Several Aspects of Exchange Rate in the UK - Term Paper Example

Exchange rates UK Introduction This paper is going to focus on several aspects of exchange rate in UK. These aspects will involve the financial institutions, the financial markets, and the financial regulations. Following the introduction of each of these financial bodies, the paper will discuss the relationship between each of the bodies and the exchange rate. After highlighting this relationship, the roles together with the operations of each body are going to be outlined in the discussion. Finally, the paper will look at the financial and monetary significance of all the bodies. Discussion Jorion (2009, p. 551) has asserted that financial institutions are fundamentally unique from other firms. Jorion has claimed that in a circumstance whereby an industrial corporation plunges into bankruptcy, the creditors, bondholders, and other shareholders suffer huge financial losses. However, the direct stakeholders feel the impact of the failure the most. With this brief description, Jorion then went ahead to give a comprehensive definition of the financial institutions. In his definition, he claims that the financial institutions are Commercial banks involved primarily in holding the customer deposits and extending credit to governments, households, and businesses; Insurance companies involved in providing life insurance coverage or property and casualty (P&C) coverage; and the Securities houses involved primarily in the intermediation in securities markets. The examples of these securities houses are: Investment banks, which are specialized in the primary markets in the first sale of securities, Broker dealers involved primarily in aiding the sale of securities in the secondary markets. Economists define a market as an arrangement or an institution whose primary function is to facilitate the sale and the purchase of goods and services, as well as other things. Consequently, a financial market is an arrangement or an institution whose primary function is to facilitate the process through which the financial instruments are exchanged. These financial instruments being exchanged include the government bonds, corporate bonds and stocks, loans, deposits, as well as the more exotic instruments like the future contracts and options. In other words, a financial market is the market whereby such financial instruments as securities, assets, and financial claims are traded. The transactions of a financial market may occur at either a particular location or place. For instance, stock exchange, or may be conducted via other mechanisms like electronic media, telex, and telephone. In this case, the price for using investible funds is normally the interest charged on the transacted funds (Gurusamy 2004 p. 75). The financial market regulation can be defined based on the work it does. Consequently, the primary role of the financial market regulation is to seek for the microeconomic and macroeconomic stability. In order to safeguard the stability of the financial markets, the financial market regulation resorts to the macro controls over securities settlement systems, clearing houses, and financial exchanges. In this case, measures involving the intermediaries’ micro stability can be broken into two categories. The first category involves the general rules guiding the stability of all entrepreneurial activities and business enterprises, for instance the amount of capital that is legally required, the integrity requirements, and the borrowing limits. The second category involves the more specific rules based on the intermediation’s special nature, for instance limits given to portfolio investments, capital ratios that are risk based, and the regulation given to off-balance activities (Gup 2008, p. 8). Exchange rates and financial institutions Madura (2009) outlines the different ways through which the different types of financial institutions use the foreign exchange markets. In commercial banks, the foreign exchange market makes the banks to act as financial intermediaries who buy or sell foreign currencies with the aim of accommodating customers. The banks are also involved in speculation of the movements of foreign currency by taking short positions in particular currencies, or long positions in others. The banks also play a role in providing customers with forward contracts. Lastly, there are some other commercial banks, which can give currency options to clients. These currency options have been tailored to meet the specific customer needs. They are different from the standardized currency options. The international mutual funds are the second type of financial institution with some important roles to play in the foreign exchange markets (Blake 2002, p. 243). The first role of the international mutual funds is that of using the foreign exchange markets in exchanging the currencies during the reconstruction of their portfolios. In addition, the international mutual funds have a significant role of using the foreign exchange derivatives in hedging a hedge a portion of their coverage. The third categories of financial institutions that have a role to play in the foreign exchange markets are the securities firms and brokerage firms. In this case, some securities firms and brokerage firms take part in the foreign security transactions, either for their clients or for their own business (Rezaee & Riley 2009, p. 43). The fourth type of financial institution, which has a role to play in the foreign exchange market, is the insurance companies. Insurance companies use the foreign exchange markets for different purposes. One of the uses comes when the insurance companies want to exchange currencies for the sake of their international operations. The second use arises when the insurance companies want to buy the foreign securities for their investment collection or when they want to sell the foreign securities. The last use of foreign exchange markets for the insurance companies that of using the foreign exchange derivatives in hedging a portion of their coverage (Litan & Herring 2003, p. 263). The last type of financial institution having a role to play in the foreign exchange markets is the pension funds. These pension funds, when they want to invest in foreign securities, either for their bond portfolios or for their stock, will need to exchange the foreign currencies. The other use of foreign exchange markets for the insurance companies that of using the foreign exchange derivatives in hedging a portion of their coverage (Blejer 1991, p. 87). Exchange rates and financial markets From the definition of the financial markets, the sale and purchase of stock comes in handy. Therefore, the aspect of exchange rates is also evident as far as financial markets are concerned. Exchange rates have a lot of impact on the financial markets whose primary role is to trade with the financial instruments under which is the stock. Consequently, stock prices can be affected by the dollar’s value in different ways. This means that as stock prices are affected, the financial markets also get affected. The first reason is that when the dollar is weak, the foreign investors come in strongly to buy the U.S. stocks. On the other hand, when the dollar’s value nears its peak, these foreign investors start selling the U.S. stock (Dunis 2009, p. 273). The foreign demand for the U.S. stock is therefore, always high when there is expectation that the dollar is going to strengthen, other things kept constant. Firms will always buy the stock from the financial markets. In this case, it means that in case something goes wrong with the exchange rates value, the level of trade existing between the financial markets and the firms will be affected. Consequently, when the value of the exchange rate is weak, the U.S firms involved primarily in exporting their products will have their stock prices being affected favorably. On the other hand, when the value of the exchange rate is strong, the U.S. firms involved primarily in exportation industry will have their stock prices being affected adversely (Mizen 2004, p. 362). Roles of Financial institutions In UK, the clearing and retail banks have several roles to play. These banks accomplish all the roles of the financial intermediaries. In this case, they serve as brokers who bring together lenders and borrowers. At the same time, these retail banks serve in repackaging the money coming from one group so that the money can meet the other group’s needs. the other role of the retail banks is that of providing the mechanism with which the transactions can be processed smoothly between institutions. This mechanism comes in form of the clearing of the checks within the system written on any of the UK financial institution. it is important to note that UK has the largest clearing banks in the world when it comes to market capitalization. Market capitalization in this case, refers to the share capital’s value being traded in the UK markets. The financial markets also have a special role to lay in offering different products and services to personal customers. Among these products being offered are traveler’s checks, foreign exchange, agency and personal advisory services, consumer credit and hire purchase, credit cards, insurance broking, life insurance, unit trusts, investment services, private trusts, administration of estates, loans and other mortgages, current and savings accounts (Smith 2005, p. 8). In UK, the wholesale banks refer to the intermediaries, which deal mainly with huge deposits. They have s smaller number of borrowers and depositors as compared with the retail institutions. They use parallel money markets to carry out their inter-bank lending. They have their presence in several international locations, but have no branch networks. These banks are often grouped into as British Merchant Banks, and other British banks (Braithwaite & Drahos 2000, p. 53). Roles and operations of financial markets in UK In the UK financial market system, the funds are allocated in order to ensure that they are used most efficiently amongst the competing demands. This allocation of funds comes through a properly established price mechanism. Various prices are therefore, set within the appropriate financial markets. These financial markets constitute the financial system in UK. With these financial markets in UK, it is possible for the wealth holders to change their portfolios’ composition. Within the financial system, the financial markets can also provide special financial services like the pension and insurance services (Wang 2009, p. 64). Roles and operations of financial regulation in UK Before and during the financial crisis, three main organizations were taking part in the regulation and management of the UK financial system. These were the Financial Services Authority (FSA), the Bank of England, and the Treasury. The role of the treasury was to oversee the regulatory developments in addition to producing different statutory instruments as guided by the principal legislation called the Financial Services and Markets Act 2000. The treasury also represented the interests of the government in the European committees and the EU Council of Ministers. The European committees were responsible for advising the commission on matters to do with the financial regulation. Therefore, much of the financial regulation in UK is borrowed from EU financial legislation (Manzur 1993, p. 7). On the other hand, the Bank of England has invested its responsibilities and powers in supervising the bank’s financial stability following the coming of National Labour Government. Following the Bank of England Act1998, the major role of the Bank of Africa became that of managing monetary policy. The statutory objective of ensuring the financial system’s financial stability was however retained. Several staff was consequently, employed to enable the Bank accomplish this work. In the same spirit, the Bank of England released periodic reports outlining the macro-economic developments as well as the financial institutions’ activities, which might have been having implications for the country’s financial stability. By producing these reports, the Bank of England managed to fulfill this role of ensuring financial stability. The other function of the Bank of England was that of overseeing the states of the payment systems. The Bank of England ensured that the financial markets were plumbed. The bank also were in charge of the pipes channeling the daily flow of the several amounts of money between banks as companies and people sell and buy things in the conventional course of the market activity (Fell, 2005). The bank also offers liquidity to the banks, which are taking deposits. Particularly, the Bank of England provides unique funding called Lender of Last Resort facilities in a situation where the bank has no sufficient funding from the markets. The source of the liquidity that the Bank of England provides, stem up from the bank’s own balance sheet. In case the reserves are exhausted, then the Bank of England can seek help from the government on behave of the bank having trouble (Abdelhamid 2003, p. 19). The FSA on the other hand, is seen as an integrated regulator. The duties of FSA include the regulation of all the different financial institutions taking part in a various investment business. In this case, FSA regulates the managing of financial instruments, dealing, and banking. FSA also give advice to these investment businesses. The regulation of the way these investment organizations carry out their businesses, as well as their financial soundness is done by FSA. Before anyone engages in investment business, FSA must give the authorization (Herring & Litan 1995, p. 18). Their monetary and financial significance The financial sector of UK, which is internationally oriented, sophisticated, and large features sound financial markets, institutions, and infrastructure. The UK banking system for instance is sufficiently profitable. The banking system is also entirely well capitalized to be in the position of absorbing the more probable shocks without any major challenge or distress. On the other hand, the insurance sector in UK is no different from the other insurance sectors in the world in the sense that it is under a lot of financial stress. The UK financial markets are working excellently. However, due to its structure, it is possible for the unsecured interbank market to act, in extreme circumstances as a contagion channel. In London, the activity of the Global financial market has no chances of posing major risks to the financial system in UK since major reforms in settlement and payment systems keep the financial system in UK in a manageable state (Braithwaite & Drahos 2000, p. 6). Conclusion From this discussion, it is evident that the financial institutions, financial markets, and financial regulations have various distinct roles to play in the UK financial sector. Of importance are the roles played by the financial institutions like banks. Consequently, the commercial banks in UK are making the UK’s financial sector to be sophisticated. This is because the banks are well capitalized and very profitable. The UK financial markets are also working well, despite some few shortcomings coming from their unsecured interbank market. All these great performance is owed to the active financial regulation present in UK. 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