A Brief Historical Background. by Dr. Ned Gandevani
Since its recognition in 1876, the foreign exchange market has evolved through three major phases; the gold standard, fixed exchange rate, and currently the floating rate system.
Gold Standard – It is defined as the use of gold as a base value for the currency of a country. From 1876 to 1913, each country could convert its currency into gold at a specified rate. Thus, gold was used as a guarantee and a convertibility rate for a country’s money. However, when World War I began in 1914, the gold standard was abandoned due to the fact that countries did not adhere to it. Each country had to finance its war expenses and had to circulate more money without having proper gold to back it up. Nevertheless, some countries reverted back to the gold standard in the 1920s. During the Great Depression, the gold standard was totally suspended due to a banking panic in the United Stated and Europe. Consequently, this resulted in severe restrictions on international trades for this period.
Fixed Exchange Rates – In July of 1944-45, nations gathered at the United Nations Monetary and Financial Conference in Bretton Woods New Hampshire, to discuss the postwar recovery of Europe and other monetary issues such as unstable exchange rates and restrictive protectionist trade policies.
In the 1930s, many of the world’s major economies lacked any stable currency exchange rates and used restrictive trade policies. A decade later, the United States and Great Britain proposed the creation of new financial institutions to boost trade and to stabilize exchange rates.
The delegates at Bretton Woods reached an agreement known as the Bretton Woods Agreement to establish a postwar international monetary system of convertible currencies, fixed exchange rates and free trade. To facilitate these objectives, the agreement created two international institutions: the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (the World Bank). The main intention was to provide economic aid for reconstruction of postwar Europe. An initial loan of $250 million was made to France in 1947, this was the World Bank’s first act.
The Bretton Woods Agreement which called for fixed exchange rates between currencies lasted until 1971. During this period, governments would intervene to avoid exchange rates from fluctuating more than one percent above or below their initially established levels.
By 1971, the US dollar appeared to be overvalued; the foreign demand for U.S. dollar was substantially less than the supply of dollars for sale. To adhere to the Bretton Woods agreement, the USA had to protect its gold stock fixed at $35 per ounce which was linked to its dollar. However, it did not have enough gold reserves to justify its huge dollar liabilities of dollar balances held by official institutions in other countries. America’s credibility was on the line due to its balance of payments problems. Therefore, it actively participated in the international exchange markets operations which made the fixed rate system unsustainable over time, ultimately breaking down in 1971 and finally collapsing in 1973.
To fix the US dilemma, representatives from all major countries gathered and signed the Smithsonian Agreement which devalued the US dollar relative to other major currencies. It was agreed to rest the dollar’s value and allow a fluctuation for 2 percent in either direction from the newly set rates.
Floating Exchange Rate System – By 1973, it was evident that the Smithsonian Agreement nations were still unable to hold their agreement to keep the exchange rates within the agreed boundaries. As a result, currencies were allowed to fluctuate at much wider levels according to market forces. However, history has witnessed that the capital
market should ultimately be left alone so that market forces dictate and set values for currencies. Thus, the official boundaries were all eliminated.
By 1978, most countries had moved de facto to a floating exchange rate system. On that year, the International Monetary Fund (IMF) member countries were authorized to adopt the exchange arrangement of their choices; fixed or floating, tied to another currency or to a basket of currencies.
However, by the late 1990′s, only large financial institutions were dominant forces in the FX market. In recent years, due to the advent of technology and internet access, many other speculators and traders have been able to participate actively in those markets.
Now, currency speculators and Forex traders are able to utilize their knowledge and trading experience to take advantage of these new opportunities. In this manual, you will learn how to trade the FX markets with low risk and the potential for significant profits.
Forex markets behave based on the non-linear dynamic systems theory. Like their counterpart markets such as equity futures, they exhibit stable habitual patterns. Through my own research in capital markets, I have deciphered the unique patterns of the FX market which constitutes the Winning Edge Forex System. In the following sections, I’ll go over the dynamic characteristics of the Forex markets.
Foreign Exchange
The foreign exchange market or Forex transactions, do not take place in a particular physical location or building. Multi national companies, banks and professional traders all exchange currencies through a commercial bank over a telecommunications network. Now, with the advent of internet broad band, all foreign exchange transactions are done electronically online. In the following section, I go over briefly of the two major foreign exchange markets; spot market, and futures market.
Spot Market – Most foreign exchange transactions are done to convert currencies.
The market where the spot rate is transacted is known as the spot market. The average daily trading by banks around the world is about 1.9 trillion dollars, of which more than $200 billion is conducted in the U.S.
Spot Market Structure- Many banks conduct and facilitate foreign exchange transactions, however, only the top 20 handle approximately 50 percent of the total transactions. Deutsche Bank (Germany), Citibank, and J.P. Morgan Chase are the largest leasers if foreign exchange trading. Many major banks and financial institutions have formed alliances together. For example, FX Alliance (www.fxall.com) is integrated to 57 of the world’s leading foreign exchange banks.
The high level of connectivity among leading foreign exchange banks provides a similar rate for various currencies among banks and other financial institutions for trading currencies. If there are any large discrepancies at any given time among the posted rates, other banks would buy the lower rate and sell them at higher price for profit.
There is however a foreign currency futures market which unlike spot market has a physical building named the Chicago Mercantile Exchange (www.cme.com). Although currency futures are not as active as the spot market, it is used for speculation and hedging purposes.
