In finance, an exchange rate is the rate atwhich one currency will be exchanged for another.
It is also regarded as the value of one country’scurrency in relation to another currency.
For example, an interbank exchange rate of114 Japanese yen to the United States dollar means that ¥114 will be exchanged for eachUS$1 or that US$1 will be exchanged for each ¥114.
In this case it is said that the price ofa dollar in relation to yen is ¥114, or equivalently that the price of a yen in relation to dollarsis $1/114.
Exchange rates are determined in the foreignexchange market, which is open to a wide range of different types of buyers and sellers,and where currency trading is continuous: 24 hours a day except weekends, i.
tradingfrom 20:15 GMT on Sunday until 22:00 GMT Friday.
The spot exchange rate refers to the currentexchange rate.
The forward exchange rate refers to an exchangerate that is quoted and traded today but for delivery and payment on a specific futuredate.
In the retail currency exchange market, differentbuying and selling rates will be quoted by money dealers.
Most trades are to or from the local currency.
The buying rate is the rate at which moneydealers will buy foreign currency, and the selling rate is the rate at which they willsell that currency.
The quoted rates will incorporate an allowancefor a dealer's margin (or profit) in trading, or else the margin may be recovered in theform 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 transactionshas been justified as compensating for the additional time and cost of clearing the document.
On the other hand, cash is available for resaleimmediately, but brings security, storage, and transportation costs, and the cost oftying up capital in a stock of banknotes (bills).
The retail exchange market:Currency for international travel and cross-border payments is predominantly purchased from banks,foreign exchange brokerages and various forms of bureaux de change.
These retail outlets source currency fromthe inter-bank markets, which are valued by the Bank for International Settlements at5.
3 trillion US dollars per day.
The purchase is made at the spot contractrate.
Retail customers will be charged, in the formof commission or otherwise, to cover the provider's costs and generate a profits.
One form of charge is the use of an exchangerate that is less favourable than the wholesale spot rate.
The difference between retail buying and sellingprices is referred to as the bid-ask spread.
Quotations:In the foreign exchange market, a currency pair is the quotation of the relative valueof a currency unit against the unit of another currency.
The quotation EUR/USD 1.
3225 means that 1Euro will buy 1.
3225 US dollars.
In other words, this is the price of a unitof Euro in US dollars.
Here, EUR is called the "Fixed currency",while USD is called the "Variable currency".
There is a market convention that determineswhich 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, in a conversion from EUR to AUD,EUR is the fixed currency, AUD is the variable currency and the exchange rate indicates howmany Australian dollars would be paid or received for 1 Euro.
Cyprus and Malta, which were quoted as thebase to the USD and others, were recently removed from this list when they joined theEurozone.
In some areas of Europe and in the retailmarket in the United Kingdom, EUR and GBP are reversed so that GBP is quoted as thefixed currency to the euro.
In order to determine which is the fixed currencywhen neither currency is on the above list (i.
both are "other"), market conventionis to use the fixed currency which gives an exchange rate greater than 1.
This reduces rounding issues and the needto use excessive numbers of decimal places.
There are some exceptions to this rule: forexample, the Japanese often quote their currency as the base to other currencies.
Quotation using a country's home currencyas the price currency (for example, EUR 0.
8989 = USD 1.
00 in the Eurozone) is known as directquotation or price quotation (from that country's perspective) and is used in most countries.
Quotation using a country's home currencyas the unit currency (for example, USD 1.
11 = EUR 1.
00 in the Eurozone) is known as indirectquotation or quantity quotation and is used in British newspapers ; it is also commonin Australia, New Zealand and the Eurozone.
Using direct quotation, if the home currencyis strengthening (that is, appreciating, or becoming more valuable) then the exchangerate number decreases.
Conversely, if the foreign currency is strengtheningand the home currency is depreciating, the exchange rate number increases.
Market convention from the early 1980s to2006 was that most currency pairs were quoted to four decimal places for spot transactionsand up to six decimal places for forward outrights or swaps.
(The fourth decimal place is usually referredto as a "pip").
An exception to this was exchange rates witha value of less than 1.
000 which were usually quoted to five or six decimal places.
Although there is no fixed rule, exchangerates numerically greater than around 20 were usually quoted to three decimal places andexchange rates greater than 80 were quoted to two decimal places.
Currencies over 5000 were usually quoted withno decimal places (for example, the former Turkish Lira).
(GBPOMR : 0.
765432 – : 1.
4436 – EURJPY: 165.
In other words, quotes are given with fivedigits.
Where rates are below 1, quotes frequentlyinclude five decimal places.
In 2005, Barclays Capital broke with conventionby quoting spot exchange rates with five or six decimal places on their electronic dealingplatform.
The contraction of spreads (the differencebetween the bid and ask rates) arguably necessitated finer pricing and gave the banks the abilityto try and win transactions on multibank trading platforms where all banks may otherwise havebeen quoting the same price.
A number of other banks have now followedthis system.
Exchange rate regime:Each country determines the exchange rate regime that will apply to its currency.
For example, the currency may be free-floating,pegged (fixed), or a hybrid.
If a currency is free-floating, its exchangerate is allowed to vary against that of other currencies and is determined by the marketforces of supply and demand.
Exchange rates for such currencies are likelyto change almost constantly as quoted on financial markets, mainly by banks, around the world.
A movable or adjustable peg system is a systemof fixed exchange rates, but with a provision for the revaluation (usually devaluation)of a currency.
For example, between 1994 and 2005, the Chineseyuan renminbi (RMB) 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 exchangerates with the US dollar based on the Bretton Woods system.
But that system had to be abandoned in favorof floating, market-based regimes due to market pressures and speculation, according to PresidentRichard M.
Nixon in a speech on August 15, 1971, in what is known as the Nixon Shock.
Still, some governments strive to keep theircurrency within a narrow range.
As a result, currencies become over-valuedor 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 componentcurrencies change.
A currency becomes more valuable wheneverdemand for it is greater than the available supply.
It will become less valuable whenever demandis less than available supply (this does not mean people no longer want money, it justmeans they prefer holding their wealth in some other form, possibly another currency).
Increased demand for a currency can be dueto either an increased transaction demand for money or an increased speculative demandfor money.
The transaction demand is highly correlatedto a country's level of business activity, gross domestic product (GDP), and employmentlevels.
The more people that are unemployed, the lessthe public as a whole will spend on goods and services.
Central banks typically have little difficultyadjusting the available money supply to accommodate changes in the demand for money due to businesstransactions.
Speculative demand is much harder for centralbanks to accommodate, which they influence by adjusting interest rates.
A speculator may buy a currency if the return(that is the interest rate) is high enough.
In general, the higher a country's interestrates, the greater will be the demand for that currency.
It has been argued that such speculation canundermine real economic growth, in particular since large currency speculators may deliberatelycreate downward pressure on a currency by shorting in order to force that central bankto buy their own currency to keep it stable.
(When that happens, the speculator can buythe currency back after it depreciates, close out their position, and thereby take a profit.
) For carrier companies shipping goods fromone nation to another, exchange rates can often impact them severely.
Therefore, most carriers have a CAF chargeto account for these fluctuations.
Purchasing power of currency:The real exchange rate (RER) is the purchasing power of a currency relative to another atcurrent exchange rates and prices.
It is the ratio of the number of units ofa 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 numberof units of the given country's currency that would be necessary to buy that market basketdirectly in the given country.
There are various ways to measure RER.
Thus the real exchange rate is the exchangerate times the relative prices of a market basket of goods in the two countries.
For example, the purchasing power of the USdollar relative to that of the euro is the dollar price of a euro (dollars per euro)times the euro price of one unit of the market basket (euros/goods unit) divided by the dollarprice of the market basket (dollars per goods unit), and hence is dimensionless.
This is the exchange rate (expressed as dollarsper euro) times the relative price of the two currencies in terms of their ability topurchase units of the market basket (euros per goods unit divided by dollars per goodsunit).
If all goods were freely tradable, and foreignand domestic residents purchased identical baskets of goods, purchasing power parity(PPP) would hold for the exchange rate and GDP deflators (price levels) of the two countries,and the real exchange rate would always equal 1.
The rate of change of the real exchange rateover time for the euro versus the dollar equals the rate of appreciation of the euro (thepositive or negative percentage rate of change of the dollars-per-euro exchange rate) plusthe inflation rate of the euro minus the inflation rate of the dollar.
effective exchange rate:Bilateral exchange rate involves a currency pair, while an effective exchange rate isa weighted average of a basket of foreign currencies, and it can be viewed as an overallmeasure of the country's external competitiveness.
A nominal effective exchange rate (NEER) isweighted with the inverse of the asymptotic trade weights.
A real effective exchange rate (REER) adjustsNEER by appropriate foreign price level and deflates by the home country price level.
Compared to NEER, a GDP weighted effectiveexchange rate might be more appropriate considering the global investment phenomenon.
Parallel exchange rate:In many countries there is a distinction between the official exchange rate for permitted transactionsand a parallel exchange rate that responds to excess demand for foreign currency at theofficial exchange rate.
The degree by which the parallel exchangerate exceeds the official exchange rate is known as the parallel premium.
Uncovered interest rate parity:Uncovered interest rate parity (UIRP) states that an appreciation or depreciation of onecurrency against another currency might be neutralized by a change in the interest ratedifferential.
If US interest rates increase while Japaneseinterest rates remain unchanged then the US dollar should depreciate against the Japaneseyen by an amount that prevents arbitrage (in reality the opposite, appreciation, quitefrequently happens in the short-term, as explained below).
The future exchange rate is reflected intothe forward exchange rate stated today.
In our example, the forward exchange rateof the dollar is said to be at a discount because it buys fewer Japanese yen in theforward rate than it does in the spot rate.
The yen is said to be at a premium.
UIRP showed no proof of working after the1990s.
Contrary to the theory, currencies with highinterest rates characteristically appreciated rather than depreciated on the reward of thecontainment of inflationand a higher-yielding currency.
Balance of payments model:The balance of payments model holds that foreign exchange rates are at an equilibrium levelif they produce a stable current account balance.
A nation with a trade deficit will experiencea reduction in its foreign exchange reserves, which ultimately lowers (depreciates) thevalue of its currency.
A cheaper (undervalued) currency renders thenation's goods (exports) more affordable in the global market while making imports moreexpensive.
After an intermediate period, imports willbe forced down and exports to rise, thus stabilizing the trade balance and bring the currency towardsequilibrium.
Like purchasing power parity, the balanceof payments model focuses largely on trade-able goods and services, ignoring the increasingrole of global capital flows.
In other words, money is not only chasinggoods and services, but to a larger extent, financial assets such as stocks and bonds.
Their flows go into the capital account itemof the balance of payments, thus balancing the deficit in the current account.
The increase in capital flows has given riseto the asset market model effectively.
Asset market model:The increasing volume of trading of financial assets (stocks and bonds) has required a rethinkof 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 transactionsstemming from cross border-trading of financial assets has dwarfed the extent of currencytransactions generated from trading in goods and services.
The asset market approach views currenciesas asset prices traded in an efficient financial market.
Consequently, currencies are increasinglydemonstrating a strong correlation with other markets, particularly equities.
Like the stock exchange, money can be made(or lost) on trading by investors and speculators in the foreign exchange market.
Currencies can be traded at spot and foreignexchange options markets.
The spot market represents current exchangerates, 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 currencyto keep its value low, typically by the national central bank engaging in open market operationsin the foreign exchange market.
In the early twenty-first century it was widelyasserted that the People's Republic of China had been doing this over a long period oftime.
Other nations, including Iceland, Japan, Brazil,and so on have had a policy of maintaining a low value of their currencies in the hopeof reducing the cost of exports and thus bolstering their economies.
A lower exchange rate lowers the price ofa country's goods for consumers in other countries, but raises the price of imported goods andservices for consumers in the low value currency country.
In general, exporters of goods and serviceswill prefer a lower value for their currencies, while importers will prefer a higher value.
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