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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Serie: Wiley Trading Series
- Sprache: Englisch
This book will provide a thorough introduction to the foreign exchange markets, looking at the main products through to the techniques used, coverage of the main participants, details of the various players, and an understanding of the jargon used in everyday dealings. Written in a concise and accessible manner, it will be an ideal introduction for anyone looking to become involved in the FX markets, from dealing rooms or sales perspectives, to novice investors. The new edition has been updated to reflect the changes that have taken place in the industry over the past few years. Most chapters have been enhanced and this new edition now features new material on the psychology of trading, the psychology of price movement and online trading.
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Seitenzahl: 316
Veröffentlichungsjahr: 2011
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Contents
Cover
Half Title page
Title page
Copyright page
Disclaimer
Chapter 1: Introduction
1.1 The Foreign Exchange Market
1.2 Value Terms
1.3 Coffee Houses
1.4 Spot and Forward Market
1.5 Alternative Markets
Concluding Remarks
Part I: Market Overview
Chapter 2: A Brief History of the Market
2.1 The Barter System
2.3 The Introduction of Coinage
2.3 The Expanding British Empire
2.4 The Gold Standard
2.5 The Bretton Woods System
2.6 The International Monetary Fund and The World Bank
2.7 The Dollar Rules OK
2.8 Special Drawing Rights
2.9 A Dollar Problem
2.10 The EMS and The Erm
2.11 The European Currency Unit
2.12 The Maastricht Treaty
2.13 The Treaty of Rome
2.14 Economic Reform
2.15 A Common Monetary Policy
2.16 The Single Currency
Concluding Remarks
Chapter 3: Market Overview
3.1 Global Market
3.2 No Physical Trading Floor
3.3 A ‘Perfect’ Market
3.4 The Main Instruments
3.5 The Dollar’S Role
3.6 Widely Traded Currency Pairs
3.7 Concluding Remarks
Chapter 4: Major Participants
4.1 Governments
4.2 Banks
4.3 Brokering Houses
4.4 International Monetary Market
4.5 Money Managers
4.6 Corporations
4.7 Fund Managers
4.8 Hedge Funds
4.9 Retail Clients
4.10 Others
4.11 Speculators
4.13 Trade and Financial Flows
Chapter 5: Roles Played
5.1 Market Makers
5.2 Price Takers
5.3 A Number of Roles
Concluding Remarks
Chapter 6: Purposes
6.1 Transactions
6.2 Market Making
6.3 Foreign Exchange Exposure
Concluding Remarks
Part II: Foreign Exchange Products
Chapter 7: Spot Foreign Exchange
7.1 Spot and Reciprocal Rates
7.2 European and American Terms
7.3 Spot Transactions
7.4 Direct Versus Brokered Dealing
7.6 Cross Rates
7.6 Price Determinants
7.7 Uses for Spot Transactions
Chapter 8: Forward Contracts
8.1 Interest Rate Differentials
8.2 Periods
8.3 Premium Or Discount
8.4 Calculations
8.5 How Are Forwards Quoted?
8.6 Forward Cross Rates
8.7 Uses of Forwards
Concluding Remarks
Chapter 9: Short- and Long-Dated Contracts
9.1 Short-Dated Contracts
9.2 Interest Rate Differentials
9.3 Long-Dated Contracts
Concluding Remarks
Chapter 10: Broken-Dated Contracts
10.1 Calculations
10.3 Outright Forwards
10.3 A Conversation
Glossary of Terms for Chapters 7 to 10
Chapter 11: Non-Deliverable Forwards
11.1 Fixing Methodology
11.2 Risk Management Tool
11.3 Availability
11.4 Examples
11.5 Typical Risks Encountered
11.6 The Currencies of Emerging Markets
11.7 Index-Linked Deposits
Concluding Remarks
Chapter 12: Foreign Exchange Swaps
12.1 The Value of Foreign Exchange Swaps
12.2 Calculations
12.3 Uses of Foreign Exchange Swaps
Concluding Remarks
Chapter 13: Currency Swaps
13.1 Technique Involved
13.2 Interest Payable
13.3 Benefits of Currency Swaps
Concluding Remarks
Chapter 14: Foreign Exchange Options
14.1 Definitions
14.2 Exchange vs Over-The-Counter Options
14.3 Application of Foreign Exchange Options
14.4 Alternatives to Foreign Exchange Options
14.5 Parties and The Risks Involved
14.6 Users of Foreign Exchange Options
14.7 Hedging Versus Speculation
14.8 Option Theory
14.9 Pricing Theory
14.10 Other Considerations
Concluding Remarks
Chapter 15: Picturing Profit and Loss of Options
15.1 Long Call
15.2 Short Call
15.3 Long Put
15.4 Short Put
15.5 Long Straddle
15.6 Short Straddle
15.7 Long Strangle
15.8 Short Strangle
15.9 Bull Spread
15.10 Bear Spread
15.11 Long Butterfly
15.12 Short Butterfly
15.13 Long Condor
15.14 Short Condor
15.15 Call Ratio Spread
15.16 Put Ratio Spread
15.17 Barriers
Glossary of Terms for Chapters 14 and 15
Chapter 16: Foreign Exchange Futures
16.1 Two-Sided Risk
16.2 Exchange Members
16.3 Clearing Corporation
16.4 Quoting Currency Futures
16.5 Ticks and Delivery Months
16.6 Contract Specifications
16.7 European Style Options
Concluding Remarks
Chapter 17: Exchange for Physical
17.1 Examples
17.2 Point of The Exercise
Concluding Remarks
Part III: Essential Knowledge
Chapter 18: Foreign Exchange Dealing Rooms
18.1 Composition of A Dealing Room
18.2 Back office
Chapter 19: Managing the Relationship with an Institution
19.1 Role of The Adviser
19.2 Client–Adviser Relationship
19.3 Marketing Process
Chapter 20: Foreign Exchange Dealings
20.1 Asking for A Quote
20.2 Examples
20.3 A Matter of Seconds
20.4 Information Needed
20.5 Forward Asking
Concluding Remarks
Chapter 21: Foreign Exchange Market Orders
21.1 Market Orders
21.2 At Best Orders
21.3 Stop Orders
21.4 Discretionary Price Order
Concluding Remarks
Glossary of Terms for Chapter 21
Chapter 22: Electronic Foreign Exchange Trading
22.1 Days Gone By
22.2 The Environment Today and Tomorrow
22.3 Internet Revolution
22.4 What Else to Expect?
Concluding Remarks
Chapter 23: Margin Trading
23.1 Understand How Margin Works
23.2 A Simple Example
23.3 Recognize The Risks
23.4 General Margin Rules
23.5 Margin Calls In Volatile Markets
Concluding Remarks
Part IV: Fundamentals and Technical Analysis
Chapter 24: Fundamental versus Technical Approaches
24.1 Fundamental Approach
24.2 Technical Approach
24.3 Concluding Remarks
Chapter 25: Fundamental Analysis
25.1 Purchasing Power Parity
25.2 Interest Rate Parity
25.3 Balance of Payments Model
25.4 Asset Market Model
25.5 Economic Influences On The Market
25.6 Concluding Remarks
Chapter 26: Key Factors Impacting Currencies
26.1 Factors Affecting The Yen Against The Dollar
26.2 Factors Affecting The Swiss Franc Against The Dollar
26.3 Factors Affecting The Euro Against The Dollar
26.4 Factors Affecting Sterling Against The Dollar
26.5 Factors Affecting The American Dollar
Chapter 27: Technical Analysis
27.1 Assumptions
27.2 The Basic Theories
27.3 What to Look For
27.4 Drawing Lines
27.5 Head-and-Shoulders Formation
27.6 Formation Patterns
27.7 Examples
27.8 Technical Indicators
Concluding Remarks
Glossary of Terms for Chapters 24 to 27
Chapter 28: Market Psychology
28.1 Psychology of Trading
28.2 Psychology of Price Movement
28.3 Basic Price Movement Pattern
28.4 Summary
Concluding Remarks
Chapter 29: Final Remarks
29.1 and What of The Future?
Index
A Foreign Exchange Primer
For other titles in the Wiley Trading seriesplease see www.wiley.com/finance
Copyright © 2008 Shani Shamah
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Library of Congress Cataloging-in-Publication Data
Shamah, Shani.A foreign exchange primer / Shani Shamah. — 2nd ed.p. cm.Includes bibliographical references and index.ISBN 978-0-470-75437-51. Foreign exchange futures. 2. Foreign exchange market. I. Title.HG3853.S53 2008332.4′5—dc222008040294
Disclaimer
This publication is for information purposes only and contains advice, recommendations and/or opinions that may be used as the basis for trading.
The publication should not be construed as solicitation or as offering advice for the purposes of the purchase or sale of any financial product. The information and opinions contained within this publication were considered to be valid when published.
The charts, additional examples and pictures have been kindly supplied by MMS, 4castweb.com and GFT Global Markets.
While MMS, 4CAST Limited and GFT Global Markets have attempted to be as accurate as possible with the information presented here, they do not guarantee its accuracy or completeness and make no warranties of merchantability or fitness for a particular purpose. In no event shall they be liable for direct, indirect or incidental, special or consequential damages resulting from the information herein regardless of whether such damages were foreseen or unforeseen. Any opinions expressed in this publication are given in good faith, but are subject to change without notice.
Please note: All rates and figures used in the examples are for illustrative purposes only. The contents are copyright Shani Shamah 2008 and should not be used or distributed without the author’s prior agreement.
Chapter 1
Introduction
1.1 THE FOREIGN EXCHANGE MARKET
The foreign exchange market is by far the largest financial market in the world and thrives on its enormous ocean of money. It trades across the world with an estimated $ 3.2 trillion∗ global average daily volume, which solidifies foreign exchange as an asset class. It is distinguished from other markets, for example the commodity or equity markets, by having no fixed base – no centralized marketplace. In other words, the foreign exchange market exists at the end of a telephone, the Internet or other means of instant communication; it is not located in a building, nor is it limited by fixed trading hours. Hence, unlike equities, foreign exchange has not traditionally traded in one single location, such as on a regulated exchange, but it has always been a disjointed market where trading primarily takes place in an over-the-counter market where buyers and sellers conduct business. The foreign exchange market is truly a 24-hour global trading system where traders of all types and sizes can participate. It knows no barriers and trading activity in general moves with the sun from one major financial centre to the next, starting with Wellington and Sydney and moving through the time zones and trading centres of Tokyo, Hong Kong, Singapore, London and New York to the West Coast of America. Anything that happens anywhere in the world, no matter at what time of the day or night, like terrorist attacks, US sub-prime market woes, geopolitical tensions over nuclear power, oil supply problems and pricing, and many other issues which can threaten to disrupt trade and economic relationships, will affect the foreign exchange market instantly. Reports and events reported in Japan will have an effect on happenings in all foreign exchange trading centres across the globe, thus making foreign exchange a truly global trading asset.
The foreign exchange market is a global network of buyers and sellers of currencies.
Foreign exchange or FX or Forex comprises all claims to foreign currency payable abroad, whether consisting of funds held in foreign currency with banks abroad, or bills or cheques payable abroad; i.e. it is the exchange of one currency for another.
A foreign exchange transaction is a contract to exchange one currency for another currency at an agreed rate on an agreed date.
1.2 VALUE TERMS
Throughout history, one person has traded with another, sometimes to obtain desired raw materials by barter, sometimes to sell finished products for money, and sometimes to buy and sell commodities or goods for no other reason than to make a profit from the transactions involved. The pre-historic ‘bartering’ of goods and the use of cowrie shells or similar objects of value as payment eventually gave way, approximately 4000 years ago, to the use of coins struck in precious metals. Even in those far-off days, there was international trade and payments were settled in any coinage that was acceptable to both parties. Early Greek coins, which were almost universally accepted in the then known world, were soon given values in terms of their models, and a price for any raw material or finished goods could be quoted in value terms of either Greek originals or other nations’ copies.
The first forward foreign exchange transactions can be traced back to the money-changers in Lombardy in the 1500s. Foreign exchange, as we know it today, has its roots in the Gold Standard, which was introduced in 1880. It was a system of fixed exchange rates in relation to gold and the absence of any exchange controls.
1.3 COFFEE HOUSES
Banking and financial markets closer to those of today were started in the coffee houses of European financial centres, such as the City of London. In the seventeenth century these coffee houses became the meeting places not only of merchants seeking to trade their finished goods, but also of those who bought and sold solely for profit. It is the City of London’s domination of these early markets that saw it maturing through the powerful late Victorian era, and it was strong enough to survive two world wars and the depression of the 1930s.
1.4 SPOT AND FORWARD MARKET
Today, foreign exchange is an integral part of our daily lives. Without foreign exchange, international trade would not be possible. For example, a Swiss watchmaker will incur expenses in Swiss francs. When the company wants to sell the watches, they want to receive Swiss francs to meet those expenses. However, if they sell to an English merchant, the English company will want to pay in sterling, the home currency. In between, a transaction has to occur that converts one currency into the other. That transaction is undertaken in the foreign exchange market. However, foreign exchange does not only involve trade. Trade, today, is only a small part of the foreign exchange market; movements of international capital seeking the most profitable home for the shortest term dominates.
The main participants in the foreign exchange market are:
Commercial banks – participate in the markets from the point of view of managing their own foreign exchange risks and that of their clients, and should they have a particularly strong view will also speculate on currency movements.Commercial organisations – by the nature of their business, companies could engage in commercial or capital transactions that require them to enter the currency markets to either buy or sell foreign currencies.Brokers – acts as a middleman in the same way as a stockbroker in the equities market, but brokers confine their activities to acting between banks and do not accept orders from corporate or retail clients.Central banks – their role tends to be diverse and can differ from country to country, however most are charged with the responsibility of maintaining an orderly market for the national currency.Fund managers – tend to invest across a range of countries and investment asset classes on behalf of their clients, for instance pension funds and individual investors.Hedge funds – have a tendency to be very aggressive in their investment approach and are generally concerned with managing the total risk of a pooled invest- ment.Speculators – in the narrow sense of the financial markets, buy, hold and sell (and vice versa) to profit from fluctuations in foreign exchange prices.Retail traders and investors – a new breed of participant into the foreign exchange market and have the same goals as everyone else – to make money.Most participants transact in foreign currency, not only for immediate delivery but also for settlement at specific times in the future. By using the forward markets, the participant can
A spot transaction is where delivery of the currencies is two business days from the trade date (except the Canadian dollar, which is one day).
A forward transaction is any transaction that settles on a date beyond spot.
determine today the currency equivalent of future foreign currency flows by transferring the risk of currency fluctuations (hedging or covering foreign currency exposure). The market participants on the other side of any trade must either have exactly opposite hedging needs or be willing to take a speculative position. The most common method used by participants when transacting in either spot or forward foreign currency is to deal directly with a bank, although Internet trading is currently making impressive inroads.
These banks usually have large foreign exchange sales and trading departments that not only handle the requests from their clients but also take positions to make trading profits and balance foreign currency positions arising from other bank business. Typical transactions in the bank market range from $ 1 million to $ 500 million, although banks will handle smaller amounts as requested by their clients at slightly less favourable terms.
1.5 ALTERNATIVE MARKETS
In addition to the spot and forward markets, other markets have been developed that are gaining acceptance. Foreign currency future contracts provide an alternative to the forward market and have been designed for dealing with major currencies. These contracts have the advantages of
A currency future obligates its owner to purchase a specified asset at a speci- fied exercise price on the contract maturity date.
smaller contract sizes and a high degree of liquidity for small transactions. The disadvantages include the inflexibility of standardized contract sizes, maturities, and higher costs on large transactions. Options on both currency futures and on spot currency are also available. Another
An option gives the owner the right but not the obligation to buy or sell a specified quantity of a currency at a specified rate on or before a specified date.
technique that is used to provide long-dated forward cover of foreign currency exposure, especially against the currency flow of foreign currency debt, is a foreign currency swap.
A foreign currency swap is where two currencies are exchanged for an agreed period of time and re-exchanged at maturity at the same exchange rate.
CONCLUDING REMARKS
In summary, the foreign exchange market is open for business 24-hours a day (almost seven days a week but not quite) with liquidity not being a major problem in most locations. In addition, with the advances in technology, trading over electronic platforms is becoming the norm, where foreign exchange trades are executed instantaneously. Plus, the foreign exchange market provides some of the highest leverage of any investment instrument, where it is possible to trade a sizeable position with limited funds via margin trading. It is a market which will take into account gut feelings, fundamental, economic and technical factors with enough volatility to satisfy the majority. Simply put, foreign exchange is an efficient market whereby the rates quoted by any market participant reflects all news, supply and demand issues, which way the market is weighted and potentially resting orders.
Perhaps most importantly, the foreign exchange market has depth and breadth superior to any capital markets instrument. For instance, equities, whether cash or derivatives, are all subject to what is available in an ‘order book’ and orders of any size may have to be worked before being filled. On the other hand, a foreign exchange order could be filled at one rate in a reasonable size instantaneously.
Although activity in the foreign exchange market remains predominately the domain of the large professional players – for example, major international banks, such as Citigroup, JPMorgan, HSBC and Deutsche Bank, it does not mean that the market is totally dominated by or controlled by such institutions. Other players also live in this market and include amongst others corporations, fund managers, brokers, speculators and retail investors. Though a bank’s scale of trading is vast compared to the average retail trader, they are all concerned by and affected by the same issues and happenings of the day. When all said and done, all participants, whether large or small, seek to make a profit out of their activities in the foreign exchange market. However, with liquidity and the advent of Internet trading, plus the availability of margin trading, this 24-hour market requires a much disciplined approach to trading, as profit opportunities and potential loss are equal and opposite.
∗BIS Triennial Central Bank Survey of FX and Derivatives Market Activity in April 2007, published September and December 2007
Part I
Market Overview
Chapter 2
A Brief History of the Market
Foreign exchange is the medium through which international debt is both valued and settled. It is also a means of evaluating one country’s worth in terms of another’s and, depending on circumstances, can therefore exist as a store of value.
Between 9000 and 6000 BC cattle (cows, sheep, camels) were used as the first and oldest form of money.
2.1 THE BARTER SYSTEM
Throughout history, people have traded for various reasons: sometimes to obtain desired raw materials by barter; sometimes to sell finished products for money; and sometimes to buy and sell commodities or other goods for no other reason than to try to profit from the transaction involved. For example, a farmer might need grain to make bread while another farmer might have a need for meat. They would, therefore, have the opportunity to agree terms, whereby one farmer could exchange his grain for the cow on offer from the other farmer. The barter system, in fact, provided a means for people to obtain the goods they needed as long as they had goods or services that were required by other people.
This system worked quite well and, even today, barter, as a system of exchange, remains in use throughout the world and sometimes in quite a sophisticated way. For example, during the cold war when the Russian rouble was not an exchangeable currency, the only way that Russia could obtain a much-needed commodity, such as wheat, was to arrange to obtain it from another country in exchange for a different commodity. Due to bad harvests in Russia, wheat was in short supply, while America had a surplus. America also had a shortage of oil, which was in excess in Russia. Thus Russia delivered oil to America in exchange for wheat.
Although the barter system worked quite well, it was not perfect. For instance it lacked:
Convertibility – What is the value of a cow? In other words, what could a cow convert into?Portability – How easy is it to carry a cow around?Divisibility – If a cow is deemed to be worth three pigs, how much of a cow would one pig be worth?It was the introduction of paper money – which had the three characteristics lacking in the barter system – that allowed the development of international commerce as we know it today.
2.2 THE INTRODUCTION OF COINAGE
Approximately 4000 years ago, pre-historic bartering of goods or similar objects of value as payment eventually gave way to the use of coins struck in precious metals. An important concept of early money was that it was fully backed by a reserve of gold and was convertible to gold (or silver) at the holder’s request.
Even in those days, there was international trade and payments were settled in such coinage as was acceptable to both parties. Early Greek coins were almost universally accepted in the then known world; in fact, many Athenian designs were frequently mimicked, proving the coinage’s popularity in design as well as acceptability.
Cowries (shells) were viewed as money in 1200 BC.
The first metal money and coins appeared in China in 1000 BC. The coins were made of base metals, often containing holes so that they could be put together like a chain.
The first paper bank notes appeared in China in 800 AD and, as a result, currency exchange started between some countries.
2.3 THE EXPANDING BRITISH EMPIRE
Skipping through time, some banking and financial markets nearer to those we know today began in the coffee houses of European financial centres. In the seventeenth century these coffee houses became the meeting places of merchants wishing to trade their finished products and of the entrepreneurs of the day. Soon after the Battle of Waterloo, during the nineteenth century, foreign trade from the expanding British Empire – and the finance required to fuel the industrial revolution – increased the size and frequency of international monetary transfers. For various reasons, a substitute for the large-scale transfer of coins or bullion had to be found (the ‘Dick Turpin’ era) and the bill of exchange for commercial purposes and its personal account equivalent, the cheque, were both born. At this time, London was building itself a reputation as the world’s capital for trade and finance, and the City became a natural centre for the negotiation of all such instruments, including foreign-drawn bills of exchange.
2.4 THE GOLD STANDARD
Gold was officially made the standard value in England in the nineteenth century. The value of paper money was tied directly to gold reserves in America.
Foreign exchange, as we know it today, has its roots in the Gold Standard, which was introduced in 1880. The main features were a system of fixed exchange rates in relation to gold and the absence of any exchange controls. Under the Gold Standard, a country with a balance of payments deficit had to surrender gold, thus reducing the volume of currency in the country, leading to deflation. The opposite occurred to a country with a balance of payments surplus.
Thus the Gold Standard ensured the soundness of each country’s paper money and, ultimately, controlled inflation as well. For example, when holders of paper money in America found the value of their dollar holdings falling in terms of gold, they could exchange dollars for gold. This had the effect of reducing the amount of dollars in circulation. Inevitably, as the supply of dollars fell, its value stabilized and then rose. Thus, the exchange of dollars for gold reserves was reversed. As long as the discipline of linking each currency’s value to the value of gold was maintained, the simple laws of supply and demand would dictate both currency valuation and the economics of the country.
The Gold Standard of exchange sounded ideal:
inflation was low;currency values were linked to a universally recognized store of value;interest rates were low, meaning that inflation was virtually nonexistent.The Gold Standard survived until the outbreak of World War I, after which foreign exchange, as we know it today, really began. Currencies were convertible into either gold or silver, but the main currencies for trading purposes were the British pound and, to a lesser extent, the American dollar. The amounts were relatively small by today’s transactions, and the trading centres tended to exist in isolation.
The early twentieth century saw the end of the Gold Standard.
2.5 THE BRETTON WOODS SYSTEM
Convertibility ended with the Great Depression, and the major powers left the Gold Standard and fostered protectionism. As the political climate deteriorated and the world headed for war, the foreign exchange markets all but ceased to exist. With the end of World War II, reconstruction for Europe and the Far East had as its base the Bretton Woods system.
In 1944 the Bretton Woods agreement devised a system of convertible currencies, fixed rates and free trade.
In 1944, the post-war system of international monetary exchange was established at Bretton Woods in New Hampshire, USA. The intent was to create a gold-based value of the American dollar and the British pound and link other major currencies to the dollar. This system allowed for small fluctuations in a 1 % band.
2.6 THE INTERNATIONAL MONETARY FUND AND THE WORLD BANK
The conference, in fact, rejected a suggestion by Keynes for a new world reserve currency in favour of a system built on the dollar. To help to accomplish its objectives, the Bretton Woods conference instigated the creation of the International Monetary Fund (IMF) and the World Bank. The function of the IMF was to lend foreign currency to members who required assistance, funded by each member according to size and resources. Gold was pegged at $ 35 an ounce. Other currencies were pegged to the dollar and under this system, inflation would be precluded among the member nations.
In the years following the Bretton Woods agreement, recovery was soon evident, trade expanded and foreign exchange dealings, while primitive by today’s standards, returned. While the amount of gold held in the American central reserves remained constant, the supply of dollar currency grew. In fact, the increased supply of dollars in Europe funded the post-war reconstruction of Europe in the 1950s. It seemed that the Bretton Woods accord had achieved its purpose. However, events in the 1960s once again brought turmoil to the currency markets and threatened to unravel the agreement.
2.7 THE DOLLAR RULES OK
By 1960, the dollar was supreme and the American economy was thought to be immune to adverse international developments, and the growing balance of payments deficits in America did not appear to alarm the authorities. The first cracks started to appear in November 1967. The British pound was devalued as a result of high inflation, low productivity and a worsening balance of payments. Not even massive selling by the Bank of England could avert the inevitable. President Johnson was trying to finance ‘the great society’ and fight the Vietnam War at the same time. This caused a drain on the gold reserves and led to capital controls.
In 1967, succumbing to the pressure of the diverging economic policies of the members of the IMF, Britain devalued the pound from $ 2.80 to $ 2.40. This not only increased demand for the dollar but it also increased the pressure on the dollar price of gold, which remained at $ 35 an ounce. Under this system free market forces were unable to find an equilibrium value.
2.8 SPECIAL DRAWING RIGHTS
By now markets were becoming increasingly unstable, reflecting confused economic and political concerns. In May 1968, France underwent severe civil disorder and had some of the worst street rioting in recent history. In 1969, France unilaterally devalued the franc and Germany was obliged to revalue the Deutschemark, resulting in a two-tier system of gold convertibility. Central banks agreed to trade gold at $ 35 an ounce with each other and not intercede in the open marketplace where normal pressures of supply and demand would dictate the prices.
In 1968 the IMF created Special Drawing Rights (SDRs), which made international foreign exchange possible.
In 1969, SDRs were approved as a form of reserve that central banks could exchange as a surrogate for gold.
As an artificial asset kept on the books of the IMF, SDRs were to be used as a surrogate for real gold reserves. Although the word ‘asset’ was not used, it was in fact an attempt by the IMF to create an additional form of paper gold to be traded between central banks. Later, the SDR was defined as a basket of currencies, although the composition of that basket has been changed several times since then.
During 1971 the Bretton Woods agreement was dissolved.
2.9 A DOLLAR PROBLEM
As the American balance of payments worsened, money continued to flow into Germany. In April 1971, the German Central Bank intervened to buy dollars and sell Deutschemarks to support the flagging dollar. In the following weeks, despite massive action, market forces overwhelmed the central bank and the Deutschemark was allowed to revalue upwards against the dollar. In May 1971, Germany revalued again and other currencies quickly followed. The collapse of the Bretton Woods system finally occurred when the American authorities acknowledged that there was a ‘dollar’ problem. President Nixon closed ‘the gold window’ on 15 August 1971, thereby ending dollar convertibility into gold. He also declared a tax on all imports for a short period, but signalled to the market that a devaluation of the dollar versus the major European currencies and the Japanese yen was due.
2.9.1 The Smithsonian Agreement
A final attempt was made to repair the Bretton Woods agreement during late 1971 at a meeting at the Smithsonian Institute. The result was aptly known as the Smithsonian agreement. A widening of the official intervention bands for currency values of the Bretton Woods agreement from 1 % to 2.25 % was imposed, as well as a realignment of values and an increase in the official price of gold to $ 38 per ounce.
2.9.2 The Snake
With the Smithsonian agreement the dollar was devalued. Despite the fanfare surrounding the new agreement, Germany nevertheless acted to impose its own controls to keep the Deutschemark down. In concert with its Common Market colleagues, Germany fostered the creation of the first European Monetary system, known as the ‘snake’. This system referred to the narrow fluctuation of the EEC currencies bound by the wider band of the non-EEC currencies. This short-lived system began in April 1972, but even this mechanism was not the panacea all had hoped for, and Britain left the snake, having spent millions in support of the pound.
2.9.3 The Dirty Float
During this period the dollar was still under pressure as money flowed into Germany, the rest of Europe and Japan. The final straw was the imposition of restrictions by the Italian government to support the Italian lira. This ultimately caused the demise of the Smithsonian agreement and led to a 10 % devaluation of the dollar in February 1973. Currencies now floated freely, with occasional central bank intervention. This was the era of the ‘dirty float’, and 1973 and 1974 saw a change in the dollar’s fortunes. The four-fold increase in oil prices following the Yom Kippur War, in the Middle East, created a tremendous demand for dollars, and, since oil was priced in dollars the currency soared. Those who were accustomed to selling dollars were severely tried. The collapse of the Herstatt and Franklin banks followed as a direct result of this shift in the dollar’s fortunes. The dollar was again under pressure during the mid-1970s, reflecting still worsening balance of payments figures. Treasury secretary Michael Blumenthal, in trying to foster export growth, constantly talked the dollar down, and Europe and Japan were glad to see a lower dollar, since their oil payments were correspondingly cheaper.
2.10 THE EMS AND THE ERM
The European Monetary System (EMS) and the European Rate Mechanism (ERM) were established in 1979.
2.10.1 The European Monetary System
In the EMS, member currencies were permitted to move within broad limits against each other and a central point. The EMS represented a further attempt at European economic coordination, and a grid was established, linking the value of each currency to the others. This attempt to ‘fix’ exchange rates met with near extinction during 1992–1993, when built-up economic pressures forced the devaluations of a number of weak European currencies.
The maximum permitted divergence from the EEC band of currency fluctuations was:
2.25 % among strong currencies within the EEC;6.00 % among weak currencies within the EEC;Unlimited with other countries and the dollar.Divergence beyond these boundaries required the central banks of each country to intervene in the foreign exchange markets, selling the strong currency and buying the weak to maintain their relative values.
2.10.2 The Exchange Rate Mechanism
In 1979, central banks agreed to another tool to intervene in the market. This was known as the Exchange Rate Mechanism (ERM), and allowed changes in short-term interest rates thus punishing speculators by raising rates in the weaker currencies to discourage short selling. Currencies participating in the ERM were:
Austrian schilling;Belgium franc;Danish krone;German Mark;French franc;Portuguese escudo;Spanish peseta;Dutch guilder;Irish punt.2.11 THE EUROPEAN CURRENCY UNIT
The European Currency Unit (ECU) was also introduced as a forerunner to creating a single European currency. The ECU was a currency based on the weighted average of the currencies of the common market. The ECU also served to provide a measure of relative value for each currency in the EMS.
An active market in ECU-denominated bonds developed, as well as a liquid spot and forward ECU foreign exchange market. The primary activity in these markets was to supply liquidity through speculative trading and arbitrage of the component elements of the ECU. All such trading activity served to stabilize the currency and interest markets and was, therefore, valuable.
Throughout the 1980s, the EMS suffered occasional periods of stress in the system, with speculative runs on the weak currencies of the system resulting in frequent realignments. The German Bundesbank’s conservative anti-inflationary policies were out of step with the more inflation-prone, loose money policies of Italy, France, Spain, Portugal and the Scandinavian countries. Devaluation of those currencies versus the Deutschemark was often associated with large speculative positions, which were taken by banks, hedge funds and other market participants, almost always at the expense of currency holders of the weaker countries.
2.12 THE MAASTRICHT TREATY
The quest for currency stability in Europe continued with the signing of the Maastricht treaty in 1991. This treaty proposed that a single European Central Bank be established, much as the Federal Reserve that was established in 1913 to act on behalf of American interests. After the European currencies were fixed, they were moved into a single currency, which has led to the actual replacement of many European currencies with the euro.
2.13 THE TREATY OF ROME
The euro has actually been an ambition since 1958 and the Treaty of Rome, with a declaration of a common European market as a European objective with the aim of increasing economic prosperity and contributing to ‘an ever closer union among the people of Europe’. The Single European Act and the Treaty on European Union have built on this, introducing Economic and Monetary Union (EMU) and laying the foundations for a single currency.
In 1991 the European Council approved the Treaty of the European Union. Fifteen countries signed for the European currency – the euro.
In 1992, the EMS came under the most intense pressure in its short history. In September, Britain was forced out of the ERM after less than two years as a member. Germany’s tight monetary policy proved incompatible with most of the other members of the EMS, leading to devaluations or total departures from the system.
