The foreign exchange market refers to a global over-the-counter or decentralized market that participants use to speculate, exchange, sell and buy currencies (Fratzscher, 2012). this global market is commonly referred as FX or forex and some of the major players include retail forex investors and brokers, hedge funds, commercial composes, central banks among other (Shenkar, Luo & Chi, 2014). Spot market and forward market are the two broad types of the forex market. Spot market which is the intermediate delivery market which represents that part of the foreign exchange market wherein transaction of currency is settled within two days of the deal (Menkhoff, Sarno, Schmeling & Schrimpf, 2012). the type of transaction involved is referred to as spot transaction. The forward market refers to the transactions sale and purchase of foreign exchange at some specified date in the future, usually after a period of 90 days of the deal and the type transactions involved is called forward transaction (Fratzscher, 2012).
The functions of foreign exchange market
The main functions of foreign exchange market include the following:
- Transfer function: the general and most visible function of the forex is the transfer of funds from one state to another for the settlement of payments. It involves the conversion of one currency to another, wherein the role of forex is to transfer the purchasing power from one country to another (Shenkar, Luo & Chi, 2014). For example, if an Indian wants to import goods from the USA and the payments are to be made in dollars, then the rupee conversion to dollars will be facilitated by forex.
- Credit function: forex provides short-term credit to the importers to facilitate the smooth flow of goods and services from state to state (Hill, 2011). An importer can use credit to finance the foreign purchases.
- Hedging function: The change of currencies may result in a gain or a loss due to the fluctuations in exchange rates. Thus, forex provides the hedging services to anticipated or actual liabilities in exchange for the forward contracts (Shenkar, Luo & Chi, 2014).
Sport exchange rates and its overall importance in the market
The spot exchange rate is a rate of a foreign-exchange contract for immediate delivery. Also known as "benchmark rates", "straightforward rates" or "outright rates", spot rates represent the price that a buyer expects to pay for foreign currency in another currency (Hill, 2011). The Spot exchange rate is the exchange rate at present. The spot rate on the forex changes every second and is constantly updating. Its overall importance in the market is that it reduces transaction costs and in the process avoiding high conversion charges. It eliminates uncertainty caused by exchange rate fluctuations and most importantly, it keeps the money flowing around the world (Moffett, Stonehill & Eiteman, 2014).
What is forward exchange rate and what role do they play in ensuring against foreign exchange risk?
According to Hill (2011), the forward exchange rate (also referred to as forwarding rate or forward price) is the rate at which a bank is willing to exchange one currency for another at some specified future date. The forward exchange rate is a type of forwarding price. It is the exchange rate negotiated today between a bank and a client upon entering into a forward contract agreeing to buy or sell some amount of foreign currency at a future date. Forward exchange rates have important theoretical implications in forecasting future spot exchange rates. Multinational corporations often use the forward market to hedge future payables or receivables denominated in foreign currency against foreign exchange risk by using a forward contract to lock in a forward exchange rate (Hill, 2011). Hedging with forwarding contracts is typically used for larger transactions, while futures contracts are used for smaller transactions. This is due to the customization afforded to banks by forwarding contracts traded over-the-counter, versus the standardization of futures contracts which are traded on an exchange. Banks typically quote forward rates for major currencies in maturities of 1, 3, 6, 9, or 12 months, however, in some cases, quotations for greater maturities are available up to 5 or 10 years. For example, suppose the price of the Japanese yen moves from 120 yen per dollar to 110 yen per dollar over the course of a few weeks. In market parlance, the yen is "strengthening" or "appreciating" against the dollar, which means it is becoming more expensive in dollar terms. If the new exchange rate persists, it will lead to several related effects. First, Japanese exports to the United States will become more expensive. Over time, this might cause export volumes to the United States to decline, which, in turn, might lead to job losses for exporters in Japan. Also, the higher U.S. import prices might be an inflationary influence in the United States. Finally, U.S. exports to Japan will become less expensive, which might lead to an increase in U.S. exports and a boost to U.S. employment.
Discuss at least one theory explaining how currency exchange rates are determined and their relative merits.
Exchange rates are usually influenced by market forces only in respect to floating currencies. All currencies are not floating. Indian rupee and Chinese yuan are not, for example, whereas the British pound, euro, US dollar and Japanese yen are. When a currency is not floating, its exchange rate is often fixed by authorities. For example, the yuan is pegged to the dollar. As for floating currencies, there are some explanations as to how the markets find the exchange rate.
According to Ball, (2010), Purchasing Power Parity (PPP) theory states that a currency is only as strong as its purchasing power. Interest parity theory says the country offering a higher rate of interest should be able to attract funds from the other and thus its currency should be stronger. All these are oversimplified theories, and the truth is there are several factors at work that influence the exchange rate. The US dollar, for example, has been commanding a premium disproportionate to its economy's fundamentals thanks to its first mover advantage and the TINA (there is no other alternative) factor.
Discuss and evaluate the merits of different approaches towards exchange rate forecasting.
According to Hill, (2011), several models can make foreign exchange rate forecasts highly accurate. It is of utmost significance that a company should choose the method of forecasting that best matches their needs and requirements. Exchange rate forecasting is a highly intricate task and involves great risk. Some proven techniques can make the task of forecasting a breeze for a business.
Two approaches exist when it comes to forecasting exchange rates, they are Fundamental approach and technical approach. Fundamental approach mainly embraces GNP, consumption, inflation rates, unemployment, and productivity indexes. Technical approach, on the other hand, is more of an art and concentrates on the small split of attainable or existing data (Menkhoff, Sarno, Schmeling & Schrimpf, 2012).
Usually, international exchange rates are settled in the future which necessitates the need for extensive study and in-depth analysis to ensure accurate prediction. In the absence of proper forecasting method, it will be impossible for you to assess the advantages and risks of exchanges effectively. Foreign Exchange Rate Forecasts involves several fundamental economic variables which include the GNP, trade balance, inflation rates, unemployment, productivity indexes, consumption, and trade balance. The professional experts will give you a buy or sell signal when the difference is due to a miss-pricing. They will filter out regular fluctuations and enable their company to ascertain lasting changes and indicators. These professionals will offer their company the best approach and program that best suits the business's goals and objectives.
The differences between translation, transaction and economic exposure and what Managers can do to manage each type of exposure.
Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values (Moffett, Stonehill & Eiteman, 2014). Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company. Economic exposure is the extent to which a firm's future international earning power is affected by changes in exchange rates.
According to Moore and Roche (2002), in reducing Translation and Transaction Exposure firms can minimize their foreign exchange exposure by buying forward, using swaps and leading and lagging payable and receivable-paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements. Firms can also reduce economic exposure by ensuring assets are not too concentrated in countries where likely rises in currency values will lead to damaging increases in the foreign prices of the goods and services they produced. Other steps for managing foreign exchange risk include central control of exposure which is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies. Next step entails that firms should distinguish between transaction and translation exposure on the one hand and economic exposure on the other hand. the need to forecast future exchange rates cannot be overstated. firms need to establish good reporting systems so the central finance function can regularly monitor the firm's exposure position and lastly the firm should produce monthly foreign exchange exposure reports.
Ball, D. A. (2010). International business: The challenge of global competition. Boston: McGraw-Hill Irwin.
Fratzscher, M. (2012). Official intervention in the foreign exchange market. Handbook of Exchange Rates, 717-749.
Hill, C. W. L. (2011). International Business: Competing in the global marketplace. New York: McGraw-Hill/Irwin.
Menkhoff, L., Sarno, L., Schmeling, M., & Schrimpf, A. (2012). Carry trades and global foreign exchange volatility. The Journal of Finance, 67(2), 681-718.
Moffett, M. H., Stonehill, A. I., & Eiteman, D. K. (2014). Fundamentals of multinational finance. Prentice Hall.
Moore, M. J., & Roche, M. J. (2002). Less of a puzzle: a new look at the forward forex market. Journal of International Economics.
Shenkar, O., Luo, Y., & Chi, T. (2014). International business. Routledge.
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