Market for Foreign Exchange - Essay Example

Market for foreign exchange Inserts his/her Inserts and number Inserts submittedThe foreign exchange market is one of the financial markets that is characterized by buyers and sellers of assets called ‘currencies’ (Riehl & Rodriguez, 1983). It has traditionally performed the role of converting one currency into another (Madura, 2009). It is consistent with the principles of market economy laid down by Adam Smith, according to which the value or price of a currency is determined by the market forces of demand and supply.

The terms ‘pegged’ and ‘float’ are often discussed when dealing with foreign exchange markets and are means of determining the levels of controls on one’s currency. The purpose of this paper is to define in detail and discuss critically, the workings of the foreign exchange market in the context of current world dynamics. As mentioned above, a currency maybe pegged or valued against a basket of other currencies or maybe left to the market forces of demand of supply in what is known as ‘free float’ (Madura, 2009).

In between the two, however, lies an intermediate form, the ‘balanced float’ that is characterized by some government control but is largely based on the principles of demand and supply. Taking a more realistic view, the value of a country’s currency is determined by the interplay of several factors including the economic, political, geographic environment (Madura, 2009). Tourism also positively affects the value of currency by increasing demand for the country’s currency (Levi, 2009).

For instance, a tourist who visits country A will require country A’s currency to purchase any goods and/or services in that country. Holding everything else constant, this shall result in an increase in demand for that currency, thus, bidding up its price. Furthermore, in the modern age of globalization which is characterized by free movement of capital, goods and currency it has become increasingly important for foreign exchange markets to offer sophisticated products to its customers as everything from remittances by multinationals to payments to labor by the same entities requires well developed foreign exchange markets that cater to their individual needs .

As far as the size of the foreign exchange market is concerned, it is no surprise that it encompasses a volume of trading which is 5-10 times the amount of trade in foreign goods and services. There are three major foreign exchange markets across the globe: London, New York and Tokyo. These markets provide several functions; however, the three core functions are those of transmission of purchasing power between the buying and selling party, financing the goods in transit ( credit provision) and hedging of currency risk.

As far as the purchasing power function is concerned, goods can be settled for ‘one’ currency which then maybe converted to the local currency. Financing goods in transit arises due to time consuming process of transfer of goods between countries. Finally, hedging function is associated with the transfer of currency risk from the seller of that risk to the buyer. The foreign exchange market operates in a complex environment that consists of two levels: the interbank and the retail markets (Bollerslev & Domowitz, 1993).

In general, these encompass a wide range of market participants including the dealers, brokers, users (MNCs, importers, exporters), speculators, arbitrageurs and treasury funds institutions (Coyle, 2001). Transactions in the foreign exchange market take different forms. They may take the form of spot transactions, forward transactions or Swaps (Coyle, 2001). In a Spot transaction the delivery of currency must be made immediately with a specified settlement date (Coyle, 2001). The forward market is characterized by future delivery of the currency at a specified time and amount (Coyle, 2001).

The value is determined at the time of initiation of the contract, whereas the delivery and payment are deferred till expiration or maturity of the contract. Finally, under the Swaps transaction, the delivery and sale of the currency is done at the same time for a particular amount of currency with particular value dates (Coyle, 2001). Risk for the dealer is sufficiently reduced under this type of transaction owing to the simultaneous purchase and sale of currency. Swaps are the most common type of foreign exchange transactions, followed by Spot and Forwards (Madura, 2009).

Furthermore, the foreign exchange markets consist of quotations that are characterized as either American or European (Coyle, 2001). American quotations represent the amount of USD that are required to buy one unit of foreign currency, whereas, European quotations represent the amount of foreign currency that are required to buy one USD (Coyle, 2001). The foreign exchange quotation differs significantly from the foreign exchange rate in that the former is the value of the foreign currency whereas the latter represents the value at which the buyer/seller is willing to purchase/sell the foreign currency in the market (Madura, 2009).

Theoretically, it is assumed that these quotes include no spreads; however, in the real world, these foreign exchange quotations comprise of bid-ask spreads that exist owing to the divergence between the bid price and ask price (Wang, 2009). The existence of bid-ask spreads reflects the presence of transaction costs, imperfect information and commissions (Wang, 2009). Furthermore, the economics of foreign exchange is centered on a law that states that goods homogenous in nature ought to have the same price everywhere (Wang, 2009).

This gives birth to the concept of cross rates that define the rate of exchange between two currencies based on their association with a third currency (Wang, 2009). To conclude, the foreign exchange market is a decentralized interaction between buyers and sellers of currencies that determines the relative worth of currencies. It would be impossible to have foreign trade and investment without the existence of such markets that facilitate the conversion of one currency into another. It offers high liquidity advantage to users, boundary-less trading and lower risk compared to other assets (Madura, 2009).

References: Bollerslev, T., & Domowitz, I. (1993). Trading patterns and prices in the interbank foreign exchange market. Journal of Finance , 1421–1443. Coyle, B. (2001). Foreign Exchange Markets. Chicago: Fitzroy Dearborn Publishers. Levi, M. D. (2009). International finance . Oxon: Routledge. Madura, J. (2009). International Financial Management . Mason: South-Western Cengage Learning. Riehl, H., & Rodriguez, R. M. (1983). Foreign exchange and money markets: managing foreign and domestic currency operations.

New York: Kingsport Press. Wang, P. (2009). The Economics of Foreign Exchange and Global Finance . Heidelberg: Springer-Verlag.