Forex — An Introduction

Forex, or foreign exchange, is the buying of 1

currency with that of another. Although it is called
foreign exchange, this is just a relative term. The
terms domestic and foreign is relative to the person
using the term. What is foreign to one person is
domestic to another. Currency exchange would be the
more proper term.

The main reasons to exchange foreign currency for

domestic currency is to pay for goods and services in
the foreign country, to invest in its financial assets, to
hedge against unfavorable rates of exchange in the
future, or to profit from those changes. Foreign
currency holders need to convert it back to their
domestic currency to take profits, so that businesses,
governments, and other organizations can use the
money at home.

Hedging is exchanging currency, either in the spot

market or by using forwards or futures contracts, to
protect against unfavorable changes in the future.
Most hedgers are governments and businesses that
need to buy or sell in a foreign country sometime in
the future. Speculators are people who are exchanging
currency purely for profit. Governments, usually
through their central banks, influence the exchange
rate to some extent as well, either by buying or
selling foreign currency, or by creating or destroying
domestic currency. Thus, currency rates fluctuate
because demand and supply for each currency
fluctuates.

The foreign exchange market, often called the FX

market, is an over-the-counter (OTC) market. Its
consists of a network of dealers—central banks,
commercial and investment banks, funds,
corporations, and individuals. Transactions are done
electronically, usually over the Internet, and traders
buy and sell through a broker. Thus, the forex market
operates as a spot market. Although there are futures
and forward contracts on currencies, most forex
transactions use the spot market. There is no central
exchange for the spot market, and brokers and
dealers are located throughout the world, so the forex
market is a 24 hour market during the weekdays.
Forex is the largest financial market in the world—
 over 4 trillion USD equivalent values of currency are
traded daily.

Currency rates are listed as pairs, and there are many

sites on the Internet that display current quotes. The
rate of exchange is the amount of the foreign currency
that is equal in value to a unit of domestic currency,
or, more generally, it is the amount of currency
received for each unit of the currency tendered. Thus,
for instance, the Great Britain pound (GBP) has, at 1
time, passed the $2 mark in value. That means that
$2 buys £1.

Virtually every country, with some small exceptions,

has its own currency, and most of them can be
traded. However, the currencies of a few countries
are the most actively traded, and constitute, by far,
the largest volume of trades. The big 5 are the United
States dollar (USD), Euro (EUR), Japanese yen (JPY), the
British pound (GBP), and the Swiss franc (CHF).

Each currency is symbolized using 3-letter ISO

(International Organization for Standardization)
codes: the 1 2 letters designate the country, the 3
st rd

designates the currency. The most famous illustration

of this is for the United States dollar—USD. However,
sometimes the country name or currency that is
symbolized is not the most common name. Thus, the
symbol for the Swiss franc is CHF, where CH stands
for Confederation Helvetica, which refers to
Switzerland, and MXN stands for the Mexican Nuevo
Peso, even though the most common name for
Mexico's currency is simply the peso.

Advantages of Forex Trading

There are many advantages to trading currencies for

profit. Because there are no organized exchanges for
the foreign currency spot market, there are no
clearing fees or other exchange fees, and because the
forex market is decentralized, there are no
government fees. The lack of organized exchanges
and its decentralization among worldwide trading
centers creates a 24 hour market during the
weekdays. The large size of the market provides
liquidity and fast transactions.

Investing in currencies is also a good way to diversify

assets, because it has little correlation with stocks or
bonds. You can make money regardless of whether a
 currency is rising or falling with respect to another
currency. If the target currency is expected to rise,
you buy it, then sell it later at a higher price,
hopefully; if it is falling, you sell it short, then buy it
later at a lower price, if you predicted correctly. Thus,
there is no up or down market in the FX market—if
one currency is up with respect to another, then the
other, obviously, is down, and vice versa. And
because of the FX market's huge size and
decentralization, there is no possibility that prices will
be manipulated by accounting frauds. No Enron's or
WorldCom's in this market—not even the possibility.
Nor can such a huge market be cornered. And
because currency prices are not the result of what
any single organization does, there can be no insider
trading. Nor can any bubble arise, as has happened
to stocks in the late 90's, and to real estate more
recently. The size of the market is simply too vast
and too interrelated for bubbles to form.

FX metals — gold, silver, palladium, platinum — can

also be traded in forex accounts. For instance, XAU
represents gold. Each XAU/USD pair represents 1 troy
ounce of gold. A pip is equal to a penny, 1 lot equals
10 ounces of gold and 10 FX XAU/USD lots is identical
to trading 1 lot of the traditional gold futures contract
listed on the COMEX exchange. However, the pip
spread in FX metals is 2 to 3 times greater than those
for the equivalent futures contract. Another
disadvantage is that only dealing desk brokers offer
FX metals, so the trader would be buying or selling at
the broker's price rather than the market price.

Forex Accounts

Opening an account to trade currencies requires very

little money—in some cases, as little as $200 in so-
called mini-accounts. Many firms offer up to 50:1
leverage ratios in mini-accounts, so a trader with
$200 in a mini-account can trade up to $10,000
worth of currencies. Leverage greatly amplifies both
profits and losses. Before 2010, brokers advertised
much higher leverage ratios — as high as 400:1 —
but US regulations have capped the leverage ratio to
50:1. Because currencies are naturally range-bound,
leverage is necessary to earn a reasonable profit.
That currency prices do not change much is what
allows brokers to offer such a high leverage ratio.
Is the Forex Market Liquid?

Liquidity is the ability to quickly sell an asset for what

it is worth. In illiquid markets, assets usually have to
be sold for less than what they are worth, especially if
the sale must be completed quickly. Forex brokers
love to advertise that the forex market is the most
liquid market because more than $4 trillion worth of
currency is traded daily. However, this is misleading
because the currencies are not traded on the same
network — there is no centralized exchange for
trading currencies, so there is no global price
competition for forex orders.

Liquidity depends on which currency pairs are traded,

whether the trade is with a dealing desk broker or
with an electronic communication network (ECN),
and, if using an ECN, the number and activity of the
participants on that ECN. The largest and most active
ECNs have the most liquidity.

Some currency pairs are very illiquid. Much of the

retail forex trading is done with dealing desk brokers,
who set the bid/ask prices on all the currencies that
they offer, so there is absolutely no price competition
with a dealing desk broker. Although currencies can
be bought and sold, the prices will be worse than
what could have been gotten on a competitive ECN.

Taxation of Forex Trades

Forward contracts on currencies are classified as 1256

contracts by the tax code, but gains and losses in the
forex spot market are treated as ordinary income
unless the taxpayer opts out. There are 2 methods of
reporting gains and losses in forex trading in the spot
market. The regular method, which is the default
method is governed by IRC §988, which taxes forex
trades as ordinary income. However, the trader can
opt out of the §988 treatment so that spot forex trades
are treated the same as 1256 contracts, where,
regardless of the holding period, 60% of the gain or
loss is considered long-term and the remaining 40%,
short term. This election can be beneficial since long-
term capital gains are taxed at a lower rate than
ordinary gains. Trades treated as 1256 contracts are
reported on Form 6781, Gain and Losses from
Section 1256 Contracts and Straddles.
Updated Forex Statistics

The Bank for International Settlements (BIS) surveys

central banks throughout the world in regards to their
currency transactions and reports the results
quarterly. In addition to reporting the total volume of
spot trades, it also reports statistics on:

 currency derivatives, which are used to hedge risk

or make profits
 cross currency swaps, where 2 parties agreed to
exchange interest payments in different
currencies for specified time, and
 emerging market currencies, which now account for
more than 20% of all currency trading.

Forex trading continues to grow, due to improving

and cheaper technology, with more than $4 trillion of
currency values traded daily. Hedge funds and
individual investors continue to represent a significant
part of the increase. No doubt that this trend will
continue for the foreseeable future

To buy foreign goods or services, or to invest in other

countries, individuals, companies, and other
organizations will usually need to exchange their
domestic currency for the foreign currency of the
country with which they are doing business. Some
exporters do, however, accept foreign currencies,
especially the United States dollar, which is widely
used in the import-export business. For instance,
Saudi Arabia accepts payments in U.S. dollars (USD)
for its oil, so when Canadians buy their oil, they
transact the business in the USD that they receive
from trading with the United States, even though the
United States is not involved in the oil purchase at all.

The foreign exchange rate is simply the price of one

currency in terms of another, or how much one
currency can be exchanged for another, in the same
way that the price of a good is determined by how
much money can be exchanged for it.

The foreign exchange market – otherwise known as the

FX market — consists of financial institutions, mostly
banks, that stand ready to exchange one currency for
another. Banks often negotiate exchange rates
among themselves, but forex dealers that market
 their services to the public generally post bid/ask
prices on the currency pairs in which they make a
market.

Most FX transactions take place in the United

Kingdom, United States, and Japan with most of the
rest of the market centered in Hong Kong, Singapore,
Australia, Switzerland, France, and Germany.

Because the FX market is a worldwide market, where most trading takes place on computer
networks, the FX market is open as long as any financial institution conducting forex trades is
open. Hence, when banks in New Zealand open on Monday morning, it is still Sunday in the
rest of the world, and as the day and night progresses, banks in other parts of the world start
opening up as it becomes morning there. When some banks close for the day, other banks,
farther west, open. San Francisco, in the United States, is the last major trading center to
close for the week – Friday afternoon. Hence, the FX market is open 24 hours a day for each
of the 5 business days. By contrast, few forex trades occur from late Friday afternoon in San
Francisco to Monday morning in New Zealand. Note that because London and New York are
the largest forex trading centers, most forex trading occurs between 8 AM and 12 PM Eastern
Standard Time.

The International Dateline is where, by tradition and fiat, the new calendar day starts. Since New
Zealand is a major financial center, the forex markets open there on Monday morning, while it is still
Sunday in most of the world. Source:
United States Naval Observatory.

The FX market is, by far, the largest market in the

world. Some statistics on the foreign exchange
market can be found at Bank for International
Settlements: International Financial Statistics.

Here are some key statistics released by the Foreign Exchange Committee on January 25,
2018, based on its 27th Survey of North American Foreign Exchange Volume, conducted
October 2017.
 Source: New York
Federal Reserve Bank.

Foreign Exchange Market Participants

There are several types of market participants that

engage in forex transactions to hedge risk, to
speculate for profits, or to facilitate business and
other transactions.

1. Banks and other financial institutions are the largest

volume traders, where roughly 2/3 of all FX
transactions involve banks trading directly with
each other.
2. Brokers sometimes act as intermediaries between
banks. Brokers with more extensive contacts, can
often find better prices for the banks than they
could find themselves, and they also offer
anonymity to banks seeking to buy or sell large
amounts of currency. Brokers profit by charging a
commission on the intermediated transactions.
3. Business customers require foreign currency to
transact foreign business or to make investments.
Businesses with large foreign exchange
requirements even have their own trading desks.
4. Institutional investors, such as pension funds,
hedge funds, mutual funds, and insurance
companies, engage in forex trading to either
hedge risk or to speculate for profits.
 5. Retail customers need foreign currency to travel
abroad or to make online purchases from foreign-
based companies. Some retail customers also
engage in forex trading, using their own
computers or even mobile devices, in the hope of
earning profits.
6. And, what are called foreign exchange
interventions, central banks, which act either on
behalf of their own or foreign governments,
sometimes participate in the FX market to offset
the influence of short-term shocks that can
sometimes cause temporary large movements in
the exchange rate of some currencies, such as
the rapid appreciation of the yen caused by the
2011 earthquake and tsunami in Japan.

Purposes of Foreign Exchange Trading

When currency is exchanged to conduct business, to

invest in foreign countries, or to hedge risk, the
primary concern of the forex participants is not the
short-term movements in exchange rates but to
conduct business with a minimal exchange risk.
Speculators, on the other hand, hope to profit from
short-term movements in the exchange rates by
either buying low and selling high or by selling short
and buying low, usually over a period of minutes,
hours, or sometimes days.

However, it is difficult to make profits by speculating

in foreign transactions, since short-term movements
are governed by the instantaneous supply and
demand of any currency, which cannot be predicted
by any trader. Traders attempt to forecast currency
movements by using either fundamental analysis or
technical analysis.

Fundamental analysis is used to determine long-term

trends in currency prices by examining the economic
factors that determine currency rates, such as the
relative inflation, interest rates, and the economic
strength of the countries being compared. However,
fundamental analysis cannot predict short-term prices
because it takes time to gather the information –
information that is often revised several times over a
period of months – and even if the changes in the
 fundamentals could be known in real-time, it would
not help to predict the instantaneous supply and
demand that determines short-term price
movements.

Instead, most traders have turned to technical

analysis, which is the examination of prices and
volumes of recent forex transactions in the hope that
they can be used to predict future movements. The
Efficient Market Hypothesis states that future prices
cannot be predicted from past prices, that all market
information has already been incorporated into
current prices, and, indeed, considering that most
forex transactions are independent of each other,
there is little reason to believe that future currency
movements can be predicted from past forex
transactions, even real-time transactions;
nonetheless, hope for profits springs eternal.
Although technical charts do exhibit patterns, the
pattern details and the timing change frequently,
making it difficult to profit from small movements in
currency prices, even with the 100 to 1 leverage ratio
or more that many forex companies offer to retail
customers. What technical traders hope for, at best,
is that their predictions will have an increased
probability of being correct and that they will profit
more often than not. Indeed, some technical traders
do make a profit over a long time, but are those
profits the result of skill? Or is it similar to the
proverbial monkeys that pick companies by throwing
darts on a list, where if there are enough monkeys
throwing darts, some will be successful by sheer
chance, by being at the high-end of the statistical
distribution. Another thing to consider is whether the
profits from technical trading is worth the time
invested.

Currency Trading Between Banks

Banks, who are the largest forex participants by

volume, either trade with each other directly or use
the services of a broker. Direct transactions account
for 2/3 of forex trades between banks, while brokers
mediate the remaining 1/3, charging a commission on
the transaction. A bank that wishes to buy or sell
currency directly will offer bid/ask prices – bid prices
are the prices that the bank is willing to pay for a
currency and ask prices are the prices that the bank is
 willing to sell. The dealing bank profits by the spread
between the bid and the ask price.

The size of the spread depends on how frequently the

currencies are traded. Hard currencies, such as the US
dollar, Euro, Japanese yen, and British pound,
constitute about 80% of the FX market, and thus, the
spread between these currency pairs is usually quite
narrow, often less than 4 pips. (1 pip = 1/10,000th of a
currency unit for most currencies.) Soft currencies, such as
those of less developed economies, are traded less
frequently, resulting in larger spreads.

Types of FX Transactions

There are several types of FX transactions: spot

transactions, forward transactions, swaps, futures,
and options. Other than spot transactions, the
remaining types of FX transactions span over time.
These types of transactions can help to prevent or
hedge FX risks that may result from changes in the
exchange rate.

Spot Transactions

Spot transactions are an immediate trade in what is

called the spot market, where one party agrees to
exchange 1 currency for another at an agreed-upon
rate.

Spot transactions are a major type of FX transaction,

consisting of more than 1/3 of all FX transactions.
Settlement of spot trades usually occurs in 2 business
days, especially for currencies of countries located in
different hemispheres. However, some currencies,
such as the Canadian-United States dollar, settle in 1
business day.

In a trade not involving dealers, one party typically

calls another and asks for both the bid and ask prices
for a particular currency. Even though the party only
wants to buy or sell, he will still ask for both prices,
so that the other trader is not alerted yet to his actual
intentions, since that would allow her to skew her
prices in her favor. A dealer, of course, would post
both bid and ask prices.

For a business or other organization that must often

sign long-term contracts for a stipulated price, using
spot prices of currency incurs exchange-rate risk.
Exchange Risks in Spot Transactions

Suppose a U.S. company orders machine tools from a company in Japan, which will take
6 months and cost 120 million yen. When the order is placed, the yen is trading at 120
to a dollar. The U.S. company budgets $1 million in Japanese yen to be paid when it
receives the tools (120,000,000 yen with 120 yen per dollar = $1,000,000) .

However, the yen-dollar exchange rate will almost certainly be different 6 months later.
Although the U.S. company could pay when the order is placed, it would lose the
opportunity cost of the money during the 6-month period, when it could earn interest,
for instance.

If, after the 6 months, the exchange rate is 100 yen per dollar, then the cost in U.S.
dollars would increase by $200,000 (120,000,000 / 100 = $1,200,000), which would
be a profit to the Japanese company but a loss for the American company.

But if the rate is 140 yen to a dollar, then the cost in U.S. dollars would decrease by
over $142,000 (120,000,000 / 140 = $857,142.86), which would be a profit to the
American company and a loss to the Japanese company.

Most companies eliminate this foreign exchange risk by using forward contracts.

Forward Transactions

FX risks can be prevented by forward transactions.

The parties agree to a forward contract where
negotiated prices are calculated using a forward
exchange rate that depends on the current exchange
rate, the difference in interest rates between the 2
countries, and on the settlement date, which is when
payment will be made. The settlement date, like all
the other contract terms of the forward contract, are
negotiable, but the term of the forward contract is
usually less than one year.

Forward contracts do, however, have counterparty

risk, which is the risk that a party will be unable or
unwilling to fulfill the contract on the settlement date.
There is also business risk to a forward transaction, in
that, if the needs of the parties change, the contract
cannot be amended or canceled unless both parties
agree. Counterparty and business risks increase with
the term of the contract.

Currency Swaps

Many forward contracts are used in the import/export

business, where one party is selling a good or service
and the other party is paying for it. A currency swap
(aka foreign exchange swap) is a simplified forward
contract where the parties exchange currency when
 they agree to the contract and reverse the exchange
when the contract terminates. Currency swaps are
the most common type of forward transaction. Credit
risk is limited to the difference in value of the 2
currencies on the settlement date.

Because the interest rates of the 2 countries are

probably different, there is usually an adjustment
made for the different opportunity costs of each
currency, which is similar to the adjustment made in
forward contracts.

Example — Currency Swap Transaction

An American company wants to invest €1 million in Germany for one year. It finds a
European company in the over-the-counter market that is willing to exchange €1 million
for $1.5 million, so the companies exchange the currencies when the agreement is
signed. After one year, the American company gets its $1.5 million back and the
European company gets its €1 million plus an additional adjustment for the higher
interest rate in Europe.

Foreign Currency Futures

A foreign currency future (aka forex future) is a forward

contract with standardized terms, including quantities
and settlement dates, that is traded on organized
exchanges. The exchange acts as an intermediary
between the buyer and seller and takes on the credit
risk of both parties. Hence, credit risk is minimized
because the exchange is usually much more
creditworthy than the traders and has a greater
reputation. Because futures are standardized
contracts, there is greater price transparency and
liquidity than with forward contracts and, thus, they
can be canceled or offset by purchasing or selling an
offsetting contract. Indeed, most future contracts are
terminated before the settlement date, because
speculators have no interest in the actual delivery of
currency but are only interested in the profits that
they hope to make when they close out their position.

Although standardization gives futures contracts most

of their advantages over forward contracts, they may
not serve the needs of some parties, especially
businesses with specialized needs.

Options

Forwards and futures require performance at a

settlement date. An option gives the owner the right,
but not the obligation, to buy or sell a specified
amount of foreign currency at a specified price, called
the strike price, at any time up to a specified expiration
date. A call option allows the holder to buy currency at
the strike price. A put option allows the holder to sell
currency at the strike price.

Options differ from currency futures because they do

not have to be closed out — the option holder can
just let the option expire if it is not profitable. In
contrast, at the expiration of a futures contract, the
futures buyer would have to accept delivery of the
currency, and the futures seller would have to
actually deliver the currency, unless it is a cash-
settled contract, in which case the seller would have
to pay to the buyer the equivalent value in a specified
currency

Foreign Exchange History

Before there was currency, nations traded goods

directly, paying for one good by exchanging it for
another. It was barter on a national scale. However,
barter had major disadvantages: it could not be
divided into units of equal amounts, the value of the
barter frequently depended on the quality of the
goods, and the value of those goods would generally
decrease over time. Animals, for instance, were
frequently traded, but they age and eventually die, so
their value would decline over time, eventually to
nothing. Because of its many advantages, money was
eventually created to facilitate trading. Money could
be divided into equal units that each has the same
value, and because its value did not depend on its
condition, its nominal value did not change. Thus,
money, unlike barter, can serve as a unit of account
and as a store of value, the 2 main functions of
money. Additionally, it was also a better means of
exchange: easier to carry, easier to store, and
eliminating the need that one trader had exactly what
the other trader wanted, and vice versa. In the
beginning, trading partners would use a common
form of money to conduct their business, which was
usually gold or silver. Then eventually the benefits of
paper currency became evident, but since each
country issued its own currency, it wasn't very useful
for international trading, since the purchasing power
of each currency differed considerably and could
 differ over time depending on how much currency the
countries issued.

Hence, foreign exchange history can be viewed as a

series of solutions that allowed countries to issue
their own currency and to conduct their own
monetary policy while also allowing international
trade to be conducted by providing a means of
exchanging one currency for another according to the
exchange rate between them, which was either
agreed-upon or set by the market.

Money, Currency, and Foreign Trade

One of the qualities that money requires is that it be

scarce. If it were not, it would have no value as
money. For instance, if ordinary stones were money,
then anyone could just pick some up off the ground
and pay a merchant for his goods. But why would a
merchant accept stones when he could just stoop
down to pick up stones, too. He wouldn't need to sell
merchandise, or do anything at all, if he could just
pick up some stones and use it for money. Everyone
else would think similarly. Hence, there would be no
economy, and nothing to buy with the stones.

Although many different items were used for money

in the past, people eventually discovered that gold
was the ideal material for money. It could not be
manufactured or printed, it was not easily mined, and
it was difficult to find new sources of gold. That it was
also the most ductile and malleable of metals made it
easy to fashion into coins. But gold was heavy, and
how much a person could carry is severely limited,
since a 10 dollar gold piece would be 10 times
heavier than a 1 dollar gold piece.

So governments decided that printed currency,

usually called bills or notes, was the solution. A 10
dollar bill, for instance, weighs just as much as 1
dollar bill or a 100 dollar bill. This was a good
solution, but still had some problems. What would
prevent anybody from just printing money?
Governments solved that problem by using secret
methods of printing and passing harsh laws to punish
anyone who would try.

But what would prevent the government from just

printing more money to pay itself and others? Many
governments have done that—Germany, after World
 War I, for instance. Consequently, their currency
become worthless. It took a wheelbarrow of cash to
buy a loaf of bread. Germans were literally burning
money to keep warm in the winter. Oftentimes,
people in such economies turn to hard currency, which
is a trusted currency of a stable country, because
nobody wants to buy or sell using currency that is
continually devaluing. So obviously, there must be
some way to prevent governments from just printing
money, and the way that was done was to make it
equal, by law, to something else that couldn't be
easily made, printed, or found—gold.

The advantages of using money backed by gold were

numerous:

 Since every country had gold, a natural material,

and most people were familiar with it, it provided
a common measure of value.
 It helped keep inflation in check by keeping the
money supply based on the gold standard limited,
thus stabilizing economies. Inflation is the result
of increasing supplies of money for a given
economic state. More money causes the price of
everything to go up because it increases the
demand for goods and services before the
economy has time enough to expand its supply—
so prices go up. By tying the amount of currency
to the amount of gold that a country possesses, it
limits the amount of currency that can be printed.
 Low inflation allows long-term planning. There are
many large projects that must be paid for over
time. It would be almost impossible to project
future costs without knowing what future prices
were going to be.

Fixed Exchange Rates

Before there was significant trade between countries,

there was little need for foreign exchange, and when
there was a need, it was served by gold, since gold
was used by most of the major countries. However,
as trade expanded, there was a need to exchange
currency rather than gold because gold was heavy
and difficult to transport. But how could different
 countries equalize their currency in terms of another
currency. This was achieved by equalizing all
currencies in terms of the amount of gold that it
represented—the gold-exchange standard.

Gold-Exchange Standard

Under this system, which prevailed from 1879 to

1934, the value of the major currencies was fixed in
terms of how much gold for which they could be
exchanged, and thus, they were fixed in terms of
every other currency.

Example — Calculating Exchange Rates Based on the Gold Standard

When the United States adopted the gold standard in 1879, it fixed the United States
dollar to an ounce of gold at the rate of $20.67. Also at this time, the British sterling
pound was pegged at £4.2474 per ounce. To calculate the exchange rate between
United States dollars and British pounds, divide the value of one currency by the other.
So to calculate the number of United States dollars per British pound:

$20.67/4.2474 = $4.8665

To calculate the value of British pounds in terms of dollars:

£4.2474/20.67 = £0.2055

Note that this is the same method as calculating currency cross rates, where the rate
between 2 currencies is determined by calculating their exchange rate with a 3 rd

currency where both exchange rates with the 3 currency are known.
rd

One of the requirements that the countries adhering

to the gold standard needed to follow was to maintain
their money supply to a fixed quantity of gold, so the
government could only issue more money if it had
obtained more gold. This requirement, of course, was
to prevent countries from just printing money to pay
foreigners, which had to be prevented because,
otherwise, there could be no foreign trade. Why
would a trader accept currency for his goods if the
country could just print more of it, thereby reducing
the value of the currency that was already available,
and thereby reducing the value of the currency held
by the trader?

A corollary of this requirement is that gold had to flow

freely between different countries; otherwise no
country could export more than they import, and vice
versa, and still maintain its supply of currency to the
gold it held in stock. So if there was a net transfer of
currency from one country to another, gold would
 have to follow. (Or, at least the ownership of it. The
New York Federal Reserve, for instance, held the gold
of many countries, so countries could settle in gold by
updating their accounts at the New York Fed.)

The Collapse of the Gold Standard

The main problem with the gold standard was that if

a country was not competitive in the world
marketplace, it would lose more and more gold as
more goods were imported and less exported. With
less gold in stock, the country would have to contract
the money supply, which would hurt the country's
economy. Less money in circulation reduces
employment, income, and output; more money
increases employment, income, and output. This is
the basis of modern monetary policy, which is
implemented by central banks to stimulate a sluggish
economy by increasing the money supply or to reign
in an overheating one by contracting the money
supply.

During the 1930's, the world was in the throes of the

Great Depression. Countries started abandoning the
gold standard by reducing the amount of gold backing
their currency so that they could increase the money
supply to stimulate their economies. This deliberate
reduction of value is called a devaluation of currency.
When some of the countries abandoned the gold
standard, then it just collapsed, for it was a system
that could not work unless all the trading countries
agreed to it.

Of course, at some point, something else would have

to take its place; otherwise, there could be no world
trade—at least not in the quantities that were then
occurring. As World War II was coming to a close, it
was obvious that another system would be needed.

Bretton Woods and the Adjustable-Peg System

The leaders of the allied nations met at Bretton

Woods, New Hampshire in 1944, to set up a better
system of fixed exchange rates. The U.S. dollar was
fixed at $35 per ounce of gold and all other
currencies were expressed in terms of dollars. This
official fixed rate of exchange was known as the par
value of currency (aka par of exchange, par exchange
rate).
 However, to avoid making deleterious macroeconomic
adjustments to maintain the exchange rate, the new
system provided for an adjustable peg, that allowed
the exchange rate to be altered under specific
circumstances. Thus, this Bretton Woods system was
also known as the adjustable-peg system. To actuate
this new system, the International Monetary Fund (IMF)
was created.

Each country had to maintain an account at the IMF

that was proportional to the country's population,
volume of trade, and national income. One of the
services provided by the IMF was to provide accounts
for each of the participating countries that held
Special Drawing Rights (SDR), which were units of
account that could be used to settle IMF transactions
through the transference of the SDRs. Although
initially the SDR was pegged to gold, it is currently
equalized to the weighted average of the currencies
of the 5 largest IMF exporters.

The new system required that each country value its

currency in terms of gold or the United States dollar,
which, of course, fixed the exchange rate among all
currencies. The countries were required to maintain
the exchange rate to within 1% of the peg, but, if
special circumstances required, they could allow the
exchange rate to fluctuate by up to 10%. However, if
this was not adequate, then the country would have
to seek approval from the IMF board to change the
exchange rate by more than 10%. This prevented
countries from devaluing their currency for their own
benefit.

To maintain the limits, a country could:

 use official reserves, which is the foreign currency

held by a country from a previous surplus.
 borrow from the IMF by borrowing the foreign
currency, and using its own currency as collateral.
 sell gold to a country for its currency.

The Bretton Woods system began to weaken in the

1960s, when foreigners accumulated large amounts
of U.S. dollars from post World War II aid and sales
of their exports in the United States. There were
concerns as to whether the U.S. had enough gold to
redeem all the dollars.
 With reserves of gold falling steadily, the situation
could not be sustained and the U.S. decided to
abandon this system. In 1971, President Nixon
announced that U.S. dollars would no longer be
convertible into gold, so the exchange rate was
allowed to float. Because of the central role played by
the United States, the Bretton Woods system could
not be sustained. By 1973, this action led to the
system of managed floating exchange rates that
exists today.

The Managed Floating Exchange Rate

Managed floating exchange rates are rates that float, but

are sometimes changed by countries, by having their
central banks intervene directly in the forex market,
usually by buying or selling the currency that the
country wants to influence, so that the exchange rate
is changed by the new supply or demand. However,
direct intervention by the major countries has been
rare. For instance, the Federal Reserve has only
intervened 8 days in 1995, and only 2 days in the 10-
year period 1996-2006. Many smaller countries,
however, either peg their currency to the United
States dollar, or, like Singapore, peg it to a basket of
currencies.

The major benefit of the flexible floating exchange

rate is that it corrects imbalances automatically. If a
country imports more than it exports, then its
currency will decline in relation to the importing
country's currency, which will make imports more
expensive and exports less expensive, thus reversing
the imbalance, or at least mitigating it. It also helps
to adjust the system when events happen that have a
significant impact on the balance of trade, such as
the spike in oil prices in 1973-1974 and 1981-1983,
or when countries experience significant recessions.

Another major benefit of the floating exchange rate is

that it allows countries to manage their own
economies through monetary policy, expanding the
money supply to stimulate the economy, or
contracting it to rein in inflation. Indeed, the
publication of significant changes in monetary policy,
such as the raising or lowering of interest rates, by
the major countries increases volatility in their
currencies, both before and after the news is
published. Many traders stay out of the market
 during these times because of its unpredictability.
Most major forex trading websites have a calendar of
these events for the currency pairs that they offer for
trading.

Before pegged systems were abandoned, it was

feared that flexible exchange rates would diminish
trade because of unknown changes in the rate that
could affect sales or projects that take time.
However, this problem has been solved with FX
forward contracts that eliminate any uncertainty
about future exchange rates.

Changes in the foreign exchange rates of yen

per dollar and dollars per pound from 1970-2001.

Source: New York Federal

Reserve Bank.

The International Monetary Fund and the World Bank

The IMF has survived the demise of the Bretton

Woods system. Today it loans money to developing
countries or to those in crisis, or to Communist
countries changing over to capitalism. It can impose
strict rules, if necessary, over the economies of the
loan recipients to help them repay their debt.

Another organization created by the Bretton Woods

Agreement—the International Bank for Reconstruction
and Development (IBRD), or World Bank, has also
survived. The World Bank's original purpose was to
finance the reconstruction of Europe and Asia after
World War II. Today, the World Bank loans money,
mostly to developing countries, for commercial and
infrastructure projects, and the loans must be backed
by the country receiving the loans. It does not,
however, compete with commercial banks

Foreign Exchange Reserves of India

FOREIGN EXCHANGE RESERVES
INDIA
March 01, 2019
401.777
(Billion US Dollars)
USD 2,559.50 million
(from Feb 22, 2019)
52 Week High:
426.082 bn
(Apr 13, 2018)
52 Week Low:
392.079 bn
FOREIGN EXCHANGE RESERVES
Trend
(Oct 26, 2018)
DATE
AMOUNT
CHANGE
Mar 01, 2019
401.777
0.64%
Feb 22, 2019
399.217
0.24%
Feb 15, 2019
398.273
0.04%
Feb 08, 2019
398.122
0.53%
Feb 01, 2019
400.242
0.52%
Jan 25, 2019
398.178
0.38%
(Billion US Dollars)
GOLD RESERVES OF INDIA
01 March 2019
23.25
Billion US Dollar

Created with Highcharts 6.1.0Source: Reserve Bank Of IndiaUS Dollar Billion

($)Foreign Exchange Reserve of IndiaIndiaForeign Exchange ReserveMay '18Jul
'18Sep '18Nov '18Jan '19Mar '19380.00400.00420.00440.00NumberBasket.com 1
Mar 2019● Foreign Reserve:USD 401.777 Billion
Source: Reserve Bank Of India

India's Forex Reserves

The Foreign Exchange Reserves of India stood at 401.777 Billion US Dollar as on
March 01, 2019.
This represents an increase in the Foreign Exchange Reserve by USD 2,559.50
million from last week i.e. Feb 22, 2019.
In the 52 week period, the Foreign Exchange Reserves of India touched a high of
USD 426.082 Billion on Apr 13, 2018 and recorded a low of USD 392.079 Billion on
Oct 26, 2018.

Meanwhile, the Gold Reserves of India stood at USD 23.25 Billion US Dollar as
on Mar 01, 2019. The Reserve Bank of India (RBI) reported that the Foreign
Currency Assets stood at 374.06 US Billion Dollar, the Reserve Trench position at
3.00 US Billion Dollar, SDRs (Special Drawing Rights with the IMF) at 1.46 US Billion
Dollar as on Mar 01, 2019.

India's Forex Comparision

Month 1 Year 5 Years 10 Years

Current
ago ago ago ago
401.78 400.24 420.59 294.36 249.28
Mar 2019 Feb 2019 Feb 2018 Feb 2014 Feb 2009
Billion US Dollar

What is Foreign Exchange Reserves?

Foreign exchange reserves (also called forex reserves or FX reserves) is foreign
currency or other assets held by a central bank or Government.

The main purpose of holding foreign Reserves is that the Central Bank can pay if
need be its liabilities, such as the currency issued by the central bank, as well as the
various bank reserves deposited with the central bank by the government and other
financial institutions. The higher the reserves, the higher is the capacity of the central
bank to smooth the volatility of the Balance of Payments.

Foreign Exchange Reserves Composition

Foreign Exchange Reserves include:

1. Foreign Currency Reserves held in US Dollars, Euro, British Pound or Japanese

Yen.
2. Gold Reserves.
3. International Monetary Fund Reserve Trench Positions.
4. Special Drawing Rights (SDRs). SDR represents aclaim to foreign currencies for
which it may be exchanged.

 Our foreign-exchange reserves when I took over were no more than a billion
dollars; that is, roughly equal to two weeks' imports.
 ~ Manmohan Singh
Foreign Reserve Trend of India
Foreign Excha
▼
Foreign Exchange Reserves (Dollar)

Select

Created with Highcharts 6.1.0Source: Reserve Bank Of IndiaUS Dollar BillionTotal

Foreign ReserveClick and drag in the plot area to zoom
in2002200420062008201020122014201620180.0100.0200.0300.0400.0500.0Numb
erBasket.com 11 Apr 2008● Foreign Reserve:$312.37 Billion
In India, The Reserve Bank of India the is the custodian of India’s foreign exchange
reserves and is responsible for maintaining and managing the country’s foreign
exchange reserves.

Foreign exchange reserves facilitate external trade and payment and promote
orderly development and maintenance of foreign exchange market in India. One
benefit of keeping large amount of foreign reserve is that India can effectively handle
the situation such as oil shocks or global recession