Exchange rate system alternatives

Key currencies: Share of national currencies in total

identified official holdings of foreign exchange, 1998

Key currency
US dollar
German mark
Japanese yen
British pound
French franc
ECU
Swiss franc
Netherlands guilder
Other

Carbaugh, Chap. 16

All
countries

Industrial
countries

Developing
countries

60.3%
12.1
5.1
3.9
1.3
0.8
0.7
0.4
15.4

64.3%
14.7
7.0
3.1
1.4
1.8
0.2
0.3
7.2

57.1%
10.1
3.7
4.6
1.2
1.0
0.4
21.9

 Introduction
Currencies are traded in foreign exchange markets and
the volume of money bought and sold is huge! Daily
foreign exchange market turnover averaged $4 trillion
in 2010, 20% higher than in 2007.
An exchange rate is the price of one currency in terms
of another in other words, the purchasing power of
one currency against another.
Exchange rates are an important instrument of
monetary policy

Measuring the exchange rate

Exchange rates are expressed in various ways:
Spot Exchange Rate - the spot rate is the rate for a currency at todays market
prices
Forward Exchange Rate - a forward rate involves the delivery of currency at a
specified time in the future at an agreed rate. Companies wanting to reduce risks
from exchange rate volatility can buy their currency forward on the market
Bi-lateral Exchange Rate - the rate at which one currency can be traded against
another. Examples include: $/DM, Sterling/US Dollar, $/YEN or Sterling/Euro
Effective Exchange Rate Index (EER) - a weighted index of sterling's value against a
basket of currencies the weights are based on the importance of trade between
the UK and each country.
Real Exchange Rate - this is the ratio of domestic price indices between two
countries. A rise in the real exchange rate implies a worsening
of competitiveness for a country.

 Hedging Function:
A third function of the foreign exchange market is
to hedge foreign exchange risks. In a free
exchange market when exchange rates, i.e., the
price of one currency in terms of another
currency, change, there may be a gain or loss to
the party concerned. Under this condition, a
person or a firm undertakes a great exchange risk
if there are huge amounts of net claims or net
liabilities which are to be met in foreign money.

 What is Forex?
FOREX, an acronym for Foreign Exchange, is the largest
financial market in the world. With an estimated $1.5
trillion in currencies traded daily, Forex provides income to
millions of traders and large banks worldwide. The market
is so large in volume that it would take the New York Stock
Exchange, with a daily average of under $20 billion, almost
three months to reach the amount traded in one day on
the Foreign Exchange Market.
Forex, unlike other financial markets, is not tied to an
actual stock exchange. Forex is an over-the-counter (OTC)
or off-exchange market.

 Purpose
The foreign exchange market is the mechanism
by which currencies are valued relative to one
another, and exchanged. An individual or
institution buys one currency and sells another in
a simultaneous transaction. Currency trading
always occurs in pairs where one currency is sold
for another and is represented in the following
notation: EUR/USD or CHF/YEN. The exchange
rate is determined through the interaction of
market forces dealing with supply and demand.

 Definition of 'Currency Arbitrage'

A forex strategy in which a currency trader takes advantage of different

spreads offered by brokers for a particular currency pair by making trades.
Different spreads for a currency pair imply disparities between the bid and
ask prices. Currency arbitrage involves buying and selling currency pairs
from different brokers to take advantage of this disparity.
For example, two different banks (Bank A and Bank B) offer quotes for the
US/EUR currency pair. Bank A sets the rate at 3/2 dollars per euro, and
Bank B sets its rate at 4/3 dollars per euro. In currency arbitrage, the
trader would take one euro, convert that into dollars with Bank A and then
back into euros with Bank B. The end result is that the trader who started
with one euro now has 9/8 euro. The trader has made a 1/8 euro profit if
trading fees are not taken into account.

 What is Speculation?
Currency speculation exists whenever someone
buys a foreign currency, not because she needs to
pay for an import or is investing in a foreign
business, but because she hopes to sell the
currency at a higher rate in the future (in
technical language the currency "appreciates").
This is nothing more than the old rule of buying
low and selling highonly with foreign money

 Some currency speculation is necessary to

facilitate international trade. Take, for
example, a car manufacturer in Germany
which exports cars to the United States. As the
U.S. importer of German cars is paying her bill
in U.S. dollars, the German exporter receives
U.S. currency.

Determinants of Exchange Rates

Numerous factors determine exchange rates, and all are related to the trading relationship
between two countries. Remember, exchange rates are relative, and are expressed as a
comparison of the currencies of two countries. The following are some of the principal
determinants of the exchange rate between two countries. Note that these factors are in no
particular order; like many aspects of economics, the relative importance of these factors is
subject to much debate.
1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate exhibits a rising currency
value, as its purchasing power increases relative to other currencies. During the last half of
the twentieth century, the countries with low inflation included Japan, Germany and
Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with
higher inflation typically see depreciation in their currency in relation to the currencies of
their trading partners. This is also usually accompanied by higher interest rates. (To learn
more, see Cost-Push Inflation Versus Demand-Pull Inflation.)

 . Current-Account Deficits
The current account is the balance of trade between a country and
its trading partners, reflecting all payments between countries for
goods, services, interest and dividends. A deficitin the current
account shows the country is spending more on foreign trade than
it is earning, and that it is borrowing capital from foreign sources to
make up the deficit. In other words, the country requires more
foreign currency than it receives through sales of exports, and it
supplies more of its own currency than foreigners demand for its
products. The excess demand for foreign currency lowers the
country's exchange rate until domestic goods and services are
cheap enough for foreigners, and foreign assets are too expensive
to generate sales for domestic interests. (For more,
seeUnderstanding The Current Account In The Balance Of
Payments.)

2. Differentials in Interest Rates

Interest rates, inflation and exchange rates are all highly correlated. By manipulating
interest rates, central banks exert influence over both inflation and exchange rates, and
changing interest rates impact inflation and currency values. Higher interest rates offer
lenders in an economy a higher return relative to other countries. Therefore, higher
interest rates attract foreign capital and cause the exchange rate to rise. The impact of
higher interest rates is mitigated, however, if inflation in the country is much higher than
in others, or if additional factors serve to drive the currency down. The opposite
relationship exists for decreasing interest rates - that is, lower interest rates tend to
decrease exchange rates. (For further reading, see What Is Fiscal Policy?)