By: Imran Mukati & Mohammed Elahi, Co-Founders Andes Capital Group, LLC (www.andescap.com)

Chicago, IL -- (ReleaseWire) -- 03/26/2012 --The world of foreign exchange trading (usually shortened to “forex” or just “FX”) has its roots in the closing days of World War II, as the Allies prepared to manage the postwar world. One of the many agreements negotiated during that time was the international monetary management system named for Bretton Woods, New Hampshire, where it was drafted in the summer of 1944.

Since 1875 the world’s nations had adhered to the gold standard, under which major economic powers agreed to fix the value of their currencies relative to gold. (Although international payments before this time had traditionally been made in either gold or silver, the price variations that resulted from the commoditized nature of these metals created a less-than-satisfactory situation.) Because the value of a national currency was tied to gold, an implicit requirement for the nation to maintain sufficient gold reserves to “back” its currency (that is, equal the total value in circulation) was created.

This system first broke down around the time of World War I, when the massive prewar and wartime military spending of major European nations exceeded available gold reserves. Attempts to return to the gold standard after the war ran headlong into the wall of the Great Depression, and by the start of World War II, it had been widely discarded for good.

The alternative proposed by Bretton Woods was a direct result of the overwhelming economic power of the U.S. at the end of the war. The new system for fixing currency exchange rates was based not on gold, but on the U.S. dollar, although an indirect linkage remained: the U.S. would back its own currency with gold, guaranteeing the ability of central banks to exchange dollars for gold should they so desire. This made the U.S. dollar the world’s reserve currency. (Even today, about 70% of all FX transactions worldwide involve the U.S. dollar.)

However, economic conditions in the 1960s and the expense of the Vietnam War drained U.S. gold reserves. Rather abruptly, President Richard Nixon announced on August 15, 1971 that the U.S. would no longer exchange dollars for gold. The world’s nations scrambled for interim solutions to valuation to replace the suddenly-abolished Bretton Woods system.

It was not until the Jamaica Agreement in 1976 that, guided by the International Monetary Fund (itself also a product of the Bretton Woods conference), a formal replacement came into existence. Gold was eliminated entirely as a basis for currency values, and instead those values would float relative to each other. However, a true free-floating exchange system is not what resulted. Because of the still substantial economic clout of the U.S., the dollar factored heavily into the system that resulted. Each of the world’s nations took one of three approaches:

Dollarization was the most direct, and simply replaced the original currency with that of another country. Not surprisingly, that “other country” was typically the U.S., as the very name of the practice implies. El Salvador, for example, adopted the dollar, as did Panama and Ecuador. (Other currencies used for dollarization include the Swiss franc, the euro, the Indian rupee, and the Australian and New Zealand dollars.) The drawback for the adopting nation is that its central bank loses control of the currency—it has no way to affect the value or the amount in circulation, which in the former case is determined by the currency’s home nation and in the latter by how much money the economy brings into the dollarized country.

Pegged valuation is a step away from dollarization, in that the country keeps its existing currency but fixes, or pegs, the value in direct relation to the value of another currency. As an example, the Chinese yuan was initially fixed at 2.46 per U.S. dollar and reached 1.50 by 1980, but was then devalued to make Chinese exports more competitive and dropped to 8.62 by 1994. From 1997 until 2005 it stood at 8.27, and then gradually weakened (mostly as a result of strident U.S. complaints) to 6.83 in 2008. In June 2010 China officially “unpegged” the yuan, but in practice its float is still tightly managed. As with dollarization, a nation’s central bank has little control over a pegged currency, which moves based on the policies and events that affect the currency to which it is linked.

Managed float is the policy employed by most nations. Though in theory each currency’s value changes freely in relation to others, the reality is that central banks watch their currencies carefully and will intervene if the markets send the value too high or too low. This is why financial markets watch with such close interest the announcements that follow meetings of the U.S. Federal Reserve and other central banks; policy changes and reactions to economic conditions are calculated to affect currency valuations, sometimes substantially.

It is the floating currencies that are of primary interest to the FX markets. Trading in a pegged currency is essentially no different from trading in the peg, though some pegged currencies are allowed to move within a narrow value range.

FX markets differ from equity (stock) markets in a fundamental way: they include market participants who are trading for very different reasons compared to ordinary investors. Understanding who these participants are and what motivates them is crucial for understanding the functioning of the FX marketplace.

Central banks, as should be clear from the discussion of currency valuation, are quite active in the markets. Though valuation is often addressed through internal economic and financial policies such as adjustments to short-term interest rates, central banks will also act in the marketplace to achieve policy goals. China, for example, has bought billions of dollars’ worth of U.S. Treasury bonds in order to keep the yuan at exchange rates that are beneficial for China’s export-dominated economy. (For all the ominous warnings issued by various pundits about how China could devastate the U.S. by abruptly dumping these Treasury holdings, it would suffer as much or more economic harm itself as a result of such a move.)

Corporate banks—particularly large banks—were active in the FX markets long before the speculative market now available to individual investors existed. As the institutions that handle money, banks clearly have a need to exchange currencies in order to service their clients, especially corporations that do business in multiple countries. These banks trade with each other based on credit relationships, so in this setting size matters, as does longevity to a lesser extent. Banks are the market makers of the FX world, and many profit by charging a premium on currency trades. Obviously, the better a given bank’s credit standing and the more extensive its trading relationships, the lower the price it can offer on a given currency. These same factors also explain why there is not “one” exchange rate for a given currency pair at any given time—rates will vary slightly from bank to bank.

Businesses, generally large multinational corporations, also participate in the markets for hedging purposes. A company that does business in more than one country is subject to exchange rate risk. This can manifest in many different ways. One example is when a company “brings home” its profits from a foreign market. If the value of the dollar rises sharply around the time it does so, those francs or lira or yen suddenly produce fewer dollars, which is especially painful when the company had previously converted lower-value dollars to a larger number of francs or lira or yen to buy raw materials or pay wages and now sees its profit margins shrink (or vanish) as a result.

Another example is a long-term contract for supplies, materials, or equipment. An exchange rate fluctuation three or six months or a year from now might substantially change the cost (in dollars) of that contractually-obligated expense. While that change might be positive (a stronger dollar means fewer dollars spent for the same quantity of goods and thus reduces the expense), it can also be negative. Worse, it is unpredictable, and businesses prefer being able to make reliable plans.

Companies therefore hedge in the FX markets. In the first example, in which the company brought home fewer dollars in profits because of an exchange rate change, a complementary FX futures contract which would profit from that rate change would counterbalance the loss in business profits. Similar strategies can be used to neutralize the risk from other effects of exchange rate changes.

Speculators are the investors who are trading in the FX markets for much the same reasons they would trade in the equity markets—purely to make money. While individual investors are in this group, there are players who approach the institutional traders and even central banks in power and influence, foremost among them the hedge funds. Hedge fund currency trading can be so powerful that these funds were widely blamed for the Asian financial crisis in the late 1990s, though many informed observers are more critical of Asian central bankers than of the hedge fund traders in assigning responsibility for the crisis. Retail traders—that is, individuals trading through online brokerage accounts—are only about 5% of the FX market by most estimates, so clearly it is the major players who dictate the direction of the markets.

Retail FX trading was introduced in 1996, although initial growth was relatively slow because of the scarcity of high-bandwidth Internet connections and a dearth of trade analysis software platforms. During the 2000s, retail trading expanded considerably. Overall FX trading volume worldwide has grown exponentially, from about $70 billion daily in the 1980s to $1.9 trillion in 2004, $3.21 trillion in 2007, and $3.98 trillion in 2010 (the last three figures from the Bank of International Settlements). However, given the relatively small share of retail investors in the market, most of that growth is not the result of increased retail trading. By various estimates, 70% to 90% of modern trading volume is the product of speculation.

It is important to understand that unlike most equities, FX is not traded in a central marketplace (that is, an analog of the New York Stock Exchange or London Stock Exchange), granting that today even such equity marketplaces are mostly electronic. Rather, currencies are traded “over the counter,” directly between traders over electronic networks. This highly decentralized and international nature of the market has, unfortunately, made regulation more difficult and provided numerous opportunities for criminals to defraud the unwary and inexperienced.

The FX market is also not monolithic. It is actually made up of three separate elements: the spot, forward, and futures markets. The spot market is the one in which most speculative trades take place, and consists of the immediate exchange of one currency for another (currencies are always traded in pairs, one for the other) at the current market price. The forward and futures markets are the ones primarily used by companies hedging against exchange rate risk, and deal in contracts for a specified exchange rate at a specified future date. The main difference is that the futures market, much like the equity options market, deals in contracts of standardized quantities, dates, and price increments. In the forward market, these contracts are customized between the buyer and seller rather than being standardized.

The FX market is fast-paced and operates 24 hours a day from 8:15 p.m. Greenwich Mean Time (GMT) Sunday until 10:00 p.m. GMT Friday. Although the market is, as previously discussed, highly decentralized, London has the largest individual share of trading, handling over a third of all transactions. Generic currency price quotes generally use London market values for this reason.

To learn more about the authors please visit:
www.imranmukati.com / email imukati@andescap.com / twitter: @imranmukati

Mohammed Elahi Bio