From 1944 to 1971 the world operated under a system of fixed exchange rates. The U.S. dollar was convertible into gold at a set rate and all the countries fixed their currencies to the U.S. dollar at a set rate. There was no need for a foreign exchange market.
On August 15, 1971 all that changed. President Nixon announced that the U.S. dollar could no longer be cashed in for gold. In 1973 the U.S. formally announced the permanent floating of the U.S. dollar thereby officially ending the system of fixed exchange rates.
Exchanges rates between different countries began to fluctuate widely; creating the need for a foreign exchange market where exporters and importers could lock in rates; clearly a prerequisite for doing business. Simply put, an American Hondo dealer is quoted a price per car in Japanese Yen from Honda, Japan. If the dealer could call a Bank and get a current dealable price for USDJPY, then the dealer would know for sure how much those cars were costing him and whether or not he could sell them profitably in his dealership.
And this is exactly what began happening. U.S. importers bought their Yen when they signed a contract to buy Hondos; then they left the Yen in the Bank earning interest until contract payment date. It didn’t take long for the Banks to figure out they could provide value added service by quoting the importer a price for the contract date. The Bank did this by simply starting with the current rate and adjusting the current rate to account for the net interest earned or paid from trade date to contract date. This became known as the forward rate.
On August 15, 1971 all that changed. President Nixon announced that the U.S. dollar could no longer be cashed in for gold. In 1973 the U.S. formally announced the permanent floating of the U.S. dollar thereby officially ending the system of fixed exchange rates.
Exchanges rates between different countries began to fluctuate widely; creating the need for a foreign exchange market where exporters and importers could lock in rates; clearly a prerequisite for doing business. Simply put, an American Hondo dealer is quoted a price per car in Japanese Yen from Honda, Japan. If the dealer could call a Bank and get a current dealable price for USDJPY, then the dealer would know for sure how much those cars were costing him and whether or not he could sell them profitably in his dealership.
And this is exactly what began happening. U.S. importers bought their Yen when they signed a contract to buy Hondos; then they left the Yen in the Bank earning interest until contract payment date. It didn’t take long for the Banks to figure out they could provide value added service by quoting the importer a price for the contract date. The Bank did this by simply starting with the current rate and adjusting the current rate to account for the net interest earned or paid from trade date to contract date. This became known as the forward rate.
