Foreign Exchange Market and Forward Exchange Rate Essay

Foreign Exchange Market and Forward Exchange Rate - Essay Example Foreign markets handle large transactions instantaneously at a cheap transaction cost. Rational speculative bubbles cause the exchange rates to differ from its fundamental valuation. Foreign Exchange Markets readjust to cushion the market from the departure of technical efficiency. These departures may be from panicking traders, noise traders, herding instinct, and bandwagon effects. Other factors that may lead to misalignments in the Exchange markets include traders that are caught in liquidity squeeze in other financial markets. They bring volatility to the Exchange Markets. Some forecasters strongly believe that foreign exchange markets are efficient. Similarly, they argue that forward exchange rates are unbiased predictors of future spot rates .To establish validity of efficiency in foreign exchange markets, this paper will explore the international finance theories. It will support the claims through use of appropriate examples. Efficiency in Foreign Exchange Markets Efficiency in foreign exchange market encompasses a reflection of the relevant information regarding exchange rates. Efficiency considers both the forward and spot exchange rates. Testing efficiency requires analysis of two aspects of exchange rates. These are the spot rate and the forward rate. The forward rate should have all available information about future expectations of foreign exchange rate. Analysts argue that the market is efficient when the prices reflect all relevant information. This means that the traders cannot make any alteration in order to get unjustifiable profits. The market efficiency is very beneficial to investors, exchange rate forecasters, and policy makers (Brigham & Huston, 2012: 591). The theory of efficient market demands foreign exchange markets should embrace full information of the prices. This means that traders cannot make profits through malicious old information. In addition, they cannot use the past trends of the