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Exchange market

1. Using an example, explain how a tourist participates in the foreign exchange market. Let there be a German tourist who is visiting the US and wants to purchase a souvenir whose price is $100. There can be two scenarios, namely the implications of a stronger Dollar against the Euro and a weaker Dollar against the Euro. A stronger Dollar will increase the flow of foreign currency into the country while a weaker dollar will increase the spending power of the tourist. So any minor fluctuations in the exchange rate can have a profound impact on the tourists’ influence on the market.

2. What is the difference between spot rate and forward rate? When the payment quoted for a transaction and its delivery are completed immediately, the quoted rate is called a spot rate. The transactions completed using spot rates are recorded within 2 business days. On the other hand forward rate is the rate quoted in transactions for which the terms of the transaction are agreed upon, but the payment and delivery for the transaction take place at a future date. 3. Discuss the nature of the foreign exchange market. How fast has it been growing?

Foreign exchange market can be simply defined as a place where currencies are traded through a global network of buyers and sellers. The major participants of the markets are the big banks who trade among themselves at a wholesale level and business who trade at a retail level. The foreign exchange market operates at two levels, namely spot market and forward market. Spot market is run mainly by commercial banks and customers of the commercial banks. Forward market on the other hand is controlled primarily by traders, arbitrageurs and speculators, who expect to derive a profit through speculations on the future value of the currency.

The foreign exchange market is the world’s largest financial market and it has growth has been phenomenal in the last 20 years. In 1989 daily turnover was reported to be 590 billion dollars and it has increased to 3. 7 trillion dollars in 2007. 4. Discuss the two schools of thought on exchange rate forecasting The two schools o thought on exchange rate forecasting are the Fundamental Approach and the Technical Approach. • Fundamental Approach: Forecasting using this approach is based on the data obtained from economic factors that determine exchange rates.

The economic factors on which prediction is based consist of GNP, interest rates, rate of inflation, trade balance, productivity indices, monetary policies, exchange rate policies, etc. Structural models are used to forecast exchange rates using the Fundamental approach. The structural models are often tuned to reflect changes in the forecasting based on the characteristics of the data input to the model and the forecasting history. However this requires that the forecasters’ specification and estimation of the model be as precise as possible.

• Technical Approach: In this approach forecasting is based on the past trends of exchange rates instead of underlying economic factors. The approach attempts to find patterns in the data that indicate behavioral changes and/or correlation between the various financial variables. These patterns in turn are used to forecast exchange rates. Forecasting using this method can be of two types. Forecasts can be made based on the behavior of recent time series data. Filters, moving averages and momentum indicators are commonly used for this type of prediction.

Computer models such as artificial neural networks and genetic algorithms are also in use for predictions based on time series data. The other type of forecast is made based on any correlations that are found to exist between any event and the changes effected on the exchange rates. Trading volume data and interest differentials are often used to find correlations. 5. How can a firm minimize its foreign exchange exposure? A firm can minimize its foreign exchange exposure in the following ways: • By buying forward. • By using swaps.

• By delaying or advancing monetary transactions with suppliers and customers based on expected changes in exchange rates. 6. Using an example, discuss the notion of a balance of trade equilibrium. Balance of trade can be expressed as a country’s monetary value of exports and imports, which typically measured over a period of a year. When a country exports more than it imports, it runs up a trade surplus and it runs up a trade deficit, when the monetary value of imports are higher than the exports. For example, it United States imports more from Japan than it exports, and then it must pay out more dollars than it received from Japan.

This in turns leads to the trade deficit, which in long term weakens the dollar. Hence balance of trade influences the foreign exchange market. 7. Why did the Bretton Woods system fail? In the post WW II era, a need was felt to establish a transnational organization for the promotion of free flow of international trade and monetary stability. Hence Bretton Woods agreement was devised as means of creating a system of convertible currencies and fixed rates. The gold-based value of the American dollar was created and all the other currencies were pegged to the dollar.

But the system collapsed due to the following reasons: • Although the American gold reserves remained constant, the supply of dollar increased to fund reconstruction in Europe. This in turn led to weakening position and devaluation of the dollar. • As international reserve currency the U. S. dollar ensured that fiscal policy of United States was free from external pressure but heavily influenced other economies. So just to ensure liquidity in the foreign economies, United States has to run a deficit in their balance of payments.

• Due to financing of the Vietnam War United States ran high inflationary policy, which limited the convertibility of the dollar and subsequently dollar ended up being weak. • As the confidence in dollar diminished, other nations began converting their dollars into gold, there by causing the collapse of Bretton Woods system. Finally United States announced in 1971 that it was abandoning the convertibility of the dollar. 8. Discuss the arguments for a floating exchange rate system The arguments that favor a floating exchange rate system are:

• The rates are determined based on supply and demand and are capable of “self-correction” based on differences in supply and demand. • Exchange rates need not be fixed. The balance of the economy can be effectively controlled with automatic determination of rates. • High levels of foreign country reserves unnecessary as they are not used to control the value of currency. • Eliminates the need for constraints on a country’s internal policies. • The monetary flow into a country or out of the country can be adjusted on violation of the balance of payments deficit. 9. Compare and contrast currency crises, banking crises, and foreign debt crises.

Currency crisis can also be called as balance of payment crisis and happens when the value of the currency fluctuates too quickly, thereby reducing its effectiveness as medium of exchange. Banking crisis on the other hand happens when the liquidity becomes a major problem i. e. banks do not have enough cash reserves to pay money to the depositors. Foreign debt crisis happens when a nation runs up too much of debt by paying importing much more than it exports.

Currency crisis tend to have a global impact, whereas the banking crisis and foreign debt crisis tend to have predominantly localized impact. 10. Discuss the notion of moral hazard. What is the relationship between moral hazard and IMF? Moral hazard refers to the risk inherent in a transaction when one or more parties involved in the transaction provide misleading information or do not enter the transaction in good faith. Moral hazard arises mainly due to an asymmetry in the responsibilities borne by the parties involved, thus giving some the opportunity to indulge in actions without concern for the consequences. IMF has a monetary control system that ensures global financial stability. A financial institution is morally responsible for the risks resulting from its operations.

The IMF bails out financial institutions when necessary in the interest of global financial stability. This gives rise to moral hazards when the financial institutions do not consider the consequences and risks involved in their operations, thus forcing the IMF to bear the costs of indiscretionary acts. References Foreign exchange market. (n. d. ) In Wikipedia: The Free Encyclopedia. Retrieved March 02, 2009, from http://en. wikipedia. org Shamah, S. (2003). A foreign exchange primer. West Sussex, England: John Wiley and Sons Ltd. Weithers, T. (2006). Foreign exchange: A practical guide to the FX markets. New Jersey: John Wiley and Sons, Inc.

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