The Prevailing Market Rate: Balance of Payment and Foreign Exchange - Research Paper Example

Finance is the uncertainty that professionals apply in the decision making and economics of time. The effects of uncertainty and timing enable businesses to make various economic choices that concern alternate course of action. International finance refers to the examination of institutions, their practices, and analysis of various cash flows of different countries. One of the major distinctions between the international finance and its domestic counterpart is the exchange rate risk. Exchange rate risk is the uncertainty that professionals inject into international financial decisions. These decisions arise from variances in price of a country’s currency per unit of another country’s currency (Madura, 2009). Other distinctions include foreign investment, risks that result in changes that arise in a political environment, and income. International trade is particularly vital in the country since it indicates the level of economic growth that a country is experiencing. Foreign exchange markets enhance international trade by providing markets where exchange of all currencies of the world can be done. Investments in other countries have facilitated international trade. Where a country establishes businesses in other countries, considerations of taking profits home and government imposed restrictions must exist. The long term motive of foreign exchange is capital formation while the short term objective is trade. Countries have to ensure that they obtain a favourable balance of trade for them to achieve capital formation. Sovereign states have their own business laws, currencies, and political systems. These differences lead to introduction of risks into the process of financial decision making (Madura, 2009). International Fisher Effect (IFE) is a theory in economics that explains that a change expected in the prevailing exchange rate between two currencies is equivalent to the difference between the nominal interests of the countries at that time. One can calculate this by following the equation below.   Where “E” represents the percentage change that occurs in the exchange rate, "i1" represents the interest rate of a country A, and "i2" represents the interest rate of a country B. For instance, in a case where the interest rate of country A is 10% and that of B are 5%, the currency of country B should appreciate by 5% in comparison with country A’s currency. The Fisher effect is expressed by the equation below (Madura, 2009). This implies that the interest rate () is equivalent to the nominal interest rate () when you subtract the rate of inflation () that one expects. For cases of simple rates, the equation of Fisher takes the form of .The nominal interest rate is the rate of interest that the bank offers. In cases where one has a savings account, the nominal rate alerts one on how fast the savings in the account will rise over a given period of time. The real interest rate on the other hand acts as correction to the nominal rate for the effects of inflation to determine the rate at which the purchasing power of the savings will rise in a given period of time. Significance for International Finance International finance is a key area in the international businesses that countries must always familiarize themselves with for successful existence in the market. The world is experiencing changes that arise as a result of liberalization of trade as well as globalization. International Finance helps us to understand various consumption patterns of different economies. This enables investors and businesses to predict the volume of goods to produce and determine the markets to supply with goods. Understanding of consumption patterns of different economies is noteworthy since it enables manufacturers to estimate periods of boom and recession and curb the problem of excess supply. Excess supply will have adverse effects on prices of commodities and should be avoided. International Finance is, therefore, very effective in the determination of market patterns. International Finance is tremendously influential in the determination of fields that firms should concentrate on investing. It alerts on the fully effective markets that offer the best price for the manufacturer’s commodities. For a business to be successful, an analysis of various factors such political stability, size of the market, and analysis of risks is tremendously powerful. International Finance plays a vital role during the process of determing the above factors, and hence acts as an important aid to investment (Madura, 2009). International Finance helps in understanding production. Manufactures study the market and determine the forces that affect demand of commodities. They make appropriate decisions as to the amount of production that they have to produce without making losses. This assists them in determining the appropriate amounts to maximize their profits. There exist a proportional relationship between depreciation and appreciation of currency prices to differences in interest nominal rates. International Fisher Effect attributes the changes in exchange rates to differentials in interest rate. Researchers clearly demonstrate this by an analysis of various countries, which includes UK, Germany and USA in 2011. These countries are the favourable choices that a researcher selects due to the prominence of their currencies in the world market. They are the main currencies that many countries adopt for their exchange transaction. They are, therefore, the best for evaluation. In cases where the real rate of return is constant in different countries, variances in interest rates of different countries arise as a result of differences in inflation rates. For instance, the exchange rate for the UK’s pound and the US dollar on August 22, 2011was 0.123. The interest rate in those countries was 6.56% and 7.5% respectively. International Fisher Effect suggests that the country experiencing a high nominal interest rate (US for this case) will find its currency depreciating. Professionals obtain the future expected spot rate by multiplying the foreign interest rate with the spot rate: (0.122X (1.075/1.0656) = 0.123. This also suggests that the country with a low nominal interest rate will have its currency appreciate. One obtains the future spot rate by multiplying the ratio of foreign interest rate with the spot rate: (8.249X (1.065/1.075) = 8.177 (Madura, 2009). International Fisher Effect expects the pound over dollar to depreciate to 8.177. In the end, investors of both currencies will acquire a similar average return. Changes in the rate of exchange have extremely powerful effect on macro-economy of a country affecting considerable variables such as demand for imports and exports. It will also affect inflation and unemployment, and Gross Domestic Product growth. International Fisher Effect is unpredictable due to short-term factors that influence prediction of normal rates, inflation, and exchange rates. Long term International Fisher Effect is favourable. The exchange rates offset the rate of interest differentials. Fluctuation of exchange rates and interest rates disparities presents a paramount concern affecting the world economy and consumers. Fluctuation of exchange rates affects the global market adversely by creating inefficiencies and distorting world prices. This has an overall negative effect on the profitability of investment. Investors do not realize reasonable profits from their investments and may end up making losses. Distorted prices also affect Export opportunities adversely. The country cannot realize favourable balance of trade from the value of imports and exports it makes. However, fluctuation of interest rates in the market is dependent on time. Fluctuation occurs during different periods of the year. There is peak and off-peak period during the year when the interest rate is high and low. Investors should make appropriate timing of the various periods ensure that they do not make losses and that their investments will yield profits. Fluctuations also do not occur at the same period. For instance, when the interest rates and exchange rates are high in one country, for example, UK, they might be favourable in another country like US. The investors can maximize their chances of success by incorporating alternative investment methods of investing in the favourable locations (Madura, 2009). This knowledge of the prevailing market rate is tremendously valuable to firms when it comes to making various decisions concerning the market. Manufactures and companies have to ensure that they maximize their profits. To achieve this, they have to carry out a comprehensive market study of the countries they are selling their commodities. The governments also targets to make money from favourable balance of payment and foreign exchange. It encourages exports when foreign exchange rate is favourable to the country. References Madura, J. 2009. International Financial Management, Cengage Learning Read More