Assessing and Understanding the Foreign Exchange Market - Essay Example

?Running Head: Foreign Exchange Market Insert His/her Foreign exchange market is a platform where buyers and sellers from all over the world buy, sell and discuss different matters that are related to different currencies. Such markets are very big and can be liquated easily and because of this reason they are considered as very well-organized monetary markets. (Investopedia) Chinese foreign exchange market plays an important role in the development of its economy. It is an important source of investment and income in China. The Chinese foreign exchange market mainly deals in Chinese RMB Renminbi Yuan. The basic function of Chinese foreign exchange market is to conversion the currencies. For example in this market the U.S. dollars can be converted into Chinese RMB. Another important function of Chinese currency market is that it facilitates international business transactions of China through the conversion of currencies. (Laura Acevedo) An important tool for stable economic growth is currency value and this market helps the central bank in controlling the value of its currency through buying and selling. It is also a productive source of investment for the investors in China because if they a currency at a lower rate and due to fluctuations in currency rate they are able to sell it at a higher rate than this sure is a profitable investment. (Maps of World) Spot rate is the price that a buyer is ready to pay for buying a currency in terms of another currency. Chinese spot exchange rates are determined by the central bank. This determination by the central bank is based on a number of factors which include the buying and selling of Yuan in different exchange markets, the value of Yuan in term of other currencies- as this value keeps on changing the spot rate of Chinese exchange market also changes simultaneously. These rates are very important in the Chinese currency market as they are the current exchange rate on the basis of which the day to day transactions of the Chinese stock market take place. And without these rates no business is possible in this market. (Investopedia) Forward exchange rate is the rate at which a currency can be traded for one currency at a particular time in future. This time ranges between two days to twelve months. China puts forward exchange rate reforms when necessary in order to maintain its social and economic stability. Forward exchange rate plays an important role in insuring foreign exchange risks because when a country enters in a transaction through forward exchange rate and in the meantime the exchange rates fall badly then the forward exchange rate act as insurance against unprofitable dealings. (Ozforex) One of the most important theories used for the determination of currency exchange rate is purchasing power parity theory (PPP). It is an economic theory that calculates the changes that are to be made in the currencies of two countries in order to make the difference between their exchange rates and their purchasing power equal. Mathematically this theory is represented as follows: S=P1/P2 Here “s” is the exchange rate between the two currencies. “P1” is the price of good x in country one and “P2” is the price of good x in country two. This theory can be elaborated by an example that if a cold drink costs 1.50 Yuan in china than it should be worth 1.00 us dollars if the exchange rate between U.S.A and china is 1.50 USD/RMB. This theory helps the economists in determining the standard of living in different countries. (Investopedia) It is possible that a currency may be devalued but the standards of living may remain high due the higher purchasing power of the people. Most of the economists prefer purchasing parity concept in the calculation of GDP as countries like china intentionally understate their currency value which results in the understatement of GDP. Therefore mostly the GDP of different countries is calculated through purchasing parity approach. This theory also helps in the correction of trade imbalances if they occur due to the difference between exchange rate and purchasing power. (Casey Reader) There are two approaches used for forecasting the foreign exchange preferred by the forecasters, 1) Fundamental Approach and 2) Technical Approach. The fundamental approach is based on structural (equilibrium) models while the technical approach is based on market price analysis. The Fundamental Approach is beneficial in the way that equilibrium exchange rates are determined which can be used for projections and to generate trading signals in an economy. While the Technical approach leads to the identification of current market trends, especially the price trends. International transactions are usually settled in the near future. As the businesses are globalizing in the current situation, exchange rate forecasts are essential to assess and evaluate the foreign denominated cash flows involved in international transactions. Thus, exchange rate forecasting is very important to evaluate the benefits and risks attached to the international business environment. (Exchange Rate Forecast) Translation/ accounting / balance sheet exposure relates to the restatement of foreign currency financial statements in terms of reporting currency. Transaction exposure/conversion exposure/cash flow exposures deals with the actual cash flows involved in settling the foreign exchange transactions. Economic exposure or operational exposure deals with the strategic evaluation of foreign transactions and relationships. Management of exposures must differentiate between the realized and realized currency gains and losses and must be concerned with the response required to achieve the enterprise's overall policy objectives as it concerns the following aspects, a) maintaining the reporting enterprise’s net book value of global investments in terms of translation in the reporting currency, b) maintaining the exchange value on contractual receipts and payments denominated in foreign currencies, and c) maintaining future foreign currency cash flows in terms of the reporting currency. Hedging is one of the most effectively used approaches to cover the exposures of the foreign currency fluctuation risks. References Investopedia, Foreign Exchange Market, Investopedia Online, Web, 2011. http://www.investopedia.com/terms/forex/f/foreign-exchange-markets.asp#axzz1QOi5hwl6 Acevedo, L. What Are the Functions of Foreign Currency Exchange Markets?, Web, 2011. http://www.ehow.com/about_5137009_functions-foreign-currency-exchange-markets.html Maps of World; Finance, Foreign Exchange Market China, Maps of World; Finance Online, Web, 2011. http://finance.mapsofworld.com/foreign-exchange-market/china.html Investopedia, Spot Exchange Rate, Investopedia Online, Web, 2011. http://www.investopedia.com/terms/s/spotexchangerate.asp#axzz1QOi5hwl6 Ozforex, Forward Exchange Rates, Ozforex Online, Web, 2011. http://www.ozforex.com.au/cgi-bin/forward-exchange-rates.asp Investopedia, Purchasing Power Parity- PPP, Investopedia Online, Web, 2011. http://www.investopedia.com/terms/p/ppp.asp#axzz1QkTW4Hx4 Reader, C. The Advantages of Purchasing Power Parity, Web, 2011. http://www.ehow.com/list_7284018_advantages-purchasing-power-parity.html Exchange Rate Forecast, How to Forecast Exchange Rates, Exchange Rate Forecast Online, Web, 2011. http://www.exchangerateforecast.com/exchange-rate-forecast/how-to-forecast-exchange-rates/ Read More