The Volatile Foreign Exchange Market in the United States - Report Example

The volatile foreign exchange market in the United s The foreign exchange market The foreign exchange market is a universal decentralized market for currency trading. The main players in the foreign exchange market are large international banks. There are financial centers all over the world, which act as anchor points for foreign exchange. These centers facilitate the transaction between a wide range of buyers and sellers throughout the day except on weekends. Functions of the foreign exchange market in the U.S economy The foreign exchange market serves three main functions, which are transferring the purchasing power, provision of credit for foreign trade and hedging foreign exchange risks. The most essential function is the transfer of purchasing power. Foreign exchange facilitates the conversion of one currency to another that accomplishes the transfer of purchasing power between the two countries. This transfer is conducted by use of various credit instruments such as bank drafts, foreign bills and telegraphic transfers. Another function of the market is provision of credit for foreign trade. Like to all other trades international trade requires credit, and this can be provided for by the foreign exchange market. The third function of the foreign exchange market is to hedge risks associated with foreign exchange. The foreign exchange market attains this objective by providing facilities both for buying and selling forward or spot exchange. This enables exporters and importers to hedge the risks arising from a change in the foreign exchange rate. The forward market also enables other financial facilities to run considerable exchange position to cover their obligations (Weithers, 2006). Spot foreign exchange rates A spot exchange rate is an agreement reached upon by two parties to buy a currency against selling another currency at a set upon price to be settled on the spot day. The exchange rate at which the transaction is conducted is known as the spot exchange rate. A spot transaction is a transaction that is delivered in two days except for trades between some currency pairs like the USD/CAD pair which settle the following day. The spot exchange rate represents the direct exchange between two currencies. These transactions often involve cash rather than contracts and interest is not incorporated into the transaction. Spot exchange a rate is the most common type of foreign exchange trading (Marrewijk, 2004). Forward exchange rates The forward exchange rate is an exchange rate where two parties agree to exchange one currency for another at a future date. Money does not change hands until the agreed upon time. The buyer and the seller agree on an exchange rate of a future date, and the transaction occurs at this date irrespective of the current rates. The duration of the trade varies and is agreed upon by the buyer and the seller. The forward exchange rate is determined by the parity relationship between the interest rates in the two countries and the spot exchange rate. This shows the economic equilibrium in the foreign exchange market which eliminates the opportunity of arbitrage. Foreign exchange players use forward exchange rate for hedging purposes, and this instrument has a significant implication in forecasting future spot exchange rates (Marrewijk, 2004). Interest Rate Parity theory of determining exchange rates Exchange rates are significantly influenced by changes to the monetary policy. When there is a rise in the home interest rate it is generally followed by an appreciation of the home currency and vice versa. This relationship indicates that the prices of assets play a role in the variation of exchange rates. The interest rate parity was developed by Keynes to link the exchange rate, inflation and interest rates. The theory follows two forms, which are the covered interest rate parity and the uncovered interest rate parity. The covered interest rate parity model provides for the relationship of the forward and spot exchange rates with the interest rate between two countries. In a perfectly competitive market, it is difficult for the gap between two currencies to persist for a long time. This condition is dealt with by the covered interest rate parity condition which provides that the domestic interest rate is higher than the foreign interest rate by a margin equal to the forward premium. Accordingly, if the exchange rate between two currencies is fixed then the interest of the two economies must be equal (Weithers, 2006). The uncovered interest rate parity, on the other hand, provides for the relationship between spot and future exchange and the nominal interest rates. This theory argues that the home interest rate should be higher than the foreign interest rate by a value equivalent to the increased rate of foreign currency. Similar to the purchasing power parity model both the covered and uncovered interest parity models are developed under the assumption of lack of barriers, presence of perfect competition and no arbitrage opportunities (Marrewijk, 2004). Approaches toward exchange rate forecasting in the U.S Purchasing Power Parity The purchasing power parity approach for forecasting exchange rates is based on the law of one price. This law provides that an identical good in different countries must have the same price. This implies that there ought to be no arbitrage opportunity, for individuals to profit from buying a good in one country and selling it in the other country. Based on this underlying concept, the approach forecasts that exchange rates change to offset the price changes introduced by inflation (Oberlechner, 2005). Relative Economic Strength Approach The approach considers the strength of economic growth in various countries in order to forecast the course of exchange rates. The rationale behind this approach is that high growth rates and strong economic environments are likely to attract foreign investors. In order to purchase investment in a country, an investor has to purchase the countries local currency, which result in an increased demand that causes currency appreciation. Unlike the purchasing power parity approach, this approach does not forecast what the exchange rate will be but rather forecasts if the currency will depreciate or appreciate (Walmsley, 2000). Econometric Model This approach involves integration of various factors that affect the movement of a currency. The factors employed in this model are often based on economic theories, but other factors that can affect the movement of the currency can be included. These factors are integrated to form a model that relates these factors to the exchange rate. This approach is the most complicated and time consuming compared to the other two but once the model is created new data can be easily incorporated to create new forecasts (Oberlechner, 2005). Time Series Model The time series model is an approach that is entirely technical in nature and not based on economic theories. A popular approach is the autoregressive moving average process. The approach is based on the idea that past price patterns and behavior can be used to forecast future prices and behavior. The data required in using this model is a time series data that can be used to generate a model (Walmsley, 2000). Foreign exchange risk exposure Foreign exchange risk is a risk posed by an exposure to unexpected variations in the exchange rate between currencies. There are essentially three types of risk exposures to foreign exchange. These exposures are transaction, economic and translation exposure. Transaction exposure arises when a firm has contractual cash flows whose values are exposed to unexpected fluctuations in exchange rates because of contracts being denominated in foreign currencies. When firms negotiate contracts with specific prices and deliverable dates in respect to the volatile exchange rate, these firms face a risk in variation of exchange rates. In order to manage this kind of exposure it becomes imperative for managers to use foreign exchange derivatives which include future contracts, forward contracts options and swaps, money markets or operational techniques for instance leading and lagging receipts and payments, currency invoicing and exposure netting (Bodnar & Marston, 2001).. Economic exposure arises to the extent that a market is influenced by unanticipated exchange rate fluctuations. This adjustment can affect the firm’s position and exposes the firm to financial exchange risk. This exposure can be mitigated through hedging. This can be achieved by lowering costs, adopting flexible supply chain management, diversification and product differentiation to increase inelasticity (Bodnar & Marston, 2001).. Translation exposure arises when the financial reporting of a firm is affected by movements of the exchange rates. The translation of foreign liabilities and assets can have a significant impact on the reported earnings of accompany and in extension its stock prices. This exposure is differentiated from the transaction exposure as a result of treating various aspects using different accounting standards. In order to manage translation exposure, managers can perform balance sheet hedging. Since this exposure occurs from discrepancies in net assets and liabilities in a balance sheet, a firm can obtain a proper amount of exposure to balance off the difference. Foreign exchange derivatives can also assist in hedging translation exposure (Bodnar & Marston, 2001). Reference list Bodnar, G. M., & Marston, R. C. (2001). A simple model of foreign exchange exposure. In Economic Theory, Dynamics and Markets (pp. 275-286). Springer US. Marrewijk, C. V. (2004). An introduction to international money and foreign exchange markets. EconWPA. Oberlechner, T. (2005). The psychology of the foreign exchange market (Vol. 506). Wiley. com. Walmsley, J. (2000). The foreign exchange and money markets guide (Vol. 70). Wiley. Weithers, T. (2006). Foreign exchange: a practical guide to the FX markets (Vol. 309). John Wiley & Sons. Read More