Currency Markets & Derivatives Introduction - Chapter 1

Fascinating journey of global currency markets

Currency in the form we see it today is just a few hundred years old. But currencies in different forms have been in existence since thousands of years. In early civilizations cattle, gold, silver and copper were used as currency. Coins have been minted for a much longer time and it is only recently that paper currency was introduced. To understand the evolution of currencies, we need to look at two distinct phases of world history viz. pre-Bretton Woods and post-Bretton Woods.

The Bretton Woods system prevailed from 1944 to 1971, when Richard Nixon actually pulled the dollar out of the Gold standard. Under the Bretton Woods system, all currencies were pegged to USD at a fixed rate and USD value was pegged to gold. The US guaranteed to other central banks that they could convert their currency into USD at any time and USD value will be pegged to value of gold. This resulted in the USD becoming the dominant currency of the world. By 1971 the US found that managing Bretton Woods was becoming impossible and dismantled the gold standard.

Post-1971, countries adopted a system of free float or managed float to value currencies. Developed countries moved to market determined exchange rate while emerging markets adopted a pegged currency or managed rates. In the pegged system, the value of currency is pegged to another currency or a basket of currencies. The benefit of pegged currency is that it creates an environment of stability for foreign investors as they know the value of their investment in the country at any point of time would be fixed. However, the 1998 Asian crisis revealed the risks of pegged currencies. While India does a managed float, Chinese Yuan is still pegged to the dollar.

Currency Pairs – How they are traded?

Currencies are always traded in pairs and are always expressed in terms of the price of one currency with reference to the other currency. Typically, in any currency pair, there is the base currency and the quote currency. The base is the currency which is expressed in terms of 1 unit. For example if you write USDINR = Rs.71.95, then USD is the base currency and INR is the quotation currency. The quotation currency (INR) is expressed in terms of 1 unit of the base currency i.e. $1 = Rs.71.95. Globally, the most popular pair is the EURUSD pair and it accounts for 23% of all currency trades in the world. Here EUR (Euro) is the base currency and USD is the quotation currency i.e. EUR1 = $1.25 is the dollar value expressed in terms of 1 Euro. Currencies are either traded in local currency pairs (USDINR) or cross currency pairs (EURUSD).

The free floating currencies are normally the most actively traded currencies in the world and they include the Euro (EUR), US Dollar (USD), Japanese Yen (JPY), Pound Sterling (GBP), Australian Dollar (AUD), Canadian Dollar (CAD), and the Swiss Franc (CHF). Some of the most active pairs in the world are EURUSD, USDJPY, GBPUSD, AUDUSD, CADUSD and USDCHF. In all the above pairs, the first currency is the base currency and the second currency is the quotation currency expressed as 1 unit of base currency.

According to Bureau of International Settlement, the share of major currency pairs in daily trading volume is given below:

EURUSD is the most active currency pair. Followed by USDJPY

USD acts as vehicle currency for determining price of relatively smaller currencies like Peso, INR, KRW etc.

US Dollar as the nucleus of global currency markets

The US Dollar is the most widely traded currency for 3 reasons. Firstly, the dollar has a major role as an investment currency in most capital markets. Secondly, the dollar is most important reserve currency for global central banks. Lastly, the dollar is the commonly invoiced currency for world trade. The USD is also a very important intermediate currency. For example, a trader wanting to shift funds from Indian Rupees to Malaysian Ringgit will sell INR for US Dollars and then sell the US Dollars for Ringgit. That is more because INR-MYR will not be as liquid as the dollar trades with both currencies.

Apart from the US Dollar, the other major currencies that are vehicles for global currency markets in the order of importance include the Euro (EUR), the Japanese Yen (JPY), the British Pound (GBP) and the Swiss Franc (CHF). The Euro, which was officially launched in 1999, subsumed a lot of European hard currencies including the Deutsche Mark, French Franc, Italian Lira, Spanish Peseta, Dutch Guilder etc.