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Handbook of Exchange Rates by Lucio Sarno, Ian Marsh, Jessica James

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22.2 Evolution of the Foreign Exchange Market

22.2.1 Disappointing Early Years

FX is a relatively young market and currencies as liquid market instruments have come rather late to the stage in the history of global markets. The Bretton Woods conference held in July 1944 aimed to redesign the world monetary system and is a key milestone in the history of modern currencies. As a result of the conference, a system of coordinated exchange rate management was set up that remained in place until the early 1970s. Under the Bretton Woods agreement, currencies were not permanently fixed but managed with occasional devaluations allowed to correct for imbalances in the balance of payments. During this time period of adjustable pegs, currencies were naturally not seen as instruments that could be traded to make profit. However, once the Bretton Woods System collapsed in the 1970s and currencies started to move freely, FX started to become interesting to investors.

After the collapse of Bretton Woods, exchange rates were initially expected to move according to monetary models. However, Meese and Rogoff's (1983) findings regarding the failure of economic models in forecasting exchange rates was a major disappointment and a source of confusion. In their pioneering work on exchange rate predictability in “Empirical Exchange Rate Models of the Seventies: Do they fit out-of-sample?” the authors compared the out-of-sample forecasting accuracy of various time series and structural models of exchange ...

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