The Foreign Exchange Market - Essay Example

Running Head: Foreign Exchange Market Foreign Exchange Market [Saifullah shahid] [The of the appears here] Foreign Exchange Market 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. John Sloman (1999) Let's consider how demand and supply of currency affect its exchange value; DEMAND SIDE Individuals participate in the foreign exchange market for a number of reasons. On the demand side, one principle desire for foreign currency is to purchase goods and services from another country or to send a gift or investment income payments abroad. 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 Swiss franc. When this occurs, the U.S. dollar is said to be depreciating against Swiss franc. In similar fashion, an increase in the supply of Swiss franc (to S') causes supply curve to shift to the right and the exchange rate to fall to e''. In this case, the dollar cost of Swiss franc is decreasing and dollar is said to be appreciating. Home currency depreciation or foreign currency appreciation takes place when there is an increase in the demand of the foreign currency. Similarly Home currency appreciation and foreign currency depreciation takes place when there is a decrease in the demand of foreign currency Salvatore, D (2004). Figure I. The exchange rate between two countries is determined primarily by supply and demand in the foreign exchange markets. Demand comes from individuals, firms and governments who want to buy a currency and supply comes from those who want to sell it. There are various economic variables affecting the foreign exchange of a country. INTEREST RATES AND EXCHANGE RATE It would seem logical to assume that if one country increases its interest rates, it will become more profitable to invest in that country, and so an increase in (mainly short term) investment from overseas will push up the exchange rate because of its extra demand for the currency from overseas investors Griffin, R.W. and Pustay, M.W. (2005). This is true but there is a limit to the amount of investment that will flow in the country because if higher interest rates. A major reason for this is that investors may expect a risk premium for investing in a high interest rate currency if they feel that the currency will depreciate in value. The depreciation of a currency As a result of a fall in the value of currency, exports would become relatively cheaper to foreign buyers, and so the demand for the currency would rise. The extent of this increase in export revenue would depend upon; (i) The price elasticity of demand for goods and services. (ii) The extent to which industry is able to cope up with rising demand (iii) Perhaps also the price elasticity of supply. With greater demand of their goods, producers should be able to achieve some increase in prices (according to the law of supply and d demand), and willingness of suppliers to produce more would then depend on the price elasticity of supply. The effect of a fall in the exchange rate is likely to vary in short term and long term. Given that the immediate effects will depend on the elasticity of demand for imports, demand is likely to be fairly inelastic in the short term and so total expenditure on imports will rise. A currency depreciation will improve the balance of payments current account if the sum of the elasticity's of domestic demand for imports plus foreign demand for exports exceeds 1(Marshall-Lerner condition). The Balance-Of-Payments and Exchange Rate Purchasing power parity theory is more likely to have some validity in the long run, and it is certainly true that the currency of a country which ahs much higher rate of inflation than other countries will weaken on the foreign exchange market. In other words, the rate of inflation relative to the other countries is certainly a factor which influences exchange rates Czinkota, M.R., Ronkainen, I.A. and Moffett, M.H. (2002). Although this influence is obvious, it is not predominant. This is apparent that if exchange rate did respond to demand and supply for current account items, then balance of payments in the current account of all countries would tend towards equilibrium. This is not so, and in practice other factors influence exchange rate more strongly. If a country has a persistent deficit in its balance of payments current account, international confidence in that country's currency will eventually be eroded. And in the long term, its exchange rate will fall as capital inflows are no longer sufficient to counterbalance the country's trade deficit. Speculation and Exchange Rate. Speculators in foreign exchange are investors who buy or sell assets in a foreign currency, in the expectation of a rise ir fall in the exchange rate from which they seek to make a profit. Kerr, W.A. and Perdikis, N. (1995 Speculation could be a stabilizing influence. For example, if a country has a deficit in its current account in the balance of payments, there will be pressure on its currency to weaken. However, if speculators take the view that the deficit is only temporary, they might purchase assets in the currency at that time and sell them, perhaps at a small profit, when the balance returns to surplus later. However, speculation could be destabilizing if it creates such a high volume of demand to buy or sell a particular currency that the exchange rate fluctuates to levels where it is overvalued or undervalued in terms of what hard economic facts suggest it should be. Speculation, when it is destabilizing, could damage a country's economy because the uncertainty about exchange rates disrupts trade in goods and services. Government Intervention in Foreign Exchange Markets The government can intervene in the foreign exchange (FX) markets: 1. To sell its own currency in exchange for foreign currencies, when it wants to keep down the exchange rate of it domestic currency. The foreign currencies it buys can be added to the official reserves. 2. To buy its own currency and pay for it in foreign currencies in its official reserves. It will do this when it wants to keep up the exchange rate when market forces are pushing it down. The government can also intervene indirectly, by changing domestic interest rates, and so either attracting or discouraging investors in financial investments which are denominated in the domestic currency. Exchange rates are determined through many methods one is known as Purchasing Power Parity Hypothesis which is explained below. Purchasing Power Parity Theory A measure if spot rate is mainly concerned with identifying the true equilibrium that would lead to the current account (and hence the capital account) being in balance Sawyer, W.C and Sprinkle, P. (2003). An approach commonly used to estimate the underlying true equilibrium rate is the purchasing power parity theory (PPP) approach and it exists in two versions, an absolute PPP version and a relative PPP version. Purchasing power parity theory, was developed in the 1920's, attempted to explain the exchange rate exclusively by inflation in different countries. The theory predicts that the exchange value of a foreign currency depends on the relative purchasing power of each currency in its own country. The PPP approach rests on the postulate that any given commodity tends to have the same piece worldwide when measured in the same currency. This is sometimes referred to as the law of one price, which many believe operates when if markets a re working well both nationally and internationally. Under these conditions (handling transportation), arbitrage will not cause prices to equalize between different geographical locations, but it is felt by proponents of the law of one price. If goods and services do infect follow the law of one price, then, it is argued, the absolute level of the exchange rate should be that level that causes trade goods and services to have same price in all countries when measured in same currency. This is referred to as absolute purchasing power parity. For example, if a bushel of wheat costs $4.5 in the United States and 3 in France, then the exchange rate should be equal to $4.5 per bushel divided by 3 per bushel, or $1.5/. If we organize over many goods, the absolute PPP estimate of the equilibrium exchange rate would be PPP (absolute) = Price level (us)/Price level (fr) Not surprisingly, the absolute version of PPP does not seem to be borne out empirically. Factors such as transportation costs and trade barriers, which keep prices from equalizing across different markets, combined with the difference in the composition and relative importance of various goods, explain in part why the absolute version does not seem to hold. In short, every country's measure of the price level reflects a set service of other countries. For these reasons a weaker version of PPP is often used that relates the change rate to changes in price levels in the two countries. This is referred to as relative purchasing power parity. In the PPP relative version, if the prices in the home country are rising faster than prices in the partner country, the home currency will depreciate. If prices in the home country are rising slower than the partner country, home currency will appreciate. Given an initial base period exchange rate, the equilibrium rate (PPP relative) at some later date will reflect the relative rates of price changes in the two countries. More specifically, the PPP relative rate (stated in the units of domestic currency per unit of foreign currency) should equal the initial period exchange rate multiplied by the ratio of price index in home country to the price index of partner country. For example, the PPP relative for a U.S.-France situation fir 1995, with 1990 as a base year, would be calculated as 1995 PPP$ (rel) = [e$1990] [PIUS95/PIFr95] If Australia's rate of inflation rises faster than the rate of inflation in other countries then its dollar would tend to weaken. Facts being Australia has a high tendency to import (namely food items and oil) and relies on traveling and computing equipments to offset the rising prices of imported goods. Australia in the past has enjoyed considerable trade surpluses in capital account transactions and hence its currency is fairly 'healthy' in terms of valuation. World inflation being 3-4 % Australia's inflation (CPI index 4% in 2005 Australian Bureau of Statistics) has been in line with the economy of the world and hence no further appreciation or depreciation is expected for the year 2006. References John Sloman (1999). Economics; Exchange Rate Definitions. Europe: Prentice Hall Europe. Sawyer, W.C and Sprinkle, P. (2003) International Economics; purchasing power parity theory: New Jersey: Prentice Hall Pearson Griffin, R.W. and Pustay, M.W. (2005). International Business; economic variables: 3rd Edition. New Jersey: Prentice-Hall Pearson Salvatore, D (2004) International Economics; equilibrium 8th Edition. New York: Wiley Mahoney, D., Trigg, M., Griffin, R. and Pustay, M. (1998), International Business: a managerial perspective. Melbourne: Longman Kerr, W.A. and Perdikis, N. (1995). The Economics of International Business: speculation in exchange rates. London: Chapman and Hall Czinkota, M.R., Ronkainen, I.A. and Moffett, M.H. (2002), International Business: balance of payments and exchange rates, 6th edition. Cincinnati: South Western Read More