PROJECTING FOREIGN CURRENCY VALUES

Participants in foreign exchange markets also deal for future values. Such dealing composes the forward markets or futures markets for currencies (Lu, 1997). Active forward markets exist for a few heavily traded currencies and for several time intervals corresponding to actively dealt maturities in the money market.

Risk management has been the traditional role of the futures markets. Traders, as an example, use currency futures to protect (hedge) themselves against fluctuations in exchange rates that may be detrimental to their profit margins. A United States trader who needs foreign currency for a business transaction in six months could sell a futures foreign currency contract for the same amount maturing in six months. If after six months the United States dollar depreciated relative to the foreign currency, the trader would incur losses in the spot market, but gains from the futures contract offset those losses exactly. On the other hand, if the dollar appreciated relative to the foreign currency, the trader would incur losses in the futures market that would exactly offset gains in the spot market. Thus, in a typical hedge, the gains or losses tend to offset each other (Kapila & Hendrickson, 2001).

Participants in currency the futures market require some method of projecting currency exchange rates. Although there exist many models to forecast and manage foreign exchange rate changes, three models have demonstr

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n of currency exchange rates. The basis of this model is an assumption that an equilibrium currency exchange rate will maintain a balance in a country's current account, after allowing for short-term fluctuations resulting from the effects of business cycles and trade barriers. Underlying this model is the theory that countries running current account deficits over an extended period of time will eventually become debtor countries, and that such deficits can persist only as long creditor countries are willing to absorb added debt from the country in deficit. When the willingness to absorb added debt ends, the exchange value of the deficit country's currency will be decline. Thus, the reasoning is that only those currency exchange rates that will maintain a country's current account in balance are sustainable over the long-term (Paek, 2000). While there is likely a great deal of theoretical validity in the CABM, the problems lie in application. There have been no means developed to accurately predict how long the time will be in which creditor countries will continue to absorb debt from a country in current account deficit. Thus, while current account deficits will likely cause a country's currency exchange rates to return

Category: Economics - P