CHAPTER NO.

CURRENCY PAIRS,
FOREIGN EXCHANGE
MARKET AND IMS
 Foreign Exchange Market
• Foreign Exchange market (Known as Forex Market or
Currency Market) is simply a mechanism through
which transactions can be made between one
country’s currency and another country’s currency.
• Forex Market is a meeting place where bankers
businesspersons, tourists, investors and others
exchange one foreign currency for another.
• The Participants in this market includes banks,
governments and speculator as well as individuals and
firms conducting transactions.
 Exchange Rates
• The Price of one currency in terms of another is
called the exchange rate
• There are two methods of expressing it.
– Domestic currency units per unit of foreign currency
– Foreign currency unit per unit of the domestic currency
e.g. Rs. 1=$0.0103305
or
$1=Rs. 96.8003
 Bid, Ask and Spread
• The foreign exchange traders always quote a
bid(buy) and Ask/offer (sell) rates.
• Spread: In the spot market, the spread is the
difference between the bid and offer rates and
is the margin on which the trader earns a
profit on the transaction.
Reading a Quote and Determining exchange
rates
When a currency is quoted, it is done in relation to
another currency, so that the value of one is reflected
through the value of another. Therefore, if you are
trying to determine the exchange rate between the
Currency Pair of U.S. dollar (USD) and the Japanese
yen (JPY), the forex quote would look like this:
USD/JPY = 119.50 
Base Currency VS Quoted Currency
This is referred to as a currency pair. The currency to the left of the slash
is the base currency, while the currency on the right is called the quote or
counter currency.

USD/JPY = 119.50 

The base currency (in this case, the U.S. dollar) is always equal to one unit
(in this case, US$1), and the quoted currency (in this case, the Japanese
yen) is what that one base unit is equivalent to in the other currency. The
quote means that US$1 = 119.50 Japanese yen. In other words, US$1 can
buy 119.50 Japanese yen.
 Quoting Currency Pairs
• There are two ways to quote a currency pair:
– Direct quote
– Indirect quote
 Direct VS. Indirect
• A direct currency quote is simply a currency pair in which the domestic
currency is the base currency;
• while an indirect quote, is a currency pair where the domestic currency is the
quoted currency.
• So if you were looking at the Canadian dollar as the domestic currency and
U.S. dollar as the foreign currency, a direct quote would be
CAD/USD,
• while an indirect quote would be
USD/CAD.
The direct quote varies the foreign currency, and the domestic currency, remains
fixed at one unit. In the indirect quote, on the other hand, the domestic currency
is variable and the foreign currency is fixed at one unit. 
 One Example
• For example, if Canada is the domestic
currency, a direct quote would be 0.85
CAD/USD, which means with C$1, you can
purchase US$0.85. The indirect quote for this
would be the inverse (1/0.85), which is 1.18
USD/CAD and means that USD$1 will purchase
C$1.18.
 US Dollar
• In the forex market, most currencies are
traded against the U.S. dollar, and the U.S.
dollar is frequently the base currency in the
currency pair. In these cases, it is called a
direct quote. This would apply to the above
USD/JPY currency pair, which indicates that
US$1 is equal to 119.50 Japanese yen. 
Not all currencies have Dollar Base
However, not all currencies have the U.S. dollar as the base
currency. The Queen's currencies - those currencies that
historically have had a tie with Britain, such as the British
pound, Australian Dollar and New Zealand dollar - are all
quoted as the base currency against the U.S. dollar. The euro,
which is relatively new, is quoted the same way as well. In
these cases, the U.S. dollar is the counter currency, and the
exchange rate is referred to as an indirect quote. This is why
the EUR/USD quote is given as 1.25, for example, because it
means that one euro is the equivalent of 1.25 U.S. dollars. 
 Cross Currency 
• When a currency quote is given without the U.S. dollar as
one of its components, this is called a cross currency.
• The most common cross currency pairs are the
EUR/GBP, EUR/Mex PESO and EUR/JPY
• These currency pairs expand the trading possibilities in the
forex market, but it is important to note that they do not
have as much of a following (for example, not as actively
traded) as pairs that include the U.S. dollar, which also are
called the majors.
 Determinants of Exchange Rate
• In such countries, which have adopted floating
currencies, simple economics of supply and
demand largely determine exchange rates.
This rate is called the market clearing rate or
Market equilibrium rate.
• Any price other than the equilibrium rate is
not sustainable
 For Example
For example at a rate of USD 0.500 per AUD the quantity of AUD
demand is 80 Billion, but the quantity supplied is only 60 Billion.
There is an excess demand for AUD. Dealers would not be able
to meet the demand of their clients. Clients would have to
instruct their dealers to offer a higher price. The effect of the
higher price is two-folded. First, as the price of the AUS is bid up
the supply would increase. The second effect is that some who
demanded the AUS at USD 0.500 would withdraw from the
market as the price rises. The overall effect is a reduced excess
demand. The price would continue to bid up to a rate of USD
0.5123, at which point there is no pressure for the price to
change further.
 Types of Exchange Rates
• There are two types of exchange rates,
depending on the timing of actual exchange of
the money

– Spot Exchange Rates

– Forward Exchange Rates
 Spot Exchange Rates

• A spot transaction is the purchase of foreign

exchange with delivery and payment (Referred
to as settlement) to be completed, normally
on the second following business day.
• The price at which one currency trades for
another in a spot transaction is called the spot
foreign exchange rate or more frequently,
simply the spot rate.
 Forward Exchange Rates
• A forward rate or forward exchange rate is the price
agreed on today for purchase or sale of foreign
exchange at a future date.
• Such a transaction is called a forward transaction and it
provides for the transfer(settlement) on a designated
future date of a specified amount of another currency.
• The forward exchange rate is agreed on at the time the
contract is made, but payment and delivery are not
required until maturity. Forward exchange rates are
usually agreed for less than one year.
Participants of Spot and Forward Markets

• Arbitrageurs
• Traders
• Hedgers
 Arbitrageurs

• Those persons or institutions which are doing

Arbitrage.

Arbitrage: Arbitrage involves buying a currency

in one market and selling it in another.
Such activity tend to keep the exchange rates
uniform in the various markets.
 One Example
• Suppose that the exchange rates (after taking
out the fees for making the exchange) in
London are £5 = $10 = ¥1000 and the
exchange rates in Tokyo are ¥1000 = $12 = £6.
Converting ¥1000 to $12 in Tokyo and
converting that $12 into ¥1200 in London, for
a profit of ¥200, would be arbitrage.
 Hedging
• Hedging involves entering into a contract at
the present time to buy or sell foreign
exchange at a specified price on a given future
date in order to offset an existing foreign
currency position in another market
Foreign Currency
Future Market
and
Option Market
 Option Market
• An option gives the holder the right to buy or
to sell a set amount of currency at a specified
price by some future date.
• Differences to the forward market which
entails a contractual obligation to buy or sell.
• The option buyer pays a premium for the
option.
 Future Market
• The currency futures market is conceptually similar to the
forward market.
• It employs standardized contracts for a given delivery date.
• However the minimum transactions sizes are considerably
smaller on the futures market, typically well below $
100,000/- compared to $ 1 Million or more in forward
market.
• Future market therefore allow relatively small firms
engaged in international trade to lock in exchange rates
and lower their risk.
 Hedge Funds
• A hedge funds is an investment fund that not
only buys financial assets (Such as stocks,
bonds, and currencies) but also sells them
short.
• Short selling occurs when an investor places a
speculative bet that the value of a financial
asset will decline and profits from that
decline.
 Speculators
• Speculator is simply a participant in the
foreign exchange market that takes an open
position (The speculator buys foreign currency
without simultaneously contracting to sell it,
or sells foreign exchange without possessing
the currency to meet the obligation)
• Such short or long positions may change
before3 the position is eliminated
 Law of One Price
• The law of one price states that in competitive
markets free of transportation costs and trade
barriers, identical products sold in different
countries must sell for the same price (When
their price is expressed in terms of the same
currency.
 What is IMS
• International Monetary System is the
framework within which countries borrow,
lend, buy, sell and make payments across
political frontiers.
• IMS provides the institutional setting, the
instruments and the rules and procedures
within which the foreign exchange markets
operate.
Although nations never willing to transfer to an
international agency their sovereign right to
issue currency and to control their monetary
system. They do however, recognize the mutual
need for maintaining a workable system of
international payments and have entered into
various cooperative arrangements.
Fixed Exchanged
Rate System
 The Gold Standard
• Prior to world war I the international monetary
system was based on the gold standard.
• Under the gold standard, national currencies were
linked to gold at a fixed parity; that is each nation
defined its currency unit as equal to the value of a
certain weight of pure gold. The US dollar, for
example, was defined as containing 23.22 grams of
fine gold and the price of an ounce of gold was US
$20.67. At this price US govt. freely bought and sold
gold
• In this way deficit or surpluses in a nations' external
account gave rise to gold movements that in turn
were supposed to trigger an automatic adjustment
process. A continuing surplus in one country would
increase that country’s gold stock (Money supply)
that provoking a general price rise. This price rise
would result in falling exports and rising imports until
the surplus disappeared.
• In the case of persistent deficit, the money supply
would diminish, causing the reserve phenomenon.
 How gold Standard ended
• The great depression of the 1930’s and the outbreak
of world war II in late 1939 deferred any new efforts
to re-establish a more orderly international
monetary system. Trying to spur exports and
domestic employments, a number of countries
started regularly devaluing their currencies, with the
end result that people lost confidence in the system
and started to demand gold for their currency. This
put pressure on countries gold reserves and forced
them to suspend gold convertibility
 Gold Exchange Standard (1944-1973)
• The depression of 1929 eventually ended the gold
standard. It was replaced by the gold exchange
standard in the Bretton woods agreement of
1944. the gold exchange standard involved the
united states pegging the dollar to gold and the
other countries pegging their currencies to the
dollar. In this agreement the price of gold was
fixed at $35 per ounce and the united states
promised to exchange dollar for gold at this price .
• Other countries promised to exchange their currencies
for dollars at an official, fixed exchange rate.
• The countries that pegged their exchange rates to the
dollar were obliged to keep the market rate within 1%
of the official parity rate.
• Maintaining the market rate within plus or minus 1% of
official parity required the central banks to intervene in
the foreign exchange markets by buying and selling
domestic currency of dollars whenever market forces
started to push the rate outside the permitted range.
 One Example
• Suppose that the official parity rate for the
French franc is 5 FF for $1. The permitted
range would be between 5.05FF, this signals
an excess supply of francs and the central
bank has to buy francs with its dollar reserves.
If the market tends to push the rate lower
than 4.95bFF, this signals an excess demand
for francs and the central bank has to sell
francs and buy dollars.
 The Bretton Woods System
• The initial talk on reconstructing a postwar international
monetary system started between the United States and
United Kingdom as early as 1941. The lead negotiators
were Harry Dexter for the USA and John Keynes for the
British. Given the US economic and political dominance at
the end of the war, it is not surprising that the eventual
system reflected more the US proposals.
• This system that emerged was ratified at an international
monetary conference held at
Bretton Woods, New Hampshire, attended by some 44
countries
 Features of the System
• A fixed but adjustable exchange rate
• Setting up of two new international
organizations IMF and IBRD (International Bank
for Reconstruction and Development)
commonly known as World Bank
• All participating countries agreed to try to
maintain the value of their currencies within 1%
above or below the official parity by selling
foreign exchange or gold as necessary.
 Why Bretton woods System
Broke –Down ?
• The formal demise of the fixed exchange rate system
occurred in 1973 but the breakdown of the system
began much earlier.
• The Gold Exchange Standard worked fairly well until
the 1960’s when the US and the UK began running
consistent balance of payments and budget deficits.
• Under the President Johnson, the US financed huge
increase in welfare programs and the Vietnam war
by increasing it money supply.
• Speculations the dollar would have to be devalued
relative to most other currencies, as well as
underlying economics and some forceful threats
by the US forced other countries to increase the
Value of their currency relative to the dollar.
• Bretton Wood system was based on the US Dollar
and when the US began to print money, run high
deficit and inflation the system was strained to the
breaking down.
THE Floating Exchange Rate
 Clean Float Vs. Dirty Float
• Clean Float/Flexible Float: If Govt. Policy lets the
market determine the exchange rate, the rate is free to
go wherever the market equilibrium is at that time.
This policy choice results in a pure or Clean Float.
• Market supply and demand are solely private activities.
• Dirty Float/Managed Float: An exchange rate that s
generally floating but with the govt. willing to
intervene to attempt to influence the market rate is
called a Managed Float. You can call it managed if your
optimistic and Dirty if you are pessimistic on Govt.
 The System
• The compromised international monetary regime that
emerged in the late 1970s was a mixture of fixed and
floating rates called a managed float.
• Following two consecutive devaluations of the US $ in
1973 foreign exchange markets closed for several
weeks due to chaotic conditions.
• When reopened, the gold exchange standard was at an
end.
• 1976 an accord called the Jamaica Agreement altered
the IMF character to allow for floating exchange rates.
• It means no limitation are set on each member
country decision either to fix its currency value
relative to some other currency or to allow it
to fluctuate as supply and demand dictate.
• The Jamaica agreement called for floating
exchange rate the end of gold as reserve asset
and more funds in the IMF to help countries
overcome short-term problems.
 Fixed
Vs.
Floating Exchange Rates
 Case for Floating Exchange Rate
• Strong arguments in favor of floating exchange rates
include:
– Countries ability to use independent monetary policy and
exchange rate changes to adjust internal and external
imbalances
– The country’s ability to pursue goals and policies that
meet its own domestic needs (e.g. Acceptable inflation
rate)
– The difficulty of defending fixed rates against speculative
attacks, given the large and growing amounts of financial
capital that can move quickly between countries.
 Case for Fixed Exchange Rates
• The case for a fixed exchange rate regime
claims that:
– Need to maintain fixed exchange rate imposes
monetary discipline on a country
– Avoid speculative pressure
– Provide more stability to international trade
– Promote more stable prices, far from correcting
trade imbalances, depreciating a currency on the
foreign exchange market tends to cause inflation
 Pegged Exchange Rates
• Under a pegged exchange rate regime a country
will peg the value of its currency to that of
another major currency (e.g. US Dollar, Euro)
• Simple pegging is on the Fixed Exchange Rate
• Pegging has two types:
• Adjustable Pegs
• Crawling Peg
 Adjustable Peg
• It becomes sometimes impossible for the
Govt. to remain the peg on the Fixed rate due
to substantial or fundamental disequilibrium
in the country’s international position, The
Govt. may change the pegged rate.
• This approach is called the Adjustable peg.
 Crawling Peg
• The crawling peg is an automatic system for
revising the exchange rate. It involves
establishing a par value around which the rate
can vary up to a given percent. The par value
is revised regularly according to a formula
determined by the authorities.
• Once the par value is set the central bank
intervenes whenever the market value
approaches a limit point.
 Currency Board
• Currency board is a monetary authority that holds only
international reserve assets. A country that introduces a
currency board commits itself to converting its domestic
currency on demand into another currency at a fixed
exchanged rate
• To make this commitment credible, the currency board
holds reserves of foreign currency equal at the fixed
exchange rate to at least 100% of the domestic currency
issued
• Argentina between 1991-2001 and Hong Kong are the
best-known currency boards
 Dollarization
• Dollarization involves completely replacing the
local currency with a foreign currency ( e.g. US
Dollar)
• Monetary conditions are almost completely
controlled by the foreign central bank ( For
instance the US Federal Reserve)