Final Global Business Plan

Analysis of the Foreign Exchange Market

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Analysis of the Foreign Exchange Market

A foreign exchange market is a place where buyers and sellers get involved in the business of purchasing and disposing of foreign exchange currencies. In other words, it is a market in which the currencies of other countries are bought and sold. The foreign exchange market is commonly referred to as forex, which is a global network that facilitates the exchange of foreign currencies across the world (Menkhoff & Stöhr, (2017). In this market, exporters sell foreign currencies whereas importers buy them. A foreign exchange market forms a portion of the money market in the financial centers. There is a need to appreciate the fact that the foreign exchange market is not restricted to any one country or geographical region since all financial centers are united in one single market. Among the players in foreign exchange markets include banks and acceptance houses that accept bills on behalf of customers. This paper provides a comprehensive analysis of the foreign exchange market.

Main functions of foreign exchange markets

There are several functions of foreign exchange markets. However, the main ones include transfer and hedging. Under the transfer functions, the foreign exchange market facilitates a seamless conversion of one currency into another. For example, American dollars can be converted into Euros, Pounds, and Yens. This helps in the accomplishment of the purchasing power between two nations. The transfer of purchasing power is made effective through several instruments including telegraphic transfers and bank drafts. Generally, the transfer function involves the conversion of one currency into another wherein the forex transfers the purchasing power from one nation to another (Menkhoff & Stöhr, (2017). To illustrate this, if an exporter exports good from the United States to Japan and the payment is to be made in dollars, the conversion of Yens will be made through forex. The second important function of the exchange market is hedging. Foreign exchange market hedges foreign exchange risks (Rambaldi, Pennesi & Lillo, 2015). The fluctuation in foreign exchange rates often causes parties to the foreign exchange to be afraid because the change may result in gain or loss to either party. Therefore, forex comes in to provide the services of hedging the actual or anticipated liabilities in exchange for a forward contract or contracts. Forward contracts usually last for three months where one can buy or sell the foreign exchange for another currency at a predetermined future date at a price agreed today.

The relationship between money supply and inflation

Money supply and inflation are related or linked in various ways. For example, experts warn that increasing the supply of money results in inflation. Increasing the supply of money at a rate faster than the real or actual output causes inflation in a given country. The reasoning behind this is that there will be more money chasing the same quantity of goods or services (Rambaldi et al., 2015). The effect of this is that firms will be forced to raise their prices. However, if the rate at which money is supplied is equal to the rate of real output, the prices of commodities will stay the same. One can use the quantity theory of money to explain the relationship between the supply of money and inflation. The theory is mathematically written as MV=PY, where M represents the quantity of money in circulation, V is the velocity of money supply, P represents the general price level and Y is the gross domestic product of a nation. Therefore, if P rises faster than 2% per annum, the implication is that there is too much money in the economy chasing too few goods and this leads to inflation. Therefore, to bring inflation down, the government reduces M or the quantity of money in circulation.

Difference between a freely convertible currency and a non-convertible currency

The difference between convertible currency and the non-convertible currency is that convertible currency represents a currency that is readily disposed or acquired without facing any restriction from the government when acquiring another currency. Compared to other currencies that are tightly controlled by a central bank, convertible currencies are liquid instruments that facilitate cross border business with confidence and transfer pricing (Hibbing, Smith & Alford, 2015). On the other hand, the non-convertible currency is primarily used for domestic transactions and is never traded openly in the foreign exchange market. This is because of government restriction that precludes it from being exchanged with other currencies. Because of the high restriction by the government, this currency is often referred to as blocked currency.

Technology risks facing the functions of the foreign exchange market

It is of no doubt that technological advancement is posing serious challenges to the functions of the foreign exchange market. For example, high-frequency trading tools such as Forex Meta Trader erode liquidity because they take up all available market orders. This proves drastic especially when information affecting the market is released. If this happens, the foreign exchange market experiences imbalance with the effect going either way. Elsewhere, Cryptocurrencies are currently used by global consumers as a hedge against inflation (Hibbing et al., 2015). However, caution must be taken because doing this goes against capital restrictions in countries with strict rules in place to control the flow of money. The worry is that Cryptocurrencies are used to circumvent these capital restrictions thus leading to an increase in demand from consumers.

Reference

Hibbing, J. R., Smith, K. B., & Alford, J. R. (2015). Liberals and conservatives: Non-convertible currencies. Behavioral and Brain Sciences, 38.

Menkhoff, L., & Stöhr, T. (2017). Foreign exchange market interventions: a frequently used and effective tool. DIW Economic Bulletin, 7(18/19), 181-188.

Rambaldi, M., Pennesi, P., & Lillo, F. (2015). Modeling foreign exchange market activity around macroeconomic news: Hawkes-process approach. Physical Review E, 91(1), 012819.