The Driving Force of Foreign Exchange Market - Essay Example

International finance Task Introduction The term foreign exchange is described as the process of changing currency of one nation into that of another. The currency conversion process is undertaken in the foreign exchange market and is dependent on the prevailing exchange rates. An exchange rate is the cost charged for changing the value of a country’s currency into that of another. Therefore, the driving force behind the establishment of foreign exchange market is the creation of a system that facilitates the conversion of a country’s currency into another (Sowa & Acquaye 1999, pp. 2-10). The exchange rate is a variable of the International Fisher Effect, which states that the value of a currency of a nation whose interest rate is relatively higher is likely to depreciate against the value of currency of another country whose interest rate is relatively lower (Madura 2011, pp. 114-120). On that note, the paper presents the importance of the international finance; the factors influencing the exchange rate and discussion of the findings of the IFE test. The test will be conducted using the UK interest rate and the exchange rate between the UK and Greece’s currency from the year 2005 to 2014. The method adopted during the IFE test is a regression analysis (the coefficient of correlation) (Sowa & Acquaye 1999, pp. 2-10). The International Finance The concept of the international finance can be strongly grasped after its elements are uncovered. The elements are the interest rate, the exchange rate, the inflation rate, export, and imports, etc. The following two theories are influenced by the mentioned factors: the International Fisher Effect (IFE) and the Purchasing Power Parity (PPP). The international finance refers to cross-border borrowing/lending of funds and any other transaction between the local and the foreign countries the leads to movement of funds, assets, and capital between the trading countries. The idea of Purchasing Power Parity contends that the prices of resembling products should be equal in different countries, when the currencies of the trading countries are converted into a single currency. There are two types of the purchasing power parity. That is, the absolute and relative purchasing power parity (Mankiw 2009, pp. 707-709). The theory of Absolute Purchasing Power Parity asserts that the real prices of commodities must be identical in all countries. Thus, the absolute Purchasing power parity is realizable when the purchasing strength of the local and foreign currency is alike, after the conversion of the currencies to foreign denomination, using the spot exchange rate. Conversely, the theory of relative purchasing power parity asserts that differences in the exchange rates between a local and a domestic country should be equal to the variability in the countries’ relative prices (Mankiw 2009, pp. 707-714). Reasonably, the International Fisher Effect theory demonstrates a somewhat similar behavior as the Purchasing Power Parity theory. The IFE theory asserts that the value currency of nations whose nominal interest rates are relatively higher tends to depreciate against the value of currency of nations whose nominal interest rates are comparatively lower (Siddaiah 2009), pp. 109-113). Factors affecting the exchange rate The following are some of the factors affecting the exchange rate: They are level of export and import, the interest rates, the inflation rates, etc. Only three factors are discussed in this context (inflation and interest rate and the level of exports and imports). Inflation rate - it is a situation characterized by a period of high commodity prices in a country. When the local products become more expensive as compared to the foreign goods, the local consumers turn to the relatively cheaper foreign goods. The situation leads to a high demand for foreign goods, which leads to the rise in the importation of such product. The local country would pump more of its currency in the foreign exchange market in order to pay for the imports. A further increase in the supply of a local currency beyond the level of demand leads to the weakening of the local currency value (Chen & Wu 1997, pp. 1-15). Interest rates - the dissimilarity in the rate of interest between countries is one of the leading causes of the exchange rates. An increase in the money supply in an economy (by lowering the cost of borrowing funds) increases the demand for the local goods above the supply level, assuming that the level of production neither increases nor decreases. The increase in demand increases the prices of the domestic commodities, thus, inflation. The effect would reduce the value of the local currency. The purchasing power of a foreign currency would, therefore, be greater than that of the local currency. Therefore, the value of the currency of the local country declines against the value of the foreign currency (Chen & Wu 1997, pp. 1-15). The level of exports and imports – If a local country exports more products than the imports, it receives more foreign exchange. In the process, the foreign countries that consume the local products will require the exporting country’s currency in order to make payments for the deliveries. The need to pay for deliveries will increase the demand for the local country’s currency. The high demand increases the price of the local country’s currency against that of the foreign country. Therefore, the exchange rate, from the local country’s perspective will be low. Conversely, if the local country imports more goods than it exports, the domestic country will need the exporter’s currency in order to make payments for the deliveries. The local country will, therefore, increase the supply of its currency in the foreign exchange market. A further increase in supply than demand will lower the price of the local currency, thus increase the exchange rate (Fisher 1996, pp. 1-12). Significance of the international finance Based on the knowledge of the PPP and the IFE and the factors affecting the exchange rates, the following are the advantages of the international finance: first, Multinational companies use this concept to aid the structuring of the investment plans. For instance, based on the IFE theory, Considering the theory that the currency of a country with a relatively higher interest rate is likely to depreciate, the Multinational Corporations use this information to conduct a research to determine countries whose interest rate are high. They, therefore, avoid borrowing funds from such countries to avoid the high cost of funds (high interest). However, countries with high-interest rates are suitable locations for investments since high-interest rates mean high return on investments (Severov 2006, pp. 40-50). Second, the international finance enlightens of the adverse effects of the exchange rate fluctuations. Companies, therefore, use the information to formulate risk mitigation strategies that help minimize the negative impact of the unfavorable change in the exchange rate. The following are the categories of risks: economic exposure, transaction exposure, and translation exposure. First, the economic exposure refers to the adverse effects of exchange rate fluctuation on a company’s cash flow and earnings. This exposure majorly affects the value of a firm as measured by the present value of the cash flows. The type of risk can be hedged using the following methods: forward contracts and money market hedge. Second, transaction exposure refers to the variability of firm’s future cash flows from international trade-based transactions, borrowing, and lending in foreign currencies. The economic exposure can be managed using currency option and swaps. Currency option is a strategy that involves a right, but not an compulsion to buy or sell a definite amount of currency at a pre-determined exchange rate for the future (Bradley & Moles 2002, pp. 1-16). Third, the translation exposures are losses and gains arising when the financial statements of the foreign subsidiary (expressed in foreign currency) are converted into the home currency. This type of risk can be managed using the currency of invoice and leading and lagging methods. Choice of currency invoice involves the local company invoicing the receipts in the local currency rather than foreign or vice versa, depending on the strength of the currencies between the involved countries. Leading and lagging strategy involves a firm leading (early payments/early receipts) in currency that is likely to appreciate/depreciate in value in the future or lagging (late payments/ receipts) in currency that is likely to depreciate / appreciate in the future (Bradley & Moles 2002, pp. 1-16). The IFE test As mentioned above, the IFE theory revolves around the exchange rate and the interest rates. The theory asserts that as the interest rate of a country increases, the value of the currency declines against that of the foreign country. The local state in this context is the United Kingdom, whereas, the foreign country is Greece. The legal render used in the UK is the Great Britain Pound (GBP) while the common currency in Greece is Euro. The data set for the test is the interest rate for the UK from the year 2005 o 2014 and the exchange rate GBP/Euro for the same period as displayed below. UK Time Interest GBP/Euro 2014 0.5 1.205073 2013 0.5 1.231461 2012 0.5 1.197893 2011 0.5 1.165864 2010 0.5 1.127994 2009 2 1.03739 2008 5.7 1.361267 2007 5.2 1.484504 2006 4.5 1.452861 2005 4.9 1.418087 Source: (GBP – British Pound 2015; United Kingdom Interest rate 2015) A regression analysis (Coefficient of correlation) is used to help establish the nature of the relationship between exchange rate and interest rate between the U.K. and Greece. The coefficient of correlation (r) measures the degree of relation between the dependent and independent variable. (r) Varies between positive one and the negative one. When the values of r approach positive one, it shows that as the independent variable increase or decrease, the dependent variable also increases or decrease to a higher degree. A negative (r) shows an inverse relationship between the dependent and the independent variable. Concerning IFE, an inverse relationship between the dependent and the independent variables show that IFE holds. That is, a negative (r) shows that IFE holds while a positive (r) shows that IFE does not hold. The correlation coefficient r =. During the test, Y, the dependent variable is denoted by the exchange rate. X, the independent variable is indicated by the interest rate of the UK. X Y X^2 Y^2 XY 0.5 1.205073 0.25 1.4522 0.602537 0.5 1.231461 0.25 1.5165 0.615731 0.5 1.197893 0.25 1.43495 0.598947 0.5 1.165864 0.25 1.35924 0.582932 0.5 1.127994 0.25 1.27237 0.563997 2 1.03739 4 1.07618 2.07478 5.7 1.361267 32.49 1.85305 7.759222 5.2 1.484504 27.04 2.20375 7.719421 4.5 1.452861 20.25 2.11081 6.537875 4.9 1.418087 24.01 2.01097 6.948626 SUM 24.8 12.68239 109.04 16.29 34.00407 Therefore, r = 10*34.00407 - 24.8*12.68239 {10*109.04 -(24.8)^2}^1/2 * {10*16.29 - (12.68239)^2}^1/2 (25.527428/31.26597229) r = 0.8161 Test result and conclusion Based on the above analysis, r = 0.8161, which is a positive figure. The result means that the relationship between the exchange rate and the interest rate is direct. Unfortunately, the result shows that the IFE theory did not hold between the UK and Greece for the period of study (2005 – 2014). Recapture that the IFE theory states that the exchange rate should be inversely related to the interest rate. List of References Bradley, K. & Moles, P. 2002, "Managing Strategic exchange rate exposures: Evidence from UK firms", Managerial Finance, vol. 28, no. 11, pp. 28-42. Chen, S. & Wu, J. 1997, "Sources of real exchange rate fluctuations: Empirical evidence from four Pacific basin countries", Southern Economic Journal, vol. 63, no. 3, pp. 776-787. Fisher, L.A. 1996, "Sources of exchange rate and price level fluctuations in two commodity exporting countries: Australia and New Zealand", Economic Record, vol. 72, no. 219, pp. 345-358. GBP – British Pound 2015, viewed 23 March. 2015. http://www.xe.com/currency/gbp-british-pound Mankiw, N. G. 2009, Principles of Economics, South-Western Cengage Learning, Mason, OH. Severov, G. P 2006, International finance and monetary policy, Nova Science Publishers, New York. Siddaiah, T. (2009). International financial management. Upper Saddle River, NJ, Pearson. Sowa, N.K. & Acquaye, I.K. 1999, "Financial and foreign exchange markets liberalization in Ghana", Journal of International Development, vol. 11, no. 3, pp. 385. United Kingdom Interest rate 2015, viewed 23 March. 2015. http://www.tradingeconomics.com/united-kingdom/interest-rate Read More