B.

Vocabulary
1. What is foreign exchange?
 It is money or currency of foreign country
2. Explain how the gold standard represented the beginning of a foreign exchange
system.
 The value of currencies could, on request of the owner (holder), be converted in to
gold at a country’s central bank.
 As all currencies had a gold value, they also had a certain value in relation to each
other.
3. Name six functions of a country’s central bank. Who owns it?
 Implementing monetary policy
 Controlling the nation's entire money supply
 The Government's banker and the bankers' bank ("lender of last resort")
 Managing the country's foreign exchange and gold reserves and the Government's
stock register
 Regulating and supervising the banking industry
 Setting the official interest rate - used to manage both inflation and the country's
exchange rate - and ensuring that this rate takes effect via a variety of policy
mechanisms
 Owned by government
4. Under a floating exchange rate system, what normally determined the value of
currencies?
 Value is normally determined by supply and demand.
5. Under what circumstances is an exchange rate system fixed?
 A currency's value is matched to the value of another single currency or to a
basket of other currencies, or to another measure of value, such as gold.
6. What is a spot transaction? When does delivery take place?
 Currency bought or sold today with delivery two business days later.
7. On the forward transaction, when is the payment made? When is the delivery of
funds made?
 Payment and delivery at that future date.
8. Define hedging.
 To offset a “buy” contract with a “sell” contract and vice versa, matching the
amounts and the time span exactly.
9. What does premium mean? How is it determined? What is the opposite of premium?
 The additional amount it will cost to buy or sell a currency at a given future date
 Relative to the spot or today’s price
 Opposite: Discount
10. What is involved in arbitraging? How many markets are entered?
 The transfer of funds from one currency to another to benefit from currency
differentials or disparities in interest rates.
 In arbitraging, at least two market are entered.

B. Reading
FOREIGN EXCHANGE TRADING

Without foreign exchange trading, international trade itself could not exist. In former
times trade was based on bartering - goods were exchanged for other goods. The
introduction of precious metals (i.e., gold and silver) to pay for goods can be considered
the forerunner of the foreign exchange market.
The Greeks and Romans commonly used gold as a medium of exchange. Most world
trade continued to be based on gold until the nineteenth century. By then industrialization
in Western Europe and the United States had boosted world trade to such an extent that
gold reserves were no longer adequate to meet the requirements. Governments introduced
a par value of their respective local currencies in gold. Thus, the currencies were related
to one another through a system called the gold standard. The United States joined this
system in 1879. The gold standard system determined the value of all currencies based on
gold. This meant the values of different currencies could be compared in terms of one
another.
The system worked well until World War I, when trade was interrupted. After the
war, currencies fluctuated widely in terms of gold and, thus, in relation to each other. The
value of currencies was meant to be regulated by supply and demand (the market
mechanism), buy speculators often interfered with this mechanism. So in an effort to
create more stable exchange markets, some countries, notably the United States, England,
and France, returned to the gold standard. Except for a brief period in the early 1930s the
United States stayed on the gold standard. By 1971 it was the only country whose
currency remained convertible into gold, and so, by declaring the dollar inconvertible, the
gold standard was finally abolished. The meant the holders of United States dollars could
no longer exchange their dollars for gold at par value.
In 1944 toward the end of World War II, the Western industrialized nations realized
that foreign trade would be necessary to quickly and effectively heal the wounds of war.
To create a calm and stable foreign exchange market, the United States government
called for a conference in the summer of 1944. It was held in Breton Woods, New
Hampshire. At this conference, both the International Monetary Fund (IMF) and the
International Bank for Reconstruction and Development were established.
The Breton Woods Agreement stipulated that all member countries would express the
value of their currencies in gold. However, only the United States dollar was convertible
into gold, at the price of $35 an ounce.
Central banks of the member countries were required to intervene in the foreign
exchange markets to keep the value of their currencies within 1 percent of the par value.
This intervention was achieved by actively buying or selling foreign exchange or gold. A
given currency could, therefore, never rise above nor fall below fixed points, which are
called intervention points. There are the prices beyond which the central bank intervenes.
This is called the system of fixed exchange rates.
The system of fixed exchange rated worked well until the late 1960s and early 1970s.
at that time a number of countries devalued their currencies. This meant that their
currencies were now worth less in terms of gold. England in 1967, France in 1969, and
the United States in 1971 and 1973, devalued their currencies. This caused an almost
unprecedented turbulence in the foreign exchange markets. In addition, countries such as
West Germany and Holland revalued their currencies (increased the par value of their
currencies in terms of gold). Intervention by central banks became very costly. Foreign
currency and gold reserves were drained. Countries had to buy their own currency with
gold and foreign exchange in order to keep its value above the minimum intervention
point, as agreed at Bretton Woods.
It is not surprising, then, that the world saw a return to a floating exchange rate
system. Central banks were no longer required to support their own currencies. England,
France (only temporarily), Italy, Japan, and the United States all floated their currencies.
Western Europe, united in the Common market, moved to preserve the fixed-rate system
but allowed a widening of the intervention points to within 2.25 percent of the par value
of the currencies. This system became known as the snake since these currencies move
up and down together against currencies outside the snake. The British and the Italians,
now members of the Common Market, are expected to eventually join their currencies to
the snake.
The foreign exchange market is the mechanism through which foreign currencies are
traded. It is not an actual marketplace but a system of telephone of telex communications
between banks, customers, and middlemen (foreign exchange brokers, acting for a client
vis-à-vis the bank).
Most banks have a special foreign exchange trading department, which consists of
foreign exchange dealers and an administrative staff. Customers trade with banks, banks
trade among themselves, and brokers often trade on behalf of banks or corporations.
Active participants in the foreign exchange market include tourists, investors, exporters
and importers, and governments, whose central banks intervened in the markets to
minimize fluctuations in the currencies.
The market consists of spot and forward transactions. When a French father transfers
money to his son in New York, a typical spot transaction occurs. The French father buys
the dollars spot – for immediate delivery – although business practice allows two days for
actual delivery. This permits sufficient time to consummate the transaction. The French
father, of course, pays for the dollars with his own currency, that is French francs.
A forward transaction means that delivery of a currency if specified to take place at a
future date. Japanese exporters of Toyota cars to the United States know from the sales
contracts that they will receive a specified United States dollar amount in six months. In
order to protect themselves against fluctuating exchange sales, they can sell the dollars
forward six months to their bank in Japan in return for yen. Payment and delivery are not
required until six months later. The rate of exchange is fixed, however, on the date of the
contract. Forward rates are usually quoted on a 30-, 90-, or 180-day basis, but major
currencies can have any maturity up to a year and sometimes longer.
Dealers, having concluded a forward contract, should always hedge with an offsetting
contract, so as not to leave the position open. For example, if they buy forward thirty
days, they should immediately sell forward thirty days for the same amount. Obviously,
traders try to realize a profit margin between the two transactions. If dealers do not
equalize their position, they are said to speculate. If they buy currency forward without
selling forward at the same time, this position is known as long; if they sell a currency
forward without buying forward at the same time, this is called short. Such behavior can
be disastrous if the exchange rates change rapidly. For instance, suppose that a French
company concludes a contract with an American importer, promising to deliver a certain
commodity in six months valued at 1,000,000 French francs. At the exchange rate of 22
cents for one franc, the French company expects to receive $220,000. If the franc rises to
the dollar rate of 23 cents within six months, and the French company does not sell
dollars forward, only 956,521.72 francs will be obtained. Since it cost 1,000,000 francs to
deliver the original commodities, the French company would lose 43,478.28 francs.
 Forward rates can be quoted either outright or in terms of a premium or discount on
the spot rate. The following table of British pounds on July 6, 1976, shows outright
quotations. A bid is the price dealers will pay to acquire pounds. An offer is the price
they will sell the pounds for.

July 6, 1976 Bid Offer

Spot $1.8020 $1.8030

One month forward $1.7895 $1.7915

Two months forward $1.7795 $1.7815

Three months forward $1.7695 $1.7715

Six months forward $1.7445 $1.7465

One year forward $1.7010 $1.7030

Arbitrage is the practice of transferring funds from one currency to another to benefit
from rate differentials. For instance, local supply and demand factors may result in a
dollar spot rate in London that differs from the rate in New York. If the spot rate is higher
in London, an arbitrage dealer would quickly buy dollars with pounds in New York and
sell the dollars in London for pounds. Such arbitraging makes sense only if transaction
costs (cable, paperwork, etc.) are covered and a small profit if realized. Opportunities to
realized big profits do not exist in this type of arbitraging, since communication systems
today make the price, and therefore profit opportunities, available to everyone.
Another form of arbitrage is interest arbitrage. If interest rates in England are 2
percent higher than in the United States money market, a United States investor would do
well to change United States dollars into pounds sterling and then invest the sterling at
the English interest rate. However, the exchange rate discount of sterling is 1 percent.
The investor will have to buy back dollars at a 1 percent premium, thus losing 1 percent.
Still, the investor makes an overall gain of 1 percent. Of course, such transactions can
only be realized in the absence of foreign exchange regulations, such as capital transfer
limitations, which are sometimes imposed by governments. Such restrictions serve to
protect country’s foreign exchange and gold reserves and, therefore, its balance of
payments.
The foreign exchange market is an extremely valuable mechanism for world trade. Its
main function is to reduce the risk of fluctuating exchange rates or of a change in the
parity of currencies (devaluation or revaluation).

Reading comprehension tasks

1. Name a payment mechanism used in earlier times. What was it later replaced by?
 In former times, trade was based on bartering – goods were exchanged for other
goods.
 The forerunner is precious metals (i.e., gold and silver).
 Later, it was replaced by gold standard.
2. Briefly describe the importance of the gold standard.
 Determining the value of all currencies based on gold.
3. Under the gold standard, currencies were convertible into gold. This convertibility
was abolished for most currencies. Which currency remained convertible into gold
until 1971?
 United States dollars.
4. What is the system of fixed exchange rates? Which conference agreed upon this
system?
 When central banks intervene in the foreign exchange markets at the intervention
points.
 Breton Wood Agreement.
5. What does devaluation mean? Name the countries in the Western industrialized
world that devalued their currencies between 1967 and 1973.
 Currencies were now worth less in terms of gold.
 England, France, and United States.
6. Name two countries that revalued their currencies in the early 1970s.
 West Germany and Holland.
7. Are intervention points applicable in a system of floating exchange rates? Explain
your answer.
 No.
 Central banks were no longer required to support their own currencies.
8. What is the snake? Why is it called the snake and which Common Market members
are outside it?
 The system preserves the fixed-rate system but allowed a widening of the
intervention points to within 2.25 percent of the par value of the currencies.
 This system became known as the snake since these currencies move up and down
together against currencies outside the snake.
 The British and the Italians.
9. Where and how does the foreign exchange market take place?
 It is not an actual marketplace but a system of telephone of telex communications
between banks, customers, and middlemen.
10. What is the function of a foreign exchange broker?
 Acting for a client vis-à-vis the bank.
11. Name at least five active participants in the foreign exchange market.
 Tourists, investors, exporters and importers, and governments.
12. Briefly describe spot and forward transactions. Give an example of each.
 Spot transaction in a transaction when currency is bought or sold today with
delivery two business days later.
 Eg: In New York, the French father buys the dollars spot – for immediate delivery
– although business practice allows two days for actual delivery.
 Forwarding Transaction means buying or selling a currency in the future with
payment and delivery at that future date.
 Eg: Japanese exports on Toyota cars to the US from the SC that they will receive a
specified US dollar amount in 6 months.
13. When does delivery of the foreign exchange take place in a spot transaction and
why?
 2 days later.
 A sufficient time to consummate the transaction.
14. When does payment and delivery of foreign exchange take place in a forward
transaction? At what point is the exchange rate determined?
 Couples of months later.
 On the date of the contract.
15. What causes an open position?
  A forward contract.
16. An open position is either long or short. Describe both types.
 If they buy currency forward without selling forward at the same time, this
position is known as long.
 If they sell a currency forward without buying forward at the same time, this is
called short.
17. What is the difference between a bid and an offer?
 A bid is the price dealers will pay to acquire pounds.
 An offer is the price they will sell the pounds for  selling price.
18. What is arbitrage? Is this usually a very profitable transaction for a bank?
 Arbitrage is the practice of transferring funds from one currency to another to
benefit from rate differentials.
 No.
 Such arbitraging makes sense only if transaction costs (cable, paperwork, etc.) are
covered and a small profit if realized. Opportunities to realized big profits do not
exist in this type of arbitraging, since communication systems today make the
price, and therefore profit opportunities, available to everyone.
19. Give an example of interest arbitrage. In which case is interest arbitrage not
possible?
 If interest rates in England are 2% higher than in the United States money market,
a United States investor would do well to change United States dollars into pounds
sterling and then invest the sterling at the English interest rate. However, the
exchange rate discount of sterling is 1%. The investor will have to buy back
dollars at a 1% premium, thus losing 1%. Still, the investor makes an overall gain
of 1%.
 When governments imposed capital transfer limitations.

D. Exercises
Exercise 1: Complete the following statements with the appropriate word or
phrase.
1. Bartering is based on the exchange of goods for goods.
2. The Bretton Woods Agreement stipulated that all members would express their
 currencies in gold.
3. When central banks intervene in the foreign exchange markets at the intervention
points, this is called the system of fixed exchange rates. The opposite is called the
system of floating exchange rates.
4. If dealers buy currencies forward but do not sell forward simultaneously, their
position is said to be speculation.
5. Dealers using two foreign exchange markets to benefit from rate differentials are said
to engage in arbitraging.

Exercise 2: There are some key dates in the development of exchange rate
systems around the world (1944, 1971, 1973, 1992, 2002). Match the dates with the
events:
1. Most industrialized countries switched to a system of floating rates. However,
governments and central banks occasionally attempted to influence exchange rates by
intervening in the markets. So, there was a system of managed floating exchange
rates.
 1973
2. The Bank of England lost over £5 billion in one day attempting to protect the value of
the pound sterling. After this, governments and central banks intervened much less, so
there was almost a freely floating system.
 1992
3. A fixed exchange rate system was started. The values of many major currencies were
pegged to the value of the US dollar. The American central bank, the Federal Reserve,
guaranteed that it could exchange an ounce of gold for $35.
 1944
4. Twelve states of the European Union introduced a single currency, the euro, to replace
their national currencies.
 2002
5. Gold convertibility ended because the Federal Reserve no longer had enough gold to
back to dollar, due to inflation.
 1971

Exercise 3: Matching
1 2 3 4 5 6
B D A C F E