Assessing and Understanding the Foreign Exchange Market Essay

Assessing and Understanding the Foreign Exchange Market - Essay Example (Investopedia) Chinese foreign exchange market plays an important role in the development of its economy. It is an important source of investment and income in China. The Chinese foreign exchange market mainly deals in Chinese RMB Renminbi Yuan. The basic function of Chinese foreign exchange market is to conversion the currencies. For example in this market the U.S. dollars can be converted into Chinese RMB. Another important function of Chinese currency market is that it facilitates international business transactions of China through the conversion of currencies. (Laura Acevedo) An important tool for stable economic growth is currency value and this market helps the central bank in controlling the value of its currency through buying and selling. It is also a productive source of investment for the investors in China because if they a currency at a lower rate and due to fluctuations in currency rate they are able to sell it at a higher rate than this sure is a profitable investment . (Maps of World) Spot rate is the price that a buyer is ready to pay for buying a currency in terms of another currency. Chinese spot exchange rates are determined by the central bank. This determination by the central bank is based on a number of factors which include the buying and selling of Yuan in different exchange markets, the value of Yuan in term of other currencies- as this value keeps on changing the spot rate of Chinese exchange market also changes simultaneously. These rates are very important in the Chinese currency market as they are the current exchange rate on the basis of which the day to day transactions of the Chinese stock market take place. And without these rates no business is possible in this market. (Investopedia) Forward exchange rate is the rate at which a currency can be traded for one currency at a particular time in future. This time ranges between two days to twelve months. China puts forward exchange rate reforms when necessary in order to maintain its social and economic stability. Forward exchange rate plays an important role in insuring foreign exchange risks because when a country enters in a transaction through forward exchange rate and in the meantime the exchange rates fall badly then the forward exchange rate act as insurance against unprofitable dealings. (Ozforex) One of the most important theories used for the determination of currency exchange rate is purchasing power parity theory (PPP). It is an economic theory that calculates the changes that are to be made in the currencies of two countries in order to make the difference between their exchange rates and their purchasing power equal. Mathematically this theory is represented as follows: S=P1/P2 Here â€Å"s† is the exchange rate between the two currencies. â€Å"P1† is the price of good x in country one and â€Å"P2† is the price of good x in country two. This theory can be elaborated by an example that if a cold drink costs 1.50 Yuan in ch ina than it should be worth 1.00 us dollars if the exchange rate between U.S.A and china is 1.50 USD/RMB. This theory helps the economists in determining the standard of living in different countries. (Investopedia) It is possible that a currency may be devalued but the standards of living may remain high due the higher purchasing power of the people. Most of the economists prefer purchasing parity concept in the calculation of GDP as countries like china intentionally understate their currency value which results in the understatement of GDP. Therefore mostly the GDP of different countries is calculated through purchasing parity approach. This theory also helps in the correction of trade