Covered interest rate parity

The following common approximation is valid when S is not too volatile :


An example
In short, assume that

This would imply that one dollar invested in the US < one dollar converted into a foreign currency and invested abroad. Such an imbalance would give rise to an arbitrage opportunity, where in one could borrow at the lower effective interest rate in US, convert to the foreign currency and invest abroad.

The following rudimentary example demonstrates covered interest rate arbitrage (CIA). Consider the interest rate parity (IRP) equation,


Assume:

the 12-month interest rate in US is 5%, per annum
the 12-month interest rate in UK is 8%, per annum
the current spot exchange rate is 1.5 $/£
the forward exchange rate implied by a forward contract maturing 12 months in the future is 1.5 $/£.
Clearly, the UK has a higher interest rate than the US. Thus the basic idea of covered interest arbitrage is to borrow in the country with lower interest rate and invest in the country with higher interest rate. All else being equal this would help you make money riskless. Thus,

Per the LHS of the interest rate parity equation above, a dollar invested in the US at the end of the 12-month period will be,
$1 · (1 + 5%) = $1.05
Per the RHS of the interest rate parity equation above, a dollar invested in the UK (after conversion into £ and back into $ at the end of 12-months) at the end of the 12-month period will be,
$1 · (1.5/1.5)(1 + 8%) = $1.08
Thus one could carry out a covered interest rate (CIA) arbitrage as follows,

1.Borrow $1 from the US bank at 5% interest rate.
2.Convert $ into £ at current spot rate of 1.5$/£ giving 0.67£
3.Invest the 0.67£ in the UK for the 12 month period
4.Purchase a forward contract on the 1.5$/£ (i.e. cover your position against exchange rate fluctuations)
At the end of 12-months

1.0.67£ becomes 0.67£(1 + 8%) = 0.72£
2.Convert the 0.72£ back to $ at 1.5$/£, giving $1.08
3.Pay off the initially borrowed amount of $1 to the US bank with 5% interest, i.e $1.05
The resulting arbitrage profit is $1.08 − $1.05 = $0.03 or 3 cents per dollar.

Obviously, arbitrage opportunities of this magnitude would vanish very quickly.

In the above example, some combination of the following would occur to reestablish Covered Interest Parity and extinguish the arbitrage opportunity:

US interest rates will go up
Forward exchange rates will go down
Spot exchange rates will go up
UK interest rates will go down

Interest rate parity

Interest rate parity, or sometimes incorrectly known as International Fisher effect, is an economic concept, expressed as a basic algebraic identity that relates interest rates and exchange rates. The identity is theoretical, and usually follows from assumptions imposed in economic models. There is evidence to support as well as to refute the concept.

Interest rate parity is a non-arbitrage condition which says that the returns from borrowing in one currency, exchanging that currency for another currency and investing in interest-bearing instruments of the second currency, while simultaneously purchasing futures contracts to convert the currency back at the end of the holding period, should be equal to the returns from purchasing and holding similar interest-bearing instruments of the first currency. If the returns are different, an arbitrage transaction could, in theory, produce a risk-free return.

Looked at differently, interest rate parity says that the spot price and the forward or futures price of a currency incorporate any interest rate differentials between the two currencies.

Two versions of the identity are commonly presented in academic literature: covered interest rate parity and uncovered interest rate parity.

Cost of carry

The cost of carry is the cost of " carring " or holding a position. If long , the cost of carry is the cost of interest paid on a margin account. Conversely, if short, the cost of carry is the cost of paying dividends, or opportunity cost the cost of purchasing a particular security rather than an alternative. For most investments, the cost of carry generally refers to the risk-free interest rate that could be earned by investing currency in a theoretically safe investment vehicle such as a money market account minus any future cash-flows that are expected from holding an equivalent instrument with the same risk (generally expressed in percentage terms and called the convenience yield). Storage costs (generally expressed as a percentage of the spot price) should be added to the cost of carry for physical commodities such as corn, wheat, or gold.

The cost of carry model expresses the forward price (or, as an approximation, the futures price) as a function of the spot price and the cost of carry.


where F is the forward price, S is the spot price, e is the base of the natural logarithms, r is the risk-free interest rate, s is the storage cost, c is the convenience yield, and t is the time to delivery of the forward contract (expressed as a fraction of 1 year).

The same model in currency markets is known as interest rate parity.

For example, a US investor buying a Standard and Poor's 500 e-mini futures contract on the Chicago Mercantile Exchange could expect the cost of carry to be the prevailing risk-free interest rate (around 5% as of November, 2007) minus the expected dividends that one could earn from buying each of the stocks in the S&P 500 and receiving any dividends that they might pay, since the e-mini futures contract is a proxy for the underlying stocks in the S&P 500. Since the contract is a futures contract and settles at some forward date, the actual values of the dividends may not yet be known so the cost of carry must be estimated.

Carrying charge

A carrying charge is the cost of storing a physical commodity, such as grain or metals , over a period of time. The carrying charge includes insurance , storage and interest on the invested funds as well as other incidental costs. In interest rate futures markets, it refers to the differential between the yield on a cash instrument and the cost of the funds necessary to buy the instrument. Also referred to as cost of carry.

The interest expense on money borrowed to finance a margined securities position.

Why should a convenience yield exist?

Users of a consumption asset may obtain a benefit from physically holding the asset (as inventory ) prior to T (maturity) which is not obtained from the futures contract. These benefits include the ability to profit from temporary shortages, and the ability to keep a production process running.

One of the main reasons that it appears is due to availability of stocks and inventories of the commodity in question. Everyone who owns inventory has the choice between consumption today versus investment for the future. A rational investor will choose the outcome that is best.

When inventories are high, this suggests an expected relatively low scarcity of the commodity today versus some time in the future. Otherwise, the investor would not perceive that there is any benefit of holding onto inventory and therefore sell his stocks. Hence, expected future prices should be higher than they currently are. Futures or forward prices Ft,T of the asset should then be higher than the current spot price, St. From the above formula, this only tells us that r − c > 0.

The interesting line of reasoning comes when inventories are low. When inventories are low, we expect that scarcity now is greater than in the future. Unlike the previous case, the investor can not buy inventory to make up for demand today. In a sense, the investor wants to borrow inventory from the future but is unable. Therefore, we expect future prices to be lower than today and hence that Ft,T < St. This implies that r − c < 0.

Consequently, the convenience yield is inversely related to inventory levels.

Convenience yield

A convenience yield is an adjustment to the cost of carry in the non -arbitrage pricing formula for forward prices in markets with trading constraints.

Let Ft,T be the forward price of an asset with initial price St and maturity T. Suppose that r is the continuously compounded interest rate for one year. Then, the non-arbitrage pricing formula should be

Ft,T = Ster(T − t).

However, this relationship does not hold in most commodity markets, partly because of the inability of investors and speculators to short the underlying asset, St. Instead, there is a correction to the forward pricing formula given by the convenience yield c. Hence

Ft,T = Ste(r − c)(T − t).

This makes it possible for backwardation to be observable.

Example: A trader in derivatives market, has observed that the price of 6 month gold futures price is Rs.12,000 per 10 grams and the spot price is Rs.13,710 per 10 grams. The annualized borrowing rate is 12.5% and storage cost is negligible. In this regard, the convenience yield:



12000 = 13710 + (13710 x 0.125 x 6/12 - convenience yield)

CY = Rs. 2566.875; as a percentage of spot price = 18.72%

Known Risks

The 2008-2009 Icelandic financial crisis has among its origins the undisciplined use of the carry trade. The US dollar and the yen have been the currencies most heavily used in carry trade transactions since the 1990s. There is some substantial mathematical evidence in macroeconomics that larger economies have more immunity to the disruptive aspects of the carry trade mainly due to the sheer quantity of their existing currency compared to the limited amount used for FOREX carry trades.

Currency

The term carry trade without further modification refers to currency carry trade: investors borrow low- yielding currencies and lend (invest in) high-yielding currencies. It tends to correlate with global financial and exchange rate stability, and retracts in use during global liquidity shortages.

The risk in carry trading is that foreign exchange rates may change to the effect that the investor would have to pay back more expensive currency with less valuable currency. In theory, according to uncovered interest rate parity, carry trades should not yield a predictable profit because the difference in interest rates between two countries should equal the rate at which investors expect the low-interest-rate currency to rise against the high-interest-rate one. However, carry trades weaken the currency that is borrowed, because investors sell the borrowed money by converting it to other currencies.

By early year 2007, it was estimated that some US$1 trillion may be staked on the yen carry trade. Since the mid-90's, the Bank of Japan has set Japanese interest rates at very low levels making it profitable to borrow Japanese yen to fund activities in other currencies. These activities include subprime lending in the USA, and funding of emerging markets, especially BRIC countries and resource rich countries.

Interest rates

For instance, the traditional income stream from commercial banks is to borrow cheap ( at the low overnight rate, i.e., the rate at which they pay depositors) and lend expensive (at the long-term rate, which is usually higher than the short-term rate).

This works with an upward-sloping yield curve, but it loses money if the curve becomes inverted. Many investment banks, such as Bear Stearns, have failed because they borrowed cheap short-term money to fund higher interest bearing long-term positions. When the long-term positions default, or the short-term money dries up, the bank cannot meet its short-term liabilities and goes under.

According to a popular anecdote, traditional commercial banking was characterized as a "3-6-3" business: borrow at 3%, lend at 6% (thus earning the 3% spread), be on the golf course by 3 pm.While this may have been close to the truth in the market of the 1950s to the 1970s, the modern competitive market ensures that profits are kept more in line with perceived risks.

Carry (investment)

The carry of an asset is the return obtained from holding it (if positive), or the cost of holding it (if negative).

For instance, commodities are usually negative carry assets, as they incur storage costs or may suffer from depreciation, but in some circumstances, commodities can be positive carry assets if the market is willing to pay a premium for its demand.

This can also refer to a trade with more than one leg, where you earn the spread between borrowing a low carry asset and lending a high carry one.

Carry trades are not arbitrages: pure arbitrages make money no matter what; carry trades make money only if nothing changes against the carry's favor.

Dollar versus euro

Not long after the introduction of the euro (€ ; ISO 4217 code EUR) as a cash currency in 2002, the dollar began to depreciate steadily in value.As U.S. trade and budget deficits continued to increase, the euro started rising in value. By December 2004, the dollar had fallen to new lows against all major currencies; the euro rose above $1.36/€ (under €0.74/$) for the first time, in contrast to previous lows in early 2003 (€0.87/$). In the first quarter of 2004 the U.S. dollar, with the advantage of Federal Reserve's policy of raising the interest rates, regained some standing against all major currencies, climbing from €0.78/$ to €0.84/$. However, all gains were lost in the second half of 2004, and the dollar stood at €0.74/$ at the end of 2004. Since 2002, the only year in which the dollar actually recovered against the euro was 2005. Although some analysts previewed the dollar dropping as far as $1.60/€ (€0.63/$), it finished 2005 with an increase against the euro, climbing to €0.83/$. An interest rate reduction by the Federal Reserve on September 18, 2007, raised the euro's value significantly and caused the dollar to fall below €0.70 one month later, to new record lows.Economists like Alan Greenspan suggest that another reason for the continued fall of the dollar is its decreasing role as the world's reserve currency. Jim Rogers declared that he thinks the dollar's value will fall even further, especially against the Chinese yuan. Chinese officials signaled plans to diversify the nation's $1.9 trillion reserve in response to a falling U.S. currency which also set the dollar under pressure. However, a sharp turnaround occurred in late 2008 with the global financial crisis, with the dollar and Japanese yen rising against most world currencies. One reason to this might be that the dollar was regarded as safe-haven and therefore got stronger during the initial phase of the global financial crisis. As a result of the recent global financial crisis, China, the biggest foreign owner of U.S. Treasury securities, and other countries such as India and Russia are backing away from the dollar to diversify their securities. The dollar has rebounded to near multi-year highs as of May 2010 on weakness in the European monetary union which has put pressure on central banks to reinvest in the dollar and away from euros.

Dollarization and fixed exchange rates

Other countries besides the United States use the U.S. Dollar as thier official currency, a process known as official dollarization.For instance , Panama has been using the dollar alongside the Panamanian balnoa as the legal tender since 1904 at a conversion rate of 1:1. Ecuador (2000), El Salvador (2001), and East Timor (2000) all adopted the currency independently. The former members of the U.S.-administered Trust Territory of the Pacific Islands, which included Palau, the Federated States of Micronesia, and the Marshall Islands, chose not to issue their own currency after becoming independent, having all used the U.S. dollar since 1944. Two British dependencies also use the U.S. dollar: the British Virgin Islands (1959) and Turks and Caicos Islands (1973).

Some countries that have adopted the U.S. dollar issue their own coins: See Ecuadorian centavo coins, Panamanian Balboa and East Timor centavo coins.

Some other countries link their currency to U.S. dollar at a fixed exchange rate. The local currencies of Bermuda and the Bahamas can be freely exchanged at a 1:1 ratio for USD. Argentina used a fixed 1:1 exchange rate between the Argentine peso and the U.S. dollar from 1991 until 2002. The currencies of Barbados and Belize are similarly convertible at an approximate 2:1 ratio. In Lebanon, one dollar is equal to 1500 Lebanese pound, and is used inter­changeably with local currency as de facto legal tender. The exchange rate between the Hong Kong dollar and the United States dollar has also been linked since 1983 at HK$7.8/USD, and pataca of Macau, pegged to Hong Kong dollar at MOP1.03/HKD, indirectly linked to the U.S. dollar at roughly MOP8/USD. Several oil-producing Arab countries on the Persian Gulf, including Saudi Arabia, peg their currencies to the dollar, since the dollar is the currency used in the international oil trade.

The People's Republic of China's renminbi was informally and controversially pegged to the dollar in the mid-1990s at ¥ 8.28/USD. Likewise, Malaysia pegged its ringgit at RM3.8/USD in 1997. On July 21, 2005 both countries removed their pegs and adopted managed floats against a basket of currencies. Kuwait did likewise on May 20, 2007, and Syria did likewise in July 2007. However, after three years of slow appreciation, the Chinese yuan has been de facto re-pegged to the dollar since July 2008 at a value of ¥6.83/USD; although no official announcement had been made, the yuan has remained around that value within a narrow band since then, similar to the Hong Kong dollar.

Belarus, on the other hand, pegged its currency, the Belarusian ruble, to a basket of foreign currencies (U.S. dollar, euro and Russian ruble) in 2009.

In some countries such as Peru and Uruguay, the USD is commonly accepted although not officially regarded as a legal tender. In Mexico's border area and major tourist zones, it is accepted as if it were a second legal currency. Many Canadian merchants also accept US dollars, albeit sometimes only at face value. In Cambodia, US notes circulate freely and are preferred over the Cambodian riel for large purchases, with the riel used for change to break 1 USD. After the U.S. invasion of Afghanistan, U.S. dollars are accepted as if it were legal tender. Prices of most big ticket items such as houses and cars are set in U.S. dollars.

U.S. Dollar Index

The U.S.Dollar Index (Ticker :DXY) is the creation of the New York Board of Trade (NYBOT).It was established in 1973 for tracking the value of the USD against a basket of currencies,which,at that time,represented the largest trading partners of the United States. It began with 17 currencies from 17 nations, but the launch of the euro subsumed 12 of these into one, so the USDX tracks only six currencies today.

Euro 57.6%
Japanese yen 13.6%
Pound sterling 11.9%
Canadian dollar 9.1%
Swedish krona 4.2%
Swiss franc 3.6%

The Index is described by the NYBOT as "a trade weighted geometric average".The baseline of 100.00 on the USDX was set at its launch in March 1973. This event marks the watershed between the fixed-rate system of the Bretton Woods regime and the floating-rate system of the Smithsonian regime. Since then, the USDX has climbed as high as the 160s and drifted as low as the 70s.

The USDX has not been updated to reflect new trading realities in the global economy, where the bulk of trade has shifted strongly towards new partners like China and Mexico and oil-exporting countries while the United States has de-industrialized.

The dollar as international reserve currency

The U.S.dollar is an important international reserve currency along with the euro. The euro inherited this status from the German mark, and since its introduction, has increased its standing considerably, mostly at the expense of the dollar. Despite the dollar's recent losses to the euro, it is still by far the major international reserve currency, with an accumulation more than double that of the euro.

In August 2007, two scholars affiliated with the government of the People's Republic of China threatened to sell its substantial reserves in American dollars in response to American legislative discussion of trade sanctions designed to revalue the Chinese yuan. The Chinese government denied that selling dollar-denominated assets would be an official policy in the foreseeable future.

Former Federal Reserve Chairman Alan Greenspan said in September 2007 that the euro could replace the U.S. dollar as the world's primary reserve currency. It is "absolutely conceivable that the euro will replace the dollar as reserve currency, or will be traded as an equally important reserve currency."

International use

The dollar is also used as the standard unit of currency in international markets for commodities such as gold and petroleum ( the latter sometimes called petrocurrency is the source of the term petrodollar). Some non-U.S. companies dealing in globalized markets, such as Airbus, list their prices in dollars.

The U.S. dollar is the world's foremost reserve currency. In addition to holdings by central banks and other institutions there are many private holdings which are believed to be mostly in $100 denominations. The majority of U.S. notes are actually held outside the United States. All holdings of US dollar bank deposits held by non-residents of the US are known as eurodollars (not to be confused with the euro) regardless of the location of the bank holding the deposit (which may be inside or outside the U.S.) Economist Paul Samuelson and others maintain that the overseas demand for dollars allows the United States to maintain persistent trade deficits without causing the value of the currency to depreciate and the flow of trade to readjust. Milton Friedman at his death believed this to be the case but, more recently, Paul Samuelson has said he now believes that at some stage in the future these pressures will precipitate a run against the U.S. dollar with serious global financial consequences.

Price inflation

Price inflation is a rise in the general level of prices of goods and services in an economy over period of time.Ecomists view price inflation as a result or necessary outcome of monetary inflation .

A consumer price index (CPI) is a measure estimating the average price of consumer goods and services purchased by households. The United States Consumer Price Index is a measure estimating the average price of consumer goods and services in the United States. The following chart shows that the average price of consumer goods and services in the United States has been rising significantly since the 1970s.

Purchasing power of U.S. dollar

The following table shows the equivalent amount of goods that , in a particular year, could be purchased with $ 1.The table shows that from 1774 through 2009 the U.S. dollar has lost about 96.4% of its buying power.

The value of $1 over time, in 1776 dollars.Buying power of one U.S. dollar compared to 1774 USD Year Equivalent buying power Year Equivalent buying power Year Equivalent buying power
1774 $1.00 1860 $0.97 1950 $0.33
1780 $0.59 1870 $0.62 1960 $0.26
1790 $0.89 1880 $0.79 1970 $0.20
1800 $0.64 1890 $0.89 1980 $0.10
1810 $0.66 1900 $0.96 1990 $0.06
1820 $0.69 1910 $0.85 2000 $0.05
1830 $0.88 1920 $0.39 2007 $0.04
1840 $0.94 1930 $0.47 2008 $0.04
1850 $1.03 1940 $0.56 2009 $0.04

Value of U.S. dollar

The 5th paragraph of Section 8 of Article 1 of the U.S. Constitution provides that the U.S. Congress shall have the power to "coin money" and to " regulate the valu" of domestic and foreign coins. Congress exercised those powers when it enacted the Coinage Act of 1792. That Act provided for the minting of the first U.S. dollar and it declared that the U.S. dollar shall have "the value of a Spanish milled dollar as the same is now current".

Means of issue of U.S. dollar

New dollars are issued when the Federal Reserve elects to fund the purchase of debt, primarily U.S. Treasury Bonds , by creating new reserves rather than financing the purchase with existing reserves. When the bond issuer spends the money, new dollars enter circulation.

In theory, Federal Reserve Notes are like checks: liabilities drawn on the Federal Reserve Bank. The Fed offsets these liabilities by holding U.S. Treasury Bonds as assets, which are backed by the U.S. Government's ability to levy taxes and repay.

When compared to hard money backed by gold or silver, this debt-based approach has the advantage of making the currency elastic, giving the government a means of expanding or contracting the money supply in response to changing economic conditions. The disadvantage of this approach is inflation. The money supply must be continually expanded in order to finance interest payments on the debt by which it is issued. This devalues the currency, causing inflation.

Banknotes of U.S. dollar

The U.S. Constitution provides that Congress shall have the power to " borrow money on the credit of the United States".Congress has excercised that power by authorizing twelve private companies —the Federal Reserve Banks—to issue Federal Reserve Notes. Those notes are "obligations of the United States" and "shall be redeemed in lawful money on demand at the Treasury Department of the United States, in the city of Washington, District of Columbia, or at any Federal Reserve bank." Federal Reserve Notes are designated by law as "legal tender" for the payment of debts. Congress has also authorized the issuance of more than 10 other types of banknotes, including the United States Note and the Federal Reserve Bank Note. The Federal Reserve Note is the only type that remains in circulation since the 1970s.

The largest denominations of currency currently printed or minted by the United States are the $100 bill and the $100 one troy ounce Platinum Eagle.

$1 and $2 color: White and rich gray
$5 color: Gray and some purple
$10 color: Light yellow
$20 color: Light green
$50 color: Deep blue and purple
$100 color: Rich light blue (Series 2009 redesign is scheduled for release on February 10, 2011)
Currently printed denominations are $1, $2, $5, $10, $20, $50, and $100. Notes above the $100 denomination ceased being printed in 1946 and were officially withdrawn from circulation in 1969. These notes were used primarily in inter-bank transactions or by organized crime; it was the latter usage that prompted President Richard Nixon to issue an executive order in 1969 halting their use. With the advent of electronic banking, they became less necessary. Notes in denominations of $500, $1,000, $5,000, $10,000, and $100,000 were all produced at one time; see large denomination bills in U.S. currency for details. These notes are now collector's items and are worth more than their face value to collectors.

The design of the notes has been accused of being unfriendly to the visually impaired. A U.S. District Judge ruled on November 28, 2006 that the American bills gave an undue burden to the blind and denied them "meaningful access" to the U.S. currency system. The judge ordered the Treasury Department to begin working on a redesign within 30 days.

Mint marks of U.S. dollar

Most U.S. coins bear a mint mark as part of the design , usually found on the front of the coin near te date although in the past it was more commonly found on the reverse . The Philadelphia Mint issues coins bearing a letter P (or no mark at all), while the Denver Mint uses a letter D. The San Francisco Mint uses an S, though no coins have been released from that mint for general circulation since 1980. It does, however, continue to strike proof coins for collectors. The West Point Mint uses a W, though this is rarely seen as the West Point mint generally only makes high denomination coins (with face values over $1.00) which are not meant for everyday use. A CC mark, for the Carson City Mint, was used for a short time in the mid-nineteenth century, but the mint at that location was only a temporary establishment. The New Orleans Mint used a mint mark O. It operated from the 1830s until the American Civil War, and again from 1879 to 1909. The letter D was also used for coinage of the Dahlonega Mint from 1837 to 1861, and C was used for the Charlotte Mint during the same timespan. The latter two mints struck gold coins only.

Dollar coins

The first United States dollar was minted in 1794.Known as the lowing Hair Dollar, it contained 416 grains of " standard silver" (89.25% silver and 10.75% of copper), as specified by Section 13 of the Coinage Act of 1792. It was designated by Section 9 of that Act as having "the value of a Spanish milled dollar".

Dollar coins have not been very popular in the United States. Silver dollars were minted intermittently from 1794 through 1935; a copper-nickel dollar of the same large size, featuring President Dwight D. Eisenhower, was minted from 1971 through 1978. Gold dollars were also minted in the 1800s. The Susan B. Anthony dollar coin was introduced in 1979; these proved to be unpopular because they were often mistaken for quarters, due to their nearly equal size, their milled edge, and their similar color. Minting of these dollars for circulation was suspended in 1980 (collectors' pieces were struck in 1981), but, as with all past U.S. coins, they remain legal tender. As the number of Anthony dollars held by the Federal Reserve and dispensed primarily to make change in postal and transit vending machines had been virtually exhausted, additional Anthony dollars were struck in 1999. In 2000, a new $1 coin, featuring Sacagawea, (the Sacagawea dollar) was introduced, which corrected some of the mistakes of the Anthony dollar by having a smooth edge and a gold color, without requiring changes to vending machines that accept the Anthony dollar. However, this new coin has failed to achieve the popularity of the still-existing $1 bill and is rarely used in daily transactions. The failure to simultaneously withdraw the dollar bill and weak publicity efforts have been cited by coin proponents as primary reasons for the failure of the dollar coin to gain popular support. There are indications that the dollar coin's failure was also due to the reluctance of armored transport companies to make the necessary adjustments to handle the new coins, and the government's reluctance to mandate it. The result of the armored carriers' unwillingness to handle the new coins was that they virtually never reached merchants in quantities sufficient to be given out as change on a routine basis, or for retail clerks to become used to handling them.

In February 2007, the US Mint, under the Presidential $1 Coin Act of 2005, introduced a new $1 US Presidential dollar coin. Based on the success of the "50 State Quarters" series, the new coin features a sequence of presidents in order of their inaugurations, starting with George Washington, on the obverse side. The reverse side features the Statue of Liberty. To allow for larger, more detailed portraits, the traditional inscriptions of "E Pluribus Unum," "In God We Trust," the year of minting or issuance, and the mint mark will be inscribed on the edge of the coin instead of the face. This feature, similar to the edge inscriptions seen on the British £1 coin, is not usually associated with US coin designs. The inscription "Liberty" has been eliminated, with the Statue of Liberty serving as a sufficient replacement. In addition, due to the nature of US coins, this will be the first time there will be circulating US coins of different denominations with the same President featured on the obverse (heads) side. (Lincoln/penny, Jefferson/nickel, Franklin D. Roosevelt/dime, Washington/quarter and Kennedy/half dollar.) Another unusual fact about the new $1 coin is Grover Cleveland will have two coins with his portrait issued due to the fact he was the only US President to be elected to two non-consecutive terms.

Early releases of the Washington coin included error coins shipped primarily from the Philadelphia mint to Florida and Tennessee banks. Highly sought after by collectors, and trading for as much as $850 each within a week of discovery, the error coins were identified by the absence of the edge impressions "E PLURIBUS UNUM IN GOD WE TRUST 2007 P". The mint of origin is generally accepted to be mostly Philadelphia, although identifying the source mint is impossible without opening a mint pack also containing marked units. Edge lettering is minted in both orientations with respect to "heads", some amateur collectors were initially duped into buying "upside down lettering error" coins. Some cynics also erroneously point out that the Federal Reserve makes more profit from dollar bills than dollar coins because they wear out in a few years, whereas coins are more permanent. The fallacy of this argument arises because new notes printed to replace worn out notes which have been withdrawn from circulation bring in no net revenue to the government to offset the costs of printing new notes and destroying the old ones. As most vending machines are incapable of making change in banknotes, they commonly accept only $1 bills, though a few will give change in dollar coins.

Collector coins

It should be noted the United States Mint produces Proof Sets specially for collectors and speculators. Silver Proofs tend to be the standard designs but with the dime , quater, half dollar, and in some cases the dollar having silver content. Another type of proof set is the Presidential Dollar Proof Set where four special $1 coins are minted each featuring a president.

2007 had George Washington, John Adams, Thomas Jefferson, and James Madison
2008 had James Monroe, John Quincy Adams, Andrew Jackson, and Martin Van Buren
2009 had William Henry Harrison, John Tyler, James K. Polk, and Zachary Taylor
2010 has Millard Fillmore, Franklin Pierce, James Buchanan, and Abraham Lincoln
2011 is to have Andrew Johnson, Ulysses S. Grant, Rutherford B. Hayes, and James A. Garfield

Coins of U.S. dollar

Official United States coins have been produced every year from 1792 to the present

Half-cent 1792 -1857
Penny 1793 - present
2-cent 1864- 1873
3- cent 1851-1873
Half Dime 1792-1873 (Not to be confused with the Nickel below also worth 5 cents)
Nickel 1866-present
Dime 1792-present
20-cent 1875-1878
Quarter 1796-present
Half dollar 1794-present
Dollar coin (United States) 1794-present
Quarter Eagle ($2.5 gold coin) 1792-1929
Three-dollar piece 1854-1889
Half Eagle ($5 gold coin) 1795-1929
Eagle ($10 gold coin) 1795-1929
Double Eagle ($20 gold coin) 1850-1933
Collector coins for which everyday transactions is non-existent.

American Eagles originally were not available from the Mint for individuals but had to be purchased from authorized dealers. In 2006 The Mint began direct sales to individuals of uncirculated bullion coins with a special finish, and bearing a "W" mintmark.
* American Silver Eagle $1 (1 troy ounce) silver bullion coin 1986-Present
* American Gold Eagle $5 (1/10 troy oz), $10 (1/4 troy oz), $25 (1/2 troy oz), and $50 (1/4 troy oz) Gold bullion coin 1986-Present
* American Platinum Eagle ($10, $25, $50, and $100 platinum coin) 1997–present
United States commemorative coins - special issue coins
* $50.00 (Half Union) 1915
* Presidential Proofs 2007-present
Technically, all these coins are still legal tender at face value, though some are far more valuable today for their numismatic value, and for gold and silver coins, their precious metal value. It should be noted that from 1965 to 1970 the Kennedy half dollar was the only circulating coin with any silver content though the Mint still makes what it calls Silver Proof sets for collectors.

In addition, an experimental $4.00 (Stella) coin was also minted, but never placed into circulation and is properly considered to be a pattern rather than an actual coin denomination.

The $50 coin mentioned was only produced in 1915 for the Panama-Pacific International Exposition (1915) celebrating the opening of the Panama Canal. Only 1,128 were made, 645 of which were octagonal; this remains the only US coin that was not round as well as the largest and heaviest US coin ever.

From 1934 to present the only denominations produced for circulation have been the familiar penny, nickel, dime, quarter, half dollar and dollar. The nickel is the only coin still in use today that is essentially unchanged (except in its design) from its original version. Every year since 1866, the nickel has been 75% copper and 25% nickel, except for 4 years during World War II when nickel was needed for the war

Silver and gold standards

From 1792 , when the Mint Act was passed , the dollar was pegged to silver at 371.25 grains, or 24.75 grains (1.604 g) of gold.Many historians erroneously assume gold was standardized at a fixed rate in parity with silver, however there is no evidence of Congress making this law. This has to do with Alexander Hamilton's suggestion to Congress of a fixed 15:1 ratio of silver to gold, respectively. The gold coins that were minted however, were not given any denomination whatsoever and traded for a market value relative to the Congressional standard of the silver dollar. 1834 saw a shift in the gold standard to 23.2 grains (1.50 g), followed by a slight adjustment to 23.22 grains (1.505 g) in 1837 (16:1 ratio).

In 1862, paper money was issued without the backing of precious metals, due to the Civil War. Silver and gold coins continued to be issued and in 1878 the link between paper money and coins was reinstated. This disconnection from gold and silver backing also occurred during the War of 1812. The use of paper money not backed by precious metals had also occurred under the Articles of Confederation from 1777 to 1788. With no solid backing and being easily counterfeited, the continentals quickly lost their value, giving rise to the phrase "not worth a continental". This was a primary reason for the "No state shall... make any thing but gold and silver coin a tender in payment of debts" clause in article 1, section 10 of the United States Constitution.

The Gold Standard Act of 1900 abandoned the bimetallic standard and defined the dollar as 23.22 grains (1.505 g) of gold, equivalent to setting the price of 1 troy ounce of gold at $20.67. Silver coins continued to be issued for circulation until 1964, when all silver was removed from dimes and quarters, and the half dollar was reduced to 40% silver. Silver half dollars were last issued for circulation in 1969.

Gold coins were confiscated in 1933 and the gold standard was changed to 13.71 grains (0.888 g), equivalent to setting the price of 1 troy ounce of gold at $35. This standard persisted until 1968. Between 1968 and 1975, a variety of pegs to gold were put in place. The price was at $42.22 per ounce before August 15, 1971 saw the U.S. dollar freely float on currency markets.

According to the Bureau of Engraving and Printing, the largest note it ever printed was the $100,000 Gold Certificate, Series 1934. These notes were printed from December 18, 1934 through January 9, 1935, and were issued by the Treasurer of the United States to Federal Reserve Banks only against an equal amount of gold bullion held by the Treasury. These notes were used for transactions between Federal Reserve Banks and were not circulated among the general public.

Continental currency of U.S. Dollar

In 1775 , the United States and the individual states began issuing "Continental Currency" denominated in Spanish dollars and ( for the issues of the states) the £sd currencies of the states. The dollar was valued relative to the states' currencies at the following rates:

State Value of Dollar in State Currency

1.Georgia 5 Shillings

2.Connecticut, Massachusetts, 6 Shillings

3.New Hampshire,Rhode Island, Virginia 71/2 Shillings
Delaware, Maryland

4.New Jersey, Pennsylvania
New York, North Carolina 8 Shillings

5.South Carolina 32½ Shillings

The continental currency suffered from printing press inflation and was replaced by the silver dollar at the rate of 1 silver dollar = 1000 continental dollars.

History of dollar

The first dollar coins issued by the United States Mint (founded 1792) were similar in and composition to the Spanish dollar. The Spanish, U.S. silver dollars, and Mexican silver pesos circulated side by side in the United States, and the Spanish dollar and Mexican peso remained legal tender until 1857. The coinage of various English colonies also circulated. The lion dollar was popular in the Dutch New Netherland Colony (New York), but the lion dollar also circulated throughout the English colonies during the seventeenth and early eighteenth centuries. Examples circulating in the colonies were usually worn so that the design was not fully distinguishable, thus they were sometimes referred to as "dog dollars".

The U.S. dollar was created and defined by the Coinage Act of 1792. It specified a "dollar" to be based in the Mexican peso at 1 dollar per peso and between 371 and 416 grains (27.0 g) of silver (depending on purity) and an 'eagle" to be between 247 and 270 grains (17 g) of gold (again depending on purity). The choice of the value 371 grains arose from Alexander Hamilton's decision to base the new American unit on the average weight of a selection of worn Spanish dollars (and later Mexican peso). Hamilton got the treasury to weigh a sample of Spanish dollars and the average weight came out to be 371 grains. A new Spanish dollar was usually about 377 grains in weight, and so the new US dollar was at a slight discount in relation to the Spanish dollar. The gold equivalent of the Spanish dollar in sterling was ₤1 = $4.80, whereas the gold equivalent of the US dollar was ₤1 = 4.86⅔. This exchange rate with sterling remained right up until Britain abandoned the gold standard in 1931.

The Coinage Act of 1792 set the value of an eagle at 10 dollars, and the dollar at 1/10th eagle. It called for 90% silver alloy coins in denominations of 1, 1/2, 1/4, 1/10, and 1/20; it called for 90% gold alloy coins in denominations of 1, 1/2, 1/4, and 1/10.

The value of gold or silver contained in the dollar was then converted into relative value in the economy for the buying and selling of goods. This allowed the value of things to remain fairly constant over time, except for the influx and outflux of gold and silver in the nation's economy.

The early currency of the USA did not exhibit faces of presidents, as is the custom now. In fact, George Washington was against having his face on the currency, a practice he compared to the policies of European monarchs. The currency as we know it today did not get the faces they currently have until after the early 1900s; before that "heads" side of coinage used profile faces and striding, seated, and standing figures from Greek and Roman mythology and generic native Americans. The last coins to be converted to profiles of historic Americans were the dime (1946) and the Dollar (1971).

For articles on the currencies of the colonies and states, see Connecticut pound, Delaware pound, Georgia pound, Maryland pound, Massachusetts pound, New Hampshire pound, New Jersey pound, New York pound, North Carolina pound, Pennsylvania pound, Rhode Island pound, South Carolina pound and Virginia pound.

Dollar sign

The symbol $, usually written before the numerical amount , is used for the U.S. dollar (as well as for many other currencies).The sign's ultimate origins are not certain, though it is possible that it comes from the Pillars of Hercules which flank the Spanish Coat of arms on the Spanish dollars that were minted in the New World mints in Mexico City, Potosí, Bolivia, and in Lima, Peru. These Pillars of Hercules on the silver Spanish dollar coins take the form of two vertical bars and a swinging cloth band in the shape of an "S".

An equally accepted, and better documented, explanation is that this symbol for peso was the result of a late eighteenth-century evolution of the scribal abbreviation "ps." The p and the s eventually came to be written over each other giving rise to $.

A fictional possibility suggested is that the dollar sign is the capital letters U and S typed one on top of the other. This theory, popularized by novelist Ayn Rand in Atlas Shrugged , does not consider the fact that the symbol was already in use before the formation of the United States.

Nicknames of a U.S. Dollar

The colloquialism buck ( much like the Bristish term " quid") is often used to refer to dollars of various nations, including the U.S. dollar. This term, dating to the 18th century, may have originated with the colonial fur trade. Greenback is another nickname originally applied specifically to the 19th century Demand Note dollars created by Abraham Lincoln to finance the costs of the Civil War for the North. The original note was printed in black and green on the back side. It is still used to refer to the U.S. dollar (but not to the dollars of other countries). Other well-known names of the dollar as a whole in denominations include "greenmail", "green", and "dead presidents", (the last due to the fact that late presidents are represented on the bills).

Grand, sometimes shortened to simply G, is a common term for the amount of $1,000. The suffix k (from "kilo-") is also commonly used to denote this amount (such as "$10k" to mean $10,000). In street slang, when someone refers to a "large" or "stack", they are usually referring to any amount of $1,000, such as "fifty large", meaning $50,000. Banknotes' nicknames are the same as their values (such as five, twenty, etc.) The $5 bill has been referred to as a "fin" or a "fiver" or a "five-spot;" the $10 bill as a "sawbuck," a "ten-spot," or a "Hamilton"; the $20 bill as a "double sawbuck," or a "Jackson"; the $1 bill is sometimes called a "single," or a "buck," the $2 bill a "deuce," "Jefferson," or a "T.J." and the $100 bill is nicknamed a "Benjamin," "Benji," or "Franklin" (after Benjamin Franklin, who is pictured on the note), C-note (C being the Roman numeral for 100), Century Note, or "bill" ("two bills" being $200, etc.). The dollar has also been referred to as a "bone" or "bones" (i.e., twenty bones is equal to $20) or a "bean". The newer designs are sometimes referred to as "Bigface" bills, or "Monopoly Money". Some people refer to U.S. money as "cha-chingers," "bucks," "green-backs," and also "smackers."

In Panama, the equivalent of buck is "palo" (literally "stick"). In Ecuador, the dollar is referred to as "lata". Puerto Ricans, both in Puerto Rico and in the U.S., may refer to the dollar as a peso. In French-speaking areas of Louisiana, the dollar is referred to as a piastre which is pronounced "pee-as", and cents by the French holdover of sous, pronounced "soo." In Mexico, in some places prices in dollars are referred to as "en americano" ("in American"). (In Mexico, peso is used primarily for the Mexican peso.) In Peru, a nickname for the U.S. dollar is coco, which is a pet name for Jorge (George in Spanish), a reference to the portrait of George Washington on the $1 note.

Etymology of Dollar

In the 1500s, Count Hiernymus Schlick of Bohemia began minting coins known as Joachimstalers (from Germathal, or nowadays usually Tal, "valley", cognate with "dale" in English), named for Joachimstal, the valley where the silver was mined (St. Joachim's Valley, now Jáchymov; then part of the Holy Roman Empire, now part of the Czech Republic). Joachimstaler was later shortened to the German Taler, a word that eventually found its way into Danish and Swedish as daler, Dutch as daalder, Ethiopian as talari, Italian as tallero, Flemish as daelder, and English as dollar. Alternatively, thaler is said to come from the German coin Guldengroschen ("great guilder", being of silver but equal in value to a gold guilder), minted from the silver from Joachimsthal.

Overview of U.S. Dollar

The Constitution of the United States of America provides that the United States Congress shall have the power "To coin Money". As an exerciseof that power, Congress enacted Section 5112 of Title 31 of the United States Code. Section 5112 provides that United States dollars shall be issued in two forms:
(1) a coin made of a copper alloy and
(2) a coin made of pure silver.Those coins are both designated in Section 5112 as "legal tender" in payment of debts.The Sacagawea dollar is one example of the copper alloy dollar. The pure silver dollar is known as the American Silver Eagle. Section 5112 also provides for the minting and issuance of other coins, which have values ranging from one-hundredth of one dollar to fifty dollars.These other coins are more fully described in Coins of the United States dollar.

The Constitution provides that "a regular Statement and Account of the Receipts and Expenditures of all public Money shall be published from time to time".That provision of the Constitution is made specific by Section 331 of Title 31 of the United States Code. The sums of money reported in the "Statements" are currently being expressed in U.S. dollars (for example, see the 2009 Financial Report of the United States Government). The U.S. dollar may therefore be described as the unit of account of the United States.

The word "dollar" is one of the words in the first paragraph of Section 9 of Article 1 of the U.S. Constitution. In that context, "dollars" is a reference to the Spanish milled dollar, a coin that had a monetary value of 8 Spanish units of currency, or reales. In 1792 the U.S. Congress adopted legislation titled An act establishing a mint, and regulating the Coins of the United States. Section 9 of that act authorized the production of various coins, including "DOLLARS OR UNITS—each to be of the value of a Spanish milled dollar as the same is now current, and to contain three hundred and seventy-one grains and four sixteenth parts of a grain of pure, or four hundred and sixteen grains of standard silver". Section 20 of the act provided, "That the money of account of the United States shall be expressed in dollars, or units... and that all accounts in the public offices and all proceedings in the courts of the United States shall be kept and had in conformity to this regulation". In other words, this act designated the United States dollar as the unit of currency of the United States.

The U.S. dollar bill uses the decimal system, consisting of 100 equal cents (symbol ¢). In another division, there are 1,000 mills or ten dimes to a dollar, or 4 quarters to a dollar. However, only cents are in everyday use as divisions of the dollar; "dime" is used solely as the name of the coin with the value of 10¢, while "eagle" and "mill" are largely unknown to the general public, though mills are sometimes used in matters of tax levies and gasoline prices. When currently issued in circulating form, denominations equal to or less than a dollar are emitted as U.S. coins while denominations equal to or greater than a dollar are emitted as Federal Reserve notes (with the exception of gold, silver and platinum coins valued up to $100 as legal tender, but worth far more as bullion). Both one-dollar coins and notes are produced today, although the note form is significantly more common. In the past, "paper money" was occasionally issued in denominations less than a dollar (fractional currency) and gold coins were issued for circulation up to the value of $20 (known as the "double eagle," discontinued in the 1930s). The term eagle was used in the Coinage Act of 1792 for the denomination of ten dollars, and subsequently was used in naming gold coins. In 1854, James Guthrie, then Secretary of the Treasury, proposed creating $100, $50 and $25 gold coins, which were referred to as a "Union," "Half Union," and "Quarter Union," thus implying a denomination of 1 Union = $100.

Today, USD notes are made from cotton fiber paper, unlike most common paper, which is made of wood fiber. U.S. coins are produced by the United States Mint. U.S. dollar banknotes are printed by the Bureau of Engraving and Printing, and, since 1914, have been issued by the Federal Reserve. The "large-sized notes" issued before 1928 measured 7.42 inches (188 mm) by 3.125 inches (79.4 mm); small-sized notes, introduced that year, measure 6.14 inches (156 mm) by 2.61 inches (66 mm) by 0.0043 inches (0.11 mm).

United States dollar

The United States dollar (sign: $; code: USD) is the official currency of the United States.The U.S. dollor is normally abbreviated as the dollar sign, $, or USD or US$ to distinguish it from other dollar-denominated currencies and from others that use the $ symbol. It is divided into 100 cents.

The U.S. dollar is the currency most used in international transactions. Several countries use it as their official currency, and in many others it is the de facto currency, and is also used as the sole currency in some British Overseas Territories.

Linguistic issues

The formal titles of the currency are euro for the major unit and the cent for the minor (one hundredth) unit and for official use in most eurozone languages;according to the ECB, all languages should use the same spelling for the nominative singular. This may contradict normal rules for word formation in some languages; e.g., those where there is no eu diphthong. Bulgaria has negotiated an exception; euro in the Cyrillic alphabet is spelled as eвро (evro) and not eуро (euro) in all official documents. The European Commission's Directorate-General for Translation states clearly that the plural forms euros and cents should be used in English.

Against other major currencies

After the introduction of the euro , its exchange rate against other currencies fell heavily, especially against the U.S. dollar. From an introduction at US$1.18/€, the euro fell to a low of $0.8228/€ by 26 October 2000. After the appearance of the coins and notes on 1 January 2002 and the replacement of all national currencies, the euro began steadily appreciating, and regained parity with the U.S. dollar, on 15 July 2002. The euro has not fallen below parity with the U.S. dollar since December 2002 but has risen in value.


Exchange rate evolution of the euro compared to USD, JPY and GBP. Exchange rate at start is put to 1.
Green: in Jan-1999: €1 = $1.18 ; in Jul-2008: €1 = $1.57
Red: in Jan-1999: €1 = ¥133 ; in Jul-2008: €1 = ¥168
Blue: in Jan-1999: €1 = £0.71 ; in Jul-2008: €1 = £0.80On 23 May 2003, the euro surpassed its initial ($1.18) trading value for the first time. At the end of 2004, it reached $1.3668 (€0.7316/$) as the U.S. dollar fell against all major currencies. Against the U.S. dollar, the euro temporarily weakened in 2005, falling to $1.18 (€0.85/$) in July 2005, and was stable throughout the third quarter of 2005. In November 2005 the euro again began to rise steadily against the U.S. dollar, hitting one record high after another. On 15 July 2008, the euro rose to an all-time high of $1.5990 (€0.6254/$). In a reversal, in August 2008 the euro began to drop against the U.S. dollar. In just two weeks the euro fell from its peak to $1.48 and by late October it reached a two and a half year low below $1.25 before moving back above $1.50 by November 2009.On 29 December 2008, the pound sterling fell to an all-time low of £0.97855 (€1.0219/£) against the euro, although its value recovered somewhat in 2009.In early 2010, concerns over the solvency of Greece caused a drop in the exchange rate against the dollar

Flexible exchange rates

The ECB targets interest rates rather than exchange rates and in general does not intervene on the foreign exchange rate markets, because of the implications of the Mundell-Fleming Model which suggest that a central bank cannot maintain interest rate and exchange rate targets simultaneously because increasing the money supply results in a depreciation of the currency. In the years following the Single European Act, the EU has liberalised its capital markets, and as the ECB has chosen monetary autonomy, the exchange rate regime of the euro is flexible, or floating.

Effect on interest rates

The introduction of the euro has decreased the interest rates of most members countries, in particular those with a weak currency.As a consequence the market value of firms from countries which previously had a weak currency has very significantly increased. The countries whose interest rates fell most as a result of the euro are Greece, Ireland, Portugal, Spain, and Italy.

Price convergence
The evidence on the convergence of prices in the eurozone with the introduction of the euro is mixed. Several studies failed to find any evidence of convergence following the introduction of the euro after a phase of convergence in the early 1990s. Other studies have found evidence of price convergency, in particular for cars. A possible reason for the divergence between the different studies is that the processes of convergence may not have been linear, slowing down substantially between 2000 and 2003, and resurfacing after 2003 as suggested by a recent study (2009).

Tourism
A study has found that the introduction of the euro has had a positive effect on tourism flows within the EMU, with an increase of 6.5%.

Financial integration

The introduction of the euro seems to have had a strong effect on European financial integration.According to a study on this question, it has "significantly reshaped the European financial system, especially with respect to the securities markets However, the real and policy barriers to integration in the retail and corporate banking sectors remain significant, even if the wholesale end of banking has been largely integrated." Specifically, the euro has significantly decreased the cost of trade in bonds, equity, and banking assets within the eurozone. On a global level, there is evidence that the introduction of the euro has led to an integration in terms of investment in bond portfolios, with eurozone countries lending and borrowing more between each other than with other countries.

Exchange rate risk

One of the advantages of the adoption of a common curency is the reduction of the risk associated with changes in currency exchange rates.It has been found that the introduction of the euro created "significant reductions in market risk exposures for nonfinancial firms both in and outside of Europe". These reductions in market risk "were concentrated in firms domiciled in the eurozone and in non-Euro firms with a high fraction of foreign sales or assets in Europe". These changes were however "statistically and economically small".

Evidence on the effect of the introduction of the euro

In conformity with the economic predictions , empirical studies have found that the introduction of the euro has had a positive impact on the movement of goods, financial assets, and people within the eurozone. In addition, countries which previously had weak currencies have benefited from lower interest rates and their firms now have easier access to capital.

Trade
The consensus from the studies of the effect of the introduction of the euro is that it has increased trade within the eurozone by 5% to 10%. On the lower bound, one study suggested an increase of 3%. A recent study estimates this effect to be between 9 and 14%.

Investment
Studies have found a positive effect of the introduction of the euro on investment. Physical investment seems to have increased by 5% in the eurozone due to the introduction. Regarding foreign direct investment, a study found that the intra-eurozone FDI stocks have increased by about 20% during the first four years of the EMU. Concerning the effect on corporate investment, there is evidence that the introduction of the euro has resulted in an increase in investment rates and that it has made it easier for firms to access financing in Europe. The euro has most specifically stimulated investment in companies that come from countries that previously had weak currencies. A study found that the introduction of the euro accounts for 22% of the investment rate after 1998 in countries that previously had a weak currency. The effect is however less clear for firms coming from the strong currency countries; the introduction has not been beneficial for most of them

Macroeconomic stability

Low levels of inflation are the hallmark of stable and modern economies.Because a high level of inflation acts as a (seigniorage) and theoretically discourages investment, it is generally viewed as undesirable. In spite of the downside, many countries have been unable or unwilling to deal with serious inflationary pressures. Some countries have successfully contained them by establishing largely independent central banks. One such bank was the Bundesbank in Germany; as the European Central Bank is modelled on the Bundesbank, it is independent of the pressures of national governments and has a mandate to keep inflationary pressures low. Member countries that join the bank commit to lower inflation, hoping to enjoy the macroeconomic stability associated with low levels of expected inflation. The ECB (unlike the Federal Reserve in the United States of America) does not have a second objective to sustain growth and employment.

Many national and corporate bonds denominated in euro are significantly more liquid and have lower interest rates than was historically the case when denominated in legacy currencies. While increased liquidity may lower the nominal interest rate on the bond, denominating the bond in a currency with low levels of inflation arguably plays a much larger role. A credible commitment to low levels of inflation and a stable debt reduces the risk that the value of the debt will be eroded by higher levels of inflation or default in the future, allowing debt to be issued at a lower nominal interest rate.

Price parity

Another effect of the common European currency is that differences in prices- in particular in price levels- should decrease because of the 'law of one price'. Differences in prices can trigger arbitrage, i.e. speculative trade in a commodity across borders purely to exploit the price differential. Therefore, prices on commonly traded goods are likely to converge, causing inflation in some regions and deflation in others during the transition. Some evidence of this has been observed in specific markets

Transaction costs and risks

The most obvious benefit of adopying a single currency is to ree the cost of exchanging currency, theoretically allowing businesses and individuals to consummate previously unprofitable trades. For consumers, banks in the eurozone must charge the same for intra-member cross-border transactions as purely domestic transactions for electronic payments (e.g., credit cards, debit cards and cash machine withdrawals).

The absence of distinct currencies also removes exchange rate risks. The risk of unanticipated exchange rate movement has always added an additional risk or uncertainty for companies or individuals that invest or trade outside their own currency zones. Companies that hedge against this risk will no longer need to shoulder this additional cost. This is particularly important for countries whose currencies had traditionally fluctuated a great deal, particularly the Mediterranean nations.

Financial markets on the continent are expected to be far more liquid and flexible than they were in the past. The reduction in cross-border transaction costs will allow larger banking firms to provide a wider array of banking services that can compete across and beyond the eurozone.

Optimal currency area

In economics , an optimum currency area (or region) (OCA, or OCR) is a geograhical region in which it would maximize economic efficiency to have the entire region share a single currency. There are two models, both proposed by Robert A. Mundell: the stationary expectations model and the international risk sharing model. Mundell himself advocates the international risk sharing model and thus concludes in favour of the euro. However, even before the creation of the single currency, there were concerns over diverging economies. Yet the chances of a state leaving the euro, or the chances that the whole zone would collapse, are extremely slim.

Currencies pegged to the euro

Outside the eurozone , a total of 23 countries and territories that do not belong to the EU have currencies that are directly pegged to the euro including 14 countries in mainland Africa (CFA franc and Moroccan dirham), two African island countries (Comorian franc and Cape Verdean escudo), three French Pacific territories (CFP franc) and another Balkan country, Bosnia and Herzegovina (Bosnia and Herzegovina convertible mark). On 28 July 2009, São Tomé and Príncipe signed an agreement with Portugal which will eventually tie its currency to the euro.

With the exception of Bosnia and Herzegovina (which pegged their currency against the German mark) and Cape Verde (formerly pegged to the Portuguese escudo) all of these non-EU countries had a currency peg to the French Franc before pegging their currencies to the euro. Pegging a country's currency to a major currency is regarded as a safety measure, especially for currencies of areas with weak economies, as the euro is seen as a stable currency, prevents runaway inflation and encourages foreign investment due to its stability.

Within the EU several currencies have a peg to the euro, in most instances as a precondition to joining the eurozone. The Bulgarian Lev and the Estonian kroon were formerly pegged to the German mark, other EU memberstates have a direct peg due to ERM II: the Danish krone, the Lithuanian litas and the Latvian lats.

In total, over 150 million people in Africa use a currency pegged to the euro, 25 million people outside the eurozone in Europe and another 500,000 people on Pacific islands.

Use as reserve currency

Since its introduction, the euro has been the second most widely held international reserve currency after the U.S. dollar.The share of the euro as a reserve currency has increased from 17.9% in 1999 to 26.5% in 2008, at the expense of the U.S. dollar (its share fell from 70.9% to 64.0% in the same timeframe) and the Yen (it fell from 6.4% to 3.3%). The euro inherited and built on the status of the second most important reserve currency from the German mark. The euro remains underweight as a reserve currency in advanced economies while overweight in emerging and developing economies: according to the IMF the total of euros held as a reserve in the world at the end of 2008 was equal to USD 1.1 trillion, with a share of 22% of all currency reserves in advanced economies, but a total of 31% of all currency reserves in emerging and developing economies.

The possibility of the euro becoming the first international reserve currency is now widely debated among economists. Former Federal Reserve Chairman Alan Greenspan gave his opinion in September 2007 that it is "absolutely conceivable that the euro will replace the dollar as reserve currency, or will be traded as an equally important reserve currency." In contrast to Greenspan's 2007 assessment the euro's increase in the share of the worldwide currency reserve basket has slowed considerably since the year 2007 and since the beginning of the worldwide credit crunch related recession and sovereign debt crisis.

Direct usage

The euro is the solo currency of 16 EU Member states: Austria , Belgium,Cyprus,Finland,France,Germany,Greece,Ireland,Italy,Luxembourg,Malta,the Netherlands, Portugal, Slovakia, Slovenia and Spain. These countries compose the "eurozone", some 326 million people in total. Estonia is expected to join in 2011, subject to approval from the Council.

With all but two of the remaining EU members obliged to join, together with future members of the EU, the enlargement of the eurozone is set to continue further. Outside the EU, the euro is also the sole currency of Montenegro and Kosovo and several European micro states (Andorra, Monaco, San Marino and Vatican City) as well as in three overseas territories of EU states that are not themselves part of the EU (Mayotte, Saint Pierre and Miquelon and Akrotiri and Dhekelia). Together this direct usage of the euro outside the EU affects over 3 million people.

It is also gaining increasing international usage as a trading currency, in Cuba,[29] North Korea and Syria. There are also various currencies pegged to the euro .In 2009 Zimbabwe abandoned its local currency and used major currencies instead, including the euro and the United States dollar.

Introduction of the Euro

The Euro was established by the provisions in the 1992 Maastricht Treaty.In order to participate in the currency,Member States are meant to meet strict criteria such as a budget deficit of less than three per cent of their GDP, a debt ratio of less than sixty per cent of GDP, low inflation, and interest rates close to the EU average. In the Maastricht Treaty, the United Kingdom and Denmark were granted exemptions per their request from moving to the stage of monetary union which would result in the introduction of the euro.

Economists who helped create or contributed to the euro include Fred Arditti, Neil Dowling, Wim Duisenberg, Robert Mundell, Tommaso Padoa-Schioppa and Robert Tollison.[citation needed] (For macro-economic theory, see below.) The name euro was devised on 4 August 1995 by Germain Pirlot, a Belgian Esperantist and ex-teacher of French and history, and officially adopted in Madrid on 16 December 1995.

Due to differences in national conventions for rounding and significant digits, all conversion between the national currencies had to be carried out using the process of triangulation via the euro. The definitive values in euro of these subdivisions (which represent the exchange rates at which the currency entered the euro) are shown at right.

The rates were determined by the Council of the European Union, based on a recommendation from the European Commission based on the market rates on 31 December 1998. They were set so that one European Currency Unit (ECU) would equal one euro. The European Currency Unit was an accounting unit used by the EU, based on the currencies of the Member States; it was not a currency in its own right. They could not be set earlier, because the ECU depended on the closing exchange rate of the non-euro currencies (principally the pound sterling) that day.

The procedure used to fix the irrevocable conversion rate between the drachma and the euro was different, since the euro by then was already two years old. While the conversion rates for the initial eleven currencies were determined only hours before the euro was introduced, the conversion rate for the Greek drachma was fixed several months beforehand.

The currency was introduced in non-physical form (traveller's cheques, electronic transfers, banking, etc.) at midnight on 1 January 1999, when the national currencies of participating countries (the eurozone) ceased to exist independently. Their exchange rates were locked at fixed rates against each other, effectively making them mere non-decimal subdivisions of the euro. The euro thus became the successor to the European Currency Unit (ECU). The notes and coins for the old currencies, however, continued to be used as legal tender until new euro notes and coins were introduced on 1 January 2002.

The changeover period during which the former currencies' notes and coins were exchanged for those of the euro lasted about two months, until 28 February 2002. The official date on which the national currencies ceased to be legal tender varied from Member State to Member State. The earliest date was in Germany where the mark officially ceased to be legal tender on 31 December 2001, though the exchange period lasted for two months more. Even after the old currencies ceased to be legal tender, they continued to be accepted by national central banks for periods ranging from several years to forever (the latter in Austria, Germany, Ireland and Spain). The earliest coins to become non-convertible were the Portuguese escudos, which ceased to have monetary value after 31 December 2002, although banknotes remain exchangeable until 2022.

Currency sign

A special euro currency (€) was designed after a public survey had narrowed the original ten proposals down to two.The European Commission then chose the design created by the Belgian Alain Billiet. The official story of the design history of the euro sign is disputed by Arthur Eisenmenger, a former chief graphic designer for the EEC, who claims to have created it as a generic symbol of Europe.

“ Inspiration for the € symbol itself came from the Greek epsilon (Є)– a reference to the cradle of European civilisation – and the first letter of the word Europe, crossed by two parallel lines to ‘certify’ the stability of the euro. ”
—European Commission


The European Commission also specified a euro logo with exact proportions and foreground/background colour tones. While the Commission intended the logo to be a prescribed glyph shape, font designers made it clear that they intended to design their own variants instead. Typewriters lacking the euro sign can create it by typing a capital 'C', backspacing and overstriking it with the equal ('=') sign. Placement of the currency sign relative to the numeric amount varies from nation to nation, but for texts in English the symbol (and the ISO-standard "EUR") should precede the amount.

Payments clearing, electronic funds transfer

Capital within the EU may be transferred in any amount from one country to another.All intra-EU transfers in euro are considered as domestic payments and bear the corresponding domestic transfer costs. This includes all Member States of the EU, even those outside the eurozone providing the transactions are carried out in euro. Credit/debit card charging and ATM withdrawals within the eurozone are also charged as domestic, however paper-based payment orders, like cheques, have not been standardised so these are still domestic-based. The ECB has also set up a clearing system, TARGET, for large euro transactions.

Coins and banknotes for Euros

The euro is divided into 100 cents(sometimes referred to as euro-cents,especially when distinguishing them from other currencies).In Community legislative acts the plural forms of euro and cent are spelled without the s, notwithstanding normal English usage.Otherwise, normal English plurals are recommended and used; with many local variations such as for example 'centime' in France.

All circulating coins have a common side showing the denomination or value, and a map in the background. For the denominations except the 1-, 2- and 5-cent coins that map only showed the 15 Member States which were members when the euro was introduced. Beginning in 2007 or 2008 (depending on the country) the old map is being replaced by a map of Europe also showing countries outside the Union like Norway. The 1-, 2- and 5-cent coins, however, keep their old design, showing a geographical map of Europe with the 15 Member States of 2002 raised somewhat above the rest of the map. All common sides were designed by Luc Luycx. The coins also have a national side showing an image specifically chosen by the country that issued the coin. Euro coins from any Member State may be freely used in any nation which has adopted the euro.


The common (top) and national sides of the €2 coinThe coins are issued in €2, €1, 50c, 20c, 10c, 5c, 2c, and 1c denominations. In order to avoid the use of the two smallest coins, some cash transactions are rounded to the nearest five cents in the Netherlands (by voluntary agreement) and in Finland (by law). This practice is discouraged by the Commission, as is the habit of certain shops to refuse to accept high value euro notes.

Commemorative coins with €2 face value have been issued with changes to the design of the national side of the coin. These include both commonly issued coins, such as the €2 commemorative coin for the fiftieth anniversary of the signing of the Treaty of Rome, and nationally issued coins, such as the coin to commemorate the 2004 Summer Olympics issued by Greece. These coins are legal tender throughout the eurozone. Collector's coins with various other denominations have been issued as well, but these are not intended for general circulation, and they are legal tender only in the Member State that issued them.

The design for the euro banknotes have common designs on both sides. The design was created by the Austrian designer Robert Kalina. Notes are issued in €500, €200, €100, €50, €20, €10, €5. Each banknote has its own colour and is dedicated to an artistic period of European architecture. The front of the note features windows or gateways while the back has bridges. While the designs are supposed to be devoid of any identifiable characteristics, the initial designs by Robert Kalina were of specific bridges, including the Rialto and the Pont de Neuilly, and were subsequently rendered more generic; the final designs still bear very close similarities to their specific prototypes; thus they are not truly generic. Some of the highest denominations such as the €500 are not issued in all countries, though they remain legal tender throughout the eurozone.

Administration

The ECB in Frankfurt ,Germany,is in charge of the eurozone's monetary .euro is managed and administered by the Frankfurt-based European Central Bank (ECB) and the Eurosystem (composed of the central banks of the eurozone countries). As an independent central bank, the ECB has sole authority to set monetary policy. The Eurosystem participates in the printing, minting and distribution of notes and coins in all Member States, and the operation of the eurozone payment systems.

The 1992 Maastricht Treaty obliges most EU Member States to adopt the euro upon meeting certain monetary and budgetary requirements, although not all states have done so. The United Kingdom and Denmark negotiated exemptions,while Sweden turned down the euro in a 2003 referendum, and has circumvented the obligation to adopt the euro by not meeting the monetary and budgetary requirements. All nations that have joined the EU since 1993 have pledged to adopt the euro in due course.

Euro

The euro is the official currency of the Eurozone: 16 of the 27 Member States of the European Union(EU) and is the currency used by the EU institutions. The eurozone consists of Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia and Spain. Estonia is due to join the eurozone on the 1st January 2011.The currency is also used in a further five European countries, with and without formal agreements, and is consequently used daily by some 327 million Europeans. Over 175 million people worldwide use currencies which are pegged to the euro, including more than 150 million people in Africa.

The euro is the second largest reserve currency (a status it inherited from the German mark) as well as the second most traded currency in the world after the U.S. dollar. As of October 2009[update], with more than €790 billion in circulation, the euro is the currency with the highest combined value of banknotes and coins in circulation in the world, having surpassed the U.S. dollar. Based on IMF estimates of 2008 GDP and purchasing power parity among the various currencies, the eurozone is the second largest economy in the world.

The name euro was officially adopted on 16 December 1995. The euro was introduced to world financial markets as an accounting currency on 1 January 1999, replacing the former European Currency Unit (ECU) at a ratio of 1:1. Euro coins and banknotes entered circulation on 1 January 2002.

OTC market statistics

Data provided by Pink Sheets:

1.Securities quoted exclusively on Pink Sheets - 5,019
2.Securities dually quoted on Pink Sheets and OTCBB - 3,445
3.Securities quoted exclusively on OTCBB - 130

OTC-traded stocks

In the U.S, over -the-counter trading in stock is carried out by market makers that make markets in OTCBB and Pink Sheets securities using inter-dealer quotation services such as Pink Quote (operated by Pink OTC Markets) and the OTC Bulletin Board (OTCBB). OTC stocks are not usually listed nor traded on any stock exchanges, though exchange listed stocks can be traded OTC on the third market. Although stocks quoted on the OTCBB must comply with U.S. Securities and Exchange Commission (SEC) reporting requirements, other OTC stocks, such as those stocks categorized as Pink Sheets securities, have no reporting requirements, while those stocks categorized as OTCQX have met alternative disclosure guidelines through Pink OTC Markets.

Over-the-counter

Over -the-counter(OTC) or off-exchange trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via facilities constructed for the purpose of trading (i.e., exchanges), such as futures exchanges or stock exchanges.

Risk Aversion in Forex

Risk Aversion in the Forex is a kind of trading behaviour exhibited by the foreign exchange market when a potentially adverse event happens which may affect market conditions.

This behavior is caused when risk averse traders liquidate their positions in risky assets and shift the funds to less risky assets due to uncertainty.

In the context of the forex market, traders liquidate their positions in various currencies to take up positions in safe haven currencies, such as the US Dollar.

Sometimes the choice of a safe haven currency is more of a choice based on prevailing sentiments rather than one of economic statistics.

An example would be the Financial Crisis of 2008. The value of equities across world fell while the US Dollar strengthened. This happened despite the strong focus of the crisis in the USA.

Speculation

Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly.Nevertheless, economists including Milton Friedman have argued that speculators ultimately are a stabilizing influence on the market and perform the important function of providing a market for hedgers and transferring risk from those people who don't wish to bear it, to those who do. Other economists such as Joseph Stiglitz consider this argument to be based more on politics and a free market philosophy than on economics.

Large hedge funds and other well capitalized "position traders" are the main professional speculators. According to some economists, individual traders could act as "noise traders" and have a more destabilizing role than larger and better informed actors .

Currency speculation is considered a highly suspect activity in many countries. While investment in traditional financial instruments like bonds or stocks often is considered to contribute positively to economic growth by providing capital, currency speculation does not; according to this view, it is simply gambling that often interferes with economic policy. For example, in 1992, currency speculation forced the Central Bank of Sweden to raise interest rates for a few days to 500% per annum, and later to devalue the krona.Former Malaysian Prime Minister Mahathir Mohamad is one well known proponent of this view. He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators.

Gregory J. Millman reports on an opposing view, comparing speculators to "vigilantes" who simply help "enforce" international agreements and anticipate the effects of basic economic "laws" in order to profit.

In this view, countries may develop unsustainable financial bubbles or otherwise mishandle their national economies, and foreign exchange speculators allegedly made the inevitable collapse happen sooner. A relatively quick collapse might even be preferable to continued economic mishandling. Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the blame from themselves for having caused the unsustainable economic conditions. Given that Malaysia recovered quickly after imposing currency controls directly against International Monetary Fund advice, this view is open to doubt.

Financial instruments

1. Spot
A spot transaction in o two -day delivery transaction (except in the case of trades between the US Dollar, Candian Dollar, Turkish Lira and Russian Ruble, which settle the next business day),as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction.

2. Forward

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. The duration of the trade can be a one day, a few days, months or years. Usually the date is decided by both parties.

3. Future

Foreign currency futures are exchange traded forward transactions with standard contract sizes and maturity dates — for example, $1000 for next November at an agreed rate . Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.

4. Swap

The most common type of forward transaction is the currency swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not standardized contracts and are not traded through an exchange.

Option

A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world..

Algorithmic trading in foreign exchange

In electronic financial markets, algorithmic trading or automated trading, also known as algo trading, black box trading or robo trading , is the use of computer programs for entering trading orders with the computer algorithm deciding on aspects of the order such as the timing, price, or quantity of the order, or in many cases initiating the order without human intervention. Algorithmic Trading is widely used by pension funds, mutual funds, and other buy side (investor driven) institutional traders, to divide large trades into several smaller trades in order to manage market impact, and risk. Sell side traders, such as market makers and some hedge funds, provide liquidity to the market, generating and executing orders automatically. A special class of algorithmic trading is "high-frequency trading" (HFT), in which computers make elaborate decisions to initiate orders based on information that is received electronically, before human traders are capable of processing the information they observe, in addition to which they can reduce costs of trading and improve shareholder returns.

Algorithmic trading may be used in any investment strategy, including market making, inter-market spreading, arbitrage, or pure speculation (including trend following). The investment decision and implementation may be augmented at any stage with algorithmic support or may operate completely automatically ("on auto-pilot").

A third of all EU and US stock trades in 2006 were driven by automatic programs, or algorithms, according to Boston-based financial services industry research and consulting firm Aite Group. As of 2009, high frequency trading firms account for 73% of all US equity trading volume.

In 2006 at the London Stock Exchange, over 40% of all orders were entered by algo traders, with 60% predicted for 2007. American markets and equity markets generally have a higher proportion of algo trades than other markets, and estimates for 2008 range as high as an 80% proportion in some markets. Foreign exchange markets also have active algo trading (about 25% of orders in 2006). Futures and options markets are considered to be fairly easily integrated into algorithmic trading, with about 20% of options volume expected to be computer generated by 2010. Bond markets are moving toward more access to algorithmic traders.

One of the main issues regarding high frequency trading is the difficulty in determining just how profitable it is. A report released in August 2009 by the TABB Group, a financial services industry research firm, estimated that the 300 securities firms and hedge funds that specialize in rapid fire algorithmic trading took in roughly $21 billion in profits in 2008

Market psychology

Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:

Flights to quality: Unsettling international events can lead to a "flight to quality", with investors seeking a " safe haven".There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The U.S. dollar, Swiss franc and gold have been traditional safe havens during times of political or economic uncertainty.

Long-term trends: Currency markets often move in visible long-term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends.

"Buy the rumor, sell the fact": This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought".To buy the rumor or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices.

Economic numbers: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. "What to watch" can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight.

Technical trading considerations: As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns.

Political conditions in Trading

Internal, regional, and international political conditions and events can have a profoung effect on currency markets.
All exchange rates are susceptible to political instability and anticipations and 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. Also, events in one country in a region may spur positive/negative interest in a neighboring country and, in the process, affect its currency.

Economic factors

These include :(a) economic policy, disseminated by government agencies and central banks , (b) economic conditions , generally revealed through economic reports, and other economic indicators.
* Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).
* Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency.
* Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency.
* Inflation levels and trends: Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.
* Economic growth and health: Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be.
* Productivity of an economy: Increasing productivity in an economy should positively influence the value of its currency. Its effects are more prominent if the increase is in the traded sector

Determinants of FX rates

The following theories explain fluctuations in FX rates in a floating exchange rate regime(in a fixed exchange rate regime, FX rates are decided by its government):
(a) International parity conditions: Relative Purchasing Power Parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world.

(b) Balance of payments model: This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous appreciation of dollar during 1980s and most part of 1990s in face of soaring US current account deficit.

(c) Asset market model : views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by people’s willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that “the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.”

None of the models developed so far succeed to explain FX rates levels and volatility in the longer time frames. For shorter time frames (less than a few days) algorithm can be devised to predict prices. Large and small institutions and professional individual traders have made consistent profits from it. It is understood from 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: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. 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: economic factors, political conditions and market psychology.

Trading characteristics

There is no unified or centrally cleared market for the majority of FX 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 often very close, otherwise they could be exploited by arbitrageurs instantaneously. Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. A joint venture of the Chicago Mercantile Exchange and Reuters, called Fxmarketspace opened in 2007 and aspired but failed to the role of a central market clearing mechanism.

The main trading center is London, but New York, Tokyo, Hong Kong and Singapore are all important centers as well. 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, excluding weekends.

Fluctuations in exchange rates are usually caused by actual monetary flows as well as by expectations of changes in monetary flows caused by changes in gross domestic product (GDP) growth, inflation (purchasing power parity theory), interest rates (interest rate parity, Domestic Fisher effect, International Fisher effect), budget and trade deficits or surpluses, large cross-border M&A deals and other macroeconomic conditions. 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. Each currency pair thus constitutes an individual trading product and is traditionally noted XXXYYY or XXX/YYY, where XXX and YYY are the ISO 4217 international three-letter code of the currencies involved. The first currency (XXX) is the base currency that is quoted relative to the second currency (YYY), called the counter currency (or quote currency). For instance, the quotation EURUSD (EUR/USD) 1.5465 is the price of the euro expressed in US dollars, meaning 1 euro = 1.5465 dollars. Historically, the base currency was the stronger currency at the creation of the pair. However, when the euro was created, the European Central Bank mandated that it always be the base currency in any pairing.

The factors affecting XXX will affect both XXXYYY and XXXZZZ. This causes positive currency correlation between XXXYYY and XXXZZZ.

On the spot market, according to the BIS study, the most heavily traded products were:

* EURUSD: 27%
* USDJPY: 13%
* GBPUSD (also called cable): 12%

and the US currency was involved in 86.3% of transactions, followed by the euro (37.0%), the yen (17.0%), and sterling (15.0%) (see table). Volume percentages for all individual currencies should add up to 200%, as each transaction involves two currencies.

Trading in the euro has grown considerably since the currency's creation in January 1999, 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: EURUSD and USDZZZ. The exception to this is EURJPY, which is an established traded currency pair in the interbank spot market. As the dollar's value has eroded during 2008, interest in using the euro as reference currency for prices in commodities (such as oil), as well as a larger component of foreign reserves by banks, has increased dramatically. Transactions in the currencies of commodity-producing countries, such as AUD, NZD, CAD, have also increased.