Foreign Exchange Market

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Foreign Exchange Market

The foreign exchange market is one of the most important financial markets. It affects the relative price of goods between countries and so can affect trade. It means that it affects the price of imports and so affects a country’s price level (inflation rate). It also affects the international investment and financing decision. In this project, we will try to find why exchange rate would give many risks to a company and how a company can hedge itself.

Definition of Exchange Rate

The price of one currency expressed in terms of another currency is called an exchange rate. With the price it is normal to quote them as the price for one unit of the good. The price of a jacket is how much you have to pay to get 1 jacket. The price of a car is how much you pay to get 1 car. The exchange rate between AUS and US from AUS’s point of view is how many AUS dollars you have to pay to get 1 US dollar. Since you have to pay about AUS$1.55 to get 1 US dollar the exchange rate between AUS and US is 1.55. In this case, the US dollar is the “commodity” currency and the AUS dollar is the “terms” currency.

We denote this SAUS/US=1.55. If a currency appreciates it becomes worth more and so you need less of it to buy one unit of another currency. This makes imports cheaper. For example, if the AUS dollar appreciates then SAUS/US will fall from 1.55. On the other hand, If a currency depreciates it becomes worth less and so you need more of it to buy one unit of another currency. This makes imports more expensive. For example, if the AUS dollar appreciates then SAUS/US will rise from 1.55.

Why does FX give risks to a company?

Every daily exchange rate is changing over time. It might fluctuate sli...

... middle of paper ...

...is because the government always sets its fixed exchange rate at a greater dollar value in order to import goods cheaper.

 Target zone is that there are upper and lower limits. For example, there are 5% limits and the exchange rate is equal to 2. Thus, the upper limit is 2.1 and the lower limit is 1.9. If one day the exchange is reached 2.1, the government will start to intervene and depreciate the exchange rate and vice versa. In this case, the companies may not need to hedge themselves that depends how large the target zone is.

The managed float is that there is not formal exchange rate target, the government will only intervene when the exchange depreciates or appreciates too much in a short period. The companies in that country may need to hedge themselves because there is no formal target and they can still make losses in that period.

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