Foreign Exchange Markets and Transactions - Essay Example

Foreign Exchange Markets and Transactions Answer a The foreign exchange market is the largest market in the sense that daily average trading between the currencies exceeds $ 1.2 trillion, much higher in value than any other market of the world. The US dollar/euro is the most traded pair constituting almost 30 percent of daily turnover. The most fascinating aspect of the working of foreign exchange market is that it provides opportunity to anyone to take a short-term or long-term advantage of the fluctuation (read appreciation or depreciation) between two currencies.

The exchange offers derivative instruments for trading called ‘call’ and ‘put’ options for those who wanted to take limited risks. A person who undertakes call option gets right to buy a specific currency but at the same time the person does not come under the obligation to buy it. One needs to pay some premium to buy call option. Paying small premium to get unlimited profit is the most lucrative aspect of working in the derivative options. If the rates are not favorable, the person can let the opportunity go away without exercising his or her right.

The person loses only the amount that they paid toward call option. Same is applicable with put option wherein the person has right to sell the currency but again not obliged to sell. Not only this, but the person can choose from the available range of strike rates that are associated with varied premium rates. After all, it is one’s judgmental ability that decides about the most appropriate strike rate to enter into a contract. It is important to note here that the contract of options can be bought in a specified standard volume.

In order to get profit from the call option, the price has to move above the strike price plus the premium paid to buy the call. Similarly, in the put option, the price has to move below the strike price plus the premium paid to buy the put option. It is noteworthy that the currency exchange offers opportunity both the ways whether they appreciate or depreciate.Answer bWhen an MMC from the US is interested in doing business in Japan, it is obvious that the MNC will receive all its payments in Japanese Yen.

In the long run, the objective of the MNC would be to repatriate surplus funds back to its headquarter on the prevailing exchange rate. The current rates between yen and dollar are: 1 Japanese yen = 0.0126 US dollars. If the MNC has to remit one billion yens of profit earned in Japan back to the US at the current date, the company would have, 1 billion × 0.0126 or 12.6 million dollars paid to its headquarter.Further, it is likely that the MNC does not remit profit now but only after a few months when Japanese yen would have depreciated against the US dollar.

That means every Japanese yen will have now fewer dollars.Assuming, the new rates of conversion after three months between the two currencies are 1 Japanese yen = 0.0120 US dollars. Then, one billion yens will get converted to only 12 million US dollar. It is quite clear that the MNC is in loss due to depreciation of the Japanese yen. Contrary to this, if the US dollar depreciates, the MNC would be in a position to remit more dollars back to its headquarter in the US and will get benefitted from the dollar depreciation or yen appreciation.

ReferenceDesai, M. A. (2007). Foreign Exchange Markets and Transactions. Harvard Business School.