Question

Countries around the world historically used the Gold standard (1890-1914), which, however, was changed to fixed exchange rate system through Bretton Woods since the WWII. The Bretton Woods System collapsed and most countries around the world today use either a clean float or dirty float as an exchange rate system. While removing FX controls and increasing economic integration enable investors to roam around the world, this also means that investors and countries face diverse challenges, risks and uncertainties, which they have to manage through different tools (e.g., measuring country risk and using debt management strategies such as Paris and London Club, debt-for-debt swap and debt-for-equity swap). Generating profits from investments is becoming increasingly challenging even from international diversification. Hence, some investors prefer to tilt towards their home assets (home bias). Highlight the key differences between the following terms:

i)       Gold standard vs Bretton Woods

ii)      Clean float vs dirty float

iii)      Paris vs London Club

iv)     International diversification vs home bias

Answer 1

(i): Gold standard was the system in place in which a country using gold standard guaranteed that it would redeem its currency for its value in gold. In other words the currency of that country was pegged in gold. Bretton Woods replaced the gold standard and in this arrangement the currency was pegged to U.S. dollars.

(ii): Clean float is a pure exchange rate and this occurs when the value of a currency or its exchange rate is determined mainly by the supply and demand forces in the market. In case of dirty float the exchange rate is not pure. In case of dirty float government rules, laws and regulations affect the pricing of a currency and hence its exchange rate.

(iii): It should be noted that the process of resolving an international debt crisis is similar to a three-ringed circus. The center ring constitutes of negotiations by government of the debtor country with the IMF. The purpose is to obtain balance of payments loans. The second ring comprises debtor government negotiating with creditor government for the purpose of lowering the debt servicing burden. The third ring comprises of negotiations between government and private creditors for the purpose of seeking debt relief. Paris Club comprises of the activities mentioned in the second ring while London Club is representative of the third ring mentioned and discussed above.

(iv): International diversification in investment means that investors look to invest in equities across the globe and outside the home market with the objective of benefiting from diversification. In case of home bias investors park their funds mainly in domestic equities as they believe that extra difficulties that is associated with investing in foreign equities is not worth the risk or extra effort.