You are on page 1of 45

A Brief History of the International Monetary System

Pre 1875 Bimetalism 1875-1914: Classical Gold Standard 1915-1944: Interwar Period 1945-1972: Bretton Woods System 1973-Present: Flexible (Hybrid) System

The Intrinsic Value of Money and Exchange Rates

At present the money of most countries has no intrinsic value (if you melt a quarter, you dont get $.25 worth of metal). But historically many countries have backed their currency with valuable commodities (usually gold or silver)if the U.S. treasury were to mint gold coins that had 1/35th ounces of gold and sold these for $1.00, then a dollar bill would have an intrinsic value.

When a countrys currency has some intrinsic value, then the exchange rate between the two countries is fixed.

For example, if the U.S. mints $1.00 coins that contain 1/35th ounces of gold and Great Britain mints 1.00 coins that contain 4/35th ounces of gold, then it must be the case that 1 = $4 (if not, people could make an unlimited profit buying gold in one country and selling it in another)

The Classical Gold Standard(1875-1914) had two essential features

Nations fixed the value of the currency in terms of gold Essentially a fixed rate system (Suppose the US announces a willingness to buy gold for $200/oz and Great Britain announces a willingness to buy gold for 100. Then 1=$2)

Advantage of Gold System

Disturbances in Price Levels Would be offset by the pricespecie-flow mechanism.

When a balance of payments surplus led to a gold inflow Gold inflow (country with surplus) led to higher prices which reduced surplus Gold outflow led to lower prices and increased surplus.

Interwar Period
Periods of serious chaos such as German hyperinflation and the use of exchange rates as a way to gain trade advantage. Britain and US adopted a kind of gold standard (but tried to prevent the species adjustment mechanism from working).

The Bretton Woods System (1946-1971)

U.S.$ was key currency valued at $1 = 1/35 oz. of gold All currencies linked to that price in a fixed rate system. In effect, rather than hold gold as a reserve asset, other countries hold US dollars (which are backed by gold)

Bretton Woods System: 1945-1972 German mark

Par Value

British pound

French franc

U.S. dollar
Pegged at $35/oz.


Collapse of Bretton Woods (1971)

U.S. high inflation rate U.S.$ depreciated sharply. Smithsonian Agreement (1971) US$ devalued to 1/38 oz. of gold. 1973 The US dollar is under heavy pressure, European and Japanese currencies are allowed to float 1976 Jamaica Agreement Flexible exchange rates declared acceptable Gold abandoned as an international reserve

Current Exchange Rate Arrangements

The largest number of countries, about 49, allow market forces to determine their currencys value. Managed Float-About 25 countries combine government intervention with market forces to set exchange rates. Pegged to another currency such as the U.S. dollar or euro (through franc or mark). About 45 countries - No national currency and simply uses another currency, such as the dollar or euro as their own.

Organisation of the Foreign Exchange Market

Purpose of the forex market is to permit transfers of purchasing power denominated in one currency to another.
Interbank market electronically linked wholesale market where major banks trade with one another. It is dispersed throughout the leading financial centers of the world. Foreign exchange brokers specialists in matching net supplier & demander banks.

Few terms
Transaction costs The bid ask spread is based on the breadth & depth of the market of that currency as well as on the currencys volatility. Percentage spread = {[Ask price Bid price]/ Bid price} *100

Currency arbitrage Exchange traders are continually alert to the possibility of taking advantage through currency arbitrage transactions, of exchange rate inconsistencies in different monetary centers. These transactions involve buying a currency in one market & selling it in another. Such activities also tend to keep the rates uniform in various markets.

Mechanics of Spot Transactions

Settlement date The value date for spot transactions, the date on which the monies must be paid to the parties involved, is set as the second working day after which the transaction is concluded.

Suppose a U.S importer requires French Franc 1 million to pay his French supplier. Let us look at the steps: 1. After receiving & accepting a verbal quote from the trader of a U.S bank, the importer will be asked to specify two accounts: a) The account in a U.S bank that he wants debited for the equivalent amount of dollar at the agreed exchange rate.

b) The French suppliers account that is to be credited by FF 1 million.

2. The trader will forward a dealing slip containing relevant information to the settlement section of the bank.

3. That same day, a contract note will be sent to the importer. 4. The settlement section will then cable the banks correspondent [ or branch ] in Paris, requesting tranfer of FF 1 million from its nostro account to the account specified by the importer. On the value date, the U.S bank will debit the importers account & the exporter will have its account credited by the French Correspondent. 5. The bank will update its position sheet on the currency.

The Forward market

The importer is offsetting a short positionin pounds by going long in the forward market.
2 points are worth noting: 1. Gain/Loss in the forward contract is unrelated to the the current spot rate. 2. Forward contract is not an option contract. Both parties must performed the agreed upon behaviour i.e bank must deliver the pounds & the importer must buy them at prearranged prices. Forward market participants 1. Arbitrageurs seek to earn risk free profits by taking advantage of differences in interest rate among countries. They use forward contract to eliminate the exchange risk in transferring funds across nations.

2. Traders realated to a specific payment or receipt expected at a specified point of time. 3. Hedgers mostly multinational firms engage in forward contracts to protect the home currency value of various foreign currency denominated assets & liabilities on their balance sheets that are not be realized over the life of the contracts. Forward rates are expressed either as outright rates /actual price to commercial customers or as forward discount or forward premium with differential as swap margins in the interbank market. Forward premium / discount = {[ forwrad rate spot rate]/spot rate} * {12/forward contract length inmonths}


According to interest rate parity theory, the currency of the country with a lower interest rate should be at a forward premium in terms of the currency of the country with the higher rate. More specifically, in an efficient market with no transaction costs, the interest differential should be equal to the forward differential. When this condition is met, the forward rate should be at interest parity or equilibrium prevails in the money markets.
Interest parity ensures that the return on a hedged or covered foreign investment will just be equal to the domestic interest rate on investments of identical risk & there would be no arbitrage incentive to move money from one market to the other.

ASSUME (for now) Perfect Capital Markets, which means: 1) no risk of default on loans 2) borrowing and lending rates are equal (i.e., financial intermediaries fees are negligible)

Assume there are: 1) Domestic bonds (rate of return = iUS) 2) Foreign bonds (rate of return = iFOR) Given the assumption of perfect capital markets, there is zero doubt that these bonds will pay their promised amount. The closest realworld assets that approach this riskless characteristic are government bonds (by governments that issue their own currency).

There are two ways to that individuals can invest $s that will earn a riskless return in $s:
1) Use $s to buy the (riskless) domestic bonds or

2) Follow the following (riskless) three step process:

(i) Use $s to buy foreign currency, and then; (ii) Use the foreign currency to buy (riskless) foreign bonds, while; (iii) Selling the foreign currency forward that you will earn on the foreign bond (i.e., buy $ forward with the returns on the foreign bond)

Assume one buys a 1-yr domestic bond for $X

After one year one receives: If: $X = $100 iUS = 10% $X(1+iUS)

Then: $X(1+iUS) = $100(1.1) = $110

OR, if buying the one-year foreign bond:

First, go to foreign exchange market where:

$X is exchanged for $X(e)

If: X = 100 and e = 0.5 (/$) Then: $X(e) = $100*0.5 (/$) = 50

Next, buy foreign (1 yr) bond with $X(e). At end of year: $X(e)(1+iFOR) (which is in the foreign currency) If: X=100, e=.5(/$), and iFOR = 15%

Then: $X(e)(1+iFOR) = $100(.5)(1.15) = 57.50

At the same moment of the purchase of the foreign bond, sell foreign currency forward. I.E., knowing that at the end of the year one will receive

$X(e)(1+iFOR) Sell that amount forward to receive $X(e)(1+iFOR)(1/ef) at the end of the year. If X =100, e=0.5(/$), iFOR=15%, and ef = 0.53(/$) then: $X(e)(1+iFOR)(1/ef) = $100(0.5)(1.15)(1/.53) = $108.49


If: e=0.5(/$), iFOR=15%, and ef = 0.53(/$)

Then: Devoting $100 to foreign bonds will provide $108.49 after one year i.e., $100(e)(1+iFOR)(1/ef) = $108.49 * The return on the foreign bonds IN TERMS OF $s is 8.49%
EVEN THOUGH the return is 15% IN TERMS OF the foreign currency.

Whats happening?


If: iUS=10%, e=0.5(/$), iFOR=15%, and ef = 0.53(/$)

Then: Devoting $100 to domestic bonds will provide $110 after one year i.e., $100(1+iUS) = $110 While Devoting $100 to foreign bonds will provide $108.49 after one year i.e., $100(e)(1+iFOR)(1/ef) = $108.49 * The return on the foreign bonds IN TERMS OF $s is 8.49%

INTEREST PARITY exists when the returns on bonds (and other debt instruments) are equal.

COVERED INTEREST PARITY exists when the returns on bonds denominated in different currencies are equal when it is assumed the forward markets are used to eliminate the ERR associated with future currency exchanges (i.e., when the bond matures). In the preceding example, since the return in the US (in terms of $) of 10% does not equal the return on the foreign bonds (in terms of $) of 8.49%, then COVERED INTEREST PARITY does NOT hold.

If interest parity does not exist, then (barring sufficient transactions costs) there is an opportunity for Interest Arbitrage: (1) Borrow where rate is lower (2) Lend where rate is higher
Of course, borrowing in lower rate market will push up rates there, while lending in higher rate market will lower rates there until interest parity is established.

If covered interest parity does not exist, then (barring sufficient transactions costs) there is an opportunity for
Covered Interest Arbitrage:

Covered Interest Arbitrage consists of conducting four transactions at same moment: (1) Borrow in one currency (2) Exchange for other currency in spot market (3) Lend in the other currency (4) Sell future expected returns in other currency forward
Then, when future comes: Collect returns, honor forward contract, and payoff original loan

SO, if iUS = 10%, e=0.5, iFOR=15%, and ef = 0.53 then: 1+iUS = 1.10 (= return in US in terms of $ is 10%) (e)(1+iFOR)(1/ef) = (0.5)(1.15)(1/.53) = 1.0849 (= return in UK in terms of $ is 8.49%) Since: 1+ iUS > e(1+iFOR)(1/ef) Borrow in UK and Lend in US (and cover the interest arbitrage using a forward contract).

Given: iUS = 10%, e=0.5, iFOR=15%, and ef = 0.53 An example of covered interest arbitrage: (1) Borrow 100 in UK (payback will be 115) (2) Go to spot market and exchange for $200 (3) Lend $200 in US (to receive $220 in year) (4) Sell $220 forward for 116.60

At end of year: collect payment on loan ($220) honor forward contract ($220116.60) payoff loan with 115 Gain = 1.60

The expression:

1+ iUS = e(1+iFOR)(1/ef)
is the Covered Interest Parity Condition (CIPC)

Interest Rate Parity

1. Interest rate parity (IRP) is an arbitrage condition that provides the linkage between the foreign exchange markets and the international money markets.

Interest Rate Parity (IRP)

Ft ,t 1 St 1 id 1 if

where, Ft and St are the forward and spot rates and id and if are domestic and foreign interest rates respectively.

Interest Rate Parity

The approximate form of IRP says that the % forward premium equals the difference in interest rates.

Approximation of IRP

Ft ,t 1 St

1 id i f

Ft ,t 1 St St

id i f

In general, the currency trading at a forward premium (discount) is the one from the country with the lower (higher) interest rate.

Interest Rate Parity An Example

1. Basic idea: Two alternative ways to invest funds over same time period should earn the same return. 2. Suppose the 3-month money market rate is 8% p.a. (2% for 3-months) in the U.S. and 4% p.a. (1% for 3months) in Switzerland, and the spot exchange rate is SFr1.48/$. 3. The 3-month forward rate must be SFr1.4655/$ to prevent arbitrage opportunities (i.e., interest rate parity must hold).

i $ = 8.00 % per annum (2.00 % per 90 days)

$1,000,000 1.02 Dollar money market

$1,020,000 $1,019,993*

S = SF 1.4800/$

90 days

F90 = SF 1.4655/$

Swiss franc money market SF 1,480,000 1.01 i SF = 4.00 % per annum (1.00 % per 90 days) SF 1,494,800

* Rounding error.

Interest Rate Parity: Why It Holds

1. This must hold by arbitrage. Otherwise riskless profits could be made. This is known as covered interest arbitrage (CIA) and occurs whenever IRP does not hold. CIA can involve the following steps:
Borrow the domestic currency; Exchange the domestic currency for the foreign currency in the spot market; Invest the foreign currency in an interestbearing instrument; and then Sign a forward contract to lock in a future exchange rate at which to convert the foreign currency proceeds back to the domestic currency.

Covered Interest Arbitrage: Example

1. The annual interest rate in the AUS and UK are 5% and 8% respectively. The current spot rate is $1.50/ and the 1 year forward rate is $1.48/. Can arbitrage profits be made?

1 id

Ft ,t 1 St

(1 i f )

1.48 1.05 (1.08) ?? 1.50

1.05 1.0656

2. 3. 4. 5. 6. 7.

Borrow $1m (at 5%) Purchase 666,667 using $1m Invest at 8% (will receive 720,000 in one years time) Simultaneously sell 720,000 forward ($1,065,600) Repay loan + interest of $1,050,000 ARBITRAGE PROFIT = $15,600

The Example Continued

1 Borrow


for 1 year
at i$ = 5%

<$1,050,000> $1,065,600
Cover Forward at $1.48/ 4

Convert Spot

Profit = $15,600 3 Invest for 1 year

at $1.50/

at i = 8%


Covered Interest Arbitrage

Covered interest arbitrage should continue until interest rate parity is re-established, because the arbitrageurs are able to earn risk-free profits by repeating the cycle. But their actions nudge the foreign exchange and money markets back toward equilibrium:

Purchase of Pounds in the spot market and sale of in the forward market narrow the premium on forward pounds. The demand for pound-denominated securities causes pound interest rates to fall, while the higher level of borrowing in Australia causes dollar interest rates to rise.

Uncovered Interest Arbitrage

A deviation from covered interest arbitrage is uncovered interest arbitrage (UIA).

In this case, investors borrow in countries and currencies exhibiting relatively low interest rates and convert the proceed into currencies that offer much higher interest rates.
The transaction is uncovered because the investor does no sell the higher yielding currency proceeds forward, choosing to remain uncovered and accept the currency risk of exchanging the higher yield currency into the lower yielding currency at the end of the period.