Chapter 1

Exchange rate Introduction

The exchange rate is the price of a currency in terms of another currency. Thus the exchange rate of US dollar can be expressed in terms of the British pounds, EURO or Mexican pesos to buy One dollar. Exchange rate (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one countrys currency in terms of another currency. Foreign Exchange Market

The foreign exchange market determines the relative values of different currencies

The foreign exchange market assists international trade and investment by enabling currency conversion. For example, it permits a business in the United States to import goods from the European Union member states especially Euro zone members and pay Euros, even though its income is in United States dollars. It also supports direct speculation in the value of currencies, and the carry trade, speculation based on the interest rate differential between two currencies

The foreign exchange market is unique because of the following characteristics:

its huge trading volume representing the largest asset class in the world leading to high liquidity;
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its geographical dispersion; its continuous operation: 24 hours a day except weekends, i.e., trading from 20:15 GMT on Sunday until 22:00 GMT Friday;

the variety of factors that affect exchange rates; the low margins of relative profit compared with other markets of fixed income; and the use of leverage to enhance profit and loss margins and with respect to account size.

An exchange-rate regime is the way an authority manages its currency in relation to other currencies and the foreign exchange market. It is closely related to monetary policy and the two are generally dependent on many of the same factors. The basic types are a floating exchange rate, where the market dictates movements in the exchange rate; a pegged float, where a central bank keeps the rate from deviating too far from a target band or value; and a fixed exchange rate, which ties the currency to another currency, mostly more widespread currencies such as the U.S. dollar or the euro or a basket of currencies.

How the Foreign Exchange market works

A currency pair is the quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market. The currency that is used as the reference is called the counter currency or quote currency and the currency that is quoted in relation is called the base currency or transaction currency.

Currency pairs are sometimes then written by concatenating the ISO currency codes of the base currency and the counter currency, separating them with a slash character. Often the slash character is omitted. A widely traded currency pair is the relation of the euro against the US

dollar, designated as EUR/USD. The quotation EUR/USD 1.2500 means that one euro is exchanged for 1.2500 US dollars.

The most traded currency pairs in the world are called the Majors. They involve the currencies euro, US dollar, Japanese yen, pound sterling, Australian dollar, Canadian dollar, and the Swiss francs.

Source: www.xrates.com

A currency pair is the quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market. The quotation EUR/USD 1.2500 means that 1 Euro is exchanged for 1.2500 US dollars.

There is a market convention that determines which is the base currency and which is the term currency. In most parts of the world, the order is: EUR GBP AUD NZD USD others. Accordingly, a conversion from EUR to AUD, EUR is the base currency, AUD is the term currency and the exchange rate indicates how many Australian dollars would be paid or received for 1 Euro. Cyprus and Malta which were quoted as the base to the USD and others were recently removed from this list when they joined the Euro.

In some areas of Europe and in the non-professional market in the UK, EUR and GBP are reversed so that GBP is quoted as the base currency to the euro. In order to determine which the base currency is where both currencies are not listed (i.e. both are "other"), market convention is to use the base currency which gives an exchange rate greater than 1.000. This avoids rounding issues and exchange rates being quoted to more than 4 decimal places. There are some exceptions to this rule e.g. the Japanese often quote their currency as the base to other currencies.

Quotes using a country's home currency as the price currency (e.g., EUR 0.735342 = USD 1.00 in the euro zone) are known as direct quotation or price quotation (from that country's perspective) and are used by most countries.

Quotes using a country's home currency as the unit currency (e.g., EUR 1.00 = USD 1.35991 in the euro zone) are known as indirect quotation or quantity quotation and are used in British newspapers and are also common in Australia, New Zealand and the eurozone.

Using direct quotation, if the home currency is strengthening (i.e., appreciating, or becoming more valuable) then the exchange rate number decreases. Conversely if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating.

Market convention from the early 1980s to 2006 was that most currency pairs were quoted to 4 decimal places for spot transactions and up to 6 decimal places for forward outrights or swaps. (The fourth decimal place is usually referred to as a "pip"). An exception to this was exchange rates with a value of less than 1.000 which were usually quoted to 5 or 6 decimal places. Although there is no fixed rule, exchange rates with a value greater than around 20 were usually quoted to 3 decimal places and currencies with a value greater than 80 were quoted to 2 decimal places. Currencies over 5000 were usually quoted with no decimal places (e.g. the former Turkish Lira). e.g. (GBPOMR: 0.765432 - : 1.4436 - EURJPY: 165.29). In other words, quotes are given with 5 digits. Where rates are below 1, quotes frequently include 5 decimal places.

In 2005 Barclays Capital broke with convention by offering spot exchange rates with 5 or 6 decimal places on their electronic dealing platform. The contraction of spreads (the difference between the bid and offer rates) arguably necessitated finer pricing and gave the banks the ability to try and win transaction on multibank trading platforms where all banks may otherwise have been quoting the same price. A number of other banks have now followed this system.

Trading

Currencies are traded in fixed contract sizes, specifically called lot sizes, or multiples thereof. The standard lot size is 100,000 units of the base currency. Many retail trading firms also offer 10,000 unit (mini lot) trading accounts and a few even 1,000 units (micro lot).

The officially quoted rate is a spot price. In a trading market however, currencies are offered for sale at an offering price (the ask price), and traders looking to buy a position seek to do so at their bid price, which is always lower or equal to the asking price. This price differential is known as the spread. For example, if the quotation of EUR/USD is 1.3607/1.3609, then the spread is USD 0.0002, or 2 pips. In general, markets with high liquidity exhibit smaller spreads than less frequently traded markets.

The spread offered to a retail customer with an account at a brokerage firm, rather than a large international forex market maker, is larger and varies between brokerages. Brokerages typically increase the spread they receive from their market providers as compensation for their service to the end customer, rather than charge a transaction fee. A bureau de change usually has spreads that are even larger. Example: - lets consider EUR / USD currency pair EUR / USD -- 1.33 Base currency/Quote currency

In the above case if you are buying 1EUR you will have to pay 1.33 USD conversely if you are selling 1EUR you will receive 1.33 USD (assuming no FX spread). Forex traders Buy EUR / USD pair if they believe that EUR would increase in value relative to USD, buying EUR / USD pair this way is called going long on the pair; converseley, would sell EUR / USD pair called going short on the pair, if they believe the value of EUR will go down relative to USD. It is noteworthy; that a pair is depicted only one way and never reversed for the purpose of a trade, but a buy or sells function is used at initiation of a trade. Buy a pair if bullish on the first position as compared to the second of the pair; conversely, sell if bearish on the first as compared to the second.
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Chapter 2
Working of the Market
A currency swap is a foreign-exchange agreement between two institute to exchange aspects (namely the principal and/or interest payments) of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency;. Currency swaps are motivated by comparative advantage A currency swap should be distinguished from a central bank liquidity swap.

Structure
Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps. However, unlike interest rate swaps, currency swaps can involve the exchange of the principal.

There are three different ways in which currency swaps can exchange loans:

1. The simplest currency swap structure is to exchange only the principal with the counterparty at a specified point in the future at a rate agreed now. Such an agreement performs a function equivalent to a forward contract or futures. The cost of finding a counterparty (either directly or through an intermediary), and drawing up an agreement with them, makes swaps more expensive than alternative derivatives (and thus rarely
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used) as a method to fix shorter term forward exchange rates. However for the longer term future, commonly up to 10 years, where spreads are wider for alternative derivatives, principal-only currency swaps are often used as a cost-effective way to fix forward rates. This type of currency swap is also known as an FX-swap. 2. Another currency swap structure is to combine the exchange of loan principal, as above, with an interest rate swap. In such a swap, interest cash flows are not netted before they are paid to the counterparty (as they would be in a vanilla interest rate swap) because they are denominated in different currencies. As each party effectively borrows on the other's behalf, this type of swap is also known as a back-to-back loan. 3. Last here, but certainly not least important, is to swap only interest payment cash flows on loans of the same size and term. Again, as this is a currency swap, the exchanged cash flows are in different denominations and so are not netted. An example of such a swap is the exchange of fixed-rate US dollar interest payments for floating-rate interest payments in Euro. This type of swap is also known as a cross-currency interest rate swap, or cross currency swap.

Uses
Currency swaps have two main uses:

To secure cheaper debt (by borrowing at the best available rate regardless of currency and then swapping for debt in desired currency using a back-to-back-loan).

To hedge against (reduce exposure to) exchange rate fluctuations.

Hedging example
For instance, a US-based company needing to borrow Swiss francs, and a Swiss-based company needing to borrow a similar present value in US dollars, could both reduce their exposure to exchange rate fluctuations by arranging any one of the following:

If the companies have already borrowed in the currencies each needs the principal in, then exposure is reduced by swapping cash flows only, so that each company's finance cost is in that company's domestic currency.

Alternatively, the companies could borrow in their own domestic currencies (and may well each have comparative advantage when doing so), and then get the principal in the currency they desire with a principal-only swap.

In May 2011, Charles Munger of Berkshire Hathaway Inc. accused international investment banks of facilitating market abuse by national governments. For example, "Goldman Sachs helped Greece raise $1 billion of off- balance-sheet funding in 2002 through a currency swap, allowing the government to hide debt Greece had previously succeeded in getting clearance to join the euro on 1 January 2001, in time for the physical launch in 2002, by faking its deficit figures.

History
Currency swaps were originally conceived in the 1970s to circumvent foreign exchange controls in the United Kingdom. At that time, UK companies had to pay a premium to borrow in US
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Dollars. To avoid this, UK companies set up back-to-back loan agreements with US companies wishing to borrow Sterling. While such restrictions on currency exchange have since become rare, savings are still available from back-to-back loans due to comparative advantage.

Cross-currency interest rate swaps were introduced by the World Bank in 1981 to obtain Swiss francs and German marks by exchanging cash flows with IBM. This deal was brokered by Salomon Brothers with a notional amount of $210 million dollars and a term of over ten years

During the global financial crisis of 2008, the currency swap transaction structure was used by the United States Federal Reserve System to establish central bank liquidity swaps. In these, the Federal Reserve and the central bank of a developed or stable emerging economy agree to exchange domestic currencies at the current prevailing market exchange rate & agree to reverse the swap at the same exchange rate at a fixed future date. The aim of central bank liquidity swaps is "to provide liquidity in U.S. dollars to overseas markets." While central bank liquidity swaps and currency swaps are structurally the same, currency swaps are commercial transactions driven by comparative advantage, while central bank liquidity swaps are emergency loans of US Dollars to overseas markets, and it is currently unknown whether or not they will be beneficial for the Dollar or the US in the long-term.

The People's Republic of China has multiple year currency swap agreements of the Renminbi with Argentina, Belarus, Brazil, Hong Kong, Iceland, Indonesia, Malaysia, Singapore, South Korea and Uzbekistan that perform a similar function to central bank liquidity swaps.

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Currency Swap Example

A European Company A is doing business in the USA, and it has issued a $20 million dollardenominated bond to investors in the US. An American Company B is doing business in Europe, and it has issued a bond of 15 Million Euros. The two companies can enter into an agreement to exchange the principal and interest of the bonds. The 15 million Euro-denominated bond will be the obligation of company A, and company B will be obligated to the $20 million bond.

Hard currency (also known as a safe-haven currency or strong currency), in economics, refers to a globally traded currency that is expected to serve as a reliable and stable store of value. Factors contributing to a currency's hard status might include the long-term stability of its purchasing power, the associated country's political and fiscal condition and outlook, and the policy posture of the issuing central bank.

Conversely, a soft currency indicates a currency which is expected to fluctuate erratically or depreciate against other currencies. Such softness is typically the result of political or fiscal instability within the associated country.

Many currencies are neither hard nor soft.

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In search of hard currencies

Varying theories of monetary policy, and the ever-present risk of unexpected geopolitical and policy events, preclude any claim of a currency's hardness from being called definitive.

The paper currencies of some developed countries have earned recognition as hard currencies at various times, including the United States dollar, Euro, Swiss franc, British pound sterling, Japanese yen, and to a lesser extent, the Canadian dollar and Australian dollar. Times change, and a currency that is considered weak at one time may become stronger, or vice versa. However, countries that consistently run large trade surpluses tend to have hard currencies.[

One barometer of hard currencies is how they are favored within the foreign-exchange reserves of countries:

Turmoil in hard currencies

The US dollar (USD) has been considered a strong currency for much of its history. Despite the Nixon shock of 1971, and the United States' growing fiscal and trade deficits, most of the world's monetary systems have been tied to the US dollar due to the Bretton Woods System and
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dollarization. Countries have thus been compelled to purchase dollars for their foreign exchange reserves, denominate their commodities in dollars for foreign trade, or even use dollars domestically, thus buoying the currency's value. However the late-2000s financial crisis saw the institution of quantitative easing by the Federal Reserve, downgrades of US debt by credit rating agencies (during the debt-ceiling crisis), countries diversifying their foreign exchange reserves away from the dollar, the emergence of commodity markets trading in non-US currency (such as the Iranian oil bourse), resumed appreciation of the yuan by the People's Bank of China, and the IMF proposal of the SDR as an alternative to the dollar in some applications. These events and others have eroded confidence in the US dollar.

The euro (EUR) has also been considered a hard currency for much of its short history, however the European sovereign debt crisis has eroded that confidence, with many predicting the currency's demise.

The Swiss franc (CHF) has long been considered a hard currency, and in fact was the last paper currency in the world to terminate its convertibility to gold. In the summer of 2011, the European sovereign debt crisis lead to rapid flows out of the euro and into the franc by those seeking hard currency, causing the latter to appreciate rapidly. On September 6, 2011, the Swiss National Bank announced that it would buy an "unlimited" number of euros to fix an exchange rate at 1.00 EUR = 1.20 CHF, to protect its trade. The franc fell precipitously against the euro to match this rate, and the price of gold in CHF rose 5% in a matter of minutes. This action has, at least temporarily, eliminated the franc's hard currency advantage over the euro.

In the midst of the ongoing financial crisis, countries with strong currencies are at risk of capital inflows causing appreciation. The potential impact of such appreciation on a nation's economy is
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historically unprecedented due to globalization and free trade. Thus the world's central banks are locked into a spiral of "competitive devaluation" in which the value of all fiat money systems is being eroded. This process is reflected in the escalating price of gold investors flock to gold and other precious metals as a store of value and hedge against inflation, which causes the price to increase rapidly, sometimes for several consecutive years and recently, at many times more than the rate of inflation.

Demand
Investors as well as ordinary people generally prefer hard currencies to soft currencies at times of increased inflation (or more precisely increased inflation differentials between countries), at times of heightened political or military risk, or when they feel that one or more governmentimposed exchange rates are unrealistic. There may be regulatory reasons for preferring to invest outside one's home currency, e.g. the local currency may be subject to capital controls which makes it difficult to spend it outside the host nation.

For example, during the Cold War, the ruble in the Soviet Union was not a hard currency because it could not be easily spent outside the Soviet Union and because the exchange rates were fixed at artificially high levels for persons with hard currency, such as Western tourists. (The Soviet government also imposed severe limits on how many rubles could be exchanged by Soviet citizens for hard currencies.) After the fall of the Soviet Union in December 1991, the ruble depreciated rapidly, while the purchasing power of the U.S. dollar was more stable, making it a harder currency than the ruble. A tourist could get 200 rubles per U.S. dollar in June 1992, and 500 rubles per USD in November 1992.

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In some economies, which may be either planned economies or market economies using a soft currency, there are special stores that accept only hard currency. Examples have included Tuzex stores in the former Czechoslovakia, Intershops in East Germany or Friendship stores in the People's Republic of China in the early 1990s. These stores offer a wider variety of goods many of which are scarce or imported than standard stores.

Mixed currencies
Because hard currencies may be subject to legal restrictions, the desire for transactions in hard currency may lead to a black market. In some cases, a central bank may attempt to increase confidence in the local currency by pegging it against a hard currency, as is this case with the Hong Kong dollar or the Bosnia and Herzegovina convertible mark. This may lead to problems if economic conditions force the government to break the currency peg (and either appreciate or depreciate sharply) as occurred in the Argentine economic crisis (19992002).

In some cases, an economy may choose to abandon local currency altogether and adopt a hard currency as legal tender. Examples include the adoption of the US dollar in Ecuador, El Salvador and Zimbabwe and the adoption of the German mark and later the euro in Kosovo and Montenegro.

A linked exchange rate system is a type of exchange rate regime to link the exchange rate of a currency to another. It is the exchange rate system implemented in Hong Kong to stabilise the exchange rate between the Hong Kong dollar (HKD) and the United States dollar (USD). The Macao pataca (MOP) is similarly linked to the Hong Kong dollar.

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Unlike a fixed exchange rate system, the government or central bank does not actively interfere in the foreign exchange market by controlling supply and demand of the currency in order to influence the exchange rate. The exchange rate is instead stabilized by an exchange mechanism, whereby the Hong Kong Monetary Authority (HKMA) authorises note-issuing banks are to issue new banknotes provided that they deposit an equivalent value of US dollars with the HKMA.

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Chapter 3
Exchange rate regime
Each country, through varying mechanisms, manages the value of its currency. As part of this function, it determines the exchange rate regime that will apply to its currency. For example, the currency may be free-floating, pegged or fixed, or a hybrid.

If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies and is determined by the market forces of supply and demand. Exchange rates for such currencies are likely to change almost constantly as quoted on financial markets, mainly by banks, around the world.

A movable or adjustable peg system is a system of fixed exchange rates, but with a provision for the devaluation of a currency. For example, between 1994 and 2005, the Chinese yuan renminbi (RMB) was pegged to the United States dollar at RMB 8.2768 to $1. China was not the only country to do this; from the end of World War II until 1967, Western European countries all maintained fixed exchange rates with the US dollar based on the Bretton Woods system. But that system had to be abandoned due to market pressures and speculations in the 1970s in favor of floating, market-based regimes.

Still, some governments keep their currency within a narrow range. As a result currencies become over-valued or under-valued, causing trade deficits or surpluses.

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Fluctuations in exchange rates

A market-based exchange rate will change whenever the values of either of the two component currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than available supply (this does not mean people no longer want money, it just means they prefer holding their wealth in some other form, possibly another currency).

Increased demand for a currency can be due to either an increased transaction demand for money or an increased speculative demand for money. The transaction demand is highly correlated to a country's level of business activity, gross domestic product (GDP), and employment levels. The more people that are unemployed, the less the public as a whole will spend on goods and services. Central banks typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions.

Speculative demand is much harder for central banks to accommodate, which they influence by adjusting interest rates. A speculator may buy a currency if the return (that is the interest rate) is high enough. In general, the higher a country's interest rates, the greater will be the demand for that currency. It has been argued that such speculation can undermine real economic growth, in particular since large currency speculators may deliberately create downward pressure on a currency by shorting in order to force that central bank to buy their own currency to keep it

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stable. (When that happens, the speculator can buy the currency back after it depreciates, close out their position, and thereby take a profit.)

Purchasing power of currency

The "real exchange rate" (RER) is the purchasing power of a currency relative to another. It is based on the GDP deflator measurement of the price level in the domestic and foreign countries ( ), which is arbitrarily set equal to 1 in a given base year. Therefore, the level of the RER is arbitrarily set depending on which year is chosen as the base year for the GDP deflator of two countries. The changes of the RER are instead informative on the evolution over time of the relative price of a unit of GDP in the foreign country in terms of GDP units of the domestic country. If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the GDP deflators of the two countries, and the RER would be constant and equal to one.

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Bilateral vs. effective exchange rate

Source : http://www.amosweb.com/cgibin/awb_nav.pl?s=wpd&c=dsp&k=managed+flexible+exchange+rate

Example of GNP-weighted nominal exchange rate history of a basket of 6 important currencies (US Dollar, Euro, Japanese Yen, Chinese Renmenbi, Swiss Franks, Pound Sterling

Bilateral exchange rate involves a currency pair, while an effective exchange rate is a weighted average of a basket of foreign currencies, and it can be viewed as an overall measure of the country's external competitiveness. A nominal effective exchange rate (NEER) is weighted with the inverse of the asymptotic trade weights. A real effective exchange rate (REER) adjusts NEER by appropriate foreign price level and deflates by the home country price level. Compared to NEER, a GDP weighted effective exchange rate might be more appropriate considering the global investment phenomenon.

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Manipulation of exchange rates

Countries may gain an advantage in international trade if they manipulate the value of their currency by artificially keeping its value low, typically by the national central bank engaging in open market operations. It is argued that the People's Republic of China has succeeded in doing this over a long period of time.

In 2010, other nations, including Japan and Brazil, attempted to devalue their currency in the hopes of subsidizing cheap exports and bolstering their ailing economies. A low exchange rate lowers the price of a country's goods for consumers in other countries but raises the price of goods, especially imported goods, for consumers in the manipulating country

Fixed rate programs

A fixed exchange rate, sometimes called a pegged exchange rate, is also referred to as the Tag of particular Rate, which is a type of exchange rate regime where a currency's value is fixed against the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold.

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 in which external trade forms a large part of their GDP.
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It can also be used as a means to control inflation. However, as the reference value rises and falls, so does the currency pegged to it. In addition, according to the MundellFleming model, with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability.

There are no major economic players that use a fixed exchange rate (except the countries using the euro and the Chinese yuan). The currencies of the countries that now use the euro are still existing (for old bonds). The rates of these currencies are fixed with respect to the euro and to each other. The most recent such country to discontinue their fixed exchange rate was the People's Republic of China, which did so in July 2005. However, as of September 2010, the fixed-exchange rate of the Chinese yuan has already increased 1.5% in the last 3 months.

In a fixed exchange rate system, the monetary authority picks rates of exchange with each other currency and commits to adjusting the money supply, restricting exchange transactions and adjusting other variables to ensure that the exchange rates do not move. All variations on fixed rates reduce the time inconsistency problem and reduce exchange rate volatility, albeit to different degrees.

Under dollarization/Euroization, the US dollar or the Euro acts as legal tender in a different country. Dollarization is a summary description of the use of foreign currency in its capacity to produce all types of money services in the domestic economy. Monetary policy is delegated to the anchor country. Under dollarization exchange rate movements cannot buffer external shocks. The money supply in the dollarizing country is limited to what it can earn via exports, borrow and receive from emigrant remittances.

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A currency board enables governments to manage their external credibility problems and discipline their central banks by tying their hands with binding arrangements. A currency board combines three elements: an exchange rate that is fixed to another, anchor currency; automatic convertibility or the right to exchange domestic currency at this fixed rate whenever desired; and a long-term commitment to the system. A currency board system can ultimately be credible only if central bank holds official foreign exchange reserves sufficient to at least cover the entire monetary base. Exchange rate movements cannot buffer external shocks.

A fixed peg system fixes the exchange rate against a single currency or a currency basket. The time inconsistency problem is reduced through commitment to a verifiable target. However, the availability of a devaluation option provides a policy tool for handling large shocks. Its potential drawbacks are that it provides a target for speculative attacks, avoids exchange rate volatility, but not necessarily persistent misalignments, does not by itself place hard constraints on monetary and fiscal policy and that the credibility effect depends on accompanying institutional measures and a visible record of accomplishment.

Monetary union
A currency or monetary union is a multi-country zone where a single monetary policy prevails and inside which a single currency or multiple substitutable currencies, move freely. A monetary union has common monetary and fiscal policy to ensure control over the creation of money and the size of government debts. It has a central management of the common pool of foreign exchange reserves, external debts and exchange rate policies. The monetary union has common

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regional monetary authority i.e. common regional central bank, which is the sole issuer of economy wide currency, in the case of a full currency union.

The monetary union eliminates the time inconsistency problem within the zone and reduces real exchange rate volatility by requiring multinational agreement on exchange rate and other monetary changes. The potential drawbacks are that member countries suffering asymmetric shocks lose a stabilization toolthe ability to adjust exchange rates. The cost depends on the extent of asymmetric costs and the availability and effectiveness of alternative adjustment tools.

Flexible exchange rate regimes

These systems do not particularly reduce time inconsistency problems nor do they offer specific techniques for maintaining low exchange rate volatility.

A crawling peg attempt to combine flexibility and stability using a rule-based system for gradually altering the currency's par value, typically at a predetermined rate or as a function of inflation differentials. Often used by (initially) high-inflation countries who peg to low inflation countries in attempt to avoid currency appreciation. At the margin a crawling peg provides a target for speculative attacks. Among variants of fixed exchange rates, it imposes the least restrictions, and may hence yield the smallest credibility benefits. The credibility effect depends on accompanying institutional measures and record of accomplishment.

Exchange rate bands allow markets to set rates within a specified range; endpoints are defended through intervention. It provides a limited role for exchange rate movements to counteract external shocks while partially anchoring expectations. This system does not eliminate exchange

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rate uncertainty and thus motivates development of exchange rate risk management tools. On the margin a band is subject to speculative attacks. It does not by itself place hard constraints on policy, and thus provides only a limited solution to the time inconsistency problem. The credibility effect depends on accompanying institutional measures, a record of accomplishment and whether the band is firm or adjustable, secret or public, band width and the strength of the intervention requirement.

Managed float exchange rates are determined in the foreign exchange market. Authorities can and do intervene, but are not bound by any intervention rule. Often accompanied by a separate nominal anchor, such as inflation target. The arrangement provides a way to mix marketdetermined rates with stabilizing intervention in a non-rule-based system. Its potential drawbacks are that it doesnt place hard constraints on monetary and fiscal policy. It suffers from uncertainty from reduced credibility, relying on the credibility of monetary authorities. It typically offers limited transparency.

In a pure float, the exchange rate is determined in the market without public sector intervention. Adjustments to shocks can take place through exchange rate movements. It eliminates the requirement to hold large reserves. However, this arrangement does not provide an expectations anchor. The exchange rate regime itself does not imply any specific restriction on monetary and fiscal policy.

Maintenance
Typically, a government wanting to maintain a fixed exchange rate does so by either buying or selling its own currency on the open market. This is one reason governments maintain reserves
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of foreign currencies. If the exchange rate drifts too far below the desired rate, the government buys its own currency in the market using its reserves. This places greater demand on the market and pushes up the price of the currency. If the exchange rate drifts too far above the desired rate, the government sells its own currency, thus increasing its foreign reserves.

Another, less used means of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This is difficult to enforce and often leads to a black market in foreign currency. Nonetheless, some countries are highly successful at using this method due to government monopolies over all money conversion. This was the method employed by the Chinese government to maintain a currency peg or tightly banded float against the US dollar. Throughout the 1990s, China was highly successful at maintaining a currency peg using a government monopoly over all currency conversion between the yuan and other currencies.

On the 6 September 2011, the Swiss National Bank has imposed a franc ceiling, for first time in three decades, against the euro. In 1978 a franc ceiling was set versus the Deutsche Mark to stem currency gains.

Criticisms
The main criticism of a fixed exchange rate is that flexible exchange rates serve to adjust the balance of trade. When a trade deficit occurs, there will be increased demand for the foreign (rather than domestic) currency which will push up the price of the foreign currency in terms of the domestic currency. That in turn makes the price of foreign goods less attractive to the domestic market and thus pushes down the trade deficit. Under fixed exchange rates, this automatic rebalancing does not occur.
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Governments also have to invest many resources in getting the foreign reserves to pile up in order to defend the pegged exchange rate. Moreover a government, when having a fixed rather than dynamic exchange rate, cannot use monetary or fiscal policies with a free hand. For instance, by using reflationary tools to set the economy rolling (by decreasing taxes and injecting more money in the market), the government risks running into a trade deficit. This might occur as the purchasing power of a common household increases along with inflation, thus making imports relatively cheaper.

Additionally, the stubbornness of a government in defending a fixed exchange rate when in a trade deficit will force it to use deflationary measures (increased taxation and reduced availability of money), which can lead to unemployment. Finally, other countries with a fixed exchange rate can also retaliate in response to a certain country using the currency of theirs in defending their exchange rate.

Fixed exchange rate regime versus capital control

The belief that the fixed exchange rate regime brings with it stability is only partly true, since speculative attacks tend to target currencies with fixed exchange rate regimes, and in fact, the stability of the economic system is maintained mainly through capital control. A fixed exchange rate regime should be viewed as a tool in capital control.

For instance, China has allowed free exchange for current account transactions since December 1, 1996. Of more than 40 categories of capital account, about 20 of them are convertible. These convertible accounts are mainly related to foreign direct investment. Because of capital control,

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even the renminbi is not under the managed floating exchange rate regime, but free to float, and so it is somewhat unnecessary for foreigners to purchase renminbi.

Currency band

The currency band is a system of exchange rates by which a floating currency is backed by hard money.

A country selects a range, or "band", of values at which to set their currency, and returns to a fixed exchange rate if the value of their currency shifts outside this band. This allows for some revaluation, but tends to stabilize the currency's value within the band. In this sense, it is a compromise between a fixed (or "pegged") exchange rate and a floating exchange rate. For example, the exchange rate of the renminbi of the mainland of the People's Republic of China has recently been based upon a currency band; the European Economic Community's "snake in the tunnel" was a similar concept that failed, but ultimately led to the establishment of the European Exchange Rate Mechanism (ERM) and ultimately the Euro.

Managed float: is the current international financial environment in which exchange rates fluctuate from day to day, but central banks attempt to influence their countries' exchange rates by buying and selling currencies. It is also known as a dirty float. In an increasingly integrated world economy, the currency rates impact any given country's economy through the trade balance. In this aspect, almost all currencies are managed since central banks or governments intervene to influence the value of their currencies. Managed exchange rate systems permit the government to place some influence on an exchange rate that would otherwise be freely floating. Managed means the exchange rate system has
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attributes of both systems. On one hand allowing ones currency to be dictated in its entirety by a foreign nation would be undesirable since exogenous shocks from the pegged country would affect your currency. There would be little control of the Central Bank to change expectations or impact the economy through a change in the exchange rate (thus impact interest rates through supply and demand for domestic currency) as the entire exchange system would be dependent on the foreign nations policies. The central bank will also be in a position to utilize monetary policy to its advantage, or essentially, the changes in monetary policy will have their desired effect on a market where the exchange is not fixed. Canada uses a managed exchange rate. they do not peg to the USD, and in fact permit the exchange rate to float so long as it remains with a certain target (which varies). If the CB doesnt like how much the dollar declines they can put in place measures to slow a depreciation or appreciation. However, the central banks power to change the exchange rate trend through the markets is usually limited as their influence cannot match the overall buying power of the global market.

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Chapter 4

Dollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of the domestic currency as a store of value, unit of account, and/or medium of exchange within the domestic economy. The term is not only applied to usage of the United States dollar, but generally to the use of any foreign currency as the national currency. There are two common indicators of dollarization. The first one is the share of foreign currency deposits (FCD) in the domestic banking system in the broad money including of FCD. The second measure is the share of all foreign currency deposits held by domestic residents at home and abroad in their total monetary assets.

The biggest economies to have officially dollarized as of June 2002 are Panama (since 1904), Ecuador (since 2000), and El Salvador (since 2001). As of August 2005, the United States dollar, the Euro, the New Zealand dollar, the Swiss franc, the Indian rupee, and the Australian dollar were the only currencies used by other countries for official dollarization. In addition, the Armenian dram, Turkish lira, the Israeli shekel, and the Russian ruble are used by internationally unrecognized but de facto independent states.

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Origins
After the gold standard was abandoned at the outbreak of World War I and the Bretton Woods Conference following World War II, some countries were desperately seeking exchange rate regimes to promote global economic stability and hence their own prosperity. Countries usually peg their currency to a major convertible currency. "Hard pegs" are extreme exchange rate regimes that demonstrate a stronger commitment to a fixed parity (i.e. currency boards) or relinquish control over their own currency (such as currency unions and dollarization) while "soft pegs" are more flexible and floating exchange rate regimes. When countries choose to use a major convertible currency parallel to or in place of their national currency, this is called the process of dollarization. The collapse of "soft" pegs in Southeast Asia and Latin America in the late 1990s led dollarization to become a serious policy issue.

A few cases of full dollarization until 1999 had been the consequence of political and historical factors. In all long-standing dollarization cases, historical and political reasons have been more influential than an evaluation of the effects of dollarization. Panama, the most salient dollarization example, adopted the U.S. dollar as legal tender after its independence as a result of a constitutional ruling. Ecuador and El Salvador became full dollarized economies in 2000 and 2001 respectively with different influential factors. Ecuador underwent the process of dollarization to deal with a widespread political and financial crisis resulted from massive loss of credibility in its political and monetary institutions. In contrary, El Salvador's official dollarization was as a result of internal debates and in a context of stable macroeconomic fundamentals and long-standing unofficial dollarization. The euro area adopted the euro () as their common currency and sole legal tender in 1999, which might be considered as a variety of a
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full-commitment regime similar to full dollariation despite of some differences distinguishable from other dollarization

Types
Dollarization can occur in a number of situations. The most popular type of dollarization is unofficial dollarization or de facto dollarization. Unofficial dollarization happens when residents of a country choose to hold a significant share of their financial assets denominated in foreign currency although the foreign currency lacks the legal tender They hold deposits in the foreign currency because of a bad track record of the local currency, or as a hedge against inflation of the domestic currency.

Official dollarization or full dollarization happens when a country adopts a foreign currency as its sole legal tender, and ceases to issue the domestic currency. Another effect of a country adopting a foreign currency as its own is that the country gives up all power to vary its exchange rate. There is a small number of countries adopting a foreign currency as legal tender. For example, Panama underwent a process of full dollarization by adopting the U.S. dollar as legal tender in 1904. This type of dollarization is also known as de jure dollarization.

Dollarization can be used semiofficially (or officially bimonetary systems), where the foreign currency is legal tender alongside the domestic currency.

In literature, there is a set of related definitions of dollarization such as external liability dollarization, domestic liability dollarization, banking sector's liability dollarization or namely deposit dollarization and credit dollarlization. The external liability dollarization

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measures total external debt (private and public) denominated in foreign currencies of the economy. Deposit dollarization can be measured as the share of dollar deposit in total deposit of the banking system while credit dollarization can be measured as the share of dollar credit in total credit of the banking system.

Effects

On trade and investment

One of the main advantages of adopting of a strong foreign currency as sole legal tender is to reduce the transaction costs of trade among countries using the same currency. There are at least two ways to infer this impact from data. The first one is a significantly negative effect of exchange rate volatility on trade in most cases, and the second is an association between transaction costs and the need to operate with multiple currencies. Economic integration with the rest of the world becomes easier as a result of lowered transaction costs and stabler prices in dollar terms. Rose (2000) applied the gravity model of trade and provided empirical evidence that countries sharing a common currency engage in significantly increased trade among them, and that the benefits of dollarization for trade may be large.

Dollarized economies can invoke greater confidence among international investors, inducing increased investments and growth. The elimination of the currency crisis risk due to full dollarization leads to a reduction of country risk premiums and then to lower interest ratesThese effects result in a higher level of investment. However, there is a positive association between dollarization and interest rates in a dual-currency economy.

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On monetary and exchange rate policies

Official dollarization helps to promote fiscal and monetary discipline and thus greater macroeconomic stability and lower inflation rates, to lower real exchange rate volatility, and possibly to deepen the financial system. Firstly, dollarization helps developing countries, providing a firm commitment to stable monetary and exchange rate policies by forcing a passive monetary. Adopting a strong foreign currency as legal tender will help to "eliminate the inflation-bias problem of discretionary monetary policy". Secondly, official dollarization imposes stronger financial constraint on the government by eliminating deficit financing by issuing money. An empirical finding suggests that inflation has been significantly lower in dollarized nations than in non-dollarized ones. The expected benefit of dollarization is the elimination of the risk of exchange rate fluctuations and a possible reduction in the country's international exposure. Though dollarization cannot eliminate the risk of an external crisis, it provides steadier markets as a result of eliminating fluctuations in exchange rates.

On the other hand, dollarization leads to the loss of seigniorage revenue, the loss of monetary policy autonomy, and the loss of the exchange rate instruments. Seigniorage revenues are the profits generated when monetary authorities issue currency. When adopting a foreign currency as legal tender, a monetary authority needs to withdraw the domestic currency and give up future seigniorage revenue. The country loses the rights to its autonomous monetary and exchange rate policies, even in times of financial emergency; former chairman of the Federal Reserve Alan Greenspan, for example, has stated that the central bank only considers the effects of its decisions on the US economy. In a full dollarized economy, exchange rates are indeterminate and monetary authorities cannot devalue. In a highly dollarized economy, devaluation policy is

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less effective in changing the real exchange rate because of significant pass-through effects to domestic prices. However, the cost of losing an independent monetary policy exists when domestic monetary authorities can commit an effective counter-cyclical monetary policy, stabilizing the business cycle. This cost depends adversely on the correlation between the business cycle of the client country (the dollarized economy) and the business cycle of the anchor country.In addition, monetary authorities in dollarized economies diminish the liquidity assurance to their banking system

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Conclusion The exchange rate market is very volatile and thus government intervention is important and the market cannot be left freely, both fixed and flexible exchange rate is important to an extent henceforth the concept of managed exchange rate came up. Many emerging countries like china and India both of them stick to managed exchange rates. Still both and flexible exchange rates have their own advantages and disadvantages. Countries have taken many precautions looking at disadvantages of flexible exchange rate. The US$ is a vehicle currency and most of them are pegged to that US$ and thus they change according to the fluctuations of the US$ and the economy.

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BIBLIOGRAPHY Website links

http://en.wikipedia.org/wiki/Economy_of_the_United_States#Currency_and_central_ban k http://en.wikipedia.org/wiki/Fixed_exchange_rate
http://www.reuters.com/article/2012/04/14/us-china-yuan-timeline-idUSBRE83D03820120414 http://www.ratesfx.com/rates/rate-inr.html

http://en.wikipedia.org/wiki/Floating_exchange_rate http://en.wikipedia.org/wiki/Managed_float_regime
http://www.amosweb.com/cgibin/awb_nav.pl?s=wpd&c=dsp&k=managed+flexible+exchange+rate

http://www.x-rates.com/

Books Economics of Global Trade and Finance Johnsons and Mascarehnas Manan Prakashan International Finance BMS by Dipak Abhayankar txt book Vipul Prakashan

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