2020/08/16

What is exchange rate and the forms of it

What is exchange rate
Exchange rate is "the value of one currency for the purpose of conversion to another" and is moving oppositely to each other. (The price of the local currency against other currencies) When you look at the currency pair, you can see base currency and quote currency.
For example, even if Australia's growth makes AUD stronger, when USD surges relatively more than AUD, then AUD weakens as the U.S. dollar strengthens. When regarding USD as base currency and AUD as quote currency, when USD value is higher than AUD, then traders need more AUD to secure USD.
The forms of exchange rate
The forms in which foreign exchange transactions occur can be classified into two major categories: underlying transaction and speculative transactions. 
Underlying transactions contains trade transactions by world trade (service included) and international capital transactions such as FDI(including CAPEX investment, job creations, OPEX etc) or equity acquisition.  Speculative transactions occur simply to obtain trading profits. At this time, foreign exchange transactions based on trade or global capital transactions are called actual demand transactions.

Portion of total foreign exchange market
In the classical concept of foreign exchange market, trade and international capital transactions were understood as the most important causes of foreign exchange transactions, but not now. Rather, speculative foreign exchange transactions have become even more prevalent Forex markets as more countries open their financial market.
Foreign exchange transactions by trade or international capital transactions account for a very small portion. Without speculative foreign exchange transactions aimed at simple trade gains, the pricing function in the foreign exchange market would be very weak. The volume of trade and capital transactions worldwide is less than 10 percent of the total foreign exchange volume and most speculative foreign exchange transactions are heavily involved in the pricing function of the foreign exchange market.

Why is speculative transaction important and what is the role of it
The exchange rate must have a sufficient amount of supply and demand to determine the appropriate exchange rate in the foreign exchange market, which is determined purely by market function, and speculative foreign exchange transactions must exist in order to secure such demand and supply. If speculative trading is prohibited and only underlying transactions are made on demand, the size of the market will not reach a certain level and as a result, the foreign exchange market's exchange rate may be distorted or the exchange rate-setting function may be lost.
For example, lets presume that only underlying transaction is on demand. When the demand of dollar is 2 million and supply is only 1 million, the currency rate will soar up in need for more supply, which will make Forex in extreme volatility.  However, when speculative transaction is traded actively, then the supply problem will be hugely diminished.

Above all, speculative trading serves to provide liquidity in the foreign exchange market by creating a sufficient supply of demand in the foreign exchange market and is a very key role.

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