International Currency Exchange Rate
I. THE PROBLEM WITH FOREIGN CURRENCY
When we go overseas, we often monopolized the field, be it soybeans, computers, chemicals or airplanes. We are worried about only one currency: the U.S. dollar. To our advantage, this currency is still the world's leading reserve, the one most in demand as a store of value and as an invoice currency. Most world trade is still denominated in dollars; petro-dollars in the Middle East; Euro-dollars- the world over. Trading from this position of strength, corporate America was largely able to avoid exchange rate risk. Today, the tactic still most often employed in the United States for dealing with foreign currency risk is simply not to deal in foreign currency.
According to a recent study, of 12,000 U.S. corporations filing with the Stock Exchange Commission, less than 10% made any mention of foreign exchange in their reports. Other studies confirm this non-involvement in foreign exchange. A survey by the Philadelphia Stock Exchange indicates that only about 30% of all U.S. managers hedge risk of any kind. In contrast, less than 40% of European managers do not hedge risk. These figures illustrate the provincial nature of American commerce. Europeans, unlike Americans, have a long tradition of cross-border trading. They are aware of the dynamics of currency exchange rates and know how to deal with them, often to their advantage. In fact, it is quite common for French companies to set up in house cost centers having all the earmarks of an international banking operation. Many commercial entities in France seem to thrive on currency exposure and manage it with as much enthusiasm as they do other segments of the business.
They are not alone. Today, London is the world's leading financial center for foreign exchange, having taken that position from New York by default. Japanese traders traditionally look at foreign exchange exposure from a strategic point of view as inherent in the sale. They recognize the opportunity in affords. They often assume the currency risk, always account for it and usually manage it to their advantage.
II. THE EVOLVING U.S. DOLLAR
The political and economic history of a country can be traced through its currency. In the United States, the politics of currency began with the pre-revolutionary colonies and independent states with the profligate spending habits of the Massachusetts colonial government. These were financed in part by plundering nearby Quebec. When one such expedition failed, the Massachusetts government printed paper notes to pay the soldiers so they would not mutiny. Suspecting the fiat paper would be unacceptable to the public, the government promised to redeem it for specie in a few years and to never issue paper money again. Both promises were broken in short order. This set the stage for other fiat currencies in the colonies, which soon ruined public credit throughout much of New England. The experience of turning currency into waste paper was not lost on the founding fathers. The constitution of the United States addressed the problem by giving congress the power to coin money and to regulate the value thereof. In effect, it adopted a specie standard. Following the constitutional bidding, Congress authorized the minting of a dollar coin that contained 371.25 grains of fine silver or 24.75 grains of fine gold. In addition, foreign coins circulating in the United States were specified as legal tender.
The specifications for U.S. coins did two things: they established a bi-metallic standard and they set an official exchange rate between silver and gold. Also, aware of the dangers of following politicians access to a money machine, Congress denied the executive branch the power to issue paper money for fiat currency.
The role of a central bank is intended to safeguard the legal tender and control its supply and circulation. During the early nineteenth century, the First Bank of the United States country-region and its successor, the Second Bank of the United States, were chartered by Congress.
III. CIRCULATING BANK NOTES
A quasi-private banking system with state charters emerged as the country moved west. Each bank was free to issue its own notes, which were supposed to be receipts against gold and silver held in the banks vault. It soon became a well- known practice for banks to establish themselves in distant towns, far removed from their central vault. Thus assured that their notes could not be readily redeemed, they began to over issue. Gold receipts took on the character of an un-backed currency, especially at a distance from the issuing bank in a day of slow communications and expensive travel.
IV. EUROCURRENCY
Global in scope and free from government oversight, the Euro-currency market is comprised of a network of banks and other financial institutions. Its function is to borrow and lend foreign currency. In other words, it makes loans denominated in a currency other than the home currency of the lender or borrower. The currency itself never leaves home; only foreign currency deposits are loaned, in the form of book entries or debits and credits. These deposits are not assignable and they remain in the home country bank.
U.S. dollar deposits, which comprise 70% of the Euro-currency market, are known as Euro-Dollars. These Dollar deposits are loaned extensively abroad, mostly through international branches of American banks, but also through foreign banks. The predominance of Euro-dollars in the Euro-currency market is due, in part, to the dollars stature as a lead reserve currency with its perceived low exchange risk. In addition, the Eurodollar deposit interest rate, known as the London Inter bank Offered Rate or LIBOR, is often somewhat higher than comparable term rates in the U.S. market due to U.S. banking laws requiring greater spreads between yields paid out for deposits and those charged for borrowing. The U.S. government restrictions give Euro-dollar loans a competitive edge resulting in a large demand for Euro-dollars not only from foreign borrowers, but from American companies as well.
As the name implies, the Euro-currency market originated in Europe, primarily in London. Today, however, the term describes any currency loaned or borrowed anywhere except in its home country. The yields paid are called Euro rates. It is to understand why the traders of Euro rates are also in the foreign exchange market. Interest rates and exchange rates are interrelated; in fact, it is difficult to separate operations in one area from those in the other.
V. CURRENCY AS A COMMODITY
Currency is a medium of exchange, but currencies are not the only things that can qualify as such. Various commodities have been used at different times throughout history. Gold and silver were the most common, but others served as well, including barrels of oil, bushels of corn, beaver pelts, baskets of eggs or whatever people valued. In fact, there are still some old times who talk about grocery shopping as having to go trading. Modern day trading, also known as barter, is just as straight-forward.
VI. CURRENCY PEGS
Exchange rates for some currencies are pegged or based, on another currency. Usually, a soft currency is pegged to a hard currency, which forces the government of the soft currency to restrain its policies, so they are no more inflationary than those of the hard-currency country. Sometimes the peg is not a currency at all but a mathematical indicator, such as an index or basket of currencies. Price discovery of a pegged currency is straight forward. The price is a constant percentage of the price of the currency it is pegged to.
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