The Foreign Exchange Market - Essay Example

Multinational business finance Author’s name Institutional affiliation Multinational Business Finance Question 1 Foreign exchange theory Foreign exchange market is basically a place or an avenue where currency purchasing and trading takes place. Additionally, it is specifically an avenue where official monetary institutions and banks facilitate the selling and buying of the foreign currencies (Oberlechner, 2004). Moreover, the foreign exchange market in the recent times has been one of the most liquid and largest financial markets internationally or rather in the world. By way of elaboration, the financial markets exchange dealings includes purchasing trade between large banks, currency speculators, corporations, central banks, other institutions and governments (Weithers, 2011). Functions of foreign exchange It is universally recognized that the primary purpose of the foreign exchange market globally is to basically facilitate investments and trade. In this case, the need and the demand for foreign exchange came into existence because of the multifarious global currencies such as the Sterling Pound, U.S dollars and Euros, as well as the demand and the need for purchasing and selling in such currencies (Weithers, 2011). Another primary and basic function of foreign exchange revolves around the transfer of the power to purchase between various countries (Weithers, 2011). In other words, due to the continuous shifts in the foreign currencies, foreign exchange is therefore a continuous process that does not rest in the ever evolving business world (Oberlechner, 2004). By so saying, it means that, the universal networking of foreign exchange in terms of banks, brokers, businessmen as well as the exchange owners who are interlinked internationally makes it possible to purchase across different countries. Another significant role of foreign exchange is to provide the much needed credit to the debtor who is importing. In simple terms, this is made possible because of its different and diversification for its specific business purpose (Weithers, 2011). Moreover, foreign exchange takes over the hedging function. By so doing, it covers all the risks that pertains the foreign exchange risks and transactions (Oberlechner, 2004). By way of explanation, foreign exchange transactions basically involves a group of individuals or rather one party purchasing a particular number value of a one currency in an exchange deal for paying a particular quantity value of another currency. Market participants and transactions Unlike in the stock exchange market where institutional investors trade only with potential investors, foreign exchange market conduct a number of transactions with the help of other participants. Therefore, it is of utmost importance to recognize and comprehend the transactions and functions of the main forex players in the market. Some of the main market participants include; the central bank and the government, banks and other monetary institutions, hedgers and speculators Governments and the central banks Federal governments and the central bank are the most influential forex exchange participants. Additionally, the central bank in most cases serves as government extension and therefore, it conducts its procedures and policies in respect with the government regulations. In this case, the central banks are basically employed in maintaining the foreign reserve amount in order to realize a number of economic objectives and goals. By so doing, most central banks on the other hand use the foreign market of exchange to adjust their bank reserve volumes according to the economic situations. Banks and other financial institutions Banks acts as foreign exchange dealers owing to the fact that they are willing to purchase currency at any asking or bidding price. One way that banks establish their names in the exchange market is through currency exchanging at higher value than the one they initially purchased it for. Since the foreign exchange market is a global market, it is possible to witness a number of banks with different exchange rates for the same currency. Hedgers They tend to undertake forex exchange trading since they believe that they possess liabilities and assets in foreign currency. For instance, when an importer who desperately needs foreign currency exchanges domestic currency in order to obtain foreign currency, he or she is in one way or the other termed as a hedger. By so saying, it means that the importer is experiencing a foreign exchange liability. Speculators In most cases, they are traders who are basically involved in purchasing foreign currency to realize net revenues from any expected future currency movement. In other words, they do not possess any genuine need for engaging in foreign trade. By so doing, they do not hold any stipulated cash position in the global currency market. Question 2 Purchasing power parity Purchasing power parity is basically an exchange rate determination theory and a way to compare and contrast the average costs of services and goods between different countries (Ignatiuk, 2009). Additionally, it is better suited in comparing the data between countries as compared to the exchange rate determination function since its simple form basically depends on a number of assumptions that may not count in the real world and moreover, the foreign exchange activity as a result of the exporter and importer demands is very less as compared to the investor’s activities (Ignatiuk, 2009). Nonetheless, Purchasing power parity theory remains an important school of thought in providing the fundamental background for its employment as an economic tool for cross-country comparisons in terms of incomes and wages which is in most cases used by global organizations such as the World Bank in presenting quite a number of their international data (Carbaugh, 2014). Difference between absolute purchasing power parity and relative purchasing power parity Absolute purchasing power parity simply implies that, a bundle of services and goods should bear the same price in different countries once the exchange rate is taken into account (Ignatiuk, 2009). By so saying, it means that. Any slight deviation in prices such that the price of one basket of goods is lower in one country than the other,then the relative prices as well as the exchange rate are expected to move towards a point where the basket of goods will automatically have the same prices in the two countries (Ignatiuk, 2009). Relative purchasing power parity theory describes the differences in the inflation rates between two comparing countries (Ignatiuk, 2009). By way of example, in case the price of one basket of goods in one country is higher than the other, relative theory requires that the cost of the prices to be the same in both countries hence it will try and lower the prices in the country which is higher through depreciation criteria. In the end, the depreciation percentage should be equal to the difference in inflation rates between the two countries (Carbaugh, 2014). References Carbaugh, R. J. (2014). International economics. Ignatiuk, A. (2009). The Principle, Practice and Problems of Purchasing Power Parity Theory. München: GRIN Verlag. Oberlechner, T. (2004). The psychology of the foreign exchange market. Chichester: Wiley. Weithers, T. (2011). Foreign Exchange: A Practical Guide to the FX Markets. Hoboken: John Wiley & Sons, Inc. Read More