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FOREIGN EXCHANGE MARKET.
Term Paper ID:24606
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Origins in 1944 with Bretton Woods Conference, end of gold standard for U.S., free & managed currencies, speculators, derivatives, risks, hedging.... More...
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Paper Abstract:
Origins in 1944 with Bretton Woods Conference, end of gold standard for U.S., free & managed currencies, speculators, derivatives, risks, hedging.
Paper Introduction:
Introduction
Because each nation issues its own currency, each currency is worth something different in relation to every other currency in the world. Nations which have strong economies generally have strong currencies, which is why today's currency markets are dominated by the yen, the American dollar and the mark. At some point in history, enterprising traders devised ways to trade not in goods or services from one country to another, but in the currency of various countries. Derided as gamblers by some analysts and considered reckless interlopers by others, these speculators estimate whether one currency will rise or fall in relation to another, and buy, or sell, accordingly. With the advances in technology that have occurred in the last half of this century, it is no longer necessary that traders wait for markets to open in differe
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Risk can be classified intofour types: transaction risk, translation risk, capital market risk andinvestment risk.[11] Transaction Risk Transaction risks usually involve a receivable or payable denominatedin a foreign currency, and commonly arise from a transaction such as apurchase from a foreign supplier or a sale to a foreign customer. [13]David Smith, "How to Manipulate the Markets," Management Today,February 1995, 21. By 1971, there were only 22 cents of goldfor every dollar held by foreign banks.[4] In August 1971, President Nixon took the bold step of removing theAmerican dollar from the gold standard, meaning that dollars would nolonger be converted directly into gold by the American government. The amount ofmoney involved is greater than the loss the companies would face if theyhad no such protection, and presumably less than the benefiting companiesgain from the increase in the favored currency. Multinationals received some concession from the Financial AccountingStandards Board (FASB) in 1981 when FASB 52 replaced FASB 8 with regard totranslation risk, minimizing the effects of translation on financialstatements. Other currencies were assigned values inrelationship to the dollar, with the British pound equal to $2.4 , theFrench franc set at $ .18, and the West German mark at $ .2732.[2] The United States Leaves the Gold Standard During 1958 and 1971, the United States accumulated a deficit of $56billion, which was financed in part by use of the American gold reserves(which decreased from $24.8 billion to $12.2 billion) and by incurringliabilities to foreign central banks. In their most basic form, derivatives are a wayin which companies can seek shelter from the fluctuations of the market.For example, a company which benefits if the dollar increases might enterinto a derivatives contract with another company which suffers from highdollars, but benefits from strong yen. An exporter who expectsthe currency of the purchasing country to drop would want payment as soonas possible if the currency of the importer is being used in order tominimize transaction risk. At some point in history, enterprising tradersdevised ways to trade not in goods or services from one country to another,but in the currency of various countries. An importer in a country whose currency is expected to depreciate interms of the currency of the supplier is motivated to purchase the foreigncurrency as soon as possible in order to get the most favorable rate ifpayment is due in the currency of the exporter. From this standpoint, thederivative is essentially a hedging device against the vagaries of themarket.[1 ] However, as with other contracts, derivatives can be sold to thirdparties with no direct interest in the currencies in question, but with amerely speculative interest. They are interested in making a profit ontheir transactions, but they are also interested in maintaining a healthymarket for their goods and services. Unlike the purespeculator, these companies generally take a long view with regard to theirforeign exchange practices. "Rewards Available to Currency Futures Speculators." Economic Record 68 (June 1992): S1 5-S116.Zhou, Su. Ascurrency rates move up and down, the relative performance of the company'sfortunes can rise and fall. This agreement was the basis of international monetary systemtransactions until 1971, and it placed the American dollar at the center ofthe international monetary system. [4]Ibid. These contracts are sometimes taken on by companies which do businessin multiple countries with their customers, where the customer agrees topay for goods at some point in the future and in the currency of thecompany's choosing. Unforeseen factors can affect the nominalexchange rate, and speculators can suffer extreme losses at the same timethat they stand to make high levels of profit. ----------------------- [1]Michael W. [5]John Stein, "Andrew Schnydrig: Playing the Curves AmongEconomies," Futures, September 199 , 78. Thisis in contrast to noting them as they occur, which can be particularlyvolatile in some economies and representative of "paper" profit or losses. Derided as gamblers by someanalysts and considered reckless interlopers by others, these speculatorsestimate whether one currency will rise or fall in relation to another, andbuy, or sell, accordingly. So long as the American company is able tosecure higher returns than the interest rate on the loan, there isprotection against a decline in the currency rate. Derivative contracts are not currently regulated, and theyare not limited to a single nation. Translation Risk Where transaction risk refers to the risk associated with changes incurrencies over the period of a single transaction, translation risk refersto the risk that multinational organizations take on when they must statetheir financial position in terms of a single currency, their "home"currency, on financial statements.[12] In this way, a company which has a given amount in a bank in a foreigncountry and who maintains that balance over the course of the year may findthat due to exchange rates, the balance falls when translated into dollars. [3]Ibid. Types of Speculation Instruments The simplest type of foreign exchange transaction is that which occurswhen the currency of one country is physically exchanged for the currencyof another. Thetransaction (purchase or sale) carries a risk that the currency value willchange; hence the term transaction risk. Thusan American multinational might have a subsidiary in the United Kingdom,and an English multinational might have a subsidiary in the United States.With back to back loans, each multinational loans an agreed upon figure, inthe home currency, to the subsidiary of the other multinational at thecurrent exchange rate. Similarly, if reverse conditions are present,companies may want to delay payment for as long as possible in order totake full advantage of the exchange markets. Traders who purchased dollars one day maysell them the next for yen, and so are not tied to any particular currencyfor themselves or those on whose behalf they may be working. If the currency in one of its markets falls,for example, the company might be losing money in real terms even if salesincrease in that country. "Shifting Ground." Maclean's, 2 March 1995, 28-3 .Nusbaum, David. BibliographyAvsar, Serdar A. This secondary market for derivatives is whatgets investors into trouble as they are not benefiting from the change inrates the same way that the companies who originally entered into thecontract are doing, or would be doing if they saw the derivative through toits conclusion. The Bretton Woods Conference The current era of currency trading began essentially at the end ofWorld War II with a conference held in Bretton Woods, New Hampshire in1944. [7]David Nusbaum, "Trading the Wide World of Foreign Exchange,"Futures, April 1995, 62. "Efficiency in Currency Futures Markets." Economic Record 68 (June 1992): S13 -S134.Fatemi, Ali M. Governments have an interest in thevalue of their currencies because strong currencies make their exports moreexpensive and less competitive, while relatively weaker currencies improvethe outlook for exports. Hedging is one way thatinvestors can protect themselves from some of the risks associated withthese markets, but the risks can be significant for the ignorant,particularly as new instruments such as derivatives are added to themarketing mix. The pure speculator is uninterested in theexchange rate other than as a way to make a profit. [8]Deirdre McMurdy and Andrew Willis, "Shifting Ground," Maclean's, 2 March 1995, 29. Types of Currencies There are two basic types of currencies which float: free andmanaged. It is through the actions of themultinationals that a particularly complex and potentially dangerous formof hedging, the derivative, came into being. and Amir Tavakkol. "Andrew Schnydrig: Playing the Curves Among Economies." Futures, September 199 , 78.Strauss, Jack. [12]Stephen Taylor, "Rewards Available to Currency FuturesSpeculators," Economic Record 68 (June 1992): S1 7. Typically, theinvestor purchases one currency to sell it for another, often within thesame day or even in shorter timeframes. The actions of government, private industry andspeculators combine to change the real exchange rates over long periods oftime, while short-term fluctuations are due in large part to monetarydifferentials and even the speculators themselves. "Forward Risk Premium and the Maturity of Contracts." Review of Financial Economics 2 (Fall 1992): 93-97.Klein, Michael W. Such speculation can leave both companies in poor positionsif economies worsen or the currencies do not perform as expected.[9] In recent years, attention has been given to a particular form ofcontract, the derivative. [11]Serdar Avsar, "Efficiency in Currency Futures Markets," EconomicRecord 68 (June 1992): S131. However, it is unrealistic of companies to expect thatexchange rates will not change, although criticism that losses or gainsshould be noted only when actually realized is a legitimate concern. "Trading the Wide World of Foreign Exchange." Futures, April 1995, 62-65.Smith, David. Inorder to cover the transaction risk, the multinational then may sell theagreed-upon amount to a third buyer, who sells the currency in question tothe importer at the same time. Managed currencies are subject to intervention by their governments;such intervention is normally undertaken when the government perceives thenational interest to be at stake. Since global trade is now the norm, maintaining astrong export trade is particularly important to most governments.[5] Types of Speculators There are essentially two types of speculators who invest in theforeign exchange markets. If the dollar increases against theyen, the first company pays some amount to the second company; if the yengains against the dollar, the second company pays the first. Inthe above example, the American company might borrow 1 million yen from aJapanese bank on the same day that the sale is completed and invest thosefunds for the 18 -day period. The stage was set for speculation in bothcurrencies and gold. Some of the same hedging techniques used in transaction riskmanagement can be applied to translation risk management, but there areother techniques that are generally more favorable. By 1971, however, concern was increasing both in foreign banks and inthe United States about the large amount of dollars held outside thecountry. When the loan comes due, it will be paid forwith the yen due from the importer, and the proceeds from the investmentscan be used to pay interest. One of these includesback to back loans, where two multinational companies based in twodifferent countries have subsidiaries located in the other country. Under Bretton Woods, dollars could be exchanged for gold, butthere were more dollars held by foreign banks by the mid-196 s than therewas gold left in the Treasury. Arbitrageurs are those traders whopurchase and sell currencies at essentially the same time in differentmarkets in order to take advantage of even small price differentials, whichcan be significant when large sums are involved.[6] The other type of trader is the multinational corporation which must,by default, be concerned with the currency exchange rates in the variouscountries in which the company operates. However, because of the large sums ofmoney that are typical of most foreign exchange transactions, littlephysical money actually changes hands; instead, the transactions arehandled by computer which electronically credits and debits the requisiteaccounts based on internal calculations made after sampling rates from theworld's markets.[7] Most speculation instruments include a contract where the holder ofthe contract agrees to pay a certain amount of one currency for a givenamount of another currency at a certain date.[8] At this point, thecontract itself can often be bought and sold prior to the date that itcomes due, with the result that parties well removed from the originalcontractor may end up with the contract at the end. Klein, "A Return to Bretton Woods," Journal of Commerceand Commercial, August 25, 1994, 6A. Risk and Exchange Markets There is a substantial amount of risk in the exchange markets becauseof their free-floating nature. These businesses also have investmentopportunities open to them because they conduct business in more than onecountry. In this way, both the buyer and seller benefit sincethe seller is assuming that the currency in question will increase in valuewhile the buyer has the use of the funds for some period of time, and canpresumably make more interest than will be lost due to currencyfluctuations. [9]Ali Fatemi and Amir Tavakkol, "Forward Risk Premium and theMaturity of Contracts," Review of Financial Economics 2 (Fall 1992): 94. For example, an American multinational might agree to sell $1 millionin goods to an importer in Japan and the current exchange rate might be 1 yen to the dollar. Therewere two immediate results of this action: currencies around the worldreturned to floating against each other, and the price of gold was nolonger fixed at $35 per ounce. Free currencies are not subject to direct government interventionand because there are literally billions of units of the money availablefor trade by buyers and sellers. An examplecan be provided by a multinational company which sells goods to a foreignimporter. "A Return to Bretton Woods." Journal of Commerce and Commercial, August 25, 1994, 6A.McMurdy, Deirdre and Andrew Willis. While the economicfactors which cause currency exchange rates to fluctuate are of interestfrom the standpoint that they affect the investor's strategy, they are notthe critical factors which the investor is considering. [6]Jack Strauss, "Real Exchange Rates, PPP and the Relative Price ofNontraded Goods," Southern Economic Journal 61 (April 1995): 993. The goal of the meeting was to determine how the internationalmonetary system should operate following the war, and representatives ofthe allies were present, although the United States and the United Kingdomdominated the discussions.[1] Those present at Bretton Woods agreed that stable exchange rates weredesirable, but that there should be flexibility in order to permitadjustments since floating or fluctuating exchange rates had previouslybeen unsatisfactory. If the rates move so that the yen loses against the dollar,moving to perhaps 11 to the dollar, the American company will receive only$9 9,9 9 rather than the $1 million it expected. To protect itself from this risk,companies can engage in various types of hedging, including a forwardhedge, a credit or money market hedge, or the company may choose toaccelerate or delay payment. Introduction Because each nation issues its own currency, each currency is worthsomething different in relation to every other currency in the world.Nations which have strong economies generally have strong currencies, whichis why today's currency markets are dominated by the yen, the Americandollar and the mark. "The Response of Real Exchange Rates to Various Economic Shocks." Southern Economic Journal 61 (April 1995): 936-954. Assumingthat the hedge carries with it a premium of one percent (to cover the buyeragainst changes in the rate), the multinational will receive $99 , inexchange for 1 million yen. In this way, there is no currency exchange risksince the companies will repay their loans in the same currency as it wasreceived.[13] Conclusion The type of investor who speculates in the foreign exchange market maybe a pure speculator "betting" on the rise or fall of a given currency, orit may be an institution seeking to fund operations or to conduct businessin more than one country. The transaction risk is now on the multinationalcompany. According to the agreement, the dollarwas the only currency which would be directly convertible into gold, whichwas determined to be worth $35. By trading in currencies in which they do business, companies canhedge some of the risk associated with a single currency. So long as thecontract requires a lower price than the purchase paid for it, money ismade; however, if the currency being purchased has increased in valuerelative to the other currency, the holder of the contract suffers a loss. At the end of the Bretton Woods meeting, the International MonetaryFund (IMF) was established; its articles went into effect at the end of1945. Companies can, and do, enter intocontracts with companies in various parts of the world, and the secondarymarket for derivatives is similarly unconcerned with national boundaries. "How to Manipulate the Markets." Management Today, February 1995, 21.Stein, Jon. This can prompt fears among managers that stockholders and othersinterested in the company's performance may conclude that management is notdoing its job because of the loss when the loss is not the result ofmanagement activities (necessarily) but instead is due to fluctuations inthe exchange rate. Even if the company conductsbusiness in the currency of the host nation, it generally maintains itsfinancial statements in its own currency for standardization purposes. [1 ]Ibid. A credit or money market hedge involves borrowing against the amountin question in order to make a profit over the time period in question. These liabilities increased duringthe period from $13.6 billion to $62.2 billion.[3] Foreign banks werewilling to take on so many dollars because they were treated a centralreserve asset providing liquidity growth to support growing world trade andfinance. The multinational company may accept that the importer will payat some future date the agreed upon amount in the agreed upon currency. "Real Exchange Rates, PPP and the Relative Price of Nontraded Goods." Southern Economic Journal 61 (April 1995): 991- 1 5.Taylor, Stephen J. However, themultinational could enter into a contract with a third party to sell 1 million yen to the party in exchange for $1 million in 18 days. This crude type of exchange is the one thatmost tourists are familiar with. A forward hedge is essentially a derivative contract with thecurrencies in question serving as the measure of the contract. The conferees also agreed that the governmentcontrols of trade, exchange, production and other factors which haddeveloped during the Depression were discriminatory and inefficient, andharmful to the expansion of world trade and investment. Foreign exchange markets and the risks associated with themare an undeniable fact of doing business in a global economy; investorsmust take precautions to protect themselves in this dynamic market. [2]Ibid. This researchexamines the foreign exchange market, including the mechanics of themarket, influences on rates, influences of speculators on the market, andconsiders what may be in store for currency traders in the future. Later on, the exchange may be reversed, with a profit beingmade if the rates have fallen. The importer agrees to pay the multinational 1 million yen in 18 days. With the advances in technology that haveoccurred in the last half of this century, it is no longer necessary thattraders wait for markets to open in different time zones; programmedtrading can take place from one computer to another.
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