Exchange rate systems term paper help:
Many Lebanese are perhaps familiar with foreign exchange rates because during most of the war years and even the couple of years that followed, the purchasing power, incomes, and household behaviors were hostage to the fluctuations in the foreign exchange rate. For the average Lebanese, the foreign exchange rate is the value of the Lebanese pound in exchange for American dollars or other foreign currencies. Many investors were involved in the foreign exchange markets, and mainly, they were known as speculators since they constituted a considerable buying or selling power in the market, making their profits out of purchasing currency at lower rates and selling it at higher rates. In the mid-1990s, many of these investors turned to foreign markets, especially Europe, especially as the Lebanese government succeeded in stabilizing the Lebanese currency. In 1999, a number of Lebanese investors lost considerable amounts of money as a result of speculating on the newly issued Euro. This, together with the negative perception the community had of speculators and exchange rates due to the war experience, led to misperceptions about foreign exchange rate mechanisms. In reality, however, exchange rates are of ultimate importance for all business, banks and governments, especially that it constitutes a major issue in international trade.
As international trade and investing have increased over time, so has the need to exchange currencies. Foreign exchange markets represent a global telecommunications network among the large commercial banks that serve as financial intermediaries for such exchange. These banks are located in New York, Tokyo, Hong Kong, Singapore, Frankfurt, Zurich and London. Foreign exchange transactions at these banks have been increasing over time.
What are Exchange Rates?
At any point in time, the price at which banks will buy a currency (bid price) is slightly lower than the price at which they will sell it (ask price). As with markets for other commodities and securities, the market for foreign currencies is more efficient because of financial intermediaries (commercial banks). Otherwise, individual buyers and sellers of currency would be unable to identify other parties to accommodate their needs.
Exchange rates are listed in any major newspaper on a daily basis. Together with the name of the currency is published the spot exchange rate for immediately delivery. Widely used currencies such as the British pound and German mark, forward rates are also published in daily newspapers (Schneider, p. 212) .
From 1944 to 1971, the exchange rate at which one currency could be exchanged for another was maintained by governments within one percent of a specified rate. This period was known as the Bretton Woods era, because the agreement among country representatives occurred at the Bretton Woods Conference.
By 1971, the US dollar was clearly overvalued. That is, its value was maintained only by central bank intervention. In 1971, an agreement among all major countries (known as the Smithsonian Agreement) allowed for devaluation of the dollar. In addition, the Smithsonian Agreement called for a widening of the boundaries from 1 to 2 ¼% around each currency’s set value. Governments intervened in the foreign exchange market whenever exchange rates threatened to wander outside the boundaries (Schneider, p. 211).
In 1973, the boundaries were eliminated. Since then, the exchange rates of major currencies have been floating without any government-imposed boundaries. Yet, governments may still intervene in the foreign exchange market in order to influence the market value of their currency. A system whereby exchange rates are market-determined without boundaries but subject to government intervention is called a dirty float. This can be distinguished from a freely floating system, in which the foreign exchange market is totally free from government intervention. Governments continue to intervene in the foreign exchange market from time to time.
Some currencies are still pegged to another currency or a unit of account and maintained within the specified boundaries. For example, many European currencies are part of the so-called exchange rate mechanism (ERM), in which they are pegged to a multi-currency unit of account known as the European Currency Unit (ECU). Because these currencies are pegged to the same unit of account, they are essentially pegged to each other. Governments intervene to ensure that exchange rates between these currencies are maintained within the established boundaries (Schneider, p. 213).
During the 1980s, the boundaries surrounding the exchange rates were 2.25% above and below a specified exchange rate between each pair of European currencies. However, in the early 1990s central banks were unable to maintain exchange rates between European currencies within these boundaries. Consequently, the boundaries were widened substantially in 1993.
Exchange Rate Mechanism (ERM)
The exchange rate mechanism devised by the European nations experienced severe problems in the fall of 1992, as economic conditions and goals varied among European countries. The German government focused on controlling inflation and implemented a tight monetary policy, which increased German interest rates. Money flowed out of other European countries into Germany to capitalize on the relatively high German interest rates. Because exchange rates between European currencies were tied (within boundaries), European investors could capitalize on the high German interest rate without much concern about exchange rate risk. The flow of funds out of other European countries reduced the supply of funds in these countries. Consequently, the interest rtes increased in these countries as well at a time when their respective governments were attempting to lower interest rates in order to stimulate their economies. The end result was less aggregate spending in countries because of the increase in interest rates. Such a result was especially undesirable during 1992, because some European countries were in the midst of a recession (Reague, p. 384).
Hence, when exchange rates are tied, a high interest rate in one country ahs a strong influence on interest rates in other countries. Funds will flow to the country with a more attractive interest rate, which reduces the supply of funds in the other countries and places upward pressure on their interest rates. The flow of funds should continue until the interest rate differential has been eliminated or reduced. This process will not necessarily apply to countries outside the ERM because the exchange rate risk may discourage the flow of funds to the countries with relatively high interest rates. However, because the ERM requires central banks to maintain the exchange rates between currencies within specified boundaries, investors moving funds among the participating European countries are less concerned about exchange rate risks (Reague, p. 387).
The political and economic conflicts that arose due to the ERM crisis in 1992 led Britain and Italy to suspend their participation in the ERM, especially that both countries wanted to avoid the influence of the high German interest rates. Thus, the currencies of Britain and Italy were no longer tied to the German mark and other European currencies. Thus, even if interest rates were higher in some European countries, funds in Britain and in Italy would not necessarily flow to those countries because of exchange rate risk. This means that the British and Italian interest rates would not be more dependant on local conditions than the conditions of other European countries.
Factors affecting Exchange Rates
Demand & Supply
The value of a currency adjusts to changes in demand and supply conditions, moving toward equilibrium. In equilibrium, there is no excess or deficiency of that currency. For example, a large increase in the US demand for German goods and German securities would result in an increase demand for German marks. Because the demand for marks would then exceed the supply of marks for sale, the market makers (commercial banks) would experience a shortage of marks and would respond by increasing the quoted price of marks. Therefore, the mark would appreciate, or increase its value.
Conversely, if German corporations began to purchase more US goods and German investors began to purchase more US securities, this will reflect an increased sale of marks in exchange of US dollars, causing a surplus of marks in the market. The value of the mark would therefore depreciate, or decline, in order to once again achieve equilibrium (Schneider, p. 219).
As a matter of fact, the supply and demand for a currency are influenced by a variety of factors such as differential inflation rates, differential interest rates, and government intervention.
Differential Inflation Rates
A theory that describes the relationship between inflation and exchange rates is known as the purchasing power parity (PPP). This theory suggests that the exchange rate will, on average, change by a percentage that reflects the inflation differential between the two countries of concern. To illustrate, assume an initial equilibrium situation in which the British pound’s spot is $1.60, US inflation is 3% and British inflation is also 3%. If the US inflation suddenly increased to 5%, the British pound would appreciate against the US dollar by approximately 2% according to PPP. The rationale is that the US would increase its demand for British goods as a result of the higher US prices, placing upward pressure on the pound’s value. Once the pound appreciated by 2%, the purchasing power of the US consumers would be the same whether the consumers purchased US or British goods. Although the US goods would have risen in price by a higher percentage, the British goods would then be just as expensive to US consumers because of the pound’s appreciation. Thus, a new equilibrium exchange rate results from the change in the US inflation. In reality, however, exchange rates do not always change as suggested by the PPP theory because other factors may influence such a change (Schneider, p. 216-217).
Differential Interest Rates
The influence of differential interest rates can be illustrated in a situation whereby US interest rates were to suddenly become much higher than German interest rates. The demand by US investors for German interest-bearing securities would decrease, as these securities would become less attractive. In addition, the supply of marks to be sold in exchange for dollars would increase as German investors increased their purchases of US interest-bearing securities. Both forces would place downward pressures on the mark’s value. Under the reverse situation, opposite forces would occur, resulting in upward pressure on the mark’s value. In general, the currency of the country with a higher increase (or small decrease) in interest rates is expected to appreciate, other factors held constant (Reague, p.388) .
Central banks commonly consider adjusting a currency’s value to influence economic conditions. For example, the US central bank may wish to weaken the dollar to attract more demand for its exports, which can stimulate its economy. However, a weaker dollar can also reduce foreign competition (by raising the prices of foreign goods to US consumers), which may cause US inflation. Alternatively, the US central bank may prefer to strengthen the dollar to intensify foreign competition, which can reduce US inflation.
A country’s government can intervene in the foreign exchange market to affect a currency’s value. Direct intervention occurs when a country’s central bank sells some of its currency reserves for a different currency. For example, fi the Federal Reserve Bank desired to weaken the dollar, it would sell some of its dollar reserves in exchange for foreign currencies. In essence, it would thereby increase the US demand for foreign currencies in the foreign exchange market, which could cause those currencies to appreciate against the dollar. To strengthen the dollar, it could sell some of its foreign currency reserves in exchange for dollars.
As an indirect method of intervention, the government could influence those factors such as inflation or interest rates that affect a currency’s value. Alternatively, it could place restrictions on international trade or on international investments. For example, if the US government imposed trade restrictions on US imports, this would limit the US demand for foreign currencies and would place downward pressure on those currencies’ value.
Central bank intervention can be overwhelmed by market forces, however, and therefore may not always succeed in reversing the exchange rate movements, yet it may significantly affect the foreign exchange markets in two ways. First, it may slow the momentum of exchange rate movements. Second, it may cause commercial banks and other corporations to reassess their foreign exchange strategies if they believe the central bank will continue intervention (Schneider, p. 220).
Speculation in Foreign Exchange Markets
Many commercial banks take positions in currencies to capitalize on expected exchange rate movements. For example, if a commercial bank expects the mark to depreciate against the dollar, it may take a short position in marks and a long position in dollars. That is, it will first borrow marks from another bank, then exchange the marks for dollars to provide a short-term dollar loan to a bank that needs dollars. When the loan period is over, it receives dollars back with interest, converts them back to marks, and pays off its debt in marks with interest. If the dollar strengthens over this period, the bank receives more marks per dollar than the number of marks needed to purchase each dollar in the first place.
Dynamics of Exchange Rates
The foreign exchange market has received much attention in recent years because of the degree to which currency movements can affect a firm’s performance or a country’s economic conditions. Most foreign currencies strengthened against the dollar in the late 1970s, weakened during the 1980s and began to strengthen again in the mid-1980s. Foreign currencies have frequently strengthened when their interest rates were high relative to the US interest rate. The trends in European currency values are somehow similar. Periods of increased foreign currency values reflect a weak dollar, while periods of decreased foreign currency values reflect a strong dollar (Schneider, p. 221).
Foreign Exchange Derivatives
Foreign exchange derivatives can be used to speculate on future exchange rate movements or to hedge anticipated cash inflows or outflows in a given foreign currency. As foreign security markets have been more accessible, institutional investors have increased their international investments, which has increased their exposure to exchange rate risk. Some institution investors use foreign exchange derivatives to hedge their exposure. There are four major foreign exchange derivatives, namely forward contracts, currency futures, currency swaps, and currency option contracts (Schneider, p. 244).
Forward contracts are contracts typically negotiated with a commercial bank that allow one to purchase or sell a specified amount of a particular foreign currency at a specified exchange rate on a specified future date. There is a forward market that facilitates the trading of forward contracts. This market is not in one visible place, but is essentially a telecommunications network in which large commercial banks match participants who wish to buy a currency forward with other participants who wish to sell a currency forward.
Many of the commercial banks that offer foreign exchange on a spot basis also offer forward transactions for the widely traded currencies. By enabling a corporation to lock in the price to be paid for a foreign currency, forward purchases can hedge the corporation’s risk that the currency’s value may appreciate over time (Schneider, p. 245).
A corporation receiving payments denominated in a particular foreign currency in the future could lock in the price at which the currency could be sold by selling that currency forward.
The large banks that accommodate requests for forward contracts are buying forward from some firms and selling forward to others at a given rate. They profit from the difference between the bid price at which they buy a currency forward and the slightly high ask rate at which they sell that currency forward. If a bank’s forward purchase and sale contracts do not even out for a given date, the bank is exposed to exchange rate risk.
The forward rate of a currency will sometimes exceed the existing spot rate, thereby exhibiting a premium. At other times, it will be below the spot rate, exhibiting a discount. Forward contracts are sometimes referred to in terms of their percentage premium or discount rather than their actual rate.
Case Study: Rymco
Rymco exports the majority of its cars from Japan. Accordingly, it has to make its payments to the Japanese producer in Japanese yens. At the same time, it makes other payments in US dollars while receiving all its proceeds in US dollars and Lebanese pounds. Currencies fluctuate continuously, especially the yen and the dollar against each other. For example, in 1997, the yen was too weak at a rate of 120 to 130 yens per dollar. This was an opportunity for Rymco to expand its business since it purchasing power increased. Today, however, yen has become very strong, standing at about 100 yens per dollar. Such fluctuations become very risky when the company makes its purchases at a certain rate and sells the vehicles at another. To avoid the exposure to exchange risks, the company purchases exchange rate forwards, contracts that are used to hedge against foreign currency fluctuations (Rasamny, personal interview).
In 1998, Rymco suffered a very embarrassing incident when in April it announced profits of $10 million. Two weeks later, the company corrected the figure, bringing it down to $8 million only, with the $2 million difference lost in sudden exchange rate fluctuation (Abboud, p.44). In 1999, Rymco avoided a similar fiasco by hedging almost all its exposure risk. However, its biggest cost remained the transferring of all its sales into Lebanese pounds since the Lebanese law requires the disclosure of all financial statements in local currency (Abboud, p.44).
Currency Futures Contracts
An alternative to the forward contract is a currency futures contract, which is a standardized contract that specifies an amount of a particular currency to be exchanged on a specific date and at a specified exchange rate. A firm can purchase a futures contract to hedge payables in a foreign currency by locking in the price at which it could purchase that specific currency at a particular point in time. To hedge receivables denominated in a foreign currency, it could sell futures, thereby locking in the price at which it could sell that currency. These contracts also have specific maturity dates from which the firm must choose (Reague, p. 355).
A currency swap is an agreement that allows one to periodically swap one currency for another at specified exchange rates. It essentially represents a series of forward contracts. Commercial banks facilitate currency swaps by serving as the intermediary that links two parties with opposite needs. Alternatively, commercial banks may be willing to take the position counter to that desired by a particular party. In such a case, they expose themselves to exchange rate risk unless the position they have assumed will offset existing exposure (Reague, p. 356).
Currency Options Contracts
Another instrument used for hedging is the currency option. Its primary advantage over forward and futures contracts is that it provides a right rather than an obligation to purchase or sell a particular currency at a specified price within a given period.
A currency call option provides the right to purchase a particular currency at a specified price, known as the exercise price, within a specified period. This type of option can be used to hedge future cash payments denominated in a foreign currency. If the spot rate remains below the exercise price, the option would not be exercised, because the firm would purchase the foreign currency at a lower cost in the spot market. However, options can be obtained only for a fee known as the premium, so there is a cost to a firm hedging with options, even if the options are not exercised.
A put option provides the right to sell a particular currency at a specified price known as the exercise price, within a specified period. If the spot rate remains above the exercise price, the option would not be exercised because the firm could sell the foreign currency at a higher price in the spot market. Conversely, if the spot rate is below the exercise price at the time the foreign currency is received, the firm could exercise its put option (Reague, p. 357).
When deciding whether to use the forward, futures, or options contracts for hedging, several factors should be considered. First, if the firms requires a tailor-made hedge that cannot be matched by existing futures contracts, a forward contract may be preferred. Otherwise, forward and futures contracts should generate almost similar results.
The choice of either an obligation type of contract (forward or futures) or an options contracts depends on the expected trend of the spot rate. If the currency denominating payables appreciates, the firm will benefit more from a futures or forward contract than from a call option contract. The call option contract requires an up-front fee, but it is a wiser choice when the firm is less certain of the future direction of the currency. The call option can hedge the firm against possible appreciation but still allow the firm to ignore the contract and use the spot market if the currency depreciates. Put options may be preferred over futures or forward contracts for hedging receivables when future currency movements may have a favorable effect on the firm (Reague, p. 357).
Evidently, the manner in which the exchange rate is highly important for any institution or individual involved in international trade. Businesses may not be interested in making profit out of speculating in foreign currency, but they certainly do not want to lose income as a result of foreign exchange fluctuations. Foreign exchange derivatives provide an opportunity for speculators to make money out of trading in currency for the purpose of profit, but more importantly, these derivatives have contributed to the stabilization of international trade, encouraging businesses all over the world to avoid unnecessary risks, and above all, to hedge their positions such that they could be more involved in commercial activities. Some believe that in the future, there will no longer be need to worry about foreign exchange rates as the world becomes a global village. Following the launching of the Euro in January 1999, European businesses no longer have to worry about foreign exchange rates because the Exchange Rate Mechanism (ERM) was replaced by a single currency for the member nations of the European Union. The US dollar, on the other hand is also seen as a possible global currency, and indeed, several countries in Asia and South America are already considering replacing their national currencies with the US dollar. Whether these arrangements will work or not, and whether they will be achieved in the near or far future, is still irrelevant, because so far as international trade, financial institutions, and investors and speculators worldwide are concerned, foreign exchange is still a big business.
Abboud, Reine. “Bottom gear.” Lebanon Opportunities, August 1999: pp. 44-
Abu Habib, Khatir. “Loan Insurance Company sees light.” Al-Iktisad wal-
a’amal. September 1999: p.37.
Anchassi, Reem. “Driven market.” Lebanon Opportunities, December 1999:
Rasamny, Fayez. Personal Interview. December 19, 1999.
Reague, William. Financial Operations. New Jersey: Princeton University,
Schneider, Paul. International Money Markets. New York: McGraw Hill, 1996.