Information about Exchange Rate

Foreign Exchange

Exchange Rates Currency band Exchange rate Exchange rate regime Fixed exchange rate Floating exchange rate Linked exchange rate

Markets Foreign exchange market Futures exchange

Products Currency Currency future Non-deliverable forward Forex swap Currency swap Foreign exchange option

See also Bureau de change

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 123 Japanese yen (JPY, ¥) to the United States dollar (USD, $) means that JPY 123 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 (also called base currency). For example, in a quotation that says the EUR/USD exchange rate is 1.3 (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., 0.50593 = $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., $1.97656 = £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 the Euro.

• direct quotation: 1 foreign currency unit = x home currency units
• indirect quotation: 1 home currency unit = x foreign currency units

Note that, using direct quotation, if the home currency is strengthening (i.e., appreciating, or becoming more valuable) then the exchange rate number decreases. Conversely if the foreign currency is strengthening, the exchange rate number increases and the home 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. For example : EUR/USD = 1.33866, means EUR is the base and USD the counter, so 1 EUR = 1.33866 USD.

Currency pair are given with four decimal places, except JPY with two decimal places (EUR/USD : 1.3386 - EUR/JPY : 165.29). In other words, quotes are given with 5 digits. Where rates are below 1, quotes frequently include 5 decimal places.

Free or pegged

Main article: Exchange rate regime

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 devaluation of a currency. For example, between 1994 and 2005, the Chinese yuan renminbi (RMB) was pegged to the United States dollar at RMB 8.2768 to $1. The Chinese were not the only country to do this; from the end of World War II until 1970, Western European countries all maintained fixed exchange rates with the US dollar based on the Bretton Woods system. [2]

Nominal and real exchange rates

• The nominal exchange rate is the price in domestic currency of one unit of a foreign currency.
• The real exchange rate (RER) is defined as , where is the domestic price level and the foreign price level. and must have the same arbitrary value in some chosen base year. Hence in the base year, .

The RER is only a theoretical ideal. In practice, 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. PPP appears to hold only in the long term (3–5 years) when prices eventually correct towards parity.

More recent approaches in modelling the RER employ a set of macroeconomic variables, such as relative productivity and the real interest rate differential.

Interest rate parity

Interest rate parity (IRP) 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 exceed Japanese interest rates 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.

IRP showed no proof of working after 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

This model holds that a foreign exchange rate must be at its equilibrium level - the rate which produces a stable current account balance. A nation with a trade deficit will experience reduction in its foreign exchange reserves which ultimately lowers (depreciates) the value of its currency. The cheaper currency renders the nation's goods (exports) more affordable in the global market place while making imports more expensive. After an intermediate period, imports are forced down and exports rise, thus stabilizing the trade balance and the currency towards equilibrium.

Like PPP, the balance of payments model focuses largely on tradable 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.

Asset market model

The explosion in trading of financial assets (stocks and bonds) has reshaped the way analysts and traders look at currencies. 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 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 represents current exchange rates, whereas options are derivatives of exchange rates.

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 were floating).

Foreign exchange markets

Main article: Foreign exchange market

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.

See also

• Bureau de Change
• Continuous linked settlement
• Currency Pair
• Digital gold currency
• Financial instruments
• Foreign exchange market
• Forex scam
• Gold standard
• List of international trade topics
• Table of historical exchange rates
• ISO 4217

Trade in global currency markets has soared over the past three years and is now worth more than $3.2 trillion a day (Source:Guardian September 26, 2007)

External links

• Free RSS Currency Rates Xurrency
• Benchmark Currency Rates
• Federal Reserve daily update
• Federal Reserve daily history since 2000
• Foreign Currency Units per 1 U.S. Dollar, 1948 - 2004