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Exchange rate

In finance, the exchange 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 to the Dollar means that 120 is worth the same as $1. An exchange rate is also known as a foreign exchange rate, or FX rate. The Currency Market or Foreign Exchange Market is the largest market in the world. By some estimates, about $2 trillion worth of currency changes hands every day.

An exchange rate quotation is given by stating the number of units of a price currency that can be bought in terms of a unit currency. For example, in a quotation that says the Euro-United States Dollar exchange rate is 1.2 dollars per euro, the price currency is the dollar and the unit currency is the euro.

Quotes using a country's home currency as the price currency are known as direct or price quotation (from that country's perspective) ([1]) and are used in the US and most other countries.

Quotes using a country's home currency as the unit currency are known as indirect or quality terms quotation and are used in British newspapers and are also common in Australia and New Zealand.

  • 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, i.e. if the currency is becoming more valuable) then the exchange rate number increases. Conversely if the price currency is strengthening, the exchange rate number decreases and the unit currency is depreciating.

Contents

Mechanics of trading

The only real currency market is the 'deliverable' orders for individuals and businesses who need to buy and sell x currency at any rate. If you are buying a house in New Zealand, or a farm in Ireland, you will exchange your dollars regardless of the rate. This deliverable business drives the prices up and down unless rates are pegged (see below) like China's Yuan is pegged to the US dollar 8.23 YUAN to 1 USD.

It is possible for investors to speculate on currency fluctuations and realize profits by parking funds in one currency, and after it appreciates in value, switching to another. In our floating point system actually every investment in the world is calculated in some domestic currency. So when you are making 20% on your investment in the USDollar by investing in the DJIA, realize that if the dollar has gone down by 40% then you have actually lost money. This will not be reflected in your bank statements of course, but it will be reflected in the purchasing power of your dollars when you go to spend them. This is tied to inflation. For example, if you turn a $10,000 investment into $15,000 this may at first seem like a successful investment, however if the US dollar is down by 50%, then it will costs twice as much for a gallon of gas.

Like any market there is a bid and an ask (buying price and selling price). The real spread between currencies is actually 1 or 2 pips. In the EURO/USDOLLAR price of 1.4238 a pip would be the '8' at the end. So the bid/ask quote of EUR/USD might be 1.4238/1.4239 - however a bank will mark up the difference to say 1.41 / 1.43 . To most travelers exchanging 10 or 100 or even 1,000 dollars this is only a few dollars, but if you are a business exchanging millions, this can be a huge risk. To mitigate this risk a business will hedge a currency, for example buying a contract to buy 6 months worth of EURO at a set price. He will never make money on the currency, but he will never lose, and he can make a budget for selling his products.

Free or pegged

Main article: Exchange rate regime

If a currency is free-floating its exchange rate against other countries can vary against other such currencies. In fact such exchange rates are likely to be changing almost constantly as quoted by financial markets and 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 pegged to the United States dollar.

Nominal and real exchange rates

  • The nominal exchange rate is the rate at which an organisation can trade the currency of one country for the currency of another.
  • The real exchange rate is the rate at which an organisation 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 German currency against the UK currency, the price of the good remains constant for a German despite increase in price for people in the UK.

Fluctuations in exchange rates

A market based exchange rate will change whenever the value 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.

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 the price of the Yuan jumped.

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, where options are derivatives of exchange rates.

Foreign exchange markets

Top 7 Most Traded Currencies
Rank Currency ISO 4217 Code Symbol
1 United States Dollar USD $
2 Japanese Yen JPY
3 EU Euro EUR
4 Canadian Dollar CAD $
5 British Pound Sterling GBP
6 Australian Dollar AUD $
7 Swiss Franc CHF

The foreign exchange markets are usually highly liquid as the main international banks continually provide the market with both bid (buy) and ask (sell) offers. The volume of trading in the foreign exchange markets exceeds that in any other market, liquidity is extremely high.

In the foreign exchange markets there is little or no 'inside information'. Rate fluctuations are usually to do with world economy or the national economies so significant news is released publicly so, at least in theory, everyone in the world receives the same news at the same time. This is in contrast to the equity market where a stock may lose value by 5% or more, and only later do the reasons for this become apparent when a newspaper reports that forecasts for that company have been revised downward, or that a key executive has resigned (this is why insider trading in stock markets can be a problem).

Big foreign exchange trading centres are located in New York, Tokyo, London, Hong Kong, Singapore, Paris and Frankfurt amongst others and the foreign exchange market is open 24 hours per day throughout the week (closing worldwide Friday afternoon and reopening Sunday afternoon). If the European Market is closed the Asian Market or US will be open on the other and so all world currencies can be continually in trade. Traders can react to news when it breaks, rather than waiting for the market to open, as is the case with most other markets. This enables traders to take positions anticipating the impact on the exchange rate of important news items.

In the foreign exchange markets there is never a 'bear' market. Currencies are traded in pairs; every trade involves the selling of one currency and the buying of another. If some currencies are going down, others must be going up.

Scale

Average daily international foreign exchange trading volume reached $1.9 trillion in April of 2004 according to the September 29 2004 issue of the Wall Street Journal.

See also

External links

Last updated: 10-29-2005 02:13:46