The International Monetary System

What is special about international finance?
Foreign exchange risk
E.g., an unexpected devaluation adversely affects your export market…
Political risk
E.g., an unexpected overturn of the government that jeopardizes existing negotiated contracts…
Market imperfections
E.g., trade barriers and tax incentives may affect location of production…
Expanded opportunity sets
E.g., raise funds in global markets, gains from economies of scale…

The Monetary System
Bimetallism: Before 1875
Free coinage was maintained for both gold and silver
Gresham’s Law: Only the abundant metal was used as money, diving more scarce metals out of circulation
Classic gold standard: 1875-1914
Great Britain introduced full-fledged gold standard in 1821, France (effectively) in the 1850s, Germany in 1875, the US in 1879, Russia and Japan in 1897.
Gold alone is assured of unrestricted coinage
There is a two-way convertibility between gold and national currencies at a stable ratio
Gold may be freely exported and imported
Cross-border flow of gold will help correct misalignment of exchange rates and will also regulate balance of payments.
The gold standard provided a 40 year period of unprecedented stability of exchange rates which served to promote international trade.

The Monetary System
Interwar period: 1915-1944
World War I ended the classical gold standard in 1914
Trade in gold broke down
After the war, many countries suffered hyper inflation
Countries started to “cheat” (sterilization of gold)
Predatory devaluations (recovery through exports!)
The US, Great Britain, Switzerland, France and the Scandinavian countries restored the gold standard in the 1920s.
After the great depression, and ensuing banking crises, most countries abandoned the gold standard.
Bretton Woods system: 1945-1972
U.S. dollar was pegged to gold at $35.00/oz.
Other major currencies established par values against the dollar. Deviations of ±1% were allowed, and devaluations could be negotiated.

The Monetary System
Jamaica Agreement (1976)
Central banks were allowed to intervene in the foreign exchange markets to iron out unwarranted volatilities.
Gold was officially abandoned as an international reserve asset. Half of the IMF’s gold holdings were returned to the members and the other half were sold, with proceeds used to help poor nations.
Non-oil exporting countries and less-developed countries were given greater access to IMF funds.
Plaza Accord (1985)
G-5 countries (France, Japan, Germany, the U.K., and the U.S.) agreed that it would be desirable for the U.S. dollar to depreciate.
Louvre Accord (1987)
G-7 countries (Canada and Italy were added) would cooperate to achieve greater exchange rate stability.
G-7 countries agreed to more closely consult and coordinate their macroeconomic policies.

The Monetary System
Jamaica 1978
Plaza 1985
Louvre 1987
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Current Exchange Rate Arrangements
36 major currencies, such as the U.S. dollar, the Japanese yen, the Euro, and the British pound are determined largely by market forces.
50 countries, including the China, India, Russia, and Singapore, adopt some forms of “Managed Floating” system.
41 countries do not have their own national currencies!
40 countries, including many islands in the Caribbean, many African nations, UAE and Venezuela, do have their own currencies, but they maintain a peg to another currency such as the U.S. dollar.
The remaining countries have some mixture of fixed and floating exchange-rate regimes.
Note: As of July 31, 2005.

The Euro
Product of the desire to create a more integrated European economy.
Eleven European countries adopted the Euro on January 1, 1999:
Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain.
The following countries opted out initially:
Denmark, Greece, Sweden, and the U.K.
Euro notes and coins were introduced in 2002
Greece adopted the Euro in 2001
Slovenia adopted the Euro in 2007

The Euro
Nowadays the euro (€) is the official currency of 17 out of 27 EU member countries. These countries, known collectively as the Eurozone are:
Over 175 million people worldwide use currencies which are pegged to the euro.

Will the UK (Sweden) join the Euro?
Think about:
Potential benefits and costs of adopting the euro.
Economic and political constraints facing the country.
The potential impact of British adoption of the euro on the international financial system, including the role of the U.S. dollar.
The implications for the value of the euro of expanding the EU to include, e.g., Eastern European countries.

THE ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
THE SPOT MARKET
THE FORWARD MARKET
THE FOREIGN EXCHANGE MARKET

The organization of the Foreign Exchange Market
Foreign exchange market - the market in which one country’s currency is traded for another’s.
The foreign exchange market is an over-the-counter market, so there is no single location where traders get together. Instead, market participants are located in the major commercial and investment banks around the world. They communicate using computer terminals, telephones, and other telecommunications devices. For example, by the Society for Worldwide Interbank Financial Telecommunications (SWIFT).
The many different types of participants in the foreign exchange market include the following:
1. Importers who pay for goods using foreign currencies
2. Exporters who receive foreign currency and may want to convert to the domestic
currency
3. Portfolio managers who buy or sell foreign stocks and bonds
4. Foreign exchange brokers who match buy and sell orders
5. Traders who “make a market” in foreign currencies
6. Speculators who try to profit from changes in exchange rates

The organization of the Foreign Exchange Market
An exchange rate is simply the price of one country’s currency expressed in terms of another country’s currency.
Example: JAL every year needed to raise about $800 mln to purchase aircraft from Boeing (price ranges from $35 mln to $160 mln). JAL orders aircraft 2-6 years in advance and pays Boeing 10% deposit when ordering. In that period the value of the yen against the dollar may change. Consider an order placed for 747 aircraft that was to be delivered in 5 years. Dollar value - $100 mln.
0) $1=¥240, price - ¥2,4 billion.
$1=¥300, price - ¥3,0 billion, 25% increase
$1=¥200, price - ¥2,0 billion, 16,7% decrease

The Foreign Exchange Market
The FX market encompasses:
Conversion of purchasing power from one currency to another; bank deposits of foreign currency; credit denominated in foreign currency; foreign trade financing; trading in foreign currency options & futures, and currency swaps
No central market place
World-wide linkage of bank currency traders, non-bank dealers (IBanks, insurance companies, etc.), and FX brokers—like an international OTC market
Largest financial market in the world
Daily trading is estimated to be US$3.21 trillion
Trading occurs 24 hours a day
London is the largest FX trading center

Global Foreign Exchange Market Turnover
Source: BIS Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2007.

BIS (Bank for International Settlements) Triennial Survey…

The Foreign Exchange Market
The FX market is a two-tiered market:
Interbank Market (Wholesale)
Accounts for about 83% of FX trading volume—mostly speculative or arbitrage transactions
About 100-200 international banks worldwide stand ready to make a market in foreign exchange
FX brokers match buy and sell orders but do not carry inventory and FX specialists
Client Market (Retail)
Accounts for about 17% of FX trading volume
Market participants include international banks, their customers, non-bank dealers, FX brokers, and central banks
Note: Data is from 2007.

Central Banking
The U.S. monetary authorities occasionally intervene in the foreign exchange (FX) market to counter disorderly market conditions.
The Treasury, in consultation with the Federal Reserve System, has responsibility for setting U.S. exchange rate policy, while the Federal Reserve Bank New York is responsible for executing FX intervention.
U.S. FX intervention has become less frequent in recent years.
WEDNESDAY, NOVEMBER 8, 2000
U.S. INTERVENES IN THIRD QUARTER TO BUY 1.5 BILLION EUROS NEW YORK FED REPORTS
NEW YORK – The U.S. monetary authorities intervened in the foreign exchange markets on one occasion during the third quarter, on September 22nd, buying a total of 1.5 billion euros, the Federal Reserve Bank of New York said today in its quarterly report to the U.S. Congress.
According to the report, the dollar appreciated 8.2 percent against the euro and appreciated 2 percent against the Japanese yen during the three month period that ended September 30, 2000.
The intervention was carried out by the foreign exchange trading desk at the New York Fed, operating in coordination with the European Central Bank (ECB) and the monetary authorities of Japan, Canada, and the United Kingdom. The amount was split evenly between the Federal Reserve System and the U.S. Treasury Department’s Exchange Stabilization Fund (ESF).
The report was presented by Peter R. Fisher, executive vice president of the New York Fed and the Federal Open Market Committee’s (FOMC) manager for the system open market account, on behalf of the Treasury and the Federal Reserve System.
http://www.ny.frb.org/

The Foreign Exchange Market

Overview
Currency Table

The Spot Market
The spot market involves the immediate purchase or sale of foreign exchange
Cash settlement occurs 1-2 days after the transaction
Currencies are quoted against the US dollar
Interbank FX traders buy currency for their inventory at the bid price
Interbank FX traders sell currency for their inventory at the ask price
Bid price is less than the ask price
Bid-ask spread is a transaction cost

The Spot Market – Direct Quotes
US dollar price of 1 unit of foreign currency—$ are in the numerator (foreign currency is priced in terms of dollars)
$/€ = 1.5000 (1€ costs $1.5000)
$/£ = 2.0000 (1£ costs $2.0000)
Currency changes
Suppose that today, $/€ = 1.5000 and in 1 month, $/€ = 1.5050
The $ has depreciated in value
Alternatively, the € has appreciated in value
Suppose that today, $/£ = 2.0000 and in 1 month, $/£ = 1.9950
The $ has appreciated in value
Alternatively, the £ has depreciated in value

The Spot Market – Indirect Quotes
Foreign currency price of $1—$ are in the denominator (US dollar is priced in terms of foreign currency)
€/$ = 0.6667 ($1costs €0.6667)
£/$ = 0.5000 ($1 costs £0.5000)
Currency changes
Suppose that today, €/$ = 0.6667 and in 1 month, €/$ = 0.6600
The $ has depreciated in value
Alternatively, the € has appreciated in value
Suppose that today, £/$ = 0.5000 and in 1 week, £/$ = 0.5050.
The $ has appreciated in value
Alternatively, the £ has depreciated in value

The Spot Market - Conventions
Denote the spot rate as S
For most currencies, use 4 decimal places in calculations
With exceptions: i.e. S(¥/$)=109.0750, but S($/¥)=0.009168
If we are talking about the US, always quote spot rates as the dollar price of the foreign currency
i.e. as direct quotes, S($/€), S($/C$), S($/£), etc
Increase in the exchange rate ⇒ the US dollar is depreciating
Costs more to buy 1 unit of foreign currency
Decrease in the exchange rate ⇒ the US dollar is appreciating
Costs less to buy 1 unit of foreign currency

US dollar price:
S($/£)=1.6880
£1 costs $1.6880
UK pound price:
S(£/$)=0.5924
$1 costs £0.5924
The Spot Market

The current exchange, S($/€)=1.5000. In 1 month, it is S(€/$)=0.6689
Has the US dollar appreciated or depreciated?
By what % has the exchange rate changed?
Convert S(€/$)=0.6689 to:
1/S(€/$)=S($/€)=1.4950.
Now we see that the exchange rate has decreased ⇒ US dollar has appreciated.
The % change per month is:
The Spot Market

The exchange rate between 2 currencies where neither currency is the US dollar
We know the dollar rates. What if we want to know other rates, i.e. S(€/£) ?
Calculate cross-rates from dollar rates
S($/€)=1.5000 and S($/£)=2.0000. What is S(€/£), i.e. the € price of £?
Cross Exchange Rates

Cross-rates must be internally consistent; otherwise arbitrage profit opportunities exist.
Suppose that:
A profit opportunity exists. Either S(€/£) is too high or S(€/$) or S($/£) is too low.
How does this work?
Sell high and buy low.
Cross-Exchange Rates

Cross-Exchange Rates Example
Bank1: S($/¥)=0.0084; Bank2: S($/€)=1.0500; Bank3: S(€/¥)=0.0081.
The implied cross rate between Bank 1 and 2 is: S(€/¥)=0.0080.
You have ¥1,250,000. What should you do?
Go to Bank 3.
Convert ¥1,250,000 to €10,125.00 @ 0.0081
Go to Bank 2.
Convert €10,125 to $10,631.25 @ 1.0500.
Go to Bank 1.
Convert $10,631.25 to ¥1,265,625.00 @ (1/0.0084)
The initial ¥1,250,000 becomes ¥1,265,625. You earn a risk-free profit of ¥15,625, or 1.25%.
Buy ¥ low!
Sell ¥ high!

The Forward Market
Forward market involves contracting today for the future purchase or sale of foreign exchange
Forward prices are quoted the same way as spot prices
Denote the forward price maturing in N days as FN
i.e. F30($/£), F180($/€), F90(€/ ¥), etc
The forward dollar price of the euro can be:
Same as the spot price
Higher than the spot price (euro at a premium)
Lower than the spot price (euro at a discount)

The Forward Market
For example, the spot exchange rate for the Swiss franc is SF 1 $.5871. The 180-day (6-month) forward exchange rate is SF 1 $.5887. This means that you can buy a Swiss franc today for $.5871 or you can agree to take delivery of a Swiss franc in 180 days and pay $.5887 at that time.
Notice that the Swiss franc is more expensive in the forward market ($.5887 versus $.5871). Because the Swiss franc is more expensive in the future than it is today, it is said to be selling at a premium relative to the dollar. For the same reason, the dollar is said to be selling at a discount relative to the Swiss franc.

The foreign exchange market is by far the largest financial market in the world.
Currency traders trade currencies for spot and forward delivery.
Exchange rates are by convention quoted against the U.S. dollar, but cross-rates can easily be calculated from bilateral rates.
Triangular arbitrage forces the cross-rates to be internally consistent.
The euro has enhanced trade within Europe, and the currency has the potential of becoming a major world currency.
Wrap-Up

Assignment
Suppose you are Professor Paul Krugman (Princeton University Economics Professor and NYT columnist (Op-Ed Page)).
On October 13, 2008, at 5am you receive a phone call from the Royal Swedish Academy informing you that you have been awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for your work on international trade and economic geography.
After first thinking this is a practical joke – “that is surely a fake Swedish accent” - the news sink in and you realize you have a small problem.
The prize will be awarded at a ceremony on December 10th in Stockholm, at which time you will receive the a medal, a diploma, and a prize check for SEK 10,000,000 or US$ 1,394,136 at the current spot rate (SEK 7.1729US$).
What should you do?