Factors that Influence the Volatility in Exchange Markets in China - Research Paper Example

? Factors that Influence the Volatility in Exchange Markets (China) Task Outline i. Introduction ii. Functions of the Foreign Exchange Market iii. Relevance of Spot Exchange Rate (SER) in exchange markets iv. Forward Exchange Rate and the Role They Play In Insuring Against Foreign Exchange Risk v. Purchasing Power Parity (PPP) Theory vi. Advantages of Exchange rates forecasting vii. Differences between Translation, Transaction and Economic Exposure and their management Factors that Influence the Volatility in Exchange Markets (China) Introduction Foreign exchange rates (ER) are vital for efficient performance of the international economy. The different countries exchange their respective currencies with foreign ones in trade of market securities and commodities. Clearly, the exchange amounts are initiating calculation in accordance to their contemporary exchange rates (ER) or fixed amounts (Nirav, 2011). However, in certain occurrences these rates appear to be excessively volatile and regularly interfere with the Balance of Payments (BOP). This excessive unpredictability of the rates can scare investors and eventually elevate the cost of business. Furthermore, these pressures can complicate the structures and functionality of the monetary policies. Emerging markets frequently experience financial turbulences than the established ones (Nirav, 2011). For example, China is an emerging market and is currently attracting an array of budding investors who perceive it as a tax haven. They perceive it as a worthy investment hub that will ensure sufficient returns. Stock markets in China have been considerably volatile since 2006 mid year. According to Huchet and Korinek (2011), the index of the Chinese Yuan in the Shanghai Stock Exchange has risen three times to 6124.04 by the end of 2007. Consequently, 1530 corporations listed their securities in Shanghai and Shezen Stock Markets. This paper analyzes the concepts and impacts of the exchange rates on the volatility of markets. Functions of the Foreign Exchange Market Foreign exchange influences the countries ability to conduct business relations with its trading associates. Therefore, the factors, which control the exchange patterns of a countries currency, become vital to it. Considering this, the Central banks have the mandate of monitoring the exchange fluctuations of the currency. It is in a position to instill stability of the currency by tightening the financial policies of exchange rates of banks and bureaus (Huchet & Korinek, 2011). The first role includes the “transfer function” which is essential in facilitating the transfer of the purchasing capacity of the trading countries. For example, if the exchange rate US is superior to that of China, for instance 2.68 Yuan: 1$, the Chinese firms will incur more to import from US. The second is the “credit function” role that entails the provision of credit for foreign trade. The transfer of commodities takes time, and this transit period requires financing. The trader’s exchange agents and banks furnish the foreign traders with credit facilities to facilitate trade. Thirdly, the exchange rates assist in hedging against the variation of the currency markets (Nirav, 2011). The exchange rates market has structures that importers and exporters can use to evade the excessive costs and risks of exchange rate patterns. Hedging enables corporations evade the exchange risks through exchange agreements by using the following rates: Fixed exchange rates, Forward exchange rate and Spot rate. Relevance of Spot Exchange Rate (SER) in exchange markets The spot rate is the existing transfer rate of foreign currencies in comparison to the home currency (Wang, 2009). This rate is determines by the existing economic situations in a country. Interestingly, the political circumstances of the country also have a considerable effect on the exchange rates. Therefore, changes in the future expectations can disrupt the current spot rate. Miller (2002) suggests Spot rates are crucial since they depict the exchange rate (ER) positions, exposures and risks regarding the future economic situation of the country. Secondly, the SER assists in assessing the sensitive areas of the economy that usually affect the exchange balance of foreign currencies (Wang, 2009). They highlight impacts of the economic actions of countries on the international financial transactions of a country. In addition, the spot rate indicates the need of foreign exchange in a country. If the spot rate is high, it shows the need for foreign currency by companies to facilitate their transactions with the foreign trading associates. Forward Exchange Rate and the Role They Play In Insuring Against Foreign Exchange Risk Forward exchange rates (FER) are prices that trading associate’s from different countries agree to pay each other on a specific future date. Ideally, it is a predetermined exchange value governing the cost of a particular transaction (Huchet & Korinek, 2011). Numerous corporations enter into FER arrangements to cushion themselves from the potential exchange costs they can experience in future. Therefore, corporations favor FER agreements to prevent the additional expenditure incase the future rate will be more than the existing one. For example, if a corporation on China is speculating possible depreciation of their currency against the US dollar, it can agree with the foreign firm to maintain the contemporary rates despite the effect of financial variables on the future rates. This will enable to stabilize the earnings of the Chinese firm despite the adverse conditions of the country (Wang, 2009). However, if the exchange rate depreciates it will be a loss to the Chinese Corporations since it will reimburse more. The FER’s can be of future periods from one week to even a year. Purchasing Power Parity (PPP) Theory The PPP links the Spot exchange rates to the nation’s current prices and the existing elements that are influencing the economy (Miller, 2002). Importantly, the PPP focuses on inflationary relationship of the exchange rates. The PPP theory has two categories, which consist of the Absolute PPP and the Relative PPP theory. The Absolute PPP indicates that the equilibrium of exchange rates is proportional to the ratio of prices in the two nations (Levi, 2009). Therefore, the prices of similar products should be equal in accordance to the assumptions of Absolute PPP. Alternatively, the Relative PPP suggests the alteration of the ER should be proportional to the respective changes in price in the two nations in the same period. This theory incorporates all the market price determinants, for example, tariffs, quotas, transportation costs among others (Miller, 2002). Relative PPP assumes that these imperfections are not necessarily similar in different countries. The chief indicators of the deviations of PPP are transaction costs of the goods, and the Capital controls thorough taxes or quotas. Advantages of Exchange rates forecasting The Spot Exchange Rate (SER) automatically adjusts the balance of payments incase of a variation in the ER, unlike fixed rates (Wang, 2009). For example, if China has a Balance of Payments (BOP) deficit and the Chinese Yuan exchange rates increases their importers will have to spend less than their previous assumptions. Moreover, these rates are flexible, and they change in coherence with the economic circumstances of the country. Unlike FER’s they are reflective of the prevailing conditions and prevent additional expenditure incase the exchange rate (ER) subsides. The FER also has merits that make it an attractive alternative for most firms (Levi, 2009). Forward exchange rate assist in cushion against the potential risks of uncertain conditions of markets. For example if the ER of a country is increases, it will be beneficial for the company since it has previously negotiated the payment amounts. Differences between Translation, Transaction and Economic Exposure and their management Miller (2002) affirms Transaction exposures come from foreign transactions, which a corporation is under obligation to complete in future. This means the company would be exposed to the ER fluctuations until the firm receives payment and converts it to domestic currency. Fundamentally, this is the exposure of a corporation to the fluctuations of a specific foreign currency. Managers can apply Forward Exchange Rates (FER) to mitigate the possible external shocks that can influence the transaction exposure. Translation exposure comprises the exposure arising from risks of converting the worth of assets and liabilities from foreign to domestic currency (Levi, 2009). Translation exposure usually depends on the valuation concepts of the foreign country and is not easily manageable. Finally, Economic exposure involves the possibility of a change in the ER to affect the competitive position of a firm and eventually affect its profitability. Considering the nature of economic exposure, it affects profitability for longer periods than translation exposure or transaction exposure. Management can mitigate the adverse effects of economic exposure by hedging the foreign transactions. This will ensure the losses of the business are minimal. References Huchet, M. & Korinek, J. (2011). To what extent do exchange rates and their volatility affect trade? Paris: France, Paris Retrieved from http://search.proquest.com/docview/898806832?accountid=45049 Levi, M. (2009). International Finance. New York, NY: Taylor & Francis. Miller, N. (2002). Balance of payments and exchange rate theories. Cheltenham: Elgar. Nirav, S. (2011). What are the Functions of the Foreign Exchange Market?. PreserveArticles.com. Retrieved from http://www.preservearticles.com/2012012721683/what-are-the-functions-of-the-foreign-exchange-market.html Wang, P. (2009). The economics of foreign exchange and global finance. Berlin: Springer. Read More