Foreign Exchange Markets - Assignment Example

Running header: Foreign Exchange Markets Foreign Exchange Markets Author’s Name Institutional Affiliation Date of submission 1. There are two types of quotes in the spot currency market, direct or indirect. a) Of the two types of quotes, indirect quote is used in Australia. b) In the United States, direct quote is used. c) In the Europe, indirect quote is used. d) Why Australia uses indirect quote- in reality, about 89% of the world currencies are quoted directly given that the US dollar is the dominant currency. However, there is no regulation that guides whether a country should use direct or indirect quote (Balasubramaniam, 2016). For Australia, the main reason why indirect quote is used is because Australia is a common wealth country but not any regulation. The Euro and common wealth currencies like the Australian dollar are the exceptions to using direct quote since they are typically quoted indirectly. 2. The quote in Australia is US$0.736. This means that one Australian dollar is worth 0.736 Australian dollar. To convert Australian dollars to USD, we multiply by the exchange rate. Formula: Convert US$0.736 to direct quote I USD = 1/0.736 AUD 1 USD = 1. 359 AUD To convert AUD to USD, divide by the direct quote rate (Weithers, 2016) USD = AUD/ Direct quote rate USD = AUD/1.359 = AU$100,000/1.359 = US$73,583.52. 3. The British Pound quote of 1.523-33 means that you can buy 1 pound for 1.533 dollars and you can sell one pound for 1.523 dollars. If you converted $ 15,000 to British pounds and then back to US$, its value in USD will be given by Number of pounds = Number of dollars /ask price = $15,000/1.533 = 9,784.74 British Pounds Then we convert the British pounds back to US$ Number of dollars = Number of British pounds*Bind price = 9,784.74*1.523 = US$14,902.15 Thus, if you converted $15,000 to British pounds and then back to US$, its value in US$ would be US$14,902.15. If you buy pounds at the bid rate and sell them at the ask rate One pound at bid rate = Number of dollars /Bid rate = 1/1.523 1 pound at bid rate = 0.657 dollars Thus, at bid rate, we buy = 15,000*0.657 = 9,848.98 British Pounds Then we sell them at ask rate = Number of pounds* Ask rate = 9,848.98* 1.533 = 15,098.49 Thus, if you are able to buy pounds at the bid rate and sell them at the ask rate, you will get $15,098.49. The number of pounds that you need to earn $1,500 on a round trip transaction (buying pounds for US$ and then selling the pounds for US$) is given by; Number of pounds = Intended profit/difference in bid and ask price Difference in bid and ask price = 1.533-1.523 = 0.01 Thus, the number of pounds needed to make $1,500 profit = $1,500/0.01 = 150,000 British pounds (Krugman, 2009) 4. The functions of the foreign exchange market, market participants and transactions The foreign exchange market performs a number of functions as discussed below; i) Transfer function-this is the role played by the market in facilitating the conversion of one currency into another thus accomplishing transfer of purchasing power between one country and the other. The purchasing power transfer takes place via a number of credit instruments including bank drafts, foreign bills and telegraphic transfers (Metcalf, 2016). The transfer function is effected through making payments internationally through clearance of debts simultaneously in both directions analogous to domestic clearings. ii) The foreign exchange market also provides credit both nationally and internationally in a bid to promote foreign trade. It is worth noting that in using foreign bills of exchange in international payments, a three months credit till maturity is needed. iii) The foreign exchange market also plays the hedging function by hedging foreign exchange risks. This is through assuming the risk of losing or gaining when the exchange rates between various currencies vary. There are various market participants in the foreign exchange market with each playing distinct roles. These market participants include the following; i) Governments and central banks- their main function is that of regulation. They also maintain foreign reserve volumes thus facilitating the exchange process. ii) Banks and related financial institutions- they provide foreign exchange services for people requiring foreign currency for small transactions such as travelling. They also trade in the market in the interbank market (Currencyexchangemarket.net, 2016). They also act as dealers by buying or selling currency at the bid or as price and hence they also make money in this way from the market. iii) Hedgers – they assume the risk involved in changing exchange rates and hence assume the resultant profits or losses. iv) Speculators –they make money by taking advantage of the fluctuating foreign exchange rate levels. The various transactions that take place in the foreign exchange market serve to facilitate international trade as well as transfer of purchasing power between various countries (Rajib, 2016). The transactions are diverse but they involve more than one currency. 5. The following are the strategic motives why firms become multinationals; a) Resource seeking motives – firms decide to become multinationals so that they can be able to acquire particular types of resources that are their raw materials and which at times may not be available in the home markets (Contessi, 2016). At times the resources may be available at home but the foreign markets may offer them at lower costs. For instance, a company like BHP Billiton has established itself in many countries that have resources that it uses with an aim of acquiring them and using them for production. Other companies such as IBM have established operations in such countries as China where cheap labor may be found. b) Market seeking motives- this is where firms decide to invest in foreign countries with an aim of exploiting the possibilities offered by markets for greater dimensions. For instance, many multinationals such as Unilever and Coca-Cola have established operations in many countries with an aim of expanding their markets. This has enabled them adapt to local needs while saving on costs of serving a foreign market from their home markets (Scribd.com, 2016). This at times also act to discourage potential competitors from occupying the foreign markets. c) Efficiency seeking motives- in a number of cases, firms may become multinationals in a bid to take advantage of differences in the availability and cost of traditional factor endowments in different countries. Others may become multinationals in a bid to take advantage of the economies of scale and scope as well as the differences in customers’ tastes and preferences as well as supply capabilities. 6. The theory of purchasing power parity Purchasing power parity theory means that when the purchasing power of two currencies is the same in each of the two countries, then the exchange rates between the currencies will be in equilibrium. In other words, the exchange rate between two countries ought to be equal to the ratio of the price levels of a fixed basked of goods and services in the two countries. It means that when one country’s domestic price level increases as is the case during inflation, then its exchange rate ought to be equally depreciated so as to return to purchasing power parity. Purchasing power parity would also mean that if there were no transportation and related transaction costs, the two competitive markets would equalize the price of similar or identical goods in two countries were the prices to be stated in the same currency (Economicsonline.co.uk, 2016). For instance, if a good costs USD 500 in New York, it should cost AUD 659 in Sydney when the exchange rate between Australia and US is 0.76. However, if the price was to be AUD 650 in Sydney, then US consumers would prefer buying the good in Australia which would eventually increase the value of Australian dollar making the good costly to US residents. This should continue until the price is the same in both the countries. However, this assumes that there are no transport and related transaction costs between the two countries and that there are competitive markets between the two countries. The difference between absolute and relative purchasing power parity Absolute purchasing power parity means that a basket of goods and services ought to cost the same in two different markets when the exchange rate between the two currencies is taken into account. If there are deviations from it with a basket of good being cheaper in one country than the other, the exchange rates and the relative prices between the two countries will move towards a level at which the basket of goods and services will cost the same price in the two countries. On the other hand, relative purchasing power parity incorporates the differences in inflation rates between the two countries (Investopedia.com, 2016). Thus, if the inflation in one country is higher than in the other country, the prices in the country with a higher rate of inflation will increase. Since purchasing power parity means that the basket of goods and services cost the same in the two countries, the country with the higher inflation would have to depreciate its currency vis a vis that of the country with a lower inflation rate. The percentage change in the value of the currency depreciated ought to be equal to the differences in the inflation rates between the two countries. References: Balasubramaniam, K2016, Why isn’t the EUR/USD currency pair quoted as USD/EUR? Retrieved on 2nd September 2016, from; http://www.investopedia.com/ask/answers/06/eurusd.asp Weithers, T2016, Foreign exchange: A practical guide to the FX markets, New York, John & Sons. Krugman, O2009, International economics, New South Western, Pearson Education Inc. Metcalf, T2016, What are the functions of foreign currency exchange markets? Retrieved on 2nd September 2016, from; http://peopleof.oureverydaylife.com/functions-foreign-currency-exchange-markets- 9293.html Currencyexchangemarket.net, 2016, Currency exchange markets participants, Retrieved on 2nd September 2016, from; http://www.currencyexchangemarket.net/role-currency-exchange-market- participants.html Rajib, P2016, Foreign exchange market: Market participants, Retrieved on 2nd September 2016, from; http://nptel.ac.in/courses/110105031/pr_pdf/module%204.pdf Contessi, S2016, Why would a firm want to become a multinational? Retrieved on 2nd September 2016, from; https://research.stlouisfed.org/publications/regional/09/10/reader_exchange.pdf Scribd.com, 2016, Why firms become MNC’s? Define nature and characteristics of MNC’s? Retrieved on 2nd September 2016, from; https://www.scribd.com/doc/191523872/Why-Firms-Become-MNC Economicsonline.co.uk, 2016, Purchasing power parity, Retrieved on 2nd September 2016, from; http://www.economicsonline.co.uk/Global_economics/Purchasing_power_ parity.html Investopedia.com, 2016, Absolute and relative purchasing power parity, Retrieved on 2nd September 2016, from; http://www.investopedia.com/exam-guide/cfa-level-1/global-economic- analysis/absolute-relative-purchasing-power-parity.asp Read More