BUS614: International Finance

7a. Describe the evolution of monetary standards and the different types of currencies and currency exchange rates 

• How did the monetary system evolve?
• What are the different currency exchange rate policies?

The Evolution of Monetary Standards 

Pre-World War I, the monetary system was characterized by fixing the exchange rates to gold. This was known as the gold standard. This standard was first adopted by the United Kingdom in the early 1820s when the British Pound was fixed to gold. This was done by agreeing to buy or sell an ounce of gold for a predetermined price (4.247). This was the going rate for the Pound Sterling. In the US, the US dollar was also fixed to an ounce of gold (20.67 dollars for each ounce). This means the value of the Pound was 4.867 dollars.

The more gold the country held, the more money it could print. In the wake of the First World War, countries needed to finance their operations. Thus, they needed to print more money. This resulted in more money in circulation than the country's gold reserve. Countries abandoned the system in 1939 and adopted a new monetary system, particularly after the Great Depression.

One of the first countries to adopt a new system was the UK. In 1931, the UK allowed its currency to float, leaving its value to be determined by supply and demand. In 1934, the US lowered its currency peg to the ounce, allowing more US companies to export. Other countries soon followed this move. However, in 1944, a new monetary system was established through the Bretton Woods agreement, whereby countries agreed to ensure exchange rate stability, prevent competitive devaluations, and promote economic growth.

The Bretton Woods agreement did not last long, though, as it finally fell in 1973. With many countries opting to float their currencies, smaller ones with relatively large trade sectors disliked floating rates and fixed their currency to the US dollar. Other countries opted for the German mark.

To review, see The International Monetary System.

Currency Exchange Rate Policies 

Generally, there are three major exchange rate policies. Demand-Based Exchange Rate, Managed Exchange Rate, and Fixed Exchange Rates. Demand-based exchange rates take place when a country decides to leave the determination of the currency exchange rate to supply and demand. Such currencies are known as Floating Currencies, and the exchange rate is known as a Floating Exchange Rate policy (or the clean float). The US dollar is considered a floating currency.

Managed exchange rates are currencies that have their value determined by the government. Here, the government constantly intervenes in determining the exchange rate, thus determining the limit of the floating. Countries opting for a managed exchange rate policy use the dirty float or managed float policies. An example of this would be the Malaysian Ringgit. The notable thing to remember is that the government intervenes in determining currency pricing.

Fixed exchange rates are currencies where their exchange rate is fixed to another foreign currency. For instance, the Saudi Riyal is fixed to the US dollar. There are few variants of fixed or pegged currencies. For example, a crawling peg like the Honduran Lempira is pegged to the US dollar. Here, the currency is allowed to fluctuate by around 7% against the dollar (either appreciate or depreciate). There is also the soft peg and the hard peg.

A soft peg and a hard peg. A soft peg is one by which the government allows the exchange rate to be set by the market but will intervene in instances where the exchange rate seems to be moving rapidly in one direction. Here, the aim is to stabilize the national currency against the reserve currency. This is, for example, applied to the Costa Rican Colon. A hard peg, on the other hand, is when the central bank sets a fixed and unchanging value for the exchange rate. Dollarisation, for example, is a form of hard peg where a foreign currency is accepted as a legal tender. For example, this was the approach in Argentina in 1999 and Ecuador in 2000.

Finally, there is a form of exchange rate policy by which a particular country chooses a common currency shared with one or more countries. This is known as a currency merger. For example, several countries use the Euro and the Eastern Caribbean Dollar as legal tender.

To review, see The Legal Allocation of Currency Exchange Risk in Foreign Direct Investment and Exchange Rate Policies.

7b. Compare direct and indirect quotation

• What is the difference between direct and indirect quotations?

A direct currency quote is one by which the price of domestic currency for each unit of foreign currency is determined, which means that investors will look at how many units of their national currency they need to buy one unit of foreign currency.

On the other hand, an indirect quote is the price of the domestic currency in foreign currency terms. Here, investors look at how many units of foreign currency they need to buy one unit of their national currency.

For example, if a US investor wishes to buy 1GBP, they will need 1.39$ (USD/GBP). This is a direct quote. On the other hand, if a US investor has a Mexican Peso and wants to buy 1$, they will need 0.10 Pesos (MEX$/USD); this would be regarded as an indirect quote.

The formula to calculate a direct quote is:

$\text{Direct Quote} =\dfrac{1}{\text{Indirect Quote}}$

Normally, the US dollar is used as the base currency. However, a few exceptions exist, including the British Pound and the Euro.

To review, see Currency and Foreign Exchanges.

7c. Calculate cross rates, forward rates, and currency swaps 

• How would you differentiate between spot, forward, and cross rates?

Forward rates are used for calculating the settlement price of a forward contract. They can indicate market expectations of future price movements. The spot rate is the exchange rate transacted at a particular moment by the buyer and seller of a currency. The settlement price is called the spot rate. Generally, the forward rate should equal the spot rate and any other earnings. This means that spot rates can be converted into forward rates and vice-versa.

Cross rate is the exchange rate between two currencies, neither of which are the official currencies of the country in which the exchange rate quote is given.

To review, see Spot Rates, Forward Rates, and Cross Rates and Foreign Exchange Markets and Rates of Return.

Unit 7 Vocabulary 

This vocabulary list includes the terms that you will need to know to successfully complete the final exam.

• Exchange Rate
  • The exchange Rate is the rate at which the market converts one currency into another.
• Foreign Exchange
  • Foreign Exchange refers to the price or value of a particular currency against another. It is money denominated in the currency of another country. It is money denominated in the currency of another country.
• Gold Standard
  • The gold standard was a system by which currency exchange rates were fixed to the gold.
• Float
  • Float, or clean float, is an exchange policy by which a country leaves the value of the national currency to be determined by supply and demand.
• Dirty Float
  • A dirty float is a form of exchange policy by which the government occasionally intervenes to change the value of the national currency.
• Crawling Peg
  • A crawling peg is an exchange policy by which the national currency is allowed to fluctuate within a particular ratio.
• Soft Peg
  • A soft peg is an exchange policy by which the government allows the exchange rate to be set by the market but will intervene in instances where the exchange rate seems to be moving rapidly in one direction.
• Hard Peg
  • A hard peg is an exchange policy by which the central bank sets a fixed and unchanging value for the exchange rate.
• Merged Currency
  • A merged currency refers to a country adopting a currency shared by one or more countries as its sole legal tender.
• Expansionary Monetary Policy
  • An Expansionary Monetary Policy is one by which the government decides to expand its money supply faster than usual or lowers its short-term interest rates to stimulate growth in the national economy.
• Contractionary Monetary Policy
  • Contractionary Monetary Policy is one by which the government decides to reduce its spending or reduce its monetary expansion rate to decrease the money supply to counter rising inflation.
• Tobin Tax
  • Tobin Tax is a tax levied on the international flow of capital aimed at reducing movements in exchange rates by limiting inflows and outflows of international financial capital.
• Bid
  • It is the price at which a bank or financial services firm is willing to buy a specific currency.
• Ask
  • Refers to the price at which a bank or financial services firm is willing to sell that currency
• Currency Hedging
  • Currency hedging is a technique of protecting against the potential losses that result from adverse changes in exchange rates.
• Currency Arbitrage
  • Currency arbitrage is the simultaneous and instantaneous purchase and sale of a currency for a profit.
• Currency Speculation
  • Currency speculation is buying and selling a currency expecting its value to change, resulting in a profit.
• Direct Quote
  • It determines the price of domestic currency for each unit of foreign currency. It is the amount of national currency needed to buy a unit of a foreign currency.
• Currency Appreciation
  • This refers to the value of the local currency increasing relative to a foreign one.
• Currency Depreciation
  • This refers to the value of the local currency decreasing relative to a foreign one.
• Indirect Quote
  • An indirect quote states the price of the domestic currency in foreign currency terms. It is the amount of foreign currency needed to buy one unit of the national currency.
• Spot Rate
  • The spot rate is the exchange rate transacted at a particular moment by the buyer and seller of a currency.
• Cross Rate
  • Cross rate is the exchange rate between two currencies, neither of which is the official currency in the country where the quote is provided.
• Forward Exchange Rate
  • This is the exchange rate at which a buyer and a seller agree to transact a currency at some date in the future.
• Forward Market
  • Forward Markets are currency markets for transactions at forward rates
• Forward Contract
  • Forward contracts require exchanging an agreed-on amount of a particular currency on an agreed-on date and at a specific exchange rate.
• Derivatives
  • Derivatives are financial instruments whose underlying value comes from other financial instruments, commodities, or currencies.
• Currency Swaps
  • Currency swaps are the simultaneous buying and selling of a currency on two different dates.
• Currency Options
  • Currency options are the right to exchange a specific amount at a particular future date and a specific agreed-on rate.
• Currency Futures
  • Currency futures are contracts that require exchanging a specific amount of currency at a particular future date and a specific exchange rate.
• Rate of Return
  • Is the percentage change in the value of an asset over some period
• Spot Contract
  • Spot contracts are contracts of buying or selling commodities, securities, or currencies for settlement (payment and delivery) on the spot date, which is normally two business days after the trade date.
• Forward Rates
  • Forward rates are the prices of forward contracts.
• Bootstrapping Method
  • This is a method for constructing a zero-coupon fixed-income yield curve from the prices of coupon-bearing products.
• Cross Rates
  • These are currency exchange rates between two currencies, both of which are not the official currencies of the country in which the exchange rate quote is given in.