Foreign exchange trading refers to trading one country’s money for that of another country. The need for such trade arises due to tourism, international trade, or investments across boundaries. The foreign-exchange market, as we usually think of it, refers to large commercial banks in financial centers, like New York or London, trading foreign-currency-dominated deposits among each other.

Theories aiming to explore and understand interactions in international monetary variables became increasingly more important as deregulations and international integration of financial markets throughout the world continued to evolve and increase faster than it has ever been. One theory linked two important financial variables, exchange rates and interest rates, is the International Fisher Effect (IFE).

IFE states that future spot exchange rates can be determined from nominal interest differentials. In turn, real interest rate will be equalized across the world through arbitrage. Differences in observed nominal interest rates will be stemming from differences in expected inflations. These differences in anticipated inflations are embedded in nominal interest rates as described by Fisher equation.

The effect of these variables on exchange rates are more likely to occur under flexible exchange rates where currencies are allowed to fluctuates without government interventions but rather lift to free market forces to determine the appropriate exchange rates.

In this project, some of the most important theories in international finance literature are going to be explored with an attempt to clarify the logic behind them as well as the basic mathematical formulas that describes these theories.

After that, a statistical test will be employed using regression analysis on two currencies that are viewed to be the most traded and free of, or more realistically, exhibit minimal government interventions. The test aims to verify the validity of IFE theory and its explanatory power of fluctuations in exchange rates.

However, an overview of the market is going to explore the history of foreign exchange market in addition to the major products and players in that particular market.

2. Foreign-Exchange Market: an Overview

2.1 Historical background:

Table 1: Historical background

Key aspects

Major issues

Gold Standard

From 1876 to 1913

Each currency is convertible into gold at a specified rate

Price of each currency relative to the other is determined by gold convertibility rate

Suspended when World War I began in 1914

Some attempts were made in the 1920s to go back to the gold standard, but the Great Depression stood for them

Governments had difficulty in maintaining exchange rates at their pre-specified levels