Question

The foreign exchange market is an international monetary system that among several of its functions, converts one country's currency into that of another. Understanding the foreign exchange market is an important dynamic in international trade and investment. It is, therefore, a benefit to the business student, via this assignment, to fully comprehend its functions.

Develop a minimum 700-word analysis to include the following aspects of the foreign exchange market:

• Discuss the two main functions of the foreign exchange market.
• Analyze, in detail, the relationship between money supply and inflation.
• Describe the difference between a freely convertible currency and a non-convertible currency.
• Evaluate the technology risks associated with the functions of the foreign exchange market.

Answer 1

Foreign Exchange Analysis

Foreign exchange is the exchange of one currency for another or the conversion of one currency into another currency.

The following are the two important functions of a foreign exchange market:

1. Transfer Function:The basic function of the foreign exchange market is to facilitate the conversion of one currency into another, i.e., to accomplish transfers of purchasing power between two countries. This transfer of purchasing power is effected through a variety of credit instruments, such as telegraphic transfers, bank draft and foreign bills.

2. Credit Function:Another function of the foreign exchange market is to provide credit, both national and international, to promote foreign trade. Obviously, when foreign bills of exchange are used in international payments, a credit for about 3 months, till their maturity, is required.

Money supply and Inflation

Money supply is the entire stock of currency and other liquid instruments circulating in a country's economy as of a particular time. Also referred to as money stock, money supply includes safe assets, such as cash, coins, and balances held in checking and savings accounts that businesses and individuals can use to make payments or hold as short-term investments.

Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.

The perceived relationship is that every increase in dollar money supply, will lead to a proportional increase in prices. But it doesn’t take very much insight to see the flaws in such an argument. What if the economy is growing? Do productivity increases not mean that prices should go down as it becomes easier to make things? How has the theory worked out in practice?

The statistic of concern is monetary growth, not backed by economic growth. As the economy grows through productivity increase; prices should decrease. Money supply growth in line with economic growth will result in stable prices; money supply growth above economic growth will lead to increases in prices.

Price inflation results from money supply growth that is in excess of economic growth. This may be in the face of a growing economy or a declining economy. This is the key relative relationship between money supply growth and economic growth.

Freely convertible currency and non-convertible currency

A fully convertible currency, also known as a freely convertible currency, is one which can be traded without any limitations imposed by government. They typically come from more stable countries, although there are some exceptions to this rule. A nonconvertible currency is one that is used primarily for domestic transactions and is not openly traded on a forex market. This usually is a result of government restrictions, which prevent it from being exchanged for foreign currencies.

Technology risks in foreign exchange:

1. Accounting/financial control – The accounting function ensures that FX transactions are properly recorded to the balance sheet and income statement. If transaction information is not recorded correctly, a bank’s reputation may be impaired if material restatements of financial accounts are necessary Accounting entries are first booked following the initiation of a trade. At this point, details of the deal are posted to contingent accounts (typically in a system used by operations). There might be erratic entries made in this task and this error will be carried forward through the whole system and can be risky for the entire foreign exchange market.

2. Nostro reconciliation – Nostro reconciliation occurs at the end of the trade settlement process to ensure that a trade has settled properly and that all expected cash flows have occurred. A bank should begin reconciliation as soon as it receives notification from its nostro bank that payments are received. If possible, reconciliation should be performed before the payment system associated with each currency closes. Early reconciliation enables a bank to detect any problems in cash settlement and resolve them on the settlement date. Sometimes there might be delayed delivery of settlement notifications and may cause technical errors in the greater foreign exchange.

3. Settlement – Settlement is the exchange of payments between counterparties on the value date of the transaction. The settlement of FX transactions can involve the use of various secure international and domestic payment system networks. Settlement instructions are sent one day before settlement, or on the settlement date, depending on the currency’s settlement requirements. Settlement instructions should include the counterparty’s nostro agent’s name and SWIFT address and account numbers if applicable. Systems generate predictions of expected movements in nostro accounts to help manage liquidity and reconcile actual cash movements against the nostro accounts. These settlement systems can sometimes face system problems and compromise.

4. Netting – Bilateral settlement netting is the practice of combining all trades between two counterparties due on a particular settlement date and calculating a single net payment in each currency. Multilateral settlement netting is the practice of combining all trades between multiple counterparties and calculating a single net payment in each currency. The use of an online settlement netting system is encouraged to calculate net payments in each currency. Online software for calculation of netted payments should be used to ensure proper calculations. These softwares can sometimes be compromised and twitched to give tampered results that suit a party’s needs. This is a technological risk in netting.