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____________Review____________
Vol. 66, No. 3




March 1984

5 A Guide to Foreign Exchange iYlarkets
19 The Money-GNP Link: Assessing
Alternative Transaction Measures

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Federal Reserve Bank of St. Louis
Review
M arch 1984

In This Issue .. .




In the first article of this Review, “A Guide to Foreign Exchange Markets,” K. Alec
Chrystal guides the reader through the com plexities of foreign exchange markets.
Chiystal first describes how currencies are traded, pointing out the key differences
between the retail markets and the wholesale or interbank markets for “spot”
foreign exchange. He then discusses how the existence of forward currency
markets enables importers and exporters to avoid exchange rate risk.
The author then considers the newly emergent futures and options markets in
foreign exchange and analyzes options as a method of hedging. The im portance of
various kinds of arbitrage and speculation in providing an efficient and liquid
foreign exchange market is also outlined. Finally, the author discusses the special
role of the dollar as the money of the foreign exchange markets.
In the second article of this Review, “The Money-GNP Link: Assessing Alternative
Transaction M easures,” R. W. Hafer notes that some have questioned the reliability
of the link between M l and GNP, given recent velocity developments in 1982 and
1983. He investigates the empirical relationship between econom ic activity and
two alternative transaction m easures of money. These two m easures are, respec­
tively, the narrowly defined m onetaiy aggregate, M l, and one that excludes from
M l those checkable deposits that earn explicit interest income, such as NOW
accounts. This latter measure is referred to as adjusted M l.
Arguing that the introduction of NOW accounts in 1981 represents a m ajor but
predictable shift in the relationship between GNP and money, Hafer dem onstrates
that the difficulty in explaining GNP movements disappears when the adjusted M l
series is used. The author's analysis shows that, when his measure of transaction
balances is adjusted for the NOW account effect, the relationship between ad­
justed M l and GNP displays no deterioration in overall "explanatory pow er” when
estim ated through 1983. In contrast, equations estim ated using the current M l
m easure experience about a 30 percent reduction in explanatoiy power. This
result, Hafer argues, “arises from the public’s willingness to view some portion of
interest-bearing checkable deposits as savings-type balances." Based on his em pir­
ical results, the author denies the claim that the link between transactions money,
properly defined, and GNP has been damaged irreparably.

3




A Guide to Foreign Exchange
Markets
K. Alec Chrystal

T

M . HE econom ies of the free world are becom ing
increasingly interdependent. U.S. exports now amount
to almost 10 percent of Gross National Product. For
both Britain and Canada, the figure currently exceeds
25 percent. Imports are about the same size. Trade of
this magnitude would not be possible without the
ability to buy and sell currencies. Currencies must be
bought and sold because the acceptable m eans of pay­
ment in other countries is not the U.S. dollar. As a
result, importers, exporters, travel agents, tourists and
many others with overseas business must change dol­
lars into foreign currency and/or the reverse.

be described. This will be followed by a discussion of
some of the more important activities of market partici­
pants. Finally, there will be an introduction to the
analysis of a new feature of exchange markets — cur­
rency options. The concern of this paper is with the
structure and m echanics of foreign exchange markets,
not with the determ inants of exchange rates them ­
selves.

The trading of currencies takes place in foreign ex­
change markets w hose m ajor function is to facilitate
international trade and investment. Foreign exchange
m arkets, however, are shrouded in mystery. One
reason for this is that a considerable amount of foreign
exchange market activity does not appear to be related
directly to the needs of international trade and invest­
ment.

There is an almost bewildering variety of foreign
exchange markets. Spot markets and forward markets
abound in a num ber of currencies. In addition, there
are diverse prices quoted for these currencies. This
section attem pts to bring order to this seeming dis­
array.

The purpose of this paper is to explain how these
markets work.1 The basics of foreign exchange will first

Virtually every m ajor newspaper, such as the Wall
Street Journal or the London Financial Times, prints a
daily list of exchange rates. These are expressed either
as the num ber of units of a particular currency that
exchange for one U.S. dollar or as the num ber of U.S.
dollars that exchange for one unit of a particular cur­
rency. Sometimes both are listed side by side (see
table 1).

K. Alec Chrystal, professor o f econom ics-elect, University of
Sheffield, England, is a visiting scholar at the Federal Reserve Bank
of St. Louis. Leslie Bailis Koppel provided research assistance. The
author wishes to thank Joseph Hempen, Centerre Bank, St. Louis, for
his advice on this paper.
1For further discussion of foreign exchange markets in the United
States, see Kubarych (1983). See also Dufey and Giddy (1978) and
McKinnon (1979).




THE BASICS OF FOREIGN EXCHANGE
MARKETS

Spot, Forward, Bid, Ask

For m ajor currencies, up to four different prices
typically will be quoted. One is the "sp ot” price. The
others may be “30 days forward,” “90 days forward,”

5

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1984

Table 1
Foreign Exchange Rate Quotations
Foreign Exchange

The Dollar Spot and Forward

Wednesday, September 7, 1983
The New York foreign exchange selling rates below apply to trading among banks in
amounts of $1 million and more, as quoted at 3 p.m. Eastern time by Bankers Trust Co.
Retail transactions provide fewer units of foreign currency per dollar.
Currency
U.S. $ equiv.
per U.S. $
Country
Wed.
Tues.
Wed.
Tues.
Argentina (Peso) .......... .
.09652
.09652
10.36
10.36
.8777
Australia (Dollar) .......... .
.8772
1.1340
1.1393
Austria (Schilling) ......... .
17.84
.05296
.0560
18.88
Belgium (Franc)
Commercial rate ....... .
54.01
53.90
.01851
.01855
.01844
.01846
54.21
54.15
Financial rate ............. .
Brazil (Cruzeiro) ............ .
.001459
685
671.00
.00149
.6707
Britain (Pound) ............. . 1.4910
1.5000
.6666
1.5004
.6704
6664
30-Day Forward ...... . 1.4915
6697
90-Day Forward ...... .
1.4930
1.5010
6662
.6654
180-Day Forward
. 1.4952
1.5028
6688
Canada (Dollar) ............. .
.8120
.8123
1.2315
.2310
1.2307
30-Day Forward ...... .
.8125
.8128
1.2303
.8134
.8137
1.2293
1.2289
90-Day Forward ...... .
1.2274
180-Day Forward ...... .
.8145
.8147
1.2277
.01246
80.21
Chile (Official rate) ........ .
.01246
80.21
China (Yuan) .................. .
.50499
.50489
1 9802
1 9806
Colombia (P e so )............ .
.01228
.01228
81.4
81.40
Denmark (Krone) ..........
.10405
9.65
9.6100
.10362
Ecuador (Sucre)
.02082
.02082
48.03
Official rate ................ .
48.03
Floating rate ............... .
.010917
.010917
91.60
91.60
.17424
.17485
5.7390
5.7190
Finland (Markka) .......... .
France (Franc) ............... .
.1238
.1238
8 0750
8.0750
30-Day Forward ...... .
.1235
.1230
8 0955
8.1300
90-Day Forward ...... .
.1224
1223
8.1695
8.1725
180-Day Forward ...... .
.1203
.1202
8.3100
8.3150
Greece (D rach m a )......... .
.01075
.01078
93.
92.70
Hong Kong (D o lla r)....... .
.1297
.13089
7.71
7.6400
India (Rupee) ................ .
.0980
0980
10.20
10.20
985
985
Indonesia (R u p ia h )....... .
.001015
.001015
1.1775
.8536
8493
Ireland (Punt) ................ . 1.1715
Israel (Shekel) ............... .
.0173
57.80
57.80
.0173
.000624
Italy (Lira) ...................... .
.0006255
1602.
1598.50
.004067
Japan (Yen) ................... .
.004072
245.55
245.85
30-Day Forward ...... .
.004083
.004079
244.88
245.15
.004107
243.48
90-Day Forward ......
.004102
243.75
241 10
180-Day Forward ......
.004147
004142
241.39
4.85
Lebanon (Pound) ..........
.20618
.20618
4.85
Malaysia (Ringgit) .......
.42462
2.3550
42489
2.3535
Mexico (Peso)
150.00
Floating rate ...............
.00665
00666
150.25
Netherlands (Guilder) ...
.33288
.3333
3.0040
3.000
1.5327
.6497
6505
1.5397
New Zealand (Dollar) ...
7.48
7.4625
Norway (Krone) ............. .
.13368
1340
.07518
13 30
13.30
Pakistan (Rupee) ..........
.07518
.0005105
0005105
1958 89
1958.89
Peru (S o l)........................
11.007
11.007
Philippines (Peso) ....... .
.09085
09085
.00804
00807
124 35
123.90
Portugal (Escudo) ......... .
Saudi Arabia (Riyal) ... .
.28735
.28735
3.48
3.48
.4664
Singapore (D o lla r).........
.46609
2.1455
2.1440
1.1236
South Africa (Rand) ...... .
.8870
.8900
1.1273
South Korea (Won) ......
.001285
.001285
778.20
778.20
Spain (Peseta) .............. .
.00655
.00658
152 60
151.90
7.9140
7 8950
Sweden (Krona) ............ .
.12635
12666
Switzerland (Franc) ...... .
4596
.4591
2.1755
2.1780
30-Day Forward ........
.4619
.4615
216.46
2.1666
.4657
90-Day Forward ...... .
.4662
2.1449
2.1470
.
.4728
2.1150
2.1172
180-Day Forward
.4723
Taiwan (Dollar) ............. .
40.17
40.17
.02489
.02489
Thailand (Baht) ............. .
.043459
.043459
23.01
23.01
Uruguay (New Peso)
Financial...................... .
.02798
.02798
35.73
35.73
Venezuela (Bolivar)
Official rate ..................
4.30
.23256
.23256
4.30
.07194
Floating rate .............. ..
.07272
13.90
13.75
W. Germany (Mark)
..
.3726
.3726
2.6835
2.6835
.3741
30-Day Forward .... ..
.3740
2.6731
2 6728
90-Day Forward .......
.3767
.3768
2.6540
2 6538
180-Day Forward .... ..
.3808
2.6260
.3808
2.6259
SDR

.. 1.04637

1.04903

.955685

UK|
I reland t
Canada
Nethlnd.
Belgium
Denmark
W. Ger.
Portugal
Spain
Italy
Norway
France
Sweden
Japan
Austria
Switz.

spread
1.4860-1.4975
1.1665-1.1720
1.2305-1.2320
3.0050-3.0150
54.06-54.20
9.6400-9.6800
2.6850-2.6980
124.20-125.00
152.40-152.70
1604-1608
7.4730-7.4940
8.0775-8.1225
7.9120-7.9265
245.50-246.50
18.89-18.9512
2.1770-2.1875

Close
1.4910-1.4920
1.1710-1.1720
1.2310-1.2315
3.0050-3.0070
54.06-54.08
9.6400-9.6450
2.6865-2.6875
124.40-124.70
152.50-152.60
1605-1606
7.4730-7.4780
8.0825-8.0875
7.9120-7.9170
245.65-245.75
18.89-18.90
2.1800-2.1810

One month
0.02-0.07c dis
0.36-0.30c pm
0.09-0.06c pm
1.12-1.02c pm
7-6c pm
2-21zore dis
1.07-1.02pff pm
115-290C dis
170 220c dis
10 - 10 12lire dis
1.90-2.20ore dis
2.02-2.12c dis
0.90-1.10ore dis
0.69-0.64y pm
7.50-6.70gro pm
1.10-1.05c pm

%

Three

%

pa.

months

pa.

-0 .3 6
3.39
0.73
4.26
1.44
-2 .7 9
4.66
-1 9 .5 1
-1 5 .3 3
-7 .6 5
-3 .2 9
-3 .0 7
- 1 .5 1
3.24
4.50
5.91

-0 .5 2
0.17-0.22dis
2.84
0.88-0.78 pm
0.24-0.21 pm
0.73
3.00-2.90 pm
3.92
0.92
14-11 pm
-0 .1 0
par-1? dis
3.00-2.95 pm
4.42
330-790dis
-1 7 .9 8
675-775dis
-1 8 .9 9
-7 .5 3
291r 31 dis
5.90-6.20ds
-3 .2 3
9.65 -9 .85ds
- 4 .8 1
-1 .1 9
2.25 -2 .45ds
2.11-2.03 pm
3.36
21.00-18.50 pm
4.17
3.10-3.05 pm
5.63

tU K and Ireland are quoted in U.S. currency. Forward premiums and discounts apply to the U.S. dollar and
not to the individual currency.
Belgian rate is for convertible francs. Financial franc 54.40-54.45.

London Financial Times, September 8, 1983

.9536;

Special Drawing Rights are based on exchange rates for the U.S., West German,
British, French and Japanese currencies. Source: International Monetary Fund.
z-Not quoted.


6


Day’s
Sept 7

Wall Street Journal, September 8 ,1 9 8 3

MARCH 1984

FEDERAL RESERVE BANK OF ST. LOUIS

and “180 days forward.1’ These m aybe expressed either
in “European Term s" (such as num ber of $ per £) or in
“American Term s" (such as num ber of £ per $). (See the
glossary for further explanation.)
The spot price is what you m ust pay to buy curren­
cies for immediate delivery (two working days in the
interbank market; over the counter, if you buy bank
notes or travelers checks). The forward prices for each
currency are what you will have to pay if you sign a
contract today to buy that currency on a specific future
date (30 days from now, etc.). In this m arket,you pay for
the currency w hen the contract matures.
Why would anyone buy and sell foreign currency
forward? There are some m ajor advantages from hav­
ing such opportunities available. For example, an ex­
porter who has receipts of foreign currency due at
some future date can sell those funds forward now,
thereby avoiding all risks associated with subsequent
adverse exchange rate changes. Similarly, an importer
who will have to pay for a shipm ent of goods in foreign
currency in, say, three m onths can buy the foreign
exchange forward and, again, avoid having to bear the
exchange rate risk.
The exchange rates quoted in the financial press (for
example, those in table 1) are not the ones individuals
would get at a local bank. Unless otherwise specified,
the published prices refer to those quoted by banks to
other banks for currency deals in excess of $1 million.
Even these prices will vary somewhat depending upon
w hether the bank buys or sells. The difference between
the buying and selling price is sometim es known as the
“bid-ask spread.” The spread partly reflects the banks’
costs and profit margins in transactions; however, m a­
jo r banks make their profits more from capital gains
than from the spread.2
The market for bank notes and travelers checks is
quite separate from the interbank foreign exchange
market. For smaller currency exchanges, such as an
individual going on vacation abroad might make, the
spread is greater than in the interbank market. This
presumably reflects the larger average costs — includ­
ing the exchange rate risks that banks face by holding
bank notes in denom inations too small to be sold in the
interbank market — associated with these sm aller ex­
changes. As a result, individuals generally pay a higher
price for foreign exchange than those quoted in the
newspapers.

2Notice the Wall Street Journal quotes only a bank selling price at a
particular time. The Financial Times quotes the bid-ask spread and
the range over the day.




Table 2
Dollar Price of Deutschemarks and
Sterling at Various Banks
Deutschemark
Buy

Sell

Sterling
Buy

Sell

Retail
Local (St. Louis) banks (avg.)

.3572-.3844

1.4225-1.5025

W holesale
New York banks

.3681-.3683

1.4570-1.4580

European banks (high)

.3694—.3696

1.4573-1.4583

European banks (low)

.3677-3678

1.4610-1.4620

Bankers trust

.3681

1.4588

Note: These prices were all quoted on November 28, 1983, be­
tween 2:00 p.m. and 2:45 p.m. (Central Standard Time). Prices for
local banks were acquired by telephoning for their price on a
$10,000 transaction. The prices quoted were reference rates and
not the final price they would offer on a firm transaction. Figure for
Bankers Trust is that given in the Wall Street Journal, November
29, 1983, as priced at 2:00 p.m. (Central Standard Time) on
November 28, 1983. Other prices were taken from the Telerate
information system at 2:35 p.m. New York prices were the latest
available (Morgan and Citibank, respectively). European prices
were the last prices quoted before close of trading in Europe by
various banks. Deutschemark prices were actually quoted in
American terms. The sell prices above have been rounded up. The
difference between buy and sell prices for DM in the interbank
market actually worked out at $0.00015.

An example of the range of spot exchange rates avail­
able is presented in table 2, which shows prices for
deutschemarks and sterling quoted within a one-hour
period on November 28,1983. There are two important
points to notice. First, all except those in the first line
are prices quoted in the interbank, or wholesale, mar­
ket for transactions in excess of $1 million. The sterling
prices have a bid-ask spread of only 0.1 cent (which is
only about 0.07 percent of the price, or $7 on $10,000).
On DM, the spread per dollars worth works out to be
about half that on sterling ($4 on $10,000).3
Second, the prices quoted by local banks for small, or
retail, transactions, which serve only as a guide and do
not necessarily represent prices on actual deals, in­
volve a m u ch larger bid -ask spread. T h ese retail
spreads vary from bank to bank, but are related to (and
larger than) the interbank rates. In some cases, they

3ln practice, the spread will vary during the day, depending upon
market conditions. For example, the sterling spread may be as little
as 0.01 cents at times and on average is about 0.05 cents. Spreads
generally will be larger on less widely traded currencies.

7

FEDERAL RESERVE BANK OF ST. LOUIS

may be of the order of 4 cents or less on sterling, though
the prices quoted in St. Louis involved average spreads
of 8 cents on sterling. The latter represents a spread of
about 5 Vi percent (about $550 per $10,000 transaction).
The equivalent spread for DM was 7 percent ($700 per
$10,000 transaction).
The spread on forward transactions will usually be
wider than on spot, especially for longer maturities.
For interbank trade, the closing spread on one and
three m onths forward sterling on Septem ber 8, 1983,
was .15 cents, while the spot spread was .10 cents. This
is shown in the top line of the Financial Times report in
table 1. Of course, like the spot spread, the forward
spread varies with time of day and market conditions.
At times it m aybe as low as .02 cents. No information is
available for the size of spread on the forward prices
typically offered on small transactions, since the retail
market on forward transactions is very small.

HOW DOES “T H E” FOREIGN
EXCHANGE MARKET O PERATE?
It is generally not possible to go to a specific building
and "see” the market where prices of foreign exchange
are determined. With few exceptions, the vast bulk of
foreign exchange business is done over the telephone
between specialist divisions of m ajor banks. Foreign
exchange dealers in each bank usually operate from
one room; each dealer has severed telephones and is
surrounded by video screens and news tapes. Typical­
ly, each dealer specializes in one or a small num ber of
markets (such as sterling/dollar or deutschemark/dollar). Trades are conducted with other dealers who
represent banks around the world. These dealers typi­
cally deal regularly with one another and are thus able
to make firm com m itm ents by word of mouth.
Only the head or regional offices of the larger banks
actively deal in foreign exchange. The largest of these
banks are known as "market m akers” since they stand
ready to buy or sell any of the m ajor currencies on a
more or less continuous basis. Unusually large transac­
tions, however, will only be accom m odated by market
makers on more favorable terms. In such cases, foreign
exchange brokers may be used as middlemen to find a
taker or takers for the deal. Brokers (of which there are
four m ajor firms and a handful of sm aller ones) do not
trade on their own account, but specialize in setting up
large foreign exchange transactions in return for a
comm ission (typically 0.03 cents or less on the sterling
spread). In April 1983, 56 percent of spot transactions
by value involving banks in the United States were



MARCH 1984

channeled through brokers.4 If all interbank transac­
tions are included, the figure rises to 59 percent.
Most small banks and local offices of m ajor banks do
not deal directly in the interbank foreign exchange
market. Rather they typically will have a credit line with
a large bank or their head office. Transactions will thus
involve an extra step (see figure 1). The custom er deals
with a local bank, which in turn deals with a major
bank or head office. The interbank foreign exchange
market exists between the m ajor banks either directly
or indirectly via a broker.

FUTURES AND OPTION MARKETS
FOR FOREIGN EXCHANGE
Until veiy recently, the interbank market was the
only channel through which foreign exchange transac­
tions took place. The past decade has produced m ajor
innovations in foreign exchange trading. On May 16,
1972, the International Money Market (IMM) opened
under the auspices of the Chicago M ercantile Ex­
change. One novel feature of the IMM is that it provides
a trading floor on w hich deals are struck by brokers
face to face, rather than over telephone lines. The most
significant difference between the IMM and the inter­
bank market, however, is that trading on the IMM is in
futures contracts for foreign exchange, the typical busi­
ness being contracts for delivery on the third W ednes­
day of March, June, Septem ber or Decem ber. Activity at
the IMM has expanded greatly since its opening. For
example, during 1972, 144,336 contracts were traded;
the figure for 1981 was 6,121,932.
There is an important distinction between “forward"
transactions and "futures" contracts. The form er are
individual agreements between two parties, say, a bank
and customer. The latter is a contract traded on an
organized market of a standard size and settlement
date, which is resalable at the market price up to the
close of trading in the contract. These organized mar­
kets are discussed more fully below.
While the m ajor banks conduct foreign exchange
deals in large denom inations, the IMM trading is done
in contracts of standard size which are fairly small.
Examples of the standard contracts at present are
£25,000; DM125,000; Canadian $100,000. These are
actually smaller today than in the early days of the
IMM.
Further, unlike prices on the interbank market, price
movements in any single day are subject to specific
4See Federal Reserve Bank of New York (1983).

MARCH 1984

FEDERAL RESERVE BANK OF ST. LOUIS

Figure 1
Structure of Foreign Exchange Markets

Customer buys
$ with DM

\
\
\
\
\

Local
bank

*
Stockbroker

\
%

\

\

*
Foreign exchange
broker
4 m m

\

Major banks
interbank
market

IMM
LIFFE
PSE
7

T ~

/
/

Local
bank

/

/
Stockbroker
/
/

*

/

Customer buys
DM with $
NOTE: The International Money Market (IMM) Chicago trades foreign exchange futures and DM futures options.
The London International Financial Futures Exchange (LIFFE) trades foreign exchange futures.
The Philadelphia Stock Exchange (PSE) trades foreign currency options.




9

FEDERAL RESERVE BANK OF ST. LOUIS

limits at the IMM. For example, for sterling futures,
prices are not allowed to vaiy m ore than $.0500 away
from the previous day’s settlem ent price; this limit is
expanded if it is reached in the same direction for two
successive days. The limit does not apply on the last
day a contract is traded.
Unlike the interbank market, parties to a foreign ex­
change contract at the IMM typically do not know each
other. Default risk, however, is m inor because con ­
tracts are guaranteed by the exchange itself. To m ini­
mize the cost of this guarantee, the exchange insists
upon “margin requirem ents” to cover fluctuations in
the value of a contract. This m eans that an individual or
firm buying a futures contract would, in effect, place a
deposit equal to about 4 percent of the value of the
contract.5
Perhaps the m ajor limitation of the IMM from the
point of view of im porters or exporters is that contracts
cover only eight currencies — those of Britain, Canada,
West Germany, Switzerland, Japan, Mexico, France
and the Netherlands — and they are specified in stan­
dard sizes for particular dates. Only by chance will
these conform exactly to the needs of importers and
exporters. Large firms and financial institutions will
find the market useful, however, if they have a fairly
continuous stream of payments and receipts in the
traded foreign currencies. Although contracts have a
specified standard date, they offer a fairly flexible
method of avoiding exchange rate risk because they are
marketable continuously.
A m ajor econom ic advantage of the IMM for non­
bank custom ers is its low transaction cost. Though the
brokerage cost of a contract will vary, a “round trip”
(that is, one buy and one sell) costs as little as $15. This
is only .04 percent of the value of a sterling contract and
less for some of the larger contracts. Of course, such
costs are high com pared with the interbank market,
where the brokerage cost on DM 1 million would be
about $6.25 (the equivalent-valued eight futures con ­
tracts would cost $60 in brokerage, taking $7.50 per
single deal). They are low, however, com pared with
those in the retail market, w here the spread may in­
volve a cost of up to 2.5 percent or 3 percent per
transaction.
A market similar to the IMM, the London Interna­
tional Financial Futures Exchange (LIFFE), opened in
Septem ber 1982. On LIFFE, futures are traded in ster­

5A bank may also insist upon some minimum deposit to cover a
forward contract, though there is no firm rule.

Digitized for10
FRASER


MARCH 1984

ling, deutschemarks, Swiss francs and yen in identical
bundles to those sold on the IMM. In its first year, the
foreign exchange business of LIFFE did not take off in a
big way. The m ajor provider of exchange rate risk cov­
erage for business continues to be the bank network.
Less than 5 percent of such cover is provided by mar­
kets such as IMM and LIFFE at present.
An entirely new feature of foreign exchange markets
that has arisen in the 1980s is the existence of option
markets ,B The Philadelphia Exchange was the first to
introduce foreign exchange options. These are in five
currencies (deutschemark, sterling, Swiss franc, yen
and Canadian dollar). Trades are conducted in stan­
dard bundles half the size of the IMM futures con ­
tracts. The IMM introduced an options market in Ger­
man marks on January 24, 1984; this market trades
options on futures contracts whereas the Philadelphia
options are for spot currencies.
Futures and options prices for foreign exchange are
published daily in the financial press. Table 3 shows
prices for February 14, 1984, as displayed in the Wall
Street Journal on the following day. Futures prices on
the IMM are presented for five currencies (left-hand
column). There are five contracts quoted for each cur­
rency; March, June, September, Decem ber and March
1985. For each contract, opening and last settlement
(settle) prices, the range over the day, the change from
the previous day, the range over the life of the contract
and the num ber of contracts outstanding with the
exchange (open interest) are listed.
Consider the March and Ju n e DM futures. March
futures opened at $.3653 per mark and closed at $.3706
per mark; June opened at $.3698 per mark and closed at
$.3746 per mark. Turn now to the Chicago Mercantile
Exchange (IMM) futures options (cen ter colum n).
These are options on the futures contracts just dis­
cussed (see inset for explanation of options). Thus, the
line labeled "Futu res” lists the settle prices of the
March and June futures as above.
Let us look at the call options. These are rights to buy
DM futures at specified prices — the strike price. For
example, take the call option at strike price 35. This
means that one can purchase an option to buy DM
125,000 March futures up to the March settlem ent date
for $.3500 per mark. This option will cost 2.05 cents per
mark, or $2,562.50, plus brokerage fees. The June op­
tion to buy June futures DM at $ .3500 per mark will cost
2.46 cents per mark, or $3,075.00, plus brokerage fees.

6For a discussion of options in commodities, see Belongia (1983).

MARCH 1984

FEDERAL RESERVE BANK OF ST. LOUIS

Table 3
Futures and Options Markets
Futures Prices

Futures Options

Tuesday, February 14, 1984
O pen Interest R eflects P revious T rading Day.

C hicago M ercantile Exchange

.0170 1.6010
.0170 1.5520
.0160 1.5240
.0160 1.4650
.0170 1.4625
21,242, + 7 8 .

1.3930
1.3950
1.3980
1.3990
1.4000

17.694
3,251
157
75
65

.7979
.7983
.7988
.8021
.8023

4,033
740
312
152
50

.4125
.4180
.4354
.4395

25,730
3,908
974
271

.5230 .4470
.5045 .4536
.5020 .4598
.4880 .4665
.4840 .4755
+2 9 6.

24,164
3,165
153
71
5

CANADIAN DOLLAR (IMM)— 100,000 dlrs.; S per Can S
Mar
June
Sept
Dec
Mar85
Est vol

.8010
.8014

.8024
8010 .8020
...............8169
.8029 .8013 .8023
...............8168
............................. 8026
............... 8147
.8021 .8031 .8021 .8029
...............8040
.8035 .8035 .8035 .8032
...............8035
1,087; vol Mon 535; open int 5,287, -1 0 3 .

mark
Strike
Calls— Settle
Puts— Settle
Mar
Jun
Mar
Jun
Price
34
0.01
0.01
35
2.05
2.46
0.01
0.09
1.11
36
1.66
0.06
0.25
37
0.38
1.00
0.33
0.57
0.54
38
0.10
1.00
1.02
39
0.01
0.27
Futures
.3706
.3746
Estimated total vol. 2.187.
Calls: Mon vol. 180: open int. 2,416.
Puts: Mon vol. 73: open int. 1,841.

JAPANESE YEN (IMM) 12.5 million yen; $ per yen (.00)
Mar
June
Sept
Dec
Est vol

.4276
.4315
.4354
.4416
9,133;

.4297
.4337
.4375
.4420
vol Mon

.4276 .4294 + .0011
4396
4312 .4334 + .0011 .4435
.4354 .4374 + .0012 .4450
.4400 .4415 + .0012 .4493
3,306; open int 30,883, +534.

SWISS FRANC (IMM)— 125,000 francs; $ per franc
Mar
June
Sept
Dec
Mar85
Est vol

.4495
.4564
.4632
.4705

.4556 .4486 .4549 +
.4629 .4557 .4622 +
.4692 .4632 .4688 +
.4780 .4705 .4747 +
............................. 4830 +
30,610; vol Mon 8,466; open int

.0047
.0051
.0052
.0049
.0050
27,558,

W. GERMAN MARK (IMM)— 125,000 marks; $ per mark
Mar
June
Sept
Dec
Mar85
Est vol

.3653
.3698
.3743
.3780

.3713 .3650 .3706 +
3754 .3688 .3746 +
.3790 .3743 .3780 +
.3825 .3780 .3825 +
............................. 3838 +
30,248; vol Mon 9,045; open int

.0036
4100
.0037
4002
.0034
4030
.0043
3825
0035 .3699
36,452, +680.

.3537
.3568
.3602
.3640
.3699

30,974
4,911
362
204
1

The March call option at strike price $.3900 per mark
costs only O.Ol cents per mark or $12.50. These price
differences indicate that the market expects the dollar
price of the mark to exceed $.3500, but not to rise
substantially above $.3900.
Notice that w hen you exercise a futures call option
you buy the relevant futures contract but only fulfill
that futures contract at maturity. In contrast, the Phil­
adelphia foreign currency options (right column) are
options to buy foreign exchange (spot) itself rather
than futures. So, w hen a call option is exercised, for­
eign currency is obtained immediately.
The only difference in presentation of the currency
option prices as com pared with the futures options is
that, in the former, the spot exchange rate is listed for
comparison rather than the futures price. Thus, on the
Philadelphia exchange, call options on M arch DM
62,500 at strike price $ .3500 per mark cost 1.99 cents per
mark or $1,243.75, plus brokerage. Brokerage fees here
would be of the same order as on the IMM, about $16
per transaction round trip, per contract.
We have seen that there are several different markets
for foreign exchange — spot, forward, futures, options



Philadelphia Exchange

W. GERMAN MARK— 125,000 marks, cents per

Lifetim e
Open
Open High Low Settle Change High Low Interest
BRITISH POUND (IMM)—25,000 pounds; $ per pound
Mar
1.4150 1.4400 1.4150 1.4370 +
June
1.4175 1.4435 1.4175 1.4395 +
Sept
1.4285 1.4410 1.4220 1.4410 +
Dec
1.4280 1.4435 1.4245 1.4435 +
Mar85 1.4280 1.4460 1.4270 1.4470 +
Est vol 10,651; vol Mon 1,987; open int

Foreign Currency Options
O ption & Strike
Underlying Price

C alls—Last
Mar
Jun

Puts— Last
SepMar
Jun

12.500 British Pounds-cents per unit.
BPound
140
3.40
r 5.70 0.40 1.85
143.00
.145
0.70 2.40
r
3.40
50.000 Canadian Dollars-cents per unit.
CDollar
. 80
r
r 0.68
r
62.500 West German Marks-cents per unit.
DMark
. . 34
2.67
r
r
r
36.88
. .35
1.99 2.18
r
r
36.88
36
1.04 1.59
r 0.05 0.35
36.88
. .37
0.38 1.00
r 0.37 0.56
36.88
. . .38
0.10 0.62 0.85
r
36.88
. .39
r 0.28
s
r
36.88
. . .40
0.01 0.11
s
r
6.250.000 Japanese Yen-100ths of a cent per unit.
JYen
...42
0.95 1.49 2.04
r
42.75
. . .43
0.30 0.90
r 0.50 0.60
42.75
.
44
0.04 0.45 0.99
62.500 Swiss Francs-cents per unit.
SFranc
. 44
r
r 3.15 r 0.2
45.18
. . .45
0.65
r
0.26
r
45.18
. . .46
0.28 1.09 1.82 r 1.00
45.18
. . .47
0.06
r
r
45.18
48
0.02 0.28
r
Total call vol.
2,271
Call open int.
37,349
Total put vol.
799
Put open int.
26,173
r— Not traded.
s— No option offered.
o— Old.
Last is premium (purchase price).

Sep
r

Wall Street Journal, February 15, 1984

on spot, options on futures. The channels through
which these markets are formed are, however, fairly
straightforward (see figure 1). The main channel is the
interbank network, though for large interbank transac­
tion s, foreign exch an g e b rokers may be used as
middlemen.

FOREIGN EXCHANGE MARKET
ACTIVITIES
M uch foreign exchange market trading does not
appear to be related to the simple basic purpose of
allowing businesses to buy or sell foreign currency in
order, say, to sell or purchase goods overseas. It is
certainly easy to see the usefulness of the large range of
foreign exchange transactions available through the
interbank and organized markets (spot, forward, fu­
tures, options) to facilitate trade between nations. It is
also clear that there is a useful role for foreign exchange
brokers in helping to “m ake” the interbank market.
There are several other activities, however, in foreign
exchange markets that are less well understood and
whose relevance is less obvious to people interested in
understanding what these markets accom plish.

11

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1984

Foreign Exchange Options
F ig u re 2

An option is a contract specifying the right to buy
or sell — in this case foreign exchange — within a
specific period (American option) or at a specific
date (European option). A call option confers the
right to buy. A put option confers the right to sell.
Since each of these options must have a buyer and a
seller, there are four possible ways of trading a single
option: buy a call, sell a call, buy a put, sell a put.
The buyer of an option has the right to undertake
the contract specified but may choose not to do so if
it turns out to be unprofitable. The seller of the
option must fulfill the contract if the buyer desires.
Clearly, the buyer must pay the seller some pre­
mium (the option price) for this privilege. An option
that would be profitable to exercise at the current
exchange rate is said to be “in the money." The price
at w hich it is exercised is the "exercise” or “strike"
price.
Considera call option on £ 1 000 (although options
of this size are not presently available on organized
exchanges, it is used to present a simple illustration
of the principles involved). Suppose this costs $0.03
per pound or $30 and the exercise price is $1.50 per
pound. The option expires in three months. This
means that the buyer has paid $30 for the right to
buy £1000 with dollars at a price of $1.50 per pound
any time in the next three m onths. If the current
spot price of sterling is, say, $1.45, the option is "out
of the m oney” b ecau se sterling can be bought
cheaper on the spot market. However, if the spot
price were to rise to, say, $1.55, the option would be
in the money. If sold at that time, the option buyer
would get a $50 return (1000 x $0.05), which would
m o re th a n c o v e r t h e c o s t o f th e o p t io n
($50 —$30 = $20 profit). In contrast, a put option at
the same terms would be in the m oney at the cur­
rent spot price of $1.45, but out of the money at
$1.55.
Figure 2 presents a diagrammatic illustration of
how the profitability of an option depends upon the
relationship between the exercise price and the cur­
rent spot price.1 Figure 2a illustrates the profit avail-

1The pricing of options has been the subject of a large theoretical
literature with a major contribution being made by Black and
Scholes (1973). The Black-Scholes formula has been modified
for foreign exchange options by Garman and Kohlhagen (1983)
[see also Giddy (1983)], but the Black-Scholes formula is com­
plex and beyond the scope of the present paper.

Digitized for12
FRASER


Profit from Options
Buy o Call

(b)
Buy a Pvt

Buy a Straddle

One simple relationship which is of interest may be called
“ option price parity.” This arises because arbitrage will ensure
that the difference between a call option price (per unit) and a put
option price (per unit) at the same exercise price will be equal to
the present value of the difference between the exercise price
and the forward exchange rate at maturity of the options (if the
options are marketable, it will also hold for any date to maturity).
The relationship may be expressed:

when C and P are the call and put option prices at exercise price
E. F is the forward exchange rate and r is the interest rate per
period of the contracts. This arises because the simultaneous
buying of a call and selling of a put is equivalent to buying
currency forward at price E. The forward contract, however,
would be paid for at the end of the period, whereas the options are
transacted at the beginning. Hence, the forward contract has to
be discounted back to the present.

FEDERAL RESERVE BANK OF ST. LOUIS

able from buying a call option at exercise price A. At
spot exchange rate A and anything lower, the option
will not be exercised so the loss will equal the price
of the option. At a spot exchange rate above a, the
option is sufficiently in the m oney to more than
cover its cost. Between A and a, the option is in the
money but not by enough to cover cost. The profit
from selling a call could be illustrated by reversing
the + and — signs in figure 2a, or by flipping the
profit line about the horizontal axis.
Figure 2b illustrates the profit from buying a put
option. At spot exchange rates below a, the option
with exercise price A will show a profit.
Figure 2c illustrates the profit from a sim ul­
taneous purchase of a put and call at the same

Two m ajor classes of activity will be discussed. First,
the existence of a large num ber of foreign exchange
markets in many locations creates opportunities to
profit from "arbitrage.” Second, there is implicitly a
market in (foreign exchange) risk bearing. Those who
wish to avoid foreign exchange risk (at a price) may do
so. Those who accept the risk in expectation of profits
are known as “speculators.”

Triangular Arbitrage
Triangular arbitrage is the process that ensures that
all exchange rates are mutually consistent. If, for exam­
ple, one U.S. dollar exchanges for one Canadian dollar,
and one Canadian dollar exchanges for one British
pound, th en the U.S. dollar-pound exchange rate
should be one pound for one dollar. If it differs, then
there is an opportunity for profit making. To see why
this is so, suppose that you could purchase two U.S.
dollars with one British pound. By first buying C$1 with
U.S.$1, then purchasing £ 1 with C$1, and finally buying
U.S.$2 with £ 1 , you could double your money im­
mediately. Clearly this opportunity will not last for long
since it involves making large profits with certainty.
The process of triangular arbitrage is exactly that of
finding and exploiting profitable opportunities in such
exchange rate inconsistencies. As a result of triangular
arbitrage, su ch in co n sisten cies will be elim inated
rapidly. Cross rates, however, will only be roughly con ­
sistent given the bid-ask spread associated with trans­
action costs.
In the past, the possibility of making profits from
triangular arbitrage was greater as a result of the prac­



MARCH 1984

exercise price. This com bination will show a profit
at exercise price A if the spot price goes either above
b or below a. It is known as a "straddle.” The strad­
dle is of special interest because it makes clear the
role of options as a hedge against risk. The price of a
straddle can be regarded as the market valuation of
the variability of the exchange rate. That is, the buyer
of the straddle will show a profit if the spot price
moves from some central value (the exercise price)
by more than plus or minus some known percent­
age. The seller of the straddle accepts that risk for a
lump sum. More com plicated “multiple strategies”
are also possible.2

2See Giddy (1983).

tice of expressing exchange rates in American terms in
the United States and in European term s elsewhere.
The adoption of standard practice has reduced the
likelihood of inconsistencies.7 Also, in recent years,
such opportunities for profit making have been greatly
reduced by high-speed, com puterized information
systems and the increased sophistication of the banks
operating in the market.
Arbitrage of a slightly different kind results from
price differences in different locations. This is “space”
arbitrage. For example, if sterling were cheaper in Lon­
don than in New York, it would be profitable to buy in
London and sell in New York. Similarly, if prices in the
interbank market differed from those at the IMM, it
would be profitable to arbitrage between them. As a
result of this activity, prices in different locations will
be brought broadly into line.

Interest Arbitrage
Interest arbitrage is slightly different in nature from
triangular or space arbitrage; however, the basic motive
of finding and exploiting profitable opportunities still
applies. There is no reason why interest rates denom i­
nated in different currencies should be equal. Interest
rates are the cost of borrowing or the return to lending
for a specific period of time. The relative price (ex­
change rate) of money may change over time so that
the comparison of, say, a U.S. and a British interest rate
requires some allowance for expected exchange rate
changes. Thus, it will be not at all unusual to find
7AII except U.K. and Irish exchange rates are expressed in American
terms. Futures and options contracts are expressed in European
terms.

13

FEDERAL RESERVE BANK OF ST. LOUIS

interest rates denom inated in dollars and interest rates
denom inated in, say, pounds being somewhat differ­
ent. However, real returns on assets of similar quality
should be the same if the exchange rate risk is covered
or hedged in the forward market. Were this not true, it
would be possible to borrow in one currency and lend
in another at a profit with no exchange risk.
Suppose we lend one dollar for a year in the United
States at an interest rate of rus. The am ount accum u­
lated at the end of the year per dollar lent will be 1 + rus
(capital plus interest). If, instead of making dollar loans,
we converted them into pounds and lent them in the
United Kingdom at the rate ruk, the amount of pounds
we would have for each original dollar at the end of the
year would be S(1 + ruk), w here S is the spot exchange
rate (in pounds per dollar) at the beginning of the
period. At the outset, it is not known if 1 + rus dollars is
going to be worth more than S(l + ruk) pounds in a
year’s time because the spot exchange rate in a year’s
time is unknown. This uncertainty can be avoided by
selling the pounds forward into dollars. Then the rela­
tive value of the two loans would no longer depend on
what subsequently happens to the spot exchange rate.
By doing this, we end up with | (l + ruk) dollars per
original dollar invested. This is known as the “cov­
ered,” or hedged, return on pounds.
Since the covered return in our example is denom i­
nated in dollars, it can reasonably be com pared with
the U.S. interest rate. If these returns are very different,
investors will move funds where the return is highest
on a covered basis. This process is interest arbitrage. It
is assumed that the assets involved are equally safe
and, because the returns are covered, all exchange risk
is avoided. Of course, if funds do move in large volume
between assets or between financial centers, then in­
terest rates and the exchange rates (spot and forward)
will change in predictable ways. Funds will continue to
flow between countries until there is no extra profit to
be made from interest arbitrage. This will occu r when
the returns on both dollar- and sterling-denominated
assets are equal, that is, when
(1)

MARCH 1984

Speculation
Arbitrage in the foreign exchange markets involves
little or no risk since transactions can be com pleted
rapidly. An alternative source of profit is available from
outguessing other market participants as to what fu­
ture exchange rates will be. This is called speculation.
Although any foreign exchange transaction that is not
entirely hedged forward has a speculative element,
only deliberate speculation for profit is discussed here.
Until recently, the main foreign exchange specula­
tors were the foreign exchange departm ents of banks,
with a lesser role being played by portfolio managers of
other financial institutions and international corpora­
tions. The IMM, however, has made it m uch easier for
individuals and smellier businesses to speculate. A high
proportion of IMM transactions appears to be specula­
tive in the sense that only about 5 percent of contracts
lead to ultimate delivery of foreign exchange. This
means that most of the activity involves the buying and
selling of a contract at different times and possibly
different prices prior to maturity. It is possible, how­
ever, that buying and selling of contracts before m atu­
rity would arise out of a strategy to reduce risk. So it is
not possible to say that all such activity is speculative.
Speculation is important for the efficient working of
foreign exchange markets. It is a form of arbitrage that
occurs across time rather than across space or b e­
tween markets at the same time. Just as arbitrage in­
creases the efficiency of markets by keeping prices
consistent, so speculation increases the efficiency of
forward, futures and options markets by keeping those
markets liquid. Those who wish to avoid foreign ex­
change risk may thereby do so in a well-developed
market. Without speculators, risk avoidance in foreign
exchange markets would be more difficult and, in
many cases, impossible.9

Risk Reduction
Speculation clearly involves a shifting of risk from
one party to another. For example, if a bank buys for-

(l + rus) = p-(l + ruk).

This result is known as covered interest parity. It holds
more or less exactly, subject only to a margin due to
transaction costs, so long as the appropriate dollar and
sterling interest rates are com pared.8

8Since there are many different interest rates, it obviously cannot hold
for all of them. Where (1) does hold is if the interest rates chosen are
eurocurrency deposit rates of the same duration. In other words, if for

14 FRASER
Digitized for


rus we take, say, the three-month eurodollar deposit rate in Paris and
for ruk we take the three-month eurosterling deposit rate in Paris, then
(1) will hold just about exactly. Indeed, if we took the interest rate and
exchange rate quotes all from the same bank, it would be remarkable
if (1 ) did not hold. Otherwise the bank would be offering to pay you to
borrow from it and lend straight back! That is, the price of borrowing
would be less than the covered return on lending. A margin between
borrowing and lending rates, of course, will make this even less likely
so that in reality you would lose.
9This is not to say that all speculative activity is necessarily beneficial.

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1984

Covered Interest Parity: An Example
The following interest rate and exchange rate
quotations are taken from the London Financial
Times of Septem ber 8, 1983 (table 1).
Closing
Exchange Rate:
dollars per
pound

SP ot
1.4910-1.4920

3-Month Forward
.17—.22 discount

Eurosterling

Eurodollar

9 13/ ie

10*/4

Interest Rates:
3-Month Offer
Rate

The interest rate on the three-m onth eurodollar
deposit is a little higher (.7 percent) than that on an
eurosterling deposit. If the exchange rate remains
unchanged, it would be better to hold dollars; if the
exchange rate falls, the eurosterling deposit would
be preferable. Suppose you decide to cover the ex­
change risk by selling the dollars forward into
pounds. Let us com pare the return to holding a
sterling deposit with the return to holding a dollar
deposit sold forward into sterling (assuming that
you start with sterling).
Two important points need to be clarified about
the above data. First, the interest rates are annual­
ized so they are not what would actually be earned
over a three-m onth period. For example, the threemonth rate equivalent to an annual rate of 10 lA
percent is 2.47 percent.
Second, the forward exchange rates need some
explanation. The dollar is at a discount against ster­
ling. This m eans the forward dollar buys less ster­
ling. So we have to add the discount onto the spot
price to get the forward price (because the price is
the num ber of dollars per pound, not the reverse).
Notice also that the discount is measured in frac­
tions of a cent, not fractions of a dollar! So the

ward foreign exchange from a custom er, it increases its
exposure to risk while the custom er reduces his. How­
ever, there is not a fixed am ount of risk that has to be
"shared out.” Some strategies may involve a net reduc­
tion of risk all around.
As a general rule, financial institutions (or other
firms), operating in a variety of currencies, will tiy to



bid-ask spread on the forw ard rate w ould be
1.4927-1.4942.
Now let us see if we would do better to invest in a
three-m onth eurosterling deposit or a three-month
eurodollar deposit where the dollars to be received
were sold forward into sterling. The return per £100
invested in eurosterling is £2.369 (annual interest
rate of 913/ie), whereas the return on a covered euro­
dollar deposit is
£2.251 = (100

X

1 4910
1.0247)
1.4942

100 .

Thus, we could not make a profit out of covered
interest arbitrage. Despite the fact that dollar in­
terest rates are higher, the discount on forward dol­
lars in the forward market m eans they buy fewer
forward pounds. As a result, there is no benefit to
the operation. Transaction costs for m ost indi­
viduals would be even greater than those above as
they would face a larger bid-ask spread than that
quoted on the interbank market.
Consequently, there is no benefit for the typical
investor from making a covered or hedged eurocur­
rency deposit. The return will be at least as high on a
deposit in the currency in which you start and wish
to end up. That is, if you have dollars and wish to
end up with dollars, make a eurodollar deposit. If
you have sterling and wish to end up with sterling,
make a eurosterling deposit. If you have sterling and
wish to end up in dollars, there is likely to be little or
no difference between holding a eurosterling de­
posit sold forward into dollars or buying dollars
spot and holding a eurodollar deposit. Of course, if
you hold an “uncovered” deposit and exchange
rates subsequently change, the result will be veiy
different.

minimize the risk of losses due to unexpected ex­
change rate changes. One simple way to do this is to
ensure that assets and liabilities denom inated in each
operating currency are equal. This is known as “m atch­
ing." For example, a bank that sells sterling forward to a
custom er may simultaneously buy sterling forward. In
this event, the bank is exposed to zero exchange rate
risk.

15

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1984

Why Is the D ollar the “Money” of Foreign
Exchange Markets?
One interesting aspect of the organization of the
foreign exchange markets is that the "m oney" used
in these markets is generally the U.S. dollar. This is
generally true for spot markets and universally true
for forw ard m arkets. “C ross-m ark ets’’ betw een
many currencies are very thin, and future cross
markets are virtually nonexistent. For example, the
bulk of foreign exchange trading between £ s and
cruzeiro will involve dollar-£ and dollar-cruzeiro
transactions instead of direct £-cru zeiro trading.
The only exception to this is the transactions involv­
ing the m ajor Organization for Econom ic Coopera­
tion and Development (OECD) currencies, especial­
ly within Europe. Of the $702.5 billion turnover in
foreign exchange reported by U.S. banks in April
1983, only $1.5 billion did not involve U.S. dollars.

eiy country is in payments balance vis a vis the rest
of the world, it will not necessarily be in bilateral
balance with each other country. Because som e cur­
rency has to be used to cover this residual finance, it
is natural to choose the currency that has the lowest
transaction costs. Chrystal shows there are eco­
nomic reasons why cross-m arkets between many
currencies do not exist.2 It typically will be easier
and cheaper to set up a deal in two steps via the
dollar than in a single step (cruzeiro-dollar, dollardrachm a rather than cruzeiro-drachma). This is be­
cause these cross-m arkets, if they existed, would be
fairly thin and hence relatively costly for such trans­
actions. The two markets with the dollar, on the
other hand, are well developed.

There are two explanations for this special role of
the dollar in foreign exchange markets. Both rely
upon the fact that transaction costs are likely to be
lower if the dollar is used as a medium. Krugman
shows that the clearing of foreign exchange markets
requires some "interm ediary” currency.1 Even if ev-

These analyses refer to the role of the dollar in the
interbank market. In the development of the trading
places such as the IMM in Chicago and LIFFE in
London to date, it is also true that all currency
futures are traded against the dollar.

'See Krugman (1980).

2See Chrystal (1982).

Banks often use “swaps” to close gaps in the m atu­
rity structure of their assets and liabilities in a cur­
rency. This involves the sim ultaneous purchase and
sale of a currency for different maturity dates. In April
1983, 33 percent of U.S. banks’ foreign exchange turn­
over involved swaps as com pared with 63 percent spot
c o n tr a c ts an d o n ly 4 p e r c e n t o u trig h t forw ard
contracts.10
Suppose a bank has sold DM to a custom er three
m onths forward and bought the same am ount of DM
from a different custom er six m onths forward. There
are two ways in w hich the bank could achieve zero
foreign exchange risk exposure. It could either under­
take two separate offsetting forward transactions, or it
could set up a single swap with another bank that has
the opposite m ism atch of dollar-DM flows whereby it
receives DM in exchange for dollars in three m onths
and receives back dollars in exchange for DM in six

,0See Federal Reserve Bank of New York (1983).

Digitized for16
FRASER


months. Once the swap is set up, the bank’s net profits
are protected against subsequent changes in spot ex­
change rates during the next six months.
Within the limits im posed by the nature of the con ­
tracts, a similar effect can be achieved by an appropri­
ate portfolio of futures contracts on the IMM. Thus, a
bank would buy and sell futures contracts so as to
match closely its forward com m itm ents to custom ers.
In reality, banks will use a com bination of m ethods to
reduce foreign exchange risk.
Markets that permit banks, firms and individuals to
hedge foreign exchange risk are essential in tim es of
fluctuating exchange rates. This is especially impor­
tant for banks if they are to be able to provide efficient
foreign exchange services for their custom ers. In the
absence of markets that permit foreign exchange risk
hedging, the cost and uncertainty of international
transactions would be greatly increased, and interna­
tional specialization and trade would be greatly re­
duced.

FEDERAL RESERVE BANK OF ST. LOUIS

CONCLUSION
The foreign exchange markets are com plex and, for
the outsider, hard to com prehend. The primary func­
tion of these markets is straightforward. It is to facilitate
international transactions related to trade, travel or
in v estm en t. Foreign ex ch a n g e m arkets can now
accom m odate a large range of current and forward
transactions.
Given the variability of exchange rates, it is important
for banks and firms operating in foreign currencies to

Glossary
Am erican option — an option that can be exercised any time
up to maturity.
Am erican term s — an exchange rate expressed as number of
currency units per dollar.
arbitrage — the simultaneous purchase and sale of currency in
separate markets for a profit arising from a price discrepancy
between the markets.
bid-ask spread — the difference between the buying (bid) and
selling (ask) price.
covered interest arbitrage — buying a country's currency
spot, investing for a period, and selling the proceeds forward in
order to make a net profit due to the higher interest rate in that
country. This act involves 'hedging” because it guarantees a
covered return without risk. The opportunities to profit in this way
seldom arise because covered interest differentials are normally
close to zero.
covered interest pa rity — the gap between interest rates in
foreign and domestic currencies will be matched by the forward
exchange rate differential, such that the "covered” interest rate
differential will be close to zero.
eurodollar deposits — bank deposits, generally bearing in­
terest and made for a specific time period, that are denominated in
dollars but are in banks outside the United States. Similarly, eurosterling deposits would be denominated in sterling but outside the
United Kingdom.
European option — an option that can be exercised only on a
specified date.
European term s — an exchange rate expressed as number of
dollars per currency unit.
floa ting exchange rate — an exchange rate that is allowed to
adjust freely to the supply of and demand for foreign exchange.




MARCH 1984

be able to reduce exchange rate risk whenever possi­
ble. Some risk reduction is achieved by interbank
swaps, but some is also taken up by speculation. Arbi­
trage and speculation both increase the efficiency of
spot and forward foreign exchange markets and have
enabled foreign exchange markets to achieve a high
level of efficiency. Without the successful operation of
these markets, the obstacles to international trade and
investment would be substantial and the world would
be a poorer place.

foreign exchange speculation — the act of taking a net posi­
tion in a foreign currency with the intention of making a profit from
exchange rate changes.
forw ard exchange rate — the price of foreign currency for
delivery at a future date agreed to by a contract today.
futures m arke t— a market in which contracts are traded to buy
or sell a standard amount of currency in the future at a particular
price.
hedging — or covering exchange risk, means that foreign cur­
rency is sold forward into local currency so that its value is not
affected by subsequent exchange rate changes. Say an exporter
knows he will be paid E10,000 in two months. He can wait until he
gets the money and convert it into dollars at whatever the spot rate
turns out to be. This outcome is uncertain as the spot rate may
change. Alternatively, he can sell £10,000 two months forward at
today’s two-month forward price. Suppose this is $1.5 per £. In two
months, he will receive £ 1 0 ,0 0 0 , fulfill his forward contract and
receive $15,000. This export contract has been hedged or covered
in the forward market.
m atching — equating assets and liabilities denominated in
each currency so that losses due to foreign exchange rate
changes are minimized.
options market — a market in which contracts are traded that
gives a purchaser the right but no obligation to buy (call) or to sell
(put) a currency in the future at a given price.
spot exchange rate — the price paid to exchange currencies
for immediate delivery (two business days in the interbank market,
or over the counter in the retail and travelers check market).
swap — the simultaneous purchase and sale of a currency for
different maturity dates that closes the gaps in the maturity struc­
ture of assets and liabilities in a currency.

17

FEDERAL RESERVE BANK OF ST. LOUIS

REFERENCES
Belongia, Michael T. “ Commodity Options: A New Risk Manage­
ment Tool for Agricultural Markets,” this Review (June/July 1983),
pp. 5-15.
Black, Fisher, and Myron Scholes. “The Pricing of Options and
Corporate Liabilities,” Journal of Political Economy (May/June
1973), pp. 637-54.

MARCH 1984
Federal Reserve Bank of New York. "Summary of Results of U.S.
Foreign Exchange Market Turnover Survey Conducted in April
1983” (September 8 , 1983).
Garman, Mark B., and Steven W. Kohlhagen. “ Foreign Currency
Option Values,” Journal of International Money and Finance (De­
cember 1983), pp. 231-37.
Giddy, Ian H. “ Foreign Exchange Options,” Journal of Futures Mar­
kets (Summer 1983), pp. 143-66.

Chrystal, K. Alec. “ On the Theory of International Money" (paper
presented to U.K. International Economics Study Group Confer­
ence, September 1982, Sussex, England). Forthcoming in J. Black
and G. S. Dorrance, eds., Problems of International Finance (Lon­
don: Macmillan, 1984).

Krugman, Paul. “ Vehicle Currencies and the Structure of Interna­
tional Exchange,” Journal of Money, Credit and Banking (August
1980), pp. 513-26.

Dufey, Gunter, and Ian H. Giddy.
(Prentice-Hall, 1978).

McKinnon, Ronald I. Money in International Exchange: The Con­
vertible Currency System (Oxford University Press, 1979).


18


The International Money Market

Kubarych, Roger M. Foreign Exchange Markets in the United
States. (Federal Reserve Bank of New York, 1983).

The Money-GNP Link: Assessing
Alternative Transaction
Measures
R. II. Hafer

F,

I J MPIRICAL research strongly suggests that the
growth of M l — a m easure of transaction balances — is
more closely related to GNP growth than are the broad­
er monetary m easures.1 Yet, at its October 1982 m eet­
ing, the Federal Open Market Com m ittee (FOMC),
which establishes m onetary policy for the Federal Re­
serve System, decided to attach relatively less im por­
tance to observed movements in M l in formulating
policy. Instead, it placed increased significance on the
behavior of broader, nontransaction-oriented m ea­
sures, such as M2 and M3.
This decision cam e about for two reasons: First,
some members of the FOMC believed that the behavior
of M l had been and would continue to be distorted by
the shifting of funds among new types of monetary
instrum ents that resulted from financial deregulation.
Second, velocity developments in 1982, which con-

R. W. Hafer is a senior economist at the Federal Reserve Bank of St.
Louis. Jane Mack provided research assistance.
NOTE: The empirical work presented here is based on the unrevised
M1 data.
'Transaction balances refer to those balances that are available for
immediate spending, such as demand deposits. Empirical evidence
comparing narrow (that is, transactions-oriented) and broad mone­
tary definitions is presented in Carlson and Hein (1980), Hafer (1981)
and Batten and Thornton (1983). An alternative view, advocating the
use of broader measures of money or debt, is expressed in Friedman
(1981, 1982) and Morris (1982). The use of broad monetary aggre­
gates or debt measures in the conduct of policy is examined critically
by Lawler (1981) and Davidson and Hafer (1983).




tinued into 1983, raised doubts about the stability of
the relationship betw een M l and nom inal incom e
(GNP).2
Much of the uncertainty about the usefulness of Ml
as a transactions measure arises because it includes
currency and dem and deposits — traditionally re­
garded as “m oney" — plus interest-bearing checkable
deposits, su ch as negotiable order of withdrawal
(NOW) acco u n ts, autom atic transfer system (ATS)
accounts, and credit union share drafts.3 Some have
argued, however, that these latter deposits, “while

2For a general discussion, see “ Monetary Policy Report to Congress"
(1983), especially pages 132-35. See also Solomon (1983).
3The concept of money as that asset used expressly for transaction
purposes has a long history in monetary economics. Lauchlin Currie
(1935), for example, makes clear the distinction between the concept
of money, defined as currency plus demand deposits, and broader
measures that incorporate savings-type deposits:
There is, however, an important distinction between means of payment
and what may be regarded by individuals as equivalent to means of
payment. Time deposits, in this respect, do not differ essentially from
holdings of government securities, call loans, or, indeed, any property
possessing good marketability which by sale can be converted into
means of payment. It is no more correct to say that one can spend a time
deposit than a government security. Both must first be exchanged for
cash or deposits subject to check before they can be spent.

This distinction between money and “ near money” also is noted by
Martin Bronfenbrenner (1945): “ No monetary commodity can have
any use other than cash balance uses,” where “cash balance uses”
refers to those items "held expressly (consciously) for the purpose of
future direct exchange for other goods." Recent attempts to deter­
mine empirically the transaction uses of current monetary measures
are represented by Barnett (1980) and Spindt (1983).

19

FEDERAL RESERVE BANK OF ST. LOUIS

serving the transaction needs of holders, have many of
the characteristics of savings accounts.”4 Thus, the
nature of M l as a m easure of transaction balances has
com e under question.
In this article, we investigate the relationship be­
tween two alternative m easures of transaction bal­
ances and GNP. One m easure is the current M l aggre­
gate. Because of the difficulty in reliably determining
what proportion of other checkable deposits is held as
savings instead of transaction balances, they are ex­
cluded from our alternative measure, called adjusted
M l. Thus, adjusted M l is simply M l m inus other
checkable deposits, that is, M l less its interest-bearing
com ponents.5 By exam ining the evidence obtained
from using these polar definitions of transaction bal­
an ces, som e light m ay b e sh ed on the question
w hether recent movements in M l, especially those in
1982 and early 1983, accurately reflect the actual m one­
tary stimulus to the economy.

A MODEL OF THE DEMAND FOR
TRANSACTION BALANCES
Useful theoretical models have been developed to
analyze the effect of the interest payment prohibition
on demand deposits. These models provide a founda­
tion from which to analyze the im pact of the introduc­
tion of interest-bearing checkable deposits. From these
models, we can predict some of the effects of the repeal
of interest prohibition on transaction deposits which,
in essence, occurred w hen NOW accounts becam e
avaifabfe nationwide.6
In a general m odel developed by Santomero, the
household is assum ed to allocate its wealth among
various assets in order to maximize the return from its
consum ption activities.7 The household’s initial en ­
dowment of wealth may be held as currency, demand
deposits, savings deposits or com m odity inventories.
The savings deposit pays a positive, explicit interest
rate, r*. Demand deposits yield some implicit interest,
rd, 0
i'1 ? rsK Because savings cannot be traded

MARCH 1984

directly for commodities, the model also posits trans­
action costs for currency and dem and deposits that
are strictly lower than those for savings.9 Thus, savings
are viewed as being a tem poraiy store of funds. More­
over, the theoretical model predicts that “the savings
asset will only be used as a temporary store of working
balances for intra period use if the interest rate differ­
ential [rs — rd] is sufficient to com pensate the house­
hold for the extra cost of going to the bank. If this
condition is not satisfied, the savings asset will not be
used and demand deposits will become the temporary
store o f funds."'0 Thus, as the rate paid on demand
deposits (implicit or explicit) approaches the rate paid
on savings deposits, households will increase their
average holdings of demand deposits relative to sav­
ings deposits.11 In this event, funds stored in savings
deposits will be converted into dem and deposits,
which will now possess the dual characteristics of a
tran sactio n s m edium and a “tem porary store of
funds.”12

9Let a DG and aCG represent the transactions cost of obtaining com­
modities (G) by means of using demand deposits (D) and currency
(C), respectively. If aSD and asc represent the cost of converting
savings deposits into demand deposits or currency, respectively,
then the transactions cost of using savings deposits to acquire com­
modities ( a S c . ) i s either <x s g = a s D ^ <* d g o r s g = o c s c "*■ (* c g ■The
household’s cost of transferring funds from savings to demand de­
posits (ignoring currency) and the relative return from holding sav­
ings deposits are crucially related. As Santomero notes, “the return
from the short-term interest bearing asset [rs] must be sufficient to
compensate the household for the additional cost of withdrawing
funds from S [savings] and not D [demand deposits].” See Santo­
mero (1974).
10lbid., p. 97, italics added.

"S e e also the analyses of Barro and Santomero (1972) and M. Klein
(1974).
12Formally, the solutions for average demand deposit holdings (D)

and average savings deposit holdings (S) are given as
q _

/ Y(gs ~ “ dc)

\f
o

1 \/-r

2(r® - r°)

_

/ V jj a DC~ _

\ J 2(r« - r°)

/ Y (1 ~ h) g De

2(r* - r°)

/Y (a s — « dc)

r^)
where Y = rate of consumption of lump sum income payment X
across intervals T(Y = X/T),

4“ Monetary Policy Report to Congress," p. 134.
5"Adjusted M1” is not identical to the pre-1980 M1 definition. Unlike
the previous measure, adjusted M 1 includes travelers checks and
excludes deposits due to foreign commercial banks and official in­
stitutions. For a comparison between old and current M1, see Hafer
(1980).
6lt should be noted that the analysis concerns household behavior
only: businesses currently are not allowed to hold NOW accounts.
7Santomero (1974).
8These are returns on the marginal dollar held in each deposit group.


20


h = proportion of transactions using currency,
(1 - h) = proportion of transactions using demand deposits,

a DC = cost of converting demand deposits into currency,
and r9 = return on commodity inventories (i^fO).
Holding transactions costs constant, as the rate on demand de­
posits (O approaches that on savings deposits (r*), the first term in
the demand deposit equation becomes indefinitely large as does the
expression under the radical sign in the savings equation. JThe
consequence, clearly, is for average demand deposit holdings (D) to
increase relative to average savings deposit holdings (S).

MARCH 1984

FEDERAL RESERVE BANK OF ST. LOUIS

The crucial element in this analysis is the difference
between the rates on dem and deposits and savings. If
the demand deposit rate is both "com petitive,” as sug­
gested by Klein, and Barro and Santomero, and close to
the rate paid on savings accounts, removing the in­
terest prohibition on dem and deposits (assuming that
r11 cannot exceed rs) should not appreciably affect the
household's allocation of funds. Evidence by Startz,
however, indicates that the implicit rate paid on de­
mand deposits (essentially through rem ission of ser­
vice charges) is only about one-half of the alternative
savings rate.13 Consequently, allowing explicit interest
payments on checkable deposits that approach the
rate paid on savings deposits, according to the model,
would attract funds from savings deposits that pay a
similar rate of return and are relatively less liquid.

THE IMPACT OF INTEREST
PAYMENTS ON CHECKABLE
DEPOSITS: SOME EVIDENCE
NOW accounts were made available to households
on a nationwide basis beginning in January 1981. Be­
fore then, they were available only in the New England
states.14 Frodin and Startz examined the effects of the
early NOW experience on money dem and estim ates for
the New England states relative to the rest of the United
States.15 Their results indicate that, after 1975, the in­
troduction of NOW accounts increased personal trans­
action balances by about 37 percent; in terms of total
money demand, the result was an increase of about 9
percent.
In another recent study, Badecki and Wenninger
examine m oney dem and functions for the consum er
and n on fin an cial b u sin ess se cto rs to determ ine,
among other things, the effect of NOW accounts on the
two groups during 1981 and 1982. Based on a series of
post-sam ple forecasts, they conclude that “the in­
crease in NOW accounts during that year [1981] could
not have represented just a substitution of demand

13Startz (1979) estimates two series on the implicit interest on de­
mand deposits. In 1975, the rate was calculated to be 2.47 percent
and 2.80 percent. These implicit returns paid on demand deposits
are compared with the passbook savings rate at commercial banks
of 4.87 percent and the passbook rate at savings and loans of 5.24
percent.
14NOW accounts were offered first in June 1972 by the Consumer
Savings Bank of Worcester, Massachusetts. Initially, NOWs were
limited to mutual savings banks. In January 1974, New England
commercial banks were authorized to offer NOW accounts. See
Klein (1978).
15Frodin and Startz (1982).




Table 1
Growth of M1, Adjusted M1 and Other
Checkable Deposits: 1/1982 Through
11/1983______________________________
Quarter

M1

1/1982

11 .0 %

II

3.3

Adjusted M1
3.2%
- 0 .5

O ther Checkable
Deposits
54.1%
21.3

III

6.3

2.4

23.4

IV

13.7

7.8

38.1

1/1983

14.9

5.4

55.5

II

12.7

6.7

34.3

deposits for NOW account deposits, leaving the de­
mand for total money balances unchanged.”16 More­
over, their evidence indicates that the rapid growth of
M l during 1982 was due to a continuing flow of funds
away from non-M l sources into NOW accounts as new
accounts were opened.17 Specifically, they claim that
about $8 billion of the new NOW accounts originated
outside M l.
The results of other studies by Johannes, and Joh an ­
nes and Basche, on forecasting the M l money multi­
plier imply that there was a portfolio shift between
time deposits and transaction accounts during the
early part of 1981.18 They found that a level shift adjust­
ment was necessary for five of the seven ratios used in
calculating the multiplier. Their results are roughly
consistent with the Board of Governors’ staff projec­
tions that, during eariy 1981,20 percent to 25 percent of
the funds shifting to NOW accounts were from nondemand-deposit sources.
During 1982, the growth of M l far exceeded that of
adjusted M l. The figures in table 1 indicate that M l
averaged about an 8.5 percent growth rate in that year.
Adjusted M l, on the other hand, grew an average rate
of only 3.2 percent. In early 1983, this divergence was

16Radecki and Wenninger (1983), p. 5, italics in original. It should be
noted that the results of Radecki and Wenninger are based on data
that has been questioned. Consequently, some caution is advised in
interpreting their findings.
17Data presented by Radecki and Wenninger suggest that the number
of new NOW accounts opened between November 1981 and
November 1982 totaled 3.32 million, an increase of 22 percent.
18Johannes (1981), Johannes and Rasche (1981). An opposite con­
clusion is reached by Tatom (1982).

21

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1984

even greater: M l increased at an average annual rate of
13.8 percent and adjusted M l at a 5.9 percent average
rate.

MONEY AND ECONOMIC ACTIVITY:
WHICH M l?

A recent study by Judd and McElhattan helps ex­
plain these divergent growth rates. In their study, Judd
and M cElhattan argue that the M l series overstated the
“effective” money growth rates during 1982-83. This
overstatement arises from an interest-rate-induced in­
crease in the quantity of m oney balances dem anded by
the public. That is, the sharp drop in market rates
during late 1982 precipitated an increase in the quanti­
ty of m oney balances dem anded to w hich “the Federal
Reserve responded by allowing money to grow faster
than originally targeted."19

The nationw ide in trod u ction of NOW accou n ts
attracted funds from both dem and deposits and nonM1 sources. During 1981, the growth of dem and de­
posits fell dramatically as households shifted some of
these funds into NOW accounts. For example, adjusted
M l decreased at rates of 21.4 percent, 4.7 percent and
2.3 percent, respectively, during the first three quarters
of 1981. This drop signified that the public was less
willing to hold transaction balances that did not pay
explicit interest at eveiy level of real incom e and inter­
est rates.20 O ther things unchanged , ad ju sted -M l
velocity should have shown a marked upward level
shift during this period.

The data in table 1 indicate that this increase in
money growth exists largely in the interest-bearing
com ponent of M l, not in the adjusted M l series. The
Judd-M cElhattan analysis, com bined with the data in
table 1, suggests that demand deposits and currency
have reacted differently to changes in market interest
rates than did the interest-bearing com ponent of M l.
Indeed, other checkable deposits appear to be more
in terest-e la stic than the n on -in terest-bearin g bal­
ances. Moreover, Judd and M cElhattan find that an M l
series "adjusted” for the increased quantity of money
demanded due to the sharp interest rate decline in late
1982 explains econom ic activity behavior better than
M l during the 1982-83 period. Thus, the implication is
that the increased quantity of m oney demanded was
not used to fund transactions but, rather, was held as a
store of funds.
The discussion thus far indicates that the increase in
M l in 1981 is partially attributable to the shifting of
funds from time deposits to transaction balances. In
1982, the divergent behavior of M l and adjusted M l
also suggests that the growth in the interest-bearing
com ponents of M l was, in part, for non-transaction
purposes. This result is "predicted” by the theoretical
model discussed above. The interesting policy ques­
tion that emerges from these results is: Does M l have
the same influence on econom ic activity as it did be­
fore these new interest-bearing deposits were made
available? Moreover, do transaction balances that do
not ca n y explicit interest payments display the same
relationship to total spending before and after the
change in the financial environment? The rem ainder of
this article attem pts to answ er these questions.

' 9Judd and McElhattan (1983), p. 46.

Digitized for22
FRASER


Chart 1 plots the levels of adjusted M l and M l veloci­
ties for the period 1/1960 to 11/1983. There is no discern­
ible difference between the two series before the mid1970s, because other checkable deposits were a minor
part of the public’s money holdings. The introduction
of ATS accounts, New England NOWs and credit union
share draft accounts produced the divergent behavior
of the two series since the mid-1970s. The biggest de-

20This assertion is borne out by estimates of a conventional money
demand equation for adjusted M1. For example, using the period
1/1960 through 11/1983, the adjusted-M1 equation yields the result
(absolute value of t-statistics in parentheses):
In (M/P), = - 0.247 - 0.011 D1 + 0.047 In y,
(2.64)
(2.63)
(3.24)
- 0.032 In r, + 0.970 InfM /P )^,
(6.81)
(63.35)
R2 = 0.987

SE = 0.0096

Dh = -0 .4 6

where Pis the GNP deflator (1972 = 100),yisrealG N P($1972),ris
the three-month Treasury bill rate and D1 is a (0,1) dummy term that
equals 1.0 for the period 11/1974 to 11/1983, zero elsewhere. These
results indicate an abnormally slow adjustment speed (3 percent per
quarter) and long-term income and interest elasticities that are quite
large relative to standard results.
Accounting for a level shift in the function in 1981, however,
restores the underlying economic relationship between real money
balances and its determinants. Introducing another intercept shift
term (D2), defined as 1.0 for the period 1/1981 to 11/1983 and zero
elsewhere, the results are
In (M/P), = - 0.373 - 0.023 D1 - 0.042 D2
(4.56)
(5.46)
(5.67)
+ 0.081 In y, - 0.028 In r, + 0.825 ln(M/P)t _,
(5.97)
(6.93)
(29.01)
R2 = 0.991

SE = 0.0081

Dh = 0.80

These results are similar to numerous other studies in terms of the
estimated speed of adjustment (18 percent per quarter) and the
income and interest elasticities. The significance of the D2 coeffi­
cient supports the contention of a downward level shift in the func­
tion.

MARCH 1984

FEDERAL RESERVE BANK OF ST. LOUIS

C h a rt 1

Velocity of M l and Adjusted Ml
9.0

9.0

I

8.5

8.5

■

8.0

8.0

7.5

7.5

I
IS

7.0t

6.5

AdjustFed Mt
6.0

/

■

5.5

7.0

6.5

I

SJ

5.0

4.5
1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

S h a d e d a re a s re p re s e n t p e r io d s o f bus in e s s recessions.

viation in the respective velocity m easures occurs in
1981 when NOW accounts were made available nation­
wide. For example, in 1/1981, M l velocity increased at a
13.8 percent rate, while adjusted M l velocity increased
at an unprecedented 40.0 percent rate. For the year as a
whole, M l velocity increased at an average rate of 5.3
percent, within two standard deviations of its 3.2 per­
cent average growth since 1960. Adjusted M l velocity,
in contrast, grew at an average rate of 17.4 percent.
Again in 1982, the growth of velocity m easured by
adjusted M l diverged sharply from that of M l. For
example, during 1982, adjusted-M l velocity declined at
an average 0.72 percent rate; M l velocity declined, on
average, at a 5.62 percent rate. Several researchers have
attem pted to explain this sharp drop in M l velocity.
Tatom, for example, argues that some of the drop in M l
velocity growth during the last recessio n can be
accounted for by the cyclical response of velocity to the



recession.21 As noted earlier, Judd and McElhattan
argue that the M l m easure overstates the growth of
transaction balances in 1982 that influences econom ic
activity. Using their adjusted-M l series, they find that
“[slimulations of velocity, real GNP and inflation . . .
were more accurate than those using m easured M l.’’22
Has the behavior of the interest-bearing com ponent
of M l during the past one and one-half years led to a
substantial change in its empirical relationship with
GNP growth? Once we have captured the expected
velocity shift in adjusted M l due to financial innova­
tions in 1981, has there been any deterioration in its
relationship with GNP growth?
To determine which measure of money, M l or ad­
justed M l, better explains GNP growth, both were used
2'Tatom (1983).
22Judd and McElhattan, p. 46.

23

FEDERAL RESERVE BANK OF ST. LOUIS

in estimating a variant of the reduced-form St. Louis
GNP equation.23 First, in-sam ple estim ates using M l
and adjusted M l are presented for the period 1/1960 to
IV/1979 and are used as a basis for com parison.24 The
sample period then is updated through II/1983, and
the equation is re-estimated.

MARCH 1984

Table 2
GNP Equation Estimates:
1/1960—IV/1979
Coefficient

Because the constant term in the reduced-form GNP
equation represents the average growth rate of velocity,
a failure to capture the intercept shift caused by reac­
tion to the introduction of nationwide NOW accounts
would lead to biased coefficient estim ates 25 Conse­
quently, a (0,1) dummy variable is used to capture the
short-lived aberration in adjusted-M l velocity growth
during 1981. This term (D1981) equals 1.0 for 1/1981,
11/1981 and III/1981, and zero elsewhere.

In-Sample Estimates: 1960—1979
To gauge the presum ed deterioration in the moneyGNP link, the two alternative money m easures are used
initially to explain econom ic activity during a previous,
relatively untroubled period. The results of estimating
the reduced-form GNP equation using both monetary
definitions for the period I/1960-IV/1979 are presented
in table 2.26
Not surprisingly, the em pirical estim ates are quite
similar. In terms of overall fit, the coefficient of deter­
mination (R2) of the M l equation is slightly greater than
that for adjusted M l, albeit by less than 3 percent. This
slight improvement also is reflected in the relative stan­
dard errors of the equation (SE). Moreover, as the Dur-

23The model estimated here is presented in Tatom (1981). The basic
model is expressed in the form
M
N
GNP = a 0 + Pi 2 mi M,_i + p2 ^ ej E t-j
i= 0
j=0

Q
+ p3

2 pek Pf_ 1 _ k + St +
k=0

where M is the growth of money, E is the growth of high-employment
federal expenditures, Pe is the change in the relative price of energy
and S is a variable entered to capture the effect of major strikes on
GNP.
24This specific sample period is used because monetary policy proce­
dures changed after this date, monetary policy in 1980 was influ­
enced by the Special Credit Controls program, NOW accounts were
legalized nationwide in 1981 and, finally, financial deregulation
accelerated after this period.
25See Maddala (1977), pp. 155-57.
26The monetary and fiscal actions measures are estimated using a
fourth-degree Almon polynomial with both endpoints constrained.
The relative energy price variable is estimated using a third-degree
polynomial without endpoint constraints.


24


Constant

M1
(2.46)
(2.40)
(5.57)
(3.14)
(1.69)
(0.42)
(6.26)

(2.15)
(2.55)
(5.45)
(3.12)
(1.97)
- 0 .0 1 2 (0 . 11 )
1.082 (6.15)

0.076 (1.89)
0.019 (0.56)
-0 .0 3 6 (0.97)

0.074 (1.81)
0.021 (0.59)
-0 .0 2 9 (0.79)

-0.03 1 (0.93)
0.014 (0.35)
0.043 (0.41)

-0.02 1 (0.64)
0.022 (0.56)
0.066 (0.63)
0.004
0.001
-0 .0 1 4
-0 .0 2 7
-0 .0 2 3

pe -5
pe -6
£pe_i

-0 .0 1 5
-0 .0 0 3
- 0.011
-0 .0 2 3
- 0 .0 2 0
0.013
0.095
0.035

S

-0.64 1 (3.51)

mo
m _,
m_2
m_3
m_4
2 m(
6o

e_i
e ^2
e- 3
e 4
Sei
pe 0
p e -,
pe z
pe 3
pe -4

R2
SE
DW

2.466
0.290
0.383
0.300
0.114
-0 .0 4 7
1.039

Adjusted M1

0.502
2.772
2.09

(0.56)
(0.20)
(0 .6 6 )
(1.74)
(1.18)
(0.80)
(3.20)
(0.67)

2.228
0.295
0.375
0.294
0.130

(0.15)
(0.07)
(0.80)
(2.03)
(1.33)
0 .0 1 2 (0 .6 8 )
0.091 (3.04)
0.044 (0.85)

-0 .6 4 8 (3.50)
0.487
2.813
2.04

NOTE: Absolute values of t-statistics appear in parentheses. R2
is the coefficient of determination adjusted for degrees of
freedom; SE is the regression standard error; and DW is
the Durbin-Watson test statistic.

bin-Watson (DW) test statistics indicate, neither equa­
tion is ham pered by first-order serial correlation.
The results for the individual variables also show
little difference. In each instance, the pattern of the
estim ated lags is sim ilar in magnitude and signifi­
cance. For example, the hypothesis that the cum ula­
tive effect on GNP growth of a change in money growth
is unity cannot be rejected for M l (t = 0.39) or adjusted
M l (t = 0.60). Similarly, we cannot reject the hypoth­
esis that fiscal actions and changes in relative energy
prices have no lasting, significant effects on the growth
of GNP. Thus, in term s of overall fit and individual
coefficient estimates, there appears to be little differ­
ence between M l or adjusted M l in explaining GNP
growth during the period 1960-79.

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1984

Table 3
GNP Equation Estimates:
1/ 1960- 11/1983_____________________________________
(3)
Coefficient
Constant

(1)
M1

(2)
Adjusted M1

2.743 (2.33)

3.130 (2.88)

0.262 (2.56)

0.125
0.211
0.230
0.178
0.083
0.827

D1981
m0
m ,
m ...2
m_3
m _4
XrTii

0.353
0.268
0.074
-0 .0 8 7

(5.22)
(2.96)
(1.04)
(0.82)

0.870 (4.81)

A djusted M1
w ith
Intercept Shift
2.017 (2.20)
13.112 (4.69)

(1.60)
(3.96)
(3.52)
(3.41)
(1.09)
(5.86)

0.387 (4.34)

0.024 (0.53)
0.014 (0.34)

0.034 (0.86)

0.393
0.250
0.106
0.029
1.164

(6.41)
(4.28)
(2.16)
(0.42)
(8.03)

0.044
0.012
-0 .0 1 7
-0.011
0.016
0.044

(0.99)
(0.31)
(0.40)
(0.27)
(0.35)
(0.36)
(0.40)
(0.05)
(0.44)
(0.83)
(0.24)
(1.04)
(1.91)
(1.17)

-0 .0 0 6 (0.20)
0.008 (0.48)
-0 .0 0 2 (0.12)

-0 .0 0 8 (0.29)
-0.00 1 (0.07)
-0 .0 0 5 (0.30)

pe 5
pe-e
Spe_i

0.011
0.001
-0 .0 0 8
-0.01 1
-0 .0 0 4
0.017
0.057
0.062

-0 .0 1 6
-0 .0 1 6
0.021
0.112
0.101

-0 .0 0 9
-0 .0 0 5
0.017
0.067
0.056

S

-0 .7 1 8 (3.34)

-0 .5 8 8 (2.78)

6o
6-1
e -2
6 -3
e -4
2e,
pe0
p e -i
pe -2
pe-3
p e _4

R2
SE
DW

0.360
3.369
1.71

0.011
0.026
0.039
0.113

0.371
3.339
1.78

(0.26)
(0.70)
(0.90)
(0.94)

(1.26)
(0.90)
(1.27)
(3.66)
(1.87)

0.016
-0 .0 0 5
-0 .0 0 5
0.008
0.049

(0.46)
(0.13)
(0.15)
(0.21)
(0.46)

(0.79)
(0.34)
(1.15)
(2.31)
(1.14)

- 0.654 (3.46)
0.500
2.980
2.03

NOTE: Absolute values of t-statistics appear in parentheses. R2
is the coefficient of determination adjusted for degrees of
freedom; SE is the regression standard error; and DW is
the Durbin-Watson test statistic.

In-Sample Estimates: 1960—1983
The GNP estim ates using the post-1979 data indicate
a substantial deterioration in the equation's explana­
tory power. As reported in colum ns 1 and 2 of table 3,
there is almost a 30 percent reduction in explanatory
power regardless of the M l measure used.27 Moreover,

27A similar deterioration is documented, although not explained, in
Batten and Thornton (1983).




the summed effect of money growth has declined sub­
stantially. For example, using the 1960-79 sample, a 1
percentage-point change in M l growth has a cum ula­
tive 1.039 percentage-point change in GNP growth.
When the 1960-83 sample is used, however, the esti­
mate of this cumulative effect drops to a 0.870 percentage-point change. A similar result occurs when the
sample period is updated and adjusted M l is used as
th e m o n e ta ry v a ria b le (1.082 p e r c e n t to 0.827
percent).28

The problem with the adjusted M l results shown in
colum n 2 of table 3, as noted earlier, is that the adjusted
M l results are not reliable u nless the 1981 NOW
account effect has been taken into account. Thus, the
GNP equation using adjusted M l was re-estimated for
the 1960-83 period incorporating the intercept shift
term. These results, presented in colum n 3, show that
the intercept shift term (D1981) is positive and statisti­
cally significant; thus, the hypothesis that the constant
term was subject to a significant displacem ent during
1981 is not rejected by the data. The im portance of
capturing this effect is evidenced by the dramatic
change in the equation’s explanatory power and in the
coefficient estim ates of the money variable.29

When compared with the 1960-79 estimation re­
sults, the adjusted M l equation with the intercept
adjustm ent shows no deterioration in overall fit; the R2
in creases from 0.487 to 0.500, com pared with the
approximately 30 percent decline found using M l.30
Not only is the overall fit of the equation actually im ­
proved, but the drop in the sum med coefficient esti­
mates on adjusted M l that appears when comparing

28lt should be noted that neither sum estimate is statistically different
from unity.
29Another procedure also was used to account for the rapid adjustedM1 velocity growth in 1981. Because GNP does not respond im­
mediately to changes in money growth, a rapid increase (decrease)
in money growth during a quarter will appear as a sharp decline
(increase) in velocity. Thus, to abstract from the declines in adjusted
M1 growth during the NOW account introduction, a (0,1) dummy
term is used to form an interaction variable with the adjusted M1
growth. This variable takes on the value of zero in all quarters except
1/1981, 11/1981 and 111/1981, when it equals actual adjusted M1
growth. As expected, the outcome using this approach is quite
similar to the shift-adjusted model in table 3. Again the R2 (0.50) is
increased by about 40 percent relative to the M1 equation. The
deterioration in the coefficient on the summed effect of money
growth (2 mi) found using M 1 disappears; the estimated cumulative
effect is 1.139. This result provides further evidence on the relative
usefulness of adjusted M1 in explaining GNP growth.
30For completeness, we also estimated the M1 equation with the
D1981 variable; the estimated coefficient was not statistically sig­
nificant.

25

MARCH 1984

FEDERAL RESERVE BANK OF ST. LOUIS

the results in tables 2 and 3 vanishes as well: a 1
percentage-point change in adjusted M l growth is
now estim ated to have a cumulative im pact of 1.164
percentage-point change in GNP growth, slightly high­
er than the 1.082 percentage-point change reported for
the 1960-79 sample. Thus, w hen the velocity change
during 1981 caused by the NOW account introduction
is taken into account, the adjusted M l m easure ex­
plains the growth of GNP better than does M l.31

CONCLUSION
It has been argued that M l, as it is currently defined,
may give a distorted view of actual policy actions on the
economy. This problem arises from the public’s will­
ingness to view som e portion of interest-bearing
checkable deposits as savings-type balances. Unfortu­
nately, there currently is no reliable procedure by
which we can disentangle the transaction from the
non-transaction shares of these deposits. This is espe­
cially true in terms of anticipating what those propor­
tions will be in the future.
To investigate the validity of the alleged problem
with M l, an alternative M l m easure was derived that
excluded all interest-bearing checkable deposits. This
adjusted M l m easure — defined simply as M l less
other checkable deposits — was used in a reducedform GNP equation, and the results were compared
with estim ates obtained using M l. Estim ates derived
from the 1960—83 sample period indicate that, once the
distorting effects of the NOW account introduction in
1981 are accounted for, the adjusted M l series explains
GNP growth better than M l.
Although the results suggest that recent criticism of
the Ml-GNP link is not unwarranted, they strongly
deny the associated claim that the link between trans­
actions money and GNP has been damaged irrepa­
rably. Instead, the evidence suggests that a more fruit­
ful approach would be to sharpen the distinction
between transaction deposits and those held for both
transactions and savings.

31The results suggest that the “other checkable deposit” (OCD)
component of M1 may be dominated by the growth of adjusted M1 in
explaining the growth of GNP. To test this, OCDs were added to the
adjusted M 1 equation as a separate set of independent variables.
The equation was then re-estimated for the 11/1964-11/1983 sample
period; the sample period is shorter due to the limited data availabil­
ity for OCDs. Based on a standard F-test, adding OCDs does not
significantly increase the explanatory power of the equation (F l 2 =
1.62).


26


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FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1984

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27