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The Foreign Exchange Market - Essay Example

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The foreign exchange rate is simply the price of one currency in terms of another. Not surprisingly, this price can be viewed as the result of the interaction of the forces of demand and supply for the foreign currency in any particular period of time. Under floating exchange rate mechanism the country's currency is valued through hundreds of thousands of international transactions that take place…
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The Foreign Exchange Market
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"The Foreign Exchange Market"

Download file to see previous pages For example, the desire to purchase a foreign automobile or to travel abroad produces demand for a currency in which these goods or services are produced. Second reason maybe to acquire foreign currency is to purchase financial assets in a particular currency. The desire to open a bank account, purchase foreign stocks or bonds or acquire direct ownership of real capital would fall into this category. A third reason that individual's demand foreign exchange is to avoid losses or make profits that could arise through changes in the foreign exchange rate. Individuals acquire that currency today at a low price in hopes of selling it at a profit later at a high price and thus make a profit. Such risk taking is activity is referred to as speculation in a foreign currency. Others who have to pay for an imported item in the possibility that the foreign currency will become more valuable in the future and would associate with the changes in the exchange rate is referred to as hedging. The total demand for a foreign currency at any one point in time thus reflects these three underlying demands: the demand for foreign goods and services, the demand for foreign investment and the demand based on risk taking or risk avoiding activity. It should be clear that the demands on the part of a country's citizens correspond to debit items in the balance-of-payments accounting framework.

SUPPLY SIDE
Participants on the supply side operate for similar reasons (reflecting credit items in the balance-of-payments). Foreign currency supply to the home country results firstly from foreigners purchasing home exports of goods and services or making unilateral transfers or investment income payments to the home country. For example, U.S. exports of wheat and soybeans are a source of supply for foreign exchange. A second source arises from foreign purchases of U.S. stocks and placement of bank deposits. Japanese joint ventures in U.S. automobile or electronic plants are all examples of financial activity that provides a supply of foreign exchange to U.S. Finally, foreign speculation and hedging activities can provide yet a third source of supply. The total supply of foreign exchange in any time period consists of these three sources.
The foreign exchange market in the figure below is presented from a U.S. perspective and, like any normal market, contains a downward sloping demand curve and an upward sloping supply curve. The price on the vertical axis is stated in terms of domestic currency price of the foreign currency, for example $/franc and the horizontal axis measures the units of Swiss francs supplied and demanded in at various prices (exchange rates). The intersection of the supply and demand curves determines simultaneously the equilibrium exchange rate and the equilibrium quantity of Swiss francs supplied and demanded during a given period of time. An increase in the demand of Swiss francs on the part of the United States will cause the demand curve to shift out to D' and the exchange rate to increase to e'. Note that the increase in the exchange rate means that it is taking more U.S. currency to buy each ...Download file to see next pagesRead More
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