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 (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) ([1]) 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 (RER) is an important concept in economics, though it is quite difficult to grasp concretely. It is defined by the model: RER = e(P/P*), where 'e' is the exchange rate, as the number of foreign currency units per home currency unit; where P is the price level of the home country; and where P* is the foreign price level.

Unfortunately, this compact and simple model for RER calculations is only a theoretical ideal. In practical usage, there are many foreign currencies and price level values to take into consideration. Correspondingly, the model calculations become increasingly more complex. Furthermore, the model is based on purchasing power parity (PPP), which implies a constant RER. The empirical determination of a constant RER value could never be realised, due to limitations on data collection. PPP would imply that the RER is the rate at which an organization can trade goods and services of one economy (e.g. country) for those of another. For example, if the price of a good increases 10% in the UK, and the Japanese currency simultaneously appreciates 10% against the UK currency, then the price of the good remains constant for someone in Japan. The people in the UK, however, would still have to deal with the 10% increase in domestic prices. It is also worth mentioning that government-enacted tariffs can affect the actual rate of exchange, helping to reduce price pressures.More recent approaches in modelling the RER employ 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
*USD Direct Rates

Exchange rate: Encyclopedia BETA

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