INTERNATIONAL FINANCE

Module 2: International Monetary System

By Sanjay K Sinha
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International monetary system
A set of law, rules, standards, instruments and institutions that governs
international exchange of money
Role of the international monetary system
Ensure exchange rate stability
Facilitate corrections / adjustments in balance-of-payments disequilibria
Ensure access to international liquidity
Historical overview of exchange rate regimes:
Classical Gold Standard System(1821 1914)
The Gold Standard System (1925 1931)
Bretton Woods System (1944 1973)
Floating Exchange Rates (Since1973)
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Since 1973 Flexible exchange rates
In 1973, floating rate system became widespread; countries moved to
flexible exchange rate system
Gold was abandoned as an international reserve asset
Flexible exchange rates were accepted by the IMF members
Central banks were allowed to intervene in the exchange rate markets to
iron out unwarranted volatilities
Non-oil-exporting countries and less-developed countries were given
greater access to IMF funds
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Current currency systems
Monetary standard or Currency
A monetary standard is a standard monetary unit that acts as a medium of exchange and a
measure of value of goods and services in a country
3 types of currencies in international monetary system today
National currencies
Artificial currencies
Composite currency
Different countries follow different currency exchange rate regimes
ranging from rigidly fixed to independently floating
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Exchange rate regimes
There are two exchange rate systems which have generally been in use:
Fixed Rates
An exchange rate regime in which the government of a country is committed to maintaining a fixed
exchange rate for its domestic currency
Under a fixed exchange rate regime, any increase in the exchange rate of the domestic currency
relative to a foreign currency is known as devaluation, and any decrease is called revaluation
Floating Rates
A flexible exchange rate system involves the exchange rate between two currencies that is determined
by market forces
Under a floating exchange rate regime, any increase in the exchange rate of the domestic currency
relative to a foreign currency is known as depreciation and any decrease is called appreciation
Till the collapse of BW system in 1973, fixed rate system was in use across
all the previous international monetary systems
Since 1973, floating exchange rate system came in use in varied levels of free
float
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Floating exchange rate systems
Freely floating system
Managed float
Pegged exchange rates
Hard pegging
Soft pegging
Adjustable pegging
Crawling peg
Target zone arrangement
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Foreign exchange markets
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Forex (FX) market
A market where currencies are exchanged to facilitate its participants in:
Transferring of purchasing power between countries
Acquiring or providing credit for international trade transactions
Minimizing exposure to the risks of exchange rate changes
FX market is unique in:
Largest trading volumes amongst all financial markets (Avgdaily turnover upwards of
US$ 4 trillion)
Most liquid of all the financial markets
Largest number and variety of traders in the market
Geographically, the widest market
Longest trading hours 24 hours a day, every banking weekday
Big domination by one currency US$ accounts for 85% of trade
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BIS
@
April 2010 report
9
PPT slides by Sanjay K Sinha for course on International Finance
@ : Bank for International Settlements
FX market participants
Two-tiered market
Wholesale market
Dealers (or market makers)
Include banks and non-bank dealers
Buy and sell at quoted bid and offer prices
Brokers
Serve as matchmakers but do not carry inventory/ put their own money
Retail market
Governments
Corporations
Smaller financial institutions
Individuals
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Forex transactions (1/2)
Spot transaction
It is the purchase of foreign exchange with delivery and payment on the second following
business day
Date of settlement is referred to as the value date
The price that is quoted for this immediate settlement on a currency is called the Spot Rate
Forward transaction
It is purchase of foreign exchange with delivery and payment at a future value date (usually
one, two, three, six and twelve months)
Exchange rate is established at the time of the agreement
The rate applicable for the forward transaction that is quoted is called the Forward Rate
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Forex transactions (2/2)
Swap transaction
It is simultaneous purchase and sale of a given amount of foreign exchange for two different
value dates; Both purchase and sale are conducted with the same counterparty
Common types of swap - spot against forward, forward-forward, non-deliverable forwards
(NDF)
The rate at which the swap will occur for one of the parties entering into the agreement is
called the Swap Rate
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Spot market quotes
Direct and indirect quotes
Direct quote is quote of domestic currency (DC) per unit foreign currency (FC) i.e. DC/FC
E.g. 45.25 45.75 Rs./US$
It is called direct quote because that is how people enquire/indicate the rate in any domestic market,
For e.g. how many Rupees for a kilo of wheat
Indirect quote is quote of foreign currency (FC) per unit domestic currency (DC) i.e. FC/DC
E.g. US$/Rs. 0.0219 0.0221
Therefore, indirect quote is reciprocal of direct quote
A direct quote for one party in the transaction will be the indirect quote for the other
Bid and ask prices
The bid price is the amount a dealer is willing to pay for buying a currency
The ask price is the amount the dealer wants for selling a currency
It is always that Ask Price >Bid Price; The bid-ask spread is the difference between the ask
and bid prices. Therefore, Bid-Ask spread = (Ask price Bid price) / Ask price
Some people instead take mid-point of bid and ask quotes in the denominator to find spread
Less traded and more volatile a currency, greater is the spread
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Spot market: Cross rates
When certain currency pairs are inactively traded, their exchange rate is
determined through their relationship to a widely traded third currency
Eg. An Indian importer needs Finnish Markka(FIM) to pay for purchases
from Nokia. Indian Rupee (INR) is not widely quoted against the FIM,
but both currencies are quoted against the US Dollar (USD)
Assume their rates against USD at:
INR 45/ USD
FIM 4.2/ USD
Cross rate will be:
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Interpreting bid-ask quotes (1/2)
Consider the quote of Rs.45.25 45.75 /US$
Remember this is quote offered by a dealer; so look at it from his perspective
The quote means that dealer would buy US$ from you at Rs.45.25 (he is
bidding Rs.45.25 for each dollar i.e. he will pay to buy dollar) and would
sell US$ to you at Rs.45.75 (he is asking for Rs.45.75 for each dollar i.e. he
will accept to sell dollar)
Both bid and ask quotes are always for buying or selling the denominator
currency (base currency) respectively
So, if we take a quote represented in the form of Numerator currency to Denominator
currency (like in the above example, for the bid quote of Rs.45/US$, Rs. will be the
Numerator currency and US$ the denominator currency):
Bid quotes are in the form Pay X to buy unit Denominator (i.e. Base) currency, and
Ask quotes are in the form Accept Y to sell unit Denominator (i.e. Base) currency
In other words, if I am the dealer, then the bid (ask) quotes from me would always mean how much I
will pay (accept) to buy (sell) the denominator currency
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Interpreting bid-ask quotes (2/2)
Now, as the dealer buys Dollars from you, in effect, he is selling Rupees to
you
Therefore, his bid quote for Dollars of Rs.45.25/US$ could also be construed to mean that he
would sell Rs. to you at Rs.45.25 for each Dollar
That is, Bid quote for Dollars of Pay Rs. 45.25 to buy a US$ also means Sell Rs.45.25 for
a US$ i.e. Accept 1 US$ to sell Rs.45.25 or Accept 1/45.25 US$ to sell a Re. implying an Ask
quote for Rupees of Accept 1/45.25 US$ to sell a Re.
So, if Rs. is domestic currency (DC) and US$ is foreign currency (FC), then
Bid quote for Dollar (FC) i.e. (DC/FC)
bid
=45.25
And, Ask quote for Rupees (DC) i.e. (FC/DC)
ask
=1/45.25
Multiplying the two, (DC/FC)
bid
* (FC/DC)
ask
=45.25 * (1/45.25) =1
=> (DC/FC)
bid
= 1 / (FC/DC)
ask
And similarly, (DC/FC)
ask
= 1 / (FC/DC)
bid
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Cross rate bid-ask quotes (1/2)
What is INR/Turkish Lira (TRY) rate if: USD 0.022225 /INR; USD 0.633236 /TRY?
Step 1 Establish the equation for transaction
Step 2 Break down the transaction
INR/TRY
bid
(i.e. pay INR to buy TRY) could be seen as a set of 2 transactions
Transaction 1: Pay INR to Buy USD (i.e. use INR/USD
bid
rate)
Transaction 2: Pay USD to Buy TRY (i.e. use USD/TRY
bid
rate)
Similarly, INR/TRY
ask
(i.e. accept INR to sell TRY) could be seen as:
Transaction 1: Accept INR to Sell USD (i.e. use INR/USD
ask
rate)
Transaction 2: Accept USD to Sell TRY (i.e. use USD/TRY
ask
rate)
These could be converted into easy-to-remember formulae as:
If FC
a
and FC
b
are the two foreign currencies INR and TRY respectively and DC is the
domestic currency USD, then
(FC
a
/ FC
b
)
bid
= (FC
a
/ DC)
bid
(DC/FC
b
)
bid
(FC
a
/ FC
b
)
ask
= (FC
a
/ DC)
ask
(DC/FC
b
)
ask
PPT slides by Sanjay K Sinha for course on International Finance
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Cross rate bid-ask quotes (2/2)
Step 3 Compute substituting the values
Let, FC
a
= INR; FC
b
= TRY; and DC = USD
(FC
a
/ FC
b
)
bid
= (FC
a
/ DC)
bid
(DC/FC
b
)
bid
(FC
a
/ FC
b
)
ask
= (FC
a
/ DC)
ask
(DC/FC
b
)
ask
=> (INR/TRY)
bid
= (INR/USD)
bid
x (USD/TRY)
bid
= {1/(USD/INR)
ask
} x (USD/TRY)
bid
= (1/0.0225) x (0.6332) = 28.1422
=> (INR/TRY)
ask
= (INR/USD)
ask
x (USD/TRY)
ask
= {1/(USD/INR)
bid
} x (USD/TRY)
ask
= (1/0.0222) * (0.6336) = 28.5405
INR/TRY quote would be: 28.1422 5405
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Spot market: Triangular arbitrage
A process of making money by sequentially buying and selling various
currencies, ending with the original currency
Sometimes for a very short while, inter-market prices be such that cross
rates and direct rates differ slightly; this offers an arbitrage opportunity
Not generally available to general players and only dealers are able to avail
of such arbitrage
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Forward market quotations
Quoted in either of the two forms
Outright quote
Similar to spot quotes
Generally quoted to commercial customers
Forward premium or discount / Points
These are the difference between the forward rate and the spot rate
Do not reflect the exchange rate by themselves
Forward premium for J apanese Yen for an Indian importer will be:
f
Rs./
= Forward
Rs./
Spot
Rs./
* 360 *100
Spot
Rs./
n
Where, n =no. of days in the forward contract
When Forward
Rs./
is more than Spot
Rs./
, forward is said to be at a premium i.e. is at a
premium or Rs. would depreciate
When Forward
Rs./
is less than Spot
Rs./
, forward is said to be at a discount i.e. is at a discount
or Rs. would appreciate
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