The foreign exchange market is not
really a source of corporate finance. Rather, it facilitates corporate
financial activities and international transactions. Investor use the
foreign exchange market for four main reasons.
- Currency conversion. Companies use the foreign exchange market to convert one currency into another. Suppose a Malaysian company sells a large number of computers to a customer in France. The French customer wants to pay for the computers in euros, the European Union currency, whereas the Malaysian company wants to be paid in its own ringgit. Ho do the two parties resolve this dilemma? They turn to banks to exchange the currencies for them. Companies also must convert to local currencies hen they undertake foreign direct investment. later, hen a firm’s international subsidiary earns a profit and the company wants to return some of it to the home country, it must convert the local money into the home currency.
- Currency Hedging. The practice of insuring against potential losses that result from adverse changes in exchange rates is called Currency hedging. International companies commonly use hedging for one or two purposes: (1) to lessen the risk associated with international transfers of funds (2) To protect themselves in credit transactions in which there is a time lag between billing and receipt of payment.
- Currency Arbitrage, is the instantaneous purchase and sale of a currency in different markets for profit. For example, assume that a currency trader in New York notices that the value of the European Union euro is lower in Tokyo than in New York. The trader can buy euros in Tokyo, sell them in New york, and earn a profit on the difference. High tech communication and trading system allow the entire transaction to occur within second. But if the difference between the value of the euro in Tokyo and the value of the euro in New York is not greater than the cost of conducting the transaction, the trade is not wort making. Currency arbitrage is a common activity among experienced traders of foreign exchange, very large investors, and companies in the arbitrage business.Firms hose profits are generated primarily by another economic activity, such as retailing or manufacturing, take part in currency arbitrage only if they have large sums of cash on hand.
- Currency Speculation, is the purchase or sale of a currency with the expectation that its value will change and generate a profit. The shift in value might be expected to occur suddenly or over a longer period. The foreign exchange trader may bet that a currency’s price will go either up or down in the future. Suppose a trader in London believes that the Japanese yen will increase over the next three months. She buys yen with pounds at today’s current price, intending to sell them in 90 days. If the price of yen rises in that time, she earns a profit; if it falls, she takes a loss. Speculation is much riskier than arbitrage because the value, or price, of currencies is quite volatile and i affected by many factors. similar to arbitrage, currency speculation is commonly the realm of foreign exchange specialists rather than the managers of firms engaged in other endeavors.
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