Analysis Of The Foreign Exchange Market

Introduction

This assignment is going to discuss a business article that is “Daily Foreign Exchange Market Summary”. This article has been taken from International Business Times Newspaper of Tuesday 25 August, 2009. The article basically discusses the ups and downs in currencies of some countries such as US, Europe, Japan, Canada, Australia, and New Zealand. The purpose to discuss this topic is to focus on activities of foreign exchange markets that are happening all around that affect the economy of given countries. The discussion of this article will go through the theory of foreign exchange markets that comes under international economics.

Key Issues Raised In the Article

“The foreign exchange market is the market in which individuals, firms, and banks buy and sell foreign currencies or foreign exchange” (Salvatore, 2008). The article explains that US economy is going through a hard time because the US job market is struggling having latest jobless claims. According to the article “the data came a day after the Federal Reserve indicated that the US economy was showing signs of levelling out, which boosted risk sentiment” (International Business times, 2009). However, the US economy is trying to be in better position by October. On the other hand, Euro and Pound is rising unexpectedly and employment rate is growing in Britain as well but the Japanese yen has not been that strong these years.

According to the article “The Australian dollar rose ahead of an interest rate outlook announcement from the chief of Australia’s central bank tomorrow. Investors are betting that Australia’s interest rates may rise as soon as October after the RBA sounded surprisingly upbeat in recent comments” (International Business times, 2009). The New Zealand dollar is also on rise after U.S. Fed officials gave a more upbeat outlook of the economy.

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Functions of Foreign Exchange Market

“By far the principal function of foreign exchange market is the transfer of funds or purchasing power from one nation and currency to another” (Salvatore, 2008). Foreign exchange market is the institutional framework for the exchange of one nation’s currency for others. In other words, exchange rate is a price – exactly the same as price of another country. So it is the price that is paid in one currency to get hold of another. Since it is a price, it will be determined, like any other price, by demand and supply. The demand of foreign currencies arises when visiting or investing in another country. On the other hand, supply arises when foreign expenditures, exports or receiving foreign investments. The foreign exchange market takes place between dealers and brokers in financial centres around the world. Foreign exchange traders lead an exciting and hectic life and the pressure often shortens many careers.

Supply and Demand

An exchange rate between two currencies that is allowed to fluctuate with the market forces of supply and demand. A floating rate is often termed “self-correcting”, as any differences in supply and demand will automatically be corrected in the market. Prices of goods, commodities and exchange rates are determined on open markets under the control of two forces, supply and demand. The laws of supply and demand show that the high supply causes low prices, and high demand causes high prices. When there is an abundant supply of a given commodity then the price should fall. When there is a scarce supply of a given commodity then the price should increase. Therefore, an increase in the demand for a commodity would cause it to appreciate in value, whereas an increase in supply would cause it to depreciate.

Equilibrium Exchange Rate

Because of floating exchange rate, the value of a country’s currency changes frequently. The market rate will depend on the demand and supply of that currency in the foreign exchange markets. The example has been shown below with a diagram of floating exchange rates with demand and supply of Australian dollars:

(Edge, 1999)

The above figure shows ups and downs of currency according to demand and supply as the article describes. The demand curve shows the quantity of Australian dollars that buyers are willing to purchase at each possible rate. The supply curve shows the quantity of Australian dollars that will be offered for sale at each exchange rate. At the equilibrium exchange rate of $A1.00 = $US0.50 the equilibrium quantity supplied and demanded is Q1 Australian dollars. At an exchange rate equilibrium, such as $A1.00 = $US0.60, an excess supply of Australian dollars exits and market forces will force the exchange rate down towards equilibrium. If the exchange rate is below equilibrium, such as $A1.00 = $US0.40, an excess demand situation exits and market forces will put upward pressure on the value of the Australian dollar.

Foreign Exchange Risks

A nation’s demand and supply curve for foreign exchange, causing exchange rates to vary frequently. For a dealer in foreign exchange, there are two major elements of market risk such as exchange rate risk and interest rate risk. Exchange rate risk is expected in foreign exchange trading. Interest rate risk arises when there is any mismatching or gap in the maturity structure. As the article says “the data came a day after the Federal Reserve indicated that the U.S. economy was showing signs of levelling out, which boosted risk sentiment”.

On the other hand, the economy of France and Germany is growing as consumer and spending rise so recession in Europe is also bottoming out. As the Australian dollar is rising investors are betting that Australia’s interest rates may rise as soon as October after the RBA sounded surprisingly upbeat in recent comments (International Business times, 2009).

Conclusion

The value of a currency can be viewed from a domestic as well as an international perspective. Even when the dollar may be stable domestically, the value of the dollar could rise or fall as considered by another country’s currency. According to the article, it is clear that the decisions of citizens to invest in another country can have a significant effect on their domestic economy. The buying and selling of currencies takes place in the foreign exchange market. The country has to more focus on the factors which affect on demand and supply of goods services and currency.