The different theories associated with the performance of foreign markets - Free Essay Example

Purchasing power parity According to the Law of One Price identical goods should (under certain conditions) sell for the same price in two different countries at the same time. It is the foundation for purchasing power parity (PPP) theory, which relates exchange rates and price levels The purchasing power parity (PPP) theory is the measure of purchasing power of one currency alongside another currency after taking into account their exchange rate. The basic idea of PPP was popularized by Gustav Cassel in 1918 in his journal Abnormal Deviations in International Exchanges,. According to the Abnormal Deviations in International Exchanges the rate of exchange between two countries is primarily determined by the quotient between the internal purchase power against goods of the money of each countries. The general inflation will lower the purchasing power in all countries in a very different degree , and the rate of exchange should accordingly be excepted to deviate from their old parity in proportion to the inflation of each country. There are two types of PPP. Absolute Purchasing Power Parity suggest that prices of the same basket of products in two different countries should be equal when measured in a common currency. Relative PPP describes the inflation rate. This describes that because of market imperfection, prices of the same basket of products in different countries will not necessarily be the same when measured in a common currency. Different versions of the Law of One Price and PPP Different versions of the Law of One Price and PPP Balance of payments model (MANGEMENT, Dragon Asset) This model holds that a foreign exchange rate must be at its equilibrium level the rate that produces a stable current account balance. A nation with a trade deficit will experience a reduction in its foreign exchange reserves which ultimately lowers (depreciates) the value of its currency. The cheaper currency renders the nation goods (exports) more affordable in the global market place while making imports more expensive. After an intermediate period, imports are forced down and exports rise, thus stabilising the trade balance and the currency towards equilibrium. Like PPP, the balance of payments model focuses largely on tradable goods and services, while ignoring the increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. Such flows go into the capital account item of the balance of payments, thus, balancing the deficit in the current account. The increase in capital flows has given rise to the Asset Market Model. Asset Market Model The explosion in trading of financial assets (stocks and bonds) has reshaped the way analysts and traders look at currencies. Economic variables such as growth, inflation and productivity are no longer the only drivers of currency movements. The proportion of foreign exchange transactions stemming from cross border trading of financial assets has dwarfed the extent of currency transactions generated from trading in goods and services. The asset market approach views currencies as asset prices traded in an efficient financial market. Consequently, currencies are increasingly demonstrating a strong correlation with asset markets, particularly equities. THE SUPPLY AND DEMAND THEORY The supply and demand theory, according to this one, the exchange rate is held to be determined by the supply and demand for foreign currencies. Actually, the supply and demand theory is not a theory, but instead a descriptive mechanism. To say that a rate of exchange is established by supply and demand is to tell how a rate is established, but to say a little about the factors that determine it or why the rate is at a given level and not at some other level. All of the forces, substantive, technical, and psychological, that have impact on a rate of exchange, must, by the very nature of the market itself, act by determining the demand for, and the supply of foreign exchange. What are Fundamental determinants of exchange rates? Foreign Exchange being a commodity likes any other commodities the exchange rates tend to fluctuate from time to time. There are various factors that cause the fluctuation in the rates of exchange. These factors can be divided into several following groups. These groups can affect the exchange rates on a short term as well as long-term basis. Fundamental Factors The fundamental factors include all such events that affect the basic economic and fiscal policies of the concerned government. These factors normally affect the long-term exchange rates of any currency. On short-term basis on many occasions, these factors are found to be rather inactive unless the market attention has turned to fundamentals. However, in the long run exchange rates of all the currencies are linked to fundamental causes. The fundamental factors are basic economic policies followed by the government in relation to inflation, balance of payment position, unemployment, capacity utilization, trends in import and export, etc. Normally, other things remaining constant the currencies of the countries that follow the sound economic policies will always be stronger. Similar for the countries which are having balance of payment surplus, the exchange rate will always be favourable. Conversely, for countries facing balance of payment deficit, the exchange rate will be adverse. Co ntinuous and ever growing deficit in balance of payment indicates over valuation of the currency concerned and the dis-equilibrium created can be remedied through devaluation. Political and Psychological factors Believed to have an influence on exchange rates. Many currencies have a tradition of behaving in a particular way for e.g. Swiss franc as a refuge currency. The US Dollar is also considered a safer haven currency whenever there is a political crisis anywhere in the world. Technical Factors The various technical factors that affect exchange rates Capital Movement The phenomenon of capital movement affecting the exchange rate has a very recent origin. Huge surplus of petroleum exporting countries due to sudden spurt in the oil prices could not be utilized by these countries for home consumption entirely and needed to be invested elsewhere productively. Movement of these petro dollars, started affecting the exchange rates of various currencies. Capital tended to move from lower yielding to higher yielding currencies and as a result the exchange rates moved. Relative Inflation Rates: It was generally believed until recently that one prima-facie direction for exchange rates to move was in the direction adjusted to compensate the relative inflation rates. For instance, if a currency is already overvalued, i.e., stronger than what is warranted by relative inflation rates, depreciation sufficient enough to correct that position can be expected and vice versa. It is necessary to note that exchange rate is a relative price and hence the market weighs all the relevant factors in a relative term, (in relation to the counterpart countries). The underlying reasoning behind this conviction was that a relatively high rate of inflation reduces a countrys competitiveness in international markets and weakens its ability to sell in foreign markets. This will weaken the expected demand for foreign currency (increase in supply of domestic currency and decrease in supply of foreign currency). Exchange rate policy and intervention: Exchange rates are also influenced in no small measure by expectation of changes in regulation relating to exchange markets and official intervention. Official intervention can smoothen an otherwise disorderly market but it is also the experience that if the authorities attempt half-heartedly to counter the market sentiments through intervention in the market, ultimately more steep and sudden exchange rate swings can occur. In the second quarter of 1985 the movement of exchange rates of major currencies reflected the change in the US policy in favour of co-ordinated exchange market intervention as a measure to bring down the value of dollar. Interest Rates: An important factor for movements in exchange rates in recent years has been difference in interest rates; i.e. interest differential between major countries. In this respect the growing integration of the financial markets of major currencies, the revolution in telecommunication facilities, the growth of specialized asset managing agencies, the deregulation of financial markets by major countries, the emergence of foreign exchange trading etc. having accelerated the potential for exchange rates volatility. Speculation Speculation or the anticipation of the market participants many a times is the prime reason for exchange rate movements. The total foreign exchange turnover worldwide is many a times the actual goods and services related turnover indicating the grip of speculators over the market. Those speculators anticipate the events even before the actual data is out and position themselves accordingly in order to take advantage when the actual data confirms the anticipations. The initial positioning and final profit taking make exchange rates volatile. These speculators many a times concentrate only on one factor affecting the exchange rate and as a result the market psychology tends to concentrate only on that factor neglecting all other factors that have equal bearing on the exchange rate movement. Under these circumstances even when all other factors may indicate negative impact on the exchange rate of the currency if the one factor that the market is concentrating comes out positive the curr ency strengthens. Summary of factor affecting exchange rates (JEFF, Madura) What are the different ways that a foreign exchange rate can be quoted? The foreign exchange can be quoted in two ways (YOURFOREXDIRECTORY.COM) Direct Quote A direct quote means indicates how many units of home currency traders need to buy one unit of foreign currency. In other words, its the home currency price of 1 unit of foreign currency. In a direct quote, the domestic currency is always listed as the base currency. For Example for a US trader to compare the British Pound(GBP), to say, the US Dollar, the pair will be listed as USD/GBP, which indicates how many US Dollar are required to buy one British Pound. Here, the USD is the base and the GBP is the counter currency. Indirect Quotes Indirect quote indicates how many foreign currencies are needed to purchase one unit of domestic currency. In an indirect quote, the foreign currency is the base currency and the domestic currency is the counter or quote currency. For example, if UK is the foreign market, then an Indirect Quote will be displayed as GBP/USD. This quotation is the reverse of direct quote which means that how many British Pound are needed to buy a single US Dollar. Difference between spot and forward exchange rates Spot Rate The foreign exchange transaction for immediate exchange is called Spot rate (immediate means within two days). The exchange represents a direct exchange between two currencies, has the shortest time frame, involves cash rather than a contract. Forward Rate A forward rate is a specific exchange rate at which two parties agree to trade currencies. The parties enter into a forward contract that specifies an exchange rate and a future date of exchange. Spread calculation for Spot market Income in currency market are made from the difference between the bid, which is the exchange rate at which a dealer or bank is willing to purchase a particular currency, and the ask, which is the exchange rate for which a dealer or bank is willing to sell a particular currency. The difference between the bid and ask is called the spread. Foreign currency broker or bank will quote both a bid and an ask for a particular currency. The average of the bid and ask (ask plus bid divided by two) is referred to as the midpoint price. The bid-ask spread is usually given as a percentage and it is calculated using the below formulae. (INVESTOPEDIA) Formulae for calculating spread ÂÂ   Bid Ask Dollar to Pound 0.64703 0.64719 Data taken 0n 09/09/2010 Then the bid-ask spread will be 100 ÃÆ'Æ’- (0.64719- 0.64703) / 0.64719 = 0.0247%, which is about 2.4 bps. ÂÂ   Bid Ask Pound to Dollar 1.54514 1.54552 Data taken 0n 09/09/2010 Then the bid-ask spread will be 100 ÃÆ'Æ’- (1.54552- 1.54514) / 1.54552= 0.0245%, which is about 2.4 bps. Spread calculation for Forward market The spread for a forward currency quote is calculated in the similar way as the spread for a spot currency quote. The distinctive factor linked with spreads for forward foreign currency quote is that spreads will increase as the length of time until settlement increases. Currency exchange rates would be expected to have a higher range of fluctuations over longer periods of time, which increases dealer risk. Also, as time increases, fewer dealers are willing to provide quotes, which will also tend to increase the spread.