THE FOREIGN EXCHANGE MARKET - Babson Collegefaculty.babson.edu/ricciardi/MMS/FX-2003.pdf · 2012-02-21 · The Foreign Exchange Market 1.0 Introduction Imagine yourself in a busy

THE FOREIGN EXCHANGE MARKET

Copyright © John E. Marthinsen2 April 2003

Copyright © John E. Marthinsen, 11/14/03 Revised 11/14/03

1

1

The Foreign Exchange Market

1.0 Introduction

Imagine yourself in a busy city, with an hour’s wait before your next meeting. With $20 inyour wallet, you walk by a McDonald’s restaurant and notice that it is offering a specialpromotion. The advertisement in the window says:

THIS MONTH ONLY!

GET A BIG MAC, FRIES, AND THE BEVERAGE OF

YOUR CHOICE FOR ONLY 4,569,000!

What’s going on here? Are you dreaming? Have you entered the Twilight Zone or is thissomeone’s idea of a practical joke? On the contrary, you are in Istanbul, Turkey whereprices are quoted in liras, and for each US dollar, you can get (as of 20 March 2003) about1,724,138 Turkish liras. Before buying lunch, you simply stop in the bank across thestreet from McDonald’s, exchange your $20 for about 35 million Turkish liras, and spendTL 4,569,000 (which are equivalent to about $2.65). Congratulations! In a matter ofminutes, you have not only satisfied your appetite, but you have become a multi-millionaire as well.

A quick glance at The Wall Street Journal on 21 March 2003 showed that the dollar wasworth approximately:

• 742 Chilean pesos,• 1,507 Lebanese pounds,• 1,245 South Korean wons, and• 9,017 Indonesian rupiahs.

At the same time, the US dollar was worth only about:

• 0.94 European Monetary Union euros,• 0.30 Kuwaiti dinars, and• 0.64 British pounds.


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Why are there such differences in exchange rate values? What determines a currency’sinternational value? Is the value of a nation’s currency a good measure of its health,wealth, and productivity?

Answering these questions and many others related to the foreign exchange market is thepurpose of this chapter. We will begin by discussing the basics: What are exchange rates?How does one interpret foreign exchange quotations in business periodicals? What is themeaning of appreciation and depreciation of a currency? What are the differences andsimilarities among the spot, forward, futures, and options markets in foreign exchange?What effects do foreign exchange transactions have on a nation’s monetary base andpotential money supply? What are the principal forces that cause exchange rates tochange?

1.1. What is so Special About the Foreign Exchange Market?

We will find as we systematically answer each of these questions and address the issuessurrounding them that foreign exchange markets are very similar to both commoditymarkets (e.g., wheat, sorghum, and platinum) and broadly-traded financial asset markets(e.g., stocks, bonds, and short-term securities). In fact, the similarities are so close thatmany analysts ask, “What is so special about foreign exchange markets? After all, isn’tmoney just another commodity whose international value is determined by the forces ofsupply and demand?” These particular analysts feel strongly that it is absurd forgovernments to intervene in foreign exchange markets. They ask “Why shouldgovernments tamper with currency markets when they wouldn’t consider meddling instock markets?” They bolster their case by citing the horrendous examples of resourcemisallocation and waste that have occurred over the twentieth century when governmentsintervened in agricultural markets with quotas, price supports, and subsidies.

While reading this chapter, remember that not everyone agrees that a nation’s currency isjust another commodity. In forming your own opinion on this issue, it is important tokeep a subtle distinction in mind. Virtually everyone agrees that foreign exchange marketstrade commodities called money and that the prices of these commodities are set by theforces of supply and demand (just like the prices of securities, stocks, bonds, wheat,sorghum, and platinum). At the same time, not everyone agrees that foreign exchangemarkets should be treated in the same way as the security, stock, bond, wheat, sorghum,and platinum markets. Many knowledgeable practitioners and analysts feel thatinternational currency markets deserve special treatment and that central banks and/orfederal governments should ensure that these markets remain stable.

Another question that arises is whether governments or central banks should intervene to


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ensure that foreign exchange markets remain “stable”, and what does the word stable mean?The problem is that stable means different things to different people; it also meansdifferent things to the same people at different points in time. For some individuals, stablemeans fixing the value of a currency relative to one particular currency (e.g., the dollar,euro, yen, or Yuan), a basket of foreign currencies (e.g., the Special Drawing Rights issuedby the International Monetary Fund), or a commodity (e.g., gold or silver). The wordstable to these individuals means having the government take away an element of risk facingtraders and investors in their international transactions. To others, stable means themarkets are not dominated by speculators. Rather, prices reflect the supply and demandpressures resulting from “legitimate” transactions of traders and investors.

1.2. Speculators: Who are They?

Before we move on, let’s pause to consider speculators and the business (or art) ofspeculation. By reading the popular press and listening to the graphic descriptions of somefinance ministers and politicians, one might get the impression that speculators are banditswho suddenly emerge from their lairs to wreak havoc in the financial community and thenreturn to their hideouts once the damage is done. Clearly, this view is misdirected. For themost part, speculators are the same companies that use the foreign exchange markets totrade, invest, and otherwise try to earn positive returns for their shareholders. They arealso individuals, like you and I, who are trying to save for retirement, clothe and feed theirfamilies, and give their children opportunities like studying at foreign universities. Forexample, a “speculator” may be a Thai father who bought US dollars at the beginning of1997 because his daughter studied at Babson College, and he feared a depreciation of thebaht against the US dollar. (With the precipitous drop in the value of the baht relative tothe dollar during 1997, this would have been a very smart father and a very luckydaughter).1

1.3. Foreign Exchange Regimes: Which one is Best?

From 1944 to the early 1970s, central banks of the world’s leading industrialized nations(e.g., Britain, Germany, France, and Italy) established “parity rates” against the US dollarand intervened in the foreign exchange markets to restrict their currencies from varyingoutside a narrow, two percent (plus/minus one percent) band of fluctuation. If thesecentral banks ran out of funds needed for intervention purposes, they could borrow (withinlimits) from the International Monetary Fund (IMF). In fact, serving as a source oftemporary liquidity for central banks was one of the primary reasons for creating the IMF,which began operations in 1947. Only under extreme circumstances could nations change 1 Many individuals have found that they can make small fortunes in the foreign exchange markets.Unfortunately, most of them started with large fortunes.


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4

their parity rates, and even then the changes were supposed to be discussed and pre-approved by the IMF.

Since the early 1970s, many of the nations that agreed to fix their exchange rates haveabandoned this system. Exhibit 1 shows the International Monetary Fund’s 2003classification of worldwide exchange rate arrangements and Exhibit 2 summarizes themeanings of the major categories listed in Exhibit 1.

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)11

. T

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. F

or E

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wit

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gal

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nter

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inan

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Sta

tistic

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arch

200

3, p

p. 2

– 3

.

7

Copyright © John E. Marthinsen, 11/14/03 Revised 11/14/03 7

Exhibit 2Description of Categories for Exchange Rate Regimes

ExchangeArrangements withNo Separate LegalTender

The currency of another country circulates as the sole legaltender or the member belongs to a monetary or currency union inwhich the same legal tender is shared by members of the union.

Currency Board A monetary regime based on an explicit legislative commitmentto exchange domestic currency for a specified foreign currency ata fixed exchange rate, combined with restrictions on the issuingauthority to ensure the fulfillment of its legal obligation.

Other ConventionsFixed PegArrangements

The country pegs their currencies (formally or de facto) at afixed rate to a major currency or a basket of currencies where theexchange rate fluctuates within a narrow margin of less than +/-1% around a central rate.

Pegged ExchangeRates WithinHorizontal Bands

The value of the currency is maintained within margins offluctuation around a formal or de facto fixed peg that are widerthan at least +/-1% around a central rate.

Crawling Pegs The currency is adjusted periodically in small amounts at a fixed,preannounced rate or in response to changes in selectivequantitative indicators.

Exchange RatesWithin CrawlingBands

The currency is maintained within certain fluctuation marginsaround a central rate that is adjusted periodically at a fixedpreannounced rate or in response to changes in selectivequantifiable indicators.

Managed Floatingwith No Pre-announced Path forthe Exchange Rate

The monetary authority influences the movements of theexchange rate through active intervention in the foreign exchangemarket without specifying, or precommitting to, a preannouncedpath for the exchange rate.

Independent Floating The exchange rate is market determined rates, with any foreignexchange intervention aimed at moderating the rate of change andpreventing undue fluctuations in the exchange rate, rather than atestablishing a level for it.

International Monetary Fund, International Financial Statistics, March 2003, p. 3.

8


The classifications in Exhibit 1 are not cast in concrete. They are living, ever-changingindexes of exchange rate arrangements. To highlight this point, Exhibit 3 shows the IMF’s1982 list of exchange rate arrangements. Comparing the various columns, it should be clearthat not only the exchange rate arrangements have changed, but a host of other things lookdifferent as well. For instance, how many nations can you find in Exhibit 1 that did notexist in 1982, only 21 years ago? Some of these nations were formerly part of the SovietUnion, and have since gained independence and set up their own monetary systems.Others have changed their names or witnessed the overthrow of their central governmentsby violent coups d’etat. There are also nations that have suffered the ravages ofhyperinflation and been forced to abolish their old currencies and establish new ones.

9


Exhibit 3Exchange Rate Arrangements

As of November 30, 1982

Currency pegged to

Flexibility Limited in terms ofa Single Currency orGroup of Currencies More Flexible

US DollarFrenchFranc

OtherCurrency SDR

Othercomposite2

SingleCurrency3

Cooperativearrangements4

Adjustedaccording to

a set ofindicators5

Othermanagedfloating

Independently

floatingAntigua & BarbudaBahamasBarbados

CameroonC. African Rep.

Bhutan (Indian Rupee)Equatorial

BurmaGuineaGuinea-BissauIran

AlgeriaAustriaBangladeshBotswana

AfghanistanBahrainGhanaGuyana

BelgiumDenmarkFranceGermany

BrazilChileColombiaPeru

ArgentinaAustraliaBoliviaCosta Rica

CanadaGreeceIsraelJapan

BelizeBurundi

Djibouti

ChadComoros

Congo

Guinea (Spanish Peseta)Gambia, The

Jordan

KenyaMalawi

Cape Verde

China, P.R.Cyprus

Indonesia

MaldivesQatar

Ireland

ItalyLuxembourg

Portugal Iceland

IndiaKorea

Lebanon

South AfricaUnited

DominicaDominican Rep.Ecuador

GabonIvory CoastMali

(Pound Sterling)Lesotho

MauritiusSão Tomé &Principe

FijiFinlandHungary

Saudi ArabiaThailandUnited Arab

Netherlands MoroccoNew ZealandNigeria

KingdomUnited States

Egypt

El Salvador

Niger

Senegal

(South African Rand)

Seychelles

Sierra LeoneKuwaitMadagascar

EmiratesPakistanPhilippines

EthiopiaGrenadaGuatemalaHaiti

TogoUpper Volta

Swaziland (South African Rand)

SomaliaVanuatuViet NamZaire

MalaysiaMaltaMauritania

SpainSri LankaTurkey

HondurasIraq

Zambia NorwayPapua New Guinea

UgandaUruguayWestern

JamaicaLao P.D. Rep

SingaporeSolomon Islands

SamoaYugoslavia

Liberia Sweden

LibyaMexicoNepal

TanzaniaTunisiaZimbabwe

NicaraguaOman

PanamaParaguayRomaniaRwandaSt. Lucia

St. VincentSudanSurinameSyrian Arab Rep.Trinidad and Tobago

VenezuelaYemen Arab Rep.Yemen, P.D. Rep.

End of Period

1979 1980 1981 1982

Classification status1 A QI QII QIII QI QII QIII QIV QI QII QIII Oct. Nov.Currency pegged to U.S. dollar 4 2 4 0 4 0 3 9 4 0 3 8 3 9 3 8 3 9 3 7 3 7 3 8 3 8 French franc 1 4 1 4 1 4 1 4 1 4 1 4 1 4 1 4 1 4 1 3 1 3 1 3 1 3 Other currency of which: pound Sterling

4(1)

4(1)

4(1)

4(1)

4(1)

4(1)

5(1)

5(1)

5(1)

5(1)

5(1)

5(1)

5(1)

SDR 1 4 1 5 1 5 1 5 1 5 1 4 1 5 1 5 1 5 1 6 1 6 1 6 1 6 Other currency composite 2 0 2 1 2 1 2 2 2 2 2 2 2 1 2 1 2 1 2 3 2 3 2 3 2 3Exchange rate adjusted according to a set of indicators 3 3 4 4 4 4 4 4 4 4 4 5 5Cooperative Exchange arrangements 8 8 8 8 8 8 8 8 8 8 8 8 8Other 3 3 3 3 3 3 3 4 3 3 3 6 3 6 3 7 3 8 3 9 3 9 3 7 3 7 Total 139 139 140 141 141 141 143 143 145 146 146 146 146

10


Although Exhibits 1 and 2 are helpful lists, one important piece of information they donot show is whether the exchange rates systems the nations chose were ideal. The properchoice of system matters, because sticking to the wrong arrangement for too long anddefending it with scarce resources (e.g., international reserves) can have a sizeable negativeimpact on a nation’s growth rate and lower its residents’ standards of living. Some of themost sensational exchange rate crises during the twentieth century have involved nationsthat pegged their exchange rates at unsustainable levels for extended periods.

To illustrate this point, we don’t have to go back to crises that occurred in the post WorldWar I, Great Depression, and post World War II periods. We don’t have to start in the1970s when the Bretton Woods system tumbled and then fell (1971), or when theSmithsonian Agreement collapsed (1973). Let’s not even pause to consider the series ofcrises during the 1980s (in countries like Mexico) and the turmoil set off by theinternational debt crises. If we focus only on the 1990s, we have enough examples to makea case that choosing and defending unrealistic exchange rates can be a recipe for disaster. InOctober 1992, worsening economic conditions increased the costs that central banks boreto defend their exchange rates and, in the end, forced the pound, lira, punt, peseta, andescudo out of the European Monetary System. The Mexican crisis in 1995 and the “AsianTiger” crisis in 1997 – 1998 are more recent examples of exchange rate systems that couldnot be maintained, ultimately costing billions of dollars to defend and resulting in economiccosts that are still being tallied. Later chapters in this book will investigate these crises andput them into perspective.

2.0. Exchange Rates

An exchange rate is the price of one currency in terms of another currency. For example, ifthe British pound sterling were worth $2.00, then $2.00/£ would be the expression of thisexchange rate, and the reciprocal of the dollar-pound exchange rate would be the pound-dollar exchange rate. If one pound were worth $2.00, then one dollar would be worth£0.50, and the expression for this exchange rate would be £0.50/$ (which can be stated as“one-half pound per dollar”).

2.1. The Reciprocal Nature of Exchange Rates

Understanding that exchange rates can be expressed in either of two ways should serve as awarning to anyone discussing the foreign exchange market. Always be sure that your

11


audiences (and you) understand whether it is dollars per pound or pounds per dollar that isbeing discussed.

The reciprocal nature of exchange rates also highlights one of the most fundamentalprinciples of international finance: namely, if currency A rises in value (falls in value)relative to currency B, then currency B must fall in value (rise in value) relative to currencyA. It is a mathematical necessity, and a short example will show why this is so. Supposethe dollar-pound exchange rate were $2/£ -- which could also be stated as £0.5/$. If thepound were to change in value to $1.00/£, then its reciprocal must be £1.00/$. In this case,the value of the pound fell from $2 to $1. At the same time, the value of the dollarincreased from £0.50 to £1. In other words, having the dollar’s value increase relative tothe pound carried exactly the same meaning as having the pound’s value decrease relative tothe dollar.

2.2. What Is an Appreciation or Deprecation of a Currency?

An increase in the value of currency A relative to currency B is called an appreciation (orrevaluation) of currency A. For example, a rise from $1.50/£ to $2/£ is an appreciation ofthe pound. A decrease in value of currency A relative to currency B is called a depreciationof currency A. For example, a fall from $2.00/£ to $1.50/£ is a depreciation of the pound.

3.0. The Spot Market in Foreign Exchange

3.1. Introduction to the Spot Market

Most newspaper and television analyses of foreign exchange developments focus on thespot markets -- and for good reason. The spot rate determines how much traders,investors, speculators, governments, and central banks must pay to purchase foreignexchange for current delivery. Many analysts follow movements in the spot marketclosely, because they feel such movements are indicators of the economic health of a nationrelative to its trading partners.

Day-to-day transactions for immediate (or close to immediate) delivery are conducted onthe spot exchange market – but what does “immediate” delivery mean? In the past, theadjective “spot” was more descriptive than it is today, because delivery was actually made“on the spot”. Today, settlement is normally delayed for two working days to allow forback office administrative handling of accounts, check clearing time, and ease of payment.In other words, US importers contracting on Monday to buy spot Euros must wait untilWednesday, two working days later, for actual payment and delivery of the currency to

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their accounts. If the transaction were arranged on Thursday, it would be settled on thefollowing Monday.

3.2 Size of the Foreign Exchange Markets

The foreign exchange markets are huge by any definition of the term, and they rank amongthe most competitive in the world. These markets come as close as any to the “purelycompetitive” benchmark market used in economic analyses. There are many buyers andsellers – so many that no one buyer or seller can influence the price. There is virtuallyperfect information among a periphery of active traders. Entry into and exit from themarket are impediment-free. Finally, the markets trade homogeneous products. It is hardto imagine products more homogeneous than currencies. What could be more homogeneousthan a (dematerialized) checking account?

Exhibit 4 and Exhibit 5 show the results of the most recent Bank for InternationalSettlements’ survey of foreign exchange activity. The survey was conducted during Apriland June 2001 and, according to the BIS estimates, daily transactions in all the foreignexchange markets exceeded $1.2 trillion. Daily spot transactions, the focus of this section,were $387 billion. Forwards, futures, options, and swaps (all described later in thischapter) comprised the remaining transactions.

The survey also showed that the US dollar was still the dominant currency in theinternational financial market, with 45%2 of all currency transactions having US dollars asone of the counter currencies -- a relative market share over twice as large as that of thesecond placed Euro and almost four times as large as that of the third placed Japanese yen(see Exhibit 5).

2 Notice that 45% is half the 90% figure shown in Exhibit 4. The percentages in Exhibit 4 sum to 200%because the Bank for International Settlements included both sides of each transaction. Every foreignexchange transaction involves two currencies. Therefore, a currency breakdown in which both currencies arecounted must sum to 200%.

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Exhibit 4Summary of Global Aggregates

Foreign Exchange Market Turnover a

April 1989 April 1995 April 2001

Categories

Dailyaverages

in billionsof US

dollars

Dailyaverages

inbillionsof US

dollars

Percentagechange1989-95

Dailyaverages

inbillionsof US

dollars

Percentage change1995-2001

Spot transactions 317 494 56% 387 -22%

Outright forwards 27 97 259% 131 35%

Foreign ExchangeSwaps

190 546 187% 656 20%

Estimated Gaps inReporting

56 53 -5.4% 36 -32%

All “traditional”market segments

590 1,190 102% 1,210 -2%

Futures and options c 30 70 133% 80 14%

a) Adjusted for local and cross-border double counting, except for futures and exchange-traded options; includes estimated gaps in reporting

c) Including OTC and exchange-traded options

Source: Bank for International Settlements, Monetary and Economic Department, Triennial Central BankSurvey of Foreign Exchange and Derivatives Market Activity: 2001, Basel, April and June 2001.

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Exhibit 5Use of Selected Currencies on One Side of the Transaction as a

Percentage of Global Foreign Exchange Market Turnover

(percentage shares)

Currency Apr-89 Apr-92 Apr-95 Apr-98 Apr-01

US dollar 90 82 83 87 90

German mark 27 40 37 30 NA

Japanese yen 27 23 24 20 23

Pound sterling 15 14 10 11 13

French franc 2 4 8 5 NA

Swiss franc 10 9 7 7 6

Canadian dollar 1 3 3 4 4.5

Australian dollar 2 2 3 3 4

Euro NA NA NA NA 38

ECU and OtherEMS currencies

4 12 16 17 NA

Currencies ofother reportingcountries

0 3 2 8 14.5

Other currencies 22 8 7 8 7

All currencies 200 200 200 200 200

Source: Bank for International Settlements, Monetary and Economic Department,Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity:2002, Basel, April and June 2001.

3.3 Impact of Foreign Exchange Transactions on Money Supply?

Most of us first experienced the foreign exchange market when we visited a foreign countryand had to exchange our domestic currency for a foreign currency. In these transactions, wewalked into a bank with one currency (e.g., dollars) and physically carried out another

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currency (e.g., pesos). Although, it is tempting to use these experiences from our travels asthe basis for conceptualizing the modern-day foreign exchange market, this perspectivecovers only a small minority of all daily foreign exchange transactions and, as we will seelater in this section, will only hinder your understanding of the impact foreign exchangetransactions have on nations’ money supplies.

Literally millions of foreign exchange transactions take place each day. By pure volumealone, wholesale transactions (i.e., amounts equal to or greater than one million dollars insize) are the most important. When these large transactions are conducted, the last thingparticipants want (both for security and convenience reasons) is to have the physicalcurrency delivered to their places of business. Foreign exchange transactions of anysignificant size are settled by giving participants bank deposits in the country where thecurrency was issued. In other words, if a US importer purchased yen with US dollars, shewould receive a yen deposit in a bank located in Japan. The bank in Japan could beJapanese-owned or foreign-owned. In this regard, ownership is not important. The criticalprerequisite is that it be located in Japan. Similarly, the seller of the yen would receive adollar deposit in a bank located in the US. Again, the bank in the US could be US-owned orforeign-owned.

Physical location, and not the banks’ ownership, is the key prerequisite because of therelative efficiency (i.e., cost, speed, and accuracy) of the domestic clearing systemcompared to foreign clearing systems. Typically, the domestic financial system handlestransactions involving the domestic currency far more efficiently than foreign financialsystems.

3.4. The Foreign Exchange Market and Its Effect on the Money Supply and MonetaryBase

How you conceptualize the foreign exchange market is important because some powerfulconclusions are easier to understand when they are seen in the proper light. The effect thatforeign exchange transactions have on the size of a nation’s money supply is one of them.What happens to a nation’s money supply when a foreign exchange transaction takesplace? If your mindset is that of a tourist walking into a bank, then you might be temptedto answer that the money supply falls since it has obviously left the country, but thisanswer is not correct.

To see why, let’s start by looking at the definitions of the monetary base and the M1money supply. The monetary base includes currency in circulation (i.e., currency outsidebanks) and bank reserves. M1, typically the narrowest definition of money, includescurrency in circulation and checking accounts. If customers exchanged their bank checking

16


accounts for cash, then checking accounts would fall by the same amount that currency incirculation rose. As a result, these transactions would have no effect on either themonetary base or M1. For the monetary base, the cash in circulation (i.e., the cash in ourwallets) would come from bank vaults; thus, bank reserves would fall by the same amountcurrency in circulation increased. Similarly, these transactions would have no effect on M1since checking accounts fell by the same amount that currency in circulation increased.

Suppose a Swiss resident traveled to Mexico. Upon arriving, he exchanged Swiss francs forMexican pesos at a bank in Mexico City. What would happen to the Swiss francs afterthey were exchanged? At the day’s end, the bank in Mexico would have the netaccumulation of Swiss francs in its vault (along with other currencies from nations aroundthe world). The problem with these paper currencies (and coins, if the Mexican banksaccepted them – many international banks do not) is that they do not earn interest and, inaddition, take up scarce vault space. Sure, the Mexican bank would keep some of thesefunds to meet the needs of its customers, who might want to visit these foreign nations, butmost of the hard cash would be counted, wrapped, and sent back to the country of issue (inthis case Switzerland). There, they would be deposited in correspondent bank accountsand credited to the Mexican bank. Keeping such deposits is one of the major reasons forhaving correspondent bank arrangements, and as you might have guessed, thesearrangements are plentiful.

The main point is that the funds never (really) leave the country of issue, and as a result,they do not reduce the nation’s monetary base. Even the small amounts that remain abroadin banks’ vaults and in individuals’ wallets do not reduce either the nation’s monetary baseor M1. These funds are still counted as part of the nation’s currency in circulation. Theirphysical presence in foreign countries is not netted from total outstanding currency. Weknow that most foreign exchange transactions involve buying and selling claims to checkingaccounts rather than actual cash transactions. These claims are actually legal titles ofownership to bank accounts, and these accounts do not leave the country. One can viewthe transfer of ownership on bank deposits in much the same way one views the transfer ofownership for a piece of land. The title is transferred, but the land never leaves thecountry.

With this in mind, let’s ask the same question as before (i.e., what happens to a nation’smoney supply when a foreign exchange transaction takes place?), but this time, we willimagine a multi-million Swiss franc bank account changing hands. Suppose 5 million Swissfrancs (SFr 5 million) were exchanged for 30 million Mexican pesos (Ps 30 million). Theaccount of the Swiss franc seller would fall as she gave up legal title to her Swiss francdeposit in Switzerland. At the same time, the Swiss franc buyer (i.e., the Mexican pesoseller) would gain legal title to these funds at a bank somewhere in Switzerland (but not

17


necessarily the same bank that was debiting the seller’s account). There would be nochange in either the Swiss money supply or the Swiss monetary base. Legal ownership ofthe Swiss franc checking account would simply be transferred from the seller to the buyer.Similarly, in Mexico, legal title to the 30 million Mexican pesos would be transferred fromthe peso seller to the peso buyer (both of them do not need an account at the same bank).Thus, there would be no change in either the Mexican money supply or the Mexicanmonetary base.

At the back of your mind, you might be wondering whether a nation should be concerned iftoo many foreigners own checking accounts in its banks. The answer depends on whereyour concerns lie. In general, there is no need for alarm because the checking accountsaren’t going anywhere. As it is, they never leave the country. Should foreign holders ofthese checking accounts suddenly want to get rid of them, they would have to findindividuals with foreign exchange who wanted to buy them. Of course, selling the currencywould cause its value to fall, and such a decline would have a double-edged effect on thenation’s economy. It would make imports from foreign nations more expensive and alsomake its own exports less expensive (internationally more competitive) to foreigners.

3.4 Trading Currencies in the Spot Currency Markets

Spot currencies are not bought or sold on the floor of any exchange, like the New YorkStock Exchange. Rather, trades are made on the "over-the-counter" market through myriadinstruments - telephone, telex, fax, and Internet lines that connect banks and brokers withcorporations, individuals, and other customers.

It is a market that never sleeps. When currency traders in New York City rise eachmorning at 5:00 AM, one of their first calls (even before they get to work) is to London,where it is already 10:00 AM. International foreign exchange markets overlap; therefore,quotes are transferred from market to market in a continual chain. From London to NewYork to Chicago, San Francisco, Tokyo, Hong Kong, Singapore, Zurich, and finally back toLondon, trading activity passes smoothly from time zone to time zone -- five days a week,24 hours a day.

The key features of the uniform prices of globally-traded currencies were mentioned earlier:many buyers and sellers, impediment-free entry into and exit from the market, andhomogeneous products. Uniform prices also require virtually perfect information, but thisdoes not mean that everyone who participates in the foreign exchange markets has to knowexactly what is happening all over the world 24 hours a day. What it means is that thereexists a core of marginal or peripheral traders who buy and sell currencies based on the

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latest, most up-to-date information, and that this information is available to anyone whohas the technology, time, and motivation to acquire it.

Without all the aforementioned characteristics, currency prices could vary from country tocountry and from city to city. Take for instance a trader at Union Bank of Switzerland(UBS) in Zurich who receives a huge order from the Treasurer at Roche Holding Ltd.,Basel, to purchase one billion US dollars (US$1 billion) with the company’s Swiss francdeposits. Without an international communication network, how would the trader pricethis transaction? Most likely, he would price it in the context of both the inventories ofdollars owned by UBS and the other dollar –Swiss franc transactions conducted by UBS.

Without the broader, worldwide perspective, this $1 billion order could raise the priceRoche would have to pay for the dollars, because the dealer would enter into thistransaction without knowing the worldwide demand and supply conditions. For instance,it is likely that at the same time Roche was making its US$1 billion purchase in Zurich, anequal amount of dollars was being offered by means of numerous, smaller transactions ofindividuals and businesses around the world. Under these circumstances, the dollarsdemanded by Roche could be supplied through the worldwide network of banks andbrokers. It would not be important how many dollars UBS owned or how much of thetotal dollar business was transacted through UBS. It would only matter whether UBScould buy these dollars from other banks and then funnel a total of $1 billion to Roche.This networking capability is a major function of the foreign exchange market.

Worldwide, the spot markets are so closely interconnected that exchange rates quoted inZurich, London, and Tokyo are identical to those quoted in New York City. They shouldbe! If they were not, savvy foreign exchange arbitrageurs, with access to this informationwould be able to buy in the cheap market and simultaneously sell in the dear market, rakingin millions of dollars in riskless profits. Think how easy life would be if riskless profitopportunities were available. We all could trade currencies for just a few days, and thenretire for life.

If this sounds like fun and something you might like to try, be aware that it never happenson such a grand scale, and for a simple reason: everyone wants to make riskless profits! Asa result, any slight differential in exchange rates across the globe triggers enormous flows offunds that erase any discrepancies. Again, consider the magnitudes. A "small" transactionin the spot market is considered to be anything under $1 million and the average dailyvolume exceeds $1.2 trillion. If there were a chance to earn riskless profits, the dailyvolume would rise dramatically to take advantage of the opportunity. Thousands offoreign exchange traders spend their entire workweek in front of computer screens looking

19


for opportunities to earn a few “pips”3 in profits. Earning ten guaranteed (i.e., risk-free)pips on a billion British pound deal translates into a one million dollar gain (i.e.,£1,000,000,000 x $0.0010/£) for doing about 30 seconds of work!

3.5 Interpreting Exchange Rate Quotes

Spot exchange rates are quoted in terms of a buying rate (i.e., the rate at which the bankbuys foreign exchange from the customer) and a selling rate (i.e., the rate at which the banksells foreign exchange to the customer). As Exhibit 6 shows, the buy (or bid) rate isalways lower than the sell (or ask) rate. The spread between the two is the bank’s profitmargin. In effect, banks act like any wholesaler or retailer by purchasing commodities (inthis case foreign currencies) at one price and then selling them at higher prices.

There are two related but differently priced markets for foreign exchange: the retail marketand the wholesale market. The retail market handles relatively small transactionsconducted by low volume customers, such as small- to moderate-sized corporations,tourists, and other individuals. The wholesale market is for large customers, such as banks,big corporations, central banks, governments, and supranational authorities or agencies.

Retail customers pay bid/ask spreads that are much wider than the spreads wholesalecustomers pay. One reason for the difference is that retail trades have higher transactioncosts. The larger the transaction, the greater is the opportunity for dealers to spread outtheir fixed costs and thereby lower the unit cost of the foreign exchange. After all, howmuch extra time does it take to put a few more zeros on a foreign exchange agreement?Another reason for the spread differential is the intense competition among banks in thewholesale market to tap the business of large customers.

3 A pip is typically one-hundredth of one cent or $0.0001 per unit of foreign currency.

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Exhibit 6Foreign Exchange Quotations

Bid/Ask Spread

Ask RateRate at which banks sell foreign exchange

Foreign Exchange Bank Profit Margin Quotes

Bid RateRate at which banks buy foreign exchange

3.6 Understanding the Spot Foreign Exchange Quotations in Business Publications: TheWall Street Journal

Exhibit 7 presents the foreign exchange quotations from The Wall Street Journal on Friday,March 21, 2003. Notice that these published rates are not the closing prices for March 21,but rather the closing rates for the previous working day -- in this particular case,Thursday, March 20, 2003. Immediately above the words EXCHANGE RATES, TheWall Street Journal has printed “Thursday, March 20, 2003” as the value date.

In the introductory paragraph after the words EXCHANGE RATES, some important factsabout these quotations are cited. First, they are selling (or ask) rates, meaning that they

21


are the prices at which banks would be willing and able to sell foreign currency. Thebuying (or bid) rates, as mentioned in the previous section, would be lower. Second, thequotes are for transactions that are $1 million or more in size. Therefore, they refer to thewholesale and not the retail market. Finally, the exchange rates are quoted as of 4:00 PM,Eastern Standard Time. Since foreign exchange rates change continuously throughout theday, there is no guarantee that the 4:00 PM rates were either a good reflection of theaverage rate for that day or that they hold steady overnight.

The first column of Exhibit 7 identifies the major countries and currencies in the foreignexchange market. The second column shows these currencies' values in terms of how manydollars are needed to purchase one unit of foreign currency (i.e., dollars per foreigncurrency). For example, on the line with the heading Britain (Pound) we see that Britishpounds cost $1.566 (i.e., $1.566/£) on closing of Thursday, March 20, 2003. For purposesof comparison, the third column shows the dollar per pound rates at closing onWednesday, March 19, the previous working day. Notice that the British poundappreciated from $1.5644 on Wednesday to $1.566 on Thursday. Columns four and fiveare also spot exchange rates for March 20 and 19, respectively, but are quoted in terms ofthe number of foreign currency units needed to purchase one US dollar (i.e. foreigncurrency per dollar). Looking at the Swiss franc quotes, we see that the dollar depreciatedfrom SFr 1.3941 on Wednesday to SFr 1.3873 on Thursday.

The exchange rates printed on the same line as the country names are called spot rates ofexchange. Those rates listed immediately under certain countries' (i.e. Britain, Canada,France, Germany, Japan, and Switzerland) spot rates are called forward exchange rates.The forward exchange market will be discussed in the next section.

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Exhibit 7

Foreign Exchange Quotes for Thursday, March 20, 2003From the March 21, 2003 edition of The Wall Street Journal

CURRENCY TRADING

U.S. equiv.CurrencyPer U.S. $

Country Thu Wed Thu WedPakistan (Rupee) .01730 .01730 57.804 57.804Peru (new Sol) .2867 .2869 3.488 3.4855Philippines (Peso) .01837 .01817 54.437 55.036

Thursday, March 20, 2003

EXCHANGE RATESThe foreign exchange mid-range rates below apply to tradingamong banks in amounts of $1 million and more, as quoted at4 p.m. Eastern time by Reuters and other sources. Retailtransactions provide fewer units of foreign currency per dollar. Poland (Zloty) .246 .2452 4.065 4.0783

Currency Russia (Ruble) (a) .03186 .03186 31.387 31.387U.S. $ equiv. Per U.S. $ Saudi Arabia (Riyal) .2666 .2667 3.7509 3.7495

Country Thu Wed Thu Wed Singapore (Dollar) .5660 .5645 1.7668 1.7715Argentina (Peso) .3292 .3317 3.0377 3.0148 Slovak Rep. (Koruna) .02532 .02523 39.495 39.635Australia (Dollar) .5934 .5898 1.6852 1.6955 South Africa (Rand) .123 .1221 8.1301 8.1900Bahrain (Dinar) 2.6526 2.6522 .3770 .3770 South Korea (Won) .0008035 .0007955 1244.56 1257.07Brazil (Real) .2879 .2890 3.4734 3.4602 Sweden (Krona) .1158 .1149 8.6356 8.7032Britain (Pound) 1.5660 1.5644 .6386 .6392 Switzerland (Franc) .7208 .7173 1.3873 1.3941 1-month forward 1.5629 1.5611 .6398 .6406 1-month forward .7214 .7179 1.3862 1.393 3-months forward 1.5568 1.5549 .6423 .6431 3-months forward .7226 .7190 1.3839 1.3908 6-months forward 1.5477 1.5459 .6461 .6469 6-months forward .7241 .7205 1.3810 1.3879Canada (Dollar) .6751 .6745 1.4813 1.4826 Taiwan (Dollar) .02881 .02876 34.71 34.771 1-month forward .6741 .6734 1.4835 1.485 Thailand (Baht) .02326 .02325 42.992 43.011 3-months forward .6717 .6711 1.4888 1.4901 Turkey (Lira) .00000058 .00000058 1724138 1724138 6-months forward .6678 .6671 1.4975 1.499 United Arab (Dirham) .2723 .2722 3.6724 3.6738Chile (Peso) .001347 .001354 742.39 738.55 Uruguay (Peso) ….. ….. ….. …..China (Renminbi) .1208 .1208 8.2781 8.2781 Financial .03500 .0348 28.571 28.736Colombia (Peso) .0003384 .0003382 2955.08 2956.83 Venezuela (Bolivar) .000626 .000626 1597.44 1597.44Czech. Rep. (Koruna) ….. ….. ….. ….. SDR 1.3584 1.3573 .7362 .7368 Commercial rate .03346 .03343 29.886 29.913 Euro 1.0618 1.0560 .9418 .9470Denmark (Krone) .1428 .1421 7.0028 7.0373Ecuador (U.S.$) 1.000 1.000 1.000 1.000Egypt (Pound)-y .1748 .1753 5.7198 5.7052Finland (Markka) .1842 .1845 5.4281 5.4198Hong Kong (Dollar) .1282 .1282 7.8003 7.8003Hungary (Forint) .004312 .004306 231.91 232.23India (Rupee) .02096 .02099 47.710 47.642Indonesia (Rupiah) .0001109 .0001100 9017.00 9091.00Israel (Shekel) .2103 .2102 4.7551 4.7574Japan (Yen) .008319 .008300 120.21 120.48 1-month forward .008328 .008310 120.08 120.34 3 months forward .008345 008327 119.83 120.09 6 months forward .008371 .008352 119.46 119.73Jordan (Dinar) 1.4094 1.4094 .7095 .7095Kuwait (Dinar) 3.3238 3.3241 .3009 .3008Lebanon (Pound) .0006634 .0006634 1507.39 1507.39Malaysia (Ringgit) - b .2632 .2632 3.7994 3.7994Malta (Lira) 2.5153 2.505 .3976 .3992Mexico (Peso) …… …… ……. ……. Floating rate .0924 .0922 10.8225 10.8425New Zealand (Dollar) .5533 .5482 1.8073 1.8242Norway (Krone) .1350 .1337 7.4074 7.4794

Special Drawing Rights (SDR) are based on exchange rates for the U.S.,German, British, French, and Japanese currencies. Source: International Monetary Fund. European Currency Unit (ECU) is based on a basket of community currencies. a-fixing, Moscow Interbank Currency Exchange.

The Wall Street Journal daily foreign exchange data for 1996 and 1997 may bepurchased through the Readers’ Reference Service (413) 592-3600.

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The following sections have been deleted from this chapter. If you are interested in anyof these topics, please contact Professor John Marthinsen for these pages.

4.0 The Forward Exchange Market

4.1 Forward Exchange Rate

4.2 Where Is Forward Exchange Bought and Sold?

4.3 Understanding Forward Foreign Exchange Quotations in Business Publications: TheWall Street Journal

4.4 Uses of the Forward Exchange Market

4.4.1 Example 1: US Importers’ Use of the Forward Exchange Market

4.4.2 Example 2: US Exporters’ Use of the Forward Exchange Market

4.4.3 Example 3: US Investors’ Use of the Forward Exchange Market

4.5. Why Do Forward Rates Differ From Spot Rates?

4.6. What Is the Swap Market in Foreign Exchange?

5.0 The Futures Market in Foreign Exchange

5.1 What Is the Futures Market?

5.2 Markets for Futures Contracts

5.3 Understanding Foreign Exchange Quotations: The Futures Market

5.4 Purchasing a Currency Futures Contract

5.4.1 Margins and Commissions

5.4.2 Marking to Market

5.4.3 Maintenance Margins and Margin Calls

5.4.4 Leverage

5.4.5 Do Futures Contracts Have to Be Held to Maturity?

24


5.4.6 Measuring Gains and Losses by "Pips" or "Ticks"

5.4.7 An Example of Currency Speculation: Going "Long"

5.4.8 An Example of Currency Speculation: Going "Short"

6.0 Foreign Currency Options

6.1 What Is a Foreign Currency Option?

6.2 The Risks Associated With Buying Versus Selling Currency Options

6.3 Where Are Option Contracts Bought and Sold?

6.4 Understanding Currency Option Quotations in Business Publications: The WallStreet Journal

6.4.1 Contract Sizes

6.4.2 American Style versus European Style Options

6.4.3 Strike Prices and Expiration Dates

6.4.4 Option Premium

6.5 Valuing Options

6.6 An Example of How Traders Use Call Options

6.7 An Example of How Traders Use Put Options

6.8 An Example of How Speculators Use Call Options

6.9 An Example of How Speculators Use Put Options

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7.0 The Causes of Exchange Rate Movements

The value of a nation’s currency is not a good reflection of any nation’s health, wealth, orproductivity. For instance, one cannot say that because the Turkish lira on 20 March 2003was worth only $0.00000058 and the Jordanian dinar was worth $1.41, that Jordan waseconomically stronger than Turkey (and clearly not over two and half million timesstronger than Turkey). At the same time, changes in the value of a currency are often usedas barometers of shifting relative economic conditions among nations.

Exchange rates are determined by the supply and demand forces of importers, exporters,tourists, donors and beneficiaries of gifts, borrowers, investors, speculators, central banks,and governments. To understand why exchange rates change, it is important first toidentify and explain the factors that influence the participants in these markets.

7.1 Factors Influencing Traders' and Consumers Foreign Exchange Decisions

International traders can be defined broadly as those individuals either purchasing from orselling goods and services to foreign residents. Therefore, importers, exporters, andtourists fit into this category. Domestic importers of foreign goods and services, as well asdomestic residents, who travel abroad, are influenced by many of the same general factorsthat influence a nation’s overall consumption patterns. Primary among these variables arerelative price levels (inflation rates) and relative income levels (real growth rates).

7.1.1 The Effect of Relative Price (Inflation) Differences on Traders

Relative price differences are among the most important factors determining consumerpurchases. For instance, if US prices were higher than foreign prices, there would be anincentive for both US and foreign consumers to purchase goods and services outside the USand thus more incentive for traders in the US to import these goods and services. Moregenerally, if the US inflation rate were greater than the foreign inflation rate, then US goodsand services would become increasingly less competitive relative to their foreigncounterparts and thus the traders demand in foreign countries for US Imports would keepgoing down. This change in spending behavior would increase the value of foreigncurrencies relative to dollars because of the greater demand for them.

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7.1.2 The Effect of Relative Income (and Real Growth) on Traders

Relative changes in nations' income levels have important, but perhaps conflicting,influences on international trade. A nation's income is simply a measure of the goods andservices produced by its residents (i.e., GDP). Therefore, any increase in production (orreal income) implies that more goods and services are available for consumption,investment, and government purchases by domestic residents or foreign residents in theform of exports to foreign nations. Increased exports should raise the value of the domesticcurrency (i.e., lower the value of foreign currency). On the other hand, as a nationproduces more, its residents' incomes grow, and these increased incomes give consumersthe ability to purchase more foreign goods and services. Therefore, as incomes rise, theconsumption of foreign products increases, and, thus, the value of the domestic currencyshould fall (i.e., the value of foreign currency should rise).

Combining the two effects leaves us somewhat uncertain of the eventual effect an increasein income will have on the domestic currency's international value. Most economicanalyses associate an inverse relationship between changes in a nation’s real income and itsexchange rate. In other words, when a nation’s real income rises, analyses stress theweakening effects of increased imports over the strengthening effects of greater productavailability. One justification for this conclusion is as follows: the strengthening effectsthat economic growth has on an exchange rate will occur only if the greater availability ofgoods and services lowers the country’s prices or inflation rate relative to those of othernations. As a result, changes in prices and the inflation rate, rather than changes in output,will boost the exports resulting in positive effects.

Let’s put these ideas into perspective by using Venezuela as an example and analyzing thenet effect that changes in real income might have on the value of the Bolivar (Venezuela’scurrency). Suppose Venezuela had a surge in both investment spending and technologicalbreakthroughs that resulted in faster economic growth. As a result, the greater availabilityof goods and services put downward pressures on prices, but they were only enough tooffset the upward push in prices brought on by Venezuela’s rapidly growing consumer andbusiness spending.

Note that Venezuela’s relative price and inflation situation assumed to be unchanged. Theyneither added to nor subtracted from the international value of Bolivar. At the same time,more rapid growth increased Venezuela’s income and gave its residents a greater ability topurchase foreign goods and services. As the Venezuelan demand for foreign imports rose,the value of the Bolivar fell (i.e., the value of foreign currencies rose).

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7.2 Factors Influencing Borrowers’ and Investors' Foreign Exchange Decisions

Borrowers and Investors are two sides of the same coin. Both respond to differences ininternational interest rates (net of expected inflation), taxes, risks, and expected exchangerate changes. They also respond to changes in the level of economic growth, which have animpact on anticipated dividends and capital gains.

7.2.1 The Effect of Relative Interest Rates on Borrowers and Investors

If real (i.e., inflation adjusted) interest rates in the US rose (perhaps due to the FederalReserve’s effort to curtail economic demand), worldwide investment incentives wouldchange, resulting in an increased demand for dollar investments and thus a higher valueddollar in the international markets. At the same time, borrowers would have an incentive toavoid these higher rates by borrowing foreign currencies and converting them to dollars onthe spot market. Borrowing in foreign markets would have no direct effect on the foreignexchange market, but the exchange of foreign currencies for dollars would raise the dollar’sinternational value.

7.2.2 The Effect of Relative Risks, Taxes, and Expected Exchange Rate Changes onBorrowers and Investors

Similar reasoning can be applied to taxes and the effect changes in expected exchange rateshave on the international value of the dollar. If the risk of investing in foreign nations wereto rise relative to the risk in the US (e.g., due to wars or drastic changes in administration),the value of the dollar should rise as foreign investors seek the safe US haven and as USinvestors avoid the relatively risky assets in those foreign nations. For the same reason,the dollar's international value should rise whenever the effective after tax return on USinvestments rises relative to the after tax return on foreign investments. Lower US taxesshould give foreign investors an incentive to invest in the US.

Finally, if there is an expectation that the dollar's value will rise in the future, foreign anddomestic investors will turn more toward US dollar assets, and borrowers will avoid USdebt. Foreign currency holders will want to invest in dollar assets to earn the extra capitalgain from their dollar investments. US dollar holders will want to invest in dollar assets toavoid bearing the capital losses from holding assets denominated in foreign currencies.

7.2.3 The Effect of Economic Growth on Borrowers and Investors

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Relative changes in nations' income levels have significant influences on internationalborrowing and investment decisions. It is said that “a rising tide lifts all boats” and whenthose boats are in the form of stock prices and other asset values, higher anticipated growthshould lead to increased foreign investments in the growing nation. The rising demand forthe growing nation’s currency should help to appreciate its currency.

In a similar sense, a growing economy often puts upward pressure on real interest rates asthe demand rises for loanable funds. Consequently, the expectation of higher growth couldraise current levels of borrowing by businesses and individuals as they try to beat the ratehikes. This increased demand for loanable funds would raise real interest rates, therebyincreasing the relative attractiveness of the interest-earning assets in the growing nation.More attractive financial investment rates would lead to an increase in demand for thegrowing nation’s currency and raise its value (see Section 7.2.1).

7.3 Factors Influencing Speculators' Foreign Exchange Decisions

Speculators participate in the foreign exchange markets by purchasing and selling currencieson both the spot and futures markets. Their aim is to out-guess the market and profit fromtheir superior predictions. For the most part, speculators are companies and individuals,like you and I, who trade, invest, and otherwise try to make a decent yearly income. Theyare not breeds of foreign highwaymen who materialize for the purpose of shortening theemotional, physical, and/or political lives of politicians, central bankers, or anyone else.Though they are often blamed for the currency woes of nations, they are rarely the cause ofthem. Speculators typically react to international economic conditions; seldom do theycreate them.

The fundamental incentives stimulating speculators’ to behave as they do are usuallycaused by conscious (and often misconceived) monetary polices of central bankers and/orfiscal policies of the government.

7.3.1 The Effect of Expected Exchange Rate Changes on Spot Market Speculators

Suppose you were a speculator interested in purchasing British pounds on the spot marketexpecting them to appreciate in value. Having acquired these pounds, you would be foolishto leave them in a non-interest earning account. Therefore, you would look for aninvestment opportunity with the highest rate of return commensurate with the risk youwanted to bear. Suppose you were very risk averse, wanting to avoid all default risk. As aresult, you purchased British government bonds.

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Speculation of this sort is called spot market speculation because the spot market is used toobtain the foreign exchange, and it is used again in the future when the funds are repatriated(i.e., turned back into the domestic currency). The forward, futures, or options markets arenot used in this case.

In general, an expected increase in the value of the dollar will encourage foreigners to investin US dollars and benefit from the expected capital gains. US dollar holders will bediscouraged from foreign investments if they wish to avoid any capital losses associatedwith holding assets denominated in foreign currencies. There is little disagreement over theway in which expected inflation influences exchange rates. The debate is over what(precisely) these expectations are.

7.3.2 The Effect of Expected Exchange Rate Changes on Forward Market Speculators

(This section was deleted because it is not required for managing in a GlobalEconomy.)

7.4 Factors Influencing Governments’ Foreign Exchange Decisions

Governments can participate actively in the foreign exchange markets by engaging intransactions, such as making loans to foreign nations, selling defense hardware to foreigners,providing foreign aid, and intervening in the foreign exchange markets. A multitude ofpolitical and economic factors influence the decisions regarding these transactions, but in allof them there is one common element: the government is either a buyer or a seller of foreigncurrency. Whether the demand for or supply of foreign currency comes from privatecustomers or from the government, it has the same impact on the international value of acurrency. Increases (decreases) in demand increase (decrease) a foreign currency's value andincreases (decreases) in supply decrease (increase) its value.

To show the impact that governments can have on these markets, let's look briefly at theintervention activities of central banks. In particular, we will focus our attention on thetime period around 1985, when central banks, worldwide, saw a need to reduce the USdollar's value.

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As Exhibit 11 shows, during the five years between 1981 and 1985, the US dollarappreciated precipitously in the foreign exchange markets.4 Many analysts attributed thisdramatic rise to the high level of real (i.e., inflation adjusted) US interest rates. Otherobservers credited such factors as the Reagan tax cuts and the growth in US real output.

Regardless of the cause, many central bankers and government officials felt the dollar'sinternational value surged out of line with market fundamentals (e.g., US inflation, growth,and balance of payments imbalances relative to the rest of the world), and thus strongcentral bank action was needed reestablish global order.

Each year before the annual meeting of the International Monetary Fund, the centralbankers of the seven leading industrial nations5 meet both to discuss economic problems ofmutual concern and to arrive at concerted actions to solve such problems. At the 1985 "G-7" meeting in Paris, the over-valued dollar was the prime concern, and out of this concerncame a joint agreement to actively intervene in the foreign exchange markets.

Exhibit 11The Trade Weighted Value of the US Dollar*

1980 – 1997

4 Exhibit 10 shows movements in the US effective or trade-weighted exchange rate. This exchange rateshows how the dollar fared relative to the US' major trading partners.5 Canada, England, France, Italy, Japan, West Germany, and the US.

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*Trade-Weighted Exchange Value of U.S. Dollar vs. a subset of the broad index currencies that circulatewidely outside the country of issue

Source: Federal Reserve Economic Data (FRED), St. Louis Federal Reserve Bank, March 26, 2003.

More specifically, this Louvre Accord obligated the respective central banks to bring downthe international value of the dollar by selling dollars for their own domestic currencies.The central bankers' efforts were successful – perhaps too successful. The dollar fell fromlate 1984 to 1988 and reached levels that left many analysts wondering if its value haddropped too low. Exhibit 10 shows the rise in the trade-weighted value of the dollarbetween 1980 and 2003, its decline from late 1984 to 1988, and its movement since 1988.

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THE FOREIGN EXCHANGE MARKET - Babson Collegefaculty.babson.edu/ricciardi/MMS/FX-2003.pdf · 2012-02-21 · The Foreign Exchange Market 1.0 Introduction Imagine yourself in a busy