A fixed (or pegged) exchange rate system is one where governments or central banks set official exchange rates and defend the set rates through foreign exchange market intervention and monetary polices. Under this system, the currency is pegged to another currency (or basket of currencies) and the central bank promises to exchange currency at a specified rate against the other currency. Each central bank actively buys or sells its currency in foreign exchange market whenever its exchange rate threatens to deviate from its stated par value by more than an agreed-upon percentage. For example, India pegs its Rupee to the U.S. dollar at a rate of 45 rupee per dollar. The Reserve Bank of India(RBI) must always be willing to buy rupee with dollars or to buy dollars with rupee in any amount at the fixed rate of 45 rupee per dollar. Otherwise, there could be excess supply of or Continue reading
Exchange Rate System
Exchange Rate Regimes: International Gold Standard (1875- 1914)
Though in Great Britain currency notes from the Bank of England were made fully redeemable for gold during 1821, the first full-fledged gold standard was adopted by France in 1878. Later on United States adopted it in 1879 and Russia and Japan in 1897, Switzerland, and many Scandinavian countries by 1928. An international Gold Standard is said to exist when; Gold alone is assured of unrestricted coinage There is a two way convertibility between gold and national currencies at a stable ratio And gold may be freely imported and exported. In order to support unrestricted convertibility into gold, bank notes need to be backed by gold reserve of a minimum stated ratio. In addition, the domestic money stock should rise and fall as gold flows in and out of the country. In a version called Gold Specie Standard, the actual currency in circulation consists of gold coins with Continue reading
Concept of ‘Fear of Floating’
In the modern era, many countries claim to be running a floating exchange rate. However, many of these countries actively limit fluctuation in the external value of their national monies. This behaviour has been dubbed “fear of floating”, several reasons exist for it. Firstly, there is the ‘original sin’ problem. Many emerging economies are unable to borrow overseas in their domestic currency. This leads to an accumulation of foreign debt liabilities that are unhedged. If there is a sharp depreciation in these nations’ exchange rate, the domestic currency value of their external debt will be altered and thus their economies net worth will also change. Secondly, policymakers in emerging markets suffer from a chronic lack of credibility. The economies may therefore experience large and frequent shocks to exchange rate expectations or to interest rate risk premiums. To gain confidence and credibility, the authorities who set the interest rate will therefore Continue reading
Exchange Rate Regimes: The Bretton Woods System
Bretton Woods is the name of the town in the state of New Hampshire, USA, where the delegations from over forty five countries met in 1944 to deliberate on proposals for a post-war international monetary system. The two main contending proposals were “the White plan” named after Harry Dexter White of the US Treasury and the “Keynes plan” whose architect was Lord Keynes of the UK. Following the Second World War, policy makers from victorious allied powers, principally the US and UK, took up the task of thoroughly revamping the world monetary system for the non-communist world. The outcome was the so called “Bretton Woods System” and the birth of new supra-national institutions, the International Monetary Fund (the IMF or simply the “Fund”) and the World Bank. Under this system US Dollar was the only currency that was fully convertible to gold; where other countries currencies were not directly convertible Continue reading
An Eclectic Currency Arrangement, 1973-Present
Since March 1973, exchange rates have become much more volatile and less predictable than they were during the fixed exchange rate period, when changes occurred infrequently. In general the dollar has been volatile and has weakened somewhat over the long run. On the other hand, the Japanese yen and German mark have strengthened. The emerging market currencies have been exceptionally volatile and have generally weakened. In the wake of the collapse of the Bretton Woods exchange rate system, the IMF appointed the Committee of Twenty which suggested various options for the exchange rate arrangement. These suggestions were approved at Jamaica during February 1976 and were formally incorporated into the text of the Second Amendment to the Articles of Agreement, which came into force from April 1978. The options were broadly: Floating-independent and managed Pegging of currency Crawling peg Target zone arrangement Others 1. Floating Rate System: In a floating rate Continue reading
Swaps Risk and Exposure
The great bulk of swap activity of date has concentrated on currencies and interest rates, yet these do not exhaust the swap concept’s applicability. As one moves out the yield curve, the primary interest rate swap market becomes dominated by securities transactions and in particular the Eurodollar bond market. The advent of the swap market has meant that the Eurodollar bond market now never closes due to interest rate levels: issuers who would not come to market because of high interest rates now do so to the extent that a swap is available. Indeed, the Eurodollar bond market owes much of its spectacular growth to the parallel growth of its swap market. The firms that now dominate lead management roles in the Eurodollar bond market all have substantial swap capabilities and this trend will continue. One extension is seen in the beginning of the market for equity swaps- an exchange Continue reading