are traded, typically via brokers. Foreign currencies are continually and
simultaneously bought and sold across local and global markets. The value of
traders' investments increases or decreases based on currency movements.
Foreign exchange market conditions can change at any time in response to
real-time events.
The main attractions of short-term currency trading to private investors are:
- 24-hour trading, 5 days a week with nonstop access (24/7) to global
Forex dealers. - An enormous liquid market, making it easy to trade most currencies.
- Volatile markets offering profit opportunities.
- Standard instruments for controlling risk exposure.
- The ability to profit in rising as well as falling markets.
- Leveraged trading with low margin requirements.
- Many options for zero commission trading.
The following is an overview into the historical evolution of the foreign
exchange market and the roots of the international currency trading, from the
days of the gold exchange, through the Bretton-Woods Agreement, to its
current manifestation.
The Gold exchange period and the Bretton-Woods Agreement
The Bretton-Woods Agreement, established in 1944, fixed national currencies
against the US dollar, and set the dollar at a rate of USD 35 per ounce of gold.
In 1967, a Chicago bank refused to make a loan in pound sterling to a college
professor by the name of Milton Friedman, because he had intended to use
the funds to short the British currency. The bank's refusal to grant the loan
was due to the Bretton-Woods Agreement.
Bretton-Woods was aimed at establishing international monetary stability by
preventing money from taking flight across countries, thus curbing speculation
in foreign currencies. Between 1876 and World War I, the gold exchange
standard had ruled over the international economic system. Under the gold standard, currencies experienced an era of stability because they were
supported by the price of gold.
However, the gold standard had a weakness in that it tended to create boom-
bust economies. As an economy strengthened, it would import a great deal,
running down the gold reserves required to support its currency. As a result,
the money supply would diminish, interest rates would escalate and economic
activity would slow to the point of recession. Ultimately, prices of
commodities would hit rock bottom, thus appearing attractive to other
nations, who would then sprint into a buying frenzy. In turn, this would inject
the economy with gold until it increased its money supply, thus driving down
interest rates and restoring wealth. Such boom-bust patterns were common
throughout the era of the gold standard, until World War I temporarily
discontinued trade flows and the free movement of gold.
The Bretton-Woods Agreement was founded after World War II, in order to
stabilize and regulate the international Forex market. Participating countries
agreed to try to maintain the value of their currency within a narrow margin
against the dollar and an equivalent rate of gold. The dollar gained a premium
position as a reference currency, reflecting the shift in global economic
dominance from Europe to the USA. Countries were prohibited from devaluing
their currencies to benefit export markets, and were only allowed to devalue
their currencies by less than 10%. Post-war construction during the 1950s,
however, required great volumes of Forex trading as masses of capital were
needed. This had a destabilizing effect on the exchange rates established in
Bretton-Woods.
In 1971, the agreement was scrapped when the US dollar ceased to be
exchangeable for gold. By 1973, the forces of supply and demand were in
control of the currencies of major industrialized nations, and currency now
moved more freely across borders. Prices were floated daily, with volumes,
speed and price volatility all increasing throughout the 1970s. New financial
instruments, market deregulation and trade liberalization emerged, further
stoking growth of Forex markets.
The explosion of computer technology that began in the 1980s accelerated
the pace by extending the market continuum for cross-border capital
movements through Asian, European and American time zones. Transactions
in foreign exchange increased rapidly from nearly $70 billion a day in the
1980s, to more than $3 trillion a day two decades later.
The explosion of the euro market
he rapid development of the Eurodollar market, which can be defined as US
dollars deposited in banks outside the US, was a major mechanism for
speeding up Forex trading. Similarly, Euro markets are those where currencies
are deposited outside their country of origin. The Eurodollar market came
into being in the 1950s as a result of the Soviet Union depositing US dollars
earned from oil revenue outside the US, in fear of having these assets frozen
by US regulators. This gave rise to a vast offshore pool of dollars outside the
control of US authorities. The US government reacted by imposing laws to
restrict dollar lending to foreigners. Euro markets were particularly attractive
because they had far fewer regulations and offered higher yields. From the
late 1980s onwards, US companies began to borrow offshore, finding Euro
markets an advantageous place for holding excess liquidity, providing short-
term loans and financing imports and exports.
London was and remains the principal offshore market. In the 1980s, it
became the key center in the Eurodollar market, when British banks began
lending dollars as an alternative to pounds in order to maintain their leading
position in global finance. London's convenient geographical location
(operating during Asian and American markets) is also instrumental in
preserving its dominance in the Euro market.
Euro-Dollar currency exchange
The euro to US dollar exchange rate is the price at which the world demand
for US dollars equals the world supply of euros. Regardless of geographical
origin, a rise in the world demand for euros leads to an appreciation of the
euro.
Factors affecting the Euro to US dollar exchange rate
Four factors are identified as fundamental determinants of the real euro to US
dollar exchange rate:
- The international real interest rate differential between the Federal
Reserve and European Central Bank - Relative prices in the traded and non-traded goods sectors
- The real oil price
- The relative fiscal position of the US and Euro zone
attracts the most attention. Notwithstanding the comparative importance of bilateral trade links with the US, trade with the UK is, to some extent, more
important for the euro.
The following chart illustrates the EUR/USD exchange rate over time, from
the inauguration of the euro, until mid 2006. Note that each line (the
EUR/USD, USD/EUR) is a “mirror” image of the other, since both are
reciprocal to one another. This chart is illustrates the steady (general) decline
of the USD (in terms of euro) from the beginning of 2002 until the end of
2004.
EUR-USD rates 1998-2008
In the long run, the correlation between the bilateral US dollar to euro
exchange rate, and different measures of the effective exchange rate of
Euroland, has been rather high, especially when one looks at the effective
real exchange rate. As inflation is at very similar levels in the US and the Euro
area, there is no need to adjust the US dollar to euro rate for inflation
differentials. However, because the Euro zone also trades intensively with
countries that have relatively high inflation rates (e.g. some countries in
Central and Eastern Europe, Turkey, etc.), it is more important to downplay
nominal exchange rate measures by looking at relative price and cost
developments.
The fall of the US dollar
The steady and orderly decline of the US dollar from early 2002 to early 2007
against the euro, sterling, Australian dollar, Canadian dollar and a few other
currencies (i.e. its trade-weighted average, which is what counts for purposes
of trade adjustment), remains significant.
In the wake of the sub-prime mortgage crises in the US, dollar losses
escalated and continued to feel the backlash. The Fed responded with several
rounds of rate hikes while weighing the balance of domestic growth and
inflation fears.
The basic theories underlying the US dollar to euro exchange rate
Law of One Price: In competitive markets, free of transportation cost barriers
to trade, identical products sold in different countries must sell at the same
price when the prices are stated in terms of the same currency.
Interest rate effects: If capital is allowed to flow freely, exchange rates
become stable at a point where equality of interest is established.
The dual forces of supply and demand
These two reciprocal forces determine euro vs. US dollar exchange rates.
Various factors affect these two forces, which in turn affect the exchange
rates:
The business environment: Positive indications (in terms of government
policy, competitive advantages, market size, etc.) increase the demand for
the currency, as more and more enterprises want to invest in its place of
origin.
Stock market: The major stock indices also have a correlation with the
currency rates, providing a daily read of the mood of the business
environment.
Political factors: All exchange rates are susceptible to political instability and
anticipation about new governments. For example, political instability in
Russia is also a flag for the euro to US dollar exchange, because of the
substantial amount of German investment in Russia.
Economic data: Economic data such as labor reports (payrolls, unemployment
rate and average hourly earnings), consumer price indices (CPI), producer
price indices (PPI), gross domestic product (GDP), international trade,
productivity, industrial production, consumer confidence etc., also affect
currency exchange rates.
Confidence in a currency is the greatest determinant of the real euro to US
dollar exchange rate. Decisions are made based on expected future
developments that may affect the currency.
Types of exchange rate systems
An exchange can operate under one of four main types of exchange rate
systems:
Fully fixed exchange rates
In a fixed exchange rate system, the government (or the central bank acting
on its behalf) intervenes in the currency market in order to keep the exchange
rate close to a fixed target. It is committed to a single fixed exchange rate
and does not allow major fluctuations from this central rate.
Semi-fixed exchange rates
Currency can move within a permitted range, but the exchange rate is the
dominant target of economic policy-making. Interest rates are set to meet
the target exchange rate.
Free floating
The value of the currency is determined solely by supply and demand in the
foreign exchange market. Consequently, trade flows and capital flows are the
main factors affecting the exchange rate.
The definition of a floating exchange rate system is a monetary system in
which exchange rates are allowed to move due to market forces without
intervention by national governments. The Bank of England, for example,
does not actively intervene in the currency markets to achieve a desired
exchange rate level.
With floating exchange rates, changes in market supply and demand cause a
currency to change in value. Pure free floating exchange rates are rare - most
governments at one time or another seek to “manage” the value of their
currency through changes in interest rates and other means of controls.
Managed floating exchange rates
Most governments engage in managed floating systems, if not part of a fixed
exchange rate system.
The advantages of fixed exchange rates
Fixed rates provide greater certainty for exporters and importers and, under
normal circumstances, there is less speculative activity - though this depends
on whether dealers in foreign exchange markets regard a given fixed
exchange rate as appropriate and credible.
The advantages of floating exchange rates
Fluctuations in the exchange rate can provide an automatic adjustment for
countries with a large balance of payments deficit. A second key advantage of
floating exchange rates is that it allows the government/monetary authority
flexibility in determining interest rates as they do not need to be used to
influence the exchange rate.
Participants in today’s Forex market
Hedgers account for less than 5% of the market, but are the key reason
futures and other such financial instruments exist. The group using these
hedging tools is primarily businesses and other organizations participating in
international trade. Their goal is to diminish or neutralize the impact of
currency fluctuations.
Speculators account for more than 95% of the market.
This group includes private individuals and corporations, public entities,
banks, etc. They participate in the Forex market in order to create profit,
taking advantage of the fluctuations of interest rates and exchange rates.
The activity of this group is responsible for the high liquidity of the Forex
market. They conduct their trading by using leveraged investing, making it a
financially efficient source for earning.
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