Functions of Foreign Exchange Market, Difference between Absolute and Relative Power Parity - Assignment Example

SSАY АND QUАNTITАTIVЕ РRОBLЕMS University name Student name Student id Course Date 1. In Australia, an indirect quote is used in the spot currency market. In this case, the Australian dollar is quoted as the base against the US dollar. This is because its currency historically has had a tie with the currency of Britain. In this case, the Australian dollar is traded against the US dollar. In the United States, the direct quote is the one that is typically used in the spot currency market. The United States has been using its currency as the base currency while taking other currencies like Japanese Yen to be counter currencies. While in Europe, an indirect quote is typically used in the spot currency market. Unlike it is in the case of United States, Europe does use its currency as counter currency while foreign currency as the base currency. In this case, the US dollar is the counter currency or the quoted currency and the Euro the base currency. As mentioned here above, Australia uses the indirect quote. Australia has indirect quote just because its foreign exchange market does express foreign currency that is needed for buying and selling its domestic currency. In the foreign exchange market of Australia, the foreign currency is used as the counter currency while its domestic currency being utilized as the base currency in the foreign exchange market (Dunning, 2009). For the case of the indirect quote, a decrease in the exchange rate is an indication that the Australian domestic currency is weaker as it becomes worth smaller amounts of the foreign currency used as the counter currency. 2. AU$100,000/ UA$1.32 =US$75,757.6 The cost can be obtained by (US$75,757.6*0.736) = US$55,757.6 3. Buying rate 1 US Dollar =0.76 British Pound $15,000= ($15,000*0.76) =11,400 British Pound Selling rate 0.68 British pounds =1 US dollar 11,400 British pounds divide by 0.68 British pounds =US$16,764.8 Bid rate 1.5686 Ask rate 1.5688 US$ needed to earn $1,500 The difference between the bid rate and the ask rate Ask rate 1.5688- Bid rate 1.5686 =0.0002 Therefore, the amount of dollars needed to earn $1,500 =$1,500 divide by 0.0002 =$7,500,000 4. The functions of the foreign exchange market. Transferring purchasing power Foreign exchange provides a platform that helps in converting one currency to another hence facilitating trade among nations. For example, the foreign exchange helps you to convert the Australian dollar to U.S dollar and vice versa. Also, foreign exchange market helps in transferring the purchasing power from one nation to another (Godiwalla, 2006). For instance, it helps in transferring the purchasing power from Australia to the United States of America. Purchasing power can be transferred various credit instruments that can include bank draft, foreign bills, and telegraphic transfers. Besides, foreign exchange market also provides a platform for buying and selling foreign currencies. It helps to avoid the risks involved in the trade by coming up with rates that can be used in selling and buying the foreign currencies while considering the economic conditions that prevail. This is because when the value of the currency changes as compared to the other, there is usually a loss or gain by the individuals or parties involved (Bartlett, et al. 2006). Therefore, foreign exchange gives the parties involved protection against the risks that may arise in the currency exchange trade where the foreign exchange helps parties to avoid the risks or reduces them. Credit function The foreign exchange market provides credit that is necessary for the process of carrying out a trade at both the international level and domestic level. For instance, foreign exchange market does provide a foreign bill of exchange that has played a crucial role in promoting the international trade (Laughton, 2005). Foreign exchange market promotes the trade through providing credits. Therefore, foreign exchange is of paramount importance to the survival of the parties involved in the trade where it is considered very important for the well-being of the foreign trade. Hedging foreign exchange risks Foreign exchange market has been working towards managing foreign exchange risks. The exchange risks can be associated with the free exchange market where there are fluctuations in the exchange rates leading to loss or gains in the value of foreign currencies. As a result, a company can face high exchange risks, especially when handling huge liabilities that need to be met using foreign currencies. Therefore, the foreign exchange market has then been helping in managing the exchange risks hence reducing the potential exchange rate risks (Whitelock, 2002). This has been possible as the foreign exchange market has been providing the necessary facilities for hedging the actual or anticipated liabilities using forward contracts during the exchange process. A forward contract entails buying or selling currencies at fixed future date for a price that is agreed. As a result, any possible changes in the exchange rates are ignored as the price is agreed in advance thus assisting in managing the foreign exchange risks. Market participants in foreign exchange market There are different participants in the foreign exchange with different functions. These participants include multinational commercial companies, insurance companies, central banks, mutual funds, investment firms and retail forex broker among others. The banks act to control the amount of funds that are supplied into the foreign exchange trade. It also controls the interest rates within the market and the inflation rate. Multinational commercial companies, on the other hand, their function is to carry out the activities that need the conversion of the currencies to buy and sell goods (Bartlett, et al. 2006). Financial investment firms they do the work of the managing the accounts which are considered to be large like endowments and pension accounts on behalf of the customers. Retail forex brokers are used by the other parties to do the foreign exchange trade business on their behalf. Transactions in foreign exchange markets Spot foreign exchange: this transaction entails buying foreign exchange especially from customers using spot exchange rates (Godiwalla, 2006). It applies to the domestic institutions and clients that are approved by foreign exchange administration. Forward foreign exchange: involves customers signing forward foreign exchange sale and purchase agreement specifying the rate, currency, and terms. It enables customers to make preservation concerning asset value; thus, assisting in avoiding the possible risks associated with foreign exchange. 5 Strategic motives for firms to become multinational Access major supply resources The companies that are going into the international markets can access resources that cannot be obtained locally. For instance, an organization can be in a position to access technologies in the international market that are not available in the local markets. These technologies can be crucial to the success of the company as they can be utilized to ensure that the objectives of the organization are achieved especially through achieving efficiency. Many organizations are striving to ensure that they achieve cost advantages in the markets through making use of technology that can enhance the efficiency of the operations hence assisting in reducing the costs of production (Whitelock, 2002). Other resources that can be accessed by the organizations that are moving into the international markets can include the availability of skilled manpower. Organizations that are venturing into the international markets to access skilled labor that can be crucial in transforming the operations of the organizations to achieve the set objectives. Also, companies can be motivated to go international to make sure that they get the major supplies of resources for the operations of the company to run smoothly. They target countries which provide them with cheap resources hence lowering the cost of their operations (Bartlett, et al. 2006). This helps the companies to increase the profit margin, as profit making is the motive of every firm and this has made companies multinational to acquire resources at a lower cost. Market expansion Firms are motivated to venture into the foreign markets aiming at earning additional profits through accessing new markets. Expanding into the international markets a company can be in a position to access new opportunities for making additional sales. The domestic markets operations can be experiencing low profitability hence venturing into the international markets can be considered as the option of ensuring the survival of the company. For instance, many Chinese electronic companies do experience low profits in their domestic markets hence making the Chinese companies enter the global markets to access new business opportunities. Organizations can find new ways of venturing the international markets where some can employ the use of acquisition to access new markets (Dunning, 2009). However, some organizations can expand their operations in the foreign market as a strategy of diversifying the market risks associated with the business. For instance, an organization can expand their markets in other regions to assists in managing the adverse effects that can face an organization the moment one market is faced with some crisis. Also, once the market for their products enlarges, the companies can enjoy economies of scale and gain a competitive advantage in the foreign countries. For example, Toyota Company is an example of an organization that has managed to expand its operations in various regions globally to increase its market share in the automobile industry (Laughton, 2005). It has enlarged and widened the market for its products by opening its branches in various countries all over the world. In the African continent, Toyota Corporation has many branches various countries. The expansion strategy of Toyota Company to the foreign markets has helped it to explore the economies of scale over some of the other companies in Japan. Avoid strict internal regulations Some internal regulations such as taxation can be affecting the firms operating in their domestic market negatively. For instance, the taxation rate can be high making the companies incur increased costs of production that can lead to a reduction in the profits. The increased taxation can be geared towards discouraging trade in a certain commodity where the government can be aiming at controlling the trade in that commodity where the trade in the commodity might be perceived differently by various countries (Bartlett, et al. 2006). As a result, such organizations can then decide to venture into the international markets to avoid such strict regulations. Some regulations in the domestic market can lead to low demand where the regulations can be discouraging consumption of certain products. As a result, companies can endorse some strategies to become multinational to avoid strict regulations found in the domestic market that cause a downfall in the domestic demand. Once they become multinational, they are in a capacity to increase the demand overseas and overcome the risk of making losses. For instance, the tobacco companies like British American Tobacco Company are facing strict regulations in the domestic markets as tobacco is being discouraged due to the health implications (Whitelock, 2002). Besides, some government regulations can result in saturation of the market due to relaxed conditions to enter the market leading to increased completion. As a result, companies can then venture the foreign markets to avoid the regulations leading to increased market players. 6) The theory of purchasing power parity. This is a theory concerning the currency exchange rates and their purchasing power. It states that the equilibrium of the exchange rates of the currencies is only achieved when the purchasing power of the currencies in each country is the same. This means that at the two countries, there is a state of one price. If prices in one country are increasing, its exchange rate must go down to achieve purchasing power parity. Purchasing power parity does not affect the exchange rates in a short period (Dunning, 2009). It is calculated by comparing the price of a standard good which is common in the two countries. The difference between absolute purchasing power and relative power parity. Absolute purchasing power parity entails a situation where the exchange rate is taken into account, the price goods in one country should cost the same in the other country (Bartlett, et al. 2006). For instance, bread in country A should cost the same as the bread in country B when the exchange rate is taken into account. Relative power parity tries to explain the differences that are there in the inflation rate in two different countries. For instance, given the example above, if the inflation rate in country A is higher than in country B, the price of bread in country A will go up, making the equilibrium change. References Bartlett, C.A. et al. (2006). Transactional Management. United States: McGraw- Hill. Dunning, J.H. (2009). Multinational Enterprises and the Growth of Services. The Service Industries Journal. Godiwalla, Y.H. (2006). Multinational Planning- Developing A Global Approach. Long Range Planning. Laughton. (2005). How firms internationalize their operations in B. Dawes, International Business: A European Perspective. Whitelock. J. (2002). Theories on internationalization and their impact on market entry. International marketing review. Read More