Bretton woods system

A 1944 agreement made in Bretton Woods, New Hampshire, which helped to

establish a fixed exchange rate in terms of gold for major currencies. The
International Monetary Fund was also established at this time.

Nations attempted to revive the gold standard following World War I, but it
collapsed entirely during the Great Depression of the 1930s. Some economists said
adherence to the gold standard had prevented monetary authorities from expanding
the money supply rapidly enough to revive economic activity. In any event,
representatives of most of the world's leading nations met at Bretton Woods, New
Hampshire, in 1944 to create a new international monetary system. Because the
United States at the time accounted for over half of the world's manufacturing
capacity and held most of the world's gold, the leaders decided to tie world
currencies to the dollar, which, in turn, they agreed should be convertible into gold
at $35 per ounce.

Under the Bretton Woods system, central banks of countries other than the United
States were given the task of maintaining fixed exchange rates between their
currencies and the dollar. They did this by intervening in foreign exchange
markets. If a country's currency was too high relative to the dollar, its central bank
would sell its currency in exchange for dollars, driving down the value of its
currency. Conversely, if the value of a country's money was too low, the country
would buy its own currency, thereby driving up the price.

The Bretton Woods system lasted until 1971. By that time, inflation in the United
States and a growing American trade deficit were undermining the value of the
dollar. Americans urged Germany and Japan, both of which had favorable
payments balances, to appreciate their currencies. But those nations were reluctant
to take that step, since raising the value of their currencies would increases prices
for their goods and hurt their exports. Finally, the United States abandoned the
fixed value of the dollar and allowed it to "float" -- that is, to fluctuate against
other currencies. The dollar promptly fell. World leaders sought to revive the
Bretton Woods system with the so-called Smithsonian Agreement in 1971, but the
effort failed. By 1973, the United States and other nations agreed to allow
exchange rates to float.

Economists call the resulting system a "managed float regime," meaning that even
though exchange rates for most currencies float, central banks still intervene to
prevent sharp changes. As in 1971, countries with large trade surpluses often sell
their own currencies in an effort to prevent them from appreciating (and thereby
hurting exports). By the same token, countries with large deficits often buy their
own currencies in order to prevent depreciation , which raises domestic prices. But
there are limits to what can be accomplished through intervention, especially for
countries with large trade deficits. Eventually, a country that intervenes to support
its currency may deplete its international reserves, making it unable to continue
buttressing the currency and potentially leaving it unable to meet its international
obligations.

Fixed exchange rate system

A country's exchange rate regime under which the government or central bank ties
the official exchange rate to another country's currency (or the price of gold).  The
purpose of a fixed exchange rate system is to maintain a country's currency
value within a very narrow band.  Also known as pegged exchange rate

Fixed rates provide greater certainty for exporters and importers. This also helps
the government maintain low inflation, which in the long run should keep interest
rates down and stimulate increased trade and investment. 

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
where external trade forms a large part of their GDP.

Advantages of fixed exchange rate system

1.First of all, fixed exchange rates offer much greater stability for the
enterprisers and stimulate international trade, since the exchange rates stay
on the same level, the importers and exporters can plan their policy without
begin afraid of depreciation or appreciation of the currency. Moreover, fixed
exchange rates make the producers more disciplined, i.e. they are forced to
keep up with the quality of their production and to control the costs of the
production to stay competitive compared to international enterprisers. This
advantage of fixed exchange rates allows the government to decrease
inflation level and stimulate international trade and economical growth in
the long period .
 2.Secondly, it is believed that fixed exchange rates stimulate the reduction of
speculative activity worldwide,but this statement is true under the condition
that the adopted exchange rates are profitable for the foreign dealers as well
as for domestic ones (closer examination of this condition shows us that
monetary and fiscal policies attempting to protect domestic producers –
which are often required to preserve economical stability – violate this
condition and therefore create the ground for speculative intervention).

Disadvantages of fixed exchange rate system

1.The main disadvantage of it is the high vulnerability of the economical
system to speculative attacks. Any economy experiences excess supply and
demand in either national or foreign currency: and if the national banks are
unable to cover the gap between the existing resources and demand, the
fixed rate needs to be changed,this situation reduces the positive effects of
the fixed rate exchange system and decreases the credibility of the currency

2.One more disadvantage of this system is that if the government artificially

supports the exchange rate, which is not adjusted to changed economical
condition, the development of the country’s economy is not as efficient as it
could be if the rate was adjusted to the situation. Moreover, interest rates,
which directly depend on the exchange rate, can stop possible economical
growth in case of their disparity to market needs.
In the conditions when the national currency is tied to some international
currency, there exists very significant dependence of the condition of these
countries’ economical stability. In this case the government is actually
forced to solve the economical problems of the countries, with currency of
which it is linked. This situation creates the possibility for dominating
countries to improve the state of their economy at the expense of related
countries with weaker economies and at the same time destabilizes the
market situation in these related countries.
taking into consideration the growing economical and political integration,
the strengthening of the economical connection between countries, the fast
development of world trade and economical specialization, the advantages
of fixed interest rates do not cover the losses caused by the restrictions
imposed by this system.

Floating exchange rate

A country's exchange rate regime where its currency is set by the foreign-exchange
market through supply and demand for that particular currency relative to other
currencies. Thus, floating exchange rates change freely and are determined by
trading in the forex market. This is in contrast to a "fixed exchange rate" regime.

Arguments in Favour of a Floating Exchange Rate

 Automatic balance of payments adjustment - Any balance of payments

disequilibrium will tend to be rectified by a change in the exchange rate. For
example, if a country has a balance of payments deficit then the currency
should depreciate. This is because imports will be greater than exports
meaning the supply of sterling on the foreign exchanges will be increasing
as importers sell pounds to pay for the imports. This will drive the value of
the pound down. The effect of the depreciation should be to make your
exports cheaper and imports more expensive, thus increasing demand for
your goods abroad and reducing demand for foreign goods in your own
country, therefore dealing with the balance of payments problem.
Conversely, a balance of payments surplus should be eliminated by an
appreciation of the currency.
 Freeing internal policy - With a floating exchange rate, balance of
payments disequilibrium should be rectified by a change in the external price
of the currency. However, with a fixed rate, curing a deficit could involve a
general deflationary policy resulting in unpleasant consequences for the
whole economy such as unemployment. The floating rate allows
governments freedom to pursue their own internal policy objectives such as
growth and full employment without external constraints.
 Absence of crises - Fixed rates are often characterised by crises as pressure
mounts on a currency to devalue or revalue. The fact that, with a floating
rate, such changes are automatic should remove the element of crisis from
international relations.
 Flexibility - Post-1973 there were great changes in the pattern of world trade
as well as a major change in world economics as a result of the OPEC oil
shock. A fixed exchange rate would have caused major problems at this time
as some countries would be uncompetitive given their inflation rate. The
floating rate allows a country to re-adjust more flexibly to external shocks.
 Lower foreign exchange reserves - A country with a fixed rate usually has
to hold large amounts of foreign currency in order to prepare for a time
when they have to defend that fixed rate. These reserves have an opportunity
cost.

Disadvantages of the Floating Rate

  Uncertainty - The fact that a currency changes in value from day to day
introduces instability or uncertainty into trade. Sellers may be unsure of how
much money they will receive when they sell abroad or what their price
actually is abroad. Of course the rate changing will affect price and thus
sales. In a similar way importers never know how much it is going to cost
them to import a given amount of foreign goods. This uncertainty can be
reduced by hedging the foreign exchange risk on the forward market.
 Lack of investment - The uncertainty can lead to a lack of investment
internally as well as from abroad.
 Speculation - Speculation will tend to be an inherent part of a floating
system and it can be damaging and destabilising for the economy, as the
speculative flows may often differ from the underlying pattern of trade
flows.
 Lack of discipline in economic management - As inflation is not punished
there is a danger that governments will follow inflationary economic policies
that then lead to a level of inflation that can cause problems for the
economy. The presence of an inflation target should help overcome this.
 Does a floating rate automatically remedy a deficit? - UK experience
indicates that a floating exchange rate probably does not automatically cure
a balance of payments deficit. Much depends on the price elasticity of
demand for imports and exports.
 Inflation - The floating exchange rate can be inflationary. Apart from not
punishing inflationary economies, which, in itself, encourages inflation, the
float can cause inflation by allowing import prices to rise as the exchange
rate fall.

Law of one price

The Law of One Price says that identical goods should sell for the same price in
two separate markets. This assumes no transportation costs and no differential
taxes applied in the two markets.

Economists generally assume that the law of one price can be applied in liquid
financial markets because of the possibility of arbitrage. Unlike in international
trade, where it takes time and effort to move goods physically from one place to
another, there are very little barriers in global financial markets.
What makes the law of one price work?

For example, an ounce of gold should cost the same on commodity exchanges in
Chicago and London. If the gold costs more on one exchange, then traders would
have incentive to purchase the gold on one exchange and sell it at the other one.
They would do what is called an arbitrage.

An arbitrage is a trading strategy that requires the investment of no capital, with no

risk of capital loss, and where there is some positive probability of making money.
Traders with gold would know how much they pay at one exchange and receive at
the other one. They could borrow money to realize immediate beforehand known
profit. They would realize arbitrage risk free profit.

This law does not always hold in practice. The reason is mostly transaction costs
and trade barriers. There may be limits on how much gold one can export or
import out of the country. It costs something to buy gold in Chicago and have it
shipped to London.

The law of one price in financial markets

The law of one price is an economic rule saying that a security must have a single
price in an efficient market regardless of how that security is created.

For example, if a financial instrument or a position can be created using two

different sets of underlying securities, then the aggregate price for each would be
the same or else an arbitrage opportunity would exist. Let's show this using an
example.

The purchase of a Put option while owning shares in XYZ company is a strategy
with a limited loss and (after subtracting the Put premium) unlimited profit. Profit
potential is unlimited. Losses limited as long as the Put option is owned. The
payoff of this strategy is the same like the payoff of a Long Call option position

Creating either of the position must cost the same. If one position yielded profit,
the law of one price would not hold because arbitrageurs would trade both position
until they would return to their equilibriums.

The law of one price and purchasing power parity

The purchasing power parity theory is an aggregate application of the law of one
price.
If the law of one price says that identical goods should sell for identical prices in
different markets, then the law should apply to all identical goods sold in both
markets.

In other words, if the law of one price holds for each individual item in the market
basket, then it should hold for the market baskets as well.

Purchasing Power Parity

An economic theory that estimates the amount of adjustment needed on the
exchange rate between countries in order for the exchange to be equivalent to each
currency's purchasing power.

The relative version of PPP is calculated as:

Where:
"S" represents exchange rate of currency 1 to currency 2 
"P1" represents the cost of good "x" in currency 1
"P2" represents the cost of good "x" in currency 2

In other words, the exchange rate adjusts so that an identical good in two different
countries has the same price when expressed in the same currency. 

For example, a chocolate bar that sells for C$1.50 in a Canadian city should

cost US$1.00 in a U.S. city when the exchange rate between Canada and the U.S.
is 1.50 USD/CDN. (Both chocolate bars cost US$1.00.)

Purchasing power parity (PPP) is a theory which states that exchange rates between
currencies are in equilibrium when their purchasing power is the same in each of the
two countries. This means that the exchange rate between two countries should equal
the ratio of the two countries' price level of a fixed basket of goods and services.
When a country's domestic price level is increasing (i.e., a country experiences
inflation), that country's exchange rate must depreciated in order to return to PPP.
The basis for PPP is the "law of one price". In the absence of transportation and other
transaction costs, competitive markets will equalize the price of an identical good in
two countries when the prices are expressed in the same currency.
For example, a particular TV set that sells for 750 Canadian Dollars [CAD] in
Vancouver should cost 500 US Dollars [USD] in Seattle when the exchange rate
between Canada and the US is 1.50 CAD/USD. If the price of the TV in Vancouver
was only 700 CAD, consumers in Seattle would prefer buying the TV set in
Vancouver. If this process (called "arbitrage") is carried out at a large scale, the US
consumers buying Canadian goods will bid up the value of the Canadian Dollar, thus
making Canadian goods more costly to them. This process continues until the goods
have again the same price. There are three caveats with this law of one price. (1) As
mentioned above, transportation costs, barriers to trade, and other transaction costs,
can be significant. (2) There must be competitive markets for the goods and services
in both countries. (3) The law of one price only applies to tradeable goods; immobile
goods such as houses, and many services that are local, are of course not traded
between countries.
Economists use two versions of Purchasing Power Parity: absolute PPP and relative
PPP. Absolute PPP was described in the previous paragraph; it refers to the
equalization of price levels across countries. Put formally, the exchange rate between
Canada and the United States ECAD/USD is equal to the price level in Canada PCAN
divided by the price level in the United States PUSA. Assume that the price level ratio
PCAD/PUSD implies a PPP exchange rate of 1.3 CAD per 1 USD. If today's exchange
rate ECAD/USD is 1.5 CAD per 1 USD, PPP theory implies that the CAD will appreciate
(get stronger) against the USD, and the USD will in turn depreciate (get weaker)
against the CAD.
Relative PPP refers to rates of changes of price levels, that is, inflation rates. This
proposition states that the rate of appreciation of a currency is equal to the difference
in inflation rates between the foreign and the home country. For example, if Canada
has an inflation rate of 1% and the US has an inflation rate of 3%, the US Dollar will
depreciate against the Canadian Dollar by 2% per year. This proposition holds well
empirically especially when the inflation differences are large.
 
Does PPP determine exchange rates in the short term?
 
No. Exchange rate movements in the short term are news-driven. Announcements
about interest rate changes, changes in perception of the growth path of economies
and the like are all factors that drive exchange rates in the short run. PPP, by
comparison, describes the long run behaviour of exchange rates. The economic
forces behind PPP will eventually equalize the purchasing power of currencies. This
can take many years, however. A time horizon of 4-10 years would be typical.
 
How is PPP calculated?
 
The simplest way to calculate purchasing power parity between two countries is to
compare the price of a "standard" good that is in fact identical across countries.
Every year The Economist magazine publishes a light-hearted version of PPP: its
"Hamburger Index" that compares the price of a McDonald's hamburger around
the world. More sophisticated versions of PPP look at a large number of goods and
services. One of the key problems is that people in different countries consumer
very different sets of goods and services, making it difficult to compare the
purchasing power between countries.

Foreign exchange market

The foreign exchange market (forex, FX, or currency market) is a worldwide
decentralized over-the-counter financial market for the trading of currencies.

The primary purpose of the foreign exchange market is to assist international trade
and investment, by allowing businesses to convert one currency to another
currency. For example, it permits a US business to import British goods and pay
Pound Sterling, even though the business's income is in US dollars. It also
supports speculation, and facilitates the carry trade, in which investors borrow
low-yielding currencies and lend (invest in) high-yielding currencies, and which (it
has been claimed) may lead to loss of competitiveness in some countries

In a typical foreign exchange transaction, a party purchases a quantity of one

currency by paying a quantity of another currency. The modern foreign exchange
market began forming during the 1970s 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

 its huge trading volume, leading to high liquidity

 its geographical dispersion;
 its continuous operation: 24 hours a day except weekends
 the variety of factors that affect exchange rates
 the low margins of relative profit compared with other markets of fixed
income
  the use of leverage to enhance profit margins with respect to account size.

Corporate treasury
Corporate treasury manages a company’s cash flows in the most efficient and
profitable fashion possible. It also involves forecasting future needs for funding
and seeking the best alternatives for obtaining it.

Promissory notes
A written, dated and signed two-party instrument containing an unconditional promise by
the maker to pay a definite sum of money to a payee on demand or at a specified future
date

Government securities
Government securities(G-secs) are sovereign securities which are issued by the
Reserve Bank of India on behalf of Government of India,in lieu of the Central
Government's market borrowing programme.

The term Government Securities includes:

Central Government Securities.

State Government Securities
Treasury bills
The Central Government borrows funds to finance its 'fiscal deficit'.The market
borrowing of the Central Government is raised through the issue of dated
securities and 364 days treasury bills either by auction or by floatation of loans.

Credit instruments
A promissory note or written evidence of a debtor's obligation. A credit instrument
is a term used in the banking and finance world to describe any item agreed upon
that can be used as currency. Banks issue credit instruments, in the form of credit
cards
Customers, in turn, use these credit instruments to make purchases 'on credit' and
pay the amount 'borrowed' back to the bank either at the end of the month, quarter,
or whatever term has been agreed upon.

Any item can serve as a credit instrument, so long as both parties (the borrower
and the lender) have agreed on the use of that instrument. The instrument is
basically a promise by the debtor that he/she will pay back the debtor.

A simpler example of a credit instrument is the cheque. When one person gives
another a cheque, he/she is basically saying that this piece of paper proves I owe
you a certain amount of cash, and if you take it the bank, they will gladly pay you
on my behalf. Even simpler than the cheque is the promissory note, which is also
very similar in nature.

Credit instruments are ever popular due to their convenience by not having you
carry around piles of cash everywhere you go.

Zero based budgeting

A method of budgeting in which all expenses must be justified for each new
period. Zero-based budgeting starts from a "zero base" and every function within
an organization is analyzed for its needs and costs. Budgets are then built around
what is needed for the upcoming period, regardless of whether the budget is higher
or lower than the previous one.

.  

Wealth maximization
Wealth maximization has been accepted by the finance managers, because it overcomes the
limitations of profit maximization. Wealth maximization means maximizing the net wealth of
the company’s share holders. Wealth maximization is possible only when the company pursues
policies that would increase the market value of shares of the company.