Question

Describe the key factors in foreign exchange market. Explain risk and liquidity as they relate for foreign exchange market.

Answer 1

Introduction

Foreign Exchange Market or FOREX as it is called is one of the best measures of a countries overall economic health. It helps in trading of various foreign currencies and their conversion as is required for trade.

Since, most countries across the world do not operate on a single operating currency, the problem arises that how will trade among them occur. Based on the forces of demand and supply, prices of the currency are set in the FOREX market, through which these can be converted to conduct trade. It also gains importance during remittances to foreign countries for various reasons. Thus having a clear knowledge of the same is extremely important.

A higher conversion rate when compared to any currency, translates into the economy doing bad when compared to the other counterpart respectively.

Key Factors in Foreign Exchange Market are as follows:-

• Inflation Rate

Generally speaking inflation has a big impact on the valuation of a currency in the foreign exchange. A country which has a relatively lower inflation rates compared to other counterparts will see an increase in the value of their currency when compared to others. This happens because the value of goods and services remains consistent while that in the other counterpart’s rise making the country’s currency relatively higher valued than the counterpart respectively.

• Balance of Payments

This is one of the largest factors, which tend to effect the foreign exchange market directly. A country which spends its resources on buying more imports will have its foreign exchange currency devaluated. I.e. a country with a fiscal deficit causing imports to be relatively higher than exports will lead to depreciation of currency since the country is paying more for imports respectively and is not producing goods or services that get sold in the market easily.

• Interest Rates

Developed countries tend to have a lower interest rate because utilization of loans is proper and hence the economic activity is relatively stable in nature.

On the other hand underdeveloped and developing countries require the government to keep interest rates in check. Therefore generally in a country where interest rates are lower, the currency is more stable and valued higher than the other counterparts respectively.

• Government Debts

Government debt refers to the amount of money a government of a country owes to the public be it national or international in nature. This is usually done through the use of bonds which the government offers and has a coupon rate of interest when talking about the domestic context and internationally this maybe through the use of organizations such as the World Bank and through other allies respectively.

A higher government debt has a big impact on the government debt which tends to devalue the currency and on the other hand lower debts represent high value of the currency in the foreign exchanges respectively.

• Political Stability

This is another key factor which corrects the foreign exchanges. A stable economy has lesser fluctuations in the value of the currency since demand and supply is relatively predictable. On the other hand in a country with instability this is relatively missing and rates go on changing respectively.

Explain risk and liquidity as they relate for foreign exchange market.

The concepts of risk and liquidity for the foreign exchange are interrelated. Due to volatile markets the exchange rates go on changing every day and are usually speculated for transactions that happen international. The risk of investing in these markets or speculating for transactions is that the exchange rates for most countries are never fixed. As a result transactions which take place post-delivery for example export and import, require active speculation which leads to risk as appreciation or depreciation can lead to losses for the buyer or the seller respectively. This concept of floating exchange rates is the reason for risk.

Further Liquidity is also an important factor in the foreign exchange market. There is a reason why the dollar is valued relatively higher than most other currencies. The reason for this is the amount of liquidity it has. The dollar can easily get accepted because of the fact that it is relatively more liquid in nature and is heavily traded respectively.

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