Foreign Exchange Market and Forward Exchange Rate - Essay Example

Foreign Exchange Market and Forward Exchange Rate Foreign exchange markets entail buying, borrowing, selling, and exchanging of currencies. The participants in this market comprise of banks, investment management firms, and the commercial companies. Other partners in this world of exchange include hedge funds, investors, and retail forex brokers. Sometimes anticipatory buying of the foreign currency drives the market. Anticipation can destabilise Foreign Exchange Markets. This is because the participants tend exchange their national currency more or less depending on the expected exchange rates. Most of the transactions in this market occur over the counter. This implies that the participants in this market do not have a meeting place as it happens in stock exchange. The traders have offices in big commercial banks located all over the globe. Telephones, telexes, and other electronic means facilitate communication among the traders (Madura, 2008: 448). Forward exchange involves transacting using the expected future exchange rate with no immediate payments. The forward exchange rate refers to the rate in foreign exchange that is contracted at present time for exchange of currencies in future. The forward exchange is a precautionary measure to shield the traders from potential risks that may arise in the foreign exchange markets. Most speculators use the forward exchange because they anticipate changes in currency trading. Forward rates forecast the future of foreign exchange market. The rate gives rough information on the expectations of the current exchange rates in future. Currency can strengthen or depreciate. This is subject to market forces. Selling at premium characterises the anticipation of appreciation of currencies. Conversely, selling at discount is an indication of expected weakening of currencies. Spot exchange rate on the other hand refers to the current exchange rate in the foreign exchange market. Both forward exchange rate and spot exchange rate influences the prices of local and foreign goods (Gandolfo, 2002: 48). Foreign markets handle large transactions instantaneously at a cheap transaction cost. Rational speculative bubbles cause the exchange rates to differ from its fundamental valuation. Foreign Exchange Markets readjust to cushion the market from the departure of technical efficiency. These departures may be from panicking traders, noise traders, herding instinct, and bandwagon effects. Other factors that may lead to misalignments in the Exchange markets include traders that are caught in liquidity squeeze in other financial markets (Madura, 2008: 447). They bring volatility to the Exchange Markets. Some forecasters strongly believe that foreign exchange markets are efficient. Similarly, they argue that forward exchange rates are unbiased predictors of future spot rates .To establish validity of efficiency in foreign exchange markets, this paper will explore the international finance theories. It will support the claims through use of appropriate examples. Efficiency in Foreign Exchange Markets Efficiency in foreign exchange market encompasses a reflection of the relevant information regarding exchange rates. Efficiency considers both the forward and spot exchange rates. Testing efficiency requires analysis of two aspects of exchange rates. These are the spot rate and the forward rate. The forward rate should have all available information about future expectations of foreign exchange rate. Analysts argue that the market is efficient when the prices reflect all relevant information. This means that the traders cannot make any alteration in order to get unjustifiable profits. The market efficiency is very beneficial to investors, exchange rate forecasters, and policy makers (Brigham & Huston, 2012: 591). The theory of efficient market demands foreign exchange markets should embrace full information of the prices. This means that traders cannot make profits through malicious old information. In addition, they cannot use the past trends of the market to exploitatively make gains. This theory provides an efficient method to access the movements or patterns of exchange rates in an organized manner. The market efficiency regime exchange rate should appear more unpredictable when plotted over duration of a given time. Efficient market theory quenches the views that hold unpredictability is irrational. It points out that the exchange rates, news that was not initially anticipated. This causes the exchange rate to move to any direction. The efficient market theory comprises of purchasing power parity and interest rate parity aspects (Kelvin, 2010: 36). Purchasing Power parity Swedish economist, Cassel developed this theory. Cassel asserted that the rate of foreign exchange would decline with the same proportion when the price level rose. This meant that doubling prices in United States while foreign prices remained constant the dollar would be half the price it was previously. This theory emphasises on the law of single price. This law dictates that goods should cost the same in different locations (Moyer, McGuigan, & Kretlow, 2008: 738). This ensures that there are no opportunities to get unfair profits through exploitation. For instance, suppose that the price of coffee beans sells less in Chicago compared to that of Washington D.C. A trader can buy more coffee beans in Chicago at a cheap price to sell in Washington making profit. This is exploitation through taking the advantage of differences in prices between the two towns. Arbitrage is the word that refers to the exploitative moves of greed people. The theory supposes that a currency should have the same purchasing power in all nations. This implies that United States dollar should purchase the same amount of goods in Australia and United States. Likewise, Australian dollar should acquire the same quantity of goods in United States, as it should in Australia. The purchasing power parity does not consider tariffs, taxes, transportation, and transportation costs. When there is a difference in price of a product between two countries, arbitrage sets in since the product is obtained from the country that has the lowest price (Sharan, 2011: 480). Purchasing-power parity can be expressed in the following relative version. In the above equation ‘e’ represents the rate of change in exchange rate.?1 and ?2 represents the rate of inflation for country 1 and country 2, respectively. Inflation rate negatively affects the purchasing power parity. A country with highest inflation rate means that the foreign exchange rate of currency of that country is poor compared to nations with low inflation rate. Interest Rate Parity Small and continuous changes in price affect the exchange rate movements. New and random information flow in from time to time. This is a linkage between foreign exchange markets and international money markets. Interest rate parity explains the interventions that foreign exchange markets take to restore efficiency in the currency exchange. Forward rates may differ from the spot rate by a given amount (Sharan, 2011: 481). This happens in order to offset interest rate differential between two currencies. For example, an investor from United State who invests in foreign market can receive a more interest from his/her foreign investments. However, there is an offsetting effect because the investor will pay more for a unit foreign currency (at the spot exchange rate) than is received per unit when currency is at forward rate. The traders in foreign exchange markets use interest rate quotations to compare with the forward rates in every single trading day. If the two do not represent the expected figure, then there is a possibility of distortion that may have happened during the trading day. Forward premiums should adjust to existing interest rates (Sharan, 2011: 483). For instance, if in February United States interest rate was at 4% more than euro interest rate then the euro forward premium must have been at 4%. This indicates that the forward rate of euro must exhibit a premium whenever interest rate of United State is higher than the euro interest rates. Figure 1 below compares the interest rates of United States and United Kingdom. The figure indicates that the interest rate differential is a function of individual currency rates. This data was taken from 1996 to 2006. Figure 1 represents UK and U.S interest rates. Source: FXtrek IntelliChart. Available from http://t3.gstatic.com/images?q=tbn:ANd9GcSBd9YXRKqWIaDJn4Ew5gFihHNIZlsm3yK0JDprxjuIHuXVMMZ1BMiL1sA . Available from http://www.williampolley.com/blog/2007/images/pound_rate.jpg. This is a graph showing exchange rate between United State and United Kingdom between the year 2004 and 2007. Forward Exchange Rates Unbiased Predictors of Future Spot Rates An unbiased predictor is one that is likely to overestimate or underestimate a value and the errors in the opposite direction offset each other in the long run. It differs from an accurate predictor that produces an exact forecast each time with negligible error. Forward Exchange rates is the simplest method to forecast the future spot rates. It is also a tool many participants in the foreign exchange markets use to give their expectations on the exchange rates of currencies in a future date. When the prediction is correct it indicates the efficiency in foreign exchange markets. In this case, the forward rates are underestimated or overestimated with certain value that is close to the future spot rates. Forward exchange rate then becomes an unbiased estimator of future spot rates. The expectation theory asserts that regarding the risk and the cost of transactions, the forward exchange rate will singly depend on the anticipations of the participants on future spot rates (Brigham & Huston, 2012: 592). For instance, a 4-month forward exchange rate of Rs. 43.74/ USD is quoted because the traders expect the spot rates of Rs 43.74/ USD in four month’s time. The Expectations Theory then points out that the forward exchange rates should be the same as the forex markets expected future spot rate. The expected future exchange rate can be subject to a little change at the time of delivery. This unexpected change adds value to the forward contract. For instance, an Indian trader can enter into a forward contract of four months. The spot rate at the time of the forward deal is Rs. 43.51/ USD and the four-month forward exchange rate is Rs 43.96/ USD. The forward rate of Rs. 43.96/ USD implies that after four months the spot rate will be at the amount indicated. If the realized spot rate after the four-month period is 44.16 the trader will gain 20 paise per dollar bought. This is because the trader purchases the dollar at 43.96 courtesy of forward contract. Although the uncertainty of future exchange rate can be a risk in foreign currency, it is hedged through entering into forward contracts. In the case of the example considered above, the trader can hedge the risk and do away with any possible loss in exchange markets. The trader can enter into forward contract to purchase U.S dollars at a forward exchange rate that is very close to the current rate of Rs. 43.41 for delivery in four-month time. The other party would then be compelled to sell US dollar to the trader at the exchange rate agreed. This is despite the exchange rate prevailing in the exchange market at the time of transaction. Thus, forward exchange used to circumvent the risks that might occur in the foreign exchange markets. The possible source of peril in the market is exchange rate fluctuations (Brigham & Huston, 2012: 591). For instance, importers and exporters may be exposed to foreign exchange risk due to changes in exchange rates of currencies. International trade does not all an immediate settling of transactions. It has to take time to prepare invoices that are in foreign currencies. This implies that the payable amount may increase or decrease depending on the rates in exchange market. However, when the traders enter into forward exchange the exposure of the risk is outwitted. For example, suppose that an Indian company has imported goods that amount to 200,000 USD from United States and payments due in four months. The uncertainty about the amount of rupees that will purchase the hundred U.S dollars is evident at due date. This is because there may be fluctuations in exchange rates. The company can hedge the risk through purchasing 200,000 USD forward for delivery on the due date of payment of the bill. The table below illustrates the forward exchange transaction. Export contract data Exporter Indian company Importer America company Currency of invoice US dollar Invoice value $200,000 Invoice date 1 January 2011 Credit period 4 months Due date of receipt 1 May 2011 Some exchange rate quotes in January 1, 2011 (Rs/ USD) Type of market Interest rate Offer rate Spot 43.31 43.75 Forward January 43.57 43.93 February 43.72 44.29 March 43.75 44.23 April 43.89 44.37 May 43.96 44.60 Forward Deal Transactions 1 January Indian exporting company sell $ 200,000 4-month forward at Rs. 43.96/ USD. 1 February Indian exporting company receives 200,000 from American company. 1 May Indian company delivers 200,000 USD to foreign exchange dealer and receives Rs. 8,774,000 at the rate of Rs. 43.96/ USD. Tables above indicate that the forward exchange rate is very close to the predicated spot rate. The slight disparities may be attributed to the factors captured in the spot rate. These factors were unavailable during an agreement of forward exchange rates. This indicates that the forward exchange rate incorporated all the information during its prediction. The evident small difference in monthly predictions in the tables above asserts that there is precision and consistence in the use of forward exchange rates. Available from http://t3.gstatic.com/images?q=tbn:ANd9GcTvXeeEtO2gFfnYhI1Mh58IQnhymTEF3XqgDf9fJaRwLZ5hmLP2B5BGSNw. The graph shows the expected spot rate and the forward exchange rate. The green curve represents the future spot rate and the blue curve indicates the forward exchange rate. Conclusion The discussion above shows that the exchange markets are efficient. They do provide the almost all the information available in the exchange market. This implies that the participants do not distort information for selfish gains. The alternative to use the past data of the foreign exchange market is not feasible. This is because the information that the market possess is the same in the public arenas. Investors and policy makers have a wide access to the exchange market day to day data. The interventions of participants to establish one price in all the parts of the globe is an indication of rationality in the foreign markets. This ensures that traders in this market do not take advantage of unchecked imbalances in value of currencies to exploitatively get profits. In the discussion, forward exchange rate is an unbiased predictor of the future spot rates. The results indicated in the graphs and tables indicate that the participants in this market use the forward exchange rate to predict the future exchange rate with precision. The available information in the foreign exchange market enables them to determine the forward exchange rate. This is a clear manifestation of efficient in foreign market and unbiased prediction of future spot rates. Future research should endeavour to focus on the effects of unexpected news in the foreign exchange markets. This will eliminate the large discrepancies between the forward exchange rate and future spot rate. References Brigham, E. and Huston, J. 2012. Fundamentals of financial management. New York: Cengage Learning. Gandolfo, G. 2002. International Finance and Open-Economy Macroeconomics. New York: Springer. Kelvin, S. 2009. Fundamentals Of International Financial Management. New Delhi: PHI Learning Pvt. Ltd. Kelvin, S. 2010. Commodity and Financial Derivatives. New Delhi: PHI Learning Pvt. Ltd. Madura, J. 2008. Financial markets and institutions. New York: Cengage Learning. Moyer, R. McGuigan, J., & Kretlow, W., 2008. Contemporary Financial Management. New York: Cengage Learning. Sercu, P. 2009. International Finance: Theory Into Practice. New Jersey: Princeton University Press. Sharan, V. 2011. Fundamentals of Financial Management. New Delhi: Pearson Education. Read More