Smart DirectionsEmmet O’Neal LibraryMountain Brook, AL

Understanding the Global Financial System

Disclaimer• Andreas Rauterkus is not a registered

investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Andreas Rauterkus does not purport to tell or suggest which investment securities attendants should buy or sell for themselves. You should always conduct your own research and due diligence and obtain professional advice before making any investment decision.

Objectives• What is an exchange rate?• Learn how the international monetary system

has evolved from the days of the gold standard to today’s eclectic currency arrangement

• Learn about exchange rate systems• Examine how the euro, a single currency for

the European Union, was created

The Market for Currencies• Foreign currency exchange rate is the price of

any one country’s currency in terms of another country’s currency

• US Dollar ($ or USD) / European euro (€ or EUR) exchange rate stated as “1.0743 dollars per euro” or as $1.0743/€

• Most currency quotes follow a convention as a result of some history or tradition– E.g., euros per dollar and dollars per pound

Foreign Currency Quotations

©Pearson Education 2015

Structure of the Foreign Exchange Market• Geographically, the foreign exchange market

spans the globe with prices moving and currencies trading every hour of every business day

• Major world trading starts each morning in Sydney and Tokyo

• Then moves west to Hong Kong and Singapore• Continuing to Europe and finishing on the West

Coast of the U.S.

How to calculate exchanged value• Exchange $100 into Euro

– Assume exchange rate equals $1.0743/€

– $100x $1.0743/€ = 107.43/€, can’t use $/€

– Need €/$, thus 1/$1.0743/€ = €0.9308/$

– $100 x €0.9308/$ = €93.08

The Determinants of Foreign Exchange Rates

©Pearson Education 2015

History of the International Monetary System

• The Gold Standard, 1876-1913– Countries set par value for their currency in terms

of gold– Exchange rates were in effect “fixed”– Gold reserves were needed to back a currency’s

value– The gold standard worked until the outbreak of

WWI, which interrupted trade flows and free movement of gold

History of the International Monetary System

• The Inter-War years and WWII, 1914-1944– During this period currencies were allowed to

fluctuate in terms of gold and each other– Increasing fluctuations in currency values became

realized as speculators sold short weak currencies– In 1934, the U.S. dollar was devalued to $35/oz

from $20.67/oz– During WWII and its chaotic aftermath the US dollar

was the only major trading currency that continued to be convertible

History of the International Monetary System

• Bretton Woods and the IMF, 1944– Allied Powers met in Bretton Woods, NH and created

a post-war international monetary system– The agreement established a US dollar based

monetary system and created the IMF and World Bank

– Countries fixed their currencies in terms of gold but were not required to exchange their currencies

– Only the US dollar remained convertible into gold (at $35/oz with Central banks, not individuals)

– Devaluation was not to be used as a competitive trade policy and up to a 10% devaluation was allowed without formal approval from the IMF

History of the International Monetary System

• Fixed exchange rates, 1945-1973– Bretton Woods and IMF worked well post WWII, but

diverging fiscal and monetary policies and external shocks caused the system’s demise

• The US dollar remained the key to the web of exchange rates

– Heavy capital outflows of dollars became required to meet investors’ and deficit needs and eventually created a lack of confidence in the US’ ability to convert dollars to gold

History of the International Monetary System

– This lack of confidence forced President Nixon to suspend official purchases or sales of gold on Aug. 15, 1971

– Exchange rates of most leading countries were allowed to float in relation to the US dollar

– A year and a half later, the dollar came under attack again and lost 10% of its value

– By early 1973 a fixed rate system no longer seemed feasible and the dollar, along with the other major currencies was allowed to float

History of the International Monetary System

• Floating Era, 1973-– Exchange rates became much more

volatile and less predictable they were during the “fixed” period

– Several emerging market currency crises

– EMS restructuring (1992) and introduction of the Euro (1999)

The BIS Exchange Rate Index of the Dollar

IMF Classification of Currency Regimes

• Category 1: Hard Pegs– Countries that have given up their own sovereignty over

monetary policy– E.g. dollarization or currency unions

• Category 2: Soft Pegs– AKA fixed exchange rates, with five subcategories of

classification• Category 3: Floating Arrangements

– Mostly market driven, these may be free floating or floating with occasional government intervention

• Category 4: Residual– The remains of currency arrangements that don’t well fit the

previous categorizations

A Single Currency for Europe: The Euro• In December 1991, the members of the

European Union met at Maastricht, the Netherlands, to finalize a treaty that changed Europe’s currency future.

• This treaty set out a timetable and a plan to replace all individual EMS currencies with a single currency called the euro.

A Single Currency for Europe: The Euro

• To prepare for the EMU, a convergence criteria was laid out whereby each member country was responsible for managing the following to a specific level:– Nominal inflation rates– Long-term interest rates– Fiscal deficits– Government debt

• In addition, a strong central bank, called the European Central Bank (ECB), was established in Frankfurt, Germany.

• EMU initiated by 11 members in 1999 and with 19 member states (out of 28 EU members) by 2015.– Most notable absentees: Denmark, Great Britain,

Sweden• The euro affects markets in three ways:

– Cheaper transactions costs in the eurozone– Currency risks and costs related to uncertainty are

reduced– Price transparency and increased price-based

competition

A Single Currency for Europe: The Euro