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

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24.2 Why Would One Bother With an Option?

24.2.1 History

Before early 1970s, exchange rates were in general fixed, but after the Bretton Wood agreement1 was abandoned, currencies started to shift against each other, causing volatility. The theory is that exchange rates have to float as they are the mechanisms that tackle global trade imbalances. With fixed exchange rates, importers and exporters do not need to think about currency issues; however, such a short-term benefit can create long-term economic problems. When exchange rates are fixed, the long-term economic problem should be solved by the self-regulatory nature of the market, but the short-term financial issue of revenue fluctuation is quite troublesome for the treasurers of importing and exporting companies. Floating exchange rates create volatility and uncertainty and, therefore, there is a natural demand to eliminate this uncertainty at a certain cost. Treasurers of importing and exporting companies became the first participants in the currency forward market. A forward contract provides a mechanism by which this risk is eliminated. The problem that treasurers faced was that when a forward contract produced a negative cashflow, which should, in theory, be offset by a profit, the negative cashflow would be immediately crystallized as a negative P&L, while the profit from the underlying assets remained a projected number and would need to be crystallized in the future. However, if sales went down, the offset would not ...

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