Foreign Exchange Market: Trends, Role of Central Banks & Analysis of Exchange Rates

This article discusses the history of foreign exchange regimes, exchange rate systems, currency wars, national monetary policy options, and central bank's intervention in the foreign exchange market. It also provides an analysis of the historical values of foreign exchange rates of USD, EUR, JPY, CNY, and MYR with respect to AUD.

Running head: BAO3402 GROUP ASSIGNMENT
BAO3402 GROUP ASSIGNMENT
Name of Student
Name of University
Author Note

1
BAO3402 GROUP ASSIGNMENT
Table of Contents
1. The Foreign Exchange Market, future trends and Role of national central/reserve banks..........3
2. An Exercise in Analysis of Foreign Exchange Rates..................................................................7
Reference.......................................................................................................................................14

2
BAO3402 GROUP ASSIGNMENT
1. The Foreign Exchange Market, future trends and Role of national central/reserve banks
Foreign exchange regimes in the history
International trade policies subscribed to the use of gold and silver before 1875. However
it was soon perceived that this led to difficulties with the rise and fall of prices when there was a
rise or fall in demand and supply. It was then that the gold standard was first informally
introduced. The standard was first formally then introduces in the 1900s with the signing of the
Gold Standard Act by the then US president, William Mckinley. However this came to end as the
US faced financial crisis during the World War 2. This was owing to the fact that as the
European powers continued to produce surplus money which exceeded their gold reserves to
fund the war, the US ended up having to expend large volumes of their own gold. This obviously
created a disparity in trade leading to the US to make private ownership of gold as illegal.
Following the end of the war, the US dollar was upheld as the international reserve currency with
agreement of 45 countries, establishing the Bretton Woods regime (King, Osler and Rime 2013).
Meanwhile, the International Monetary Fund (IMF) came into existence in 1947, to play
the role of a supranational entity which would promote global cooperation and trade, and to
guide and aid developing nations in monetary matters. It was following this that the Bretton
Woods regime came in 1971 to an end as with increased trade by the US led to shortage of US
dollars in other countries and US failed to meet the demand for the volume of dollars. This was
followed by a brief period of one year where the Smithsonian agreement came into effect,
according to which the new standard rates were fixed on the basis of the devalued value of the
dollar. Finally in 1976, the world saw the introduction of the first paper based currency regime,

3
BAO3402 GROUP ASSIGNMENT
when the IMF abolished gold in totality as a reserve asset as per the Jamaica Agreement and
formally established the floating exchange rate regime.
Foreign Exchange Rate Systems
Exchange rate systems can be categorized as per the degree of its “fixity” or “flexibility”.
Currently, there exists a total of 9 kinds of rating systems as per the policies of the governments
of the countries. These systems are primarily monitored and controlled by the monetary
authorities of the respective countries. These 9 regimes can be broadly divided into 3 groups as
per the degree of “fixity”.
Fixed arrangements are those which have a fixed standard exchange rate, either against a
specific value, or with respect to another currency such as the US dollar which are called dollar
pegs. Examples of such arrangements would be the CFA franc zone, which is truly fixed, the
European Union is another example, referred to as a currency union where the member countries
share the same currency. Another kind of fixed regime is a currency board, where the total asset
reserves are kept in a foreign currency equivalent to the local monetary base, by the monetary
authority (Cooper 2014). This is what the British and French did during the colonization age in
their colonial territories.
Intermediate arrangements in comparison to the fixed arrangement regimes, involve
adjustable “pegs”. Such arrangements periodically or as per convenience tend to adjust or change
the standard rates or pegs. The rate regimes, adjustable pegs, crawling pegs, basket pegs and
target zone or bands fall under this category or exchange rate regimes. Adjustable peg systems
periodically modify their pegs, basket peg on the other hand fixes the peg as a weighted measure
of a set of foreign currencies. Crawling pegs engages in changing the currency rate through
devaluating the currency serially. Countries employing target zone system have a pre-determined

4
BAO3402 GROUP ASSIGNMENT
threshold margins, the breach in which prompts the monetary authority to reset the current rates
to suit the needs of the time (Born, Juessen, and Müller 2013).
Floating exchange rates can be categorized into 2 groups, namely free floats and managed
floats. The free float system allows the market forces to freely influence the exchange rates. The
managed float system on the other hand, has the provision of the authorities to take steps and
intervene whenever the situation is seen to go against the desired direction.
Currency wars
It is well understood that relative value of currency is a key aspect which is said to
influence and act as an indicator of a country’s economy. The fall of value of currency implicates
the failure of the country in maintaining living standards and high inflation. However currency
wars such as the ongoing one between China and US stands testament to the fact that often
countries may want to devalue their own currency. This is because a cheaper currency value can
be used as a tool to boost exports and this would also mean that the price of imports would
increase which would go on to increase aggregate demand, all of which contributes to growth in
the economy (Blanchard 2016). Therefore, the competitive advantage that a cheaper currency
brings.
National monetary policy options
As per the Mundell-Fleming trilemma or impossible trinity, out of the policies of open
capital markets, monetary independence and pegged exchange rates, only 2 can be implemented
at a time. This was validated whenever a body tried to implement all 3 together, like the Bretton
woods system which was operating smoothly till monetary independence became a significant
factor in the policy leading to its demise. This was primarily because the move demanded the

5
BAO3402 GROUP ASSIGNMENT
authorities to take control of the capital market leading to a breakdown of the policy (O’Rourke
2014).
Central bank’s intervention in the foreign exchange market
A central authority such as the national bank or reserve bank may intervene in the
exchange market in 2 ways. It was choose to exercise its powers of laying down regulations and
restrictions, through its control of interest rates, control of outstanding credit by means of credit
ceilings or through implementing directed lending, hence directly controlling the market or it
may take a more subtle indirect route (Engel 2014). The authority instead of interfering in the
market by setting up parameters, may instead choose to control the market by prompting signals
to the market. These can be achieve via open market operations such as selling or buying
financial instruments like treasury bills, commercial pares and central bank notes in the primary
and secondary market. Another approach to indirect control is via enabling lending facilities
which involves rediscounting the assets of high quality. Yet another way is to implement reserve
requirements, wherefore it is made mandatory for all the banks to keep a specific part of their
portfolios in the central bank (King, Osler and Rime 2013).
The choice of the authorities to exercise direct or indirect control policies however lie
solely with the kind of outcome that is felt to be more aligned with their strategy. Direct control
is simple to execute and helps the authorities to control the credit aggregates, both distribution
and cost. It is also seen that fiscal cost if implementation is low for such policies. Although, this
also come with the addition price of ensuring efficient resource allocation. This can lead to a
situation which is unfavorable for new financial institutions due to the heavy reliance on the
existing banks for determining credit ceilings. It also has the risk of financial repression by

6
BAO3402 GROUP ASSIGNMENT
economic powers of all of its competition, overhanging of liquidity and even disintermediation
leading to flow of fund into the informal, unregulated market (King, Osler and Rime 2013).
Indirect control on the other hand has been seen to facilitate intermediation via the formal
sector. The indirect control policy allows for more flexibility in policy, making the introduction
of smaller but frequent modification easier, so that the authorities may be able to respond to
situations more readily.
International trade and exchange rate control
A typical kind of control that the central banks or a government monetary authorities may
seek to exercise it that of the foreign exchange resources. Such policies intercept and regulate the
dealing of exporters and importers. This allows for the authorities to control the amount of
foreign currency flowing into the nation and thereby control the exchange market conditions.
Practices such as import licensing and making the foreign transactions exclusively through the
central or reserve banks so that the amount may be monitored (Neely and Weller 2013). This
however may end up restricting the importing business and hence are deemed as non-tariff
barriers.
2. An Exercise in Analysis of Foreign Exchange Rates
The historical values of the foreign exchange rates of the currencies, US Dollar (USD),
Euro (EUR), the Japanese Yen (JPY), Chinese Yuan (CNY) and Malaysian Ringgit (MYR)
between January 2013 and January 2018 were analyzed with respect to the Australian currency.
The exchange rates of the USD was seen to show a decreasing trend. However the values are
seen to be following an increasing trend with a low positive slope when focusing since 2016,
which seems to be stabilizing. The overall exchange rate has however decreased since 2013. In

7
BAO3402 GROUP ASSIGNMENT
fact it is observed that the value of the AUD fell below that of the USD since May of 2013. The
value of 1 AUD seems to be around 0.8 USD since 2017.
an02-J -13
Mar27- -13
un19-J -13
Sep11- -13
Dec04- -13
eb26-F -14
May21- -14
Aug13- -14
ov05-N -14
an28-J -15
Apr22- -15
ul15-J -15
ct07-O -15
Dec30- -15
Mar23- -16
un15-J -16
Sep07- -16
ov30-N -16
eb22-F -17
May17- -17
Aug09- -17
ov01-N -17
0.0000
0.2000
0.4000
0.6000
0.8000
1.0000
1.2000
Foreign exchange rates for USD between 2013
and 2017
Figure 1: Historical Exchange Rate of USD compared to AUD
The exchange rate of CNY with respect to AUD was seen to follow a downward trend.
This implies that either there is an increase in the value of currency of AUD has decreased or that
the value of CNY has increased. However it can be seen that from the exchange rates that 1
AUD has decreased from a little above 6 CNY to about 5 AUD over the period. The currency
exchange rates seem to have gone back to a stable trend since.

8
BAO3402 GROUP ASSIGNMENT
an02-J -13
Mar27- -13
un19-J -13
Sep11- -13
Dec04- -13
eb26-F -14
May21- -14
Aug13- -14
ov05-N -14
an28-J -15
Apr22- -15
ul15-J -15
ct07-O -15
Dec30- -15
Mar23- -16
un15-J -16
Sep07- -16
ov30-N -16
eb22-F -17
May17- -17
Aug09- -17
ov01-N -17
0.0000
1.0000
2.0000
3.0000
4.0000
5.0000
6.0000
7.0000
oreign e change rates for C betweenF x NY 2013
and 2017
Figure 2: Historical Exchange Rate of CNY compared to AUD
The exchange rate has been to remain ore or lee the same across the period, showing a
dip around 2016 but then again increased to suggest that the rates have not changed much at the
end of the period. The exchange rate is however quite high with 1 AUD being equivalent to
around 90 JPY.
an02-J -13
Mar27- -13
un19-J -13
Sep11- -13
Dec04- -13
eb26-F -14
May21- -14
Aug13- -14
ov05-N -14
an28-J -15
Apr22- -15
ul15-J -15
ct07-O -15
Dec30- -15
Mar23- -16
un15-J -16
Sep07- -16
ov30-N -16
eb22-F -17
May17- -17
Aug09- -17
ov01-N -17
0.00
20.00
40.00
60.00
80.00
100.00
120.00
oreign e change rates for betweenF x JPY 2013
and 2017
Figure 3: Historical Exchange Rate of JPY compared to AUD

9
BAO3402 GROUP ASSIGNMENT
The value of the EUR is seen to be greater than the AUD. However the plot of the
historical exchange rates show that the rate values have shown a low sloped downward trend.
This means that either the AUD has increased in value of the EUR has decreased, however the
decrease is very slow. The rates however stabilize by the end of 2013, during which there was a
dip of 0.8 to 0.7.
an02-J -13
Mar27- -13
un19-J -13
Sep11- -13
Dec04- -13
eb26-F -14
May21- -14
Aug13- -14
ov05-N -14
an28-J -15
Apr22- -15
ul15-J -15
ct07-O -15
Dec30- -15
Mar23- -16
un15-J -16
Sep07- -16
ov30-N -16
eb22-F -17
May17- -17
Aug09- -17
ov01-N -17
0.0000
0.1000
0.2000
0.3000
0.4000
0.5000
0.6000
0.7000
0.8000
0.9000
oreign e change rates for R betweenF x EU 2013
and 2017
Figure 4: Historical Exchange Rate of EUR compared to AUD
The value of MYR is seen to be historically lower than that of the AUD. The rates
however are seen to be increasing since 2015 after a period of slow decrease till before that. The
overall change from before and after the period is seen to not be large. The value of 1 AUD is
seen to be equal to be around 3 MYR at the end of the period.

10
BAO3402 GROUP ASSIGNMENT
an02-J -13
Mar27- -13
un19-J -13
Sep11- -13
Dec04- -13
eb26-F -14
May21- -14
Aug13- -14
ov05-N -14
an28-J -15
Apr22- -15
ul15-J -15
ct07-O -15
Dec30- -15
Mar23- -16
un15-J -16
Sep07- -16
ov30-N -16
eb22-F -17
May17- -17
Aug09- -17
ov01-N -17
0.0000
0.5000
1.0000
1.5000
2.0000
2.5000
3.0000
3.5000
4.0000
oreign e change rates for M R betweenF x Y 2013
and 2017
Figure 5: Historical Exchange Rate of MYR compared to AUD
The annual average change in daily exchange rates of the five currencies with respect to
the AUD are given in the table as follows. The annual average of daily change in the rates for US
are seen to be negative but very close to zero except in 2017 which was also close to zero.
Table 1: Average of Daily exchange rate change
Row Labels USD MYR CNY EUR JPY
2013 -0.000606819 -0.000304978 -0.000728653 -0.000765065 0.000152923
2014 -0.000330758 -8.47975E-05 -0.000234278 0.00017292 0.000186127
2015 -0.000430354 0.00037824 -0.000248952 -5.35405E-06 -0.000398023
2016 -1.4807E-05 0.000154905 0.000251716 0.000139369 -0.000107837
2017 0.000313241 -8.85407E-05 5.40855E-05 -0.000191659 0.000175864
Grand Total -0.000214179 1.159E-05 -0.000181021 -0.000129303 1.23274E-06
Table 1: Average of Daily exchange rate change

11
BAO3402 GROUP ASSIGNMENT
Table 2: Standard deviation of exchange rate change
Row Labels USD MYR CNY EUR JPY
2013 0.006416566 0.005669423 0.006315867 0.006498649 0.008370908
2014 0.005667336 0.004680472 0.005537618 0.00561403 0.005723571
2015 0.00758102 0.006874385 0.007365845 0.008065891 0.007951027
2016 0.006875216 0.005692816 0.006297399 0.007455697 0.01043887
2017 0.00510748 0.004679824 0.004503639 0.005008657 0.005454358
Grand
Total 0.006389394
0.00557656
9 0.00608004 0.006626225 0.007799414
Table 2: Standard deviation of exchange rate change
The value at risk is the measure of expected loss, which in this case assumed a 95%
confidence interval. The following table contains the computed values of VaR for the overall
period for each of the currencies. This could affect foreign direct investment as higher VaR
would discourage foreign trade (Hayakawa, Kimura and Lee 2013).
USD MYR CNY EUR JPY
VaR -0.010756679 -0.010756679 -0.010756679 -0.010756679 -0.010756679
Table 2: VaR for each of the currencies.
The maximum and minimum value of the foreign exchange rate changes are given im the
table as follows
USD MYR CNY EUR JPY
Max change of rate in
2016
0.01346061
6
0.01346061
6
0.01346061
6
0.01346061
6
0.01346061
6
Min change of rate in -0.01349023 - -0.01349023 - -0.01349023

12
BAO3402 GROUP ASSIGNMENT
2016 0.01349023 0.01349023
Table 2: Maximum and minimum change in rate
The currencies USD, JPY and EUR showed an overall decreasing trend, this can be
owing to higher inflation than. This can also be said to impact CYN, however it could also be
impacted owing to the lower interest rates imposed by the central monetary body of China,
leading to lower exchange rates (Engel 2014). The MYP however seemed to be more or less
constant if not show a slight increase in exchange rates. This could be owing to either lower
inflation or higher interest rates in Malaysia.

13
BAO3402 GROUP ASSIGNMENT
Reference
Blanchard, O., 2016. Currency wars, coordination, and capital controls (No. w22388). National
Born, B., Juessen, F. and Müller, G.J., 2013. Exchange rate regimes and fiscal
multipliers. Journal of Economic Dynamics and Control, 37(2), pp.446-465.
Cooper, R.N., 2014. Exchange rate choices.
Engel, C., 2014. Exchange rates and interest parity. In Handbook of international
economics (Vol. 4, pp. 453-522). Elsevier.
Hayakawa, K., Kimura, F. and Lee, H.H., 2013. How does country risk matter for foreign direct
investment?. The Developing Economies, 51(1), pp.60-78.
King, M.R., Osler, C.L. and Rime, D., 2013. The market microstructure approach to foreign
exchange: Looking back and looking forward. Journal of International Money and Finance, 38,
pp.95-119.
Neely, C.J. and Weller, P.A., 2013. Lessons from the evolution of foreign exchange trading
strategies. Journal of Banking & Finance, 37(10), pp.3783-3798.
O’Rourke, K.H., 2014. A tale of two trilemmas. In Enacting Globalization (pp. 287-297).
Palgrave Macmillan, London.