Exchange rate

In finance, the exchange rate (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies specifies how much one currency is worth in terms of the other. For example an exchange rate of 120 Japanese yen (JPY, ¥) to the United States dollar (USD, $) means that JPY 120 is worth the same as USD 1. The foreign exchange market is one of the largest markets in the world. By some estimates, about 2 trillion USD worth of currency changes hands every day.

The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date.

Quotations

An exchange rate quotation is given by stating the number of units of a price currency that can be bought in terms of 1 unit currency. For example, in a quotation that says the EUR-USD exchange rate is 1.2 USD per EUR, the price currency is USD and the unit currency is EUR.

Quotes using a country's home currency as the price currency (e.g., £0.574744 = $1 in the UK) are known as direct quotation or price quotation (from that country's perspective) (^*) and are used by most countries.

Quotes using a country's home currency as the unit currency (e.g., $1.73990 = £1 in the UK) are known as indirect quotation or quantity quotation and are used in British newspapers and are also common in Australia, New Zealand and Canada.

direct quotation: Home Currency / Foreign Currency
indirect quotation: Foreign Currency / Home Currency

Note that, using direct quotation, if a unit currency is strengthening (i.e., appreciating, or becoming more valuable) then the exchange rate number decreases. Conversely if the price currency is strengthening, the exchange rate number increases and the unit currency is depreciating.

When looking at a currency pair such as EUR/USD, many times the first component (EUR in this case) will be called the base currency. The second is called the counter currency.

Free or pegged

If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies and is determined by the market forces of supply and demand. Exchange rates for such currencies are likely to change almost constantly as quoted on financial markets, mainly by banks, around the world. If the value of the currency is "pegged" its value is maintained by the government in question at a fixed rate relative to the other currency. For example, in 1983 the Hong Kong dollar was linked to the United States dollar. And the Nepalese rupee is always pegged to the Indian rupee at Re 1.0 = NRs 1.6

Nominal and real exchange rates

The nominal exchange rate is the rate at which an organization can trade the currency of one country for the currency of another.
The real exchange rate is an important concept in economics though difficult to grasp in reality. The real exchange rate is defined as rer=e(P/P*) where e is the exchange rate as number of foreign currency units per home currency unit and P is the price level of the home country and P* the foreign price level.

Unfortunately, in real life there is not just one foreign currency and not just one price level -so the calculation of the real exchange rate gets more complex. Further, the above definition is based on purchasing power parity (PPP) which implies a constant real exchange rate which could not be verified empirically. PPP would imply that i.e. the real exchange rate was the rate at which an organization can trade goods and services of one country for those of another. For example, say the price of a good increases 10% in the UK, and there is also a 10% appreciation in the Japanese currency against the UK currency, the price of the good remains constant for someone in Japan despite increase in price for people in the UK. In cases where tariffs become an issue, this would be less the case. More recent approaches try to model the real exchange rate by a set of macroeconomic variables such as relative productivity and the real interest rate differential.

Fluctuations in exchange rates

A market based exchange rate will change whenever the values of either of the two component currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than available supply (this does not mean people no longer want money, it just means they prefer holding their wealth in some other form, possibly another currency).

Increased demand for a currency is due to either an increased transaction demand for money, or an increased speculative demand for money. The transaction demand for money is highly correlated to the country's level of business activity, gross domestic product (GDP), and employment levels. The more people there are out of work, the less the public as a whole will spend on goods and services. Central banks typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions.

The speculative demand for money is much harder for a central bank to accommodate but they try to do this by adjusting interest rates. An investor may choose to buy a currency if the return (that is the interest rate) is high enough. The higher a country's interest rates, the greater the demand for that currency. It has been argued that currency speculation can undermine real economic growth, in particular since large currency speculators may deliberately create downward pressure on a currency in order to force that central bank to sell their currency to keep it stable (once this happens, the speculator can buy the currency back from the bank at a lower price, close out their position, and thereby take a profit).

In choosing what type of asset to hold, people are also concerned that the asset will retain its value in the future. Most people will not be interested in a currency if they think it will devalue. A currency will tend to lose value, relative to other currencies, if the country's level of inflation is relatively higher, if the country's level of output is expected to decline, or if a country is troubled by political uncertainty. For example, when Russian President Vladimir Putin dismissed his Government on February 24, 2004, the price of the ruble dropped. When China announced plans for its first manned space mission, synthetic futures on Chinese yuan jumped (since China's currency is officially pegged, synthetic markets have emerged that can behave as if the yuan was floating).

Like the stock exchange, money can be made or lost on the foreign exchange market by investors and speculators buying and selling at the right times. Currencies can be traded at spot and foreign exchange options markets. The spot_market represents current exchange rates, whereas options are derivatives of exchange rates.

Foreign exchange markets

The foreign exchange markets are usually highly liquid as the world's main international banks provide a market around-the-clock. The Bank for International Settlements reported that global foreign exchange market turnover daily averages in April was $650 billion in 1998 (at constant exchange rates) and increased to $1.9 trillion in 2004 (Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity 2004 - Final Results). The biggest foreign exchange trading centre is London, followed by New York and Tokyo.

External links

BBC cross rates
Disk Lectures MBA level audio lecture with slideshow on foreign exchange rates
Federal Reserve daily update
Federal Reserve daily history since 2000
Foreign Currency Units per 1 U.S. Dollar, 1948 - 2004

Macroeconomics | International trade | International economics | Currency

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