Currencies of the world
Currencies of the world
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Inside the lid, there is a Chinese character written below. Cowries were used as money during the Shang dynasty (1600 - 1046 BC) |
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Until recently, this market was used mostly by banks, who fully appreciated the excellent opportunities to increase their profits. Today, it is accessible to any investor enabling him to diversify his portfolio.
The emergence of Yen as a major currency, and new Euro, in addition to the Dollar beside many other currencies, and the frequent fluctuations in relative value of these currencies provide a great opportunity to generate substantial profits. Chinese Renminbi is convertible on current account, but not on capital account. When it becomes fully convertible, which is not likely to occur until 2020 or later, it will fundamentally affect the foreign exchange market due to its sheer volume.
The foreign exchange market operates 24 hours a day permitting intervention in the major international foreign exchange markets at any point in time.
Average daily transactions in 1998 was over $2.5 trillion. $637B (London), $351B (New York), $149B (Tokyo).
Before the single currency euro was launched in 2002, the composition of foreign currency transactions in the New York market in 1985 was as follows: Mark 32%, Pound 23%, Canada $ 12%, Yen 10%, Swiss Franc 10%, others 13%.
The introduction of euro in 2002 dramatically changed the composition of these foreign currencies as most of European currencies were no longer circulated. The foreign exchange markets were handling over $450 billion per day through New York, London and Frankfurt. (most market economies have less GNP). Today it is estimated to be more than $5T a day.
The selling price refers to the price at which a large customer could have bought the currency from the dealers. The buying price at which one could have sold foreign currency to the dealers is normally 0.1% below the selling price, which represents the commission of FE dealers or banks. This is called interbank trading as it occurs usually between foreign exchange dealers in different banks in major financial centers. Obviously, the "retail" rates for corporate customers are less favorable than the "wholesale" rates.
This spread can be higher in foreign exchange markets other than New York/London, and also in exchange crisis, and in rarely traded currencies. Because the market participants know this customary spread, usually selling prices are published.
Transactions agreed on Monday will result in payments on Wednesday. Those agreed on Thursday will be available on Monday. Canadian/US dollar business is cleared in one day (because Toronto and New York are in the same time zone).
Some New York banks maintain 2 shifts (one arriving at office at 3 am when London and Frankfurt are open). Large New York banks also have branches in Tokyo, Frankfurt, and London. Thus, they are in contact with all financial centers 24 hours.
FE dealers typically maintain a trading room equipped with telephones and telex machines. They ususally communicate directly with the trading rooms of banks in other centers. They go through a broker when dealing with other banks in the same center. They are exposed to FE risks.
Videotape (June 4, 1985)
World Poker Championship: Cards are shown only to the viewers. Apparently, viewers cannot convey any message to the players. The winner's prize is over $2 million.
With sharp minds, the players can incorporate all the information on the displayed cards and calculate the probability of a desired card. In the case of poker, there are only 52 possible cards. Accordingly, bright individuals can compute the probabilities of winning of his own and competing players. These probabilities of winning are almost instantaneously computed for TV viewers. Since so many things can possibly affect the probability that a currency will rise against another, computer programs or formulas for the price of a given stock or currency to rise cannot be devised. Some investment companies will claim they have developed a certain formula or program to buy and sell currencies (or stocks), but they are doomed. If a particular method brings profits to the investor, more people will invest money into that formula, thereby driving the prices of currencies/stocks downward and raising the prices of those they are selling, eventually eliminating profits.
Instead of relying on a fixed formula, currency dealers can incorporate all the available information about the currency markets and other news on world events which affect the currency values.
Ronnie Schlaefer, Swiss, lives in New York
long term speculator (he holds foreign currencies even over night)
has a bunch of medical doctors who invests a minimum of $0.5
million.
13 rich investors, around the world 50% profit rate in 1984.
management fee = fixed.
performance fee = 20- 25% once a year.
made many mistakes of missing the moment to sell mark, but breaks even at the end of
the day
Richard Hill, 31 years old, works for London Barclay. gets
No commission.
The majority of traders are 20 - 35 years old.
Chris Pablo: boss. A sterling dealer, old. Traders must concentrate when working.
People get nervous. Traders earn fixed salary. No commission, but pushed aside
if when a big mistake is made.
Hill finds out that Russians (Moscow) are buying £ with mark, jumps on the bandwagon by buying £, thereby raising the price a little and then sells it later.
Hill bought and sold 750 million £ and profited π = $160,000 (£91,400) that day. (one day's interest at 1% is £20547). The rate of return is about 8% per year.
U: = you, pls = please
Barclay: 8 dealers, made $150 million profit, 1984
($.5 million a day) Today, their profits from foreign exchange transactions
would be over $1 million a day.
William Wong (works for Chemical bank, Hong Kong) sold £20 million, made ($20,000 morning) pounds he bought worth $30,000 less (from Richard Hill).
Salary = $40,000 + 3% commission.
When selling a large amount of FE, people notice it and price falls. To avoid it, William Wong requests the assistance of other dealers and sell £ simultaneously.
At the end of the day, he bought and sold 120 million £, with profit = $30,000 (£17,142), which is equivalent to one day's interest on the principal at 5.2 % per year.
They go short by selling FE if they expect a fall in the exchange rate,
sell FE if ESt+1 < St.
if F90 > ES90, then sell forward pound
if F90 < ES90, then buy forward pound.
Figure 1. Effects of speculation
Figure 2. Speculation and Currency Instability
President Nixon once tried to punish these specualtors by dumping gold, effectively raising the official price of gold, but eventually he gave up. On August 15, 1971, President Nixon announced:
In recent weeks, the speculators have been waging an all-out war on the American dollar. The strength of a nation's currency is based on the strength of that nation's economy-and the American economy is by far the strongest in the world. Accordingly, I have directed the Secretary of the Treasury to take the action necessary to defend the dollar against the speculators.
I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets,except in amounts and conditions determined to be in the interest of monetary stability and in the best interests of the United States.
Foward markets do not operate during periods of hyperinflation. Because inflation rates accelerate at an unknown rate, even speculators stay away from such currencies. Inflation rates differ amont countries due to differences in monetary and fiscal policies. Single currency in Europe means member countries cannot conduct their own monetary policies, i.e., they cannot increase money supply independently because it is the European Central Bank that controls the money supply. However, freedom is useful only when discretion is exercised. Just look at what happened to Germany after World War I.
(World War I, or the Great War, ended on November 11, 1918. The Versailles Treaty was signed on January 12, 1919 and Germany promised to pay war reparation payment of £6.6 billion.) The value of money can be totally undermined when the government prints so many pieces of paper currency. High inflation rate causes a capital flight. When the inflation rate was 6000% per year, it caused a dramatic capital flight. Workers converted their money into other stable currencies. As a result, stores refused to sell goods, and citizens looted many stores.
The infamous post-World War I inflation in Germany is a good example. In December 1919 there were about 50 billion marks in circulation in Germany. Exactly four years later, this figure expanded to 497 quintillion (497,000,000,000,000,000,000) marks. That is, the money supply increased 10 billion times.
From August 1922 to November 1923, inflation averaged 322 percent per month. Prices at the end of that German hyperinflation (i.e., particularly high inflation) were 10 billion times the original level. (Someone who lived through hyperinflation defined it as follows: hyperinflation is when it is cheaper to pay for your lunch before you start eating it than after you finish).
This sample of German banknotes during this period is from Trinity
Doubline College, Ireland.
In October 1923, the prices increased 100 times. In October 15, 1923, a monetary reform was announced, a new unit of currency called Rentenmark replaced the old currency Reichsmark. One unit of the new currency was set equal to 1 trillion units of the old currency. A new bank was established to take over the function of note issue.
Excerpt from a book (lost the source).
Porsche had received three luxury cars as partial compensation when he left Austro- Daimler. The three cars, called City Coaches, were elaborate creations. In front they offered open seats for the chauffeurs and passengers. Behind these were two more open seats with a movable cover in case of rain, and at the rear was a closed compartment for passengers for use in case of severe weather. The manufacturer boasted that the city Coach combined the best features of an open car, a convertible, and a limousine. Porsche approached a friend in Stuttgart, business executive Alfred Neubauer. He found a buyer in Backnang for one of these cars. He recalled later that Mr. Porsche was delighted with the price, which was in the millions of marks.
The car was delivered to the buyer. One week later the money reached Stuttgart. During that week, however, the pace of inflation had accelerated. Porsche had sold one of the grandest vehicles in the worldžbut by the time he got the money, it was just enough to pay for six rides on the local streetcar line.
The forward exchange market resembles the futures markets found in organized commodity markets, such as wheat and coffee. The primary function of forward market is to afford protection against the risk of fluctuations in exchange rates. Forward markets are most useful
If pound appreciates during the investment period, the foreign investors will reap additional gain in the change in the exchange rate. However, if pound depreciates, they will experience an exchange loss. The exchange loss may partially or more than offset the gain in the interest income.
To avoid this exchange loss, dollar investors want cover against the exchange loss by selling pound forward. The amount of forward pound to sell is equal to the purchase of spot pound plus the interest earned in London. This practice is called interest arbitrage. Interest arbitrage links the two national money markets and the forward market.
Assume: a US investor has A dollars to invest, either in New York or in London. The annual interests in the US and the UK are 8% and 12%, respectively. The quarterly interest rates in the US and UK are then 2% and 3%, respectively.
Do Nothing (Take Risk)
(1) Invest in New York for 90 days.
$1M(1 + .02) = $1.02M
(2) Invest in London
£t=0 = $1M/spot = $1M/1.5 = £666,667.
If St=90 = St=0, then investing overseas is better ($10,000 more return).
If St=90 = 1.65 (£ rose 10%), then
$10,000 (interest gain) + $103,000 (appreciation of £) = $113,000 (foreign investment is definitely better).
If St=90 = 1.35 (£ fell 10%), then
$10,000 (interest gain) - $103,000 (depreciation of £) = - $93,000.
Most investors would rather avoid this exchange risk.
How does one avoid this risk?
You may enter the forward exchange market. As long as the return from overseas investment is greater than the domestic return, one would sell forward pound (or whichever currency in question). Only when the forward transactions are made, the risk can be avoided. However, avoiding the foreign exchange risk may be too costly, in which case it is not profitable to avoid the risk.
If F = $1.47, then
St=90 = 686.667 x 1.47 < 1.02 million. You are worse off. Even if i* > i, do not invest in the UK. (That is, taking the foreign exchange risk is cheaper)
If F = $1.53, then
St=90 = 686.667 x 1.53 >1.02 million. You are better off. Invest in the UK. (In this case, forward transactions are profitable and eliminate the foreign exchange risk.)
Enter the Forward Exchange Market
(1) A(1 + i)
i = i90 = annual interest rate ÷4. However, the subscript 90 is suppressed (too cumbersome)
(2) A(1 + i*)(F/S)
F = price of one pound sterlilng for delivery 90 days hence
S = price of one pound sterling in the spot market
Interest arbitrarage will cause the forward rate to adjust to the interest rate differential until it reaches an equilibrium rate. This equilibrium rate F is determined by
(3) A(1 + i) = A (1 + i*)(F/S).
(4) F = S(1 + i)/(1 + i*).
Since i and i* are small fractions, this is approximately equal to:
F = S(1 + i - i*), or
i - i* = (F - S)/S.
That is, if the domestic interest rate is higher, the forward pound must be sold at a premium. Specifically, the domestic interest advantage (i - i*) must be equal to %premium on the forward pound when the forward rate is at its parity. For example, if the domestic interest is 1% above the foreign interest rate, forward pound must be higher than the spot rate by the same proportion to prevent capital flows.
Covered Arbitrage Margin (CAM) = (i - i*) - (F - S)/S.
If i - i* > (F - S)/S, then K* inflow occurs. (Domestic investors have no incentive to invest abroad, but foreign investors will invest in America)
If i - i* < (F - S)/S, then K outflow occurs. (Foreign investors will stay put, but domestic investors will move funds abroad)
Remark: If i = i*, there is no incentive for any investors to move funds between countries, except for the forward premium. In this case, if F > S, domestic investors would make money by selling forward currency and invest abroad. As a matter of fact, if the forward premium is sufficiently large and more than offset the possible interest loss (i - i* > 0), one could invest overseas.
If i - i* = (F - S)/S, then no capital flow.
Let Fo be the rate at which no capital flow occurs. If F = Fo, then the forward rate is at its interest parity.
Federal Reserve Bulletin publishes CAM, e, i, i*. CAM are very nearly zero.
Figure 1. Interest Rate Parity
Keynes' theory does not take into account differing investment risks between the two countries.
(1) Interest rates in developing and transition economies are generally higher, due to higher risks.
(2) Inflation rates also differ between countries. It is not the nominal payoffs, but real interest rates. Thus, different inflation rates will affect investment decisions.