This chapter talks about what foreign exchange is and explains the meaning of a foreign exchange market, shows how the market works and indicates the forces that determine exchange rates, explains the association between exchange rates and international business and highlights the functions of the foreign market. Foreign exchange is a market concept that means converting the currency of one country into that of another.
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Therefore, the foreign exchange market is the market that hosts the currency conversion process. The process of currency conversion depends on exchange rates. An exchange rate is a cost charged for converting the value of a country’s currency into the value of another. Therefore, the establishment of a foreign exchange market was to create a system that could facilitate the conversion of a country’s currency into another and offer insurance services against adverse consequences of foreign exchange rate fluctuation (Hill, 2011).
Companies use the foreign exchange market services to make payments to other companies in foreign countries. Speculators use the fluctuation of exchange rates to make profits by buying currencies when the price is low and sell them when the price increases to make gains. A spot exchange rate is a rate used in an instant currency conversion agreement between two or more parties. The spot exchange is carried out in a spot exchange market, which is part of the foreign exchange market. On the other hand, the forward exchange rate is the rate agreed on today to convert currencies at a future date specified in the agreement (Hill, 2011).
Companies need to predict future exchange rates. Companies would use the information to plan for future transactions and decision-making processes. A forecasted rate could be the collective prediction of the spot rate at a future period (Hill, 2011).
How exchange rate fluctuations affect businesses
A volatile exchange rate has adverse effects on the performance of a business. Consider a US company that enters into a forward agreement to pay another Japanese company $ 1million converted into Japanese Yen. If the spot exchange rate was $1= ¥ 92.4 and the company decided to complete the payment immediately, it would pay ¥ 92.4 million to the Japanese company. However, due to the volatile exchange rate, if the future exchange rate changes to $1= ¥ 93.7, the Japanese company would benefit from the fluctuation by getting ¥ 93.7 million, whereas the US company would lose by paying more than it would if it went for an immediate transaction.
A real-life example of the explained effect is the Caterpillar Company. In the 1980s, the company lost a large portion of its market share to its rival machinery producer, Komatsu. During that year, the US dollar was stronger than the Japanese Yen. In financial terms, it means that the price of the US dollar against the Japanese Yen was higher. The event rendered Caterpillar tractors more expensive compared to Komatsu tractors. Customers went for a cheaper option that was Komatsu. That is why the US-based tractor company reported a poor performance that year (Hill, 2011).
The significance of hedging strategies
Hedging means to reduce the risk. There are several methods of reducing the risks associated with exchange rate fluctuations. They include forward market hedge, money market hedge, currency swaps, and currency options. Each of the mentioned methods has different terms and conditions. These hedging strategies are facilitated by the use of derivatives. Derivatives are instruments whose prices depend on the prices of the underlying assets. The hedging strategies provide companies with methods of reducing losses associated with exchange rate fluctuation (Hill, 2011).
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Hill, C. W. L. (2011). International Business: Competing in the global marketplace. New York: McGraw-Hill/Irwin.