Coins and banknotes are the two most common forms of currency. Pictured
are several denominations of the euro.
A currency (from Middle English curraunt, meaning in circulation) in the
most specific use of the word refers to money in any form when in actual
use or circulation, as a medium of exchange, especially circulating paper
money. This use is synonymous with banknotes, or (sometimes) with
banknotes plus coins, meaning the physical tokens used for money by a
A much more general use of the word currency is anything that is used in
any circumstances, as a medium of exchange. In this use, "currency" is a
synonym for the concept of money.
A definition of intermediate generality is that a currency is a system of
money (monetary units) in common use, especially in a nation. Under this
definition, British pounds, U.S. dollars, and European euros are
different types of currency, or currencies. Currencies in this definition
need not be physical objects, but as stores of value are subject to
trading between nations in foreign exchange markets, which determine the
relative values of the different currencies. Currencies in the sense used
by foreign exchange markets, are defined by governments, and each type
has limited boundaries of acceptance.
The former definitions of the term "currency" are discussed in their
respective synonymous articles banknote, coin, and money. The latter
definition, pertaining to the currency systems of nations, is the topic
of this article.
Currency evolved from two basic innovations, both of which had occurred
by 2000 BC. Originally money was a form of receipt, representing grain
stored in temple granaries in Sumer in ancient Mesopotamia, then Ancient
This first stage of currency, where metals were used to represent stored
value, and symbols to represent commodities, formed the basis of trade in
the Fertile Crescent for over 1500 years. However, the collapse of the
Near Eastern trading system pointed to a flaw: in an era where there was
no place that was safe to store value, the value of a circulating medium
could only be as sound as the forces that defended that store. Trade
could only reach as far as the credibility of that military. By the late
Bronze Age, however, a series of treaties had established safe passage
for merchants around the Eastern Mediterranean, spreading from Minoan
Crete and Mycenae in the northwest to Elam and Bahrain in the southeast.
Although it is not known what functioned as a currency to facilitate
these exchanges, it is thought that ox-hide shaped ingots of copper,
produced in Cyprus may have functioned as a currency. It is thought that
the increase in piracy and raiding associated with the Bronze Age
collapse, possibly produced by the Peoples of the Sea, brought this
trading system to an end. It was only with the recovery of Phoenician
trade in the ninth and tenth centuries BC that saw a return to
prosperity, and the appearance of real coinage, possibly first in
Anatolia with Croesus of Lydia and subsequently with the Greeks and
Persians. In Africa many forms of value store have been used including
beads, ingots, ivory, various forms of weapons, livestock, the manilla
currency, ochre and other earth oxides, and so on. The manilla rings of
West Africa were one of the currencies used from the 15th century onwards
to buy and sell slaves. African currency is still notable for its
variety, and in many places various forms of barter still apply.
These factors led to the shift of the store of value being the metal
itself: at first silver, then both silver and gold, at one point there
was bronze as well. Now we have copper coins and other non-precious
metals as coins. Metals were mined, weighed, and stamped into coins. This
was to assure the individual taking the coin that he was getting a
certain known weight of precious metal. Coins could be counterfeited, but
they also created a new unit of account, which helped lead to banking.
Archimedes' principle provided the next link: coins could now be easily
tested for their fine weight of metal, and thus the value of a coin could
be determined, even if it had been shaved, debased or otherwise tampered
with (see Numismatics).
In most major economies using coinage, copper, silver and gold formed
three tiers of coins. Gold coins were used for large purchases, payment
of the military and backing of state activities. Silver coins were used
for midsized transactions, and as a unit of account for taxes, dues,
contracts and fealty, while copper coins represented the coinage of
common transaction. This system had been used in ancient India since the
time of the Mahajanapadas. In Europe, this system worked through the
medieval period because there was virtually no new gold, silver or copper
introduced through mining or conquest. Thus the overall ratios of the
three coinages remained roughly equivalent. It is most significant.
In premodern China, the need for credit and for circulating a medium that
was less of a burden than exchanging thousands of copper coins led to the
introduction of paper money, commonly known today as banknotes. This
economic phenomenon was a slow and gradual process that took place from
the late Tang Dynasty (618–907) into the Song Dynasty (960–1279). It
began as a means for merchants to exchange heavy coinage for receipts of
deposit issued as promissory notes from shops of wholesalers, notes that
were valid for temporary use in a small regional territory. In the 10th
century, the Song Dynasty government began circulating these notes
amongst the traders in their monopolized salt industry. The Song
government granted several shops the sole right to issue banknotes, and
in the early 12th century the government finally took over these shops to
produce state-issued currency. Yet the banknotes issued were still
regionally valid and temporary; it was not until the mid 13th century
that a standard and uniform government issue of paper money was made into
an acceptable nationwide currency. The already widespread methods of
woodblock printing and then Pi Sheng's movable type printing by the 11th
century was the impetus for the massive production of paper money in
At around the same time in the medieval Islamic world, a vigorous
monetary economy was created during the 7th–12th centuries on the basis
of the expanding levels of circulation of a stable high-value currency
(the dinar). Innovations introduced by Muslim economists, traders and
merchants include the earliest uses of credit, cheques, promissory notes,
savings accounts, transactional accounts, loaning, trusts, exchange
rates, the transfer of credit and debt, and banking institutions for
loans and deposits.
In Europe, paper money was first introduced on a regular basis in Sweden
in 1661 (although Washington Irving records an earlier emergency use of
it, by the Spanish in a siege during the Conquest of Granada). Sweden was
rich in copper, thus, because of copper's low value, extraordinarily big
coins (often weighing several kilograms) had to be made.
The advantages of paper currency were numerous: it reduced transport of
gold and silver, and thus lowered the risks; it made loaning gold or
silver at interest easier, since the specie (gold or silver) never left
the possession of the lender until someone else redeemed the note; and it
allowed for a division of currency into credit and specie backed forms.
It enabled the sale of stock in joint stock companies, and the redemption
of those shares in paper.
However, these advantages held within them disadvantages. First, since a
note has no intrinsic value, there was nothing to stop issuing
authorities from printing more of it than they had specie to back it
with. Second, because it increased the money supply, it increased
inflationary pressures, a fact observed by David Hume in the 18th
century. The result is that paper money would often lead to an
inflationary bubble, which could collapse if people began demanding hard
money, causing the demand for paper notes to fall to zero. The printing
of paper money was also associated with wars, and financing of wars, and
therefore regarded as part of maintaining a standing army. For these
reasons, paper currency was held in suspicion and hostility in Europe and
America. It was also addictive, since the speculative profits of trade
and capital creation were quite large. Major nations established mints to
print money and mint coins, and branches of their treasury to collect
taxes and hold gold and silver stock.
At this time both silver and gold were considered legal tender, and
accepted by governments for taxes. However, the instability in the ratio
between the two grew over the course of the 19th century, with the
increase both in supply of these metals, particularly silver, and of
trade. This is called bimetallism and the attempt to create a bimetallic
standard where both gold and silver backed currency remained in
circulation occupied the efforts of inflationists. Governments at this
point could use currency as an instrument of policy, printing paper
currency such as the United States Greenback, to pay for military
expenditures. They could also set the terms at which they would redeem
notes for specie, by limiting the amount of purchase, or the minimum
amount that could be redeemed.
By 1900, most of the industrializing nations were on some form of gold
standard, with paper notes and silver coins constituting the circulating
medium. Private banks and governments across the world followed Gresham's
Law: keeping gold and silver paid, but paying out in notes. This did not
happen all around the world at the same time, but occurred sporadically,
generally in times of war or financial crisis, beginning in the early
part of the 20th century and continuing across the world until the late
20th century, when the regime of floating fiat currencies came into
force. One of the last countries to break away from the gold standard was
the United States in 1971.
No country anywhere in the world today has an enforceable gold standard
or silver standard currency system.
A banknote (more commonly known as a bill in the United States and
Canada) is a type of currency, and commonly used as legal tender in many
jurisdictions. With coins, banknotes make up the cash form of all money.
Banknotes are mostly paper, but Australia's Commonwealth Scientific and
Industrial Research Organisation developed the world's first polymer
currency in the 1980s that went into circulation on the nation's
bicentenary in 1988. Now used in some 22 countries (over 40 if counting
commemorative issues), polymer currency dramatically improves the life
span of banknotes and prevents counterfeiting.
To find out which currency is used in a particular country, check list of
Currency use is based on the concept of lex monetae; that a sovereign
state decides which currency it shall use. Currently, the International
Organization for Standardization has introduced a three-letter system of
codes (ISO 4217) to define currency (as opposed to simple names or
currency signs), in order to remove the confusion that there are dozens
of currencies called the dollar and many called the franc. Even the pound
is used in nearly a dozen different countries, all, of course, with
wildly differing values. In general, the three-letter code uses the ISO
3166-1 country code for the first two letters and the first letter of the
name of the currency (D for dollar, for instance) as the third letter.
United States currency, for instance is globally referred to as USD. It
is also possible for a currency to be internet-based and digital, for
instance, Bitcoin, the Ripple Pay system or MintChip, and not tied to any
The International Monetary Fund uses a variant system when referring to
Control and production
In most cases, a central bank has monopoly control over emission of coins
and banknotes (fiat money) for its own area of circulation (a country or
group of countries); it regulates the production of currency by banks
(credit) through monetary policy.
In order to facilitate trade between these currency zones, there are
different exchange rates, which are the prices at which currencies (and
the goods and services of individual currency zones) can be exchanged
against each other. Currencies can be classified as either floating
currencies or fixed currencies based on their exchange rate regime.
In cases where a country does have control of its own currency, that
control is exercised either by a central bank or by a Ministry of
Finance. In either case, the institution that has control of monetary
policy is referred to as the monetary authority. Monetary authorities
have varying degrees of autonomy from the governments that create them.
In the United States, the Federal Reserve System operates without direct
oversight by the legislative or executive branches. A monetary authority
is created and supported by its sponsoring government, so independence
can be reduced by the legislative or executive authority that creates it.
Several countries can use the same name for their own distinct currencies
(for example, dollar in Australia, Canada and the United States). By
contrast, several countries can also use the same currency (for example,
the euro), or one country can declare the currency of another country to
be legal tender. For example, Panama and El Salvador have declared U.S.
currency to be legal tender, and from 1791–1857, Spanish silver coins
were legal tender in the United States. At various times countries have
either re-stamped foreign coins, or used currency board issuing one note
of currency for each note of a foreign government held, as Ecuador
Each currency typically has a main currency unit (the dollar, for
example, or the euro) and a fractional currency, often valued at 1?100 of
the main currency: 100 cents = 1 dollar, 100 centimes = 1 franc, 100
pence = 1 pound, although units of 1?10 or 1?1000 are also common. Some
currencies do not have any smaller units at all, such as the Icelandic
Mauritania and Madagascar are the only remaining countries that do not
use the decimal system; instead, the Mauritanian ouguiya is divided into
5 khoums, while the Malagasy ariary is divided into 5 iraimbilanja. In
these countries, words like dollar or pound "were simply names for given
weights of gold." Due to inflation khoums and iraimbilanja have in
practice fallen into disuse. (See non-decimal currencies for other
historic currencies with non-decimal divisions).
Convertibility of a currency determines the ability of an individual,
corporate or government to convert its local currency to another currency
or vice versa with or without central bank/government intervention. Based
on the above restrictions or free and readily conversion features
currencies are classified as:
Fully Convertible - When there are no restrictions or limitations on the
amount of currency that can be traded on the international market, and
the government does not artificially impose a fixed value or minimum
value on the currency in international trade. The US dollar is an example
of a fully convertible currency and for this reason, US dollars are one
of the major currencies traded in the FOREX market.
Partially Convertible - Central Banks control international investments
flowing in and out of the country, while most domestic trade transactions
are handled without any special requirements, there are significant
restrictions on international investing and special approval is often
required in order to convert into other currencies. The Indian Rupee is
an example of a partially convertible currency.
Nonconvertible - Neither participate in the international FOREX market
nor allow conversion of these currencies by individuals or companies. As
a result, these currencies are known as blocked currencies. e.g.: North
Korean Won and the Cuban Peso
In economics, a local currency is a currency not backed by a national
government, and intended to trade only in a small area. Advocates such as
Jane Jacobs argue that this enables an economically depressed region to
pull itself up, by giving the people living there a medium of exchange
that they can use to exchange services and locally produced goods (In a
broader sense, this is the original purpose of all money.) Opponents of
this concept argue that local currency creates a barrier which can
interfere with economies of scale and comparative advantage, and that in
some cases they can serve as a means of tax evasion.
Local currencies can also come into being when there is economic turmoil
involving the national currency. An example of this is the Argentinian
economic crisis of 2002 in which IOUs issued by local governments quickly
took on some of the characteristics of local currencies.
One of the best examples of a local currency is the original LETS
currency, founded on Vancouver Island in the early 1980s. In 1982 the
Canadian Central Bank’s lending rates ran up to 14% which drove chartered
bank lending rates as high as 19%. The resulting currency and credit
scarcity left island residents with few options other than to create a
Asian Currency Unit: proposed for the ASEAN +3, or the East Asian
Bancor: an international currency proposed by John Maynard Keynes in the
negotiations that established the Bretton Woods system (never
Currency for Caribbean area—CARICOM states except the Bahamas.
East African shilling: East African Community (Burundi, Kenya, Rwanda,
Eco: West African Monetary Zone (the Gambia, Ghana, Guinea, Nigeria,
Sierra Leone, possibly Liberia)
Khaleeji (currency): Gulf Cooperation Council (Bahrain, Kuwait, Oman,
Qatar, Saudi Arabia, United Arab Emirates)
Metica: Mozambique (never implemented)
Perun: Montenegro (never implemented)
Gaucho (currency): Currency for bilateral commerce (never implemented)
Toman: The new currency that is proposed by the Central Bank of Iran
which would replace the Iranian Rial by slashing four zeros off the
country's national currency.
Caribbean guilder, the new currency for Curaçao and Sint Maarten for 2012
replacing the Netherlands Antillean guilder.
A currency future, also FX future or foreign exchange future, is a
futures contract to exchange one currency for another at a specified date
in the future at a price (exchange rate) that is fixed on the purchase
date; see Foreign exchange derivative. Typically, one of the currencies
is the US dollar. The price of a future is then in terms of US dollars
per unit of other currency. This can be different from the standard way
of quoting in the spot foreign exchange markets. The trade unit of each
contract is then a certain amount of other currency, for instance
€125,000. Most contracts have physical delivery, so for those held at the
end of the last trading day, actual payments are made in each currency.
However, most contracts are closed out before that. Investors can close
out the contract at any time prior to the contract's delivery date.
Currency futures were first created in 1970 at the International
Commercial Exchange in New York. But the contracts did not "take off" due
to the fact that the Bretton Woods system was still in effect. They did
so a full two years before the Chicago Mercantile Exchange (CME) in 1972,
less than one year after the system of fixed exchange rates was abandoned
along with the gold standard. Some commodity traders at the CME did not
have access to the inter-bank exchange markets in the early 1970s, when
they believed that significant changes were about to take place in the
currency market. The CME actually now gives credit to the International
Commercial Exchange (not to be confused with the ICE for creating the
currency contract, and state that they came up with the idea
independently of the International Commercial Exchange). The CME
established the International Monetary Market (IMM) and launched trading
in seven currency futures on May 16, 1972. Today, the IMM is a division
of CME. In the fourth quarter of 2009, CME Group FX volume averaged
754,000 contracts per day, reflecting average daily notional value of
approximately $100 billion. Currently most of these are traded
Other futures exchanges that trade currency futures are Euronext.liffe
, Tokyo Financial Exchange  and IntercontinentalExchange .
As with other futures, the conventional maturity dates are the IMM dates,
namely the third Wednesday in March, June, September and December. The
conventional option maturity dates are the first Friday after the first
Wednesday for the given month.
Investors use these futures contracts to hedge against foreign exchange
risk. If an investor will receive a cashflow denominated in a foreign
currency on some future date, that investor can lock in the current
exchange rate by entering into an offsetting currency futures position
that expires on the date of the cashflow.
For example, Jane is a US-based investor who will receive €1,000,000 on
December 1. The current exchange rate implied by the futures is $1.2/€.
She can lock in this exchange rate by selling €1,000,000 worth of futures
contracts expiring on December 1. That way, she is guaranteed an exchange
rate of $1.2/€ regardless of exchange rate fluctuations in the meantime.
Currency futures can also be used to speculate and, by incurring a risk,
attempt to profit from rising or falling exchange rates.
For example, Peter buys 10 September CME Euro FX Futures, at $1.2713/€.
At the end of the day, the futures close at $1.2784/€. The change in
price is $0.0071/€. As each contract is over €125,000, and he has 10
contracts, his profit is $8,875. As with any future, this is paid to him
More generally, each change of $0.0001/€ (the minimum Commodity tick
size), is a profit or loss of $12.50 per contract.
In finance, a forward contract or simply a forward is a non-standardized
contract between two parties to buy or sell an asset at a specified
future time at a price agreed upon today. This is in contrast to a spot
contract, which is an agreement to buy or sell an asset today. The party
agreeing to buy the underlying asset in the future assumes a long
position, and the party agreeing to sell the asset in the future assumes
a short position. The price agreed upon is called the delivery price,
which is equal to the forward price at the time the contract is entered
The price of the underlying instrument, in whatever form, is paid before
control of the instrument changes. This is one of the many forms of
buy/sell orders where the time and date of trade is not the same as the
value date where the securities themselves are exchanged.
The forward price of such a contract is commonly contrasted with the spot
price, which is the price at which the asset changes hands on the spot
date. The difference between the spot and the forward price is the
forward premium or forward discount, generally considered in the form of
a profit, or loss, by the purchasing party.
Forwards, like other derivative securities, can be used to hedge risk
(typically currency or exchange rate risk), as a means of speculation, or
to allow a party to take advantage of a quality of the underlying
instrument which is time-sensitive.
A closely related contract is a futures contract; they differ in certain
respects. Forward contracts are very similar to futures contracts, except
they are not exchange-traded, or defined on standardized assets. Forwards
also typically have no interim partial settlements or "true-ups" in
margin requirements like futures – such that the parties do not exchange
additional property securing the party at gain and the entire unrealized
gain or loss builds up while the contract is open. However, being traded
over the counter (OTC), forward contracts specification can be customized
and may include mark-to-market and daily margining. Hence, a forward
contract arrangement might call for the loss party to pledge collateral
or additional collateral to better secure the party at gain.
The value of a forward position at maturity depends on the relationship
between the delivery price () and the underlying price () at that time.
For a long position this payoff is:
For a short position, it is:
How a forward contract works
Suppose that Bob wants to buy a house a year from now. At the same time,
suppose that Andy currently owns a $100,000 house that he wishes to sell
a year from now. Both parties could enter into a forward contract with
each other. Suppose that they both agree on the sale price in one year's
time of $104,000 (more below on why the sale price should be this
amount). Andy and Bob have entered into a forward contract. Bob, because
he is buying the underlying, is said to have entered a long forward
contract. Conversely, Andy will have the short forward contract.
At the end of one year, suppose that the current market valuation of
Andy's house is $110,000. Then, because Andy is obliged to sell to Bob
for only $104,000, Bob will make a profit of $6,000. To see why this is
so, one needs only to recognize that Bob can buy from Andy for $104,000
and immediately sell to the market for $110,000. Bob has made the
difference in profit. In contrast, Andy has made a potential loss of
$6,000, and an actual profit of $4,000.
The similar situation works among currency forwards, where one party
opens a forward contract to buy or sell a currency (ex. a contract to buy
Canadian dollars) to expire/settle at a future date, as they do not wish
to be exposed to exchange rate/currency risk over a period of time. As
the exchange rate between U.S. dollars and Canadian dollars fluctuates
between the trade date and the earlier of the date at which the contract
is closed or the expiration date, one party gains and the counterparty
loses as one currency strengthens against the other. Sometimes, the buy
forward is opened because the investor will actually need Canadian
dollars at a future date such as to pay a debt owed that is denominated
in Canadian dollars. Other times, the party opening a forward does so,
not because they need Canadian dollars nor because they are hedging
currency risk, but because they are speculating on the currency,
expecting the exchange rate to move favorably to generate a gain on
closing the contract.
In a currency forward, the notional amounts of currencies are specified
(ex: a contract to buy $100 million Canadian dollars equivalent to, say
$114.4 million USD at the current rate—these two amounts are called the
notional amount(s)). While the notional amount or reference amount may be
a large number, the cost or margin requirement to command or open such a
contract is considerably less than that amount, which refers to the
leverage created, which is typical in derivative contracts.
Example of how forward prices should be agreed upon
Continuing on the example above, suppose now that the initial price of
Andy's house is $100,000 and that Bob enters into a forward contract to
buy the house one year from today. But since Andy knows that he can
immediately sell for $100,000 and place the proceeds in the bank, he
wants to be compensated for the delayed sale. Suppose that the risk free
rate of return R (the bank rate) for one year is 4%. Then the money in
the bank would grow to $104,000, risk free. So Andy would want at least
$104,000 one year from now for the contract to be worthwhile for him –
the opportunity cost will be covered.
For liquid assets ("tradeables"), spot–forward parity provides the link
between the spot market and the forward market. It describes the
relationship between the spot and forward price of the underlying asset
in a forward contract. While the overall effect can be described as the
cost of carry, this effect can be broken down into different components,
specifically whether the asset: pays income, and if so whether this is on
a discrete or continuous basis incurs storage costs is regarded as an
investment asset, i.e. an asset held primarily for investment purposes
(e.g. gold, financial securities);or a consumption asset, i.e. an asset
held primarily for consumption (e.g. oil, iron ore etc.)
For an asset that provides no income, the relationship between the
current forward () and spot () prices is
where is the continuously compounded risk free rate of return, and T is
the time to maturity. The intuition behind this result is that given you
want to own the asset at time T, there should be no difference in a
perfect capital market between buying the asset today and holding it and
buying the forward contract and taking delivery. Thus, both approaches
must cost the same in present value terms. For an arbitrage proof of why
this is the case, see Rational pricing below.
For an asset that pays known income, the relationship becomes:
Where the present value of the discrete income at time , and is the
continuously compounded dividend yield over the life of the contract. The
intuition is that when an asset pays income, there is a benefit to
holding the asset rather than the forward because you get to receive this
income. Hence the income ( or ) must be subtracted to reflect this
benefit. An example of an asset which pays discrete income might be a
stock, and example of an asset which pays a continuous yield might be a
foreign currency or a stock index.
For investment assets which are commodities, such as gold and silver,
storage costs must also be considered. Storage costs can be treated as
'negative income', and like income can be discrete or continuous. Hence
with storage costs, the relationship becomes:
where the present value of the discrete storage cost at time , and is the
continuously compounded storage cost where it is proportional to the
price of the commodity, and is hence a 'negative yield'. The intuition
here is that because storage costs make the final price higher, we have
to add them to the spot price.
Consumption assets are typically raw material commodities which are used
as a source of energy or in a production process, for example crude oil
or iron ore. Users of these consumption commodities may feel that there
is a benefit from physically holding the asset in inventory as opposed to
holding a forward on the asset. These benefits include the ability to
profit from temporary shortages and the ability to keep a production
process running, and are referred to as the convenience yield. Thus, for
consumption assets, the spot-forward relationship is:
Discrete storage costs:
Continuous storage costs:
where is the convenience yield over the life of the contract. Since the
convenience yield provides a benefit to the holder of the asset but not
the holder of the forward, it can be modelled as a type of 'dividend
yield'. However, it is important to note that the convenience yield is a
non cash item, but rather reflects the market's expectations concerning
future availability of the commodity. If users have low inventories of
the commodity, this implies a greater chance of shortage, which means a
higher convenience yield. The opposite is true when high inventories
Cost of carry
The relationship between the spot and forward price of an asset reflects
the net cost of holding (or carrying) that asset relative to holding the
forward. Thus, all of the costs and benefits above can be summarised as
the cost of carry, . Hence,
Relationship between the forward price and the expected future spot price
The market's opinion about what the spot price of an asset will be in the
future is the expected future spot price. Hence, a key question is
whether or not the current forward price actually predicts the respective
spot price in the future. There are a number of different hypotheses
which try to explain the relationship between the current forward price,
and the expected future spot price, .
The economists John Maynard Keynes and John Hicks argued that in general,
the natural hedgers of a commodity are those who wish to sell the
commodity at a future point in time. Thus, hedgers will collectively hold
a net short position in the forward market. The other side of these
contracts are held by speculators, who must therefore hold a net long
position. Hedgers are interested in reducing risk, and thus will accept
losing money on their forward contracts. Speculators on the other hand,
are interested in making a profit, and will hence only enter the
contracts if they expect to make money. Thus, if speculators are holding
a net long position, it must be the case that the expected future spot
price is greater than the forward price.
In other words, the expected payoff to the speculator at maturity is:
, where is the delivery price at maturity
Thus, if the speculators expect to profit,
, as when they enter the contract
This market situation, where , is referred to as normal backwardation.
Since forward/futures prices converge with the spot price at maturity
(see basis), normal backwardation implies that futures prices for a
certain maturity are increasing over time. The opposite situation, where
, is referred to as contango. Likewise, contango implies that futures
prices for a certain maturity are falling over time.
If is the spot price of an asset at time , and is the continuously
compounded rate, then the forward price at a future time must satisfy .
To prove this, suppose not. Then we have two possible cases.
Case 1: Suppose that . Then an investor can execute the following trades
at time :
go to the bank and get a loan with amount at the continuously compounded
with this money from the bank, buy one unit of stock for ;
enter into one short forward contract costing 0. A short forward contract
means that the investor owes the counterparty the stock at time .
The initial cost of the trades at the initial time sum to zero.
At time the investor can reverse the trades that were executed at time .
Specifically, and mirroring the trades 1., 2. and 3. the investor
' repays the loan to the bank. The inflow to the investor is ;
' settles the short forward contract by selling the stock for . The cash
inflow to the investor is now because the buyer receives from the
The sum of the inflows in 1.' and 2.' equals , which by hypothesis, is
positive. This is an arbitrage profit. Consequently, and assuming that
the non-arbitrage condition holds, we have a contradiction. This is
called a cash and carry arbitrage because you "carry" the stock until
Case 2: Suppose that . Then an investor can do the reverse of what he has
done above in case 1. But if you look at the convenience yield page, you
will see that if there are finite stocks/inventory, the reverse cash and
carry arbitrage is not always possible. It would depend on the elasticity
of demand for forward contracts and such like.
Extensions to the forward pricing formula
Suppose that is the time value of cash flows X at the contract expiration
time . The forward price is then given by the formula:
The cash flows can be in the form of dividends from the asset, or costs
of maintaining the asset.
If these price relationships do not hold, there is an arbitrage
opportunity for a riskless profit similar to that discussed above. One
implication of this is that the presence of a forward market will force
spot prices to reflect current expectations of future prices. As a
result, the forward price for nonperishable commodities, securities or
currency is no more a predictor of future price than the spot price is -
the relationship between forward and spot prices is driven by interest
rates. For perishable commodities, arbitrage does not have this
The above forward pricing formula can also be written as:
Where is the time t value of all cash flows over the life of the
For more details about pricing, see forward price.
Theories of why a forward contract exists
Allaz and Vila (1993) suggest that there is also a strategic reason (in
an imperfect competitive environment) for the existence of forward
trading, that is, forward trading can be used even in a world without
uncertainty. This is due to firms having Stackelberg incentives to
anticipate their production through forward contracts.
John C. Hull, (2000), Options, Futures and other Derivatives, Prentice-
Keith Redhead, (31 October 1996), Financial Derivatives: An Introduction
to Futures, Forwards, Options and Swaps, Prentice-Hall
Abraham Lioui & Patrice Poncet, (March 30, 2005), Dynamic Asset
Allocation with Forwards and Futures, Springer
Check Yahoo answers 
Forward Contract on Wikinvest
Allaz, B. and Vila, J.-L., Cournot competition, futures markets and
efficiency, Journal of Economic Theory 59,297-308.
In finance, a non-deliverable forward (NDF) is an outright forward or
futures contract in which counterparties settle the difference between
the contracted NDF price or rate and the prevailing spot price or rate on
an agreed notional amount. It is used in various markets such as foreign
exchange and commodities. NDFs are prevalent in some countries where
forward FX trading has been banned by the government (usually as a means
to prevent exchange rate volatility).
The NDF market is an over-the-counter market. NDFs began to trade
actively in the 1990s. NDF markets developed for emerging markets with
capital controls, where the currencies could not be delivered offshore.
Most NDFs are cash-settled in US dollars.
The more active banks quote NDFs from between one month to one year,
although some would quote up to two years upon request. The most commonly
traded NDF tenors are IMM dates, but banks also offer odd-dated NDFs.
NDFs are typically quoted with the USD as the reference currency, and the
settlement amount is also in USD.
List of currencies with NDF market
Below is a (non-exhaustive) list of currencies where non-deliverable
forwards are traded. Not all non-convertible currencies have a NDF market
(e.g. BDT had no active market as of 2011). A currency may be convertible
by some market participants while being non-convertible to others.
Asia Pacific Europe, Middle East and Africa Latin
KRWSouth Korean Won
PENPeruvian nuevo sol
Structure and features
An NDF is a short-term, cash-settled currency forward between two
counterparties. On the contracted settlement date, the profit or loss is
adjusted between the two counterparties based on the difference between
the contracted NDF rate and the prevailing spot FX rates on an agreed
The features of an NDF include:
notional amount: This is the "face value" of the NDF, which is agreed
between the two counterparties. It should again be noted that there is
never any intention to exchange the notional amounts in the two
fixing date: This is the day and time whereby the comparison between the
NDF rate and the prevailing spot rate is made.
settlement date (or delivery date): This is the day when the difference
is paid or received. It is usually one or two business days after the
contracted NDF rate: the rate agreed on the transaction date, and is
essentially the outright forward rate of the currencies dealt.
prevailing spot rate (or fixing spot rate): the rate on the fixing date
usually provided by the central bank, and commonly calculated by calling
a number of dealers in the market for a quote at a specified time of day,
and taking the average. The exact method of determining the fixing rate
is agreed when a trade is initiated.
Because an NDF is a cash-settled instrument, the notional amount is never
exchanged. The only exchange of cash flows is the difference between the
NDF rate and the prevailing spot market rate—that is determined on the
fixing date and exchanged on the settlement date—applied to the notional,
i.e. cash flow = (NDF rate – spot rate) × notional.
Consequently, since NDF is a "non-cash", off-balance-sheet item and since
the principal sums do not move, NDF bears much lower counter-party risk.
NDFs are committed short-term instruments; both counterparties are
committed and are obliged to honor the deal. Nevertheless, either
counterparty can cancel an existing contract by entering into another
offsetting deal at the prevailing market rate.
Pricing and valuation
An investor enters into a forward agreement to purchase a notional
amount, N, of the base currency at the contracted forward rate, F, and
would pay NF units of the quoted currency. On the fixing date, that
investor would theoretically be able to sell the notional amount, N, of
the base currency at the prevailing spot rate, S, earning NS units of the
quoted currency. Therefore, the profit, , on this trade in terms of the
base currency, is given by:
The base currency is usually the more liquid and more frequently traded
currency (for example, USD).
Synthetic foreign currency loans
NDFs can be used to create a foreign currency loan in a currency, which
may not be of interest to the lender.
For example, the borrower wants dollars but wants to make repayments in
euros. So, the borrower receives a dollar sum and repayments will still
be calculated in dollars, but payment will be made in euros, using the
current exchange rate at time of repayment.
The lender wants to lend dollars and receive repayments in dollars. So,
at the same time as disbursing the dollar sum to the borrower, the lender
enters into a non-deliverable forward agreement with a counterparty (for
example, on the Chicago market) that matches the cash flows from the
foreign currency repayments.
Effectively, the borrower has a synthetic euro loan; the lender has a
synthetic dollar loan; and the counterparty has an NDF contract with the
Under certain circumstances, the rates achievable using synthetic foreign
currency lending may be lower than borrowing in the foreign currency
directly, implying that there is a possibility for arbitrage. Although
this is theoretically identical to a second currency loan (with
settlement in dollars), the borrower may face basis risk: the possibility
that a difference arises between the swap market's exchange rate and the
exchange rate on the home market. The lender also bears counterparty
The borrower could, in theory, enter into NDF contracts directly and
borrow in dollars separately and achieve the same result. NDF
counterparties, however, may prefer to work with a limited range of
entities (such as those with a minimum credit rating).
It is estimated that between 60 to 80 per cent of NDF trading is
speculative. The main difference between the outright forward deals and
the non-deliverable forwards is that the settlement is made in dollars
since the dealer or counterparty can not settle in the alternative
currency of the deal.
Misra, Sangita; Behera, Harendra (2006), "Non Deliverable Foreign
Exchange Forward Market: An Overview", Reserve Bank of India Occasional
Papers 27 (3)
Ma, Guonan; Ho, Corrinne; McCauley, Robert N. (2004), "The markets for
non-deliverable forwards in Asian currencies", BIS Quarterly Review (June
Foreign exchange swap
In finance, a foreign exchange swap, forex swap, or FX swap is a
simultaneous purchase and sale of identical amounts of one currency for
another with two different value dates (normally spot to forward). see
Foreign exchange derivative.
A foreign exchange swap consists of two legs:
a spot foreign exchange transaction, and
a forward foreign exchange transaction.
These two legs are executed simultaneously for the same quantity, and
therefore offset each other.
It is also common to trade forward-forward, where both transactions are
for (different) forward dates.
By far and away the most common use of foreign exchange swaps is for
institutions to fund their foreign exchange balances.
Once a foreign exchange transaction settles, the holder is left with a
positive (or long) position in one currency, and a negative (or short)
position in another. In order to collect or pay any overnight interest
due on these foreign balances, at the end of every day institutions will
close out any foreign balances and re-institute them for the following
day. To do this they typically use tom-next swaps, buying (or selling) a
foreign amount settling tomorrow, and then doing the opposite, selling
(or buying) it back settling the day after.
The interest collected or paid every night is referred to as the cost of
carry. As currency traders know roughly how much holding a currency
position will make or cost on a daily basis, specific trades are put on
based on this; these are referred to as carry trades.
The relationship between spot and forward is known as the interest rate
parity, which states that
F = forward rate
S = spot rate
rd = simple interest rate of the term currency
rf = simple interest rate of the base currency
T = tenor (calculated according to the appropriate day count convention)
The forward points or swap points are quoted as the difference between
forward and spot, F - S, and is expressed as the following:
if is small. Thus, the value of the swap points is roughly proportional
to the interest rate differential.
A foreign exchange swap should not be confused with a currency swap,
which is a much rarer, long term transaction, governed by a slightly
different set of rules.
A currency swap is a foreign-exchange agreement between two institute to
exchange aspects (namely the principal and/or interest payments) of a
loan in one currency for equivalent aspects of an equal in net present
value loan in another currency; see foreign exchange derivative. Currency
swaps are motivated by comparative advantage. A currency swap should be
distinguished from a central bank liquidity swap.
Currency swaps are over-the-counter derivatives, and are closely related
to interest rate swaps. However, unlike interest rate swaps, currency
swaps can involve the exchange of the principal.
There are three different ways in which currency swaps can exchange
The simplest currency swap structure is to exchange only the principal
with the counterparty at a specified point in the future at a rate agreed
now. Such an agreement performs a function equivalent to a forward
contract or futures. The cost of finding a counterparty (either directly
or through an intermediary), and drawing up an agreement with them, makes
swaps more expensive than alternative derivatives (and thus rarely used)
as a method to fix shorter term forward exchange rates. However for the
longer term future, commonly up to 10 years, where spreads are wider for
alternative derivatives, principal-only currency swaps are often used as
a cost-effective way to fix forward rates. This type of currency swap is
also known as an FX-swap.
Another currency swap structure is to combine the exchange of loan
principal, as above, with an interest rate swap. In such a swap, interest
cash flows are not netted before they are paid to the counterparty (as
they would be in a vanilla interest rate swap) because they are
denominated in different currencies. As each party effectively borrows on
the other's behalf, this type of swap is also known as a back-to-back
Last here, but certainly not least important, is to swap only interest
payment cash flows on loans of the same size and term. Again, as this is
a currency swap, the exchanged cash flows are in different denominations
and so are not netted. An example of such a swap is the exchange of
fixed-rate US dollar interest payments for floating-rate interest
payments in Euro. This type of swap is also known as a cross-currency
interest rate swap, or cross currency swap.
Currency swaps have two main uses:
To secure cheaper debt (by borrowing at the best available rate
regardless of currency and then swapping for debt in desired currency
using a back-to-back-loan).
To hedge against (reduce exposure to) exchange rate fluctuations.
For instance, a US-based company needing to borrow Swiss francs, and a
Swiss-based company needing to borrow a similar present value in US
dollars, could both reduce their exposure to exchange rate fluctuations
by arranging any one of the following:
If the companies have already borrowed in the currencies each needs the
principal in, then exposure is reduced by swapping cash flows only, so
that each company's finance cost is in that company's domestic currency.
Alternatively, the companies could borrow in their own domestic
currencies (and may well each have comparative advantage when doing so),
and then get the principal in the currency they desire with a principal-
In May 2011, Charles Munger of Berkshire Hathaway Inc. accused
international investment banks of facilitating market abuse by national
governments. For example, "Goldman Sachs helped Greece raise $1 billion
of off- balance-sheet funding in 2002 through a currency swap, allowing
the government to hide debt." Greece had previously succeeded in getting
clearance to join the euro on 1 January 2001, in time for the physical
launch in 2002, by faking its deficit figures.
Currency swaps were originally conceived in the 1970s to circumvent
foreign exchange controls in the United Kingdom. At that time, UK
companies had to pay a premium to borrow in US Dollars. To avoid this, UK
companies set up back-to-back loan agreements with US companies wishing
to borrow Sterling. While such restrictions on currency exchange have
since become rare, savings are still available from back-to-back loans
due to comparative advantage.
Cross-currency interest rate swaps were introduced by the World Bank in
1981 to obtain Swiss francs and German marks by exchanging cash flows
with IBM. This deal was brokered by Salomon Brothers with a notional
amount of $210 million dollars and a term of over ten years.
During the global financial crisis of 2008, the currency swap transaction
structure was used by the United States Federal Reserve System to
establish central bank liquidity swaps. In these, the Federal Reserve and
the central bank of a developed or stable emerging economy agree to
exchange domestic currencies at the current prevailing market exchange
rate & agree to reverse the swap at the same exchange rate at a fixed
future date. The aim of central bank liquidity swaps is "to provide
liquidity in U.S. dollars to overseas markets." While central bank
liquidity swaps and currency swaps are structurally the same, currency
swaps are commercial transactions driven by comparative advantage, while
central bank liquidity swaps are emergency loans of US Dollars to
overseas markets, and it is currently unknown whether or not they will be
beneficial for the Dollar or the US in the long-term.
The People's Republic of China has multiple year currency swap agreements
of the Renminbi with Argentina, Belarus, Brazil, Hong Kong, Iceland,
Indonesia, Malaysia, Singapore, South Korea and Uzbekistan that perform a
similar function to central bank liquidity swaps.
Currency Swap Example
A European Company A is doing business in the USA, and it has issued a
$20 million dollar-denominated bond to investors in the US. An American
Company B is doing business in Europe, and it has issued a bond of €15
Million Euros. The two companies can enter into an agreement to exchange
the principal and interest of the bonds. The €15 million Euro-denominated
bond will be the obligation of company A, and company B will be obligated
to the $20 million bond.
In finance, a foreign-exchange option (commonly shortened to just FX
option or currency option) is a derivative financial instrument that
gives the owner the right but not the obligation to exchange money
denominated in one currency into another currency at a pre-agreed
exchange rate on a specified date. See Foreign exchange derivative.
The foreign exchange options market is the deepest, largest and most
liquid market for options of any kind. Most trading is over the counter
(OTC) and is lightly regulated, but a fraction is traded on exchanges
like the International Securities Exchange, Philadelphia Stock Exchange,
or the Chicago Mercantile Exchange for options on futures contracts. The
global market for exchange-traded currency options was notionally valued
by the Bank for International Settlements at $158.3 trillion in 2005.
For example a GBPUSD contract could give the owner the right to sell
£1,000,000 and buy $2,000,000 on December 31. In this case the pre-agreed
exchange rate, or strike price, is 2.0000 USD per GBP (or GBP/USD 2.00 as
it is typically quoted) and the notional amounts (notionals) are
£1,000,000 and $2,000,000.
This type of contract is both a call on dollars and a put on sterling,
and is typically called a GBPUSD put, as it is a put on the exchange
rate; although it could equally be called a USDGBP call.
If the rate is lower than 2.0000 on December 31 (say at 1.9000), meaning
that the dollar is stronger and the pound is weaker, then the option is
exercised, allowing the owner to sell GBP at 2.0000 and immediately buy
it back in the spot market at 1.9000, making a profit of (2.0000 GBPUSD –
1.9000 GBPUSD)*1,000,000 GBP = 100,000 USD in the process. If they
immediately convert the profit into GBP this amounts to 100,000/1.9000 =
Call option – the right to buy an asset at a fixed date and price.
Put option – the right to sell an asset a fixed date and price.
Foreign exchange option – the right to sell money in one currency and buy
money in another currency at a fixed time and relative price.
Strike price – the asset price at which the investor can exercise an
Spot price – the price of the asset at the time of the trade.
Forward price – the price of the asset for delivery at a future time.
Notional – the amount of each currency that the option allows the
investor to sell or buy.
Ratio of notionals – the strike, not the current spot or forward.
Non-linear payoff – the payoff for a straightforward FX option is linear
in the underlying currency, denominating the payout in a given numéraire.
Numéraire – the currency in which an asset is valued.
Change of numéraire – the implied volatility of an FX option depends on
the numéraire of the purchaser, again because of the non-linearity of .
The difference between FX options and traditional options is that in the
latter case the trade is to give an amount of money and receive the right
to buy or sell a commodity, stock or other non-money asset. In FX
options, the asset in question is also money, denominated in another
For example, a call option on oil allows the investor to buy oil at a
given price and date. The investor on the other side of the trade is in
effect selling a put option on the currency.
To eliminate residual risk, match the foreign currency notionals, not the
local currency notionals, else the foreign currencies received and
delivered don't offset.
In the case of an FX option on a rate, as in the above example, an option
on GBPUSD gives a USD value that is linear in GBPUSD using USD as the
numéraire (a move from 2.0000 to 1.9000 yields a .10 * $2,000,000 /
$2.0000 = $100,000 profit), but has a non-linear GBP value. Conversely,
the GBP value is linear in the USDGBP rate, while the USD value is non-
linear. This is because inverting a rate has the effect of , which is
Corporations primarily use FX options to hedge uncertain future cash
flows in a foreign currency. The general rule is to hedge certain foreign
currency cash flows with forwards, and uncertain foreign cash flows with
Suppose a United Kingdom manufacturing firm expects to be paid US$100,000
for a piece of engineering equipment to be delivered in 90 days. If the
GBP strengthens against the US$ over the next 90 days the UK firm loses
money, as it will receive less GBP after converting the US$100,000 into
GBP. However, if the GBP weakens against the US$, then the UK firm
receives more GBP. This uncertainty exposes the firm to FX risk. Assuming
that the cash flow is certain, the firm can enter into a forward contract
to deliver the US$100,000 in 90 days time, in exchange for GBP at the
current forward rate. This forward contract is free, and, presuming the
expected cash arrives, exactly matches the firm's exposure, perfectly
hedging their FX risk.
If the cash flow is uncertain, a forward FX contract exposes the firm to
FX risk in the opposite direction, in the case that the expected USD cash
is not received, typically making an option a better choice.
Using options, the UK firm can purchase a GBP call/USD put option (the
right to sell part or all of their expected income for pounds sterling at
a predetermined rate), which:
protects the GBP value that the firm expects in 90 days' time (presuming
the cash is received)
costs at most the option premium (unlike a forward, which can have
yields a profit if the expected cash is not received but FX rates move in
A 'free-lunch' option is an option that has been stripped out into a prop
book for zero cost and offers the trader a chance to lock in a huge
payout if the underlying trades through the strike as it will not be
delta hedged. It is a very popular term used globally and an essential
part of a FX Option trader's terminology handbook.
Valuation: the Garman–Kohlhagen model
As in the Black–Scholes model for stock options and the Black model for
certain interest rate options, the value of a European option on an FX
rate is typically calculated by assuming that the rate follows a log-
In 1983 Garman and Kohlhagen extended the Black–Scholes model to cope
with the presence of two interest rates (one for each currency). Suppose
that is the risk-free interest rate to expiry of the domestic currency
and is the foreign currency risk-free interest rate (where domestic
currency is the currency in which we obtain the value of the option; the
formula also requires that FX rates – both strike and current spot be
quoted in terms of "units of domestic currency per unit of foreign
currency"). The results are also in the same units and to be meaningful
need to be converted into one of the currencies.
Then the domestic currency value of a call option into the foreign
The value of a put option has value
is the current spot rate
is the strike price
is the cumulative normal distribution function
is domestic risk free simple interest rate
is foreign risk free simple interest rate
is the time to maturity (calculated according to the appropriate day
and is the volatility of the FX rate.
A wide range of techniques are in use for calculating the options risk
exposure, or Greeks (as for example the Vanna-Volga method). Although the
option price produced by every model agree (with Garman–Kohlhagen), risk
numbers can vary significantly depending on the assumptions used for the
properties of spot price movements, volatility surface and interest rate
After Garman–Kohlhagen, the most common models are SABR and local
volatility, although when agreeing risk numbers with a counterparty (e.g.
for exchanging delta, or calculating the strike on a 25 delta option)
Garman–Kohlhagen is always used.
United Nations Monetary and Financial Conference
Mount Washington Hotel
The United Nations Monetary and Financial Conference, commonly known as
the Bretton Woods conference, was a gathering of 730 delegates from all
44 Allied nations at the Mount Washington Hotel, situated in Bretton
Woods, New Hampshire, United States, to regulate the international
monetary and financial order after the conclusion of World War II.
The conference was held from 1 to 22 July 1944, when the agreements were
signed to set up the International Bank for Reconstruction and
Development (IBRD), the General Agreement on Tariffs and Trade (GATT),
and the International Monetary Fund (IMF)
Purposes and goals
The Bretton Woods Conference took place in July 1944, but did not become
operative until late December 1958, when all the European currencies
became convertible. Under this system, the IMF and the IBRD were
established. The IMF was developed as a permanent international body. The
summary of agreements states, "The nations should consult and agree on
international monetary changes which affect each other. They should
outlaw practices which are agreed to be harmful to world prosperity, and
they should assist each other to overcome short-term exchange
difficulties." The IBRD was created to speed up post-war reconstruction,
to aid political stability, and to foster peace. This was to be fulfilled
through the establishment of programs for reconstruction and development.
The main terms of this agreement were:
Formation of the IMF and the IBRD (at present part of the World Bank).
Adjustably pegged foreign exchange market rate system: The exchange rates
were fixed, with the provision of changing them if necessary.
Currencies were required to be convertible for trade related and other
current account transactions. The governments, however, had the power to
regulate ostentatious capital flows.
As it was possible that exchange rates thus established might not be
favourable to a country's balance of payments position, the governments
had the power to revise them by up to 10%.
All member countries were required to subscribe to the IMF's capital.
Encouraging open markets
The seminal idea behind the Bretton Woods Conference was the notion of
open markets. In Henry Morgenthau's farewell remarks at the conference,
he stated that the establishment of the IMF and the World Bank marked the
end of economic nationalism. This meant countries would maintain their
national interest, but trade blocks and economic spheres of influence
would no longer be their means. The second idea behind the Bretton Woods
Conference was joint management of the Western political-economic order,
meaning that the foremost industrial democratic nations must lower
barriers to trade and the movement of capital, in addition to their
responsibility to govern the system.
The Bank for International Settlements controversy
In the last stages of the Second World War, in 1944 at the Bretton Woods
Conference, the Bank for International Settlements became the crux of a
fight that broke out when the Norwegian delegation put forth evidence
that the BIS was guilty of war crimes and put forth a motion to dissolve
the bank; the Americans, specifically President Franklin Delano Roosevelt
and Henry Morgenthau, supported this motion. This resulted in a fight
between, on one side, several European nations, the American and the
Norwegian delegation, led by Henry Morgenthau and Harry Dexter White; and
on the other side, the British delegation, headed by John Maynard Keynes
and Chase Bank representative Dean Acheson, who tried to veto the
dissolution of the bank.
The problem was that the BIS, formed in 1930, had as the main proponents
of its establishment the then Governor of the Bank of England, Montagu
Norman, and his colleague Hjalmar Schacht, later Adolf Hitler's economics
minister. The Bank was as far as known, originally primarily intended to
facilitate money transfers arising from settling an obligation from the
peace treaty after WWI. After World War I, the need for the bank was
suggested in 1929 by the Young Committee, as a means of transfer for
German reparations payments ('see: Treaty of Versailles'). The plan was
agreed in August of that year at a conference at the Hague, and a charter
for the bank was drafted at the International Bankers Conference at Baden
Baden in November. The charter was adopted at a second Hague Conference
on January 20, 1930. The Original board of directors of the BIS included
two appointees of Hitler, Walter Funk and Emil Puhl, as well as Herman
Schmitz the director of IG Farben and Baron von Schroeder the owner of
the J.H. Stein Bank, the bank that held the deposits of the Gestapo.
As a result of allegations that the BIS had helped the Germans loot
assets from occupied countries during World War II, the United Nations
Monetary and Financial Conference recommended the "liquidation of the
Bank for International Settlements at the earliest possible moment." This
dissolution, which was originally proposed by Norway and supported by
other European delegates, as well as the United States and Morgenthau and
Harry Dexter White, was never accomplished.
In July 1944, Dean Acheson interrupted Keynes in a meeting, fearing that
the BIS would be dissolved by President Franklin Delano Roosevelt. Keynes
went to Henry Morgenthau to prevent or postpone the dissolution of the
BIS, but the next day the dissolution of the BIS was approved. The
British delegation did not give up, however, and the dissolution of the
bank was still not accomplished when Roosevelt died. In April 1945, the
new president Harry S. Truman and the British suspended the dissolution
and the decision to liquidate the BIS was officially reversed in 1948.
Monetary order in a post-war world
The need for postwar Western economic order was resolved with the
agreements made on monetary order and open system of trade at the 1944
Bretton Woods Conference. These allowed for the synthesis of Britain's
desire for full employment and economic stability and the United States'
desire for free trade.
International Trade Organization
The Conference also proposed the creation of an International Trade
Organization (ITO) to establish rules and regulations for international
trade. The ITO would have complemented the other two Bretton Woods
proposed international bodies: the IMF and the World Bank. The ITO
charter was agreed on at the U.N. Conference on Trade and Employment
(held in Havana, Cuba, in March 1948), but the charter was not ratified
by the U.S. Senate. As a result, the ITO never came into existence.
However, in 1995, during the Uruguay Round of GATT negotiations
established the World Trade Organization (WTO) as the replacement body
for GATT. The GATT principles and agreements were adopted by the WTO,
which was charged with administering and extending them.
International Clearing Union
John Maynard Keynes (right) represented the UK at the conference, and
Harry Dexter White represented the US.
John Maynard Keynes proposed the ICU as a way to regulate the balance of
trade. His concern was that countries with a trade deficit would be
unable to climb out of it, paying ever more interest to service their
ever greater debt, and therefore stifling global growth. The ICU would
effectively be a bank with its own currency (the "bancor"), exchangeable
with national currencies at a fixed rate. Nations would be the unit for
accounting between nations, so their trade deficits or surpluses could be
measured by it.
On top of that, each country would have an overdraft facility in its
"bancor" account with the ICU. Keynes proposed having a maximum overdraft
of half the average trade size over five years. If a country went over
that, it would be charged interest, obliging a country to reduce its
currency value and prevent capital exports. But countries with trade
surpluses would also be charged interest at 10% if their surplus was more
than half the size of their permitted overdraft, obliging them to
increase their currency values and export more capital. If, at the year's
end, their credit exceeded the maximum (half the size of the overdraft in
surplus), the surplus would be confiscated.
Lionel Robbins reported that "it would be difficult to exaggerate the
electrifying effect on thought throughout the whole relevant apparatus of
government ... nothing so imaginative and so ambitious had ever been
discussed". However, Harry Dexter White, representing America which was
the world's biggest creditor said "We have been perfectly adamant on that
point. We have taken the position of absolutely no."
Instead he proposed an International Stabilisation Fund (now the IMF),
which would place the burden of maintaining the balance of trade on the
deficit nations, and imposing no limit on the surplus that rich countries
could accumulate. White also proposed creation of the IBRD (now part of
the World Bank) which would provide capital for economic reconstruction
after the war.
The USA was represented at the conference by Harry Dexter White
The UK was represented at the conference by John Maynard Keynes
Australia was represented at the conference by Leslie Melville
India was represented by Sir Chint?man Dw?rak?n?th Deshmukh
Mexico's delegation included Víctor Urquidi.
China was represented by Dr. H.H. Kung.
"The economic health of every country is a proper matter of concern to
all its neighbors, near and far."
— U.S. President Franklin D. Roosevelt at the opening of Bretton Woods
Proceedings and Documents of the United Nations Monetary and Financial
Conference, Bretton Woods, New Hampshire, July 1-22, 1944
Documents relating to the Bretton Woods meetings, legislation, and
analysis of the results.
Transcripts and other resources for the conference hosted at the centre
for financial stability
The Smithsonian Agreement was a December 1971 agreement that adjusted the
fixed exchange rates established at the Bretton Woods Conference of 1944.
Although the other currencies were still pegged to the dollar until 1973,
the main difference from the previous regime was the abolition of the
dollar's convertibility into gold guaranteed by U.S. Treasury, making the
dollar effectively a fiat currency.
The Bretton Woods Conference of 1944 established an international fixed
exchange rate regime in which currencies were pegged to the United States
dollar, which was based on the gold standard.
By 1970, however, it was clear that the exchange rate regime was under
threat, as the United States dollar was greatly overvalued because of
heavy American spending on Lyndon B. Johnson's Great Society and the
Vietnam War. The American economy was also coming under serious
inflationary pressures due to the aging economic infrastructure.
In response, on August 15, 1971, President Richard Nixon unilaterally
suspended the convertibility of dollars into gold, effectively ending the
gold standard. The United States then entered negotiations with its
industrialized allies to appreciate their own currencies, in response to
Meeting in December 1971 at the Smithsonian Institution, the Group of Ten
signed the Smithsonian Agreement. In the Agreement, the countries agreed
to appreciate their currencies against the United States dollar.
Although the Smithsonian Agreement was hailed by President Nixon as a
fundamental reorganization of international monetary affairs, it quickly
proved to be too little and of only temporary benefit. The gold value of
the dollar was realigned again in 1973, from $38.02 to $42.22 per ounce.
In addition, further devaluation of the dollar occurred against European
currencies. The end of the system came in March 1973 when the major
currencies began to float against each other, as governments still had
difficulties maintaining the exchange rates within the +/-2.25% band
stated in the agreement, essentially bringing into effect the floating
exchange rate system which determined exchange rates based on the market
forces of supply and demand. A few currencies, such as the British pound,
had begun to float earlier.
Foreign Exchange Rate Transition (DEM/USD, FRF/USD, GBP/USD and JPY/USD)
from January 1981 to December 1990
In the first half of 1980s, the United States dollar (USD) was stronger
than the Deutsche Mark (DEM), French franc (FRF), pound sterling (GBP)
and Japanese yen (JPY), but before and after the Plaza Accord, the USD
The Plaza Accord or Plaza Agreement was an agreement between the
governments of France, West Germany, Japan, the United States, and the
United Kingdom, to depreciate the U.S. dollar in relation to the Japanese
yen and German Deutsche Mark by intervening in currency markets. The five
governments signed the accord on September 22, 1985 at the Plaza Hotel in
New York City.
Between 1980 and 1985 the dollar had appreciated by about 50% against the
Japanese yen, Deutsche Mark, French Franc and British pound, the
currencies of the next four biggest economies at the time. This caused
considerable difficulties for American industry but at first their
lobbying was largely ignored by government. The financial sector was able
to profit from the rising dollar, and a depreciation would have run
counter to the Reagan administration's plans for bringing down inflation.
A broad alliance of manufacturers, service providers, and farmers
responded by running an increasingly high profile campaign asking for
protection against foreign competition.
Major players included grain exporters, car producers, engineering
companies like Caterpillar Inc., as well as high-tech companies including
IBM and Motorola. By 1985, their campaign had acquired sufficient
traction for Congress to begin considering passing protectionist laws.
The prospect of trade restrictions spurred the White House to begin the
negotiations that led to the Plaza Accord.
The justification for the dollar's devaluation was twofold: to reduce the
U.S. current account deficit, which had reached 3.5% of the GDP, and to
help the U.S. economy to emerge from a serious recession that began in
the early 1980s. The U.S. Federal Reserve System under Paul Volcker had
halted the stagflation crisis of the 1970s by raising interest rates, but
this resulted in the dollar becoming overvalued to the extent that it
made industry in the U.S. (particularly the automobile industry) less
competitive in the global market.
Devaluing the dollar made U.S. exports cheaper to purchase for its
trading partners, which in turn allegedly meant that other countries
would buy more American-made goods and services.
The exchange rate value of the dollar versus the yen declined by 51% from
1985 to 1987. Most of this devaluation was due to the $10 billion spent
by the participating central banks. Currency speculation caused the
dollar to continue its fall after the end of coordinated interventions.
Unlike some similar financial crises, such as the Mexican and the
Argentine financial crises of 1994 and 2001 respectively, this
devaluation was planned, done in an orderly, pre-announced manner and did
not lead to financial panic in the world markets. The Plaza Accord was
successful in reducing the U.S. trade deficit with Western European
nations but largely failed to fulfill its primary objective of
alleviating the trade deficit with Japan. This deficit was due to
structural conditions that were insensitive to monetary policy,
specifically trade conditions.
The manufactured goods of the United States became more competitive in
the exports market but were still largely unable to succeed in the
Japanese domestic market due to Japan's structural restrictions on
The recessionary effects of the strengthened yen in Japan's export-
dependent economy created an incentive for the expansionary monetary
policies that led to the Japanese asset price bubble of the late 1980s.
The Louvre Accord was signed in 1987 to halt the continuing decline of
the U.S. dollar.
The signing of the Plaza Accord was significant in that it reflected
Japan's emergence as a real player in managing the international monetary
system. Yet it is postulated that it contributed to the Japanese asset
price bubble, which ended up in a serious recession, the so-called Lost
Announcement the Ministers of Finance and Central Bank Governors of
France, Germany, Japan, the United Kingdom, and the United States (Plaza
U.S. Treasury - Exchange Stabilization Fund, Intervention Operations
Plaza Agreement, ANZ Financial Dictionary from Language of Money by Edna
The Louvre Accord was signed by the then G6 (France, West Germany, Japan,
Canada, the United States and the United Kingdom) on February 22, 1987 in
Paris, France. Italy had been an invited member, but declined to finalize
the agreement. The goal of the Louvre Accord was to stabilize the
international currency markets and halt the continued decline of the US
Dollar caused by the Plaza Accord (of which a primary aim was
depreciation of the US dollar in relation to the Japanese yen and German
Deutsche Mark by the mutual agreement of the G7 Minister of Finance
meeting (i.e. a conference of ministers of the "group of seven") that had
been held in Louvre in Paris in 1987. Since the Plaza accord, the dollar
rate had continued to slide, reaching an exchange rate of ¥150 per US$1
in 1987. The ministers of the G7 nations gathered at the Louvre in Paris
to "put the brakes" on this decline.
France agreed to reduce its budget deficits by 1% of GDP and cut taxes by
the same amount for corporations and individuals. Japan would reduce its
trade surplus and cut interest rates. Great Britain would agree to reduce
public expenditures and reduce taxes. Germany, the real object of this
agreement because of its leading economic position in Europe, would agree
to reduce public spending, cut taxes for individuals and corporations,
and keep interest rates low. The United States would agree to reduce its
fiscal 1988 deficit to 2.3% of GDP from an estimated 3.9% in 1987, reduce
government spending by 1% in 1988 and keep interest rates low.
The dollar continued to weaken in 1987 against the Deutsche Mark and
other major currencies, reaching a low of 1.57 marks per dollar and 121
yen per dollar in early 1988. The dollar then strengthened over the next
18 months, reaching over 2.04 marks per dollar and 160 yen per dollar, in
tandem with the Federal Reserve raising interest rates aggressively, from
6.50% to 9.75%.
Bureau de change
A bureau de change (plural bureaux de change, both pron.:
/?bj??ro?d??????/) (British English) or currency exchange (American
English) is a business whose customers exchange one currency for another.
Although originally French, the term “bureau de change” is widely used
throughout Europe, and European travellers can usually easily identify
these facilities when in other European countries. It is also common to
find a sign saying "exchange" or "change." Since the adoption of the
euro, many exchange offices incorporate its logotype prominently on their
The term “bureau de change” is not used in the United States. Instead,
the terms used in the United States and Canada are “currency exchange”
and sometimes “money exchange”, sometimes with various additions such as
“foreign”, “desk”, “office”, “counter”, “service”, etc.; for example,
“foreign currency exchange office”.
A bureau de change is often located at a bank, at a travel agent,
airport, main railway station or large stores—namely, anywhere there is
likely to be a market for people needing to convert currency. So they are
particularly prominent at travel hubs, although currency can be exchanged
in many other ways both legally and illegally in other venues. Some of
the major players include Travelex and HSBC.
A bureau de change makes profit and competes by manipulating two
variables: the exchange rate they use to calculate transactions, and an
explicit commission for their service.
The exchange rates charged at bureaux are generally related to the spot
prices available for large interbank transactions, and are adjusted to
guarantee a profit. The rate at which a bureau will buy currency differs
from that at which it will sell it; for every currency it trades both
will be on display, generally in the shop window.
So the bureau sells at a lower rate from that at which it buys. For
example a UK bureau may sell €1.40 for £1 but buy €1.60 for £1.
So if the spot price on a particular day is €1.50 to £1, in theory £2
will buy €3, but in practice this would be hard if not impossible for
average consumers to get. If the bureau de change buys £1 from a consumer
for €1.40 and then sells £1 for €1.60, the 20¢ difference makes a profit.
This business model can be upset by a currency run when there are far
more buyers than sellers (or vice versa) because they feel a particular
currency is overvalued or undervalued and becomes “not worth a
The business may also charge a commission on the transaction. Commission
is generally charged as a percentage of the amount to be exchanged, or a
fixed fee, or both. Some bureaux advertise themselves as commission-free,
which mathematically just means they further load their offered exchange
rates. As an additional complexity some bureaux offer special deals for
customers returning unspent foreign currency after a holiday. Bureaux de
change rarely buy or sell coins, but sometimes will at a higher profit
margin, justifying this by the higher cost of storage and shipping
compared with banknotes.
A bureau de change at an airport.
Changing money at a bureau is often more expensive than withdrawing it
from a automatic teller machine at one’s destination or paying directly
by debit or credit card, but this varies depending on the card issuer and
the type of account. Some people may feel uncomfortable carrying a lot of
cash and so prefer to use a card.
Some may also prefer to hold foreign currency rather than change it back
if they are expecting to return to where it is used. Companies that
frequently send employees abroad may essentially act as their own
exchange by reimbursing their employees in the local currency and holding
the foreign currency. If exchange rates are relatively stable, the fees
charged by a bureau may exceed any likely fluctuation and it also makes
the company’s accountancy easier.
In the alternate, some prefer to buy their currency before they travel,
either just for a sense of security, or because they speculate the
exchange rate is better at that time than it will be when they make their
In 2002, many bureaux reported substantial reductions in profit due to
the replacement of many European currencies with the euro.
A number of countries require bureaux de change to register as Money
Service Businesses that come under Anti-money laundering controls.
However in countries where currency exchange is lightly regulated they
can be used as front organizations for money laundering. Customers bring
legally obtained money and receive illegally obtained money in return.
The owners of the bureau may themselves launder money.
In popular culture
The 1994 news parody The Day Today featured a spoof soap opera called The
Bureau, set in "a 'high class' bureau de change" and run by soap-opera
stereotypes (the arrogant boss, the gay man, etc.). In the programme, the
soap supposedly replaced the BBC Nine O'Clock News, and then failed to
attract large audiences leading to it being sent on tour on the back of a
lorry. This was a reference to the failed BBC soap opera Eldorado.
Hard currency (also known as a safe-haven currency or strong currency),
in economics, refers to a globally traded currency that is expected to
serve as a reliable and stable store of value. Factors contributing to a
currency's hard status might include the long-term stability of its
purchasing power, the associated country's political and fiscal condition
and outlook, and the policy posture of the issuing central bank.
Conversely, a soft currency indicates a currency which is expected to
fluctuate erratically or depreciate against other currencies. Such
softness is typically the result of political or fiscal instability
within the associated country.
Many currencies are neither hard nor soft.
In search of hard currencies
Varying theories of monetary policy, and the ever-present risk of
unexpected geopolitical and policy events, preclude any claim of a
currency's hardness from being called definitive.
The paper currencies of some developed countries have earned recognition
as hard currencies at various times, including the United States dollar,
Euro, Swiss franc, British pound sterling, Japanese yen, and to a lesser
extent, the Canadian dollar and Australian dollar. Times change, and a
currency that is considered weak at one time may become stronger, or vice
versa. However, countries that consistently run large trade surpluses
tend to have hard currencies.
One barometer of hard currencies is how they are favored within the
foreign-exchange reserves of countries:
Currency composition of official foreign exchange reserves
1995 1996 1997 1998 1999 2000
2001 2002 2003 2004 2005 2006
2007 2008 2009 2010 2011
US dollar 59.0% 62.1% 65.2%
69.3% 71.0% 70.5% 70.7%
66.5% 65.8% 66.0% 66.4%
65.7% 64.1% 64.1% 62.1%
61.8% 62.1% 61.8%
18.8% 19.8% 24.2% 25.3%
24.9% 24.3% 25.2% 26.3%
26.4% 27.6% 26.0% 24.9%
German mark 15.8% 14.7% 14.5%
French franc 2.4% 1.8% 1.4% 1.6%
Pound sterling 2.1% 2.7% 2.6% 2.7% 2.9%
2.8% 2.7% 2.9% 2.6% 3.2% 3.6%
4.2% 4.7% 4.0% 4.3% 3.9% 3.8%
Japanese yen 6.8% 6.7% 5.8% 6.2% 6.4%
6.3% 5.2% 4.5% 4.1% 3.8% 3.7%
3.2% 2.9% 3.1% 2.9% 3.7% 3.6%
Swiss franc 0.3% 0.2% 0.4% 0.3% 0.2%
0.3% 0.3% 0.4% 0.2% 0.2% 0.1%
0.2% 0.2% 0.1% 0.1% 0.1% 0.3%
Other 13.6% 11.7% 10.2% 6.1%
1.6% 1.4% 1.2% 1.4% 1.9% 1.9%
1.9% 1.5% 1.8% 2.2% 3.1% 4.4%
Turmoil in hard currencies
The US dollar (USD) has been considered a strong currency for much of its
history. Despite the Nixon shock of 1971, and the United States' growing
fiscal and trade deficits, most of the world's monetary systems have been
tied to the US dollar due to the Bretton Woods System and dollarization.
Countries have thus been compelled to purchase dollars for their foreign
exchange reserves, denominate their commodities in dollars for foreign
trade, or even use dollars domestically, thus buoying the currency's
value. However the late-2000s financial crisis saw the institution of
quantitative easing by the Federal Reserve, downgrades of US debt by
credit rating agencies (during the debt-ceiling crisis), countries
diversifying their foreign exchange reserves away from the dollar, the
emergence of commodity markets trading in non-US currency (such as the
Iranian oil bourse), resumed appreciation of the yuan by the People's
Bank of China, and the IMF proposal of the SDR as an alternative to the
dollar in some applications. These events and others have eroded
confidence in the US dollar.
The euro (EUR) has also been considered a hard currency for much of its
short history, however the European sovereign debt crisis has eroded that
confidence, with many predicting the currency's demise.
The Swiss franc (CHF) has long been considered a hard currency, and in
fact was the last paper currency in the world to terminate its
convertibility to gold. In the summer of 2011, the European sovereign
debt crisis lead to rapid flows out of the euro and into the franc by
those seeking hard currency, causing the latter to appreciate rapidly. On
September 6, 2011, the Swiss National Bank announced that it would buy an
"unlimited" number of euros to fix an exchange rate at 1.00 EUR = 1.20
CHF, to protect its trade. The franc fell precipitously against the euro
to match this rate, and the price of gold in CHF rose 5% in a matter of
minutes. This action has, at least temporarily, eliminated the franc's
hard currency advantage over the euro.
In the midst of the ongoing financial crisis, countries with strong
currencies are at risk of capital inflows causing appreciation. The
potential impact of such appreciation on a nation's economy is
historically unprecedented due to globalization and free trade. Thus the
world's central banks are locked into a spiral of "competitive
devaluation" in which the value of all fiat money systems is being
eroded. This process is reflected in the escalating price of gold —
investors flock to gold and other precious metals as a store of value and
hedge against inflation, which causes the price to increase rapidly,
sometimes for several consecutive years and recently, at many times more
than the rate of inflation.
Investors as well as ordinary people generally prefer hard currencies to
soft currencies at times of increased inflation (or more precisely
increased inflation differentials between countries), at times of
heightened political or military risk, or when they feel that one or more
government-imposed exchange rates are unrealistic. There may be
regulatory reasons for preferring to invest outside one's home currency,
e.g. the local currency may be subject to capital controls which makes it
difficult to spend it outside the host nation.
For example, during the Cold War, the ruble in the Soviet Union was not a
hard currency because it could not be easily spent outside the Soviet
Union and because the exchange rates were fixed at artificially high
levels for persons with hard currency, such as Western tourists. (The
Soviet government also imposed severe limits on how many rubles could be
exchanged by Soviet citizens for hard currencies.) After the fall of the
Soviet Union in December 1991, the ruble depreciated rapidly, while the
purchasing power of the U.S. dollar was more stable, making it a harder
currency than the ruble. A tourist could get 200 rubles per U.S. dollar
in June 1992, and 500 rubles per USD in November 1992.
In some economies, which may be either planned economies or market
economies using a soft currency, there are special stores that accept
only hard currency. Examples have included Tuzex stores in the former
Czechoslovakia, Intershops in East Germany or Friendship stores in the
People's Republic of China in the early 1990s. These stores offer a wider
variety of goods — many of which are scarce or imported — than standard
Because hard currencies may be subject to legal restrictions, the desire
for transactions in hard currency may lead to a black market. In some
cases, a central bank may attempt to increase confidence in the local
currency by pegging it against a hard currency, as is this case with the
Hong Kong dollar or the Bosnia and Herzegovina convertible mark. This may
lead to problems if economic conditions force the government to break the
currency peg (and either appreciate or depreciate sharply) as occurred in
the Argentine economic crisis (1999–2002).
In some cases, an economy may choose to abandon local currency altogether
and adopt a hard currency as legal tender. Examples include the adoption
of the US dollar in Ecuador, El Salvador and Zimbabwe and the adoption of
the German mark and later the euro in Kosovo and Montenegro.
we and the adoption of
the German mark and later the euro in Kosovo and Montenegro.