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.
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
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
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.
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
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 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,
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
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
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 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
Example of GNP-weighted nominal exchange rate history of a basket of 6
important currencies (US Dollar, Euro, Japanese Yen, Chinese Renmenbi,
Swiss Franks, Pound Sterling.
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.
Uncovered interest rate parity
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
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
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.
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
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
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.
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.
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.
Pegged floating currencies are pegged to some band or value, either fixed
or periodically adjusted. Pegged floats are:
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.
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.
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 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
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as Shock Absorbers," NBER Working Papers 9867, National Bureau of
Economic Research, Inc. ().
Kiguel, Andrea & Levy Yeyati, Eduardo (2009) "Back to 2007: Fear of
appreciation in emerging economies" ().
Tiwari, Rajnish (2003): Post-Crisis Exchange Rate Regimes in Southeast
Asia, Seminar Paper, University of Hamburg. ( 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. ()
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in the interwar period“.International Center for Economic Research
Working Paper, Torino, No 34, 2006
Nenovsky. N, G. Pavanelli and Dimitrova, K(2007). Rate Control in Italy
and Bulgaria in the Interwar Period: History and
Prospectives“.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, Center for Economic and Policy Research, April
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
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
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
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.
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
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
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
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
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.
Worldwide use of the U.S. dollar and the euro:
External adopters of the US dollar
Currencies pegged to the US dollar
Currencies pegged to the US dollar within narrow band
External adopters of the euro
Currencies pegged to the euro
Currencies pegged to the euro within narrow band
Worldwide official use of foreign currency or pegs:
U.S. dollar users, including the United States
Currencies pegged to the US dollar
Euro users, including the Eurozone
Currencies pegged to the Euro
Australian dollar users, including Australia
New Zealand dollar users, including New Zealand
South African rand users (CMA, including South Africa)
Indian rupee users and pegs, including India
Pound sterling users and pegs, including the United Kingdom
Special drawing rights or other currency basket pegs
Three cases of a country using or pegging the currency of a neighbor
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 indicators of dollarization. The first one
is the share of foreign currency deposits (FCD) in the domestic 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 States dollar, the Euro, the New Zealand
dollar, the Swiss franc, the Indian rupee, and the Australian dollar were
the only currencies used by other countries for official dollarization.
In addition, the Armenian dram, Turkish lira, the Israeli shekel, and the
Russian ruble are used by internationally unrecognized but de facto
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 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.
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
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.
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
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:
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.
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 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
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.
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.
Federated States of Micronesia (Micronesia used the U.S. dollar since
Palau (Palau adopted the U.S. dollar since 1944)
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
Belize (Belizien Dollar pegged 2/1 but USD is accepted)
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)
Haiti (uses the U.S Dollar alongside its domestic currency, the Gourde)
Vietnam (along with the Vietnamese Dong)
Somalia (along with the Somali Shilling)
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)
Kiribati (issues its own coins; Kiribati has used Australian currency
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
Due to the hyperinflation and official abandonment of the Zimbabwean
dollar several currencies are used instead:
British Pound Sterling
South African rand
United States dollar
The U.S. dollar has been officially adopted for all transactions
involving the new power-sharing government.
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)
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
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 monopoly over all currency conversion between the yuan and
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.
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
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.
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
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.
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.
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
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 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
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
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.
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.
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 increase, 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
Linked Exchange Rate System at Hong Kong Monetary Authority (HKMA)
, p. 22
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
Papua New Guinea
São Tomé and Príncipe
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.
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
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
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.
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.
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
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.
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.
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
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
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).
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
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.
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
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.
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
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
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
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
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 "kollybist?s") 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
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.
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
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.
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.
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).
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
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.
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, $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
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 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.
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.
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
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 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
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.
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
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
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 $95 billion.
The largest and best known provider is Western Union with 345,000 agents
globally followed by UAE Exchange
Bureaux de change or currency transfer companies provide low value
foreign exchange services for travelers. These are typically located at
airports and stations or at tourist locations and allow physical notes to
be exchanged from one currency to another. They access the foreign
exchange markets via banks or non bank foreign exchange companies.
Most traded currencies by value
Currency distribution of global foreign exchange market turnover
Rank Currency ISO 4217code
(Symbol) % daily share
1 United States dollar USD ($) 84.9%
2 Euro EUR (€)
3.Japanese yen JPY (¥) 19.0%
4. Pound sterling GBP (£) 12.9%
5 Australian dollar AUD ($) 7.6%
6 Swiss franc CHF (Fr) 6.4%
7 Canadian dollar CAD ($) 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%
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'
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:
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 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):
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.
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.
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.
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
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
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
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 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 .
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 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
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
"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
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.
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
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.
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
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
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
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 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
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
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
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.
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 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.
A user's guide to the Triennial Central Bank Survey of foreign exchange
market activity, Bank for International Settlements
London Foreign Exchange Committee with links (on right) to committees in
NY, Tokyo, Canada, Australia, HK, Singapore
United States Federal Reserve daily update of exchange rates
Bank of Canada historical (10-year) currency converter and data download
Microstructure effects, bid-ask spreads and volatility in the spot
foreign exchange market pre and post-EMU
OECD Exchange rate statistics (monthly averages)
National Futures Association (2010). Trading in the Retail Off-Exchange
Foreign Currency Market. Chicago, Illinois.