Table of contents:
1. Introduction
2. The Balanced Portfolio Investment Theory and the Purchasing Power Parity Theory
3. The significance of the Balanced Portfolio Investment Theory to currency dealers on the Foreign Exchange Market
4. Conclusion
5. Works cited
Introduction
Basically, the development of the world economy is characterized by the growing impact of the process of globalization which affects practically all countries of the world and, to a significant extent, determines the development of business. In this regard, currency transactions should be viewed in the context of the process of globalization. At this point, it is important to underline the fact that the development of currency transactions in the contemporary world is basically determined by the growing international cooperation and openness of markets of countries. In fact, nowadays, there are practically no fiscal barriers on the way of the international trade that naturally stimulates the development of international currency transactions. The latter is actually the natural result of the rapid development of international trade.
Obviously, international currency exchange is an essential part of any international transactions since whatever the product or service is a company needs to exchange the currency received in the result of the transactions and get the national currency that is valid within the country where the company is actually based. In this respect, it should be said that the development of the international currency exchange is based on the application of various theories which can help investors to achieve possibly better results. It is not a secret that companies traditionally focus on the maximization of their profits and, in such a situation, the application of the effective theory or strategy in relation to the international currency exchange may be very helpful and contribute consistently to the market performance of a company.
Among the most widely spread theories which produce a profound impact on the development of theoretical basis of the international currency exchange and the adequate assessment of the potential of currencies, it is possible to name the Balanced Portfolio Investment Theory and the Purchasing Power Parity Theory.
The Balanced Portfolio Investment Theory and the Purchasing Power Parity Theory
First of all, it should be pointed out that one of the major challenges the contemporary international currency market faces is the problem of the precise definition of the currency exchange rate. In fact, this problem is very important in regard to the growing importance of the adequate assessment of the currency potential in different markets. What is meant here is the fact that the development of international trades contributes consistently to the penetration of companies into new markets as well as to the development of the international trade. Naturally, in such a situation, companies have to take into consideration the local currency rate in order to adequately assess its perspectives in the process of entering new markets. At the same time, the precise definition of the currency rate is extremely important in terms of the international trade because it can influence substantially the price of products and services in different markets.
In this respect, it is necessary to underline that companies operating worldwide naturally tend to maintain the price at such a level that could allow them to maximize their profit and create the positive basis for the further development of business in a particular country. Obviously, in order to adequately price products and services companies need to adequately assess and define the local currency rate. At the same time, many multinational corporations tend to develop the policy, including pricing policy that could be universal that makes the precise definition of the currency rate particularly significant. In fact, any problems in definition of the precise currency rate inevitably lead to the misbalancing of business at large because the company that deals with a specific market cannot develop business normally if the currency rate is not defined correctly because it will inevitably lead to substantial losses, if the currency rate is defined lower than it actually is, or, in stark contrast, the overestimation of the actual currency rate will lead to the establishment of too high price of product or services sold by a company in the market.
In such a situation, it is necessary to develop a clear mechanism that can assist to the solution of the problem of the precise definition of the international currency rate. In this regard, it is possible to refer to two major theories that are particularly popular nowadays ”“ the Balanced Portfolio Investment Theory and the Purchasing Power Parity Theory. Basically, these theories may be viewed as similar in a way, but still, it is necessary to emphasize that each theory has its own distinguishable feature which make it really unique, especially in the context of the definition of the international currency exchange.
Speaking about the Balanced Portfolio Investment Theory, it should be said that the major principle, the backbone of this theory is the idea that in order to optimize portfolio it is necessary to use diversification. On the one hand, the diversification will optimize the portfolio performance, while on the other hand, it will portfolio risks. Basically, such a result is achieved by means of holding a diversified portfolio of assets (Lintner, 23). It should be pointed out that the balance of the portfolio may change in the course of time and, therefore, it is necessary to maintain the balance and improve the performance in order to avoid possible portfolio risks. In actuality, there are two major ways of minimization of risks and improvement of the portfolio performance. In fact, it is possible either to sell down shares or currency, for instance, or, alternatively, it is possible to increase investment exposure to other assets.
On applying this theory to the problem of the definition of the international currency rate, it should be said that it is possible to define the currency rate through the analysis of the current demand for this currency and its stability. In fact, it is important to understand that investors, as the portfolio changes inevitably face a problem of choice between selling down the currency or investment to other assets. This means that at certain point, companies may need to sell down the currency under the impact of portfolio changes. Consequently, the sales of the currency indicate to its current weakness because the demand for the currency decreases proportionally to the growth of sales. On the other hand, it is possible to increase the investments to other assets that means that it is possible to use the currency for the investments to other currencies. In such a situation, investors, as a rule, prefer the more stable currency. At the same time, the growing attention of investors to the particular currency will naturally increase its rate. As a result, on the basis of the growing demand on the particular currency it is possible to define the international currency rate through its comparison to other currencies and basic trends that they demonstrate in the world market.
In such a situation, it is possible to speak about the balance in investments which actually define the position of the currency since the growing investments indicate to the growth of the international currency rate, while sales down of the currency indicate to its dropping rate. At the same time, it is important to underline that at certain points the currency is in a kind of balance when investments in the currency and its sales are balanced and match each other. At such points, it is possible to speak about the stability of the international currency rate and often such stable currency may be viewed as samples to which other currencies may be compared to. In this respect, it should be said that traditionally, the US dollar was one of such currencies, though, recently, its international currency rate has been undermined and nowadays investors prefer to sell down this currency, though this process has not reached the mass scale yet.
As for the Purchasing Power Parity Theory, it should be said that basically this theory implies that a unit of any given currency should be able to buy the same quantity of goods in all countries. In fact, in terms of the Purchasing Power Parity Theory the international currency rate may be defined on the basis of the purchasing power of currency in regard to the identical product sold in different countries. In such a context, the example of Big Mac may be viewed as a universal example that perfectly explains the essence of the Purchasing Power Parity Theory. In this respect, it should be said that Big Mac is viewed as a kind of the universal criterion on the basis of which the actual currency rate is defined. To put it more precisely, Big Mac is sold in many countries of the world and basically its price is considered to be identical in all countries where this product is sold. As a result, the disparity in the price of Big Mac may be viewed as indicators of the currency rate since Big Mac is supposed to have the same price worldwide.
Consequently, as its price is the same than the currency rate is defined by its price.
In order to better understand the essence of the Purchasing Power Parity Theory, it is necessary to point out that this theory is based on the law of one price (Cooper, 211), as it has been just described in the example concerning Big Mac. This law of one price implies that a good must sell at the same price, regardless of location. This is the basic principle of the theory which reveals the mechanism with the help of which it is possible to define the international currency rate and which distinguishes the Purchasing Power Parity Theory from the Balanced Portfolio Investment Theory, which rather implies not the purchasing power of certain goods that have the same price, but rather the balance of currency and the demand for and investment in currency.
The significance of the Balanced Portfolio Investment Theory to currency dealers on the Foreign Exchange Market
It proves beyond a doubt that the Balanced Portfolio Investment Theory plays a very important role in the international currency exchange market. In this respect, it should be said that currency dealers should take into consideration basic ideas and principles of the Balanced Portfolio Investment Theory in order to maintain the portfolio positive performance and, therefore, achieve positive results in their market performance at large. It is important to underline that the Balanced Portfolio Investment Theory provides currency dealers with the theoretical foundation for the development of their business.
In actuality, the practical application of this theory implies that currency dealers can react adequately on the change of their portfolio and, what is more important, maximize their profits while selecting their strategy of actions and their policy in response to the changing business environment. Basically, the Balanced Portfolio Investment Theory, being applied to the Foreign Exchange Market may be very helpful because the Foreign Exchange Market is susceptible to the significant fluctuations of currency rate which may vary consistently depending on the changes in the business environment, as well as some political changes or natural disasters can also affect considerably the international currency rate and the Foreign Exchange Market at large.
It should be said that the Balanced Portfolio Investment Theory is particularly important in regard to efforts of currency dealers to re-balance their portfolio. The latter occurs often because of the frequent international currency rate change. According to the Balanced Portfolio Investment Theory, currency dealers can re-balance their portfolio applying traditional tools, which have been already defined above. To put it more precisely, it is possible either to sell currency which rate is progressively dropping to minimize potential losses or, instead, it is possible to invest to another currency and, thus, re-balance the portfolio.
However, in terms of the Balanced Portfolio Investment Theory, it is possible to offer a different solution to re-balance the portfolio, which, by the way, is very popular at the present moment. What is meant here is the so-called strategy of cash extraction, which may be applied by currency dealers on the Foreign Exchange Market.
Traditionally, this strategy involves exchanging shares for the equivalent number of installments plus cash (Heilbroner and Milberg, 173). The same mechanism may be applied to currency and this may help re-balance the portfolio consistently minimizing losses and risks for currency dealers on the Foreign Exchange Market.
Conclusion
Thus, taking into account all above mentioned, it is possible to conclude that the international currency rate is extremely important in the contemporary business environment because of the growing international cooperation and free trade between countries. At the same time, there remains a problem of the precise definition of the international currency rate and, in this regard, various theories may be applied, but the Balanced Portfolio Investment Theory and the Purchasing Power Parity Theory seem to be the most effective. At any rate, these two theories are the most popular and widely spread in the contemporary business environment and they are widely applied to define the international currency rate. In such a situation, it is quite natural that the Balanced Portfolio Investment Theory is very important to currency dealers operating on the Foreign Exchange Market and it may be very helpful in re-balancing their portfolios.