Interest Rates, Exchange Rates and Inflation - Coursework Example

The Effects of Interest Rates on Exchange Rates between Two Currencies Interest rates, exchange rates and inflation are related and affect how one country trades with another. Interest rates can be manipulated by central banks so that they have control over the inflation rates and the exchange rates. In addition, the changing interest rates are responsible for the rising inflation in some countries and the decline in currency values (Madura, 1998: 14). The most notable effect of interest on exchange rates is witnesses in situations whereby a country has higher interest rates. Higher interest rates mean that lenders in a particular economy are able to enjoy higher return, more that in countries where there are low interest rates. Further, high interest rates are able to attract foreign capital and lead to high exchange rates. The effects of high interest rates are solved if inflation in a particular country is slightly higher than in other countries. There are also cases whereby the impact of high interest rates can be mitigated through other factors that function to lower the currency (Madura, 1998: 14). Effective exchange rates are usually used to determine country’s currency value in relation to other strong currencies in the index. Some of the world’s currency indexes include the U.S dollar, Japanese Yea and the euro. These currencies are adjusted to lower the effects of inflation in some countries. In addition, effective exchange may also refer to the value consumers are likely to pay for an imported commodity. The price usually comprises of any tariffs and other costs incurred as a result of the process of importation (Somanath, 2011: 220). 2. Inefficiencies in Exchange Rates and Arbitrage Profits Arbitrage profits are made when traders purchase and sell their assets so that they can take advantage of the difference in the price. In particular, arbitrage profits arise due to the exploitation of price differences and takes place in similar financial instruments. In addition, prices can be exploited on different markets as well as in different ways. Arbitrage profits arise due to the efforts geared towards ensuring that prices do not fall from fair value over long periods of time (Clark and Ghosh, 2004: 2). Further, arbitrage refers to the simultaneous buying and selling of a commodity or asset in different markets with the main aim of making profits from the difference in buying and selling prices. For example, the dollar price of a British pound may be 1.70 pounds in London but 1.40 pounds in Paris, a trader can buy 1 pound in Paris then sell that pound in London and make some profit (0.3) per pound sold. If the trader buys 10 million pounds, 3000,000 pounds profit will be realized before any transaction costs, if any exist (Clark and Ghosh, 2004: 2). Arbitrage can be seen as an exploitation of the misalignment of market quotes. In a perfectly competitive market, the evident price differentials that lead to arbitrage profits cannot exist. In essence, arbitrage profit is as a result of market imperfection in which traders buy cheap and sell expensively. In foreign exchange markets, traders have the opportunity to buy and sell continuously. This takes place through the exchange of one currency for another and again for another currency, finally getting back to the original currency in the series of instantaneous transactions, and thus leading to profits (Clark and Ghosh, 2004: 2). 3. Problems of Making Payment in a Foreign Currency in the Future The demand of a foreign currency will certainly affect the price of products to be purchased from that country. Trader therefore, needs to know demand on foreign currencies. The cost of a product may be higher compared to domestic substitutes when the demand of a foreign currency is high. Further, the choice of foreign currency also depends on the investment opportunities available in the particular country and those available in the domestic market. A trader will demand a foreign currency if he or she can transact business cheaply. The demand of a currency at a certain point in the future can also lead to problems of choosing a foreign currency. The demand for a currency is never static and can change over time. When there is an increased demand for a currency, investors will be willing to pay more for a unit in a foreign currency (Sundaram, 2005: 201). The trader should also note that the exchange rates do not remain constant for long period of time. There are various factors that lead to varying exchange rates such as changes in the relative inflation between one country and another, differences in the relative rates of return from one nation to another, and the government interference. One notable government intervention may involve imposing restrictions on foreign exchange, when such incidences occur, the trader is likely to incur loses. Further, the government can also intervene through including quotas on imports thus affecting the future prospects of choosing a foreign currency (Salvatore, 1995; 141). 4. Alternative Ways of Exchanging Dollars Received other than Spot Rates If 1.995 is the 30 day forward rate of an exchange rate of a British pound for a U.S dollar, it means that the parties agree that for 1 pound, one must pay $1.955, but the payer of $1.955 receives 1 pound on the 30th day from the time of agreement. 1 pound =$1.995. In the case whereby the UK exporter is due to receive 1million $ U.S, the amount of pounds sterling he will receive equals to: 1000000 ?1.995= 501253.13 sterling pounds The best alternative the exporter can exchange or make use of the dollars received is to wait until time to borrow. During this time, traders are allowed to borrow at the spot rate. Viewing this alternative from time to time, the future rate is random, meaning that there a chance for distribution around the positive values traders can borrow. The values can be higher or less than the current rate. The second alternative is to contract today. The normal rate traders are allowed to use is the forward rate. In this alternative, there is no risk that can arise due to the borrowing rate. The benefit of this idea depends on the supply and demand that traders are willing to wait versus engaging in contract today, for borrowing and lending in the future. Such decisions are complex and involves the availability of funds, risks, and the expectation that the future spot rate will not lead to losses (Jarrow, 2002:91) References Clark, E And Ghosh, D (2004), Arbitrage, Hedging, And Speculation; The Foreign Exchange Market, New York; Greenwood Publishing Group. Jarrow, R (2002), Modeling Fixed-Income Securities and Interest Rate Options, Landon: Stanford University Press. Madura, J (1998), International Financial Management, New York: Cicinnati. Salvatore, D (1995), Schaum’s Outline of International Economics, New York; McGraw-Hill Professional. Somanath, V (2011), International Financial Management, London: I.K. International Ltd. Sundaram, J (2005), Derivatives and Risk Management, New York; Pearson Education. Read More