Volatile Exchange In the Global Market

Discuss and explain the functions of the foreign exchange market. The role of the foreign exchange market in international business and how it impacts a country's ability to do business is simple: It keeps the money flowing around the world. The foreign exchange (FOREX) market provides a place for nations to purchase, borrow, or sell their own currency to members of other nations. What the FOREX do in this regard is provide the resources for countries to make payments and transfer funds across borders, and provides purchasing power from one currency to another. These provisions make valuations of currency available to determine one of the greatest functions of the FOREX, the exchange rate. (Hill, 2011) The exchange rate is a price determined by the number of units of one nation's currency that must be surrendered in order to acquire one unit of another nation's currency. The exchange rate between two currencies is dependent upon official or private participants to buy and sell its currency to maintain an authorized pegged rate. The exchange rates in FOREX are set then by the market and not by governments. Even with these determinations, the biggest player in defining the exchange rates rely on supply and demand of American goods and currency. International business relies directly on the functionality of the FOREX. In addition to international business, citizens traveling to foreign nations have to rely on a standard in which they can pay for foreign goods and services. FOREX make these situations possible. As we know, every nation has its own currency and monetary system. The FOREX makes it possible for U.S. citizens to travel to foreign nations and buy goods and services in forms acceptable to foreigners. Thus, we can say that another function of FOREX is the participation in the growth of developing nations; helping them to eliminate poverty and internationalize their goods and services. (Hill, 2011)

Discuss spot exchange rates and its overall importance in the market. The spot exchange rates is a rate of a foreign-exchange contract for immediate delivery. Also known as "benchmark rates", "straightforward rates" or "outright rates", spot rates represent the price that a buyer expects to pay for a foreign currency in another currency. The Spot exchange rate is the exchange rate at the present time. The spot rate on the FOREX changes every second and is constantly updating. It’s overall importance in the market is, it reduces transaction costs avoiding high conversion charges. It eliminates uncertainty caused by exchange rate fluctuations. And most importantly, it keeps the money flowing around the world. (Investopedia)
What is forward exchange rate and what role do they play in insuring against foreign exchange risk?

The forward exchange rate (also referred to as forward rate or forward price) is the rate at which a bank is willing to exchange one currency for another at some specified future date. The forward exchange rate is a type of forward price. It is the exchange rate negotiated today between a bank and a client upon entering into a forward contract agreeing to buy or sell some amount of foreign currency at a future date. The forward exchange rate is determined by the relationship among the spot exchange rate and differences in interest rates between two countries. Forward exchange rates have important theoretical implications in forecasting future spot exchange rates. (Hill, 2011)
Multinational corporations often use the forward market to hedge future payables or receivables denominated in a foreign currency against foreign exchange risk by using a forward contract to lock in a forward exchange rate. Hedging with forward contracts is typically used for larger transactions, while futures contracts are used for smaller transactions. This is due to the customization afforded to banks by forward contracts traded over-the-counter, versus the standardization of futures contracts, which are traded on an exchange. Banks typically quote forward rates for major currencies in maturities of 1, 3, 6, 9, or 12 months, however in some cases quotations for greater maturities are available up to 5 or 10 years. (Investopedia)
Discuss at least one theory explaining how currency exchange rates are determined and their relative merits.

Exchange rates are to some extent determined by market forces only in respect of floating currencies. All currencies are not floating. Indian rupee and Chinese yuan are not, for example, whereas the British pound, euro, US dollar and Japanese yen are. When a currency is not floating, its exchange rate is often fixed by authorities. For example, the yuan is pegged to the dollar. As for floating currencies , there are a number of explanations as to how the markets find the exchange rate. (Hill, 2011) Purchasing Power Parity (PPP) theory says a currency is only as strong as its purchasing power. Interest parity theory says the country offering higher rate of interest should be able to attract funds from the other and thus its currency should be stronger. All these are oversimplified theories and the truth is there are several factors at work that influence the exchange rate. The US dollar for example has been commanding a premium disproportionate to its economy's fundamentals thanks to its first mover advantage and the TINA (there is no other alternative) factor. (Hill, 2011)
Discuss and evaluate the merits of different approaches toward exchange rate forecasting.
There are several models that can make Foreign Exchange Rate Forecasts highly accurate. It is of utmost significance that a company should choose the method of forecasting that best matches their needs and requirements. Exchange Rate Forecasting is a highly intricate task and involves great risk. There are some proven techniques that can make the task of forecasting a breeze for a business. (Hill, 2011)
Usually international exchange rates are settled in the future which necessitates the need of extensive study and in-depth analysis to ensure accurate prediction. In the absence of proper forecasting method it will be impossible for you to effectively assess the advantages and risks of exchanges. Foreign Exchange Rate Forecasts involves several fundamental economic variables which include the GNP, trade balance, inflation rates, unemployment, productivity indexes, consumption, and trade balance. The professional experts will give you a buy or sell signal when the difference is due to a miss-pricing. They will filter out regular fluctuations and enable their company to ascertain lasting changes and indicators. These professionals will offer their company the best approach and program that best suits the business’s goals and objectives (Hill, 2011).
Discuss the differences between translation, transaction and economic exposure and what managers can do to manage each type of exposure.

Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company. Economic exposure is the extent to which a firm’s future international earning power is affected by changes in exchange rates. (Cross, 1998)
In reducing Translation and Transaction Exposure firms can minimize their foreign exchange exposure by: * buying forward * using swaps * leading and lagging payables and receivables - paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements

(Cross, 1998)

Firms can also reduce economic exposure by ensuring assets are not too concentrated in countries where likely rises in currency values will lead to damaging increases in the foreign prices of the goods and services they produced. Other steps for managing foreign exchange risk are to: (a) central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies; (b) firms should distinguish between transaction and translation exposure on the one hand, and economic exposure on the other hand; (c) the need to forecast future exchange rates cannot be overstated; (d) firms need to establish good reporting systems so the central finance function can regularly monitor the firm’s exposure position; (e) the firm should produce monthly foreign exchange exposure reports. (Cross, 1998)

References:
Hill, C. W. (2011). International Business: Competing in the Global Marketplace. 8th ed. New York: McGraw Hill.

Cross, S. Y. (1998). The foreign Exchange Market in the United States [Electronic version]. New York: Federal Reserve Bank of New York.

Investopedia. (2015, May 01). Interest rate parity. Retrieved from Investopedia: http://www.investopedia.com/terms/i/interestrateparity.asp