A Direct Quote and Purchasing Power Parities - Assignment Example

Running Header: Finance Finance Course Name Professor’s Name Institutional Affiliation City and State Where Institution is Located Date Finance 1. A direct quote is also known as a price quotation due to the fact that it expresses the price of a unit of a foreign currency in terms of the domestic currency. On the other hand, an indirect quote is also called quantity quotation since it expresses the quantity of foreign currency required to buy units of the domestic currency (Sap.com, 2017). Based on this therefore; i) Direct currency quote is used in the United States ii) Indirect currency quote is used in Europe iii) Indirect currency quote is used in Australia. Reason: There is no particular reason why Australia uses an indirect currency quote. The decision as to whether a country uses direct or indirect quote is mostly conventional and there are no strict rules as to whether a currency will be quoted directly or indirectly (admiralmarkets.com, 2017). It can only be stated that Australia prefers to use indirect quote as opposed to direct quote. 2. If the quote in Australia is USD 0.801, then it means that one AUD is equivalent to 0.801 USD. Thus, to determine how much AUD 250,000 would cost in USD, you would have to multiply the number of AUD with 0.801 (Stackexchange.com, 2017). This is shown below; Number of USD = Number of AUD * 0.801 USD = AUD 250,000 * 0.801 = $200,250 Thus, the AUD 250,000 will be worth $200,250. 3. If the GBP quote is USD1.2772-87, it means that the bid price or the price we have bought a GBP is $1.2772 while on the other hand, the ask price or the price at which we will sell it is $1.2787. a) If you converted $20,000 to GBP, you would have to divide the USDs by 1.2772 in order to arrive at the number of GBP you will have bought. Ie; No. of GBP = USD/1.2772 GBP = $20,000/1.2772 = GBP 15,659. 25 Then we convert the GBP 15,659.25 back into USD. In so doing, we use the rate of one GBP is equal to $1.2787 meaning we multiply the GBP 15,659.25 by 1.2787 as follows; No of USD = No. of GBP * 1. 2787 = 15,659.25 * 1.2787 = $20,023.49 Thus, its value in USD will be $20,023.49. b) If you are able to buy pounds at the bid rate and sell them at the ask rate, the number of USD one would need to earn $1,750 on a round trip transaction (buying GPB for USD then selling GBP for USD) would be given by (Investopedia.com, 2017); NB// $1,750 is the profit made from the transaction. Profit is given by selling price minus buying price. In other words; Let’s assume the number of pounds bought are y, then the profit will be given by; $1,750 = 1.2787y- 1.2772y $1,750 = 0.0015y To get the value of y, you divide both sides by 0.0015. Thus, 0.0015y/0.0015y = $1,750/0.0015 y= 1,166,666.67 Thus, you would need to have bought $1,166,666.67 in order to earn $1,750 on a round trip transaction. 4. The functions and contribution to society of the foreign exchange market, market participants and transactions are discussed below; Functions of foreign exchange market i) Transfer of purchasing power- the foreign exchange market plays a primary function of the transfer of purchasing power from a country to the other and from a currency to the other. This is a vital function in facilitating capital movement as well as international trade. ii) Providing credit- the foreign exchange market plays the vital role in facilitating foreign trade since the conduct of foreign trade is largely dependent on availability of credit facilities (herald.co.zw, 2017). The market avails pre and post shipment credit to exporters while also availing credit facilities for importers. Markets such as the Euro dollar market are considered major international credit markets. iii) Minimization of foreign exchange risk – foreign exchange market also provides hedging facilities. This facilitates covering of foreign trade risks by providing vital mechanisms for participants in foreign trade to guard themselves against losses that arise from fluctuations in exchange rates. To perform the above functions, the foreign exchange market has a number of participants. Among the functions they perform is provision of capital in the market while facilitating the conduction of the various transactions in the market that act to facilitate international trade while providing income earning opportunities to the participants. They include; i) Foreign exchange dealers-they serve to provide capital or currency in the market and profit from buying foreign exchange at a bid price and selling it at a higher price. their worldwide competition amongst themselves narrow the spread between bid and ask prices thus contributing to making the foreign exchange market more efficient. In large international banks, the dealers function as market makers. ii) Importers and exporters, international portfolio investors, multinational firms, tourists and other users make use of the foreign exchange market in a bid to facilitate execution of commercial or investment transactions. They also enter the market in a bid to hedge foreign exchange risk and thus it can be concluded that they also act to provide capital to the market. iii) Speculators and arbitragers – they profit from profiting in the market and profit from foreign exchange rate changes (Zacks.com, 2017). In essence, they also provide currency or capital to the market. iv) Central banks and treasuries – they enter the market to acquire or spend their countries foreign exchange reserves in a bid to influence the price at which their own currency is traded. They in many instances are also willing loss takers in the market hence stabilizing the market. v) Foreign exchange brokers- they facilitate trading between dealers without becoming principals in the transactions. They profit from the commissions they charge. They also act to provide capital in the market. There are a number of transactions that take place in the foreign exchange market. They include spot transactions, outright forward transactions and Swap transactions. The function of these transactions is to facilitate foreign trade through facilitating foreign exchange. In other words, the transactions are the avenues through which foreign exchange takes place thus facilitating the execution of international trade and capital movement. Contribution of the foreign exchange market, participants and the transactions to the society As stated above, the greatest role played by the foreign exchange market is that of facilitating international trade as well as capital movement. In this regard, it allows those who don’t have to by what they don’t have from foreign markets while facilitating those who have surplus to sell it. Through international trade and movement of capital, the foreign exchange market contributes to international development. It also contributes in alleviation of poverty through direct creation of employment opportunities through trade and profiting from changes in foreign exchange rates. In addition, the market also facilitates movement of foreign financial aid for the development thus facilitating development in the society while helping alleviate poverty. 5. There are many reasons why firms decide to become multinationals. These strategic reasons are explained below; i) Potential for growth – This is an important reason why firms become multinationals. Though firms always start locally and grow from the foundations they have established at home, sometimes when they have grown and increased sales in a number of years, sales may suddenly fall flat. In other words, sometimes you have reached the glass ceiling where you no longer have potential for making new customers. In such a case, companies may decide to go multinational and start conquering the world. A similar move may be undertaken to increase potential for growth by spreading risks when the economy is slow or when the demand at home is dropping. In such a case, firms decide to venture into other countries where demand may be thriving. For example, owing to markets being saturated at home, many telecommunication companies such as MTN have found it increasingly important to establish operations in Africa. ii) Becoming a multinational is a move to discourage local competitors. For example, US companies such as Euclid Analytics, Square and Airbnb have their European counterparts in Zittle, Wimdu and Walkbase. One of the reasons for the European start-ups is since the US companies had not yet ventured into the European market thus paving the way for others to take the lead (Oded, 2009). By getting into the foreign market, these companies were discouraging their competitors from getting into the same space they are. These new markets come with more benefits such as more customers, potential for growth as well as a large market on offer and by taking advantage of these at an early stage before the others can move into the market, you will have formed a base before they make a move which might discourage them from moving there. iii) Another strategic reason is the need to reduce cost since by becoming a multinational, a company is able to set up production units near the customers thus avoiding transportation costs while taking advantage of low local cost of production while avoiding the use of middlemen which ensures maximum profitability. For instance, many US technology companies such as IBM have plants in China to take advantage of the low local cost of labor and hence reduced cost of production as well as the large market available in China. Reasons why a firm may not go global One of the major reasons why a firm may not become a multinational is because of lack of capital (Robert, 2016). A firm may be struggling to compete in the domestic market and hence concentrates its financial muscles in ensuring that it becomes a better competitor domestically leaving it with little resources to go international. Alternatively, the firm may even be performing well domestically but still lack the capital required to go international bearing in mind that a lot of capital is required to establish international operations. It is for this reason that the firm may opt to remain domestic. For instance, a local food outlet although doing very well financially may not have the financial muscles as well as other resources that may be needed to establish international operations. Such a firm would rather first expand domestically in a bid to gain the financial muscles required for multinational operations. 6. The theory of purchasing power parity The theory of purchasing power parity assumes that a basket of goods in country A ought to cost the same in another country. In other words, if the currencies used in the two countries are in equilibrium or at par as far as the exchange rate is concerned, then the basket of goods should cost the same in the two countries. If the bundle of goods is priced differently in the two countries, it will still adjust itself to the equilibrium. Difference between absolute purchasing power parity and relative purchasing power parity Absolute purchasing power parity assumes that exchange rates will be in equilibrium where the value of a country’s basket of goods and services is the same between two countries. If the prices are not equal, then the absolute purchasing power parity implies that market forces will cause the exchange rate to adjust to an equilibrium where the prices will be equal (Oecd.org, 2016). On the other hand, relative purchasing power parity considers the effect of inflation on purchasing power. In other words, it relates to how changes in two countries expected inflation rates affect the exchange rates. The effect of inflation is to reduce a nation’s currency purchasing power. For instance, where country A has x rate of inflation, then the country’s currency will purchase x% less real goods. Thus, relative purchasing power parity shows the relative price changes between two countries with the exchange rates changing to compensate for the different levels of inflation between the two countries. Purchasing power parity is useful in practice. An example of how it is applied is the Big Mac Index which tracks the price of McDonald’s Corp’s Big Mac burger. The index measures PPP between different countries using the price of big mac as the benchmark. The index suggests that the changes in exchange rates between currencies affect the price paid (marketbusinessnews.com, 2017). Thus, it is useful in adjusting for the price differences between countries. For instance, if country A produces $10 billion worth of goods with country B producing $8 billion, the two countries can only be compared when the cost of living or PPP is taken in to account. PPP solves the issue of comparing countries with different living standards as it recalculates the value of goods with regard to the living standard. It should however be noted that the theory has some weaknesses which limit its application. For instance, though a big mac bugger may cost differently in two countries, the differences may be as a result of ingredients and availability meaning that PPP may not be correct after all. References: Stackexchange.com, 2017, Exchange rates- When to multiply or divide, Retrieved on 1st September 2017, from; https://money.stackexchange.com/questions/50662/exchange-rates-when-to-multiply-or- divide Investopedia.com, 2017, Round trip transaction costs, Retrieved on 1st September 2017, from; http://www.investopedia.com/terms/r/rttc.asp Sap.com, 2017, Direct and indirect quotation for exchange rates, Retrieved from 1st September 2017, from; https://help.sap.com/erp2005_ehp_07/helpdata/en/ae/c38d5377a0ec23e10000000a174cb4 /frameset.htm admiralmarkets.com, 2017, Forex direct quote vs forex indirect quote, Retrieved on 1st September 2017, from; https://admiralmarkets.com/education/articles/forex-basics/forex-direct-quote-vs-forex- indirect-quote Zacks.com, 2017, The role of the stock exchange in the economy, retrieved on 1st September 2017, from; http://finance.zacks.com/role-stock-exchange-economy-5026.html herald.co.zw, 2017, Role of banks in the economy, Retrieved on 1st September 2017, from; http://www.herald.co.zw/role-of-banks-in-the-economy/ Oded, S2009, Becoming multinational: Challenges for Chinese firms, Journal of Chinese Economic and Foreign Trade Studies, vol. 2, no. 3, pp. 149-162. Robert, A2016, Internationalization strategies for global companies: A case study of Aral foods, Denmark, Retrieved on 1st September 2017, from; https://www.omicsonline.org/open-access/internationalization-strategies-for-global- companies-a-case-study-of-arlafoods-denmark-2168-9601-1000191.php?aid=80434 Oecd.org, 2016, Purchasing power parities, Retrieved on 1st September 2017, from; http://www.oecd.org/std/prices-ppp/purchasingpowerparities- frequentlyaskedquestionsfaqs.htm marketbusinessnews.com, 2017, What is purchasing power parity (PPP)? Why is it important? Retrieved on 1st September 2017, from; http://marketbusinessnews.com/financial-glossary/purchasing-power-parity-ppp/ Read More