Foreign-exchange reserves

 

Foreign-exchange reserves (also called forex reserves or FX reserves) is money or other assets held by a central bank or other monetary authority so that it can pay its liabilities if needed, such as the currency issued by the central bank, as well as the various bank reserves deposited with the central bank by the government and other financial .

In addition they are traded by speculators who hope to capitalize on their expectations of exchange rate movements. With these resources, the government buys foreign assets. Financial centers around the world function as anchors of trading between a wide range of multiple types of buyers and sellers around the clock, with the exception of weekends. The growth of electronic execution and the diverse selection of execution venues has lowered transaction costs, increased market liquidity, and attracted greater participation from many customer types. Because of the sovereignty issue when involving two currencies, Forex has little if any supervisory entity regulating its actions.

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Foreign-exchange reserves (also called forex reserves or FX reserves) is money or other assets held by a central bank or other monetary authority so that it can pay its liabilities if needed, such as the currency issued by the central bank, as well as the various bank reserves deposited with the central bank by the government and other financial .

Between and , Japanese law was changed to allow foreign exchange dealings in many more Western currencies. President, Richard Nixon is credited with ending the Bretton Woods Accord and fixed rates of exchange, eventually resulting in a free-floating currency system.

In —62, the volume of foreign operations by the U. Federal Reserve was relatively low. This was abolished in March Reuters introduced computer monitors during June , replacing the telephones and telex used previously for trading quotes. Due to the ultimate ineffectiveness of the Bretton Woods Accord and the European Joint Float, the forex markets were forced to close [ clarification needed ] sometime during and March Volume 18 , this event indicated the impossibility of the balancing of exchange stabilities by the measures of control used at the time and the monetary system and the foreign exchange markets in "West" Germany and other countries within Europe closed for two weeks during February and, or, March Exchange markets had to be closed.

March 1 " that is a large purchase occurred after the close. In developed nations, the state control of the foreign exchange trading ended in when complete floating and relatively free market conditions of modern times began. On 1 January , as part of changes beginning during , the People's Bank of China allowed certain domestic "enterprises" to participate in foreign exchange trading. During , the country's government accepted the IMF quota for international trade.

Intervention by European banks especially the Bundesbank influenced the Forex market on 27 February The United States had the second amount of places involved in trading. During , Iran changed international agreements with some countries from oil-barter to foreign exchange. The foreign exchange market is the most liquid financial market in the world.

Traders include governments and central banks, commercial banks, other institutional investors and financial institutions, currency speculators , other commercial corporations, and individuals. In April , trading in the United Kingdom accounted for Trading in the United States accounted for So the order became: Foreign exchange futures contracts were introduced in at the Chicago Mercantile Exchange and are traded more than to most other futures contracts.

Most developed countries permit the trading of derivative products such as futures and options on futures on their exchanges. All these developed countries already have fully convertible capital accounts. Some governments of emerging markets do not allow foreign exchange derivative products on their exchanges because they have capital controls.

The use of derivatives is growing in many emerging economies. The growth of electronic execution and the diverse selection of execution venues has lowered transaction costs, increased market liquidity, and attracted greater participation from many customer types. In particular, electronic trading via online portals has made it easier for retail traders to trade in the foreign exchange market.

Retail foreign exchange traders. The biggest geographic trading center is the United Kingdom, primarily London. According to TheCityUK , it is estimated that London increased its share of global turnover in traditional transactions from Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. For instance, when the International Monetary Fund calculates the value of its special drawing rights every day, they use the London market prices at noon that day.

Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the interbank foreign exchange market , which is made up of the largest commercial banks and securities dealers. Within the interbank market, spreads, which are the difference between the bid and ask prices, are razor sharp and not known to players outside the inner circle. The difference between the bid and ask prices widens for example from 0 to 1 pip to 1—2 pips for currencies such as the EUR as you go down the levels of access.

This is due to volume. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread.

The levels of access that make up the foreign exchange market are determined by the size of the "line" the amount of money with which they are trading.

An important part of the foreign exchange market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short-term impact on market rates.

Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational corporations MNCs can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants. National central banks play an important role in the foreign exchange markets. They can use their often substantial foreign exchange reserves to stabilize the market.

Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses, like other traders would. There is also no convincing evidence that they actually make a profit from trading.

Foreign exchange fixing is the daily monetary exchange rate fixed by the national bank of each country. The idea is that central banks use the fixing time and exchange rate to evaluate the behavior of their currency. Fixing exchange rates reflect the real value of equilibrium in the market. Banks, dealers and traders use fixing rates as a market trend indicator. The mere expectation or rumor of a central bank foreign exchange intervention might be enough to stabilize a currency.

However, aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank.

Investment management firms who typically manage large accounts on behalf of customers such as pension funds and endowments use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases. Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk.

While the number of this type of specialist firms is quite small, many have a large value of assets under management and can therefore generate large trades. Individual retail speculative traders constitute a growing segment of this market. Currently, they participate indirectly through brokers or banks. Retail brokers, while largely controlled and regulated in the USA by the Commodity Futures Trading Commission and National Futures Association , have previously been subjected to periodic foreign exchange fraud.

Those NFA members that would traditionally be subject to minimum net capital requirements, FCMs and IBs, are subject to greater minimum net capital requirements if they deal in Forex. A number of the foreign exchange brokers operate from the UK under Financial Services Authority regulations where foreign exchange trading using margin is part of the wider over-the-counter derivatives trading industry that includes contracts for difference and financial spread betting. There are two main types of retail FX brokers offering the opportunity for speculative currency trading: Brokers serve as an agent of the customer in the broader FX market, by seeking the best price in the market for a retail order and dealing on behalf of the retail customer.

They charge a commission or "mark-up" in addition to the price obtained in the market. Dealers or market makers , by contrast, typically act as principals in the transaction versus the retail customer, and quote a price they are willing to deal at.

Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as "foreign exchange brokers" but are distinct in that they do not offer speculative trading but rather currency exchange with payments i.

The volume of transactions done through Foreign Exchange Companies in India amounts to about USD 2 billion [70] per day This does not compete favorably with any well developed foreign exchange market of international repute, but with the entry of online Foreign Exchange Companies the market is steadily growing.

These are typically located at airports and stations or at tourist locations and allow physical notes to be exchanged from one currency to another. They access the foreign exchange markets via banks or non bank foreign exchange companies.

There is no unified or centrally cleared market for the majority of trades, and there is very little cross-border regulation. Due to the over-the-counter OTC nature of currency markets, there are rather a number of interconnected marketplaces, where different currencies instruments are traded. This implies that there is not a single exchange rate but rather a number of different rates prices , depending on what bank or market maker is trading, and where it is.

In practice, the rates are quite close due to arbitrage. A joint venture of the Chicago Mercantile Exchange and Reuters , called Fxmarketspace opened in and aspired but failed to the role of a central market clearing mechanism.

Banks throughout the world participate. Currency trading happens continuously throughout the day; as the Asian trading session ends, the European session begins, followed by the North American session and then back to the Asian session.

Fluctuations in exchange rates are usually caused by actual monetary flows as well as by expectations of changes in monetary flows. Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time. However, the large banks have an important advantage; they can see their customers' order flow. Currencies are traded against one another in pairs.

The first currency XXX is the base currency that is quoted relative to the second currency YYY , called the counter currency or quote currency. The market convention is to quote most exchange rates against the USD with the US dollar as the base currency e.

On the spot market, according to the Triennial Survey, the most heavily traded bilateral currency pairs were:. Trading in the euro has grown considerably since the currency's creation in January , and how long the foreign exchange market will remain dollar-centered is open to debate. Until recently, trading the euro versus a non-European currency ZZZ would have usually involved two trades: The following theories explain the fluctuations in exchange rates in a floating exchange rate regime In a fixed exchange rate regime, rates are decided by its government:.

None of the models developed so far succeed to explain exchange rates and volatility in the longer time frames. For shorter time frames less than a few days , algorithms can be devised to predict prices. It is understood from the above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces of demand and supply.

The world's currency markets can be viewed as a huge melting pot: No other market encompasses and distills as much of what is going on in the world at any given time as foreign exchange. Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: Internal, regional, and international political conditions and events can have a profound effect on currency markets.

All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation's economy. For example, destabilization of coalition governments in Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect.

Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:. A spot transaction is a two-day delivery transaction except in the case of trades between the US dollar, Canadian dollar, Turkish lira, euro and Russian ruble, which settle the next business day , as opposed to the futures contracts , which are usually three months.

Spot trading is one of the most common types of Forex Trading. Often, a forex broker will charge a small fee to the client to roll-over the expiring transaction into a new identical transaction for a continuation of the trade.

This roll-over fee is known as the "Swap" fee. One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then.

With these resources, the government buys foreign assets. Thus, the government coordinates the savings accumulation in the form of reserves. Sovereign wealth funds are examples of governments that try to save the windfall of booming exports as long-term assets to be used when the source of the windfall is extinguished.

There are costs in maintaining large currency reserves. Price fluctuations in exchange markets result in gains and losses in the purchasing power of reserves. In addition to fluctuations in exchange rates, the purchasing power of fiat money decreases constantly due to devaluation through inflation. Therefore, a central bank must continually increase the amount of its reserves to maintain the same power to manipulate exchange rates.

Reserves of foreign currency provide a small return in interest. However, this may be less than the reduction in purchasing power of that currency over the same period of time due to inflation, effectively resulting in a negative return known as the "quasi-fiscal cost".

In addition, large currency reserves could have been invested in higher yielding assets. Several calculations have been attempted to measure the cost of reserves. The traditional one is the spread between government debt and the yield on reserves. The caveat is that higher reserves can decrease the perception of risk and thus the government bond interest rate, so this measures can overstate the cost.

Alternatively, another measure compares the yield in reserves with the alternative scenario of the resources being invested in capital stock to the economy, which is hard to measure. One interesting [6] measure tries to compare the spread between short term foreign borrowing of the private sector and yields on reserves, recognizing that reserves can correspond to a transfer between the private and the public sectors.

In the context of theoretical economic models it is possible to simulate economies with different policies accumulate reserves or not and directly compare the welfare in terms of consumption. Results are mixed, since they depend on specific features of the models. A case to point out is that of the Swiss National Bank , the central bank of Switzerland. The Swiss franc is regarded as a safe haven currency , so it usually appreciates during market's stress.

In the aftermath of the crisis and during the initial stages of the Eurozone crisis , the Swiss franc CHF appreciated sharply. The central bank resisted appreciation by buying reserves. After accumulating reserves during 15 months until June , the SNB let the currency appreciate. The modern exchange market as tied to the prices of gold began during Official international reserves, the means of official international payments, formerly consisted only of gold, and occasionally silver.

But under the Bretton Woods system, the US dollar functioned as a reserve currency, so it too became part of a nation's official international reserve assets. From —, the US dollar was convertible into gold through the Federal Reserve System, but after only central banks could convert dollars into gold from official gold reserves, and after no individual or institution could convert US dollars into gold from official gold reserves.

Since , no major currencies have been convertible into gold from official gold reserves. Individuals and institutions must now buy gold in private markets, just like other commodities.

Even though US dollars and other currencies are no longer convertible into gold from official gold reserves, they still can function as official international reserves. Central banks throughout the world have sometimes cooperated in buying and selling official international reserves to attempt to influence exchange rates and avert financial crisis.

Historically, especially before the Asian financial crisis , central banks had rather meager reserves by today's standards and were therefore subject to the whims of the market, of which there was accusations of hot money manipulation, however Japan was the exception.

In the case of Japan, forex reserves began their ascent a decade earlier, shortly after the Plaza Accord in , and were primarily used as a tool to weaken the surging yen. This build-up has major implications for today's developed world economy, by setting aside so much cash that was piled into US and European debt, investment had been crowded out , the developed world economy had effectively slowed to a crawl, giving birth to contemporary negative interest rates.

By , the world had experienced yet another financial crisis, this time the US Federal Reserve organized Central bank liquidity swaps with other institutions. Developed countries authorities adopted extra expansionary monetary and fiscal policies, which led to the appreciation of currencies of some emerging markets. The resistance to appreciation and the fear of lost competitiveness led to policies aiming to prevent inflows of capital and more accumulation of reserves.

This pattern was called currency war by an exasperated Brazilian authority, and again in followed the commodities collapse , Mexico had warned China of triggering currency wars. The IMF proposed a new metric to assess reserves adequacy in Those liquidity needs are calculated taking in consideration the correlation between various components of the balance of payments and the probability of tail events. The higher the ratio of reserves to the developed metric, the lower is the risk of a crisis and the drop in consumption during a crisis.

Besides that, the Fund does econometric analysis of several factors listed above and finds those reserves ratios are generally adequate among emerging markets. Reserves that are above the adequacy ratio can be used in other government funds invested in more risky assets such as sovereign wealth funds or as insurance to time of crisis, such as stabilization funds.

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