• Value of currency determined by government or central bank. Demand & supply of currency usually not in balance under this system so government has to use reserves if demand for foreign currency is greater than supply.
• If there is too much pressure on overseas currency reserves, government may be forced to devalue or place severe restrictions on the movement of funds.
• Conversely, with supply of foreign currency exceeding demand, a reduction may be necessary if the government begins to hold too many reserves.
Floating Exchange Rates
• Exchange rates set by market forces = markets determine FX price price discovery
• NZD was floated in March 1985.
• The FX market will remain in balance under this system in terms of all cash flows.
FX Market Participants
Firms conducting international trade transactions
Investors/borrowers in international money/capital markets
- FX Dealers
Organisations acting as principals in FX market
Institutions that quote buy(bid) and sell(offer) prices for foreign currencies
Institutions include commercial/investment banks, merchant banks
- Central Banks
Enter FX market periodically
Various reasons to enter include:
1) acquire foreign currency to pay for govt's import purchases and to pay interest/redeem govt overseas borrowings
2) Change composition of central bank's holdings of foreign currencies as part of their management of official reserve assets
3) Influence exchange rate
- Firms conducting international trade transactions
Country exporting G&S = often receive payment in foreign payment. Sell foreign $, buy local currency via FX market.
Country importing products = need to pay for goods in $ not recipient's home country. Sell local currency, buy foreign $
Take advantage of buy/sell price differences between markets
Arbitrageurs = carry out simultaneous buy/sell transactions in 2+ markets, in order to achieve risk-free profit.