GOLD EXCHANGE STANDARD

It was the failure of the gold-exchange standard which drove Forex forward because prior to that forex was pretty unimportant. Since then however it has grown into the beating heart of international economics. Another big development involving a currency in more recent times was the introduction of the Euro. The roots of this currency started way back in 1958 with the Treaty of Rome and a declaration of a common European market, during which a European objective to achieve ‘an ever-closer union among the people of Europe’ was declared.

The European Exchange Rate Mechanism (ERM) was introduced by the European Community in March 1979, as part of the European Monetary System (EMS) to reduce exchange-rate variability and achieve monetary stability in Europe, and before the introduction of the Euro exchange rates were based on the European Currency Unit (ECU), whose value was determined as a weighted average of the participating countries.

On December 31st, 1998, the ECU exchange rates of the Eurozone countries were frozen and the value of the Euro, which superseded the ECU on a 1:1 basis, was thus established. As the next stage of the Euro dream rolled forward in January 2002 the Euro became the legal tender for the twelve participating countries.

The Forex market is incredibly liquid mainly because there is always someone, somewhere that will quote a price, as the financial trading day is 24 hours day 7 days a week. The true function of the Forex market is as follows:

• Transfer of purchasing power
• Provision of credit
• Minimize foreign exchange risk

CENTRAL BANKS

Despite the size and importance of the foreign exchange market, it remains largely unregulated. There is no international organization that supervises it, not any institution that sets rules. However, since the advent of the flexible exchange rate system in 1973, governments and central banks occasionally intervene to maintain stability in the FX market.

ROLE OF CENTRAL BANKS

There is no standard definition for instability or a disorderly market – circumstances must be evaluated on a case-by-case basis. Sharp rapid fluctuation of exchange rates and traders’ reluctance to be ready to either buy or sell currencies may be signs of disorderly market. To restore stability, the central banks often work together.

However, a country taking a conservative view on intervention would act only in response to unusual circumstances that require immediate action, like political unrest or natural disasters. Most monetary authorities would be less likely to intervene to counteract the fundamental forces that drive FX markets, such as trade patterns, interest rate differentials and capital flows.

INTERVENTION

Where it is deemed necessary for Central Banks to intervene they could for example buy the currency of their country and sell foreign currencies to support the value of theirs. It could also sell its currency and buy foreign currency to try and exert downward pressure on the price of its currency. When central bank intervention occurs, it is in the form of small transactions compared to the total volume of trading in the FX market. Their actions will not shift the balance of supply and demand immediately. Instead, intervention is used as a vehicle to signal a desired exchange rate movement to affect the behaviour of investors in the FX market.

Usually, intervention operations will be undertaken in collaboration with other central banks. The New York Fed often intervenes in the FX market as an agent for other central banks and international organizations to execute transactions related to flows of international capital. Some countries have special arrangements with other countries to help them keep their currencies stable. Many less developed countries have their soft currencies pegged to hard currencies, so their value rises and falls simultaneously with the stronger currency. Some peg, or target, their currency to a basket of hard currencies, the average of a group of selected currencies.

Countries that are part of the European Union had pegged their currencies to the euro. There were formulas set for converting from the euro to the currency of each member nation. However, since January 2002, all currencies that were part of the Economic and Monetary System of the EU ceased to exist. Intervention in the FX market is not the only way monetary authorities can affect the value of their countries’ currencies. Central banks can also affect foreign exchange rates indirectly by influencing interest rates. If the interest rates in Europe were 5% and in U.S. were 3% then demand for Euro will increase.