In finance, an exchange rate between two currencies is the rate at which one currency will be
exchanged for another.
It is also regarded as the value of one country’s currency in terms of another currency.
For example, an interbank exchange rate of 91 Japanese yen to the United States dollar
means that ¥91 will be exchanged for each US$1 or that US$1 will be exchanged for each
¥91.
Exchange rates are determined in the foreign exchange market, which is open to a wide range
of different types of buyers and sellers where currency trading is continuous: 24 hours a
day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday.
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.
In the retail currency exchange market, a different buying rate and selling rate will
be quoted by money dealers.
Most trades are to or from the local currency.
The buying rate is the rate at which money dealers will buy foreign currency, and the
selling rate is the rate at which they will sell the currency.
The quoted rates will incorporate an allowance for a dealer's margin in trading, or else
the margin may be recovered in the form of a "commission" or in some other way.
Different rates may also be quoted for cash, a documentary form or electronically.
The higher rate on documentary transactions is due to the additional time and cost of
clearing the document, while the cash is available for resale immediately.
Some dealers on the other hand prefer documentary transactions because of the security concerns
with cash.
Retail exchange market People may need to exchange currencies in
a number of situations.
For example, people intending to travel to another country may buy foreign currency in
a bank in their home country, where they may buy foreign currency cash, traveler's cheques
or a travel-card.
From a local money changer they can only buy foreign cash.
At the destination, the traveler can buy local currency at the airport, either from a dealer
or through an ATM.
They can also buy local currency at their hotel, a local money changer, through an ATM,
or at a bank branch.
When they purchase goods in a store and they do not have local currency, they can use a
credit card, which will convert to the purchaser's home currency at its prevailing exchange rate.
If they have traveler's cheques or a travel card in the local currency, no currency exchange
is necessary.
Then, if a traveler has any foreign currency left over on their return home, they may want
to sell it, which they may do at their local bank or money changer.
The exchange rate as well as fees and charges can vary significantly on each of these transactions,
and the exchange rate can vary from one day to the next.
There are variations in the quoted buying and selling rates for a currency between foreign
exchange dealers and forms of exchange, and these variations can be significant.
For example, consumer exchange rates used by Visa and MasterCard offer the most favorable
exchange rates available, according to a Currency Exchange Study conducted by CardHub.com.
This studied consumer banks in the U.S., and Travelex, showed that the credit card networks
save travelers about 8% relative to banks and roughly 15% relative to airport companies.
Quotations
A currency pair is the quotation of the relative value of a currency unit against the unit
of another currency in the foreign exchange market.
The quotation EUR/USD 1.3533 means that 1 Euro is able to buy 1.3533 US dollar.
In other words, this is the price of a unit of Euro in US dollar.
Here, EUR is called the "Fixed currency", while USD is called the "Variable currency".
There is a market convention that determines which is the fixed currency and which is the
variable currency.
In most parts of the world, the order is: EUR – GBP – AUD – NZD – USD – others.
Accordingly, a conversion from EUR to AUD, EUR is the fixed currency, AUD is the variable
currency and the exchange rate indicates how many Australian dollars would be paid or received
for 1 Euro.
Cyprus and Malta which were quoted as the base to the USD and others were recently removed
from this list when they joined the Eurozone.
In some areas of Europe and in the non-professional market in the UK, EUR and GBP are reversed
so that GBP is quoted as the base currency to the euro.
In order to determine which is the base currency where both currencies are not listed, market
convention is to use the base currency which gives an exchange rate greater than 1.000.
This avoids rounding issues and exchange rates being quoted to more than four decimal places.
There are some exceptions to this rule, for example, the Japanese often quote their currency
as the base to other currencies.
Quotes using a country's home currency as the price currency are known as direct quotation
or price quotation and are used by most countries.
Quotes using a country's home currency as the unit currency are known as indirect quotation
or quantity quotation and are used in British newspapers and are also common in Australia,
New Zealand and the Eurozone.
Using direct quotation, if the home currency is strengthening then the exchange rate number
decreases.
Conversely, if the foreign currency is strengthening, the exchange rate number increases and the
home currency is depreciating.
Market convention from the early 1980s to 2006 was that most currency pairs were quoted
to four decimal places for spot transactions and up to six decimal places for forward outrights
or swaps..
An exception to this was exchange rates with a value of less than 1.000 which were usually
quoted to five or six decimal places.
Although there is not any fixed rule, exchange rates with a value greater than around 20
were usually quoted to three decimal places and currencies with a value greater than 80
were quoted to two decimal places.
Currencies over 5000 were usually quoted with no decimal places.
e.g.. In other words, quotes are given with five digits.
Where rates are below 1, quotes frequently include five decimal places.
In 2005, Barclays Capital broke with convention by offering spot exchange rates with five
or six decimal places on their electronic dealing platform.
The contraction of spreads arguably necessitated finer pricing and gave the banks the ability
to try and win transaction on multibank trading platforms where all banks may otherwise have
been quoting the same price.
A number of other banks have now followed this system.
Exchange rate regime
Each country, through varying mechanisms, manages the value of its currency.
As part of this function, it determines the exchange rate regime that will apply to its
currency.
For example, the currency may be free-floating, pegged or fixed, or a hybrid.
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.
A movable or adjustable peg system is a system of fixed exchange rates, but with a provision
for the revaluation of a currency.
For example, between 1994 and 2005, the Chinese yuan renminbi was pegged to the United States
dollar at RMB 8.2768 to $1.
China was not the only country to do this; from the end of World War II until 1967, Western
European countries all maintained fixed exchange rates with the US dollar based on the Bretton
Woods system.
[1] But that system had to be abandoned in favor of floating, market-based regimes due
to market pressures and speculations in the 1970s.
Still, some governments strive to keep their currency within a narrow range.
As a result, currencies become over-valued or under-valued, leading to excessive trade
deficits or surpluses.
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.
Increased demand for a currency can be due to either an increased transaction demand
for money or an increased speculative demand for money.
The transaction demand is highly correlated to a country's level of business activity,
gross domestic product, and employment levels.
The more people that are unemployed, 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.
Speculative demand is much harder for central banks to accommodate, which they influence
by adjusting interest rates.
A speculator may buy a currency if the return is high enough.
In general, the higher a country's interest rates, the greater will be the demand for
that currency.
It has been argued that such speculation can undermine real economic growth, in particular
since large currency speculators may deliberately create downward pressure on a currency by
shorting in order to force that central bank to buy their own currency to keep it stable.
For carrier companies shipping goods from one nation to another, exchange rates can
often impact them severely.
Therefore, most carriers have a CAF charge to account for these fluctuations.
Purchasing power of currency The real exchange rate is the purchasing power
of a currency relative to another at current exchange rates and prices.
It is the ratio of the number of units of a given country's currency necessary to buy
a market basket of goods in the other country, after acquiring the other country's currency
in the foreign exchange market, to the number of units of the given country's currency that
would be necessary to buy that market basket directly in the given country . There are
different kind of measurement for RER.
Thus the real exchange rate is the exchange rate times the relative prices of a market
basket of goods in the two countries.
For example, the purchasing power of the US dollar relative to that of the euro is the
dollar price of a euro times the euro price of one unit of the market basket divided by
the dollar price of the market basket, and hence is dimensionless.
This is the exchange rate times the relative price of the two currencies in terms of their
ability to purchase units of the market basket.
If all goods were freely tradable, and foreign and domestic residents purchased identical
baskets of goods, purchasing power parity would hold for the exchange rate and GDP deflators
of the two countries, and the real exchange rate would always equal 1.
The rate of change of this real exchange rate over time equals the rate of appreciation
of the euro plus the inflation rate of the euro minus the inflation rate of the dollar.
Bilateral vs. effective exchange rate
Bilateral exchange rate involves a currency pair, while an effective exchange rate is
a weighted average of a basket of foreign currencies, and it can be viewed as an overall
measure of the country's external competitiveness.
A nominal effective exchange rate is weighted with the inverse of the asymptotic trade weights.
A real effective exchange rate adjusts NEER by appropriate foreign price level and deflates
by the home country price level.
Compared to NEER, a GDP weighted effective exchange rate might be more appropriate considering
the global investment phenomenon.
Uncovered interest rate parity
Uncovered interest rate parity states that an appreciation or depreciation of one currency
against another currency might be neutralized by a change in the interest rate differential.
If US interest rates increase while Japanese interest rates remain unchanged then the US
dollar should depreciate against the Japanese yen by an amount that prevents arbitrage.
The future exchange rate is reflected into the forward exchange rate stated today.
In our example, the forward exchange rate of the dollar is said to be at a discount
because it buys fewer Japanese yen in the forward rate than it does in the spot rate.
The yen is said to be at a premium.
UIRP showed no proof of working after the 1990s.
Contrary to the theory, currencies with high interest rates characteristically appreciated
rather than depreciated on the reward of the containment of inflation and a higher-yielding
currency.
Balance of payments model The balance of payments model holds that foreign
exchange rates are at an equilibrium level if they produce a stable current account balance.
A nation with a trade deficit will experience a reduction in its foreign exchange reserves,
which ultimately lowers the value of its currency.
A cheaper currency renders the nation's goods more affordable in the global market while
making imports more expensive.
After an intermediate period, imports will be forced down and exports to rise, thus stabilizing
the trade balance and bring the currency towards equilibrium.
Like purchasing power parity, the balance of payments model focuses largely on trade-able
goods and services, ignoring the increasing role of global capital flows.
In other words, money is not only chasing goods and services, but to a larger extent,
financial assets such as stocks and bonds.
Their flows go into the capital account item of the balance of payments, thus balancing
the deficit in the current account.
The increase in capital flows has given rise to the asset market model effectively.
Asset market model
The increasing volume of trading of financial assets has required a rethink of its impact
on exchange rates.
Economic variables such as economic growth, inflation and productivity are no longer the
only drivers of currency movements.
The proportion of foreign exchange transactions stemming from cross border-trading of financial
assets has dwarfed the extent of currency transactions generated from trading in goods
and services.
The asset market approach views currencies as asset prices traded in an efficient financial
market.
Consequently, currencies are increasingly demonstrating a strong correlation with other
markets, particularly equities.
Like the stock exchange, money can be made on trading by investors and speculators in
the foreign exchange market.
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.
Manipulation of exchange rates A country may gain an advantage in international
trade if it controls the market for its currency to keep its value low, typically by the national
central bank engaging in open market operations.
The People's Republic of China has been acting this way over a long period of time.
Other nations, including Iceland, Japan, Brazil, and so on also devalue their currencies in
the hopes of reducing the cost of exports and thus bolstering their economies.
A lower exchange rate lowers the price of a country's goods for consumers in other countries,
but raises the price of imported goods and services, for consumers in the low value currency
country.
In general, a country that exported goods and services will prefer a lower value on
their currencies, while a country that imported goods and services will prefer a higher value
on their currencies.
See also
Bureau de change Currency pair
Currency strength Effective exchange rate
Euro calculator Foreign exchange market
Foreign exchange fraud Functional currency
Tables of historical exchange rates to the USD
Telegraphic transfer USD Index
References