Essay Sample on The Foreign Exchange Markets

The Foreign Exchange market (FX) is among the fastest-growing markets in the field of commerce. This is because businesses have to deal with the currency of a foreign country whenever they go abroad. In the absence of a foreign exchange market, the flow of businesses would become stagnant. It can be defined as a place hosting the buying and selling of foreign money. While importers buy foreign currencies, exporters sell them. The paper focuses on the important functions and the key players in foreign exchange alongside a comparison between interest and exchange rates.

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Important Functions of Foreign Exchange

Several functions are involved:

• Transfer Function: The purchasing power among countries enable the transfer of finance between them. It is the basic function as it facilitates the conversion of currencies from one to the other. It leads to the accomplishment of transferring the purchasing power between the countries involved. The transfer is effected through remittance or foreign bills made through the transfer function (Novitskaya, 2019). This is facilitated through the credit instruments that involve telegraphic transfers, foreign bills, and bank drafts. The foreign exchange market employs an analogous method to make domestic clearings through performing the transfer function. It is done through the market carrying out payments internationally in both countries while clearing debts.
• Credit Function. A function of providing credit in international trade. Through this, function, credits are delivered both internationally and nationally, to promote and improve foreign trade, a credit of around three months is always required when international payments are used to settle foreign bills of exchange (Novitskaya, 2019).
• Hedging Function: Hedging is defined as avoiding foreign exchange risk. It is the function of availing hedging facilities, that is, either forward foreign exchange or facilitate selling and buying spot. In an event where the rate of exchange in a free exchange market changes, there can either be a loss or gain to the party concerned (Novitskaya, 2019). In such situations, a firm or a person undertakes a great risk in exchange if the net liabilities or net claims needed to be met in foreign money are huge amounts.

Foreign Exchange Key Players

• Traders: are short term system followers with the resources, skills, knowledge, and commitment. They are the risk-takers (Menkhoff et al., 2016).
• Government: it is the long term enabler of regional, national, and global economic goals. They can be market disruptors.
• Banks: are the ancillary forex players, credit suppliers, and the market makers.
• Corporations: are long term players who require protection via active hedgers and treasury management (Menkhoff et al., 2016).
• Investment funds: they are the risk avoiders, committed to following trends in trade through resources, high level of skills.

Quoting Foreign Exchange

There are two ways of quoting the exchange rates; direct and indirect quotations. A direct quotation involves domestic currency since it is the unit of foreign currency involved. In Indirect quotation, one of the units of domestic currency involved is in terms of foreign currency.

Purchasing Power Parity (PPP): it implies that the price level changes between the two countries involved affect the exchange rate. When the inflation rate of a country rises in relation to the other country, there occurs a depreciation in the former currency. The concepts of PPP, such as relative and absolute PPP, there exists a difference in the nature of exchange in terms of the rate of exchange.

The absolute purchasing power parity operates similarly to one price. The policy of one price implies that the costs for a given product when should equity if the common currency is used for measurement. Considering the exchange rate of the British-American dollar, the values obtained in different should be equitable. However, there exist market imperfections considering aspects such as quotas, tariffs, transportation cost, nontransferable inputs, and other related elements imposed on products. In this case, relative purchasing power parity plays a central role in streamlining these market imperfections. Relative purchasing power parity is used to relax the apparent relationship between the price levels and the exchange rates between the countries under study (Ferreira, 2019). The balance between price differences is achieved by putting into consideration the relationship between the change in price ratio and the exchange rates.

Relationship between Interest Rates and Exchange Rates

When dealing with foreign exchange, exchange rates, and interest rates, both play a critical role in shaping the market. The imposition of a high-interest rate is a crucial indicator that a country’s currency has a higher value. Therefore, considering the foreign investor’s viewpoint, investing in aa country with higher interest rates means the investment is likely to yield a higher amount. Consequently, the country’s demand tends to rise (Wickremasinghe, 2019). Investors, therefore, move their funds to the target country due to increasing demand. The high exchange rate means the value for a given currency is appreciating or increasing strength. Therefore, a significant improvement in the exchange rates is recorded. Importers are likely to enjoy a steady currency exchange rate. However, exporters may experience a significant challenge when the exchange rate is high.

When a country’s interest rate drops, the currency value tends to decrease significantly. Consequently, the demand for exchange rate falls as well. A weak exchange rate is therefore experienced with depreciation and vice versa for other stable currency. In a case where a given country with a low demand currency value, imports goods from another country with a stable currency, the target country experiences a trade deficit with the other country (Iyke, 2019). Currency depreciation combined effect results in competitive exports while imports are becoming more expensive. The importing country experiences significant inflation in its economy. Other challenges associate with low exchange rates on a particular country includes expensive borrowing, the overall rise in domestic interest rates, and reduction of the country’s purchasing power.

Both interest rates and exchange rates play a vital role in multinational corporations. Economic power is built on the currency value of a given country. Therefore, multinational corporations represent a substantial economic power across the globe, accounting for more than half of the total assets owned by the United States. Multinational companies control assets worth over $4.2 trillion and account for over $3.5 sales equivalent to 60% of America’s total Assets. Therefore, multinational corporations occupy a critical position within global trade. An incidence of exchange rate appreciation or depreciation accounts for investment dampening or stimulation by enhancing demand in the export market and domestic level. Consequently, it increases or decreases investment due to cost increase due to the use of capital cost or an increase in imported goods cost.

Reference

Ferreira, A. (2019). Expectation errors in the foreign exchange market. Journal of International Money and Finance, 95, 44-51. https://www.sciencedirect.com/science/article/pii/S026156061830010X

Iyke, B. N. (2019). A test of the efficiency of the foreign exchange market in Indonesia. Buletin Ekonomi Moneter dan Perbankan, 21, 439-464. https://bmeb-bi.org/index.php/BEMP/article/view/976

Menkhoff, L., Sarno, L., Schmeling, M., & Schrimpf, A. (2016). Information flows in foreign exchange markets: Dissecting customer currency trades. The Journal of Finance, 71(2), 601-634. https://onlinelibrary.wiley.com/doi/abs/10.1111/jofi.12378?casa_token=VBadGbdvrDkAAAAA:08Q27S797gClof05VVjjrfAsxapY2Qwg8iVVd44KxEbeKeanWDtvgtiKfFwtZtvFfuSJJStm8sxMhfdZ

Novitskaya, M. S. (2019). ESSENCE AND FUNCTIONS OF THE FOREIGN EXCHANGE MARKET. TYPES OF FOREIGN EXCHANGE MARKET. KEY PARTICIPANTS. In Nauka XXI veka: aktualny'e voprosy', problemy' i perspektivy' (pp. 79-82). https://elibrary.ru/item.asp?id=42310409

Wickremasinghe, G. B. (2019). Is the PNG foreign exchange market efficient?. https://openresearch-repository.anu.edu.au/handle/1885/157769