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Foreign Exchange. Business and Financial Reporting (JMSC6004) March 18, 2002. Intl Monetary System. Bretton Woods, July 1944 US$ became primary medium of intl exchange Exchange rate fixed, plus/minus one pct. Gold fixed at $35/oz Smithsonian Agreement, Dec 1971

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Foreign exchange l.jpg

Foreign Exchange

Business and Financial Reporting (JMSC6004)

March 18, 2002


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Intl Monetary System

  • Bretton Woods, July 1944

    • US$ became primary medium of intl exchange

    • Exchange rate fixed, plus/minus one pct.

    • Gold fixed at $35/oz

  • Smithsonian Agreement, Dec 1971

    • gold fixed at $38/oz, fluctuation band 2.25 pct

  • Floating exchange rate, 1973


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European Development

  • Treaty of Rome, 1957, called for the creation of the Euopean Economic Community (EEC)

    • Common Market

    • European Monetary System (EMS)

    • ECU, a GDP weighted average of the EMS currencies, individual currencies fluctuating in a band of 2.25 pct.


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G-7

  • G-5: U.S., Japan, Germany, UK, France, later adding Italy and Canada.

    • Economic ministers meet regularly

    • Goals change with economic conditions and the political agenda.

  • Plaza Agreement, Sept 1985

    • G-5 agreed to coordinated intervention to lower the value of the dollar; $ fell 4 pct in 24 hrs.


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Intervention

  • Finance Ministers often believe that their currency is mispriced by the mkt

  • Struggle between govts and mkts

    • Contest of will

  • Central Bank “vigilantes”


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Forex Dealing

  • Customer order facilitation

    • normally no commission, only bid/ask spread

    • handled on agency basis, back-to-back trade

    • in some cases, may take a counterparty position to accommodate a cutomer’s buy/sell order

  • Proprietary trading

    • using own capital trading for profit


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Quotation Conventions

  • “American”

    • the number of US dlrs that are equivalent to one unit of foreign currency, Br Pound = $1.47; A$ = $0.51.

    • British pound, Irish punt, Aussie dlr, NZ dlr.

  • “European”

    • the number of units of foreign currency per one U,S. dlr. E.g. $= 120 yen; US$=HK$7.8


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Varieties of Fx

  • Spot

    • settled in two business days

  • Forward

    • to be settled in one- three-, six- 12 mths

  • Cross Rate

    • exchange rate in which neither currency is the US dlr, e.g. DM = 57 yen.


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Pricing of a currency

  • Purchasing Power Parity (PPP)

    • “Big Mac” index

  • Interest Parity Theorem

    • If the interest rate on a foreign ccy is different from that of the domestic ccy, the forward exchange rate will have to trade away from spot exchange rate by a sufficient amount to make profitable arbitrage impossible.


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Hedging Currency Risks

  • Forward

  • Futures

  • Options


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Hard vs Soft currencies

  • Convertibility

  • Is the capital account open or closed?


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The Almighty Dollar

  • Dollarization

  • Currency Peg

  • Currency Board