Question

Exchange rate influences business operations for corporations. How can currency traders benefit from exchange rate differentials? What are the advantages and disadvantages for a nation with a strong currency? Do you agree or disagree that currency hedging against exchange rate risk will always be beneficial to a company? Do you think a common currency as Euro would solve many issues related to Exchange Rate Risk? What are the issues related to having a common currency? You must provide examples and support your arguments with facts and examples. Include references.

Answer 1

The Forex market is worldwide so trading is pretty much continuous as long as there's a market open somewhere in the world. Trading starts when the markets open in Australia on Sunday evening and ends after markets close in New York on Friday.

Liquidity is the ability of an asset to be converted into cash quickly and without any price discount. In Forex, this means we can move large amounts of money into and out of foreign currency with minimal price movement.

The cost of a transaction is typically built into the price in Forex. It's called the spread. The spread is the difference between the buying and selling price.

Forex brokers allow traders to trade the market using leverage, which is the ability to trade more money on the market than what is actually in your account. If you were to trade at 50:1 leverage, you could trade $50 on the market for every $1 that was in your account. This means you could control a trade of $50,000 using only $1,000 of capital.

The Forex market has no restrictions for directional trading. This means that if you think a currency pair is going to increase in value, you can buy it or go long. Similarly, if you think it could decrease in value, you can sell it or go short.

1. Lower inflation: A strong currency lowers the cost of imported goods, enabling lower prices for consumers. This leaves more money in their pockets for local expenditure.
2. Lower costs for some exporters: those exporters that import raw materials from abroad in order to make their products, pay less for those materials. This offers some compensation for lower competition due to the stronger currency.
3. Acquisition Opportunities: A company from a country with a strong currency can buy a similar company or a supplier, in a country that has a weak currency. This enables the buying company to enjoy the strong currency in order to lower costs.
4. Low funding costs for governments: By having a strengthening currency, flows from outside the country often go into local government bonds. This flow can lower the yield and enable the country with the strong currency to raise money at cheaper rates in the markets.
5. Sense of wealth: While rising stock prices and rising home values have a stronger wealth effect, also a stronger currency helps: citizens of a country with a strong currency find it cheaper to take vacations abroad, improving their quality of life.

If a currency appreciates, then it can lead to a fall in domestic demand. Exports are less competitive, imports are cheaper. For an economy which is already growing slowly, a strong currency will worsen this economic slowdown.

A strong currency can also cause a deterioration in the current account

From 2002 to 2012, some members of the Euro found that they became very uncompetitive in the Euro. The currency was too strong for the relative price of their exports. Because they couldn’t allow the currency to depreciate, it led to a serious deterioration in their current account. With Portugal, Spain and Greece all experiencing record levels of a current account deficit.

foreign exchange hedge (also called a FOREX hedge) is a method used by companies to eliminate or "hedge" their foreign exchange risk resulting from transactions in foreign currencies (see foreign exchange derivative). This is done using either the cash flow hedge or the fair value method. The accounting rules for this are addressed by both the International Financial Reporting Standards (IFRS) and by the US Generally Accepted Accounting Principles (US GAAP) as well as other national accounting standards.

A foreign exchange hedge transfers the foreign exchange risk from the trading or investing company to a business that carries the risk, such as a bank. There is cost to the company for setting up a hedge. By setting up a hedge, the company also forgoes any profit if the movement in the exchange rate would be favourable to it.

Given the weight of the euro area in the world economy and the legacy of the former national currencies which have been replaced by the euro, it is no surprise that the euro is the second most widely used currency at the international level. In this respect, the stance of the Eurosystem, consisting of the European Central Bank and the national central banks of the euro area, is based on two basic principles. First, since the internationalisation of the euro is mainly a market-driven process, the Eurosystem adopts a neutral stance, neither fostering nor hindering the international use of its currency. Second, the implications of the international role of the euro for domestic monetary policy will not prevent the Eurosystem from maintaining price stability as its primary objective. Price stability is also a key precondition for a currency to develop an international role. It is a necessary requirement for investors outside the euro area to be confident that their purchasing power will be preserved over time, since price instability constitutes one of the main factors which cause exchange rate and asset price volatility.

Arguments against a single currency

1. "One size fits all policy" - a single currency requires a single monetary policy. This means interest rates being set centrally for all Euro countries. Say an individual country is suffering a downturn in economic activity, but the rest are booming. The European Central Bank may want to increase interest rates, but that would simply worsen the recession for that country.
2. Differing policy effects - even when countries are closely in line, it may be possible that a single policy will have different effects on different countries. For example, a much larger proportion of people own their own house in the UK than many other European countries. This makes the UK much more reliant on mortgage lending. A change in interest rates then, may have a different effect on the UK from other countries.
3. Shocks - external economic shocks may have an adverse impact. An example could be a rapid rise in oil prices (as happened in the 1970s and 80s). This may affect different countries in different ways, depending on how reliant they are on oil. The UK produces its own North Sea Oil and so may be affected differently to Luxembourg, which does not!
4. Transition costs - moving into a single currency economic union involves short term transition costs (which would disappear once the new currency was fully established). For example, new money has to be issued and the old withdrawn, vending machines have to be adapted to take the new coins,and foreign exchange departments may shrink in size in some financial institutions.