Factors That Influence Exchange Rates - Essay Example

In order for the United s to be able to sell its goods and services in the international markets often the foreign exchange market must be utilized in order to be able to complete the monetary transactions with an international client. The foreign exchange markets serve the purpose of facilitating international investments and trade between parties utilizing different currencies (Investopedia, 2011). In the case of a U.S. based company selling products or services internationally, the business has a choice of either receiving payment for the sale in U.S. dollars from the foreign buyer or accepting payment in the foreign currency. There are advantages and disadvantages of utilizing either approach. The decision of what payment method to use solely depends on what the U.S. based company think its best interests are. There are many advantages of only accepting payments in U.S. dollars for a domestic company; it all depends on what the value of the dollar is versus the other currency. For example (Umflint): In the case of weak dollar vs. strong foreign currency- It helps lower the price of goods exported to foreign markets, therefore it will tend to increase the demand for U.S. manufactured goods and services. Additionally it will help increase domestic tourism since it will lower the cost of travel and increase the tourist’s expenditure in local goods and services. On the other hand it will increase the cost of importing goods to the U.S. This not only applies to the importation of finished goods for the consumer market, but also for the purchase of raw materials from the international market to be used in manufacturing. In the case of strong dollar vs. weak foreign currency- The purchase of foreign goods and services becomes cheaper for domestic users including travel. The disadvantages lie in the fact that goods and services provided by domestic companies become more expensive for foreign buyers. Therefore it makes U.S. companies less competitive in the global market so usually overall total export sales decline. 2) Interest rate parity is one of the applications of the Law of One Price. This law says that the purchase price for homogeneous identical goods should be the same and any price differences should quickly equalize as long as the free market conditions are prevalent without any trade barriers and both transportation and transaction costs are low(Eh, 2010) . Simply stated interest rate parity means that the spot and forward price of a specific currency incorporate any risk free interest rate differences between one currency and the other. When interest rate parity is violated an opportunity to profit through arbitrage would occur. This is not a common occurrence in the foreign exchange markets and when they do occur is very short lived. There are two types of interest rate parities (Nobletrading, 2011): 1. Covered Interest Rate Parity-When covered interest rate parity is present it is assumed that the published foreign exchange forward and spot exchange rates between two specific currencies already incorporate any risk-free interest rate differences between both currencies. 2. Uncovered Interest Rate Parity-It assumes that the difference between the interest rates of two countries will be covered by the depreciation of the currency with the higher interest rates. In the real world this condition does not always occur. Ever since floating exchange rates were introduced in the 1970’s currencies with a high interest rates have had a tendency to appreciate in price instead of depreciating as theory suggests. It has been suggested that speculators have been taking advantage of arbitrage opportunities by borrowing in low-interest currencies, selling the borrowed amounts, and investing the profits in higher interest bearing currencies and financial instruments (Investopedia, 2011). 3) In order to calculate the forward exchange rate of any two specific currencies we need to find the current spot rate for each currency and the current risk-free interest rate for the countries involved. In order to calculate the forward rate the following formula will be used: Forward rate = Spot Rate x (1 + interest rate of foreign country) (1 + interest rate of domestic country) For May 19, 2011 in the foreign exchange markets the spot rate of the U.S. dollar vs. the Egyptian pound is 5.95730 EGP per U.S. dollar. The risk-free interest rates for the U.S. and Egypt are .25% and 8.25%. 1 U.S. dollar = 5.95730 x (1.0825) (1.0025) = 6.4327 So the forward exchange rate for the U.S. dollar and Egyptian pound is 6.4327 EGP per U.S. dollar. 4) Monetary policy is the process of controlling a country’s monetary supply and its growth rate often controlling the interest rate in order to promote economic development and stability (Ehow, 2011). If the monetary supply grows too rapidly the countries rate of inflation will inevitably also increase and vice versa. Monetary policy is also often used to influence the exchange rate of the country’s currency. If for example, the interest rate for the U.S. dollar is low (like it is right now) compared to other currencies it will reduce overall demand for dollars and dollar based investments. Countries in general have policies relating to exchange rates, fixed and floating. In the case of floating interest rates, supply, and demand for the countries currency are the sole determinants of the country’s exchange rate. The government does little or no intervention to control exchange rates. Lots of countries choose to use a fixed exchange rate policy. In order to keep it fixed central banks buy and sell their countries currency in sufficient volumes to offset the influence of supply and demand in the exchange rate. Fixing the exchange rate provides many advantages to the country by providing by eliminating currency risk in the business transaction and it can artificially keep exchange prices low in order to maintain a lower cost of goods for all its exports. 5) There are a number of factors that in addition to interest rates also affect the exchange rates for a given currency (Bergen, 2011): 1. Differences in relative inflation rates between countries-As a general rule the country with the lower average inflation rate tends to exhibit a rising currency value. Countries with generally higher inflation rates have a general tendency to see a drop in their currency value. The problem with inflation is that it devalues the currency of a nation lowering the purchasing power of the community. If the inflation rate of a country is 10% the nation after a year later will have a loss in purchasing power equal to the inflation rate. 2. Current government budget deficits and large public debt-Increased foreign government borrowing to cover deficiencies in GDP will inevitably lower the currency value of the country since it is supplying more of its currency than it what the market needs, therefore lowering currency value. 3. Unstable political or economic climate-Having an unstable political or economic climate will discourage foreign trade and investment so it will lower overall exports, bringing down the currency value. When international companies audit a country’s political status they must ensure that stability is presents. Countries that in the middle of civil wars or countries that utilize socialist regimes are usually more unstable than countries that use a democratic system such as the United States. In the case of Egypt it is evident how political, social, and economic uprising has affected the country in general and its economy. References Bergen, J.V. (2011). 6 Factors That Influence Exchange Rates. Retrieved May 18, 2011 from http://www.investopedia.com/articles/basics/04/050704.asp Investopedia.com (2011). Foreign Exchange Markets. Retrieved May 18, 2011 from http://www.investopedia.com/terms/forex/f/foreign-exchange-markets.asp Eh.com (2010). The Law of one Price. Retrieved May 18, 2011 from http://eh.net/encyclopedia/article/persson.LOOP Ehow.com (2011). How Do Interest Rate Affect Interest Rates? Retrieved May 18, 2011 from http://www.ehow.com/how-does_4571522_interest-rates-affect-exchange-rates.html Nobletrading.com (2011). What is Interest Rate Parity? Retrieved May 18, 2011 from http://blog.nobletrading.com/2008/10/what-is-interest-rate-parity.html Umflint.edu. Chapter 7: Foreign Exchange Markets. Retrieved May 18, 2011 from http://www.umflint.edu/~mjperry/Money7a.htm Read More