Exchange Rate

The exchange rate, when used in finance, is the term which is used to describe the value of a home country’s currency in reference to the currency of another country. For example, the value of the Australian dollar (AUD) when compared to that of the United States dollar (USD) is currently 0.988084 . This means that 0.988084 U.S. dollars are equivalent to 1 AUD. The term exchange rate can also be used synonymously with foreign exchange rate, FX rate, or forex rate. The market for foreign exchange is, today, one of the largest in the entire world.

The current rate of exchange is referred to as the spot exchange rate with the forward exchange rate referring to the projected exchange rate which will exist in the future. The forward exchange rate is used to trade and quote payments today with delivery or payment not occurring until some date in the future.

Quotations

A quotation for an exchange rate is determined using “quote currency” units which are then exchanged for the “base currency” unit. For example, when determining a quotation for the exchange from Australian to American, the base currency would be AUD and the quote currency would be USD. The exchange rate would therefore be calculated to be 0.988084, meaning that each AUD is equivalent to 0.988084 USD.

A market convention is used to determine which the term currency is and which currency is the base currency. The typical order in most areas of the world is EUR – GBP – AUD – NZD – USD – other currencies. Therefore, if a conversion is being calculated from AUD to USD, AUD would be considered the base currency and USD would be the term currency. The exchange rate would then state how many USD would be equivalent to one AUD. In order to determine which currency is the base currencies in non-listed countries, the market convention determines the country with the exchange rate that is higher than 1.000. This negates issues with rounding as well as problems with exchange rates exceeding 4 decimal places. There are, however, some exceptions.

Quotations which are given based on the home currency being used as a price currency are referred to as price quotations or direct quotations and are used by the majority of countries. Quotations which use the home currency as a unit currency, such as AUD 1.00 = 0.988084 USD are referred to as quantity quotations and indirect quotations and are commonly used in New Zealand and Australia.

With a direct quotation, if a strengthening of the home currency or appreciation is occurring, the exchange rate of the home country will inevitably decrease. On the other hand, if the foreign currency is strengthening or appreciating, the exchange rate will increase and the currency of the home country will depreciate.

From the early 1980s to the year 2006, market convention has stated that currency pairs for spot transactions be quoted to 4 decimal places and, for swaps and forward outrights, to 6 decimal places. The “pip” is typically the term which is used to refer to the fourth decimal place. There are, however, exceptions to these rules. One exception is in the case of rates which have values less than:

1. In this case, the exchange rate is typically quoted to up to 6 decimal places. Although no set rule exists, exchange rates which exceed 20.0 are quoted to around 3 places and rates higher than 80.0 are quoted to




2. 2. Currencies which exceed 5000.0 are usually not given any decimal places at all. An example of this was the Turkish Lira, which is no longer being used. For the most part, currency exchange rates are typically given with 5 digits.

Barclay Capital deviated from the norm in 2005 by using 5 to 6 places for spot exchange rates. Finer pricing was necessary for the difference between offer and bid rates, known as the contraction of spreads. This allowed banks to potentially win transaction of trading multiband platforms as opposed to receiving the same price quote across all banks. Numerous banks have since adopted this method.

Although official quotes use a complete number, numerous analysts and investors use only the numbers following the decimal point. For example, 1.3568 would become 3568. This type of numbering system is used predominantly in cases such as move in prices.

Free or Pegged Currency

Free currency means that the rate of exchange is permitted to vary in relation to other country’s currencies and the rate is determined based upon supply and demand in the market. The exchange rates for free currencies are subject to constant change by financial markets such as banks worldwide.

On the other hand, an adjustable peg or movable system is one which consists of fixed rates of exchange. However, the system does take into account currency devaluation. One such example is, between the years ’94 and ’05, RMB or Chinese yuan renminbi was determined to be 8.2768 to 1 USD. Other countries also decided to adopt this pegged system. Countries in Western Europe, after WWII until the year 1967, maintained fixed rates with the USD per the Bretton Woods system.

The Real Exchange Rate, or RER, is used to describe the power of purchasing between two comparable currencies. This rate is determined by the GDP or Gross Domestic Product deflator measurement in the countries in question, both foreign and domestic. The rate is set to 1 arbitrarily during the base year. The changes that occur in the RER are indicative of the unit price evolution which occurs from the base year onwards. The rate indicates the relative unit price of the GDP in the foreign country as compared to the unit price of the GDP in the domestic or home country. If all of a country’s goods are able to be freely traded and the same items were purchased by two different countries, the PPP or purchasing power parity would remain for each of the country’s GDP deflators and the RER would remain 1 between the domestic and the foreign countries.

Bilateral Exchange Rate vs. Effective Exchange Rate

The bilateral exchange rate consists of a currency pair while the effective exchange rate is the average of several currencies of foreign countries. The effective exchange rate is a overall indicator of a country’s competitiveness when compared with other countries. Furthermore, the NEER or nominal effective exchange rate is calculated using the asymptotic trade weights inverse. In contrast, the REER or real effective exchange rate alters the NEER based on the price level of the foreign country as well as the domestic country’s deflation. When compared to nominal effective exchange rate, the GDP weighted effective exchange rate is often considered to be more accurate.

Uncovered Interest Rate Parity

UIRP or uncovered interest rate parity refers to the neutralization of the depreciation or appreciation of one currency to another which takes place due to changes in the differential of interest rates. For example, if Australian interest rates elevate while the rates in the U.S. remain the same, than the AUD would depreciate when compared to the USD by a certain amount which would prevent the occurrence of arbitrage. Although this is the goal, the opposite often occurs.

Uncovered interest rate parity has not been shown to work following the 1990s. In contrast to the proposed theory of UIRP functioning, the currencies which possess high rates of interest typically appreciated instead of depreciating due to contained inflation and a currency of higher yield.

Balance of Payments Model

The balance of payments model states that exchange rate of a foreign country must be at equilibrium, meaning the rate that produces a stable balance for the current account. A country which possesses a trade deficit will inevitably experience depletion in foreign exchange reserves which serves to depreciate currency value. The currency, once it possesses a lower value, makes the goods of the nation more affordable in global markets but serves to make the importation of goods more expensive. Eventually the number of imports will decrease and the number of exports will increase, which will stabilize the balance of trade and the currency will reach equilibrium.

As is the case with PPP, the balance of payments model is largely concentrated on services and goods which can be traded. This means that that the money pursues both services and goods as well as bonds and stocks and other assets. The flow of money services to balance the deficit present in the current account. This capital increase has caused the development of the asset market model from the balance of payments model.

Asset Market Model

The increase in the amount of financial asset trading, such as bonds and stocks, has changed the way in which traders and analysts view currencies. Variables in the economy such as inflation, productivity, and economic growth are not the only drivers of currency movement in the economy. Transactions involving currency which are generated from the trading of services and goods have become dwarfed by the transactions of foreign exchange due to trading of financial assets across country borders.

The approach of the asset market model is to view financial currencies as prices to financial assets which are traded on the financial market. Because of this, currencies demonstrate a strong link with equities and other markets.

Similar to the stock exchange, currency can be lost or gained on the forex market by speculators or investors who sell and buy at the correct times. Currency can also be traded at foreign and spot exchange markets. Current exchange rates are represented by the spot market.

Exchange Rate Fluctuations

An exchange rate based on the market is subject to change when the currency values of the two components change. The currency of one of the components will increase in value when the demand is greater than the supply. In reverse, the currency will decrease in value when the demand is less than the supply that is available for consumption. This occurs when individuals hold their wealth in different forms than the currency under consideration.

Increased currency demand can be caused by an increased speculative or transaction demand for the currency. The demand for currency via transaction is strongly linked to business activity in the country, the GDP or gross domestic product, as well as levels of employment. The higher the unemployment rate, the less the population of a country will spend on services and goods. Central banks usually find it easy to adjust to the new supply of money in order to take into account changes in money demands because of business related transactions.

The speculative money demand is harder to accommodate by the central bank but is typically done through the adjusting of interest rates. An investor can buy a particular currency if the interest rate return is high. The higher the interest rate, the more in demand that currency will be. Some believe that the speculation of currency can decrease economic growth since speculators may choose to decrease the currency pressure. This forces the central banks to sell the currency in order to keep the currency stable. Once the banks have reached the decision to sell the currency, the speculator can purchase the currency at a discount price, close their position, and turn a profit.

Exchange Rate Manipulation

If a country manipulates their currency value by forcing the value to remain low, they may be able to gain the advantage in their international trading market. It is believed that the People’s Republic of China has managed to do this over a long time period to maintain their competitiveness in the global market. However, in actuality, appreciation in 2005 of the Chinese yuan by 22 percent was quickly followed by a 38.7 percent increase in Chinese imports to the United States.

In the year 2010, other countries such as Brazil and Japan tried to decrease the value of their currency in order to subsidize inexpensive exports and bolster their economies which were failing. A low rate of exchange serves to lower the price of the goods provided by that country to other country’s consumers.