Forex: Foreign exchange market, Currency band, Exchange rate, Exchange-rate regime,Exchange-rate flexibility, Dollarization, Fixed exchange rate, Floating exchange rate, Linked exchange rate, Managed float regime,Futures exchange, Retail foreign exchange platform.
Forex Foreign Exchange Market PDF generated using the open source mwlib toolkit. See http://code.pediapress.com/ for more information. PDF generated at: Mon, 18 Feb 2013 01:57:30 UTC Contents Articles Foreign exchange market 1 Currency band 17 Exchange rate 18 Exchange-rate regime 23 Exchange-rate flexibility 25 Dollarization 27 Fixed exchange rate 33 Floating exchange rate 35 Linked exchange rate 37 Managed float regime 38 Futures exchange 39 Retail foreign exchange platform 43 References Article Sources and Contributors 45 Image Sources, Licenses and Contributors 47 Article Licenses License 49 Foreign exchange market 1 Foreign exchange market The foreign exchange market (forex, FX, or currency market) is a form of exchange for the global decentralized trading of international currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. EBS and Reuters' dealing 3000 are two main interbank FX trading platforms. The foreign exchange market determines the relative values of different currencies. The foreign exchange market assists international trade and investment by enabling currency conversion. For example, it permits a business in the United States to import goods from the European Union member states especially Eurozone members and pay Euros, even though its income is in United States dollars. It also supports direct speculation in the value of currencies, and the carry trade, speculation based on the interest rate differential between two currencies. In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying some quantity of another currency. The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system. The foreign exchange market is unique because of the following characteristics: • its huge trading volume representing the largest asset class in the world leading to high liquidity; • its geographical dispersion; • its continuous operation: 24 hours a day except weekends, i.e., trading from 20:15 GMT on Sunday until 22:00 GMT Friday; • the variety of factors that affect exchange rates; • the low margins of relative profit compared with other markets of fixed income; and • the use of leverage to enhance profit and loss margins and with respect to account size. As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding currency intervention by central banks. According to the Bank for International Settlements, as of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007. Some firms specializing on foreign exchange market had put the average daily turnover in excess of US$4 trillion. The $3.98 trillion break-down is as follows: • $1.490 trillion in spot transactions • $475 billion in outright forwards • $1.765 trillion in foreign exchange swaps • $43 billion currency swaps • $207 billion in options and other products Foreign exchange market 2 History Ancient Forex first occurred in ancient times. Money-changing people, people helping others to change money and also taking a commission or charging a fee were living in the times of the Talmudic writings (Biblical times). These people (sometimes called "kollybistẻs") used city-stalls, at feast times the temples Court of the Gentiles instead. The money-changer was also in more recent ancient times silver-smiths and, or, gold-smiths. During the fourth century the Byzantium government kept a monopoly on forexes. Medieval and later During the fifteenth century the Medici family were required to open banks at foreign locations in order to exchange currencies to act for textile merchants. To facilitate trade the bank created the nostro (from Italian translated - "ours") account book which contained two columned entries showing amounts of foreign and local currencies, information pertaining to the keeping of an account with a foreign bank. During the 17th (or 18th ) century Amsterdam maintained an active forex market. During 1704 foreign exchange took place between agents acting in the interests of the nations of England and Holland. Early modern The firm Alexander Brown & Sons traded foreign currencies exchange sometime about 1850 and were a leading participant in this within the U.S. of A. During 1880 J.M. do Espírito Santo de Silva (Banco Espírito e Comercial de Lisboa) applied for and was given permission to begin to engage in a foreign exchange trading business. 1880 is considered by one source to be the beginning of modern foreign exchange, significant for the fact of the beginning of the gold standard during the year. Prior to the first world war there was a much more limited control of international trade. Motivated by the outset of war countries abandoned the gold standard monetary system. Modern to post-modern Before WWII From 1899 to 1913 holdings of countries foreign exchange increased by 10.8%, while holdings of gold increased by 6.3%. At the time of the closing of the year 1913, nearly half of the world's forexes were being performed using sterling. The number of foreign banks operating within the boundaries of London increased in the years from 1860 to 1913 from 3 to 71. In 1902 there were altogether two London foreign exchange brokers. In the earliest years of the twentieth century trade was most active in Paris, New York and Berlin, while Britain remained largely uninvolved in trade until 1914. Between 1919 and 1922 the employment of a foreign exchange brokers within London increased to 17, in 1924 there were 40 firms operating for the purposes of exchange. During the 1920s the occurrence of trade in London resembled more the modern manifestation, by 1928 forex trade was integral to the financial functioning of the city. Continental exchange controls, plus other factors, in Europe and Latin America, hampered any attempt at wholesale prosperity from trade for those of 1930's London. During the 1920s foreign exchange the Kleinwort family were known to be the leaders of the market, Japhets, S,Montagu & Co. and Seligmans as significant participants still warrant recognition. In the year 1945 the nation of Ethiopias' government possessed a foreign exchange surplus. Foreign exchange market 3 After WWII After WWII the Bretton Woods Accord was signed allowing currencies to fluctuate within a range of 1% to the currencies par. In Japan the law was changed during 1954 by the Foreign Exchange Bank Law, so, the Bank of Tokyo was to become because of this the centre of foreign exchange by September of that year. Between 1954 and 1959 Japanese law was made to allow the inclusion of many more Occidental currencies in Japanese forex. President Nixon is credited with ending the Bretton Woods Accord, and fixed rates of exchange, bringing about eventually a free-floating currency system. After the ceasing of the enactment of the Bretton Woods Accord (during 1971 ) the Smithsonian agreement allowed trading to range to 2%. During 1961-62 the amount of foreign operations by the U.S. of America's Federal Reserve was relatively low. Those involved in controlling exchange rates found the boundaries of the Agreement were not realistic and so ceased this in March 1973, when sometime afterward none of the major currencies were maintained with a capacity for conversion to gold, organisations relied instead on reserves of currency. During 1970 to 1973 the amount of trades occurring in the market increased three-fold. At some time (according to Gandolfo during February–March 1973) some of the markets' were "split", so a two tier currency market was subsequently introduced, with dual currency rates. This was abolished during March 1974. Reuters introduced during June 1973 computer monitors, replacing the telephones and telex used previously for trading quotes. -markets close Due to the ultimate ineffectiveness of the Bretton Woods Accord and the European Joint Float the forex markets were forced to close sometime during 1972 and March 1973. The very largest of all purchases of dollars in the history of 1976 was when the West German government achieved an almost 3 billion dollar acquisition (a figure given as 2.75 billion in total by The Statesman: Volume 18 1974 → ), this event indicated the impossibility of the balancing of exchange stabilities by the measures of control used at the time and the monetary system and the foreign exchange markets in "West" Germany and other countries within Europe closed for two weeks (during February and, or, March 1973. Giersch, Paqué, & Schmieding state closed after purchase of "7.5 million Dmarks" Brawley states "... Exchange markets had to be closed. When they re-opened ... March 1 " that is a large purchase occurred after the close). after 1973 In fact 1973 marks the point to which nation-state, banking trade and controlled foreign exchange ended and complete floating, relatively free conditions of a market characteristic of the situation in contemporary times began (according to one source), although another states the first time a currency pair were given as an option for U.S.A. traders to purchase was during 1982, with additional currencies available by the next year. On 1 January 1981 (as part of changes beginning during 1978 ) the Bank of China allowed certain domestic "enterprises" to participate in foreign exchange trading. Sometime during the months of 1981 the South Korean government ended forex controls and allowed free trade to occur for the first time. During 1988 the countries government accepted the IMF quota for international trade. Intervention by European banks especially the Bundesbank influenced the forex market, on February the 27th 1985 particularly. The greatest proportion of all trades world-wide during 1987 were within the United Kingdom, slightly over one quarter, with the U.S. of America the nation with the second most places involved in trading. During 1991 the republic of Iran changed international agreements with some countries from oil-barter to foreign exchange. Foreign exchange market 4 Market size and liquidity The foreign exchange market is the most liquid financial market in the world. Traders include large banks, central banks, institutional investors, currency speculators, corporations, governments, other financial institutions, and retail investors. The average daily turnover in the global foreign exchange and related markets is continuously growing. According to the 2010 Triennial Central Bank Survey, coordinated by the Bank for International Settlements, average daily turnover was US$3.98 trillion in April 2010 (vs $1.7 trillion in 1998). Of this $3.98 trillion, Main foreign exchange market turnover, 1988–2007, measured in billions of USD. $1.5 trillion was spot transactions and $2.5 trillion was traded in outright forwards, swaps and other derivatives. Trading in the United Kingdom accounted for 36.7% of the total, making it by far the most important centre for foreign exchange trading. Trading in the United States accounted for 17.9%, and Japan accounted for 6.2%. Turnover of exchange-traded foreign exchange futures and options have grown rapidly in recent years, reaching $166 billion in April 2010 (double the turnover recorded in April 2007). Exchange-traded currency derivatives represent 4% of OTC foreign exchange turnover. Foreign exchange futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts. Most developed countries permit the trading of derivative products (like futures and options on futures) on their exchanges. All these developed countries already have fully convertible capital accounts. Some governments of emerging economies do not allow foreign exchange derivative products on their exchanges because they have capital controls. The use of derivatives is growing in many emerging economies. Countries such as Korea, South Africa, and India have established currency futures exchanges, despite having some capital controls.  Top 10 currency traders % of overall volume, May 2012 Rank Name Market share 1 Deutsche Bank 14.57% 2 Citi 12.26% 3 Barclays Investment Bank 10.95% 4 UBS AG 10.48% 5 HSBC 6.72% 6 JPMorgan 6.6% 7 Royal Bank of Scotland 5.86% 8 Credit Suisse 4.68% 9 Morgan Stanley 3.52% 10 Goldman Sachs 3.12% Foreign exchange market 5 Foreign exchange trading increased by 20% between April 2007 and April 2010 and has more than doubled since 2004. The increase in turnover is due to a number of factors: the growing importance of foreign exchange as an asset class, the increased trading activity of high-frequency traders, and the emergence of retail investors as an important market segment. The growth of electronic execution and the diverse selection of execution venues has lowered transaction costs, increased market liquidity, and attracted greater participation from many customer types. In particular, electronic trading via online portals has made it easier for retail traders to trade in the foreign exchange market. By 2010, retail trading is estimated to account for up to 10% of spot turnover, or $150 billion per day (see retail foreign exchange platform). Foreign exchange is an over-the-counter market where brokers/dealers negotiate directly with one another, so there is no central exchange or clearing house. The biggest geographic trading center is the United Kingdom, primarily London, which according to TheCityUK estimates has increased its share of global turnover in traditional transactions from 34.6% in April 2007 to 36.7% in April 2010. Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. For instance, when the International Monetary Fund calculates the value of its special drawing rights every day, they use the London market prices at noon that day. Market participants Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the interbank market, which is made up of the largest commercial banks and securities dealers. Within the interbank market, spreads, which are the difference between the bid and ask prices, are razor sharp and not known to players outside the inner circle. The difference between the bid and ask prices widens (for example from 0-1 pip to 1-2 pips for a currencies such as the EUR) as you go down the levels of access. This is due to volume. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the foreign exchange market are determined by the size of the "line" (the amount of money with which they are trading). The top-tier interbank market accounts for 39% of all transactions. From there, smaller banks, followed by large multi-national corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail market makers. According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s.” (2004) In addition, he notes, “Hedge funds have grown markedly over the 2001–2004 period in terms of both number and overall size”. Central banks also participate in the foreign exchange market to align currencies to their economic needs. Commercial companies An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants. Central banks National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading. Foreign exchange market 6 Foreign exchange fixing Foreign exchange fixing is the daily monetary exchange rate fixed by the national bank of each country. The idea is that central banks use the fixing time and exchange rate to evaluate behavior of their currency. Fixing exchange rates reflects the real value of equilibrium in the market. Banks, dealers and traders use fixing rates as a trend indicator. The mere expectation or rumor of a central bank foreign exchange intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank. Several scenarios of this nature were seen in the 1992–93 European Exchange Rate Mechanism collapse, and in more recent times in Asia. Hedge funds as speculators About 70% to 90% of the foreign exchange transactions are speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency. Hedge funds have gained a reputation for aggressive currency speculation since 1996. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor. Investment management firms Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases. Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. While the number of this type of specialist firms is quite small, many have a large value of assets under management) and, hence, can generate large trades. Retail foreign exchange traders Individual Retail speculative traders constitute a growing segment of this market with the advent of retail foreign exchange platforms, both in size and importance. Currently, they participate indirectly through brokers or banks. Retail brokers, while largely controlled and regulated in the USA by the Commodity Futures Trading Commission and National Futures Association have in the past been subjected to periodic Foreign exchange fraud. To deal with the issue, in 2010 the NFA required its members that deal in the Forex markets to register as such (I.e., Forex CTA instead of a CTA). Those NFA members that would traditionally be subject to minimum net capital requirements, FCMs and IBs, are subject to greater minimum net capital requirements if they deal in Forex. A number of the foreign exchange brokers operate from the UK under Financial Services Authority regulations where foreign exchange trading using margin is part of the wider over-the-counter derivatives trading industry that includes Contract for differences and financial spread betting. There are two main types of retail FX brokers offering the opportunity for speculative currency trading: brokers and dealers or market makers. Brokers serve as an agent of the customer in the broader FX market, by seeking the best price in the market for a retail order and dealing on behalf of the retail customer. They charge a commission or mark-up in addition to the price obtained in the market. Dealers or market makers, by contrast, typically act as principal in the transaction versus the retail customer, and quote a price they are willing to deal at. Foreign exchange market 7 Non-bank foreign exchange companies Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but rather currency exchange with payments (i.e., there is usually a physical delivery of currency to a bank account). It is estimated that in the UK, 14% of currency transfers/payments are made via Foreign Exchange Companies. These companies' selling point is usually that they will offer better exchange rates or cheaper payments than the customer's bank. These companies differ from Money Transfer/Remittance Companies in that they generally offer higher-value services. Money transfer/remittance companies and bureaux de change Money transfer companies/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country. In 2007, the Aite Group estimated that there were $369 billion of remittances (an increase of 8% on the previous year). The four largest markets (India, China, Mexico and the Philippines) receive $95 billion. The largest and best known provider is Western Union with 345,000 agents globally followed by UAE Exchange Bureaux de change or currency transfer companies provide low value foreign exchange services for travelers. These are typically located at airports and stations or at tourist locations and allow physical notes to be exchanged from one currency to another. They access the foreign exchange markets via banks or non bank foreign exchange companies. Trading characteristics Most traded currencies by value  Currency distribution of global foreign exchange market turnover Rank Currency ISO 4217 % daily code share (Symbol) (April 2010) 1 United States dollar USD ($) 84.9% 2 Euro EUR (€) 39.1% 3 Japanese yen JPY (¥) 19.0% 4 Pound sterling GBP (£) 12.9% 5 Australian dollar AUD ($) 7.6% 6 CHF (Fr) 6.4% Swiss franc 7 Canadian dollar CAD ($) 5.3% 8 Hong Kong dollar HKD ($) 2.4% 9 Swedish krona SEK (kr) 2.2% 10 New Zealand dollar NZD ($) 1.6% 11 South Korean won KRW (₩) 1.5% 12 Singapore dollar SGD ($) 1.4% 13 Norwegian krone NOK (kr) 1.3% 14 Mexican peso MXN ($) 1.3% 15 Indian rupee INR (₹) 0.9% Foreign exchange market 8 Other 12.2%  200% Total There is no unified or centrally cleared market for the majority of trades, and there is very little cross-border regulation. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currencies instruments are traded. This implies that there is not a single exchange rate but rather a number of different rates (prices), depending on what bank or market maker is trading, and where it is. In practice the rates are quite close due to arbitrage. Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. Major trading exchanges include EBS and Reuters, while major banks also offer trading systems. A joint venture of the Chicago Mercantile Exchange and Reuters, called Fxmarketspace opened in 2007 and aspired but failed to the role of a central market clearing mechanism. The main trading centers are New York and London, though Tokyo, Hong Kong and Singapore are all important centers as well. Banks throughout the world participate. Currency trading happens continuously throughout the day; as the Asian trading session ends, the European session begins, followed by the North American session and then back to the Asian session, excluding weekends. Fluctuations in exchange rates are usually caused by actual monetary flows as well as by expectations of changes in monetary flows caused by changes in gross domestic product (GDP) growth, inflation (purchasing power parity theory), interest rates (interest rate parity, Domestic Fisher effect, International Fisher effect), budget and trade deficits or surpluses, large cross-border M&A deals and other macroeconomic conditions. Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time. However, the large banks have an important advantage; they can see their customers' order flow. Currencies are traded against one another in pairs. Each currency pair thus constitutes an individual trading product and is traditionally noted XXXYYY or XXX/YYY, where XXX and YYY are the ISO 4217 international three-letter code of the currencies involved. The first currency (XXX) is the base currency that is quoted relative to the second currency (YYY), called the counter currency (or quote currency). For instance, the quotation EURUSD (EUR/USD) 1.5465 is the price of the euro expressed in US dollars, meaning 1 euro = 1.5465 dollars. The market convention is to quote most exchange rates against the USD with the US dollar as the base currency (e.g. USDJPY, USDCAD, USDCHF). The exceptions are the British pound (GBP), Australian dollar (AUD), the New Zealand dollar (NZD) and the euro (EUR) where the USD is the counter currency (e.g. GBPUSD, AUDUSD, NZDUSD, EURUSD). The factors affecting XXX will affect both XXXYYY and XXXZZZ. This causes positive currency correlation between XXXYYY and XXXZZZ. On the spot market, according to the 2010 Triennial Survey, the most heavily traded bilateral currency pairs were: • EURUSD: 28% • USDJPY: 14% • GBPUSD (also called cable): 9% and the US currency was involved in 84.9% of transactions, followed by the euro (39.1%), the yen (19.0%), and sterling (12.9%) (see table). Volume percentages for all individual currencies should add up to 200%, as each transaction involves two currencies. Trading in the euro has grown considerably since the currency's creation in January 1999, and how long the foreign exchange market will remain dollar-centered is open to debate. Until recently, trading the euro versus a non-European currency ZZZ would have usually involved two trades: EURUSD and USDZZZ. The exception to this is EURJPY, which is an established traded currency pair in the interbank spot market. As the dollar's value has eroded during 2008, interest in using the euro as reference currency for prices in commodities (such as oil), as well as a larger component of foreign reserves by banks, has increased dramatically. Transactions in the currencies of Foreign exchange market 9 commodity-producing countries, such as AUD, NZD, CAD, have also increased Determinants of exchange rates The following theories explain the fluctuations in exchange rates in a floating exchange rate regime (In a fixed exchange rate regime, rates are decided by its government): 1. International parity conditions: Relative Purchasing Power Parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world. 2. Balance of payments model (see exchange rate): This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous appreciation of dollar during 1980s and most part of 1990s in face of soaring US current account deficit. 3. Asset market model (see exchange rate): views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by people's willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that “the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.” None of the models developed so far succeed to explain exchange rates and volatility in the longer time frames. For shorter time frames (less than a few days) algorithms can be devised to predict prices. It is understood from the above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces of demand and supply. The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange. Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology. Economic factors These include: (a) economic policy, disseminated by government agencies and central banks, (b) economic conditions, generally revealed through economic reports, and other economic indicators. • Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates). • Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency. • Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency. • Inflation levels and trends: Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation. • Economic growth and health: Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a Foreign exchange market 10 country's economy, the better its currency will perform, and the more demand for it there will be. • Productivity of an economy: Increasing productivity in an economy should positively influence the value of its currency. Its effects are more prominent if the increase is in the traded sector . Political conditions Internal, regional, and international political conditions and events can have a profound effect on currency markets. All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation's economy. For example, destabilization of coalition governments in Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive/negative interest in a neighboring country and, in the process, affect its currency. Market psychology Market psychology and trader perceptions influence the foreign exchange market in a variety of ways: • Flights to quality: Unsettling international events can lead to a "flight to quality", a type of capital flight whereby investors move their assets to a perceived "safe haven". There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The U.S. dollar, Swiss franc and gold have been traditional safe havens during times of political or economic uncertainty. • Long-term trends: Currency markets often move in visible long-term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends. • "Buy the rumor, sell the fact": This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought". To buy the rumor or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices. • Economic numbers: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. "What to watch" can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight. • Technical trading considerations: As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns. Foreign exchange market 11 Financial instruments Spot A spot transaction is a two-day delivery transaction (except in the case of trades between the US Dollar, Canadian Dollar, Turkish Lira, Euro and Russian Ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction. Forward One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be one day, a few days, months or years. Usually the date is decided by both parties. Then the forward contract is negotiated and agreed upon by both parties. Swap The most common type of forward transaction is the swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not standardized contracts and are not traded through an exchange. A deposit is often required in order to hold the position open until the transaction is completed. Future Futures are standardized forward contracts and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts. Option A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has 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. The options market is the deepest, largest and most liquid market for options of any kind in the world. Speculation Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly. Nevertheless, economists including Milton Friedman have argued that speculators ultimately are a stabilizing influence on the market and perform the important function of providing a market for hedgers and transferring risk from those people who don't wish to bear it, to those who do. Other economists such as Joseph Stiglitz consider this argument to be based more on politics and a free market philosophy than on economics. Large hedge funds and other well capitalized "position traders" are the main professional speculators. According to some economists, individual traders could act as "noise traders" and have a more destabilizing role than larger and better informed actors. Currency speculation is considered a highly suspect activity in many countries. While investment in traditional financial instruments like bonds or stocks often is considered to contribute positively to economic growth by providing capital, currency speculation does not; according to this view, it is simply gambling that often interferes with economic policy. For example, in 1992, currency speculation forced the Central Bank of Sweden to raise interest rates for a few days to 500% per annum, and later to devalue the krona. Former Malaysian Prime Minister Foreign exchange market 12 Mahathir Mohamad is one well known proponent of this view. He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators. Gregory J. Millman reports on an opposing view, comparing speculators to "vigilantes" who simply help "enforce" international agreements and anticipate the effects of basic economic "laws" in order to profit. In this view, countries may develop unsustainable financial bubbles or otherwise mishandle their national economies, and foreign exchange speculators made the inevitable collapse happen sooner. A relatively quick collapse might even be preferable to continued economic mishandling, followed by an eventual, larger, collapse. Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the blame from themselves for having caused the unsustainable economic conditions. Risk aversion Risk aversion is a kind of trading behavior exhibited by the foreign exchange market when a potentially adverse event happens which may affect market conditions. This behavior is caused when risk averse traders liquidate their positions in risky assets and shift the funds to less risky assets due to uncertainty. In the context of the foreign exchange market, traders liquidate their positions in various currencies to take up positions in safe-haven Fig.1 Chart showing MSCI World Index of  Equities fell while the US Dollar Index rose. currencies, such as the US Dollar. Sometimes, the choice of a safe haven currency is more of a choice based on prevailing sentiments rather than one of economic statistics. An example would be the Financial Crisis of 2008. The value of equities across the world fell while the US Dollar strengthened (see Fig.1). This happened despite the strong focus of the crisis in the USA. Carry Trade Currency carry trade refers to the act of borrowing one currency that has a low interest rate in order to purchase another with a higher interest rate. A large difference in rates can be highly profitable for the trader, especially if high leverage is used. However, with all levered investments this is a double edged sword, and large exchange rate fluctuations can suddenly swing trades into huge losses. Forex Signals Forex trade alerts, often referred to as Forex Signals are trade strategies provided by either experienced traders or market analysts. These signals which are often charged a premium fee for can then be copied or replicated by a trader to his own live account. Forex Signal products are packaged as either alerts delivered to a users inbox or sms, or can be installed to a trader's trading platform. 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SRSBQ_o0-Ek& pbx=1& bav=on. 2,or. r_gc. r_pw. r_cp. r_qf. ,cf. osb& fp=e1175ee4201d696b& biw=1280& bih=845)  J Chen - Essentials of Foreign Exchange Trading (http:/ / books. google. co. uk/ books?id=8zTsnBYiDGkC& pg=PA1& dq=history+ of+ foreign+ exchange& hl=en& sa=X& ei=SKYAUNKqII6o0AWV3KSGBw& redir_esc=y#v=onepage& q=history of foreign exchange& f=false) John Wiley & Sons, 9 Mar 2009 Retrieved 2012-07-13 ISBN 0470390867  (page 1 of) A Hicks - Managing Currency Risk Using Foreign Exchange Options (http:/ / books. google. co. uk/ books?id=vIuavf6a1R8C& pg=PA1& dq=history+ of+ Foreign+ exchange& hl=en& sa=X& ei=wcIBUIy5J6O_0QW2-8SLBw& ved=0CEQQ6AEwAg#v=onepage& q=history of Foreign exchange& f=false) Woodhead Publishing, 2000 Retrieved 2012-07-14 ISBN 1855734915  (secondary) -GG Johnson Formulation of Exchange Rate Policies in Adjustment Programs (http:/ / books. google. co. uk/ books?id=8FQWkffo7wwC& pg=PA15& dq=foreign+ exchange+ 1982& hl=en& sa=X& ei=nsQBUPO1JunN0QXLi9CuBw& ved=0CHUQ6AEwCQ#v=onepage& q=foreign exchange 1982& f=false) International Monetary Fund, 15 Aug 1985 Retrieved 2012-07-14 ISBN 0939934507  JA Dorn - China in the New Millennium: Market Reforms and Social Development (http:/ / books. google. co. uk/ books?id=BIGnLYA4PtsC& pg=PA208& dq=foreign+ exchange+ in+ 1981& hl=en& sa=X& ei=A9kBUIm2MOmo0AXmloiSBw& ved=0CFgQ6AEwBTgK#v=onepage& q=foreign exchange in 1981& f=false) Cato Institute, 1998 Retrieved 2012-07-14 ISBN 1882577612 Foreign exchange market 16  B Laurens, H Mehran, M Quintyn, T Nordman - Monetary and Exchange System Reforms in China: An Experiment in Gradualism (http:/ / books. google. co. uk/ books?id=PJwCbEC9lJYC& pg=PT131& dq=foreign+ exchange+ in+ 1981& hl=en& sa=X& ei=59cBUMfYLIKf0QWA4vSuBw& ved=0CGwQ6AEwCA#v=onepage& q=foreign exchange in 1981& f=false) International Monetary Fund, 26 Sep 1996 Retrieved 2012-07-14 ISBN 1452766126  Y-I Chung - South Korea in the Fast Lane: Economic Development and Capital Formation (http:/ / books. google. co. uk/ books?id=-0n9n3vNMeYC& pg=PA106& dq=foreign+ exchange+ in+ 1981& hl=en& sa=X& ei=zNUBUNbPLKXB0QXpjejHBw& redir_esc=y#v=onepage& q=foreign exchange in 1981& f=false) Oxford University Press, 20 Jul 2007 Retrieved 2012-07-14 ISBN 0195325451  KM Dominguez, JA Frankel - Does Foreign Exchange Intervention Work? (http:/ / books. google. co. uk/ books?id=i6QViZToLTIC& pg=PA9& dq=history+ of+ foreign+ exchange+ 1983& hl=en& sa=X& ei=5csBUKGvE8mw0QW_kq24Bw& ved=0CEcQ6AEwAjgK#v=onepage& q=history of foreign exchange 1983& f=false) Peterson Institute, 1993 Retrieved 2012-07-14 ISBN 0881321044  (page 211 - [source BIS 2007])H Van Den Berg - International Finance and Open-Economy Macroeconomics: Theory, History, and Policy (http:/ / books. google. co. uk/ books?id=1Qhfgvkf4S0C& pg=PA210& dq=foreign+ exchange+ history& hl=en& sa=X& ei=k9oBUIfEB-PQ0QWZ3ZGhBw& ved=0CDoQ6AEwADgK#v=onepage& q=foreign exchange history& f=false) World Scientific, 31 Aug 2010 Retrieved 2012-07-14 ISBN 9814293512  PJ Quirk Issues in International Exchange and Payments Systems (http:/ / books. google. co. uk/ books?id=fcUjRujvzt4C& pg=PA26& dq=foreign+ exchange+ in+ 1981& hl=en& sa=X& ei=wtYBULDjH4ah0QWm1qG7Bw& ved=0CFwQ6AEwBQ#v=onepage& q=foreign exchange in 1981& f=false) International Monetary Fund, 13 Apr 1995 Retrieved 2012-07-14 ISBN 1557754802  BIS Triennial Central Bank Survey (http:/ / www. bis. org/ publ/ rpfx10. pdf), published in September 2010.  "Derivatives in emerging markets" (http:/ / www. bis. org/ publ/ qtrpdf/ r_qt1012f. htm), the Bank for International Settlements, December 13, 2010  Source: Euromoney FX survey FX survey 2012 (http:/ / www. euromoney. com/ poll/ 3301/ PollsAndAwards/ Foreign-Exchange. html): The Euromoney FX survey is the largest global poll of foreign exchange service providers.'  "The $4 trillion question: what explains FX growth since the 2007 survey? (http:/ / www. bis. org/ publ/ qtrpdf/ r_qt1012e. htm), the Bank for International Settlements, December 13, 2010  Gabriele Galati, Michael Melvin (December 2004). "Why has FX trading surged? Explaining the 2004 triennial survey" (http:/ / www. bis. org/ publ/ qtrpdf/ r_qt0412f. pdf). Bank for International Settlements. .  Alan Greenspan, The Roots of the Mortgage Crisis: Bubbles cannot be safely defused by monetary policy before the speculative fever breaks on its own. (http:/ / opinionjournal. com/ editorial/ feature. html?id=110010981), the Wall Street Journal, December 12, 2007  McKay, Peter A. (2005-07-26). "Scammers Operating on Periphery Of CFTC's Domain Lure Little Guy With Fantastic Promises of Profits" (http:/ / online. wsj. com/ article/ SB112233850336095645. html?mod=Markets-Main). The Wall Street Journal (Dow Jones and Company). . Retrieved 2007-10-31.  Egan, Jack (2005-06-19). "Check the Currency Risk. Then Multiply by 100" (http:/ / www. nytimes. com/ 2005/ 06/ 19/ business/ yourmoney/ 19fore. html?_r=2& adxnnl=1& oref=slogin& adxnnlx=1191337503-g1yHfewhqPWye0XtI+ Eq0A& oref=slogin). The New York Times. . Retrieved 2007-10-30.  The Sunday Times (UK), 16 July 2006  The 5 largest in the UK are Travelex, Moneycorp, HiFX, World First and Currencies Direct  The total sum is 200% because each currency trade always involves a currency pair.  The Microstructure Approach to Exchange Rates, Richard Lyons, MIT Press (http:/ / faculty. haas. berkeley. edu/ lyons/ docs/ bookch1. pdf) (pdf chapter 1)  http:/ / papers. ssrn. com/ sol3/ papers. cfm?abstract_id=711362  Safe haven currency (http:/ / glossary. reuters. com/ index. php/ Safe_Haven_Currency)  John J. Murphy, Technical Analysis of the Financial Markets (New York Institute of Finance, 1999), pp. 343–375.  Investopedia (http:/ / www. investopedia. com/ terms/ o/ overbought. asp)  Sam Y. Cross, All About the Foreign Exchange Market in the United States (http:/ / www. newyorkfed. org/ education/ addpub/ usfxm/ ), Federal Reserve Bank of New York (1998), chapter 11, pp. 113–115.  Michael A. S. Guth, " Profitable Destabilizing Speculation (http:/ / michaelguth. com/ economist/ chap1. htm)," Chapter 1 in Michael A. S. Guth, Speculative behavior and the operation of competitive markets under uncertainty, Avebury Ashgate Publishing, Aldorshot, England (1994), ISBN 1-85628-985-0.  What I Learned at the World Economic Crisis (http:/ / www. globalpolicy. org/ socecon/ bwi-wto/ critics/ 2000/ whatilearned. htm) Joseph Stiglitz, The New Republic, April 17, 2000, reprinted at GlobalPolicy.org  Summers LH and Summers VP (1989) 'When financial markets work too well: a Cautious case for a securities transaction tax' Journal of financial services  But Don't Rush Out to Buy Kronor: Sweden's 500% Gamble - International Herald Tribune (http:/ / www. iht. com/ articles/ 1992/ 09/ 17/ perc. php)  Gregory J. Millman, Around the World on a Trillion Dollars a Day, Bantam Press, New York, 1995.  "Risk Averse" (http:/ / www. investopedia. com/ terms/ r/ riskaverse. asp). Investopedia. . Retrieved 2010-02-25. Foreign exchange market 17  "Global markets-US stocks rebound, dollar gains on risk aversion" (http:/ / www. reuters. com/ article/ idUSN0515775320100205). Reuters. 2010-02-05. . Retrieved 2010-02-27.  Stewart, Heather (2008-04-09). "IMF says US crisis is 'largest financial shock since Great Depression'" (http:/ / www. guardian. co. uk/ business/ 2008/ apr/ 09/ useconomy. subprimecrisis). London: guardian.co.uk. . Retrieved 2010-02-27. External links • A user's guide to the Triennial Central Bank Survey of foreign exchange market activity, Bank for International Settlements (http://www.bis.org/publ/qtrpdf/r_qt1012h.htm) • London Foreign Exchange Committee with links (on right) to committees in NY, Tokyo, Canada, Australia, HK, Singapore (http://www.bankofengland.co.uk/markets/Pages/forex/fxjsc/) • United States Federal Reserve daily update of exchange rates (http://www.federalreserve.gov/releases/h10/ update/) • Bank of Canada historical (10-year) currency converter and data download (http://www.bankofcanada.ca/en/ rates/exchform.html) • Microstructure effects, bid-ask spreads and volatility in the spot foreign exchange market pre and post-EMU (http://www.cfr.statslab.cam.ac.uk/events/content/20056/mcgroarty2.pdf) • OECD Exchange rate statistics (monthly averages) (http://stats.oecd.org/Index.aspx?QueryId=169) • National Futures Association (2010). Trading in the Retail Off-Exchange Foreign Currency Market (http://www. nfa.futures.org/nfa-investor-information/publication-library/forex.pdf). Chicago, Illinois. Currency band The currency band is a system of exchange rates by which a floating currency is backed by hard money. A country selects a range, or "band", of values at which to set their currency, and returns to a fixed exchange rate if the value of their currency shifts outside this band. This allows for some revaluation, but tends to stabilize the currency's value within the band. In this sense, it is a compromise between a fixed (or "pegged") exchange rate and a floating exchange rate. For example, the exchange rate of the renminbi of the mainland of the People's Republic of China has recently been based upon a currency band; the European Economic Community's "snake in the tunnel" was a similar concept that failed, but ultimately led to the establishment of the European Exchange Rate Mechanism (ERM) and ultimately the Euro. Exchange rate 18 Exchange rate In finance, an exchange rate (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency. For example, an interbank exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (US$) means that ¥91 will be exchanged for each US$1 or that US$1 will be exchanged for each ¥91. Exchange rates are determined in the foreign exchange market, which is open to a wide range of different types of buyers and sellers where currency trading is continuous: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date. In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers. Most trades are to or from the local currency. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell the currency. The quoted rates will incorporate an allowance for a dealer's margin (or profit) in trading, or else the margin may be recovered in the form of a "commission" or in some other way. Different rates may also be quoted for cash (usually notes only), a documentary form (such as traveller's cheques) or electronically (such as a credit card purchase). The higher rate on documentary transactions is due to the additional time and cost of clearing the document, while the cash is available for resale immediately. Some dealers on the other hand prefer documentary transactions because of the security concerns with cash. Retail exchange market People may need to exchange currencies in a number of situations. For example, people intending to travel to another country may buy foreign currency in a bank in their home country, where they may buy foreign currency cash, traveller's cheques or a travel-card. From a local money changer they can only buy foreign cash. At the destination, the traveller can buy local currency at the airport, either from a dealer or through an ATM. They can also buy local currency at their hotel, a local money changer, through an ATM, or at a bank branch. When they purchase goods in a store and they do not have local currency, they can use a credit card, which will convert to the purchaser's home currency at its prevailing exchange rate. If they have traveller's cheques or a travel card in the local currency, no currency exchange is necessary. Then, if a traveller has any foreign currency left over on their return home, may want to sell it, which they may do at their local bank or money changer. The exchange rate as well as fees and charges can vary significantly on each of these transactions, and the exchange rate can vary from one day to the next. There are variations in the quoted buying and selling rates for a currency between foreign exchange dealers and forms of exchange, and these variations can be significant. For example, consumer exchange rates used by Visa and MasterCard offer the most favorable exchange rates available, according to a Currency Exchange Study conducted by CardHub.com. This studied consumer banks in the U.S., and Travelex, showed that the credit card networks save travellers about 8% relative to banks and roughly 15% relative to airport companies. Exchange rate 19 Quotations A currency pair is the quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market. The quotation EUR/USD 1.2500 means that 1 Euro is exchanged for 1.2500 US dollars. There is a market convention that determines which is the base currency and which is the term currency. In most parts of the world, the order is: EUR – GBP – AUD – NZD – USD – others. Accordingly, a conversion from EUR to AUD, EUR is the base currency, AUD is the term currency and the exchange rate indicates how many Australian dollars would be paid or received for 1 Euro. Cyprus and Malta which were quoted as the base to the USD and others were recently removed from this list when they joined the Euro. In some areas of Europe and in the non-professional market in the UK, EUR and GBP are reversed so that GBP is quoted as the base currency to the euro. In order to determine which is the base currency where both currencies are not listed (i.e. both are "other"), market convention is to use the base currency which gives an exchange rate greater than 1.000. This avoids rounding issues and exchange rates being quoted to more than 4 decimal places. There are some exceptions to this rule e.g. the Japanese often quote their currency as the base to other currencies. Exchange rates display in Thailand Quotes using a country's home currency as the price currency (e.g., EUR 0.735342 = USD 1.00 in the euro zone) are known as direct quotation or price quotation (from that country's perspective) and are used by most countries. Quotes using a country's home currency as the unit currency (e.g., EUR 1.00 = USD 1.35991 in the euro zone) are known as indirect quotation or quantity quotation and are used in British newspapers and are also common in Australia, New Zealand and the eurozone. Using direct quotation, if the home currency is strengthening (i.e., appreciating, or becoming more valuable) then the exchange rate number decreases. Conversely if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating. Market convention from the early 1980s to 2006 was that most currency pairs were quoted to 4 decimal places for spot transactions and up to 6 decimal places for forward outrights or swaps. (The fourth decimal place is usually referred to as a "pip"). An exception to this was exchange rates with a value of less than 1.000 which were usually quoted to 5 or 6 decimal places. Although there is no fixed rule, exchange rates with a value greater than around 20 were usually quoted to 3 decimal places and currencies with a value greater than 80 were quoted to 2 decimal places. Currencies over 5000 were usually quoted with no decimal places (e.g. the former Turkish Lira). e.g. (GBPOMR : 0.765432 - : 1.4436 - EURJPY : 165.29). In other words, quotes are given with 5 digits. Where rates are below 1, quotes frequently include 5 decimal places. In 2005 Barclays Capital broke with convention by offering spot exchange rates with 5 or 6 decimal places on their electronic dealing platform. The contraction of spreads (the difference between the bid and offer rates) arguably necessitated finer pricing and gave the banks the ability to try and win transaction on multibank trading platforms where all banks may otherwise have been quoting the same price. A number of other banks have now followed this Exchange rate 20 system. Exchange rate regime Each country, through varying mechanisms, manages the value of its currency. As part of this function, it determines the exchange rate regime that will apply to its currency. For example, the currency may be free-floating, pegged or fixed, or a hybrid. If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies and is determined by the market forces of supply and demand. Exchange rates for such currencies are likely to change almost constantly as quoted on financial markets, mainly by banks, around the world. A movable or adjustable peg system is a system of fixed exchange rates, but with a provision for the devaluation of a currency. For example, between 1994 and 2005, the Chinese yuan renminbi (RMB) was pegged to the United States dollar at RMB 8.2768 to $1. China was not the only country to do this; from the end of World War II until 1967, Western European countries all maintained fixed exchange rates with the US dollar based on the Bretton Woods system.  But that system had to be abandoned due to market pressures and speculations in the 1970s in favor of floating, market-based regimes. Still, some governments keep their currency within a narrow range. As a result currencies become over-valued or under-valued, causing trade deficits or surpluses. Fluctuations in exchange rates A market-based exchange rate will change whenever the values of either of the two component currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than available supply (this does not mean people no longer want money, it just means they prefer holding their wealth in some other form, possibly another currency). Increased demand for a currency can be due to either an increased transaction demand for money or an increased speculative demand for money. The transaction demand is highly correlated to a country's level of business activity, gross domestic product (GDP), and employment levels. The more people that are unemployed, the less the public as a whole will spend on goods and services. Central banks typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions. Speculative demand is much harder for central banks to accommodate, which they influence by adjusting interest rates. A speculator may buy a currency if the return (that is the interest rate) is high enough. In general, the higher a country's interest rates, the greater will be the demand for that currency. It has been argued that such speculation can undermine real economic growth, in particular since large currency speculators may deliberately create downward pressure on a currency by shorting in order to force that central bank to buy their own currency to keep it stable. (When that happens, the speculator can buy the currency back after it depreciates, close out their position, and thereby take a profit.) For carrier companies shipping goods from one nation to another, exchange rates can often impact them severely. Therefore, most carriers have a CAF charge to account for these fluctuations. Purchasing power of currency The "real exchange rate" (RER) is the purchasing power of a currency relative to another. It is based on the GDP deflator measurement of the price level in the domestic and foreign countries ( ), which is arbitrarily set equal to 1 in a given base year. Therefore, the level of the RER is arbitrarily set depending on which year is chosen as the base year for the GDP deflator of two countries. The changes of the RER are instead informative on the evolution over time of the relative price of a unit of GDP in the foreign country in terms of GDP units of the Exchange rate 21 domestic country. If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the GDP deflators of the two countries, and the RER would be constant and equal to one. Bilateral vs. effective exchange rate Bilateral exchange rate involves a currency pair, while an effective exchange rate is a weighted average of a basket of foreign currencies, and it can be viewed as an overall measure of the country's external competitiveness. A nominal effective exchange rate (NEER) is weighted with the inverse of the asymptotic trade weights. A real effective exchange rate (REER) adjusts NEER by appropriate foreign price level and deflates by the home country price level. Compared to NEER, a GDP weighted effective exchange rate might be more appropriate considering the global investment phenomenon. Example of GNP-weighted nominal exchange rate history of a basket of 6 important currencies (US Dollar, Euro, Japanese Yen, Chinese Uncovered interest rate parity Renmenbi, Swiss Franks, Pound Sterling Uncovered interest rate parity (UIRP) states that an appreciation or depreciation of one currency against another currency might be neutralized by a change in the interest rate differential. If US interest rates increase while Japanese interest rates remain unchanged then the US dollar should depreciate against the Japanese yen by an amount that prevents arbitrage (in reality the opposite, appreciation, quite frequently happens in the short-term, as explained below). The future exchange rate is reflected into the forward exchange rate stated today. In our example, the forward exchange rate of the dollar is said to be at a discount because it buys fewer Japanese yen in the forward rate than it does in the spot rate. The yen is said to be at a premium. UIRP showed no proof of working after the 1990s. Contrary to the theory, currencies with high interest rates characteristically appreciated rather than depreciated on the reward of the containment of inflation and a higher-yielding currency. Balance of payments model This model holds that a foreign exchange rate must be at its equilibrium level - the rate which produces a stable current account balance. A nation with a trade deficit will experience reduction in its foreign exchange reserves, which ultimately lowers (depreciates) the value of its currency. The cheaper currency renders the nation's goods (exports) more affordable in the global market place while making imports more expensive. After an intermediate period, imports are forced down and exports rise, thus stabilizing the trade balance and the currency towards equilibrium. Like PPP, the balance of payments model focuses largely on trade-able goods and services, ignoring the increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. Their flows go into the capital account item of the balance of payments, thus balancing the deficit in the current account. The increase in capital flows has given rise to the asset market model. Exchange rate 22 Asset market model The expansion in trading of financial assets (stocks and bonds) has reshaped the way analysts and traders look at currencies. Economic variables such as economic growth, inflation and productivity are no longer the only drivers of currency movements. The proportion of foreign exchange transactions stemming from cross border-trading of financial assets has dwarfed the extent of currency transactions generated from trading in goods and services. The asset market approach views currencies as asset prices traded in an efficient financial market. Consequently, currencies are increasingly demonstrating a strong correlation with other markets, particularly equities. Like the stock exchange, money can be made (or lost) on the foreign exchange market by investors and speculators buying and selling at the right (or wrong) times. Currencies can be traded at spot and foreign exchange options markets. The spot market represents current exchange rates, whereas options are derivatives of exchange rates Manipulation of exchange rates Countries may gain an advantage in international trade if they manipulate the value of their currency by artificially keeping its value low, typically by the national central bank engaging in open market operations. It is argued that the People's Republic of China has succeeded in doing this over a long period of time. In 2010, other nations, including Japan and Brazil, attempted to devalue their currency in the hopes of subsidizing cheap exports and bolstering their ailing economies. A low exchange rate lowers the price of a country's goods for consumers in other countries but raises the price of goods, especially imported goods, for consumers in the manipulating country. References  O'Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action (http:/ / www. pearsonschool. com/ index. cfm?locator=PSZ3R9& PMDbSiteId=2781& PMDbSolutionId=6724& PMDbCategoryId=& PMDbProgramId=12881& level=4). Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 458. ISBN 0-13-063085-3. .  The Economist – Guide to the Financial Markets (https:/ / docs. google. com/ fileview?id=0B_Qxj5U7eaJTZTJkODYzN2ItZjE3Yy00Y2M0LTk2ZmUtZGU0NzA3NGI4Y2Y5& hl=en& pli=1) (pdf)  "Currency Exchange Study" (http:/ / education. cardhub. com/ currency-exchange-study/ ). CardHub.com. .  Understanding foreign exchange: exchange rates (http:/ / www. inlandrevenue. gov. uk/ manuals/ cfmmanual/ cfm7011. htm)  http:/ / www. finextra. com/ fullstory. asp?id=13480  http:/ / www-econ. stanford. edu/ faculty/ workp/ swp99020. pdf#search=%22western%20europe%20fixed%20exchange%20rate%201970%20us%20dollar%22  "Currency Adjustment Factor - CAF" (http:/ / investment_terms. enacademic. com/ 4858/ Currency_Adjustment_Factor_-_CAF). Academic Dictionaries and Encyclopedias. .  "Currency Adjustment Factor" (http:/ / globalforwarding. com/ blog/ currency-adjustment-factor). Global Forwarding. .  The Microstructure Approach to Exchange Rates, Richard Lyons, MIT Press (http:/ / faculty. haas. berkeley. edu/ lyons/ docs/ bookch1. pdf) (pdf chapter 1)  "More Countries Adopt China’s Tactics on Currency" (http:/ / www. nytimes. com/ 2010/ 10/ 04/ world/ 04currency. html) article by David E. Sanger and Michael Wines in The New York Times October 3, 2010, accessed October 4, 2010 Exchange-rate regime 23 Exchange-rate regime An exchange-rate regime is the way an authority manages its currency in relation to other currencies and the foreign exchange market. It is closely related to monetary policy and the two are generally dependent on many of the same factors. The basic types are a floating exchange rate, where the market dictates movements in the exchange rate; a pegged float, where a central bank keeps the rate from deviating too far from a target band or value; and a fixed exchange rate, which ties the currency to another currency, mostly more widespread currencies such as the U.S. dollar or the euro or a basket of currencies. Types Float Floating rates are the most common exchange rate regime today. For example, the dollar, euro, yen, and British pound all are floating currencies. However, since central banks frequently intervene to avoid excessive appreciation or depreciation, these regimes are often called managed float or a dirty float. Floating exchange ratefree float regime managed float regime different types of currency pegCurrency peg types: fixed exchange rate system, currency board, linked exchange rate, fixed/crawling peg, fixed/crawling band. Dollarizationusage of foreign Pegged float currency Pegged floating currencies are pegged to some band or value, either fixed or periodically adjusted. Pegged floats are: Crawling bands the rate is allowed to fluctuate in a band around a central value, which is adjusted periodically. This is done at a preannounced rate or in a controlled way following economic indicators. Crawling pegs the rate itself is fixed, and adjusted as above. Pegged with horizontal bands the rate is allowed to fluctuate in a fixed band (bigger than 1%) around a central rate. Exchange-rate regime 24 Fixed Fixed rates are those that have direct convertibility towards another currency. In case of a separate currency, also known as a currency board arrangement, the domestic currency is backed one to one by foreign reserves. A pegged currency with very small bands (< 1%) and countries that have adopted another country's currency and abandoned its own also fall under this category. Dollarization Dollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of the domestic currency. The term is not only applied to usage of the United States dollar, but generally to the use of any foreign currency as the national currency. Zimbabwe is a good example of dollarization since the collapse of the Zimbabwean dollar. Further reading • Edwards, Sebastian & Levy Yeyati, Eduardo (2003) "Flexible Exchange Rates as Shock Absorbers," NBER Working Papers 9867, National Bureau of Economic Research, Inc. ( (http://ideas.repec.org/p/nbr/nberwo/ 9867.html)). • Kiguel, Andrea & Levy Yeyati, Eduardo (2009) "Back to 2007: Fear of appreciation in emerging economies" ( (http://www.voxeu.org/index.php?q=node/3917)). • Tiwari, Rajnish (2003): Post-Crisis Exchange Rate Regimes in Southeast Asia, Seminar Paper, University of Hamburg. ( PDF (http://www.rrz.uni-hamburg.de/RRZ/R.Tiwari/papers/exchange-rate.pdf)) • Levy-Yeyati, Eduardo & Sturzenegger, Federico & Reggio, Iliana (2006) "On the Endogeneity of Exchange Rate Regimes," Working Paper Series rwp06-047, Harvard University, John F. Kennedy School of Government. ( (http://ideas.repec.org/p/ecl/harjfk/rwp06-047.html)) • Nenovsky. N (http://www.nikolaynenovsky.com), K. Dimitrova(2006). Rate and Inflation: France and Bulgaria in the interwar period“ (http://www.nikolaynenovsky.com/uploads/file/ICERwp34-06. pdf''„Exchange).International Center for Economic Research Working Paper, Torino, No 34, 2006 • Nenovsky. N (http://www.nikolaynenovsky.com), G. Pavanelli and Dimitrova, K(2007). Rate Control in Italy and Bulgaria in the Interwar Period: History and Prospectives“ (http://www.nikolaynenovsky.com/uploads/ file/monetary theory/nenovsky_pavanalli_dimitrova_ICERwp40-07.pdf„Exchange).International Center of Economic Research Working Paper,Torino, No 40, 2007 • Roberto Frenkel and Martín Rapetti, A Concise History of Exchange Rate Regimes in Latin America (http:// www.cepr.net/documents/publications/exchange-rates-latin-america-2010-04.pdf), Center for Economic and Policy Research, April 2010 Exchange-rate flexibility 25 Exchange-rate flexibility A flexible exchange-rate system is a monetary system that allows the exchange rate to be determined by supply and demand. Every currency area must decide what type of exchange rate arrangement to maintain. Between permanently fixed and completely flexible however, are heterogeneous approaches. They have different implications for the extent to which national authorities participate in foreign exchange markets. According to their degree of flexibility, post-Bretton Woods-exchange rate regimes are arranged into three categories: currency unions, dollarized regimes, currency boards and conventional currency pegs are described as “fixed-rate regimes”; Horizontal bands, crawling pegs and crawling bands are grouped into “intermediate regimes”; Managed and independent floats are described as flexible regimes. All monetary regimes except for the permanently fixed regime experience the time inconsistency problem and exchange rate volatility, albeit to different degrees. Fixed rate programs In a fixed exchange rate system, the monetary authority picks rates of exchange with each other currency and commits to adjusting the money supply, restricting exchange transactions and adjusting other variables to ensure that the exchange rates do not move. All variations on fixed rates reduce the time inconsistency problem and reduce exchange rate volatility, albeit to different degrees. Under dollarization/Euroization, the US dollar or the Euro acts as legal tender in a different country. Dollarization is a summary description of the use of foreign currency in its capacity to produce all types of money services in the domestic economy. Monetary policy is delegated to the anchor country. Under dollarization exchange rate movements cannot buffer external shocks. The money supply in the dollarizing country is limited to what it can earn via exports, borrow and receive from emigrant remittances. A currency board enables governments to manage their external credibility problems and discipline their central banks by “tying their hands” with binding arrangements. A currency board combines three elements: an exchange rate that is fixed to another, “anchor currency”; automatic convertibility or the right to exchange domestic currency at this fixed rate whenever desired; and a long-term commitment to the system. A currency board system can ultimately be credible only if central bank holds official foreign exchange reserves sufficient to at least cover the entire monetary base. Exchange rate movements cannot buffer external shocks. A fixed peg system fixes the exchange rate against a single currency or a currency basket. The time inconsistency problem is reduced through commitment to a verifiable target. However, the availability of a devaluation option provides a policy tool for handling large shocks. Its potential drawbacks are that it provides a target for speculative attacks, avoids exchange rate volatility, but not necessarily persistent misalignments, does not by itself place hard constraints on monetary and fiscal policy and that the credibility effect depends on accompanying institutional measures and a visible record of accomplishment. Monetary union A currency or monetary union is a multi-country zone where a single monetary policy prevails and inside which a single currency or multiple substitutable currencies, move freely. A monetary union has common monetary and fiscal policy to ensure control over the creation of money and the size of government debts. It has a central management of the common pool of foreign exchange reserves, external debts and exchange rate policies. The monetary union has common regional monetary authority i.e. common regional central bank, which is the sole issuer of economy wide currency, in the case of a full currency union. The monetary union eliminates the time inconsistency problem within the zone and reduces real exchange rate volatility by requiring multinational agreement on exchange rate and other monetary changes. The potential Exchange-rate flexibility 26 drawbacks are that member countries suffering asymmetric shocks lose a stabilization tool—the ability to adjust exchange rates. The cost depends on the extent of asymmetric costs and the availability and effectiveness of alternative adjustment tools. Flexible exchange rate regimes These systems do not particularly reduce time inconsistency problems nor do they offer specific techniques for maintaining low exchange rate volatility. A crawling peg attempt to combine flexibility and stability using a rule-based system for gradually altering the currency's par value, typically at a predetermined rate or as a function of inflation differentials. Often used by (initially) high-inflation countries who peg to low inflation countries in attempt to avoid currency appreciation. At the margin a crawling peg provides a target for speculative attacks. Among variants of fixed exchange rates, it imposes the least restrictions, and may hence yield the smallest credibility benefits. The credibility effect depends on accompanying institutional measures and record of accomplishment. Exchange rate bands allow markets to set rates within a specified range; endpoints are defended through intervention. It provides a limited role for exchange rate movements to counteract external shocks while partially anchoring expectations. This system does not eliminate exchange rate uncertainty and thus motivates development of exchange rate risk management tools. On the margin a band is subject to speculative attacks. It does not by itself place hard constraints on policy, and thus provides only a limited solution to the time inconsistency problem. The credibility effect depends on accompanying institutional measures, a record of accomplishment and whether the band is firm or adjustable, secret or public, band width and the strength of the intervention requirement. Managed float exchange rates are determined in the foreign exchange market. Authorities can and do intervene, but are not bound by any intervention rule. Often accompanied by a separate nominal anchor, such as inflation target. The arrangement provides a way to mix market-determined rates with stabilizing intervention in a non-rule-based system. Its potential drawbacks are that it doesn’t place hard constraints on monetary and fiscal policy. It suffers from uncertainty from reduced credibility, relying on the credibility of monetary authorities. It typically offers limited transparency. In a pure float, the exchange rate is determined in the market without public sector intervention. Adjustments to shocks can take place through exchange rate movements. It eliminates the requirement to hold large reserves. However, this arrangement does not provide an expectations anchor. The exchange rate regime itself does not imply any specific restriction on monetary and fiscal policy. References  Sullivan, arthur; Steven M. Sheffrin (2003). Economics: Principles in action (http:/ / www. pearsonschool. com/ index. cfm?locator=PSZ3R9& PMDbSiteId=2781& PMDbSolutionId=6724& PMDbCategoryId=& PMDbProgramId=12881& level=4). Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 462. ISBN 0-13-063085-3. . Dollarization 27 Dollarization Dollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of the domestic currency as a store of value, unit of account, and/or medium of exchange within the domestic  economy. The term is not only applied to usage of the United States dollar, but generally to the use of any foreign currency as the national currency. There are two common Worldwide use of the United States dollarU.S. dollar and the euro: United indicators of dollarization. The first States External adopters of the US dollar Currencies pegged to the US dollar Currencies one is the share of foreign currency pegged to the US dollar within narrow band Eurozone External adopters of the deposits (FCD) in the domestic euro Currencies pegged to the euro Currencies pegged to the euro within narrow band banking system in the broad money including of FCD. The second measure is the share of all foreign currency deposits held by domestic residents at home and abroad in their total monetary assets. The biggest economies to have officially dollarized as of June 2002 are Panama (since 1904), Ecuador (since 2000), and El Salvador (since 2001). As of August 2005, the United Worldwide official use of foreign currency or pegs: United States dollarU.S. dollar States dollar, the Euro, the New users, including the United States Currencies pegged to the US dollar Euro users, Zealand dollar, the Swiss franc, the including the Eurozone Currencies pegged to the Euro Australian dollar users, including Australia New Zealand dollar users, including New Zealand South African rand users Indian rupee, and the Australian dollar (Common Monetary AreaCMA, including South Africa) Indian rupee users and pegs, were the only currencies used by other including India Pound sterling users and pegs, including the United Kingdom Special countries for official dollarization. In drawing rights or other currency basket pegs Three cases of a country using or pegging addition, the Armenian dram, Turkish the currency of a neighbor lira, the Israeli shekel, and the Russian ruble are used by internationally unrecognized but de facto independent states. Origins After the gold standard was abandoned at the outbreak of World War I and the Bretton Woods Conference following World War II, some countries were desperately seeking exchange rate regimes to promote global economic stability and hence their own prosperity. Countries usually peg their currency to a major convertible currency. "Hard pegs" are extreme exchange rate regimes that demonstrate a stronger commitment to a fixed parity (i.e. currency boards) or relinquish control over their own currency (such as currency unions and dollarization) while "soft pegs" are more flexible and floating exchange rate regimes. When countries choose to use a major convertible currency parallel to Dollarization 28 or in place of their national currency, this is called the process of dollarization. The collapse of "soft" pegs in Southeast Asia and Latin America in the late 1990s led dollarization to become a serious policy issue. A few cases of full dollarization until 1999 had been the consequence of political and historical factors. In all long-standing dollarization cases, historical and political reasons have been more influential than an evaluation of the effects of dollarization. Panama, the most salient dollarization example, adopted the U.S. dollar as legal tender after its independence as a result of a constitutional ruling. Ecuador and El Salvador became full dollarized economies in 2000 and 2001 respectively with different influential factors. Ecuador underwent the process of dollarization to deal with a widespread political and financial crisis resulted from massive loss of credibility in its political and monetary institutions. In contrary, El Salvador's official dollarization was as a result of internal debates and in a context of stable macroeconomic fundamentals and long-standing unofficial dollarization. The euro area adopted the euro (€) as their common currency and sole legal tender in 1999, which might be considered as a variety of a full-commitment regime similar to full dollariation despite of some differences distinguishable from other dollarization. Types Dollarization can occur in a number of situations. The most popular type of dollarization is unofficial dollarization or de facto dollarization. Unofficial dollarization happens when residents of a country choose to hold a significant share of their financial assets denominated in foreign currency although the foreign currency lacks the legal tender. They hold deposits in the foreign currency because of a bad track record of the local currency, or as a hedge against inflation of the domestic currency. Official dollarization or full dollarization happens when a country adopts a foreign currency as its sole legal tender, and ceases to issue the domestic currency. Another effect of a country adopting a foreign currency as its own is that the country gives up all power to vary its exchange rate. There is a small number of countries adopting a foreign currency as legal tender. For example, Panama underwent a process of full dollarization by adopting the U.S. dollar as legal tender in 1904. This type of dollarization is also known as de jure dollarization. Dollarization can be used semiofficially (or officially bimonetary systems), where the foreign currency is legal tender alongside the domestic currency. In literature, there is a set of related definitions of dollarization such as external liability dollarization, domestic liability dollarization, banking sector's liability dollarization or namely deposit dollarization and credit dollarlization. The external liability dollarization measures total external debt (private and public) denominated in foreign currencies of the economy. Deposit dollarization can be measured as the share of dollar deposit in total deposit of the banking system while credit dollarization can be measured as the share of dollar credit in total credit of the banking system. Effects On trade and investment One of the main advantages of adopting of a strong foreign currency as sole legal tender is to reduce the transaction costs of trade among countries using the same currency. There are at least two ways to infer this impact from data. The first one is a significantly negative effect of exchange rate volatility on trade in most cases, and the second is an association between transaction costs and the need to operate with multiple currencies. Economic integration with the rest of the world becomes easier as a result of lowered transaction costs and stabler prices in dollar terms. Rose (2000) applied the gravity model of trade and provided empirical evidence that countries sharing a common currency engage in significantly increased trade among them, and that the benefits of dollarization for trade may be large. Dollarization 29 Dollarized economies can invoke greater confidence among international investors, inducing increased investments and growth. The elimination of the currency crisis risk due to full dollarization leads to a reduction of country risk premiums and then to lower interest rates. These effects result in a higher level of investment. However, there is a positive association between dollarization and interest rates in a dual-currency economy. On monetary and exchange rate policies Official dollarization helps to promote fiscal and monetary discipline and thus greater macroeconomic stability and lower inflation rates, to lower real exchange rate volatility, and possibly to deepen the financial system. Firstly, dollarization helps developing countries, providing a firm commitment to stable monetary and exchange rate policies by forcing a passive monetary. Adopting a strong foreign currency as legal tender will help to "eliminate the inflation-bias problem of discretionary monetary policy". Secondly, official dollarization imposes stronger financial constraint on the government by eliminating deficit financing by issuing money. An empirical finding suggests that inflation has been significantly lower in dollarized nations than in non-dollarized ones. The expected benefit of dollarization is the elimination of the risk of exchange rate fluctuations and a possible reduction in the country's international exposure. Though dollarization cannot eliminate the risk of an external crisis, it provides steadier markets as a result of eliminating fluctuations in exchange rates. On the other hand, dollarization leads to the loss of seigniorage revenue, the loss of monetary policy autonomy, and the loss of the exchange rate instruments. Seigniorage revenues are the profits generated when monetary authorities issue currency. When adopting a foreign currency as legal tender, a monetary authority needs to withdraw the domestic currency and give up future seigniorage revenue. The country loses the rights to its autonomous monetary and exchange rate policies, even in times of financial emergency; former chairman of the Federal Reserve Alan Greenspan, for example, has stated that the central bank only considers the effects of its decisions on the US economy. In a full dollarized economy, exchange rates are indeterminate and monetary authorities cannot devalue the currency. In a highly dollarized economy, devaluation policy is less effective in changing the real exchange rate because of significant pass-through effects to domestic prices. However, the cost of losing an independent monetary policy exists when domestic monetary authorities can commit an effective counter-cyclical monetary policy, stabilizing the business cycle. This cost depends adversely on the correlation between the business cycle of the client country (the dollarized economy) and the business cycle of the anchor country. In addition, monetary authorities in dollarized economies diminish the liquidity assurance to their banking system. On banking systems In a fully dollarized economy, monetary authorities cannot act as lender of last resort to commercial banks by printing money. The alternatives to lending to the bank system may include taxation and issuing government debt. The loss of the lender of last resort is considered a cost of full dollarization. This cost depends on the initial level of unofficial dollarization before moving to a full dollarized economy. This relation is negative because in a heavily dollarized economy, the central bank already fears difficulties in providing liquidity assurance to the banking system. However, literature points out the existence of alternative mechanisms to provide liquidity insurance to banks, such as a scheme by which the international financial community charges an insurance fee in exchange for a commitment to lend to a domestic bank. Commercial banks in countries where saving accounts and loans in foreign currency are allowed may face two types of risks: 1. Currency mismatch risk: Assets and liabilities on the balance sheets may be in different denominations. This may arise if the bank converts foreign currency deposits into local currency and lends in local currency, or vice versa. 2. Default risk: Arises if the bank uses the foreign currency deposits to lend in foreign currency. However, dollarization eliminates the probability of a currency crisis that impacts negatively on the banking system through the balance sheet channel. Dollarization may reduce the possibility of systematic liquidity shortages and the Dollarization 30 optimal reserves in the banking system. Research has shown that official dollarization has played a significant role in improving bank liquidity and asset quality in Ecuador and El Salvador. Determinants of the dollarization process The dynamics of the flight from domestic money High and unanticipated inflation rates decrease the demand for domestic money and raise the demand for alternative assets, including foreign currency and assets dominated by foreign currency. This phenomenon is called the "flight from domestic money". It results in a rapid and sizable process of dollarization. In countries with high inflation rates, the domestic currency tends to be gradually displaced by a stable currency, such as the U.S. dollar. At the beginning of this process, the store-of-value function of the domestic currency is replaced by the foreign currency. Then, the unit-of-account function of the domestic currency is displaced when many prices are quoted in a foreign currency. A prolonged period of high inflation will induce the domestic currency to lose its function as medium of exchange when the public carries out many transactions in foreign currency. Ize and Levy-Yeyati (1998) examine the determinants of deposit and credit dollarization, concluding that dollarization is driven by the volatility of inflation and the real exchange rate. Dollarization increases with inflation volatility and decreases with the volatility of the real exchange rate. Institutional factors The flight from domestic money depends on a country's institutional factors. The first factor is the level of development of the domestic financial market. An economy with a well-developed financial market can offer a set of alternative financial instruments dominated in domestic currency, reducing the role of foreign currency as an inflation hedge. The pattern of the dollarization process also varies across countries with different foreign exchange and capital controls. In a country with strict foreign exchange regulations, the demand for foreign currency will be satisfied in the holding of foreign currency assets abroad and outside the domestic banking system. This demand often puts pressure on the parallel market of foreign currency and on the country's international reserves. Evidence for this pattern is given in the absence of dollarization during the pre-reform period in most transition economies, because of constricted controls on foreign exchange and the banking system. In contrary, by facilitating the domestic holding of foreign currency, a country might mitigate the shift of assets abroad and strengthen its external reserves in exchange for a dollarization process. However, the effect of this regulation on the pattern of dollarization depends on the public's expectations of macroeconomic stability and the sustainability of the foreign exchange regime. U.S. dollar Countries using the U.S. dollar exclusively • British Virgin Islands • Caribbean Netherlands (from 1 January 2011) • East Timor (uses its own coins) • Ecuador (uses its own coins in addition to U.S. coins; Ecuador adopted the U.S. dollar as its legal tender in 2000. • El Salvador • Marshall Islands • Federated States of Micronesia (Micronesia used the U.S. dollar since 1944) • Palau (Palau adopted the U.S. dollar since 1944) Dollarization 31 • Panama (uses its own coins in addition to U.S. coins. This country has adopted the U.S. dollar as legal tender since 1904). • Turks and Caicos Islands Countries using the U.S. dollar alongside other currencies • Bahamas • Belize (Belizien Dollar pegged 2/1 but USD is accepted) • Uruguay • Nicaragua • Cambodia (uses Cambodian Riel for many official transactions but most businesses deal exclusively in dollars) • Lebanon (along with the Lebanese pound) • Liberia (was fully dollarized until 1982, when the National Bank of Liberia began issuing five dollar coins; U.S. dollar still in common usage alongside the Liberian dollar) • Zimbabwe • Haiti (uses the U.S Dollar alongside its domestic currency, the Gourde) • Vietnam (along with the Vietnamese Dong) • Somalia (along with the Somali Shilling) Euro • Andorra (formerly French franc and Spanish peseta since 1278) • Kosovo (formerly German mark and Yugoslav dinar) • Monaco (formerly French franc since 1865; issues its own euro coins) • Montenegro (formerly German mark and Yugoslav dinar) • San Marino (formerly Italian lira; issues its own euro coins) • Vatican City (formerly Italian lira; issues its own euro coins) New Zealand dollar • Cook Islands (issues its own coins and some notes) • Nauru (alongside Australian dollar from 25 May 2013) • Niue • Pitcairn Island • Tokelau Australian dollar • Kiribati (issues its own coins; Kiribati has used Australian currency since 1943) • Nauru (has fully used Australian currency since 1914) • Tuvalu (issues its own coins; Tuvalu has used Australian currency alongside its domestic currency since 1892) South African rand • Lesotho • Namibia • Swaziland Dollarization 32 Zimbabwe Due to the hyperinflation and official abandonment of the Zimbabwean dollar several currencies are used instead: • British Pound Sterling • Botswana pula • Euro • South African rand • United States dollar The U.S. dollar has been officially adopted for all transactions involving the new power-sharing government. Others • Armenian dram: Nagorno-Karabakh Republic • Russian ruble: Abkhazia and South Ossetia (de facto independent states, but recognized as part of Georgia by nearly all other states) • Indian rupee: Bhutan and Nepal • Swiss franc: Liechtenstein • Israeli shekel: Palestinian territories • Turkish lira: Turkish Republic of Northern Cyprus (de facto independent state, but recognized as part of Cyprus by all states but Turkey) References  Savastano, Miguel (1996). "Dollarization in Latin America: Recent Evidence and Some Policy Issues". IMF Working Paper WP/96/4: iii.  Savastano, Miguel (1996). "Dollarization in Latin America: Recent Evidence and Some Policy Issues". IMF Working Paper WP/96/4: 7.  Yeyati, Eduardo (2003). Dollarization. Massachusetts Institute of Technology. pp. 1.  Rochon, Louis-Philippe (2003). Dollarization Lessons from Europe and the Americas. London and New York: Routledge. pp. 1.  Yeyati, Eduardo (2003). Dollarization. Massachusetts Institute of Technology. pp. 3.  Yeyati, Eduardo (2003). Dollarization. Massachusetts Institute of Technology. pp. 5.  Balino; Berensztein (1999). "Monetary Policy in Dollarized Economies". IMF Occasional paper 171.  Bogetic (200). "Official Dollarization: Current Experiences and Issues". Cato Journal 20 (2): 179–213.  Berkmen, Pelin; Eduardo (2009). "Exchange Rate Policy and Liability Dollarization: What Do the Data Reveal about Causality?". IMF Working Paper (WP/07/33): 6.  Pinon, Marco (2008). Macroeconomic Implications of Financial Dollarization The Case of Uruguay. Washington DC: International Monetary Fund. pp. 22.  Alesina, Alberto; Barro (2001). "Dollarization". The American Economic Review 91 (2): 381–385. JSTOR 2677793.  Yeyati, Eduardo (2003). Dollarization. London: The MIT Press. pp. 22.  Berg, Andrew; Borensztein, Eduardo (2000). "The Pros and Cons of Full Dollarization" (http:/ / www. imf. org/ external/ pubs/ ft/ issues/ issues24/ index. htm). Full dollarization (IMF) (00/50). . Retrieved 13 October 2011.  Rose, Andrew (2000). "One Money, One Market: the effect of common currencies on trade,". Economic Policy.  Honohan, Patrick (2007). "Dollarization and Exchange Rate Fluctuations". World Bank Policy Research Working Paper (4172).  Alesina, Alberto; Barro (2001). "Dollarization". The American Economic Review 91 (2): 382. JSTOR 2677793.  Yeyati, Eduardo (2003). Dollarization. London: The MIT Press. pp. 23.  Edwards, Sebastian; Magendzo. "Dollarization, Inflation and Growth". NBER Working Paper (8671).  Broda, Levy Yeyati, Christian, Eduardo. "Endogenous deposit dollarization" (http:/ / ideas. repec. org/ p/ fip/ fednsr/ 160. html). Federal Reserve Bank of New York. .  Moreno-Bird, Juan Carlos (Fall 1999). "Dollarization in Latin America: Is it desirable?" (http:/ / www. drclas. harvard. edu/ revista/ articles/ view/ 473). ReVista: Harvard Review of Latin America. .  John, Kareken; Wallace (1981). "On the Indeterminacy of Equilibrium Exchange Rates". Quarterly Journal of Economics 96: 207–222.  Levy Yeyati, Eduardo. "Liquidity Insurance in a Financially Dollarized Economy, NBER Working Papers 12345" (http:/ / ideas. repec. org/ p/ nbr/ nberwo/ 12345. html). National Bureau of Economic Research, Inc.. .  Bencivenga, Valerie; Huybens, Smith (2001). "Dollarization and the Integration of International Capital Markets: a Contribution to the Theory of Optimal Currency Areas". Journal of Money, Credit and Banking 33 (2, Part 2): 548–589. JSTOR 2673916.  Broda, Christian; Yeyati (2001). "Dollarization and the Lender of Last Resort". Book: Dollarization: 100–131.  Yeyati, Eduardo (2003). Dollarization. London: The MIT Press. pp. 31. Dollarization 33  Kutan, Rengifo, Ozsoz, Ali, Erick, Emre. "Evaluating the Effects of Deposit Dollarization in Bank Profitability" (http:/ / stage. web. fordham. edu/ images/ academics/ graduate_schools/ gsas/ economics/ dp2010_07_kutan_rengifo_ozsoz. pdf). Fordham University Economics Department. .  Yeyati, Eduardo (2003). Dollarization. London: The MIT Press. pp. 34.  Federal Reserve Bank of Atlanta, Official Dollarization and the Banking System in Ecuador and El Salvador, 2006 (http:/ / www. frbatlanta. org/ filelegacydocs/ erq306_quispe. pdf)  Savastano, Miguel (1996). "Dollarization in Latin America: Recent Evidence and Some Policy Issues". IMF Working Paper WP/96/4.  Sahay, Ratna; Vegh (1995). "Dollarization in Transition Economies: Evidence and Policy Implications". IMF Working Paper WP/95/96: 1.  Catão, Luis; Terrrones (2007). "Determinants of Dollarization: The Banking Side". IMF Working Paper WP/00/146: 5.  Sahay, Ratna; Vegh (1995). "Dollarization in Transition Economies: Evidence and Policy Implications". IMF Working Paper WP/95/96: 13.  Edwards, Sebastian (2001). "Dollarization and Economic Performance: An Empirical Investigation" (http:/ / www. nber. org/ papers/ w8274). NBER Working Paper (8274): 1. .  Edwards, Sebastian (2001). "Dollarization and Economic Performance: An Empirical Investigation" (http:/ / www. nber. org/ papers/ w8274). NBER Working Paper (8274): 17. .  Edwards, Sebastian (2001). "Dollarization and Economic Performance: An Empirical Investigation" (http:/ / www. nber. org/ papers/ w8274). NBER Working Paper (8274): 6. .  Pinon, Marco; Gelos, Gaston (28 August 2008). "Uruguay's Monetary Policy Effective Despite Dollarization" (http:/ / www. imf. org/ external/ pubs/ ft/ survey/ so/ 2008/ CAR082808A. htm). IMF Survey Magazine. . Retrieved 4 March 2012.  Edwards, Sebastian (2001). "Dollarization and Economic Performance: An Empirical Investigation" (http:/ / www. nber. org/ papers/ w8274). NBER Working Paper (8274): 3. . Fixed exchange rate A fixed exchange rate, sometimes called a pegged exchange rate, is also referred to as the Tag of particular Rate, which is a type of exchange rate regime where a currency's value is fixed against the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold. A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable and is especially useful for small economies in which external trade forms a large part of their GDP. It can also be used as a means to control inflation. However, as the reference value rises and falls, so does the currency pegged to it. In addition, according to the Mundell–Fleming model, with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability. There are no major economic players that use a fixed exchange rate (except the countries using the euro and the Chinese yuan). The currencies of the countries that now use the euro are still existing (for old bonds). The rates of these currencies are fixed with respect to the euro and to each other. The most recent such country to discontinue their fixed exchange rate was the People's Republic of China, which did so in July 2005. Maintenance Typically, a government wanting to maintain a fixed exchange rate does so by either buying or selling its own currency on the open market. This is one reason governments maintain reserves of foreign currencies. If the exchange rate drifts too far below the desired rate, the government buys its own currency in the market using its reserves. This places greater demand on the market and pushes up the price of the currency. If the exchange rate drifts too far above the desired rate, the government sells its own currency, thus increasing its foreign reserves. Another, less used means of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This is difficult to enforce and often leads to a black market in foreign currency. Nonetheless, some countries are highly successful at using this method due to government monopolies over all money conversion. This was the method employed by the Chinese government to maintain a currency peg or tightly banded float against the US dollar. Throughout the 1990s, China was highly successful at maintaining a currency peg using a government Fixed exchange rate 34 monopoly over all currency conversion between the yuan and other currencies. On the 6 September 2011, the Swiss National Bank has imposed a franc ceiling, for first time in three decades, against the euro. In 1978 a franc ceiling was set versus the Deutsche Mark to stem currency gains. Criticisms The main criticism of a fixed exchange rate is that flexible exchange rates serve to adjust the balance of trade. When a trade deficit occurs, there will be increased demand for the foreign (rather than domestic) currency which will push up the price of the foreign currency in terms of the domestic currency. That in turn makes the price of foreign goods less attractive to the domestic market and thus pushes down the trade deficit. Under fixed exchange rates, this automatic rebalancing does not occur. Governments also have to invest many resources in getting the foreign reserves to pile up in order to defend the pegged exchange rate. Moreover a government, when having a fixed rather than dynamic exchange rate, cannot use monetary or fiscal policies with a free hand. For instance, by using reflationary tools to set the economy rolling (by decreasing taxes and injecting more money in the market), the government risks running into a trade deficit. This might occur as the purchasing power of a common household increases along with inflation, thus making imports relatively cheaper. Additionally, the stubbornness of a government in defending a fixed exchange rate when in a trade deficit will force it to use deflationary measures (increased taxation and reduced availability of money), which can lead to unemployment. Finally, other countries with a fixed exchange rate can also retaliate in response to a certain country using the currency of theirs in defending their exchange rate. Fixed exchange rate regime versus capital control The belief that the fixed exchange rate regime brings with it stability is only partly true, since speculative attacks tend to target currencies with fixed exchange rate regimes, and in fact, the stability of the economic system is maintained mainly through capital control. A fixed exchange rate regime should be viewed as a tool in capital control. For instance, China has allowed free exchange for current account transactions since December 1, 1996. Of more than 40 categories of capital account, about 20 of them are convertible. These convertible accounts are mainly related to foreign direct investment. Because of capital control, even the renminbi is not under the managed floating exchange rate regime, but free to float, and so it is somewhat unnecessary for foreigners to purchase renminbi. Literature • Tiwari, Rajnish (2003): Post-Crisis Exchange Rate Regimes in Southeast Asia, Seminar Paper, University of Hamburg. (PDF ) Fixed or Flexible? • Getting the Exchange Rate Right in the 1990s References  Goodman, Peter S. (2005-07-22). "China Ends Fixed-Rate Currency" (http:/ / www. washingtonpost. com/ wp-dyn/ content/ article/ 2005/ 07/ 21/ AR2005072100351. html). Washington Post. . Retrieved 2010-05-06.  Goodman, Peter S. (2005-07-27). "Don't Expect Yuan To Rise Much, China Tells World" (http:/ / www. washingtonpost. com/ wp-dyn/ content/ article/ 2005/ 07/ 26/ AR2005072600681. html). Washington Post. . Retrieved 2010-05-06.  Griswold, Daniel (2005-06-25). "Protectionism No Fix for China's Currency" (http:/ / www. cato. org/ pub_display. php?pub_id=3946). Cato Institute. . Retrieved 2010-05-06.  Suranovic, Steven (2008-02-14). International Finance Theory and Policy. Palgrave Macmillan. p. 504.  http:/ / www. rrz. uni-hamburg. de/ RRZ/ R. Tiwari/ papers/ exchange-rate. pdf Fixed exchange rate 35  Caramazza, Francesco; Jahangir Aziz (April 1998). "Fixed or Flexible? - Getting the Exchange Rate Right in the 1990s" (http:/ / www. imf. org/ external/ pubs/ ft/ issues13/ index. htm). International Monetary Fund. . Retrieved 2010-05-06. Floating exchange rate A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency. Economic rationale There are economists who think that in most circumstances, floating exchange rates are preferable to fixed exchange rates. As floating exchange rates automatically adjust, they enable a country to dampen the impact of shocks and foreign business cycles, and to preempt the possibility of having a balance of payments crisis. However, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty. That may not necessarily be true, considering the results of countries that attempt to keep the prices of their currency "strong" or "high" relative to others, such as the UK or the Southeast Asia countries before the Asian currency crisis. The debate of making a choice between fixed and floating exchange rate regimes is set forth by the Mundell–Fleming model, which argues that an economy (or the government) cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. It must choose any two for control and leave the other to market forces. The primary argument for a floating exchange rate is that it allows monetary policies to be useful for other purposes. Under fixed rates, monetary policy is committed to the single goal of maintaining exchange rate at its announced level. Yet the exchange rate is only one of many macro economic variable that monetary policy can influence. A system of floating exchange rate leaves monetary policy makers free to pursue other goals such as stabilizing employment or prices. In cases of extreme appreciation or depreciation, a central bank will normally intervene to stabilize the currency. Thus, the exchange rate regimes of floating currencies may more technically be known as a managed float. A central bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price "ceiling" and "floor". Management by the central bank may take the form of buying or selling large lots in order to provide price support or resistance or, in the case of some national currencies, there may be legal penalties for trading outside these bounds. Floating currency A floating currency is a currency that uses a floating exchange rate as its exchange rate regime. A floating currency is contrasted with a fixed currency. In the modern world, the majority of the world's currencies are floating. Central banks often participate in the markets to attempt to influence exchange rates. Such currencies include the most widely traded currencies: the United States dollar, the euro, the Norwegian krone, the Japanese yen, the British pound, the Swiss franc and the Australian dollar. The Canadian dollar most closely resembles the ideal floating currency as the Canadian central bank has not interfered with its price since it officially stopped doing so in 1998. The US dollar runs a close second with very little change in its foreign reserves; by contrast, Japan and the United Kingdom intervene to a greater extent. From 1946 to the early 1970s, the Bretton Woods system made fixed currencies the norm; however, in 1971, the United States government would no longer uphold the dollar exchange at 1/35th of an ounce of gold, so that the US Floating exchange rate 36 dollar was no longer a fixed currency. After the 1973 Smithsonian Agreement, most of the world's currencies followed suit. A floating currency is one where targets other than the exchange rate itself are used to administer monetary policy. See open market operations. Fear of floating A free floating exchange rate increases foreign exchange volatility. There are economists who think that this could cause serious problems, especially in emerging economies. These economies have a financial sector with one or more of following conditions: • high liability dollarization • financial fragility • strong balance sheet effects When liabilities are denominated in foreign currencies while assets are in the local currency, unexpected depreciations of the exchange rate deteriorate bank and corporate balance sheets and threaten the stability of the domestic financial system. For this reason emerging countries appear to face greater fear of floating, as they have much smaller variations of the nominal exchange rate, yet face bigger shocks and interest rate and reserve movements. This is the consequence of frequent free floating countries' reaction to exchange rate movements with monetary policy and/or intervention in the foreign exchange market. The number of countries that present fear of floating increased significantly during the 1990s. References  http:/ / www. google. com/ search?hl=en& safe=off& client=qsb-win& rlz=1R3GGIH_en-GBGB323GB323& tbo=1& tbs=tl%3A1& q=%22swiss+ national+ bank%22+ %22swiss+ franc%22+ intervention+ history& aq=f& oq=& aqi=  http:/ / www. google. com/ search?hl=en& safe=off& client=qsb-win& rlz=1R3GGIH_en-GBGB323GB323& tbo=1& tbs=tl%3A1& q=canadian+ dollar+ bank+ of+ canada+ intervention+ history& btnG=Search& aq=f& oq=& aqi=  http:/ / www. google. com/ search?hl=en& safe=off& client=qsb-win& rlz=1R3GGIH_en-GBGB323GB323& tbo=1& tbs=tl%3A1& q=dollar+ federal+ reserve+ intervention+ history& btnG=Search& aq=f& oq=& aqi=  http:/ / www. google. com/ search?hl=en& safe=off& client=qsb-win& rlz=1R3GGIH_en-GBGB323GB323& tbo=1& tbs=tl%3A1& q=yen+ bank+ of+ japan+ intervention+ history& aq=f& oq=& aqi=  http:/ / www. google. com/ search?q=sterling+ bank+ of+ england+ intervention+ history& hl=en& safe=off& client=qsb-win& rlz=1R3GGIH_en-GBGB323GB323& tbs=tl:1& tbo=1& ei=EWpbSrLzJdDMjAfP1NAb& sa=X& oi=timeline_result& ct=title& resnum=11  Calvo, G.; Reinhart, C. (2002). "Fear of Floating". Quarterly Journal of Economics 117 (2): 379–408. doi:10.1162/003355302753650274.  Levy-Yeyati, E.; Sturzenegger, F. (2005). "Classifying Exchange Rate Regimes: Deeds vs. Words". European Economic Review 49 (6): 1603–1635. doi:10.1016/j.euroecorev.2004.01.001. Linked exchange rate 37 Linked exchange rate A linked exchange rate system is a type of exchange rate regime to link the exchange rate of a currency to another. It is the exchange rate system implemented in Hong Kong to stabilise the exchange rate between the Hong Kong dollar (HKD) and the United States dollar (USD). The Macao pataca (MOP) is similarly linked to the Hong Kong dollar. Unlike a fixed exchange rate system, the government or central bank does not actively interfere in the foreign exchange market by controlling supply and demand of the currency in order to influence the exchange rate. The exchange rate is instead stabilized by an exchange mechanism, whereby the Hong Kong Monetary Authority (HKMA) authorises note-issuing banks are to issue new banknotes provided that they deposit an equivalent value of US dollars with the HKMA. History As a response to the Black Saturday crisis in 1983, the linked exchange rate system was adopted in Hong Kong on October 17, 1983 through the currency board system. The redemption of certificates of indebtedness (for backing the banknotes) were sent out by note-issuing banks to peg the domestic currency against the US dollar at an internal fixed rate of HKD 7.80 = USD 1. The Hong Kong Monetary Authority (HKMA), Hong Kong's de facto central bank, authorised note-issuing banks are to issue banknotes. These banks are required to have the same amount of USD to issue banknotes. The HKMA guarantees to exchange USD into HKD, or vice versa, at the rate of 7.80. When the market rate is below 7.80, the banks will convert USD for HKD from the HKMA, HKD supply will be decreased, and the market rate will climb back to 7.80. The same mechanism also works when the market rate is above 7.80, and the banks will convert HKD for USD. In practice, the HKMA also set a lower limit at 7.80 (7.85 as an upper limit and 7.75 as a lower limit since May 18, 2005) for the HKD to flow within. The HKMA will sell or buy HKD in the market when the exchange rate is at (or extremely close) the lower limit and upper limit respectively. The HKD is backed by one of the world's largest foreign exchange reserves, which is several times the amount of money supplied in circulation. Notes and references  Jao YC.  (2001). The Asian Financial Crisis and the Ordeal of Hong Kong. Quorum, Greenwood. ISBN 1-56720-447-3  Linked Exchange Rate System (http:/ / www. info. gov. hk/ hkma/ eng/ currency/ link_ex/ link_ex_b_main. htm#1) at Hong Kong government website (3 Aug 2011) External links • Linked Exchange Rate System (http://www.info.gov.hk/hkma/eng/currency/link_ex/index.htm) at Hong Kong Monetary Authority (HKMA) • (http://www.amcm.gov.mo/publication/quarterly/Apr/Financial_EN.pdf), p. 22 Managed float regime 38 Managed float regime Managed float regime is the current international financial environment in which exchange rates fluctuate from day to day, but central banks attempt to influence their countries' exchange rates by buying and selling currencies. It is also known as a dirty float. In an increasingly integrated world economy, the currency rates impact any given country's economy through the trade balance. In this aspect, almost all currencies are managed since central banks or governments intervene to influence the value of their currencies. List of countries with managed floating currencies Source IMF  as of April 31, 2008 • Afghanistan • Algeria • Armenia • Burundi • Cambodia • Colombia • Dominican Republic • Egypt • Gambia • Georgia • Ghana • Guatemala • Guinea • Haiti • India • Indonesia • Jamaica • Kenya • Kyrgyzstan • Laos • Liberia • Madagascar • Malaysia • Mauritania • Mauritius • Moldova • Mozambique • Myanmar • Nigeria • Pakistan • Papua New Guinea • Paraguay • Peru • Romania • São Tomé and Príncipe Managed float regime 39 • Serbia • Singapore • Sudan • Tanzania • Thailand • Uganda • Ukraine • Uruguay • Vanuatu References  https:/ / www. imf. org/ external/ np/ mfd/ er/ 2008/ eng/ 0408. htm Futures exchange A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future. These types of contracts fall into the category of derivatives. Such instruments are priced according to the movement of the underlying asset (stock, physical commodity, index, etc.). The aforementioned category is named "derivatives" because the value of these instruments is derived from another asset class. History of futures exchanges One of the earliest written records of futures trading is in Aristotle's Politics. He tells the story of Thales, a poor philosopher from Miletus who developed a "financial device, which involves a principle of universal application". Thales used his skill in forecasting and predicted that the olive harvest would be exceptionally good the next autumn. Confident in his prediction, he made agreements with local olive-press owners to deposit his money with them to guarantee him exclusive use of their olive presses when the harvest was ready. Thales successfully negotiated low prices because the harvest was in the future and no one knew whether the harvest would be plentiful or pathetic and because the olive-press owners were willing to hedge against the possibility of a poor yield. When the harvest-time came, and a sharp increase in demand for the use of the olive presses outstripped supply, he sold his future use contracts of the olive presses at a rate of his choosing, and made a large quantity of money. It should be noted, however, that this is a very loose example of futures trading and, in fact, more closely resembles an option contract, given that Thales was not obliged to use the olive presses if the yield was poor. The first modern organized futures exchange began in 1710 at the Dojima Rice Exchange in Osaka, Japan. The United States followed in the early 19th century. Chicago has the largest future exchange in the world, the Chicago Mercantile Exchange. Chicago is located at the base of the Great Lakes, close to the farmlands and cattle country of the Midwest, making it a natural center for transportation, distribution, and trading of agricultural produce. Gluts and shortages of these products caused chaotic fluctuations in price, and this led to the development of a market enabling grain merchants, processors, and agriculture companies to trade in "to arrive" or "cash forward" contracts to insulate them from the risk of adverse price change and enable them to hedge. In March 2008 the Chicago Mercantile Exchange announced its acquisition of NYMEX Holdings, Inc., the parent company of the New York Mercantile Exchange and Commodity Exchange. CME's acquisition of NYMEX was completed in August 2008. Futures exchange 40 For most exchanges, forward contracts were standard at the time. However, most forward contracts were not honored by both the buyer and the seller. For instance, if the buyer of a corn forward contract made an agreement to buy corn, and at the time of delivery the price of corn differed dramatically from the original contract price, either the buyer or the seller would back out. Additionally, the forward contracts market was very illiquid and an exchange was needed that would bring together a market to find potential buyers and sellers of a commodity instead of making people bear the burden of finding a buyer or seller. In 1848 the Chicago Board of Trade (CBOT–) was formed. Trading was originally in forward contracts; the first contract (on corn) was written on March 13, 1851. In 1865 standardized futures contracts were introduced. The Chicago Produce Exchange was established in 1874, renamed the Chicago Butter and Egg Board in 1898 and then reorganised into the Chicago Mercantile Exchange (CME) in 1919. Following the end of the postwar international gold standard, in 1972 the CME formed a division called the International Monetary Market (IMM) to offer futures contracts in foreign currencies: British pound, Canadian dollar, German mark, Japanese yen, Mexican peso, and Swiss franc. In 1881 a regional market was founded in Minneapolis, Minnesota, and in 1883 introduced futures for the first time. Trading continuously since then, today the Minneapolis Grain Exchange (MGEX) is the only exchange for hard red spring wheat futures and options. The 1970s saw the development of the financial futures contracts, which allowed trading in the future value of interest rates. These (in particular the 90‑day Eurodollar contract introduced in 1981) had an enormous impact on the development of the interest rate swap market. Today, the futures markets have far outgrown their agricultural origins. With the addition of the New York Mercantile Exchange (NYMEX) the trading and hedging of financial products using futures dwarfs the traditional commodity markets, and plays a major role in the global financial system, trading over $1.5 trillion per day in 2005. The recent history of these exchanges (Aug 2006) finds the Chicago Mercantile Exchange trading more than 70% of its Futures contracts on its "Globex" trading platform and this trend is rising daily. It counts for over $45.5 billion of nominal trade (over 1 million contracts) every single day in "electronic trading" as opposed to open outcry trading of futures, options and derivatives. In June 2001 IntercontinentalExchange (ICE) acquired the International Petroleum Exchange (IPE), now ICE Futures, which operated Europe’s leading open-outcry energy futures exchange. Since 2003 ICE has partnered with the Chicago Climate Exchange (CCX) to host its electronic marketplace. In April 2005 the entire ICE portfolio of energy futures became fully electronic. In 2006 the New York Stock Exchange teamed up with the Amsterdam-Brussels-Lisbon-Paris Exchanges "Euronext" electronic exchange to form the first transcontinental futures and options exchange. These two developments as well as the sharp growth of internet futures trading platforms developed by a number of trading companies clearly points to a race to total internet trading of futures and options in the coming years. In terms of trading volume, the National Stock Exchange of India in Mumbai is the largest stock futures trading exchange in the world, followed by JSE Limited in Sandton, Gauteng, South Africa. Nature of contracts Exchange-traded contracts are standardized by the exchanges where they trade. The contract details what asset is to be bought or sold, and how, when, where and in what quantity it is to be delivered. The terms also specify the currency in which the contract will trade, minimum tick value, and the last trading day and expiry or delivery month. Standardized commodity futures contracts may also contain provisions for adjusting the contracted price based on deviations from the "standard" commodity, for example, a contract might specify delivery of heavier USDA Number 1 oats at par value but permit delivery of Number 2 oats for a certain seller's penalty per bushel. Futures exchange 41 Before the market opens on the first day of trading a new futures contract, there is a specification but no actual contracts exist. Futures contracts are not issued like other securities, but are "created" whenever Open interest increases; that is, when one party first buys (goes long) a contract from another party (who goes short). Contracts are also "destroyed" in the opposite manner whenever Open interest decreases because traders resell to reduce their long positions or rebuy to reduce their short positions. Speculators on futures price fluctuations who do not intend to make or take ultimate delivery must take care to "zero their positions" prior to the contract's expiry. After expiry, each contract will be settled, either by physical delivery (typically for commodity underlyings) or by a cash settlement (typically for financial underlyings). The contracts ultimately are not between the original buyer and the original seller, but between the holders at expiry and the exchange. Because a contract may pass through many hands after it is created by its initial purchase and sale, or even be liquidated, settling parties do not know with whom they have ultimately traded. Compare this with other securities, in which there is a primary market when an issuer issues the security, and a secondary market where the security is later traded independently of the issuer. Legally, the security represents an obligation of the issuer rather than the buyer and seller; even if the issuer buys back some securities, they still exist. Only if they are legally cancelled they can disappear. Standardization The contracts traded on futures exchanges are always standardized. In principle, the parameters to define a contract are endless (see for instance in futures contract). To make sure liquidity is high, there is only a limited number of standardized contracts. Clearing and settlement There is usually a division of responsibility between provision of trading facility, and that of clearing and settlement of those trades. While derivative exchanges like the CBOE and LIFFE take responsibility for providing efficient, transparent and orderly trading environments, settlement of the resulting trades are usually handled by clearing houses that serve as central counterparties to trades done in the respective exchanges. For instance, the Options Clearing Corporation (OCC) and LCH.Clearnet (London Clearing House) respectively are the clearing corporations for CBOE and LIFFE. A well known exception to this is the case of Chicago Mercantile Exchange and ICE, which clear trades themselves. Central counterparty Derivative contracts are leveraged positions whose value is volatile. They are usually more volatile than their underlying asset. This can lead to credit risk, in particular counterparty risk, those situations where one party to a trade loses a big sum of money and is unable to honor its settlement obligation. In a safe trading environment, the parties to a trade need to be assured that their counterparty will honor the trade, no matter how the market has moved. This requirement can lead to messy arrangements like credit assessment, setting of trading limits and so on for each counterparty, and take away most of the advantages of a centralised trading facility. To prevent this, a clearing house interposes themselves as counterparties to every trade and extend guarantee that the trade will be settled as originally intended. This action is called novation. As a result, trading firms take no risk on the actual counterparty to the trade, but on the clearing corporation. The clearing corporation is able to take on this risk by adopting an efficient margining process. Futures exchange 42 Margin and Mark-to-Market A margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty, in this case the central counterparty clearing houses. Clearing houses charge two types of margins: the Initial Margin and the Mark-To-Market margin (also referred to as Variation Margin). The Initial Margin is the sum of money (or collateral) to be deposited by a firm to the clearing corporation to cover possible future loss in the positions (the set of positions held is also called the portfolio) held by a firm.Several popular methods are used to compute initial margins. They include the CME-owned SPAN (a grid simulation method used by the CME and about 70 other exchanges), STANS (a Monte Carlo simulation based methodology used by the OCC), TIMS (earlier used by the OCC, and still being used by a few other exchanges like the Bursa Malaysia). The Mark-to-Market Margin (MTM margin) on the other hand is the margin collected to offset losses (if any) that have already been incurred on the positions held by a firm. This is computed as the difference between the cost of the position held and the current market value of that position. If the resulting amount is a loss, the amount is collected from the firm; else, the amount may be returned to the firm (the case with most clearing houses) or kept in reserve depending on local practice. In either case, the positions are 'marked-to-market' by setting their new cost to the market value used in computing this difference. The positions held by the clients of the exchange are marked-to-market daily and the MTM difference computation for the next day would use the new cost figure in its calculation. Clients hold a margin account with the exchange, and every day the swings in the value of their positions is added to or deducted from their margin account. If the margin account gets too low, they have to replenish it. In this way it is highly unlikely that the client will not be able to fulfill his obligations arising from the contracts. As the clearing house is the counterparty to all their trades, they only have to have one margin account. This is in contrast with OTC derivatives, where issues such as margin accounts have to be negotiated with all counterparties. Regulators Each exchange is normally regulated by a national governmental (or semi-governmental) regulatory agency: • In Australia, this role is performed by the Australian Securities and Investments Commission. • In the Chinese mainland, by the China Securities Regulatory Commission. • In Hong Kong, by the Securities and Futures Commission. • In India, by the Securities and Exchange Board of India and Forward Markets Commission (FMC) • In Japan, by the Financial Services Agency. • In Pakistan, by the Securities and Exchange Commission of Pakistan. • In Singapore by the Monetary Authority of Singapore. • In the UK, futures exchanges are regulated by the Financial Services Authority. • In the USA, by the Commodity Futures Trading Commission. • In Malaysia, by the Securities Commission Malaysia. • In Spain, by the Comisión Nacional del Mercado de Valores (CNMV). • In Brazil, by the Comissão de Valores Mobiliários (CVM). • In South Africa, by the Financial Services Board (South Africa). Futures exchange 43 References  Aristotle, Politics, trans. Benjamin Jowett, vol. 2, The Great Books of the Western World, book 1, chap. 11, p. 453.  Private ordering at the world's first futures exchange. (Dojima Rice Exchange in Osaka, Japan) - Michigan Law Review | Encyclopedia.com (http:/ / www. encyclopedia. com/ doc/ 1G1-70742768. html)  MGEX via U.S. Futures Exchange (2007). "Minneapolis Grain Exchange" (http:/ / www. usfe. org/ minneapolis-grain-exchange. asp). . and Minter, Adam (August 2006). "Gimme Grain!" (http:/ / www. rakemag. com/ stories/ section_detail. aspx?itemID=19477& catID=146& SelectCatID=146). The Rake. . and "Buyers & Processors" (http:/ / www. ndwheat. com/ buyers/ default. asp?ID=294). North Dakota Wheat Commission. 2007. . Retrieved 2007-03-29.  http:/ / www. tribuneindia. com/ 2007/ 20071129/ biz. htm#2 Retail foreign exchange platform Retail foreign exchange trading is a small segment of the large foreign exchange market. In 2007 it had been speculated that volume from retail foreign exchange trading represents 5 percent of the whole foreign exchange market which amounts to $50–100 billion in daily trading turnover. The retail foreign exchange market has been growing. In general retail customers are able to trade spot currencies. Due to the increasing tendency in the past years of the gradual shift from traditional intrabank 'paper' trading to the more advanced and accurate electronic trading, there has been spur in software development in this field. This change provided different types of trading platforms and tools intended for the use by banks, portfolio managers, retail brokers and retail traders. One of the most important tools required to perform a foreign exchange transaction is the trading platform providing retail traders and brokers with accurate currency quotes. History and new developments Electronic foreign exchange trading was first introduced to the retail public in 1996. The development was closely related with the development of the internet and can be roughly split into three waves. First wave 1996-2001 In 1996 several forex brokers started offering electronic retail forex trading facilities, some developed their own platform while those who lacked the sufficient tools to developed their own trading platforms used software based on ACT foreign exchange trading technology. The 1st retail FX brokers were MG Forex, The Matchbook FX ECN, Global Forex Trading (GFT), CMC Markets, FXCM, Saxo Bank (then known as Midas) and a handful of others. Most except CMC, Saxo & Matchbook FX were based on the ACT foreign exchange trading technology and GUI. These platforms were good enough at the time but required constant investments in research and development and this development cost too much. Second wave 2001-2006 The second wave started in the early 2000s when several software companies entered the retail foreign exchange trading market by launching their own versions of trading platforms, like Apbg Group, Ctn Systems, Tradestation and MetaTrader 4 from MetaQuotes Software which allowed the users to create their own trading indicators and automatic strategies. Typically these versions were cumbersome for both front-end users (retail traders) and back-end users (retail brokers) due to the misunderstanding of the developers about the foreign exchange market and also because of the insufficient programming tools/languages at the time. Simultaneously most of the retail brokers kept using and developing their own systems as they waited for better platforms which were yet to be developed. Retail foreign exchange platform 44 Third wave 2006-2011 Starting in 2007, web based trading platforms started to emerge. These platforms put much stronger emphasis on the user interface (GUI) making it more accessible to the retail traders while making trading on it very simple and intuitive. Some platforms also started to focus on social networking as a way to attract new users, after the emergence of Facebook, Twitter and other social media networks. Social trading has been growing intensely in the last years, especially after platforms like ZuluTrade, Currensee, Zecco.com, eToro or FXStat appeared. Moreover, a very strong emphasis was put on the back-end which allowed the retail brokers better control over their operations, better reporting and accurate system and ways to manage marketing campaigns. Gradually this wave is replacing the previous second wave with a major shift now to the friendlier and more intuitive systems of the third wave which according to Aite Group are necessary in order to maintain growth. Peer-to-peer trading systems In the South Pacific, "peer-to-peer" foreign exchange services, supported by local government agencies, are emerging in an attempt to reduce transaction costs to heavily remittance-dependent nations, such as Tonga and Samoa. Banks In 2006 a few banks started offering foreign exchange trading services to individual traders and money managers. DBFX and CitiFX Pro are some of the banks that were offering this service. However Deutsche Bank shut down its DBFX service in 2011. References  Triennial Central Bank Survey (http:/ / www. bis. org/ publ/ rpfxf07t. pdf) (December 2007), Bank for International Settlements  Greenwich Associates Report (http:/ / www. thetradenews. com/ trading/ foreign-exchange/ 772)  Aite Group's report about platform retail trading critical issues (http:/ / www. aitegroup. com/ reports/ 200707161. php) Article Sources and Contributors 45 Article Sources and Contributors Foreign exchange market Source: http://en.wikipedia.org/w/index.php?oldid=538425945 Contributors: $1000000000ten0one1, (GD), 2010triennialsurvey, 2D, Abdullais4u, Abj1, Acather96, Accesspig, Acmforex, Adamforex, Adamminstry, Adfx-sa, Adrie7, Ahunt, Alansohn, Alast0r, Alastairgbrown, Alberto.aff, Ale jrb, Alex771, AlexBraun, AlexiusHoratius, AllanManangan, Als7imy, Altasoul, Ammirajua, Amr.rs, Andrew Maiman, Andyjsmith, Antandrus, Antifa82, Aotf01, Araignee, Arakesh999, Arjayay, Arthena, Ashlux, Asperal, Assarkareem, Aude, Auntof6, Barek, Barticus88, Barts1a, Bbatsell, Beedi, Beetstra, Ben Gaskin, Berlus, Bilalmanzoorrana, Bill37212, Billw2, Bisnisfx, Bjoleniacz, Blacksabbath4343, Blanchardb, BlazerKnight, Blue rose yy, Bluemoose, Bob walker99, Bobzchemist, Bonadea, Bongomatic, Borsaegypt, Boyd Reimer, Brandsen, Briantieling, Bruguiea, Buchandan, BusterBluth, Capricorn42, Casperdc, Catgut, Cerowyn, Chetannada, Chi0585, Chillpill1984, Chimidan, Chochopk, Chris the speller, Chris51659, ChrisEvans, Chrisch, Chrserad, ClamDip, Clerks, Clevercatskin, CliffC, Cliftonflack, Cneeds, Coopeajj, Coventgardenfx, Createmilk, Cst17, CurrencyMike, Cyun, DARTH SIDIOUS 2, DMacks, DOSGuy, DVdm, Da Vynci, Daddy32, Dancter, Daniel Renfoh, Danlaycock, Dargente, David Legrand, David Shay, DavidBoden, Davidjholden, Davidoff, Dawnseeker2000, Db099221, Deed89, Deepsnow, Delijaworld, Denisarona, Deon Steyn, DerHexer, Dfdferer22, DiamondJoeQuimby, Dijinkv, Dina Jones, Dinomite, Dionyziz, Discospinster, Djcyanide, Dneprolab, DocendoDiscimus, Doutrax, Dplayonline, 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Contributors: 1ForTheMoney, 1gluon, 35KSK, Absurdist, Alinor, Amake, Amakuru, Atlastawake, Benjamin22b, Benjamnjoel2, Bjarki S, Bkwillwm, Bogong, Boing! said Zebedee, Breadandcheese, Cassowary, Cenarium, Chicocvenancio, Chochopk, Cybercobra, DandyDan2007, DanielCD, Danlaycock, Davidlrc, Denisarona, Diotime, Dricherby, Dropnote, DuncanHill, Dwo, Eassin, Edward, Ely1984, Emurphy42, Enlil Ninlil, Ewawer, Farolif, Fjmustak, Fry1989, Funandtrvl, Gettingtoit, Gibnews, Grant bud, GregorB, Gwen-chan, Gzornenplatz, Hajor, Headbomb, Henning Makholm, Hobawido, Holycharly, Hoshie, Iamorlando, Ikke19, JLogan, Jimm36, Joncnunn, Jonsdj, Joseph Solis in Australia, Khutuck, Kintetsubuffalo, Kiril Simeonovski, Lac.ideas, Laneways, Lemonade100, MPD01605, Mhockey, Mild Bill Hiccup, Monkbel, Monosig, Mschiffler, Murry1975, Neutrality, Nickshanks, Nightstallion, Nsaa, PabloStraub, Passportguy, Ph8l, Praetor alpha, Raccoon Fox, Ravensfan5252, RexNL, Reywas92, Rich Farmbrough, Rumping, SimonP, Smadnani, 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Stevertigo, Terjepetersen, Tomas e, Tony1, Underpants, Wapman, William Avery, Wittylama, 81 anonymous edits Linked exchange rate Source: http://en.wikipedia.org/w/index.php?oldid=526351805 Contributors: A bit iffy, Andystwong, AshbyJnr, Benjwong, Chengdi, DocendoDiscimus, Fitzwilliam, Funandtrvl, Gecko G, GoingBatty, Instantnood, Isnow, Joseph Solis in Australia, Kwertii, LG4761, Lawrencekhoo, Nightstallion, R10623, Richarocks, Soobrickay, Thomas Blomberg, Wai Wai, Welsh, 20 anonymous edits Managed float regime Source: http://en.wikipedia.org/w/index.php?oldid=528845128 Contributors: AzaToth, Bill37212, Bluemoose, Chili oasis, Chochopk, Cretog8, Crystallina, Eric Shalov, Flauto Dolce, Former user, G.W., Hisabness, John Quiggin, Mild Bill Hiccup, Passionless, Rajat Bhargav, Rich Farmbrough, Rjwilmsi, Takamaxa, 16 anonymous edits Futures exchange Source: http://en.wikipedia.org/w/index.php?oldid=538406655 Contributors: -Majestic-, -oo0(GoldTrader)0oo-, Afrique, Alanscottwalker, 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