Exchange rate

Exchange rate


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

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