The international business context requires trading and investing in assets denominated in different currencies. Foreign assets or liabilities add a new dimension to the risk profile of a firm or an investor's portfolio: foreign exchange risk. To understand foreign exchange risk, we need to understand the terminology, history and behavior of currency markets. This chapter has two goals. First, this chapter introduces the terminology and reviews the recent history of exchange rate markets. Second, this chapter presents the instruments used in currency markets.

1.A An Exchange Rate is Just a Price

The foreign exchange (FX or FOREX) market is the market where exchange rates are determined. Exchange rates are the mechanisms by which world currencies are tied together in the global marketplace, providing the price of one currency in terms of another.

For example, the U.S. dollar/Mexican peso exchange rate is the price of a peso expressed in U.S. dollars. On March 6, 1999, this exchange rate was .1011 U.S. dollars per Mexican peso, or, in market notation, .1011 USD/MXP.

1.A.1 Changes in Exchange Rates and Foreign Exchange Risk

Exhibit I.1: Demand and Supply determine the price of foreign currency (S_t^E).

[GRAPH Missing]

What are the determinants of supply and demand in the foreign exchange market? For the time being, we can think of domestic and foreign companies engaged in foreign trade, domestic and foreign investors, and domestic and foreign tourism as the forces driving the demand and supply of foreign currency in a given country. Over time, these determinants of demand and supply in the foreign exchange market will change, forcing exchange rates to adjust to new equilibrium levels.

Changes in exchange rates are usually measured by percentage changes or returns. The currency return from time t to T, s_t,T, is given by:

s_t,T = (S_T/S_t) - 1,

where S_t represents the exchange rate in terms of numbers of units of domestic currency for one unit of the foreign currency (the spot rate).

Risk arises every time actual outcomes can differ from expected outcomes. Assets and liabilities are exposed to financial price risk when their actual values may differ from expected values. In foreign exchange markets, we are in the presence of foreign exchange risk (currency risk) when the actual exchange rate is different from the expected exchange rate. That is, if there is foreign exchange risk, s_t,T cannot be predicted perfectly at time t. In statistical terms, we can think of s_t,T as a random variable.

1.B Exchange Rate Systems

1.B.1 Flexible Exchange Rate System

The first pure exchange rate system is the flexible exchange rate system. In a flexible exchange rate system the monetary authority –the central bank- allows the exchange rate to adjust to equate the supply and demand for foreign currency.

[GRAPH Missing]

In this particular example, the exchange rate can move from USD .74 per CHF to a level such as USD .80 per CHF, making Swiss goods more expensive in USD and thus reducing the demand for CHF by U.S. residents. ¶

As the above example illustrates, in a flexible exchange rate system, the central bank has an independent monetary policy. That is, the monetary policy is not solely dictated by exchange rate concerns. Monetary policy, however, impacts exchange rates. For example, an expansive monetary policy will reduce domestic interest rates, and, then, the supply and the demand for foreign currency. Foreign investors will find the domestic interest rates not very attractive and capital will flow out of the country. That is, the capital outflows will reduce the supply of foreign currency in the domestic market and the foreign currency will increase in value. In general, an expansive domestic monetary policy increases the price of the foreign currency.

A currency depreciates (appreciates) when, under a flexible exchange rate system, it becomes less (more) expensive in terms of foreign currency. For example, if the USD/CHF exchange rate changes from .74 USD/CHF to .80 USD/CHF, the CHF is appreciating with respect to the USD. At the same time, we can also say that the USD is depreciating against the CHF.

In Remark I.1, we pointed out that an exchange rate is just another price. We can also think that goods appreciate or depreciate against the domestic currency. For example, if the price of one gallon of milk changes from USD 2.50 to USD 2.60, we can say that milk is appreciating against the USD.

Under flexible exchange rates, a country automatically adjusts to external imbalances. Suppose a country is having a balance of payment surplus. That is, there is an excess demand for the country's currency at the prevailing exchange rate in the foreign exchange market. Under a flexible exchange rate regime, the external value of the country's currency will appreciate to the level where the balance of payments imbalance disappears. The external balance is automatically achieved.

1.B.2 Fixed Exchange Rate System

The second pure exchange rate system is the fixed exchange rate system. In order to fix the price of a foreign currency in terms of the domestic currency, a central bank needs two things. First, the central bank needs a large stock of the foreign currency (reserves) to supply to the market whenever there is a tendency for the market price of the foreign currency to increase. Second, the central bank also needs a large stock of the domestic currency to buy the foreign currency whenever there is a tendency for the market price of the foreign currency to go down. Therefore, in a fixed exchange rate system a central bank is ready to buy and sell its domestic currency at a fixed price in terms of foreign currency.

The major countries had fixed exchange rates against one another from the end of World War II until 1973. For example, during the 1960s the German Central Bank, the Bundesbank, would buy and sell any amount of USD at 4 deutsche marks (DEM) per USD. When the market for the USD showed upward pressures, the Bundesbank would sell USD. On the other hand, when the market for the USD showed downward pressures, the Bundesbank would buy USD.

A devaluation (revaluation) takes places when the price of foreign currencies under a fixed exchange rate regime is increased (decreased) by official action. For example, until 1967 the official exchange rate set by the Bank of England was USD 2.80 per British pound (GBP). But in that year the GBP was devalued and the rate became 2.40 USD/GBP. In 1971 the GBP was revalued at 2.60 USD/GBP.

In a fixed rate system, the central banks have to finance any balance of payments surplus or deficit that arises at the official exchange rate. They do so by buying or selling all the foreign currency that is not supplied in private transactions. Every time a central bank sells (buys) foreign currency, the domestic money supply decreases (increases). Therefore, in a fixed exchange rate system the domestic money supply is endogenous to the system. That is, under a fixed exchange rate system, a central bank does not have an independent monetary policy. The money supply is linked to the balance of payments. Surpluses imply automatic monetary expansion, while deficits imply monetary contraction.

The monetary policy of a central bank has to be consistent with the fixed exchange rate. Otherwise, market forces will force the central bank to change the official parity. For example, suppose that a central bank suddenly increases the money supply. Under a fixed exchange rate system, such an expansive monetary policy will create devaluation pressures, since demand will exceed supply at the fixed exchange rate price. Fearing that this disequilibrium in the foreign exchange market will force the government to devalue, speculators will try to buy foreign currency from the central bank at the official rate. If the central bank does not have enough reserves, speculators will deplete official reserves.

Some countries use a variation of the pure fixed exchange rate system: the value of their domestic currency is pegged to a foreign currency, or to some unit of account. Under a pegged exchange rate system, the value of the domestic currency is fixed in terms of a selected unit of account (or foreign currency). The domestic currency moves in line with the unit of account to which is pegged against other currencies. Sometimes the exchange rate against the unit of account is allowed to fluctuate only within narrow limits.

Many countries that have a fixed exchange rate system do not have enough reserves to support the fixed parity. The survival of the fixed exchange rate system, however, is based on the good reputation of the government and investors' confidence on the government's promise to support the parity. As soon as the confidence of investors weakens, a run against the official reserves might force a government to devalue.

On December 20, 1994, the Mexican government under new president Zedillo announced a 14% devaluation of the Mexican peso (MXP) against the USD. This decision weakened the confidence of domestic and international investors, who started to change the composition of their portfolio, exchanging MXP denominated assets for USD denominated asset. By early January, the government, unable to support the fixed exchange rate system, decided to float the currency. That is, the government allowed supply and demand to freely determine the price of the MXP/USD. The MXP fell against the USD by more than 40% and this fall started a severe recession in Mexico and other countries in Latin America. This recession lasted until mid 1996. ¶

In 1994, the government of Brazil stabilized its economy with the so-called "Real Plan." Among many measures, the Real Plan created a new currency, the real (BRR), which was allowed to fluctuate in a narrow range against the USD. By the end of 1998, due to excessive budget deficits and the Russian crisis, Brazil's foreign reserves were dwindling. On Wednesday, January 13, 1999, Mr. Gustavo Franco, one of the main defenders of a strong real, resigned as president of the Central Bank of Brazil. His successor, Mr. Francisco Lopes, announced a widening and lowering of the real trading band against the dollar -in effect a devaluation of the BRR against the USD of 8%. This devaluation shattered the confidence of investors on the Brazilian government's commitment to the fixed exchange rate system. An estimated USD 1.5 billion left Brazil following the devaluation's announcement. The real plunged quickly from 1.20 BRR/USD to the new bands' outer limit, 1.32 BRR/USD. On Friday, January 15, the Brazilian Central Bank announced it was not going to intervene on the exchange rate market, effectively switching from a fixed exchange rate system to a free floating exchange rate system. Following the announcement the real fell to 1.50 BRR/USD. A month later, the real was trading above 2 BRR/USD. ¶

Some countries have relied on an old mechanism to bring credibility to the fixed exchange rate system called currency board agreement. The currency board agreement is a system in which a country pegs its money to a hard currency such as the U.S. dollar or the Euro in a consistent manner. Under this system, the Currency Board can increase the money supply only when there is a corresponding increase in the foreign currency reserves held at the Currency Board. That is, at all times, the Currency Board has foreign reserves that are at least equal to the monetary base of the country. The Currency Board holds no other assets -i.e., domestic government bonds. Because it requires severe conditions, a currency board raises political and financial credibility, as it gives a country a highly credible tool for defending a fixed exchange rate

Under fixed exchange rates, it is possible to achieve a reduction of economic uncertainty. Under a fixed exchange rate system, there is obviously no uncertainty about future exchange rates. This reduction in uncertainty might stimulate business in foreign trade that otherwise firms would not pursue. Therefore, a fixed exchange rate regime might improve the allocation of resources of a country.

1.B.3 Other Exchange Rate Systems

In practice, the flexible exchange rate system, in effect in the developed countries since 1973, has not been one of clean (i.e., no central bank intervention) floating. Instead, the exchange rate system of choice has been a managed, or dirty, float. This system is an intermediate arrangement that combines features of the free floating and fixed systems. The exchange rate is managed, but allowed to fluctuate over some limited interval. That is, while the exchange rate is allowed to change, the Central Bank allows only limited fluctuations. Under a managed exchange rate system, policy influences the exchange rate. We will call the act of buying and selling foreign currency by a central bank intervention. Under managed floating, central banks intervene to buy and sell foreign currencies in attempts to influence exchange rates. Official reserve transactions are not equal to zero under managed floating.

In some markets, the government enjoys exclusive power to determine the allocation and use of available foreign exchange. Residents cannot freely buy and sell foreign exchange. Thus, demand and supply do not determine exchange rates. The government sets exchange rates. The government, however, will sell foreign exchange at the official rate only for some types of transactions (in general, officially recognized foreign imports). For all the other transactions, a black market is created. For example, in 1993, China had an official rate of 5.7 yuans (CHY) per USD, while the black market rate was 10 CNY/USD.

1.B.4 Different Policy Tools: A Comparison of Fixed and Flexible Exchange Rate Regimes

During the 1960s, the economics profession had a very interesting debate: should a country use a fixed or a flexible exchange rate regime? The debate is still open, which should be obvious, given that we observe different countries operating different exchange rate regimes.

Using a simple open macroeconomic model, called the Mundell-Fleming model, we can illustrate the main arguments for both exchange rate regimes. The Mundell-Fleming model extends the standard IS-LM model to an open economy under the assumption of perfect capital mobility. We say that capital is perfectly mobile internationally when investors can purchase assets in any country they choose, quickly, with low transactions costs, and in unlimited amounts. That is, when capital is perfectly mobile, investors are willing and able to move large amounts of capital in search of the highest rate of return.

The policy arguments for flexible exchange rates are centered around monetary policy. Under a fixed exchange rate system, the money supply is endogenous and, thus, the central bank has no power to alter interest rates. Under a flexible exchange rate regime, however, a central bank can pursue independent monetary policies to stimulate the economy. For example, an expansive monetary policy tends to reduce interest rates. Under perfect capital mobility, this reduction in interest rate will create capital outflows, thus, depreciating the value of the domestic currency. The depreciation of the domestic currency increases foreign demand for domestic products and, as a result, domestic output increases.

On the other hand, the policy arguments for fixed exchange rates rest on fiscal policy. Under a fixed exchange rate regime, a fiscal expansion under conditions of capital mobility, might be effective in raising equilibrium output. For example, a fiscal expansion tends to increase both interest rates and the level of output. The higher interest rate, under perfect capital mobility, will attract capital inflows into the country, reducing the domestic interest rate. For flexible rates, by contrast, a fiscal expansion does not affect equilibrium output. The fiscal expansion tends to increases output and interest rates. The increase in interest rates produces an offsetting appreciation of the domestic currency and an increase in imports and a decrease in exports, thereby reducing output. That is, fiscal policies, under flexible exchange rates, shift the composition of domestic demand toward foreign goods away from domestic goods.

The above arguments show that the choice between the two regimes involves a trade-off. Each of the two alternatives has only one independent policy tool for internal purposes. A government, under fixed exchange rates, can attempt to expand domestic output using fiscal policies. On the other hand, a government under flexible exchange rates can attempt to use monetary policies to affect domestic output.

1.C Central Bank Intervention

Sometimes central banks buy and sell foreign currency with the purpose of changing the value of their domestic currency to different level than what the free market would set. In the case of an appreciating domestic currency, central banks usually buy foreign currency, raising the price of the foreign currency in terms of the domestic currency. Exhibit I.2 illustrates the opposite intervention, where the domestic central bank sells foreing currency (and buys domestic currency!). Suppose that due to an increase demand for Swiss goods, the demand for CHF switches from D₀ to D₁.Thus, the equilibrium changes from A to B. The USD depreciates against the CHF, from .74 USD/CHF to .80 USD/CHF. The Federal Reserve decides to intervene to stop the depreciation and bring the value of the CHF back to USD .80. The Federal Reserve sells CHF (usually CHF bonds), moving the supply of CHF from S₀ to S₁. As a final result, the equilibrium changes to C, where the USD appreciates back to the .74 USD/CHF level. Note that the Federal Reserve sold an amount of CHF equal to AC (and received an equivalent amount in USD) to support the .74 USD/CHF exchange rate.

Exhibit I.2

Central Bank Intervention to Halt Depreciation of Domestic Currency

[GRAPH Missing]

Central banks do not have enough foreign reserves in stock to effectively affect exchange rates. To this purpose, central banks have established reciprocal currency (swap) arrangements. For example, the Federal Reserve of the U.S. has established with the Swiss National Bank a swap arrangement of up to USD 4,000 million that may be drawn upon when needed. Any large central bank intervention in the FX market involves either the Federal Reserve or a foreign bank drawing from the swap facility currency balances, which are repaid at a later date.

1.C.1 Central Bank Intervention: Some Issues

As we stated above, when a central bank buys foreign currency gives to the FX sellers domestic currency, thereby increasing the domestic money supply. On the hand, when a central bank sells foreign currency, the domestic money supply shrinks. Central bank intervention affects money markets. Thus, interest rates will be affected by central bank intervention in the FX market.

Many central banks want to have an independent monetary policy. Therefore, central banks need to take some offsetting actions to avoid the indirect effects of intervention in the FX market. Sterilization refers to the actions taken by a central bank to neutralize the effects of international reserve flows in money markets. For example, take the case of Exhibit I.2, where the Federal Reserve sells CHF to halt the appreciation of the CHF against the USD. To neutralize the increase in interest rates, due to the decrease in the U.S. money supply, the Federal Reserve uses an open market operation (OMO). Through the OMO, the Federal Reserve buys Treasury Bills in the U.S. to increase money supply. If the Federal Reserve coordinates both operations perfectly, the U.S. money supply will not be affected by the central bank intervention. This kind of intervention is called sterilized intervention.

Behind intervention, we have the implicit notion of "overvalued" or "undervalued" market exchange rates. As Milton Friedman has noted, this argument implies that central banks will realize a profit from foreign exchange intervention. But if the central bank can earn a speculative profit this way, why can't private market speculators perform the same role? To justify central bank intervention, we have to assume that there is insufficient intervention or that the central bank has "superior" information.

Many students will imagine that an international monetary system is a set of rules set by officials and experts at an international conference. The Bretton Woods Agreement to manage exchange rates and balance of payments, which emerged from an international conference in 1944, might be considered a typical example. Monetary rules established by international agreements, however, are the exception, not the rule. More commonly, international rules have arisen out of the individual choices of countries constrained by the prior decisions of their neighbors and by other historical events.

The emergence of the classical gold standard before World War I is an example of this spontaneous process. The gold standard evolved out of the variety of commodity-money standards that emerged before the development of paper money. Its development was one of the accidents of modern times. It owed much to Great Britain's accidental adoption of a de facto gold standard in 1717, when Sir Isaac Newton, as master of the mint, set too low a gold price for silver, causing silver coins to disappear from circulation. With Britain's emergence in the nineteenth century as the world's leading financial and commercial power, British monetary practices became an attractive alternative to silver-based money for countries seeking to trade and borrow from the British Union. Out of these independent decisions of national governments an international system of fixed exchange rates, based on gold, was born.

2.A The Gold Standard

Silver was the dominant money during medieval times and into the modern era. Other metals were too heavy (copper) or too light (gold) when cast into coins of a value convenient for transactions. Gold coins were used to settle large transactions. This mixture of silver and gold (and copper in Sweden in 1625) was the basis for international settlements. When the residents of a country purchased abroad more than they sold, or lent more than they borrowed, they settled the difference with money acceptable to their creditors.

In the early nineteenth century, the monetary system of many countries permitted the simultaneous minting and circulation of both gold and silver coins. The U.S., The Netherlands and France had a bimetallic standard. These countries were on a bimetallic standard. Only Britain was fully on the gold standard from the start of the century. The German states, the Austro-Hungarian Empire, Scandinavia, Russia, and the Far East operated silver standards. Countries with bimetallic standards provided the link between the gold and silver blocs.

The French law of 1803 was representative of their bimetallic statutes: it required the mint to supply coins with legal-tender status to individuals presenting specified quantities of silver or gold. The mint ratio of the two metals was 15½ to 1 (one could obtain from the government's mint coins of equal value containing a certain amount of gold or 15½ times as much silver). Maintaining the circulation of both metals was difficult. If the market price was higher than the mint ratio, say 17 to 1, then there was an incentive for arbitrage. The arbitrageur could import 15½ ounces of silver and have it coined at the mint. She could exchange at the mint that silver coin for one containing an ounce of gold. She could export the gold and trade it for 17 ounces of silver on foreign markets, leaving the arbitrageur a profit of 1½ ounces of silver.

Gold discoveries in California in 1848 and Australia in 1851 increased the production of gold by 1,000%. The price of gold dropped substantially and gold was shipped to bimetallic countries, where the mint stood ready to purchase it at a fixed price. For example, French silver, which was undervalued, left France for the Far East and other silver standard countries. When silver deposits were discovered in Nevada, the opposite happened. Silver invaded bimetallic countries and French gold left for Britain.

At the beginning of the second half of the 1800s, countries with commercial and financial ties with Britain started to adopt the gold standard. Portugal adopted the gold standard in 1854. Germany followed in 1871. Soon, the majority of the entire European continent was in the gold standard. By the end of the nineteenth century Spain was the only European country still on inconvertible paper. The U.S. omitted reference to silver in the Coinage Act of 1873; when the greenback rose to par and convertibility was restored in 1879, the U.S. was effectively on gold. The system was adopted in Asia and in Latin America. Silver remained the monetary standard only in China and a few Central American countries.

During this time and until World War I, each nation defined the gold content of its currency and passively stood ready to buy and sell any amount of gold at that price. Since the gold content in one unit of each currency was fixed, exchange rates were also fixed. This was called the mint parity. The exchange rate could then fluctuate above and below the mint parity by the cost of shipping an amount of gold equal to one unit of the foreign currency between the two monetary centers. We can think of exchange rates being determined by a country's stock of gold. After World War I, several attempts were made to reestablish the gold standard in several countries, but they failed because of either overvaluation (Great Britain in 1925) or undervaluation (France in 1926). By 1933 the only currency that was officially convertible into gold was the U.S. dollar.

In its simplest form, as described by English economist David Hume more than two centuries ago, flows of gold would automatically keep economies and trade in balance. A surplus in trade would attract gold, producing an expansion of money supply. Spending would rise, along with prices, which in turn would attract imports. On the other hand, a trade deficit would then lead to an outflow of gold, contracting money stock, deflating prices, which would make the nation's exports more competitive, until a trade surplus emerged and the cycle started anew.

David Hume's version of the gold standard involved no central bank or government involvement. During the classic gold period, from 1880 until 1914, the Bank of England assisted the process. It would react to outflows of gold by raising the bank rate, which would deflate prices, making British goods more competitive and reducing demand for imports. Higher interest rates would also attract gold (capital) to the London money market.

The price adjustment mechanism is given by the Quantitative Theory of Money (QTM). Formally,

M_S V = P Y,

where M_S represents the quantity of gold (money) supplied in a given economy, V represents money's velocity, Y represents real output, and P represents nominal prices. In the short run, the velocity of money, and real output are considered stable. Therefore, in the short-run, any changes in M_s will be reflected in P. For example, a 10% increase in the quantity of gold in England will cause a 10% increase in English prices.

War disrupted financial affairs. To raise armies and pay for weapons and munitions kings and governments are forced to spend more than they have. A gold standard was usually abandoned in favor of printed money. By printing money, kings and governments were raising revenue through inflationary taxation. Such was the case in Britain during the Napoleonic Wars and in the U.S. with the Civil War. Inflation would be the by-product of war, and deflation and depression its aftermath. Prices in England and the U.S., however, were roughly the same at the beginning of the 20th century as they were early in the 19th century.

2.B Bretton Woods Agreements (1944-1973)

The leaders of the Allied countries met at Bretton Woods, New Hampshire in July 1944. They agreed to support a new international monetary system. To help to implement this system, the Bretton Woods Agreements created two institutions: the International Monetary Fund (IMF) and the World Bank. The agreement established regulation of foreign exchange rates that worked as follows:

(1) The central banks of all IMF member countries would keep their foreign exchange reserve in USD or GBP.

(2) Each member country would establish its currency's par value against the U.S. dollar. Thereafter, it would be responsible for maintaining its currency against the dollar within a band of plus or minus 1 percent. The IMF would help countries with temporary balance account problems.

(3) The U.S. agreed to maintain the dollar value by purchasing and selling gold at USD 35 per ounce.

To successfully fix the price of gold in terms of dollars, the Bretton Woods Agreements needed a player with a large stock of gold to supply to the market whenever there was a tendency for the market price of gold to increase, and a large stock USD with which to purchase gold whenever there is a tendency for the market price of gold to go down. The U.S. had plenty gold (nearly 60% of the world's stock) and, obviously, plenty of USD. Thus, the Bretton Woods system would have the U.S. remain the ultimate bulwark, maintaining the value of the dollar stable versus gold. The USD became the main reserve currency held by central banks and was the currency used for international transactions. Other nations would keep a stable, but flexible exchange rate mechanism.

By the late 1960s, the cost of the Vietnam War, plus the cost of the new domestic programs of the Great Society, began to put pressure on the USD. The U.S. was spending more than it produced. As a consequence, in 1958 the U.S. began to have large balance of payment deficits, which were partially financed with the creation of USD. High U.S. inflation caused the (private) market price of gold to rise above the Bretton Woods Agreements price of USD 35 per ounce. That is, the market value of the USD was below the official rate, relative to foreign currencies. A run on the USD followed as speculators (including investors, banks, and governments) rushed to buy gold from the U.S. at the official rate of USD 35 per ounce.

In March 1968, the effort to control the private market of gold was abandoned. A dual system was established. Official transactions (i.e., transactions among Central Banks) in gold would be carried out at the official rate of USD 35 per ounce. The private market could trade at the equilibrium market price. The private price of gold immediately increased to USD 43 per ounce. By the end of 1969, the price of gold went back to USD 35 per ounce.

The "dollar crisis of 1971" led President Nixon to suspend, in August 15, 1971, the dollar's convertibility into gold (due to expansive monetary policies). In the meantime, exchange rates of most of the leading countries were allowed to float in relation to the USD. By the end of 1971, most of the major trading currencies had appreciated vis-a-vis the USD. In December 1971, a major modification to Bretton Woods was declared (The Smithsonian Agreement). The price of gold was raised to USD 38 and the band of fluctuation was widened to plus or minus 2.25 percent. In early 1973 the U.S. dollar came under attack once again, forcing a second devaluation on February 12, 1973, this time the prices of gold was raised to USD 42.22. By late February 1973 the system totally collapsed. The major exchange markets were actually closed for several weeks in March 1973, and when they reopened, most currencies were allowed to float. The dual system that started in March 1968 was abandoned in November 1973. By then, the price of gold had reached USD 100 per ounce. Since that time (dirty) floating exchange rates have prevailed for the major countries.

Several economists argue that the Bretton Woods system worked acceptably well until the late 1960s. The market periodically forced countries to devalue their currencies, but the system helped to facilitate cross-border trade and stimulated economic development.

2.C Managed floating system and the G-7 Council

After the collapse of the Bretton Woods Agreements, the world observed a period of high risk in financial markets. High government deficits, high inflation and the OPEC oil embargo increased financial price volatility. Whether floating rates was the cause or the effect of monetary instability is the subject of continuing debate. Exchange rate volatility has been considered too high many times during the past 25 years. Overall, the world has had a managed (by central banks) floating exchange rate system.

In January 1976, the IMF convened a monetary summit in Jamaica to reach some agreement on a new monetary system. The Jamaica Accords formally recognized the managed floating system and allowed nations the choice of a foreign exchange regime as long as their actions did not prove disruptive to trade partners and the world economy. Gold was demonetized as a reserve asset. The Jamaica Accords were ratified in April 1978.

World leaders, however, still attempt to coordinate exchange rate policies. The most recent manifestation is so-called the "G-7" council of economic ministers. The exact goals of the council seem to change with economic conditions. In two of these meeting, the G-7 council of economic ministers agreed on a set of policies with regard to exchange rates. The Plaza Accord (September 1985), signed in the Plaza Hotel in New York City, agreed to coordinate an intervention aimed at lowering the value of the U.S. dollar. The dollar had already started to weaken in value during the summer of 1985 and the announcement of the Plaza Accord accelerated the U.S. dollar's decline. In fact, after this announcement, the dollar fell 4 percent in 24 hours. By the end of 1986, the G-7 council considered that the U.S. had depreciated "too much." The Louvre Accord (February 1987) agreed to stabilized exchange rates. This meant limiting the size of exchange rate fluctuations with the use of coordinated central bank intervention. This accord lasted until April 1990.

2.D Europe's Exchange Rate Mechanism and the Euro

Following the Smithsonian Agreements in April 1972, the European Economic Community -now, European Union (EU)- suggested that its members' countries limit the movement of their bilateral exchange rate to a 1.125 percent band. It became known as the "snake in the tunnel" or "snake." Expansive monetary policies forced the GBP out of the "snake" in two months. The "snake" lasted one year, but it was the basis for the European Monetary System, EMS, (March 1979) and its Exchange Rate Mechanism (ERM). The EMS called for the creation of a new currency, the European Currency Unit (XEU), or "ecu." The XEU was a GDP weighted average of the EMS currencies. Each member of the ERM had an assigned "XEU central rate" which was its targeted rate of exchange for the XEU, measured as the number of currency equal to one XEU. The ratio of any two currencies' XEU central rates was defined as their "bilateral central rate." The crux of the ERM was the requirement that each member must keep its currency's exchange rate around the bilateral parity rates. Originally, the margin was plus or minus 2.25 percent. The U.K. was admitted with a 6 percent band. Occasionally, countries were forced out of the ERM by market forces. Reentry into the system was usually at a much lower exchange rate than when the country had left, resulting in a currency devaluation. By September 1992, with the exception of Greece and Portugal, all EU members belonged to the ERM. Several European central banks, although not officially part of the EU, were voluntarily attaching their currencies to the ERM.

In December 1991, the then twelve members of the EU signed the Maastricht Treaty. The Treaty specified a plan to establish a full European Monetary Union (EMU), with single currency, the euro (EUR), and central bank, by January 1, 1999. The idea behind a single currency for the EU is that exchange rate fluctuations disrupt trade and market integration. Multiple currencies complicate price comparisons requires importers and exporters to hedge, and reduces the volume of intra-regional trade. The single currency created a new European monetary authority, the European Central Bank (ECB), which is now located in Frankfurt. The ECB and the National Central Banks (NCB) of the EU members form the European System of Central Banks (ESCB). The ESCB is based on the concept of a dual-layer central bank system. The decision-making is fully centralized at the ECB, while the implementation of the monetary policy is carried out by the NCBs. The highest decision-making body is the ECB Governing Council. The Council is composed of the six members of the ECB Executive Board and the Governors of the eleven NCBs of the participating members. The ECB Governing Council controls the overall monetary policy, which has a stated goal of "price stability."

The Maastricht Treaty also called for the integration and coordination of the member countries' monetary and fiscal policies. The idea was that, by the time the EMU started, the financial conditions of all the members had to be similar. Before becoming a full member of the EMU, each member had to meet the following criteria:

(1) Nominal inflation should be no more than 1.5% above the average for the three members of the EU with the lowest inflation rates during the previous year.

(2) Long-term deficit should be no more than 3% of GDP.

(3) Long-term interest rates should be no more than 2% above the average for the three members with the lowest interest rates.

(4) Government debt should have a continuous and significant movement towards a cap of 60% of GDP.

On January 1, 1999, eleven EU members joined the EMU: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Sweden. Permanent exchange rates -Austrian schilling (ATS) against EUR, French Franc (FRF) against EUR, and so on- for these eleven EMU members were set by the ECB on January 1, 1999. For example, a EUR was set to be equal to ATS 13.7603, and FRF 6.55957. The value of the EUR against the USD and other currencies fluctuates from January 1, 1999. Great Britain, Denmark and Sweden will decide later whether to join the EMU. Greece hopes to qualify early in the next decade.

The period from February 1992 to December 1998 was needed to decide on a name and a design for the new European currency. It was thought, all along, that the name of the new currency would be ecu. This stood for European Currency Unit and if spelled écu it represents the name of a medieval French coin. The German government, in 1995, demanded to drop the name ecu: ein ecu sounded too much like eine Kuh -in Germany, the new coin would be confused with a cow. The Spanish government suggested "euro." The Greeks did not approve of the name euro: it sounded like the Greek word for "urine." But Greece is not Germany in the EU, and the name euro was chosen.

For the composition of the coins, the European mint had decided on using nickel, which is abundant in France. The Swedes demanded a change: in Sweden nickel coins are banned, since it is believed they produce an allergic skin reaction. (Never mind that the Swedes produce copper.) Now, the lowest denomination euro coins -the 1-, 2-, and 5-cent coins) will be copper-platted steel. The 10-, 20-, and 50-cent coins will be made from a new yellowish alloy, invented in Finland. The 1- and 2-euro coins will contain nickel and most of it will be sandwiched inside a copper alloy, patented by the German company Krupp.

The euro is used by business conducting electronic and other noncash transactions. Euronotes and coins will not begin circulating until January 1, 2002. That is, during the three-year transition period, the euro is the legal currency for use in financial markets and other business activities. But the national currencies are still used for cash transactions. From January 1, 2002 to June 30, 2002, prices will be displayed in both old and new currencies. From July 1, 2002, the euro will be the only legal tender in member countries.

The creation of a single currency eliminates foreign exchange charges for cross-border European trade -the commission that banks now charge for changing GBP to DEM, FRF to ATS. It is estimated that the euro would save USD 65 billion a year in costs involved in exchanging currencies in the EU. Making Europe's currencies one will create a vast pool of capital that is far more mobile than before.

The eleven separate government bond markets have created a single, USD 2 trillion giant market. Europe's illiquid corporate bond market has the potential to grow into an active USD 800 billion market, more than four times its size in 1997. In only a few years, the Europeans hope to establish the sort of unified financial market that can compete with the U.S. financial market.

The common currency will also create problems and costs. EMU members have lost their independent monetary policies. The ECB decides the monetary policy for all the EMU members. It is natural to suppose that not all the EMU members will necessarily agree on a common monetary policy. For example, a national central bank increases the domestic money supply by buying domestic government bonds. When the ECB decides to increase the EUR money supply, what kind of bonds will the ECB buy: German, Dutch, or Irish? There will be a lot of disagreements about monetary policies.

Unemployment could also increase because of the common currency. Given the rigid European labor market and the lack of a common language, adjustments to shocks in a national economy will probably increase unemployment. Suppose that there is a sudden recession in Italy. Before January 1, 1999, the Central Bank of Italy could allow the depreciation of the Italian lire to increase foreign demand for Italian products. After the monetary union, the Central Bank of Italy cannot modify exchange rates. Therefore, Italian firms are not able to adjust salaries to reduce prices. Thus, Italian unemployment can increase.

3.A Organization

The foreign exchange market is the generic term for the worldwide institutions that exist to exchange or trade the currencies of different countries. It is loosely organized in two tiers: the retail tier and the wholesale tier. The retail tier is where the small agents buy and sell foreign exchange. The wholesale tier is an informal, geographically dispersed, network of about 1200 banks and currency brokerage firms that deal with each other and with large corporations. The foreign exchange market is open 24 hours a day, split over three time zones. Computer screens continuously show exchange rate prices. A trader enters a price for the USD/CHF exchange rate on her machine, and can then receive messages from anywhere in the world from people willing to meet that price. It does not matter to her whether the counterparties are sitting in London, Singapore, or, in theory, Buenos Aires. The foreign exchange market has no physical venue where traders meet to deal in currencies. When the financial press and economic textbooks talk about the foreign exchange market they refer to the wholesale tier. In this chapter we will follow this convention.

Currency markets are the largest of all financial markets in the world. A typical transaction in USD is about 10 million ("ten dollars," in dealer slang). In the last survey conducted by the Bank of International Settlements (BIS) in April 1998, it was estimated that the daily volume of trading on the foreign exchange market -spot, forward, and swap- was more than USD 1.5 trillion. This is about ten times the daily volume of international trade in goods and services and sixty times the U.S. daily GDP. The exchange market's daily turnover is also equal to the combined reserves of all central banks of IMF member states.

In April 1998, the major markets were London, with daily trades averaging USD 637 billion, New York (USD 350 billion), Tokyo (USD 149 billion) and Singapore (USD 139 billion). Frankfurt, Zurich, Paris, and Hong Kong have a daily volume between USD 70 and 95 billion. The top three traded currencies were USD, DEM, and JPY. London is the single biggest market. The USD and DEM were more heavily traded in the U.K. than in the U.S. or Germany.

Given the international nature of the market, the majority (66%) of all foreign exchange transactions involves cross-border counterpaties. This highlights one of the main concerns in the foreign exchange market: counterparty risk. A good settlement and clearing system is clearly needed.

3.A.1 Settlement of transactions

At the wholesale tier, no real money changes hands. There are no messengers flying around the world with bags full of cash. All transactions are done electronically using an international clearing system. The primary clearing system for international transactions is operated by SWIFT (Society for Worldwide Interbank Financial Telecommunication). The headquarters of SWIFT are located in Brussels, Belgium. SWIFT has global routing computers located in Brussels, Amsterdam, and Culpeper, Virginia, USA. The electronic transfer system works in a very simple way. Two banks involved in a foreign currency transaction will simply transfer bank deposits through SWIFT to settle a transaction.

The foreign accounts used to settle international payments can be held by foreign branches of the same bank, or in an account with a correspondent bank. A correspondent bank relationship is established when two banks maintain a correspondent bank account with one another. The majority of the large banks in the world have a correspondent relationship with other banks in all the major financial centers in which they do not have their own banking operation. For example, a large bank in Tokyo will have a correspondent bank account in a Malayan bank, and the Malayan bank will maintain one with the Tokyo bank. The correspondent accounts are also called nostro accounts, or due from accounts. They work like current (checking) accounts.

The foreign exchange market is largely an unregulated market. Only exchange-traded derivative contracts are subject to formal regulation. The U.S. banks participating in the spot market are supervised by the Federal Reserve System and must report their foreign exchange position on a periodic basis.

3.A.2 Activities

Speculation is the activity that leaves a currency position open to the risks of currency movements. Speculators take a position to "speculate" with the direction of the exchange rates. A speculator takes on a foreign exchange position on the expectation of a favorable currency rate change. That is, a speculator does not take any other position to reduce or cover the risk of this open position.

Hedging is a way to transfer part of the foreign exchange risk inherent in all transactions, such as an export or an import, that involve two currencies. That is, by contrast to speculation, hedging is the activity of covering an open position. A hedger makes a transaction in the foreign exchange market to cover the currency risk of another position.

Arbitrage refers to the process by which banks, firms or individuals attempt to make a risk-profit by taking advantage of discrepancies among prices prevailing simultaneously in different markets. The simplest form of arbitrage in the foreign exchange market is spatial arbitrage, which takes advantage of the geographically dispersed nature of the market. For example, a spatial arbitrageur will attempt to buy GBP at 1.61 USD/GBP in London and sell GBP at 1.615 USD/GBP in New York. Triangular arbitrage takes advantage of pricing mistakes between three currencies. As we will see below, cross-rates are determined by triangular arbitrage. Covered interest arbitrage takes advantage of a misalignment of spot and forward rates, and domestic and foreign interest rates.

3.A.3 Players and Dealing in Foreign Exchange Markets

The players in the foreign exchange markets are speculators, corporations, commercial banks, currency brokers, and central banks. Corporations enter into the market primarily as hedgers; however, corporations might also speculate. Central banks tend to be speculators, that is, they enter into the market without covering their positions. Commercial banks and currency brokers primarily act as intermediaries, however, at different times, they might be also speculators, arbitrageurs, and hedgers. All the parties in the foreign exchange market communicate through traders or dealers.

Commercial banks account for the largest proportion of total trading volume. In 1995, the BIS reported that 89 percent of all foreign exchange trading was either interbank (74%) or between banks and financial institutions including investment houses and securities firms (15%). Only 11 percent of the trading was done between banks and corporations. The high volume of interbank trading is partially explained by the geographically dispersed nature of the market and the price discovering process.

3.A.3.i Dealers, Market Makers and Brokers

A dealer's main responsibility is to make money without compromising their employer's image in any way. To this end, they take positions, that is, buy and sell securities using their employer's capital.

Many dealers act as market makers. Therefore, they are obliged to provide bids and offers to both competitors and clients upon request. That is, any interested parties can ask market makers for a two-way quote, a bid and an ask quote. Once given, the quote is binding, that is, the market maker will buy foreign exchange at the bid quote and sell at the ask quote. The difference between the bid and the ask is the spread. Market makers make a profit from the bid-ask spread. Bid-ask spreads are close to .03%, which are significantly lower than spreads in any other financial market with the exception of the Treasury bill market. The arithmetic average of the bid rate and the ask rate is called the mid rate. Market makers profit from the high volume in the foreign exchange market.

Another channel for dealing is through a broker. For example, a Bertoni Bank dealer contacts a broker offering to buy, say, JPY 500 million. The broker provides two prices: a bid and an ask, without revealing the name of the counterparty. If Bertoni Bank accepts the ask, then the broker will reveal the name of the counterparty so the electronic settlement of the transaction can be performed. If the broker cannot provide immediately a price, the broker will shop around and see if there are any sellers for this volume. Brokers make a profit from a fixed commission paid by both parties. Instead of going to a broker, Bertoni Bank can contact another bank and try to purchase directly from the other bank. This transaction is an interbank or direct dealing transaction. Direct dealing saves the commission charged by the broker. Direct dealing also reveals information about the position of other parties. Discovering other dealers' prices help dealers to determine the position of the market and then establish own prices.

A study by Richard Lyons, published in the Journal of Financial Economics, in 1995, analyzes the transactions of an interbank spot trader over a five-day period. This trader completed 267 transactions per day, that is one transaction every 67 seconds. The average daily volume traded by this trader was USD 1.2 billion. The majority of the transactions were direct deals; however, this trader tended to use brokers for larger than average transactions. In this study, Richard Lyons reports that the median spread between the bid and ask prices was DEM .0003, which represented less than 0.02 percent of the spot rate.

In 1992 Reuters introduced an automated brokerage system, Reuters Dealing 2000-2. The Reuters system allows dealers to enter their live prices. Prices appear on a screen as anonymous live quotations. Traders from around the world can hit a price from their terminals, then Reuters 2000 checks for mutual credit availability between the two counterparties and completes the transaction with ticket writing and confirmations.

Since the introduction of Reuters 2000, other competing systems were developed. The main competitors of Reuters 2000 are MINEX, developed by Japanese banks and Dow Jones Telerate, and Electronic Brokering Service, developed by Quotron and a consortium of U.S. and European banks.

3.B The Products of the Foreign Exchange Market

3.B.1 The Spot Market

The spot market is the exchange market for payment and delivery today. In practice, "today" means today only in the retailer tier. Currencies traded in the wholesale tier spot market have customary settlement in two business days.

In the interbank market, dealers quote the bid and the ask, willing to either buy or sell up to USD 10 million at the quoted prices. These spot quotations are good for a few seconds. If a trade is not done immediately over the phone or the computer, the quotes are likely to change over the next seconds. Traders use a particular system when quoting exchange rates. For example, the USD/JPY bid-ask quotes: .009002-.009063. The ".0090" is called the big figure, and it is assumed that all traders know it. The last two digits are referred as the small figure. Thus, it is clear for traders the meaning of a telephone quote of "02-63."

In 1995, the BIS estimated that the daily volume of spot contracts was USD 679.8 billion. Again, the majority of the spot trading is done between financial institutions. Only 11 percent of the daily spot transactions involved non-financial customers. The high volume of interbank trading is partially explained by the geographically dispersed nature of the market. Dealers trade with one another to take and lay off risks, and to discover transaction prices. Discovering other dealers' prices help dealers to determine the position of the market and then establish own prices.

3.B.1.i Direct and Indirect Quotations

An exchange of currencies involves two currencies, either of which may arbitrarily be thought as the currency being bought. That is, either currency may be placed in the denominator of an exchange rate quotation. When exchange rates are quoted in terms of the number of units of domestic currency per unit of foreign currency, the quote is referred to as direct quotation. On the other hand, when exchange rates are quoted in terms of the number of foreign currency units per unit of domestic currency, the quote is referred to as indirect quotation. The indirect quotation is the reciprocal of the corresponding direct quotation.

Most currencies are quoted in terms of units of currency that one USD will buy. This quote is called "European" quote. Exceptions are the "Anglo Saxon" currencies (British Pound (GBP), Irish punt (IEP), Australian dollar (AUD), the New Zealand dollar (NZD)), and the EUR. This second type of quote is also called "American quote."

(A) Indirect quotation: JPY/USD (European quote).

Suppose a U.S. tourist wishes to buy JPY at Los Angeles International Airport. A quote of JPY 110.34-111.09 means the dealer is willing to buy one USD for JPY 110.34 (bid) and sell one USD for JPY 111.09 (ask). For each USD that the dealer buys and sells, she makes a profit of JPY .75.

(B) Direct quotation: USD/JPY (American quote).

If the dealer at Los Angeles International Airport uses direct quotations, the bid-ask quote will be USD .009002-.009063 per one JPY. ¶

It is easy to generate indirect quotes from direct quotes. And viceversa. As Example I.6 illustrates:

S(direct)_bid = 1/S(indirect)_ask,

S(direct)_ask = 1/S(indirect)_bid.

The discussion about exchange rate movements sometimes is confusing because some comments refer to direct quotations while other comments refer to indirect quotations. From now on, unless stated otherwise, we will use direct quotations -that is, the domestic currency will always be in the numerator while the foreign currency will always be in the denominator.

In the foreign exchange market, banks act as market makers. They realize their profits from the spread. Market makers will try to pass the exposure from one transaction to another client. For example, a bank that buys JPY from a client will try to cover its exposure by selling JPY to another client. Sometimes, a bank that expects the JPY to appreciate over the next hours may decide to speculate, that is, wait before selling JPY to another client. During the day, bank dealers manage their exposure in a way that is consistent with their short-term view on each currency. Toward the end of the day, bank dealers will try to "square" the banks' position. A dealer who accumulates too large an inventory of JPY could induce clients to buy them by slightly lowering the price. Thus, because quoted prices reflect inventory positions, it is advisable to check with several banks before deciding to enter into a transaction.

3.B.1.ii Cross-rates

The direct/indirect quote system is related to the domestic currency. The European/American quote system involves the USD. But if a Malayan trader calls a Hong Kong bank and asks for the JPY/CHF quote, the Hong Kong bank will quote a rate that does not fit under either quote system. The Hong Kong bank will quote a cross rate. Most currencies are quoted against the USD, so that cross-rates are calculated from USD quotations, using triangular arbitrage strategies. For example, the JPY/GBP is calculated using the USD/JPY and USD/GBP rates. This usually implies a larger bid-ask spread on cross exchange rates.

S_bid,JPY/GBP= S_bid,JPY/USD x S_bid,USD/GBP= [(1/.0108) JPY/USD]x[(1.5670) USD/GBP] = 145.0926 JPY/GBP.

That is, Housemann Bank will never set the JPY/GBP bid rate below 145.0926 JPY/GBP.

Using a similar argument, Housemann Bank will set the ask JPY/GBP rate (sell GBP-buy JPY) using the following formula:

Consider, again, Example I.7. Suppose, now, that a Housemann Bank trader observes the following exchange rate quote: S_ask,JPY/GBP = 143.00 JPY/GBP. We can see that the JPY is overvalued in terms of GBP, since it is below the arbitrage-free bid rate of 145.0926 JPY/GBP. The trader automatically starts a triangular arbitrage strategy:

(1) Sell USD 1,000,000 at the rate .0108 USD/JPY. Then, the trader buys JPY 92,592,592.59.

(2) Sell JPY 92,592,592.59 at the rate of 143.00 JPY/GBP. The trader buys GBP 647,500.65.

(3) Sell GBP 647,500.65 at the rate 1.5670 USD/GBP. The trader buys USD 1,014,633.51.

This operation makes a profit of USD 14,633.51. The Housemann trader will try to repeat this operation as many times as possible. After several operations, the bank offering S_ask,JPY/GBP = 143.00 JPY/GBP

3.B.2 The Forward Market

A forward transaction is similar to a spot transaction. The settlement date, however, is deferred much further into the future. No cash moves on either side until that settlement date. That is, the forward market involves contracting today for the future purchase or sale of foreign currency. Forward transactions are indicated on dealing room screens for intervals of one, two, three and twelve month settlements. Most bankers today quote rates up to ten years forward for the most traded currencies. Forward contracts are tailor-made to meet the need of bank customers. Therefore, if one customer wants a 63-day forward contract a bank will offer it. Nonstandard contracts, however, are more expensive.

Forward quotes are given by "forward points." The points corresponding to a 180-day forward GBP might be quoted as .0100-.0108. These points can also be quoted as 8-100. The first number represents the points to be added to the second number to form the ask small figure, while the second number represents the small figure to be added to the bid's big figure. These points are added from the spot bid-ask spread to obtain the forward price if the first number in the forward point "pair" is smaller than the second number. The forward points are subtracted from the spot bid-ask spread to obtain the forward price, if the first number is higher than the second number. The combination of the forward points and the spot bid-ask rate is called the "outright price."

(A) Addition

The 180-days forward points are .0100-.0108 (8-100), then F_t,180 = 1.5770-1.5785 USD/GBP.

(B) Subtraction

The 180-days forward points are .0072-.0068 (68-4), then F_t,180 = 1.5602-1.5605 USD/GBP. ¶

Forward contracts allow firms and investors to transfer the risk inherent in every international transaction. Suppose a U.S. investor holds British bonds worth GBP 1,000,000. This investor believes the GBP will loose value against the USD, in the next 90 days. This U.S. investor can buy a 90-day GBP forward contract to transfer the currency risk of her British bond position.

A forward transaction can be classified into two classes: outright and swap. An outright forward transaction is an uncovered speculative position in a currency, even though it might be part of a currency hedge to the other side of the transaction. A foreign exchange swap transaction helps to reduce the exposure in a forward trade. A swap transaction is the simultaneous sale (or purchase) of spot foreign exchange against a forward purchase (or sale) of approximately an equal amount of the foreign currency.

In 1995, the daily volume of outright forward contracts amounted to USD 116 billion, or 7.3% of the total volume of the foreign exchange market. Unlike the spot market, 31% of transactions involved a non-financial customer. These non-financial customers typically use forward contracts to manage currency risk.

3.B.2.i Forward Premium and Forward Discount

A foreign currency is said to be a premium currency if its interest rate is lower than the domestic currency. On the other hand, a foreign currency is said to be a discount currency if its interest rate is higher than the domestic currency. Forwards will exceed the spot for a premium currency and will be less than the spot for a discount currency. For example, on November 9, 1994 (see Example I.11 below), the (forward) British pound was a discount currency. That is, the British pound is cheaper in the forward market.

It is common to express the premium and discount of a forward rate as an annualized percentage deviation from the spot rate. When annualized, the forward premium is compared to the interest rate differential between two currencies. The forward premium, p, is calculated as follows:

p = [(F_t,T - S_t)/S_t] x (360/T).

Note that p could be a premium (if p > 0), or a discount (if p < 0).

p = [(1.6167 - 1.62)/1.62] x (360/180) = -.0041.

The 180-day forward premium is -.41%. That is, the GBP is trading at a .41% discount for delivery in 180 days. ¶

3.B.3 The Foreign Exchange Swap Market

As mentioned above, in a foreign exchange swap transaction, a trader can simultaneously sell currency for spot delivery and buy that currency for forward delivery. A foreign exchange swap involves two currencies. For example, a sale of GBP is a purchase of USD and a purchase of GBP is a sale of USD. A foreign exchange swap can be described as a simultaneous borrowing of one currency and lending of another currency.

Swaps are typically used to reduce exposure to the short-term risk of currency rate changes. For example, a U.S. trader wants to invest in 7-day GBP certificates of deposit (CDs). Then, the U.S. trader buys GBP spot, uses the funds to purchase the short-term GBP CDs, and sells GBP forward. The sale of GBP forward protects the U.S. trader from an appreciation of the USD against the GBP, during the life of the GBP CD. Traders also use foreign exchange swaps to change the maturity structure of their overall currency position.

The foreign exchange swap market is the segment of the foreign exchange rate market with the highest daily volume. In 1995, currency swap transactions accounted for USD 776.6 billion out of the USD 1.5 billion daily foreign exchange market turnover. Foreign exchange swaps are usually very short-term contracts. The majority of them (71%) have a maturity of less than one week.

The foreign exchange swaps should not be confused with the currency swaps to be discussed in Chapter XI.

3.B.4 Newspaper quotes

Argentina (Peso)..... 1.01 1.01 .99 .99

Australia (Dollar).... .7532 .7535 1.3277 1.3271

Austria (Schilling)... .09415 .09364 10.62 10.68

Bahrain (Dinar)....... 2.6529 2.6529 .3770 .3770

Belgium (Franc) ..... .03219 .03203 31.07 31.22

Brazil (Real)........... 1.1848 1.1848 .8440 .8440

Britain (Pound)....... 1.6200 1.6137 .6173 .6197

30-Day Forward.. 1.6193 1.6130 .6173 .6197

90-Day Forward.. 1.6188 1.6125 .6177 .6202

180-Day Forward.. 1.6167 1.6104 .6185 .6210

Canada (Dollar)...... .7375 .7369 1.3560 1.3570

30-Day Forward.. .7375 .7369 1.3560 1.3570

90-Day Forward.. .7378 .7273 1.3553 1.3563

180-Day Forward.. .7372 .7366 1.3565 1.3575

3.C.1 Currency Futures

Currency futures are contracts traded in organized exchanges. They are standardized contracts that work like commodity futures. The International Monetary Market (IMM), a division of the Chicago Mercantile Exchange, lists contracts on major currencies with respect to the USD. The Philadelphia Board of Trade, the MidAmerica Commodity Exchange, and the Singapore International Monetary Exchange (SIMEX) also list currency futures contracts. Take the IMM's yen contract as an example. It settles in the months of March, June, September and December and calls for delivery of JPY 12.5 million at expiration. Margins are required.

3.C.2 Currency Options

Currency options are both exchange-listed and over-the-counter (OTC). Call options are contracts giving the owner ("buyer") the right, but not the obligation, to purchase a quantity of foreign currency at a fixed price (strike price) for a limited interval of time. Put options give the buyer the right to sell. The seller of the option is called the writer. The buyer pays an amount called a "premium" to the seller for the put or call option. The Philadelphia Stock Exchange lists calls and puts on foreign currency. Calls and puts on currency futures contracts are listed on the IMM and SIMEX.

IV. Looking Ahead

Foreign exchange rate risk refers to the possibility that a domestic investor's holding of foreign currency will change in purchasing power when converted back to the domestic currency.

How can we measure the effect of changes in exchange rates have on the price of foreign assets and liabilities? A simple mathematical relation links the rates of returns measured in the local currency of the foreign asset with those in the home country, or domestic, currency:

(1+r_d) = (1+r_f)(1+s_t,T) (I.1)

r_d: return in the domestic currency from t to t+T.

r_f: return on the foreign asset from t to t+T.

s_t,T: change of the foreign currency in terms of the domestic currency from t to t+T.

r_{d-US investor} = (1.1092)(1.0403) - 1 = .1539 (15.39%).

On the other hand, for a Japanese investor, investing in the U.S., the picture is different. During 1980-1999, the return on U.S. equities averaged an annual 12.60%. The USD depreciated against the JPY -3.87% annually. The return on U.S. equities for a Japanese investor was:

r_{d-Japanese investor} = (1.1260)(.9613) - 1 = .0824 (8.24%).

That is, both U.S. and Japanese investors would have been better off by investing in the Japanese stock market during the period 1980 and 1999. ¶

As Example I.12 points out, currency fluctuations have a very important role in the determination of r_d. We want to study what are the determinants that influence s_t. We also want to study to minimize the impact of unexpected changes in s_t,T on r_d. That is, we want to study how to hedge currency risk.

4.A Introduction to Currency Risk Management: Hedging and Insuring

Hedging programs attempt to lessen or eliminate the risk of a foreign currency exposure. For instance, a U.S. investor who buys (goes long) an Argentinean peso (ARS) bond could hedge the risk of a depreciation of the ARS by selling (going short) it forward. If the ARS were to fall (rise), there would be a decline (increase) in the U.S. dollar value of the bond. But this would be matched by a profit (loss) from the forward sale of the Argentinean peso. Hedges are symmetric with respect to exchange rate movements.

Insurance programs are asymmetric with respect to exchange rates. When combined with the currency exposure of the underlying position, downside losses are possible, but only to some maximum loss floor, and, of course, there is the chance of some upside profit. For instance, the same U.S. investor who buys an ARS bond could reduce the risk of a depreciation of the ARS by buying a call option on the USD. The call option gives the U.S. investor the right to buy USD at a set price. The investor will exercise the call option, only if it convenient. If the ARS appreciates, the investor will let not exercise the call option. That is, insurance programs are asymmetric with respect to exchange rate movements.

Situation:

It is January 1999. A U.S. investor is considering buying an ARS 100 bond. In January 1999, the exchange rate is 1 ARS/USD (S₉₉=1.00). The ARS 100 bond has a return of 10% in ARS. That is, if she buys the ARS bond, investing USD 100, in January 2000 she will receive ARS 110. The U.S. investor, however, does not care about ARS returns, but USD returns. She is facing currency risk: the USD value of her ARS investment in January 2000 is uncertain, since S₀₀ is not known. She is considering using currency forwards and currency options to reduce currency risk.

A. Hedging with Forward Contracts.

Suppose the U.S. investors decides to buy the ARS bond and at the same time she sells 110 ARS (buys USD) forward to an Argentinean bank. The one-year forward contract trades at 1.02 ARS/USD.

The hedged USD return on this investment is: (110/1.02) - 100 = USD 7.84. (This return is known in January 1999, regardless of the spot rate in January 2000.)

Now, suppose the investor does not hedge and there is a devaluation of the ARS of 10%, that is, S₀₀ = 1.10 ARS/USD. The no-hedge USD return is: (110/1.10) - 100 = 0.

B. Hedging with Option Contracts. (Insurance.)

Suppose that in January 1999, the same investor decides to buy the ARS 100 bond, but she prefers not to use a forward contract. Instead, she buys an ARS-put/USD-call option to sell ARS 110, with a strike price of 1.04 ARS/USD. The total premium for this option is ARS 1.

The minimum (exercised) return is: (110/1.04) - 100 - 1 = USD 4.76. (This minimum return is known in January 1999, regardless of the spot rate in January 2000.)

If S₀₀ = 1.10 ARS/USD, the investor will exercise the option and will obtain a return of USD 4.76.

If S₀₀ = 1.00 ARS/USD (no devaluation), the investor will not exercise the option and will obtain a return of (110/1.00) - 100 - 1 = USD 9. ¶

For a journalist perspective on the problems associated with fixed-exchange rates, see the first chapter of Lost Prophets: An Insider's History of the Modern Economists, by Alfred J. Malabre, Jr.

Part II of The New Market Wizards (interview with currency trader Bill Lipschutz), by Jack D. Schwager.

Parts of Chapter I were based on the following books:

International Financial Markets, by J. Orlin Grabbe, published by McGraw-Hill.

International Financial Markets and The Firm, by Piet Sercu and Raman Uppal, published by South Western.

International Investments, by Bruno Solnik, published by Addison Wesley.

Exercises:

1.- During the second semester of 2000, many currencies dropped to historic record-lows against the USD. According to observers, these currencies were the victims of a strong demand for U.S. assets? Take the South African rand (ZAR). What is the effect of a strong demand for U.S. assets on the ZAR/USD? (Hint: You are in South Africa. Draw a graph.)

2.- On September 19, 2000, the Wall Street Journal reported that the ECB Vice President Christian Noyer said "the euro is dangerously undervalued." How can the ECB intervene to increase the value of the euro? Draw a graph. Describe the effect of ECB intervention on European money markets.

4.- The Brazilian real is quoted 1.1848 BRR/USD, while the Argentinean peso is quoted 1.01 ARS/USD. Provide the BRR/ARS cross-rate.

5.- The ZAR is quoted as USD/ZAR=.2210-50, that is, the bid rate is .2210 and the ask rate is .2260. The Egyptian pound (EGP) is quoted as the USD/EGP=.3100-40. What is the implicit ZAR/EGP quotation?

6.- A BT-Alex Brown trader observes the following quotes:

S_JPY/USD = 123.39-49 JPY/USD.

S_CHF/USD = 1.7445-87 CHF/USD

S_JPY/CHF = 61.5450-107 JPY/CHF.

Can the BT-Alex Brown trader profit from these quotes?

i. What is the cross rate HKD/JPY?

ii. Compute the 90-day forward discount or premium for the JPY/HKD whose 90-day forward rate is 18 JPY/HKD. State whether your answer is a discount or premium.

8.- Describe the effects of the following events under the QTM:

i. A country is flooded with gold, while income remains constant.

ii. Income increases, while the stock of gold remains constant.

iii. The velocity of money increases, while income and stock of gold remain constant.

9.- The return of a Polish investment in USD was 22.87% during a nine-month period. During the same nine-month period the Polish zloty (PLN) devalued 5.23% against the USD. What was the return for the same period for a Polish investor (i.e., in PLN)?

10.- Go back to Example I.13.

Suppose the investor buys a call option to buy USD 100, with a strike price of 1.05 ARS/USD. The premium was ARS .90.

a) What is the minimum (exercised) return for our investor?

b) If S₀₀ = 1.04 ARS/USD, what is the net return of the operation?