International Monetary System and Foreign Exchange

Why the need to understand Foreign Exchange? The world is integrated today. It is a fact of life that goods and services produced in one country will be traded in another. The currency that one will receive/pay in exchange for goods sold/bought will be other than ones home currency.

Foreign Exchange Management

Therefore, we need to understand how currency fluctuations or volatility of currency markets affects our decision-making ability as a buyer/seller of goods/services. Domestic and international transactions differ in the use of more than one currency for international trade. Thus international business creates a need for buying, selling or borrowing foreign currencies.

Foreign Exchange Management

It is important to understand how the exchange rates are set and why the rates change. This would help the managers in making decisions that are dependent on those changes. The price at which one currency is traded for another is referred to as exchange rates.

Money
Hard (International) Currencies vs. Soft Currencies Hard Currency refers to a globally traded currency that is expected to serve as a reliable and stable store of value. Factors contributing to a currencys hard status might include the long-term stability of its purchasing power, the associated countrys political and fiscal condition and outlook and the policy posture of the issuing central bank.

Money
Soft Currency indicates a currency which is expected to fluctuate erratically or depreciate against other currencies. Such softness is typically the result of political or fiscal instability within the associated country.

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

Foreign Exchange Management

Exchange-Rate Systems - Gold Standard - Par Value (Adjustable Peg) Crawling Peg : a fixed exchange rate in which regular (frequent?) periodic adjustments Floating (Flexible) System: No Government Interference, Market Forces dictate equilibrium exchange rates, Value of a nations currency allowed to float down or up

Foreign Exchange Management

Exchange-Rate Systems

- The exchange rate system we see today is the latest stage in a world of continuing change. The systems that have preceded the present floating exchange rate system have been varied.

Foreign Exchange Management

Exchange-Rate Systems

Gold Standard Till 1939, the world exchange (monetary) system was based on Gold Standard which fixed exchange value between gold and currency e.g. 1 = 30 gm and 1Re = 2 gm.
Then 1 = Rs. 15.

Foreign Exchange Management

Exchange-Rate Systems

Gold Standard There was no problem with this system as rate of exchange remained more or less constant. Gold Standard could work successfully if all countries observed certain rules universally.

Foreign Exchange Management

For e.g. USA exports to UK were more than the USA imports from UK. This meant that the US trade balance was better than that of UK. The balance will move from UK to USA in the form of gold. Rule: When gold moves out of UK, the supply of money in UK goes down. In USA on the other hand, price level will increase due to the increased supply of money.

Foreign Exchange Management

This meant that in future the UK has more scope to export as price levels in UK decline, which is not the case in USA. Therefore, an equilibrium established. Unfortunately, during 1930s, USA was constantly in surplus but did not increase the level/supply of money. They said the extra gold was kept in cold storage and not given to the monetary authority. Therefore, soon the European countries refused to pay in gold as they could not get back.

Foreign Exchange Management

The Bretton Woods System The 1920s and 1930s were a dark period for world trade and currency markets. During the World Wars, many countries suffered very badly. In order to correct the BOP disequilibrium, many countries had to resort to devaluation of their currencies. International trade suffered a near death blow.

Foreign Exchange Management

United States and Great Britain took the lead and a conference was convened at Bretton Woods in US in July 1944. In accordance with the agreement reached at the Conference, the International Monetary Fund (IMF) was established in 1946. The exchange rate system under the IMF came to be known as Bretton Woods system and was followed by member countries from 1946 to 1971.

Foreign Exchange Management

The Bretton Woods system required the IMF member countries to fix the parities of their currencies in terms of US dollars or gold. The objective of stable exchange rates were achieved as the countries were obliged to keep the fluctuations within 1% of the declared parity. It was agreed that no change in parity could take place without the IMFs approval. The US fixed the parity of the US dollars in terms of gold at $ 35 per ounce.

Foreign Exchange Management

Others were allowed to buy gold from USA at this rate. This virtually fixed the notional gold equivalent and also the price. In 1968 there was a major crisis in USA. It suffered a massive BOP deficit and accelerated inflation. USA decided to devalue the dollar and said that it was not interested in maintaining the fixed value of gold. This led to increase in international gold prices. The other major countries issued a floating rate of exchange wherein gold equivalent was rejected.

Official Classification of Exchange Rate Regimes

Floating Exchange Rate Regimes Intermediate Exchange Rate Regimes Hard Peg Regimes
- independently floating regimes - managed floating regimes

- soft pegs - tightly managed floating regimes - currency boards - exchange rate regimes with no separate legal tender

Official Classification of Exchange Rate Regimes

Floating Exchange Rate Regimes
- independently floating regimes Pure Floating Rates (Free Float) Under the pure floating rate arrangement, the exchange rate of the currency of a country is determined entirely by market considerations such as demand and supply. The government or the Central Bank makes no effort to fix the exchange rate. Also referred to as a clean float.

 Floating Exchange Rate Regimes

Official Classification of Exchange Rate Regimes

- managed floating regimes Few countries have been able to long resist the temptation to intervene actively in the foreign exchange market in order to reduce the economic uncertainty associated with a clean float. The fear is that too abrupt a change in the value of a nations currency could imperil its export industries (if the currency appreciates) or lead to a higher rate of inflation (if the currency depreciates).

 Floating Exchange Rate Regimes

Official Classification of Exchange Rate Regimes

- managed floating regimes Most countries, with floating currencies have attempted through central bank intervention to smooth out exchange rate fluctuations. Such a system of managed exchange rates, called a managed float, is also known as a dirty float.

 Intermediate Exchange Rate Regimes

Official Classification of Exchange Rate Regimes

- soft pegs - tightly managed floating regimes Pegging under a pegging arrangement, a country links the value of its currency to that of another currency, usually that of its major trading partner. Pegging to a particular currency implies that the value of pegged currency moves along with the currency to which it is pegged.

 Intermediate Exchange Rate Regimes

- soft pegs - tightly managed floating regimes

Official Classification of Exchange Rate Regimes

There are soft and hard pegs. Soft pegs generally let their exchange rate fluctuate through a desired bracket. Crawling Pegs the peg system is situated between the fixed-rate and float-rate systems. The crawling peg is a system establishing a par value around which the rate can vary up to a given percentage point.

 Hard Peg Regimes

Official Classification of Exchange Rate Regimes

- currency boards - exchange rate regimes with no separate legal tender Hard pegs follow the anchor currency more strictly.

Currency Board Arrangements A monetary regime based on an implicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate.

 Hard Peg Regimes

Official Classification of Exchange Rate Regimes

- currency boards - exchange rate regimes with no separate legal tender

Exchange Rate arrangements with No Separate Legal tender - The currency of another country circulates as the sole legal tender or the member belongs to a monetary or currency union in which the same legal tender is shared by the members of the union.

Foreign Exchange Market

Credit (Financing) Clearing Hedging Spot Market vs. Forward Market

Foreign Exchange Market

Hedging Exposures to currency risk can be eliminated by hedging. The literary meaning if the word is risk management. The aim is to ensure that profits or costs are more predictable. One commonly used instrument is the forward contract. Spot Market vs. Forward Market

Foreign Exchange Market

Spot Market vs. Forward Market A spot transaction is a contract to buy or sell a quantity of a foreign currency for immediate settlement or value. The exchange rate for such a transaction is known as spot rate. Forward means any day beyond spot.