The need for futures markets in currencies.

• Author: Friedman, Milton
• Position: Essay

Under the Bretton Woods system, the central banks of the world undertook to keep the exchange rates of their currencies in terms of the dollar within [+ or -] 1 percent of the par value as determined by the official values of gold registered with the International Monetary Fund. In practice, the central banks generally kept the margins even narrower: [+ or -] 1/2 of 1 percent or [+ or -] 3/4 of 1 percent. So long as they had confidence that these limits would be maintained indefinitely, persons engaged in foreign trade were subject to negligible risk from fluctuations in exchange rates. Even so, large traders with sharp pencils found it desirable to hedge any future transactions by buying foreign currencies forward to meet commitments coming due or selling foreign currencies forward to match scheduled receipts. These forward transactions were handled bythe large commercial banks, often with the active participation of foreign central banks in the forward market.

Episodically, confidence that the par value could be maintained waned. Whenever this occurred, there were major movements of funds both in the spot and futures markets. Since there was seldom any doubt which way the exchange rate would be changed, if it were changed, the movement was in one direction only, and the funds could be absorbed only by large scale central bank operations in both the spot and futures market. The most recent episodes of this kind were in the spring of 1971, when appreciation of the German mark became widely expected; and after President Nixon's August 15 measures, when appreciation of the Japanese yen became widely expected. The German central bank bought something over $5 billion before finally letting the mark float; the Japanese central bank [bought] a similar or even larger sum before letting the yen float. In both cases, the currencies appreciated promptly by over 5 percent as soon as they were permitted to float and then continued to appreciate subsequently.

Under the system of rigidly fixed rates that do not change--the ideal envisioned by some supporters of Bretton Woods--there is only limited room or need for a broad, resilient public futures market in currencies. The central banks plus the large commercial banks can readily provide the need. Under a system of rigidly fixed rates subject to large jumps from time to time--the Bretton Woods system in practice--there is great need for a futures market in currencies to permit foreign traders and investors to hedge against the occasional large changes that will occur. But it is almost impossible for such a market to exist because most of the time there is little for it to do, and when there is a role for it, the speculation is one-sided.

The End of Bretton Woods: An Opportunity for a Vibrant Futures Market in Currencies

Bretton Woods is now dead. The president's action on August 15 in closing the gold window was simply a public announcement of the change that had really occurred when the two-tier system was established in early 1968. No one can be sure just what kind of a system will develop in coming years--whether the world will continue on a dollar standard or whether a substitute international standard will emerge; what role the International Monetary Fund will play; whether the formal...