Unit 3 Course Project: International Finance

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Course Learning Outcomes for Unit III Upon completion of this unit, students should be able to:

5. Evaluate the major characteristics of the foreign exchange markets. 5.1 Identify the definitions and distinctions between foreign exchange financial instruments. 5.2 Discover the forms of currency quotations used by currency dealers, financial institutions, and

recognize agents when conducting foreign exchange transactions. 5.3 Analyze the interaction between changing currency values, cross exchange rates, and the

opportunities arising from inter-market arbitrage.

Reading Assignment Chapter 5: The Foreign Exchange Market Chapter 6: International Parity Conditions

Unit Lesson Foreign exchange is the conversion of currency from one country’s value to another (Moffett, Stonehill, & Eiteman, 2015). The foreign exchange market is the governing body or institution that monitors the process. More specifically, the market is the supporting structure that facilitates the conversion of one country’s currency to another. For example, if a U.S. citizen opted to purchase goods from an individual or business in Russia, the foreign exchange market would convert U.S. dollars into Russian rubles. This conversion process results in utilizing an exchange rate. Exchange rates can be applied either through a fixed rate, floating or flexible rate, or managed rate (Moffett et al., 2015). Fixed rate conversions typically are facilitated by the nation’s bank. Floating or flexible rates are controlled by external forces stimulated by market conditions. Managed rates are produced through methods of supply and demand. The principal function of the foreign exchange market can be observed through the empowering of two parties from different countries to physically conduct transactions, utilizing their respective country’s monetary value. During the transit of the goods or transactions between the two countries, provisions must be allocated through financing or sources of credit. Subsequently, hedging or protection is assumed by the foreign exchange market. The foreign exchange market’s function is implemented through its structure, transactions, size, and methodology of quoting and processing exchange rates (Moffett et al., 2015). The functions are not limited to boundaries of time zones, platforms, participants, trading categories, or instruments. The dichotomy structure includes banks and the retail market. Transactions are conducted by banks, individuals, arbitragers, central banks, and brokers. Foreign exchange market transactions are fulfilled through spot, outright forward, or swap approaches (Moffett et al., 2015). Spot transactions typically allow delivery value and payment value to take place rather quickly, usually the following business day. Forward transactions, however, generate a future value date for delivery and payment. Swap allows for the purchase and sale to assume two different value dates. The size and financial activity of the foreign exchange market was reported at daily transactions of 5.7 trillion in April of 2013, and it continues to grow exponentially (Moffett et al., 2015). Foreign exchange quotes express the willingness of buyers and sellers. Quotes take on the form of direct or indirect. Exchange rates of


The Foreign Exchange Market and International Parity Conditions

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direct quotes express the home-value pricing of currency, while exchange rates of indirect quotes express foreign-value pricing of currency. Supporting theories on the formulation of exchange rates can be identified through the lens of international parity conditions (Moffett et al., 2015). The law of one price asserts that pricing of products should remain constant or the same for all markets, when conditions are the same. The purchasing power parity (PPP) theory suggests that exchange rates are the same as long as purchasing power is the same for participating countries. Purchasing power parity is produced in two formats, absolute and relative. Absolute PPP is determined by relative prices of similar products. Relative PPP is reflected over change and time. Determining overvalued or undervalued exchange rates is achieved through indices. Approaches to the determination of rate indices include real and nominal methods. Real methods evaluate the actual rate, while nominal methods analyze changes in rates. The Fisher effect asserts that nominal interest rates are equal to the required, real rate of return along with adjustments for inflation. Nominal rate of interest’s components are nominal rate of interest, real rate of interest, and expected rate of interest. Fisher effect parity condition suggests that increases or decreases in inflation will result in an increase or decrease in the interest rate. Additionally, the application of forward rate asserts an equilibrium between premiums and expected change. Interest rate parity (IRP) theory connects foreign exchange markets to international money markets, indicating an equilibrium between the difference in national interest rates and forward discounts of foreign currency. Conditions creating covered interest arbitrage include when markets (spot and forward) are not equal. Money provides purchasing power both nationally and internationally. However, international purchasing requires a monetary conversion process known as foreign exchange. Hence, the foreign exchange market has become the greatest financial market world-wide. Likewise, international financial management impacts exchange rates, investment, and financing opportunities.

References International Monetary Fund. (2014). Currency composition of official foreign exchange reserves. Retrieved

from http://www.imf.org/external/np/sta/cofer/eng/ Moffett, M. H., Stonehill, A. I., & Eiteman, D. K. (2015). Fundamentals of multinational finance (5th ed.).

Boston, MA: Pearson Education. Wong, A. (2014). Dollar approaches strongest in 2 years versus euro. Bloomberg News. Retrieved from

http://www.bloomberg.com/news/2014-10-01/euro-near-two-year-low-before-ecb-as-share-of- reserves-declines.html

Suggested Reading Corbo, V. (2002). Exchange rate regimes in the Americas: is dollarization the solution? Monetary and

Economic Studies (Special edition). Retrieved from http://www.imes.boj.or.jp/research/papers/english/me20-s1-6.pdf