Essay Example on Foreign Exchange Market: An Illustrative Speculative Auction

Introduction

The foreign exchange market is an illustration of a speculative auction market that trades the funds of several nations progressively around the world. Trading of currencies occurs through telex, fax or email. The majority of trading happens through banks, and they do so by selling and purchasing bank deposits denominated in foreign currency (Kumar & Hetamsaria, 2010). The largest trading centers include London, New York, and Tokyo, and during the trading of moneys, several instruments are used spot, forward, swaps, and options market. The spot rate is defined as the price of a currency that is transacted contemporaneously or traded in the current period. It institutes about 70 percent of the exchange rate market transactions (MSU n.d).

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Forward contracts are provided at maturities o 30, 60, 90 and 360 days (MSU n.d). Under the spot rate, there are two categories of quotations; American terms, and European terms. The American terms refer to the quotation where the spot rate is quoted in terms of the figure of the US dollars per unit of foreign currency, such as $/Franc (MSU n.d). The European terms denote the quotation where the spot rate is quoted in terms of foreign currency units per US dollar, e.g. $-L (MSU n.d). The forward exchange market is a type of market situation where currencies are bought and sold for delivery in the future.

The current futures are depicted by risk premiums, which can emanate due to covariation of future prices with consumption and wealth. The forward rate can only be used as a practical estimate of the future spot rate if ex-ante risk premiums are not available. The contemporary theory of forwarding exchange rate plays an integral role in exchange rate determination. It mainly encompasses two components- interest rate parity, and forward rate expectations (speculators). For example, the Covered Interest Rate Arbitrage Model is an investment plan, where an investor purchases a financial instrument denominated in foreign currency and concurrently to hedge his or her financial position.

Describe the Effectiveness of these Transactions to the Financial Situation of the Company?

Measuring and managing exchange rate risk exposure is essential for decreasing a company's shortcomings from major exchange rate movements which could negatively impact its profit margins and value of assets (Papaioannou, 2006). Based on this context, companies use the Value-at-Risk evaluation to analyze the riskiness of a foreign exchange position ensuing from a firm's activities, including the foreign exchange position of its treasury over a definite period under normal conditions (Papaioannou, 2006). The VaR analysis bases on 3 parameters; the holding period, the confidence level, and the unit level. The holding period is defined as the period in which the foreign exchange position is expected to be held, ideally, the holding period lasts for 1 day (Papaioannou, 2006).

Upon identifying the categories of exchange rate risk, and assessing the relative risk exposure, a company will need to decide whether to hedge or not these underlying financial risks. In international finance hedging, strategies are used by companies to strategically maintain cash flows and earning, hellbent on the company's treasury perspective on the future movements of the currencies involved (Bolton et al., 2013). For instance, the mean of oil future risk premia in 2009 was $38,700, and it meant the aggregate difference between the one-year contracted oil future prices in 2008, and the realized oil spot price in 2009 (Hong et al., 2020). This example can be used in analyzing the regression of the hedging profits in 2009. The average of Oil Futures Risk Premia is negative in all year apart from 2009, while the Gas Futures Risk Premia is positive all through albeit in 2008 (Hong et al., 2020). One strong explanation for analyzing the positive profits in the hedge is that the producers in the US market are earning profits on hedging due to the positive risk premia experienced during the short sample phase. Finally, about 25 percent of companies earn negative profits each year due to negative risk premia.

From the above paragraph, the following economic ramifications can be stated. U.S. oil and gas producers might generate profits from hedging strategies due to their impeccable trading skills (Hong et al., 2020). These producers are expected to excel in the interest rate and foreign exchange derivatives markets. Many US firms were exposed to interest rate risk, but the good thing is that they used interest rate derivatives (particularly swaps ) to mitigate the risks (Hong et al., 2020). The producers used derivatives not only for pure hedging, but also for market timing to attain higher profit, and based on their strategy other producers might pose a question on whether such transaction and hedging outcomes can augment firm's risk instead of plummeting the risk (Chernenko & Faulkender, 2011). If they are destined to augment a company's risk, then such activities may decrease the firm value.

The best practices that firms can follow to strengthen their exchange rate risk management include; establishment of an exchange rate risk management plan (Papaioannou, 2006). Afterward, a comprehensive currency hedging approach should be developed. A company must explain the entire currency risk management policy on the operational phase, including the implementation process of currency hedging, and the hedging strategies to be implemented (Papaioannou, 2006).

References

Bolton, P., Chen, H., & Wang, N. (2013). Market timing, investment, and risk management. Journal of Financial Economics, 109(1), 40-62. https://www.nber.org/papers/w16808.pdf

Chernenko, S., & Faulkender, M. (2011). The two sides of derivatives usage: Hedging and speculating with interest rate swaps. Journal of Financial and Quantitative Analysis, 46(6), 1727-1754. https://pdfs.semanticscholar.org/5663/dd396a5ac3c74b37e94ce19abae55bf6077e.pdf

Hong, L., Li, Y., Xie, K., & Yan, C. J. (2020). On the Market Timing of Hedging: Evidence from US Oil and Gas Producers. Review of Quantitative Finance and Accounting, 54(1), 297-334. https://www.researchgate.net/profile/Kangzhen_Xie2/publication/330589038_On_the_Market_Timing_of_Hedging_Evidence_from_US_Oil_and_Gas_Producers/links/5d8a31d6a6fdcc8fd62157c5/On-the-Market-Timing-of-Hedging-Evidence-from-US-Oil-and-Gas-Producers.pdf

Kumar, S., & Hetamsaria, N. (2010). Relationship between future currency exchange rate and current currency futures prices. Economics Bulletin, 30(3), 1-20. file:///C:/Users/User/Downloads/RelationshipBetweenFutureCurrencySpotRateandCurrentCurrencyFuturesPrices.pdf

MSU. The foreign exchange market: The structure of the market. 1-9. https://msu.edu/course/ec/340/Kilic/lecture7.pdf

Papaioannou, M. G. (2006). Exchange rate risk measurement and management: Issues and approaches for firms (No. 2006-2255). International Monetary Fund. file:///C:/Users/User/Downloads/SSRN-id947372.pdf