The foreign exchange market is an international monetary system that among sever

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.

Assignment Steps

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.

Explanation / Answer

Foreign exchange market is meant to facilitate the flow of currency across international borders. Two main functions of foreign exchaneg markets are::

1.) Supply of foreign currency: Mani functions of foreign exchange market is to supply foreign currency like US dollars to foreign players Multi National Companies (MNCs), sovereign countries etc. A MNC would want foreign currency for overseas investment and sovereign country for increase in forex reserves, controlling depreciation of local currency etc.

2.) Hedging against exchange rate risk: Foreign exchange market is used by overseas investors to hedge against risk of change in exchange rate in future by participating in financial contracts like currency swaps, currency forwards etc. These types of contracts are actively traded in foreign exchange market.

Money supply and inflation are directly related most of the times. Increase in money supply will lead to increase in aggregate demand. However, if the country is not able to match the increase in aggregate demand with increase in aggregate supply there will be no increase in real output. Therefore as a result the inflation will increase.

Freely convertibe currency is traded freely in foreign exchange market. This is easily available to foreign players for investment purpose, hedging purpose etc. Examples of freely conervtibe currencies are US Dollar, Indian Rupee etc. Non convertible currencies are the ones which is issued by a country for its own domestic purpose. Because of government restrictions this currency is not traded freely in the foreign exchange market. This type of currency is alos known as 'blocked' currency. Certain currencies are also cateogorized as blocked currency because of economic sanctions imposed on a particular country. For example North Korean currency is a restricted currency and is not available for trade worldwide.

For a smooth functioning of foreign exchange market we need a robust IT infrastructure. This IT infrastructure is required to maintain proper back up of forex data, provide real time interface for active trading, hassle free settlement etc. The technology risks are very critical in foreign exchange market. For example: if the servers in Forex market goes down for even an hour, there would be huge transactional losses worldwide. The settlement exposures would shoot up and this would lead to world wide chaos. IT infrastructure should also be covered with disaster management, saved from terrorist attacks etc. A terrorist attack like 9/11 can crumble the whole forex market in seconds which will shatter the worldwide economy.

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