LEGAL TENDERMoney created by a govt. that must (by law) be accepted as payment of debt

Legal tender - $100 billNot legal tender - $100 check (issued by bank and not govt.)

Overview and Terminology

Great Seal of United StatesReverse side:American Eagle and Number 13: whole country and original 13 states

Front of Great Seal:Annuit Cerptis: “he has favored our undertaking” – Reference to all seeing deity whose eye is at the apex of pyramid

Identification mark of Fed Reserve Bank that issued Bill: B is for New York

GOLD STANDARD: 1876 until 1913 (World War I)1. Relative value of currencies was measured against precious metals like gold or silver2. Each country set the rate at which its currency could be converted to gold3. Must maintain adequate reserves of gold (Fort Nox) for redemption4. Gold standard implied a fixed exchange rate5. Implicitly limited the rate at which any individual country could expand its money supply

(had to have adequate gold on hand)6. Worked very well until 1913 when WWI interrupted free movement of gold for reserves

1879-1971: U.S. stopped redeeming its paper currency with gold.

Overview and Terminology

.

Example: US$ gold rate was $20.67/oz, British pound was pegged at £4.2474/ozUS$/£ rate calculation is $20.67/£4.2472 = $4.8665/£

1945-1973: Fixed Exchange Rates

• Dollar main reserve currency held by central banks-key to web of exchange rate value

• US running persistent + growing deficits – heavy outflow of dollars required to finance deficit + meet growing demand for dollars from business/investors

• Lack of confidence of US to meet its commitment to convert dollars to gold forced President Nixon to suspend official purchases or sales of gold on Aug. 15, 1971

• Exchange rates of most leading countries were allowed to float in relation to the US dollar

• By the end of 1971, most of the major trading currencies had appreciated vis-à-vis the US dollar; i.e. the dollar depreciated

• A year and a half later, the dollar came under attack again and lost 10% of its value

• By early 1973 a fixed rate system no longer seemed feasible and the dollar, along with the other major currencies was allowed to float

• By June 1973, the dollar had lost another 10% in value

WWI to 1971

1971: gold standard abandoned1971 + : currencies ‘FLOAT’

influenced by :supply and demand greater demand for nation’s product = greater demand for currency greater demand for nation’s stocks/bonds = greater demand for currency low inflation rate stable government and governmental policiesgovernment intervention regarding currency management governmental intervention to defend value of its currency agreements to lower interest rates deliberate devaluation of a currency (make exports more competitive)

Govt. Intervention: Group of 5 effort to depreciate the dollar by 35% in 10 months: Sept 1985 – selling billions of dollars to drive down the value of dollar.

1971 forward

FEDERAL RESERVE SYSTEM- founded in 1913• Guardian of the Nation’s money• 12 separate distinct banks, 25 regional branches• System run by 7-member Board of Governors (appointed by President, confirmed by Congress)• Open Market Committee- responsible for guiding day to day money decisions• discount rate

Fed Reserve System

The euro, €, was launched on Jan. 4, 1999 Effects for countries using the euro currency include

• Cheaper transaction costs, • Currency risks and costs related to exchange rate uncertainty are

reduced, • All consumers and businesses, both inside and outside of the euro zone

enjoy price transparency and increased price-based competition

Euro and Monetary Unification

Convergence criteria called for countries’ monetary and fiscal policies to be integrated and coordinated

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

– Long-term interest rates should be no more than 2% above average for the three members of the EU with lowest interest rates

– Fiscal deficit should be no more than 3% of GDP– Government debt should be no more than 60% of GDP

European Central Bank (ECB) was established to promote price stability within the EU

Euro and Monetary Unification

Free-Floating Regime

• Currency value is free to float up and down with international market forces

• Independent monetary policy and free movement of capital allowed, but at the loss of stability

• Increased volatility may be more than what a small financial market can withstand

Currency Board or Dollarization

• Currency Board fixes the value of the local currency or basket; Dollarization replaces currency with the US dollar

• Independent monetary policy is lost; political influence on monetary policy is eliminated

• Seignorage, the benefits accruing to a government from the ability to print its own money, is lost

Emerging Market Country

High capital mobility is forcing emerging market nations to choose between two extremes

Emerging Markets and Currency Regime Choices

Foreign Exchange Markets The FOREX market provides the physical and institutional structure

through which the money of one country is exchanged for that of another country

A foreign exchange transaction is an agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified rate

Overview and Terminology

Geographically, the FOREX market spans the globe with prices moving and currencies trading on a 24 hour basis

Major exchanges are located in Singapore, Hong Kong and Tokyo in the East

Then it moves to Bahrain, and London for the European area And on to New York, San Francisco and Sydney

Geographics

0

5,000

10,000

15,000

20,000

25,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

Measuring FOREX Market Activity: Average Electronic Conversations Per Hour

Greenwich Mean Time

Tokyoopens

Asiaclosing

10 AMIn Tokyo

Afternoonin America

Londonclosing

6 pmIn NY

Americasopen

Europeopening

LunchIn Tokyo

Geographics

0

100

200

300

400

500

600

700

800

1989 1992 1995 1998 2001

Spot

Forwards

Swaps

Global Foreign Exchange Market Turnover (daily averages in April, billions of US dollars)

Source: Bank for International Settlements, “Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001,” October 2001, www.bis.org.

Market Size

0

100

200

300

400

500

600

700

1989 1992 1995 1998 2001

United States

United Kingdom

Japan

Singapore

Germany

Geographic Distribution of Foreign Exchange Market Turnover (daily averages in April, billions of US dollars)

Source: Bank for International Settlements, “Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001,” October 2001, www.bis.org.

Market Size

0

10

20

30

40

50

60

70

80

90

1989 1992 1995 1998 2001

US dollar

euro

Deutshemark

French franc

EMS currencies

Japanese yen

Pound sterling

Swiss franc

Currency Distribution of Global Foreign Exchange Market Turnover (percentage shares of average daily turnover in April)

Source: Bank for International Settlements, “Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001,” October 2001, www.bis.org.

Market Size

The FOREX market is the mechanism by which participants transfer:• purchasing power between countries• obtains or provides credit for international trade• minimizes exposure to exchange rate risk

FOREX: each party wants to transact in its own currency FOREX market provides credit (letters of credit) FOREX market provides ‘hedging’ facilities

Functions

The FOREX market consists of two tiers– Interbank– Client or retail market

Five broad categories of participants operate within these two tiers• Bank and non bank foreign exchange dealers• Individuals and firms conducting commercial or investment

transactions• Speculators and arbitragers• Central banks and treasuries• Foreign exchange brokers

Market Participants

These participants profit from buying currencies at a bid price and then reselling them at an offer or ask price

Competition among dealers – Narrows the spread between the bid and offer rate – Promotes the market’s efficiency

Dealers on behalf of large international banks often act as market makers, often willing to stand in and buy or sell these currencies without having a counterpart with which to unload the “inventory”

They trade amongst other banks and dealers in order to keep their inventory levels at manageable levels

Currency trading is profitable and often contributes between 10% - 20% of a banks’ average net income

Small- to medium-sized banks rarely act as market makers yet still participate in the interbank market

Bank and Non-Bank Dealers

Importers, exporters, portfolio investors, MNEs, tourists and others use the FOREX market to facilitate execution of commercial or investment transactions

Some of these participants use the market to hedge foreign exchange rate risk

Individuals/Firms Conducting Commercial/Investment Transactions

Speculators and arbitragers seek to profit from trading in the market itself

They operate for their own interest, without need or obligation to serve clients or ensure a continuous market

Speculators seek all their profit from exchange rate changes

Arbitragers try to profit from simultaneous differences in exchange rates in different markets

A large proportion of speculation and arbitrage is conducted on behalf of major banks by traders employed by those banks

Speculators and Arbitragers

Acquire/spend their country’s currency reserves Influence the price at which their own currency trades Support the value of their currency Motive is not to profit but rather influence the foreign exchange value of their

currency in a manner that will benefit their interests

Central Banks and Treasuries

Foreign exchange brokers are agents who facilitate trading between dealers without themselves becoming principals in the transaction

For this service they charge a small commission They maintain instant access to hundreds of dealers worldwide via open lines and

at times may maintain such lines with several banks, with separate lines for differing currencies, spot and forward rates

Foreign Exchange Brokers

A spot transaction in the interbank market is the purchase of

foreign exchange, with delivery and payment between banks to

take place, normally, on the second following business day• The settlement date is often referred to as the value date• This is the date when most dollar transactions are settled

through the computerized Clearing House Interbank Payment Systems (CHIPS) in New York

Spot Transactions

MONEY: Currency Cross Rates

Foreign Exchange Quotes:1. Direct: quote is the price of a foreign currency unit in terms of the home currency (dollar

denominator)2. Indirect: quote is the price of a unit of home currency measured in the foreign currency.

Indirect = USD/EUR = 0.79 is the same as .79 Euro will buy $1 dollarDirect = EUR/USD = 1.26 is the same as $1.26 buys 1 euro (this is how the markets quotes the Euro

(how many dollars to buy 1 Euro). This is NOT a FRACTION but as “Euros in dollar prices”.

USD GBP CHF JPY CAD AUD EUR NZD DKK SEK

SEK 9.2331 14.39 6.2109 7.5255 5.8967 5.1419 9.0936 4.4905 1.2238

DKK 7.5448 11.76 5.0752 6.1495 4.8185 4.2017 7.4309 3.6694 0.8172

NZD 2.0561 3.2047 1.3831 1.6759 1.3132 1.1451 2.0251 0.2725 0.2227

EUR 1.0153 1.5825 0.6830 0.8276 0.6484 0.5654 0.4938 0.1346 0.1100

AUD 1.7957 2.7987 1.2079 1.4636 1.1468 1.7685 0.8733 0.2380 0.1945

CAD 1.5658 2.4405 1.0533 1.2762 0.8720 1.5422 0.7615 0.2075 0.1696

JPY 122.69 191.23 82.53 78.36 68.33 120.84 59.67 16.26 13.29

CHF 1.4866 2.3170 1.2117 0.9494 0.8279 1.4642 0.7230 0.1970 0.1610

GBP 0.6416 0.4316 0.5230 0.4098 0.3573 0.6319 0.3120 0.0850 0.0695

USD 1.5586 0.6727 0.8151 0.6387 0.5569 0.9849 0.4864 0.1325 0.1083

USD GBP CHF JPY CAD AUD EUR NZD DKK SEK

SEK 9.2331 14.39 6.2109 7.5255 5.8967 5.1419 9.0936 4.4905 1.2238

DKK 7.5448 11.76 5.0752 6.1495 4.8185 4.2017 7.4309 3.6694 0.8172

NZD 2.0561 3.2047 1.3831 1.6759 1.3132 1.1451 2.0251 0.2725 0.2227

EUR 1.0153 1.5825 0.6830 0.8276 0.6484 0.5654 0.4938 0.1346 0.1100

AUD 1.7957 2.7987 1.2079 1.4636 1.1468 1.7685 0.8733 0.2380 0.1945

CAD 1.5658 2.4405 1.0533 1.2762 0.8720 1.5422 0.7615 0.2075 0.1696

JPY 122.69 191.23 82.53 78.36 68.33 120.84 59.67 16.26 13.29

CHF 1.4866 2.3170 1.2117 0.9494 0.8279 1.4642 0.7230 0.1970 0.1610

GBP 0.6416 0.4316 0.5230 0.4098 0.3573 0.6319 0.3120 0.0850 0.0695

USD 1.5586 0.6727 0.8151 0.6387 0.5569 0.9849 0.4864 0.1325 0.1083

USD GBP CHF JPY CAD AUD EUR NZD DKK SEK

SEK 9.2331 14.39 6.2109 7.5255 5.8967 5.1419 9.0936 4.4905 1.2238

DKK 7.5448 11.76 5.0752 6.1495 4.8185 4.2017 7.4309 3.6694 0.8172

NZD 2.0561 3.2047 1.3831 1.6759 1.3132 1.1451 2.0251 0.2725 0.2227

EUR 1.0153 1.5825 0.6830 0.8276 0.6484 0.5654 0.4938 0.1346 0.1100

AUD 1.7957 2.7987 1.2079 1.4636 1.1468 1.7685 0.8733 0.2380 0.1945

CAD 1.5658 2.4405 1.0533 1.2762 0.8720 1.5422 0.7615 0.2075 0.1696

JPY 122.69 191.23 82.53 78.36 68.33 120.84 59.67 16.26 13.29

CHF 1.4866 2.3170 1.2117 0.9494 0.8279 1.4642 0.7230 0.1970 0.1610

GBP 0.6416 0.4316 0.5230 0.4098 0.3573 0.6319 0.3120 0.0850 0.0695

USD 1.5586 0.6727 0.8151 0.6387 0.5569 0.9849 0.4864 0.1325 0.1083

USDUSDUSD GBPGBPGBP CHFCHFCHF JPYJPYJPY CADCADCAD AUDAUDAUD EUREUREUR NZDNZDNZD DKKDKKDKK SEKSEKSEK

SEKSEKSEK 9.23319.2331 14.3914.39 6.21096.2109 7.52557.5255 5.89675.8967 5.14195.1419 9.09369.0936 4.49054.4905 1.22381.2238

DKKDKKDKK 7.54487.5448 11.7611.76 5.07525.0752 6.14956.1495 4.81854.8185 4.20174.2017 7.43097.4309 3.66943.6694 0.81720.8172

NZDNZDNZD 2.05612.0561 3.20473.2047 1.38311.3831 1.67591.6759 1.31321.3132 1.14511.1451 2.02512.0251 0.27250.2725 0.22270.2227

EUREUREUR 1.01531.0153 1.58251.5825 0.68300.6830 0.82760.8276 0.64840.6484 0.56540.5654 0.49380.4938 0.13460.1346 0.11000.1100

AUDAUDAUD 1.79571.7957 2.79872.7987 1.20791.2079 1.46361.4636 1.14681.1468 1.76851.7685 0.87330.8733 0.23800.2380 0.19450.1945

CADCADCAD 1.56581.5658 2.44052.4405 1.05331.0533 1.27621.2762 0.87200.8720 1.54221.5422 0.76150.7615 0.20750.2075 0.16960.1696

JPYJPYJPY 122.69122.69 191.23191.23 82.5382.53 78.3678.36 68.3368.33 120.84120.84 59.6759.67 16.2616.26 13.2913.29

CHFCHFCHF 1.48661.4866 2.31702.3170 1.21171.2117 0.94940.9494 0.82790.8279 1.46421.4642 0.72300.7230 0.19700.1970 0.16100.1610

GBPGBPGBP 0.64160.6416 0.43160.4316 0.52300.5230 0.40980.4098 0.35730.3573 0.63190.6319 0.31200.3120 0.08500.0850 0.06950.0695

USDUSDUSD 1.55861.5586 0.67270.6727 0.81510.8151 0.63870.6387 0.55690.5569 0.98490.9849 0.48640.4864 0.13250.1325 0.10830.1083

Indirect

Direct

Convention:• quote’s definition depends on country of

reference• NY bankers established European Terms

Convention, which uses the US Dollar as the common denominator.

• Traders in US, Switzerland, etc would quote CHF as 1.4866 / $1 dollar. (1.4866 Swisse to buy $1) INDIRECT

• Exceptions: British Pound Sterling, Australia, New Zealand and Euro-quoted DIRECT

The Spot Market: Conventions

10/29/02: Live FX Spot Market as Offered by IFX LONDONNotice the conventions:• Euro quoted as direct (EUR/USD)• Swiss Franc quoted as indirect (USD/CHF)• Pound Sterling quoted as direct (GBP/USD)

Quoting Foreign Exchange (FX)-Spot Pricing

SPOT EXCHANGE RATE MARKET• FX trading is normally undertaken on the basis of margin trading (‘gearing’).• Small deposit needed to control a much larger position in market-possible because one buys one

currency and simultaneously sell another• Margins are set by dealer• To swing $1,000,000, one must deposit $20,000 in account – margins are 2%

Commercial Banks normally trade in $1M lotsIFX allows trading in partial lotsNotice, trade is .2 lots (margin is 2 x $2,000= $4K)

Hypothetical AccountInitial Deposit $20,000.00Trade Size 0.50Initial Margin $10,000.00Play $10,000.00

Spot Transaction Trading: Retail Trading