. In some areas of Europe and in the
non-professional market in the UK, EUR and GBP are reversed so that GBP is quoted as the base
currency to the euro. In order to determine which is the base currency where both currencies are
not listed (i.e. both are "other"), market convention is to use the base currency which gives an
exchange rate greater than 1.000. This avoids rounding issues and exchange rates being quoted to
more than 4 decimal places. There are some exceptions to this rule e.g. the Japanese often quote
their currency as the base to other currencies.
Quotes using a country's home currency as the price currency (e.g., EUR 0.735342 = USD 1.00
in the euro zone) are known as direct quotation or price quotation (from that country's
perspective)[2] and are used by most countries.
Quotes using a country's home currency as the unit currency (e.g., EUR 1.00 = USD 1.35991 in
the euro zone) are known as indirect quotation or quantity quotation and are used in British
newspapers and are also common in Australia, New Zealand and the eurozone.
• direct quotation: 1 foreign currency unit = x home currency units
• indirect quotation: 1 home currency unit = x foreign currency units
Note that, using direct quotation, if the home currency is strengthening (i.e., appreciating, or
becoming more valuable) then the exchange rate number decreases. Conversely if the foreign
currency is strengthening, the exchange rate number increases and the home currency is
depreciating.
Market convention from the early 1980s to 2006 was that most currency pairs were quoted to 4
decimal places for spot transactions and up to 6 decimal places for forward outrights or swaps.
(The fourth decimal place is usually referred to as a "pip"). An exception to this was exchange
rates with a value of less than 1.000 which were usually quoted to 5 or 6 decimal places.
Although there is no fixed rule, exchange rates with a value greater than around 20 were usually
quoted to 3 decimal places and currencies with a value greater than 80 were quoted to 2 decimal
places. Currencies over 5000 were usually quoted with no decimal places (e.g. the former
Turkish Lira). e.g. (GBPOMR : 0.765432 - EURUSD : 1.5877 - GBPBEF : 58.234 - EURJPY :
165.29). In other words, quotes are given with 5 digits. Where rates are below 1, quotes
frequently include 5 decimal places.
In 2005 Barclays Capital broke with convention by offering spot exchange rates with 5 or 6
decimal places on their electronic dealing platform.[3] The contraction of spreads (the difference
between the bid and offer rates) arguably necessitated finer pricing and gave the banks the ability
to try and win transaction on multibank trading platforms where all banks may otherwise have
been quoting the same price. A number of other banks have now followed this.
While official quotations are given with the full number, for example 1.4320, many investors and
analysts drop the integer for convenience and use only the fractional part, such as 4320. These
are used frequently where a move in price is being described, for example 4320 to 4290 as
opposed to 1.4320 to 1.4290.[4]
[edit] Free or pegged
Main article: Exchange rate regime

If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies
and is determined by the market forces of supply and demand. Exchange rates for such
currencies are likely to change almost constantly as quoted on financial markets, mainly by
banks, around the world. A movable or adjustable peg system is a system of fixed exchange
rates, but with a provision for the devaluation of a currency. For example, between 1994 and
2005, the Chinese yuan renminbi (RMB) was pegged to the United States dollar at RMB 8.2768
to $1. China was not the only country to do this; from the end of World War II until 1967,
Western European countries all maintained fixed exchange rates with the US dollar based on the
Bretton Woods system. [1]
The RER (Real Exchange Rate) refers to the purchasing power of two currencies relative to one
another. It is based on the GDP deflator measurement of the price level in the domestic and
foreign countries (P,Pf), which is arbitrarily set equal to 1 in a given base year. Therefore, the
level of the RER is arbitrarily set, depending on which year is chosen as the base year for the
GDP deflator of two countries. The changes of the RER are instead informative on the evolution
over time of the relative price of a unit of GDP in the foreign country in terms of GDP units of
the domestic country. If all goods were freely tradable, and foreign and domestic residents
purchased identical baskets of goods, purchasing power parity (PPP) would hold for the GDP
deflators of the two countries, and the RER would be constant and equal to one.
[edit] Bilateral vs. effective exchange rate
Bilateral exchange rate involves a currency pair, while effective exchange rate is weighted
average of a basket of foreign currencies, and it can be viewed as an overall measure of the
country's external competitiveness. A nominal effective exchange rate (NEER) is weighted with
the inverse of the asymptotic trade weights. A real effective exchange rate (REER) adjust NEER
by appropriate foreign price level and deflates by the home country price level. Compared to
NEER, a GDP weighted effective exchange rate might be more appropriate considering the
global investment phenomenon.
[edit] Uncovered interest rate parity
See also: Interest rate parity#Uncovered interest rate parity

Uncovered interest rate parity (UIRP) states that an appreciation or depreciation of one currency
against another currency might be neutralized by a change in the interest rate differential. If US
interest rates increase while Japanese interest rates remain unchanged then the US dollar should
depreciate against the Japanese yen by an amount that prevents arbitrage (in reality the opposite
(appreciation) quite frequently happens, as explained below). The future exchange rate is
reflected into the forward exchange rate stated today. In our example, the forward exchange rate
of the dollar is said to be at a discount because it buys fewer Japanese yen in the forward rate
than it does in the spot rate. The yen is said to be at a premium.
UIRP showed no proof of working after the 1990s. Contrary to the theory, currencies with high
interest rates characteristically appreciated rather than depreciated on the reward of the
containment of inflation and a higher-yielding currency.
[edit] Balance of payments model
This model holds that a foreign exchange rate must be at its equilibrium level - the rate which
produces a stable current account balance. A nation with a trade deficit will experience reduction
in its foreign exchange reserves which ultimately lowers (depreciates) the value of its currency.
The cheaper currency renders the nation's goods (exports) more affordable in the global market
place while making imports more expensive. After an intermediate period, imports are forced
down and exports rise, thus stabilizing the trade balance and the currency towards equilibrium.
Like PPP, the balance of payments model focuses largely on trade-able goods and services,
ignoring the increasing role of global capital flows. In other words, money is not only chasing
goods and services, but to a larger extent, financial assets such as stocks and bonds. Their flows
go into the capital account item of the balance of payments, thus, balancing the deficit in the
current account. The increase in capital flows has given rise to the asset market model.
[edit] Asset market model
See also: Capital asset pricing model and Net Capital Outflow

The expansion in trading of financial assets (stocks and bonds) has reshaped the way analysts
and traders look at currencies. Economic variables such as economic growth, inflation and
productivity are no longer the only drivers of currency movements. The proportion of foreign
exchange transactions stemming from cross border-trading of financial assets has dwarfed the
extent of currency transactions generated from trading in goods and services.
The asset market approach views currencies as asset prices traded in an efficient financial
market. Consequently, currencies are increasingly demonstrating a strong correlation with other
markets, particularly equities.
Like the stock exchange, money can be made or lost on the foreign exchange market by investors
and speculators buying and selling at the right times. Currencies can be traded at spot and foreign
exchange options markets. The spot market represents current exchange rates, whereas options
are derivatives of exchange rates
[edit] Fluctuations in exchange rates

Exchange rates display

A market based exchange rate will change whenever the values of either of the two component
currencies change. A currency will tend to become more valuable whenever demand for it is
greater than the available supply. It will become less valuable whenever demand is less than
available supply (this does not mean people no longer want money, it just means they prefer
holding their wealth in some other form, possibly another currency).
Increased demand for a currency is due to either an increased transaction demand for money, or
an increased speculative demand for money. The transaction demand for money is highly
correlated to the country's level of business activity, gross domestic product (GDP), and
employment levels. The more people there are unemployed, the less the public as a whole will
spend on goods and services. Central banks typically have little difficulty adjusting the available
money supply to accommodate changes in the demand for money due to business transactions.
The speculative demand for money is much harder for a central bank to accommodate but they
try to do this by adjusting interest rates. An investor may choose to buy a currency if the return
(that is the interest rate) is high enough. The higher a country's interest rates, the greater the
demand for that currency. It has been argued that currency speculation can undermine real
economic growth, in particular since large currency speculators may deliberately create
downward pressure on a currency by shorting in order to force that central bank to sell their
currency to keep it stable (once this happens, the speculator can buy the currency back from the
bank at a lower price, close out their position, and thereby take a profit).
[edit] Manipulation of exchange rates
Countries may gain an advantage in international trade if they manipulate the value of their
currency by artificially keeping its value low. It is argued that the People's Republic of China has
succeeded in doing this over a long period of time. However, in a real-world situation, a 2005
appreciation of the Yuan by 22% was followed by a 38.7% increase in Chinese imports to the
US.[5][6]
In 2010 other nations, including Japan and Brazil, attempted to devalue their currency in the
hopes of subsidizing cheap exports and bolstering their ailing economies. A low exchange rate
lowers the price of a country's goods for consumers in other countries but raises the price of
goods, especially imported goods, for consumers in the manipulating country.[7]

Fixed exchange rate

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Foreign exchange

Exchange rates
Currency band
Exchange rate
Exchange rate regime
Fixed exchange rate
Floating exchange rate
Linked exchange rate

Markets
Foreign exchange market
Futures exchange
Retail forex

Products
Currency
Currency future
Non-deliverable forward
Forex swap
Currency swap
 Foreign exchange option

Historical agreements
Bretton Woods Conference
Smithsonian Agreement
Plaza Accord
Louvre Accord

See also
Bureau de change /
currency exchange (office)

Worldwide official use of foreign currency or pegs: U.S. dollar users, including the
United States Currencies pegged to the US dollar Euro users, including the
Eurozone Currencies pegged to the Euro
Australian dollar users, including Australia New Zealand dollar users,
including New Zealand South African rand users (CMA, including South Africa)
Indian rupee users and pegs, including India Pound sterling users and pegs,
including the United Kingdom
Special Drawing Rights or other currency basket pegs Three cases of a
country using or pegging the currency of a neighboor

A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate
regime wherein a currency's value is matched to the value of another single currency or to a
basket of other currencies, or to another measure of value, such as gold.
A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is
pegged to. This makes trade and investments between the two countries easier and more
predictable, and is especially useful for small economies where external trade forms a large part
of their GDP.
It can also be used as a means to control inflation. However, as the reference value rises and
falls, so does the currency pegged to it. In addition, according to the Mundell-Fleming model,
with perfect capital mobility, a fixed exchange rate prevents a government from using domestic
monetary policy in order to achieve macroeconomic stability.
There are no major economic players that use a fixed exchange rate (except the countries using
the Euro and the Chinese Yuan). The currencies of the countries that now use the euro are still
existing (e.g. for old bonds). The rates of these currencies are fixed with respect to the euro and
to each other. The most recent such country to discontinue their fixed exchange rate was the
People's Republic of China[citation needed], which did so in July 2005.[1] However, as of September
2010, the fixed-exchange rate of the Chinese Yuan has already increased 1.5% in the last 3
months. [2]

Contents
[hide]
• 1 Maintenance
• 2 Criticisms
• 3 Fixed exchange rate regime versus capital
control
• 4 Literature
• 5 See also
• 6 References

[edit] Maintenance
Typically, a government wanting to maintain a fixed exchange rate does so by either buying or
selling its own currency on the open market. This is one reason governments maintain reserves
of foreign currencies. If the exchange rate drifts too far below the desired rate, the government
buys its own currency in the market using its reserves. This places greater demand on the market
and pushes up the price of the currency. If the exchange rate drifts too far above the desired rate,
the government sells its own currency, thus increasing its foreign reserves.
Another, less used means of maintaining a fixed exchange rate is by simply making it illegal to
trade currency at any other rate. This is difficult to enforce and often leads to a black market in
foreign currency. Nonetheless, some countries are highly successful at using this method due to
government monopolies over all money conversion. This was the method employed by the
Chinese government to maintain a currency peg or tightly banded float against the US dollar.
Throughout the 1990s, China was highly successful at maintaining a currency peg using a
government monopoly over all currency conversion between the yuan and other currencies.[3][4]
[edit] Criticisms
The main criticism of a fixed exchange rate is that flexible exchange rates serve to automatically
adjust the balance of trade.[5] When a trade deficit occurs, there will be increased demand for the
foreign (rather than domestic) currency which will push up the price of the foreign currency in
terms of the domestic currency. That in turn makes the price of foreign goods less attractive to
the domestic market and thus pushes down the trade deficit. Under fixed exchange rates, this
automatic rebalancing does not occur.
Governments also have to invest many resources in getting the foreign reserves to pile up in
order to defend the pegged exchange rate. Moreover a government, when having a fixed rather
than dynamic exchange rate, cannot use monetary or fiscal policies with a free hand. For
instance, by using reflationary tools to set the economy rolling (by decreasing taxes and injecting
more money in the market), the government risks running into a trade deficit. This might occur
as the purchasing power of a common household increases along with inflation, thus making
imports relatively cheaper.
Additionally, the stubbornness of a government in defending a fixed exchange rate when in a
trade deficit will force it to use deflationary measures (increased taxation and reduced
availability of money) which can lead to unemployment. Finally, other countries with a fixed
exchange rate can also retaliate in response to a certain country using the currency of theirs in
defending their exchange rate.
[edit] Fixed exchange rate regime versus capital control
The belief that the fixed exchange rate regime brings with it stability is only partly true, since
speculative attacks tend to target currencies with fixed exchange rate regimes, and in fact, the
stability of the economic system is maintained mainly through capital control. A fixed exchange
rate regime should be viewed as a tool in capital control.
For instance, China has allowed free exchange for current account transactions since December
1, 1996. Of more than 40 categories of capital account, about 20 of them are convertible. These
convertible accounts are mainly related to foreign direct investment. Because of capital control,
even the renminbi is not under the managed floating exchange rate regime, but free to float, and
so it is somewhat unnecessary for foreigners to purchase renminbi.