The Basics of Foreign Exchange Markets

William D. Gerdes

• Publisher: Business Expert Press
• Year: 2018
• ISBN:
  9781947098718
• Edition: 2
• Topic: Business
• Subtopic: Foreign Exchange
• Index: Business

In an increasingly interdependent global economy, an understanding of foreign exchange markets is more critical than ever. These markets are inextricably entwined with underlying monetary standards and consequently they are treated conjointly in this book. Four different foreign exchange rate regimes are analyzed including exchange rates under commodity money, fiduciary money, fiat money (with fixed exchange rates), and fiat money (with flexible exchange rates).

For more than eight decades, most countries have operated with fiat money. Proponents maintain that fiat money provides individual countries with much greater monetary autonomy. Yet both analytics and experience indicate that this is not always the case. Whether a country has more monetary autonomy depends on whether fiat money is paired with fixed or flexible exchange rates. Although flexible exchange rate regimes are not without their critics, it has become increasingly apparent that fiat money with flexible rates provides individual countries much greater monetary autonomy. This arrangement allows participants in foreign exchange markets greater latitude for adjusting to the wide variations in national monetary policies that are prevalent with fiat money.

Several audiences may find this book beneficial: undergraduate students in economics and finance, students of international business, graduate students, students in executive programs who need to expand their knowledge of international finance, and practicing executives and managers—especially those who are employed by companies operating globally.

CHAPTER 1

Introduction

Foreign Exchange Markets: Street Smart

The equatorial mid-day humidity is stifling as I traverse, by foot, the city center of Dar es Salaam. As a newcomer to the country, I am marveling at the beehive of activity that is this city of nearly two million in a country that was once the German colony of Tanganyika, and later a part of the British Empire. Sidewalks are lined with card tables where vendors are actively hawking their wares, some with marketing skills that would put many westerners to shame.

I purchase a few German coins (dated 1916) that once circulated in the colonial days. Nearby is an entrepreneur selling cigarettes individually for those who cannot afford to buy a full pack. (I later find out that it is possible to purchase a cigarette by the puff.) A table with stacked copies of The Economist magazine catches my attention, but my interest wanes when I discover that the most recent one is nearly four years old. An attractive young woman dressed in a flowing green, pink, and white sari is selling tomatoes that are meticulously arranged in threesomes. A brief conversation reveals that she is a registered nurse, but can earn more by selling vegetables than by plying her nursing skills in a country that is starved for medical services.

The streets are crowded, and I continue to zigzag along sidewalks, occasionally glancing downward at cement slabs that are sometimes chipped or broken and generally showing much wear and tear since originally laid by the British. Suddenly, I bump shoulders with a young Tanzanian man with one hand cusped around his lips, who says just loudly enough for me to hear, “Change money, my friend?” As I looked back, I did not recognize this friend. However, he had certainly identified me as Mr. Hard Currency, and I had just been propositioned. For me, this was my informal entrance into a very vibrant corner of the foreign exchange market in this African country.

Although I declined this young man’s offer, I soon learned much about the black market where U.S. dollars were exchanged for Tanzanian shillings. Indeed, expatriate faculty members were active participants, and some offered to assist me in obtaining a better rate for my U.S. dollars. University students in my classes approached me with the story that they needed to do a foreign exchange transaction with me to purchase an economics book priced in U.S. dollars. I was somewhat caught off guard when, on a visit to the U.S. embassy, a ranking embassy official cautioned me: Be certain to get a good rate for your dollars.

Six months later, I enjoy a very pleasant lunch in the open-aired restaurant atop the Kilimanjaro Hotel. We are surrounded by bougainvillea, now in full bloom. Perched before us in the middle of the Dar es Salaam harbor (possibly since Genesis) is the partially submerged ship, its bow forever pointed skyward. My waiter smiles broadly when I order Pepsi mbili (two Pepsis, right away). Once acclimated, life in the tropics can be utterly enchanting. Following my sumptuous meal, I pay and exit. The charge was $10 or $3.33, respectively, depending on whether one exchanges dollars with the government of Tanzania or in the black market.

As I enter my white Peugeot parked outside the hotel, two Tanzanian men dressed in business suits approach me. They identify themselves as police officers and state that they had a report that I had violated the foreign exchange control laws of Tanzania. Although my heart rate accelerates, I deny this allegation and suggest that they had the wrong individual.

When asked if I would mind coming down to the police station, I willingly comply. Outside the station, a third individual in full police uniform joins us. The three of them question me with the suggestion eventually made that we move under a nearby tree to avoid the heat. While the questions are rapid-fire, the officers thoughtfully remind me that one of their major concerns is to preserve my good name as a distinguished visitor in the country. After about 10 minutes of back-and-forth questions and answers, I more clearly comprehend the drift of their inquiries and pass the gentlemen 400 shillings. All depart.

Afterward, I walk down a nearby street attempting to process all that had transpired during the encounter. Suddenly, it hit me like a thunderbolt that, in all likelihood, at most only one of these three individuals was actually a police officer. In universities we refer to the payment I had just rendered as tuition—the remuneration offered for the privilege of learning.

These episodes in no way intimate that reading this book will help you become a more street-smart participant in foreign exchange markets. Quite the opposite, the intent is to make you more book-smart. This book provides you with a solid analytical foundation for understanding foreign exchange markets, and how they relate to underlying monetary standards. As you read, you will become better acquainted with important issues such as exchange-rate stability brought about by market forces, and how it differs from exchange rate stability occasioned by government price-fixing, what it means for a country to have a nonconvertible currency, how the central...