Foreign Exchange Market, Theory of Purchasing Power Parity - Assignment Example

International Trade – Questions Name: Institution: International Trade – Questions Question 1 A: In America, the direct quote is typically used in the spot currency market. The value of the American dollar is stated as a single unit of measurement, which is used to compare the value of another foreign currency. In this type of quotation, the United States currency is used as a unit if value, which can be used to purchase another currency. The direct currency quotation is also used to determine which currency is domestic and which is foreign. B: In Europe, a widely traded currency is the dollar. However, the indirect quote can be used in the currency market (Gallo, 2014). This is whereby the currency in use is stated as the per unit value of the United States dollar. In this type of quotation, one is able to determine the value of a foreign currency in relation to the Euro or dollar. An example of a European currency quote would be CAD 1.3 per USD 1. In this example, it shows that it would take 1.3 Canadian dollars to purchase one United States dollar. C: The Australian currency quotation, similar to that of the United States currency. Question 2 The foreign exchange market is the financial market system where there exist buyers and sellers of foreign currencies. Some of the main participants include individuals, organizations, brokers of foreign exchange, the central banks, and commercial banks, among others. Here, dealers are able to become intermediaries within the international market and facilitate the buying and selling of currencies from one country to another. The foreign exchange market is commonly referred to as FOREX. It operates on a global scale, and facilitates the transfer of resources and assets through international trade as well. One of the main functions of the foreign exchange market is to transferring of money from one local market to another (Gallo, 2014). This transfer of funds facilitates in trade and payments for two or more parties which are operating and interacting in different parts of the world. Another characteristic of funds transfer is that there is the ability to accurately convert the value of one currency to fit the equivalence of another. On a global scale, currencies come in many different values such that the Japanese Yen is not equivalent to the American dollar of the Euro. As such, conversion of these currencies facilitates easier transfer of funds from a local financial account to a foreign one. The function of conversion is particularly important from an economic perspective. For local and international traders, payment of goods and services which have been imported from other countries is first converted by the foreign exchange market before it is charged or credited to another account. The foreign exchange market also performs the function of providing credit for foreign trade. Within systems of international payments, there exist bills which are provided to individuals or parties, which contain a certain period of maturity. In this case, an individual or party that requires funds to make purchases of international products and services will be able to receive these funds, which they can pay at a later date. This is yet another important function for international trade because it allows business people to make purchases of goods and services within an efficient period, thus keeping their businesses going smoothly. Lack of this function would lead to many challenges in obtaining goods from other countries, and thus interfere with local industries, and subsequently the larger national economies. Foreign exchange markets perform hedging. This is the ability to provide a sense of stability within the market, especially with rising significant variations in values of currencies. Variations in currencies may often lead to significant losses for individuals or parties that often engage in international trade. As such, hedging provides an opportunity for parties to engage in short and long term business transactions without the fear of fluctuations, which may lead to losses on their part. For instance, with a forward contract, parties will agree to buy and sell goods and services at the agreed upon rates, regardless of the future changes in exchange rates. The forward contract can be for three or more months in advance depending on the longevity of business transactions. Essentially, the forward contract is an agreement that needs to be acknowledged by concerned parties (Kristoufek & Vosvrda, 2016). One importance of this function is that it provides significant financial security for business owners who operate internationally, through the process of hedging, individuals and parties engaging in foreign financial transactions are secure in the knowledge that fluctuations and marker volatility will not affect their trade in a negative way. This further provides parties with the ability to make transactions that contribute towards building the local economy. There exist several different types of foreign exchange transaction in this market system. The spot transaction is one of the quickest ways of buying and selling currencies, where the interacting parties complete their transfers within two days. With this speed, the participants will not need to establish any forms of contracts. In a forward transaction, a buyer and seller will enter into a contract of about 90 days. The rates of exchange will be fixed and the fluctuations will not affect their trade. In swap transactions, buyers and sellers will borrow and lend money by investors. Question 3 Over the decades, the business environment in international markets has become more favorable, which has resulted in many organizations branching out. Transformation of companies has been facilitated by various elements within the financial and social systems, which provide both stability and certainty for the future. Through globalization, similar goods and services are now consumed by people from different parts of the world. Globalization has been made possible through improved technological advancements, which has made transport and communication more efficient on a global scale. This will result in a ready market for people in foreign regions. Therefore, organizations that once operated locally alone will seize the opportunity to serve the new demands. Another reason for companies becoming multinational corporations is the relative ease of operating in some foreign markets. For instance, a food and beverage company will find an environment more business friendly when there exists limited trade restrictions, import duties, and regulations of standards of goods and services provided. Here, this business will also incur significantly lower costs of production, and therefore gain more marginal profits as compared to even their home countries where the business originated. Many multinational corporations have been able to take advantage of the differences in trade restrictions in various countries in order to expand therein and gain more profits as a result. Within the manufacturing industries, there can be significant costs incurred in obtaining raw materials, assembly, and distribution within the country (Clegg et al, 2015). As such, many manufacturing countries, especially those in the Western countries have taken the advantage of manufacturing their products in Eastern countries, where labor is significantly cheaper. Cheap labor stems from not only the less expensive living standards as compared to America and Europe, but also weak labor laws which do not sufficiently protect low skilled workers from facing economic exploitation. For instance, labor laws in America and Europe have established labor laws which do not permit any worker from receiving payment that is less than a certain determined amount. In the event that manufacturers find this figure too high to maintain, labor will be outsourced to these international workers. Some of the common organizations that have opted to operate in this manner include those in the retail, textile, automobile, and phone companies. Manufacturing can also be carried out within the countries in which goods are being sold. One advantage is that companies will be able to keep competition at bay because of the proprietary rights of intellectual and technological property. This allows them to incorporate their own types of technology, whether in the manufacturing, transportation, or distribution of their products. Thus, the operations that are carried out in the original country can be easily replicated in the foreign markets. This further encourages local companies to make global ventures. For example, Coca Cola is able to retain their secret recipes for making their signature drinks. Their style of distribution is similar across the globe. One reason why firms do not venture into foreign markets is the significant difference in culture, which affects many other elements of doing trade. For instance, a difference in culture will also mean a different style of management, which organization decision makers are not familiar with (Korine & Alexander, 2008). Furthermore, the difference in culture may also lead to variations in consumption habits, which may not have been anticipated by members of the organization. This leads to a high level of perceived risk, which subsequently discourages many companies from expanding internationally. Even the most successful brands in the world will often face the risk of being unsuccessful without a good international strategy and business mode. An example is the failed attempt at expanding Target into the Canadian market. The losses that were experienced were attributed to a culture shock, which led them to close several of their stores and relocate back to the United States. The risks proven to be less profitable, as the company CEO reported that the profits would not be experienced until 2021 (Dahloff, 2015). Question 4 The theory of purchasing power parity can be defined as a system which compares two or more different currencies through a method known as basket of goods. Here, the concept relies on achieving equilibrium when certain goods and services are valued at the same price within these two countries (Amadeo, 2017). The aim of this is to ensure that there is a similar price of goods provided, which is also consistent with other variations and external factors such as standards of living and imports costs. In such a case, there is also a need to consider the overall rates of inflation, which will affect domestic goods. In order for the balance in prices to be achieved, there is a need to reduce the exchange rate. The purchasing power parity stems from market competitiveness. For instance, when the price of goods are valued at significantly lower prices in country 2 than country 1, consumers in country 1 will opt to make more purchases from the second country, which affect the overall exchange rate of country1’s currency. In such a case, there is likelihood that the currency of country 2 will be increased in value, which will eventually make consumers therein develop less purchasing power over time. Thanks to international trade, more consumers as well as organizations are able to access goods and services from foreign markets. This is why the purchasing power parity is important to maintain. Purchasing power parity is obtained through determining the valuations of basic goods or services existing between two countries in question (McKinnon & Ohno, 2016). For instance, a product such as a liter of milk within a developed country can be said to have achieved equilibrium when the purchasing power is equal to that of consumers within a developing country, even though the prices are significantly different from one another. With absolute purchasing power parity, the essential idea is derived from the law of one price. Here, the price of a good or service will be equal to the relative price of those two countries. For instance, when the price of milk is valued at a certain amount, this amount must remain constant for as long as the exchange rates are the same. In the event that the price has been increased in another country, the overall competitiveness of milk will be reduced therein, thus distorting the balance of trade and purchasing power (Kristoufek & Vosvrda, 2016). The absolute purchasing power parity can be calculated as S=P/P* where S is the spot exchange rate between the two countries. P and P* are the pricing indices for countries one and two respectively. Therefore, it would be in the best interests of both countries to obtain a balance of the purchasing power parity in order to experience the advantages of competitiveness within the international markets. With relative purchasing power parity, the changes are dependent on the relative rates of inflation in one country, and how it affects the other country. Thus, the main aim of relative purchasing power parity is to establish equilibrium of purchasing power over time, and especially with response to effects of inflation. The exchange rates will offset the overall differences gained in the purchasing power within a given time, such as a year. The relative purchasing power parity can be established as follows: S1 / S0 = (1 + Iy) ÷ (1 + Ix). S0 is the spot exchange rate, S1 is the spot exchange rate after inflation has been taken into consideration, and IY is the expected rate of inflation for the foreign country while IX is the expected annual inflation rate for the home country (Al-Zyoud, 2015). Overall, the theory of foreign exchange rates in relation to purchasing power would be too tedious to approach on a practical level. Based on the Big Mac Index, the foreign exchange rates valuing a burger at different prices have taken into considerations the overall cost of living within countries such as United States and China. Thus, the PPP serves only as a basis as to how the exchange rates operate from a theoretical perspective. References Al-Zyoud, H. (2015). An empirical test of purchasing power parity theory for Canadian dollar-US dollar exchange rates. International Journal of Economics and Finance, 7(3), 233. Amadeo, K. (2017). Purchasing power parity: Calculation and how it is used. The Balance. Retrieved 5 September 2017 from https://www.thebalance.com/purchasing-power-parity-3305953 Clegg, S. R., Kornberger, M., & Pitsis, T. (2015). Managing and organizations: An introduction to theory and practice. Sage. Dahloff, D. (2015). Why Target’s Canadian expansion failed. Harvard Business Review. Retrieved 5 September 2017 from https://hbr.org/2015/01/why-targets-canadian-expansion-failed Gallo, C. (2014). The Forex market in practice: a computing approach for automated trading strategies. International Journal of Economics and Management Sciences, 3(169), 1-9. Korine, H. & Alexander, M. (2008). When you shouldn’t go global. Harvard Business Review. Retrieved 5 September 2017 from https://hbr.org/2008/12/when-you-shouldnt-go-global Kristoufek, L., & Vosvrda, M. (2016). Gold, currencies, and market efficiency. Physica A: Statistical Mechanics and its Applications, 449, 27-34. McKinnon, R. I., & Ohno, K. (2016). 7 Purchasing power parity as a monetary. The Future of the International Monetary System: Change, Coordination of Instability? Change, Coordination of Instability?, 42. Read More