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Foreign Exchange

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

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  1. Foreign Exchange Business and Financial Reporting (JMSC6004) March 18, 2002

  2. 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

  3. 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.

  4. 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.

  5. Intervention • Finance Ministers often believe that their currency is mispriced by the mkt • Struggle between govts and mkts • Contest of will • Central Bank “vigilantes”

  6. 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

  7. 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

  8. 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.

  9. 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.

  10. Hedging Currency Risks • Forward • Futures • Options

  11. Hard vs Soft currencies • Convertibility • Is the capital account open or closed?

  12. The Almighty Dollar • Dollarization • Currency Peg • Currency Board

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