Financial Markets and Instruments

Question: Discuss about the Financial Markets and Instruments. Answer: Introduction This research is based on identifying the influence of various economic factors on the exchange rate of AUD/ USD. Exchange rate refers to the rate at which a particular currency can be exchanged for another. The objective of this research is to identify the direction of movement of AUD/ USD due to changing economic scenarios. Firstly, it has been found that Chinese economy will have a fall in near future and it will impact world's commodity prices. The paper undergoes a research which states that there is a relation between falling global prices and exchange rates which will discussed in detail later. Secondly, it is also known that inflation in Australia will rise at higher rate than that of USA. Currency movements impact all the related exchange rates as described below. Besides that, there are also some forecasts regarding interest rate movements in both the countries which will again have a significant bearing on exchange rates. This will be considered in later parts of the paper . By summarizing the report, impact of exchange rates movements on financial markets is discussed. It is also known that current AUD/ USD rate is 0.6842. Few graphs and calculations have been used to substantiate the arguments. Impact of slowing down of Chinese economy on AUD/ USD exchange rate It has been forecasted that there are some pitfalls in Chinese economy and researchers say that it will have a downfall in near future. The intensity of such scenario is not so clear, but one thing is evident that it will impact the exchange rate of AUD with USD because fall in Chinese economy will have a direct bearing on the global prices of commodities. Impact of falling commodity prices Commodities, generally involve unprocessed raw materials or agricultural, mining products. They are salient for Australian economy because they hold a share of 11% in Australian GDP and a share of 55% in the country's exports. This is a significant number confirming that their price movements will have an effect on demand and supply of AUD. It is also known that a supply-demand factor causes a change in exchange rates (Lagi, Bar-Yam, Bertrand, Bar-Yam, 2015). The main reason of this impact is that commodity prices are influenced according to international markets' demand and supply. So, no single country is the price maker for commodities. Since Australian exports of commodities are relatively very small than that of the entire globe's, it is a price taker. Hence, price of commodities is an exogenous (will not be influenced in return) variable in determining exchange rate movements (Omar Kabir, 2013). If prices of commodities fall, exports of commodities will become cheaper. The law of demand says that as the prices go down, demand increases. As a result, there will be a rise in demand for Australian dollar, since Australia exports a lot in terms of commodities. This will have a positive impact on the Australian currency. Furthermore, USA is the second largest exporter in the world. But, its major export areas do not include commodities significantly. Hence, it can be concluded that Australian Dollar will become stronger in comparison to USD. This depreciation in AUD will lead to a fall in exchange rate of AUD/USD (Bhar, 2015). Impact of inflation on AUD/ USD exchange rate Another prediction affirms that there will be a rise in inflation rates in both the countries. This is a positive indicator of economic growth, and it will also have a vital impact on the countries' exchange rate. It has been ascertained that there will be a rise of 4.5% in inflation rate in Australian economy. While US inflation rates are anticipated to rise by just 2%, considerably lesser than that of Australia. The inflationary trends of USA show that there has been an increase in inflation rates in 2016. However, such increase in rates is at a very slow pace. For an economy to rise, a modest inflation is necessary. And, such a small rise will hardly impact the country's exchange rate. And, even if there is a movement in exchange rate, that would be very minimal (McDonald, 2015). (Ahmed Rogers, 2000) On the other hand, there has been a significant rise in inflation rates of Australia. The rise is higher than that of USA. The forecastsshow a rather high rise in coming future. It will also decrease the demand of currency, influencing the country's exchange rate in context of USD, as illustrated below. (Argy Nevile, 2016) If inflation rates are high in a country, this means that Consumer Price Index is rising. This implies that general level of prices of all the goods and services are likely to rise. This will render Australian produce less attractive since they will be expensive to buy.So, there will be a fall in demand of Australian currency. As a result, the currency will depreciate and AUD/USD is likely to rise. Apart from that, it will be argued that inflation in USA is also increasing. This will also lead to a fall in US currency. Hence, US currency should also depreciate. However, it is true in context of USA. But it should be noted that depreciation in US currency will be less as compared to the Australian currency since rise in inflationary rates is higher in Australia. So, overall, the impact will show an upward trend in AUD/USD exchange rate. So, conclusively, it can be said that good news about inflation implies a bad news for exchange rates in a country and vice versa (Aizenman, Hutchison , Noy, 2011). Here is a formula that can help in assessing the impact practically. D= pA pU In this formula, D stands for depreciation in one currency in relation to the other. PA and PU stands for inflation rates in Australia and USA. So, depreciation in the Australian currency in context with the USD will be 4.5% - 2% = 2.5%. This will lead to increase in the exchange rate AUD/ USD (Viney Phillips, 2015). Impact of interest rate movements on AUD/ USD exchange rate There are future predictions in regard to the interest rates movement of Australia and USA. Anticipators say that there will be a reduction in difference between Australian and US interest rates in the near future. It is also known that current interest rate in Australia is 1.75%, whereas in USA, it is just 0.500%. But it is also been estimated that US is likely to increase interest rates up to 1%. This will definitely have a bearing on foreign exchange markets in general and AUD/ USD, in particular. The graph given below clearly shows that there is a likely increase in interest rates in coming future, as the trends can be seen from now only. (Trading Economics, 2016) There is another chart showing interest rate movements in Australian economy. The rates had been decreasing in past years and continue to show the same trend, rather it can be said that the rates will remain constant in near future. (Trading Economics, 2016) First, let's have inferences on Australian currency. Interest rates in Australia are higher than that of America. Hence, Australian bonds are less attractive in comparison to the American bonds. This implies that there will be low demand of AUD and a high demand of USD. It can be said that AUD will remain feeble in comparison to USD. However, USD will be affected in a different manner. Currently, interest rates are low, so bonds will be quite attractive and there will be a high demand of currency. But, assuming the forecasts to be true, rise in interest rate will shift the market's inclination against US bonds. Hence, there will be a fall in demand of USD. But since the increased interest rates will still be lower than that of Australian, so USD will remain stronger. So, it will lead to rise in AUD/ USD exchange rate, which implies depreciation in Australian currency (Faust, Rogers, Wang, Wright, 2007). Impact on forward market exchange rate based on current scenario Forward points= spot rate [{1 + (It* forward days/ days in a year)}/ {1 + (Ib* forward days/ days in a year)}-1] In the given formula, It stands for interest rate of terms currency and Ib stands for interest rate of base currency. The base currency is the one which is listed first in the direct quote or the domestic currency. Hence, AUD is the base currency. The terms currency is the one in whose term the base currency is defined. In this case, terms currency is USD. Spot rate is given at 0.6842. Earlier, assuming interest rates have not changed, It is 0.5% and Ib is 1.75%. So, forward market points after, say 30 days, will be 0.01826 using Day count convention of actual/ 360. If the situations change as they are anticipated, then It will b 1% and Ib will remain same. Now, forward market points will be 0.04636. Hence, the forward or spot market exchange rates will rise (Viney Phillips, 2015). Impact of rate of economic growth on AUD/ USD exchange rate There has been some anticipation that are difficult to be digested. According to OECD (Organization for Economic Co- operation and Development), the economic growth rate of Australia will slow down for the first time after the global financial crisis that happened in 2008. Australian economy had been strong or performing on an average, but there has never been slowdown news. It further asserts that the USA's economic growth rate will be at a higher pace as compared to Australia. Economic events will certainly impact the exchange rates under study. The picture below shows a rise in economic growth rate of USA, as researched Bureau of economics, USA. There has been a significant rise in GDP in second quarter of 2016 as compared to the first quarter results. This shows that the economy has an upright growth rate. (US Department of Commerce, 2016) As compared to the US economy's trends of growth, Australia has a slow pace of growth as evident by the report published in Trading Economics. A glimpse is shown below in the graph. (Trading Economics, 2016) The economic growth of a country implies that there will be arise in gross domestic product, i.e. total production of goods and services in the country. It will also imply a rise in national income and even, the personal disposable income of the population. Besides that, other economic factors will also be rising like inflation, interest rates, employment levels, etc. Overall, this shows that an economy is becoming strong. However, this is not so in context of current case study of Australia and USA. Australian economy is showing a downward trend. Hence, AUD will be fragile in comparison to USD. This is also evident from the fact that the US economy is rising at faster pace. Hence, USD will appreciate and AUD will depreciate. The overall impact on the AUD/ USD exchange rate will be that it will rise (Rodrik, 2008). Impact of change in exchange rates on financial markets Financial markets comprise many instruments like T- bills, bonds, Commercial papers, Certificate of Deposits, Equity, Debentures, Derivatives, Foreign exchange, etc. Out of all of this, equity and debentures are considered to be the most significant financial instruments. It has been recently identified that there has been a significant relationship between the stock returns and exchange rates. Researchers have conducted studies to show that both factors have a bi- directional bearing on each other. In US markets, a study had been conducted which had shown that there is a negative relationship that exist between the exchange rates and stock market returns. To substantiate the argument, it has been stated that if a currency becomes strong, then bonds and stocks in different currency becomes cheaper. This is so because in conversion, one will get more holdings by giving the same amount of money. Hence, demand for foreign market stocks will rise. This implies that the host country's fin ancial markets performance will deteriorate and the same impact will be on stock market returns. The same studies have been conducted in Asian countries as well, which have supported the argument (Chaney, 2016). Conclusion The concluding comments on the AUD/ USD exchange rates in a single sentence will say that Australian Dollar will depreciate under the current scenario. Hence, AUD/ USD exchange rate is likely to rise. In more concrete terms, the current situations say that increase in inflation in Australia will lead to rise in AUD/ USD exchange rate. It has also been identified that decrease in global prices of commodities will lead to fall in this exchange rate. Further, interest rate movements will have an upward bearing on the exchange rate of AUD/ USD. Also, slowdown in rate of economic growth will raise this exchange rate. Hence, an overall impact will be that the underlying exchange rate will rise. Besides that, movement in exchange rates will also influence financial markets and in particular, trading in currency markets. Particularly, for this situation, more of AUD will be paid to acquire 1USD. References Ahmed, S., Rogers, J. H. (2000). Inflation and the great ratios: Long term evidence from the US. Journal of Monetary Economics, 45(1), 3-35. Aizenman, J., Hutchison, M., Noy, I. (2011). Inflation targeting and real exchange rates in emerging markets. World Development, 39(5). Argy, V. 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