SOME BACKGROUND INFORMATION.
The Swiss Franc, the JapaneseYen, the US Dollar --every currency around the world is worth some particular amount in relation to any other currency.For example recently the Swiss Franc has been worth about $0.75 (US), or,1 and 1/3 (1.33) Swiss Francs to the Dollar.These exchange rates change everyday for many major currencies.That is the currencies "float" in relationship to each other.All it means is that the relative values are determined by simple supply and demand.If there is a wave of Swiss Francs offered for exchange for Dollars, the Swiss Franc will lose value -- say, falling to $0.65.Currency transactions are constantly taking place in major banking centers around the clock and around the world.
When exchange rates change,it may have tremendous importance to individuals, to firms, and to the countries themselves.Let's say you were a business person who had agreed to accept Swiss Francs in payment for some goods you were selling to a Swiss company.If the Swiss Franc fell from $0.75 to $0.65 you would lose nearly 15% of what you were expecting to receive.If the payment was to be worth $10,000, it would now be worth around $8500.In all probability the profit you were expecting to make on the deal would be wiped out by the exchange rate change.Similarly, say your firm had a subsidiary in Switzerland, and it was planning to "repatriate" (send back) profits it had earned of 5,000,000 Swiss Francs.Assume it would represent a record, and that the Swiss division, under your supervision, had done remarkably well.Now the Swiss Franc falls and your banner year turns into a so-so result, after the conversion to Dollars.Your sage business strategy is nullified by bad luck on the exchange rate front.So it goes in the world of international business!
Some countries let their currency float, while others attempt to peg the value of their currency to that of some trading partner.This latter approach is especially likely in the case of small countries which are heavily tied to a major economy such as the US, or Japan.And, up until around 30 years ago, the world's currencies were fixed in value in relation to each other (actually, they were fixed in relation to the Dollar, and the Dollar was defined in terms of gold.
How could a country prevent the value of its currency from fluctuating (rising or falling)?Answer: if its currency were freely convertible, then the government would have to do more than declare its value to be fixed; it would have to stand ready to buy or sell its own currency in currency markets in order to stabilize its value.For example if it were tending to fall, the government would have to buy the currency (using reserves of other currencies it was holding).If the country didn't have much in the way of foreign currency holdings, it might be out of luck. Its currency would depreciate -- unless some other government did it the favor of buying the currency in its place.Of course there could be other strategies found to help the situation: a ban on foreign travel by citizens of the country, steep import tariffs to cut back on the amount of goods entering the country, or maybe a policy of very high domestic interest rates to try to attract in foreign capital.
MARKET FORCES AND ARBITRAGE
Market forces tend to guarantee that the various exchange rates are "consistent".If onedubloon equals two dinaros, and two dinarosin turn equal one moolah; then one dubloon better equal one moolah.What if one dubloon was worth 1.5 moolahs?You'd convert your dubloons to moolahs then convert the moolahs to dinaros, and finally convert the dinaros to dubloons.Each time you did that you would make a profit -- you'd never have to work again!Unfortunately, everyone else would be doing the same thing -- unleashing massive supply/demand forces which would cause new values of the currencies to come about, until the opportunities for profit had been eliminated.Such a situation as described here is called an arbitrage opportunity.When they do appear they are very small and short-lasting.
An arbitrage tester can be easily created with a spreadsheet.Just set up the template to convert Dollars to say,Pounds on one line, Francs on the second line, Marks on the third line, etc.Then convert the second currency to a third, using the "cross rate", and finally convert the third back to Dollars.Ideally, the current exchange rates would be automatically downloaded to your spreadsheet from the www in "real-time". If there is a profit opportunity, an alarm sounds, or better still, a set of currency trade orders would be electronically placed with your favorite currency dealer.Don't plan on hearing the alarm very often!!