AVANT Financial Services

1737 Smith South Ln. Apopka Fl, 32489

November 14, 2014

Mr. Charles Martin

Dear Mr. Martin:

On November 8, 2014 you ask me some questions about foreign exchange markets

characteristics and functioning as part of your strategy of driving this company to new global

markets. As a response to those inquiries, I am sending you this report in which you can find the

answer to all those matters that can prevent this company in going global.

Brief history of the development of foreign exchange system

We could say that currency trading dates from Middle Ages when countries established the

first trading system. This system evolves until what was the creation of a real worldwide foreign

exchange market in 1875. Is in that year when the gold standard monetary system was created as

the first form of exchange between nations for all their international payments.

The value of these metals was unstable in time because it was constantly being affected by

the changes in the supply and demand, and the countries decided to go return to the use of their

national currencies. by a certain amount of gold. By the twentieth century, most of the countries

pegged their currencies to one ounce of gold, so the difference in price of one ounce of gold

between two currencies became their exchange rate.

The gold standard was abandoned during the World War I in order to finance the war

efforts and also because since governments were issuing too money there was not enough gold to
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support that demand. During the World War II the same thing happened and Allied countries

decided to create a new monetary system. The Bretton Woods monetary system, as the result of

these efforts, replaced gold with the US dollar as the new exchange currency. However, this

system failed when the US decided to end the exchange of gold for US dollars by foreign banks

in 1971. In this situation the Bretton Woods Agreement was broken and countries could freely

exchange their money. Two years after this, market deregulation opened the industry more and

speculators appeared. In the 1980s, cross-border capital movements accelerated with the advent

of computers and technology, extending market continuum through Asian, European and

American time zones. Transactions in foreign exchange rocketed from about $70 billion a day in

the 1980s.

Even though that until 1998, the Foreign Exchange Market was a closed market with

transactions limited to large corporations, major banks and financial institutions, that same year

the market was opened to individual investors. This increased its daily volume to over hundred

times the total share market, and now it transacts over three trillion dollars a day. It is estimated

that the market is made up 95% of speculating and hedging. It is a conservative estimate that this

market produced more than $1.5 trillion a day by the year 2000, and was expected to reach $7

trillion by 2007.

Reasons why gold standard was eliminated

Even though gold was the first standard in the exchange market some of its disadvantages

provoked its elimination. The first reason for this action was predicted in the erroneous thought

that the size and health of a country's economy is dependent upon its supply of gold. In this way

of thinking, countries without any gold are at a competitive disadvantage.

Another problem with the gold standard was that countries to become obsessed with

keeping their gold, rather than improving the business climate. For example, during the Great
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Depression, the Federal Reserve raised interest rates to make dollars more valuable and prevent

people from demanding gold, instead of lowering rates to stimulate the economy.

Finally, governmental actions to protect their gold reserves caused large fluctuations in its

own economy. Taking the United States as an example again, between 1890 and 1905 its

economy suffered five major recessions for this reason.

Floating exchange rate system

When talking about floating exchange rate system we should begin by defining what an

exchange rate system is. An exchange rate system is the rate at which one currency can be

exchanged for another currency. In simple words, is the value of another country's currency

compared to another one. An exchange rate can be determined in two ways: (1) fixed rate, (2)

floating rate. The fixed rate or pegged rate is a rate that the government sets through its Central

Bank and maintains as the official exchange rate. A set price will be determined against a major

world currency, usually the U.S. dollar. In order to maintain the local exchange rate, the central

bank buys and sells its own currency on the foreign exchange market in return for the currency to

which it is pegged.

On the other hand, the gloating exchange rate is determined by the private market through

supply and demand. A floating rate is often termed "self-correcting," because any differences in

supply and demand will automatically be corrected in the market. A floating exchange rate is

constantly changing. In a floating rate system, the government may also intervene when it is

necessary to ensure stability of its currency and to avoid inflation.

Manage float or Managed floating exchange system

Managed floating exchange system is a typo of floating exchange rate in which a

government intervenes at some frequency to change the direction of the float by buying or selling
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currencies. Since most floating currencies manage their regimes with occasional governmental

intervention this term applies mainly to frequent or dramatic interventions.

Consequences of governmental intervention in exchange markets

In some occasions governments through its Central Banks intervenes in the currency

market by purchasing or selling a currency in an effort to strengthen or weaken that currency

relative to other currencies. As an example, when the Federal Reserve System decides to

intervene in the currency market by buying United States dollars and selling European Euros is

because it’s trying to strengthen the U.S. dollar over the euro.

Even though it is not illegal or prohibited those Central banks around the world intervene in

the Foreign Exchange market they have to be careful that their actions are not interpreted as

currency manipulation. On the other hand, most Central banks claim that their interventions are

in the best interest of the country, economic or as part of a strategy or monetary policy. Because

the objective of most central banks is to promote economic growth along with maintaining price

stability, a central bank main be provoked to intervene in the currency market if its currency’s

valuation possess a threat against economic growth.

Also countries must constantly monitor the exchange markets because Central banks have

the power to change the direction of a currency’s trading price. If the global community isn’t

pushing a currency’s trading price too heavily then the powerful Central bank can change its

trading direction with a single intervention by pushing the currency’s trading price in another

direction.

Finally, Central bank interventions can damage a currency trader’s trade when it intervenes

in the currency markets without notice. If a Central bank intervenes and causes a currency pair to

suddenly and rapidly move in the opposite direction it was originally headed, it can cause

currency traders around the world to lose profit or even lose principle.
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Pegging currency to a dollar

When we hear the expression “pegging currency to a dollar” what it means is that the

currency of that country is fixing its exchange rate by matching its value to the value of another

single currency or to a basket of other currencies, or to another measure of value, such as gold or

silver. In this case the currency of another country is fixing its value to the U.S. dollar. The

advantage of pegging a currency to another currency is that it facilitates trade and investments

between the two countries, especially those small economies. Another use that some countries

have for pegging their currency is as a means to control inflation.

Advantages of Eurobonds over normal bonds

If we want to talk about the advantages of Eurobonds over normal bonds first we need to

understand what are the characteristics of that long term financial measure. Even though a

Eurobond is a bond that can be denominated in any currency, the prefix "euro" indicates that the

currency borrowed by issuing the bond is held outside the country corresponding to that

currency. As an example, if a U.S. company wants to issue Eurodollars that means that is a bond

to borrow U.S. dollars from outside the U.S. in the Eurodollar market. Some of the advantages of

this bond is that they are generally restricted to large, single issues ($50 million or more), and is

limited to large companies, banks or governments. Also, the maturity term of these bonds are

usually around 10 years or less.

In terms of investment issuing Eurobonds can help a multinational company to raise foreign

debt in large amounts, for long periods of time, and usually at a fixed interest rate. These

characteristics of the bonds help these companies to finance large, long-term, overseas

developments, such the establishment of a subsidiary. Finally, another consideration about

Eurobonds is the offsetting of currency risks. As a subsidiary has the responsibility of paying
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interest for those bonds by issuing Eurobonds they can prevent the mismatches between currency

and interest rate and also prevent interest rate swaps.

Our recommendation as Comptroller of this company is, that all these characteristics and

functions of the foreign exchange system should be weighted with precaution before making any

business decision on going global.

__________________________
Alejandro Ramirez
Comptroller
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References

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currency-market/

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for-a-eurobond

StudyForex (s.f.). The history of foreign exchange. Retrieved on November 8, 2014 from
http://www.studyforex.com/history.html

The Free Dictionary (s.f.). Managed float. Retrieved on November 10, 2014 from http://financial-
dictionary.thefreedictionary.com/Managed+Floating+Exchange+Rate+System

Wordpress (s.f.) What is currency peg? Retrieved on November 10, 2014 from
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