Exchange rate is a term used in foreign currency market to denote the value of one currency in terms of another currency. It is the rate that determines how many units of a specific currency one gets in exchange for another specific currency. In other words, it is the value of one currency expressed in another currency. As an example, when the exchange rate of the Australian dollars (AUD) to US dollar (USD) is expressed as 1.01, it means that one US$ can be exchanged for 1.01 AUD or the other way round that 1.01 AUD will be exchanged for one US$.
The foreign exchange market or the forex market determines the exchange rates of different currencies in relation to other currencies. A wide range of buyers and sellers, banks, institutions and retail traders, participate in the foreign exchange market, which is open all through the day for five days a week, meaning that it is open for trading from Sunday 20.15 GMT to Friday 22.00 GMT. Trading is done on spot rates or current exchange rates as well as forward rates, which are rates quoted for trade today but settlement (payment and delivery) at a stipulated future date.
The retail foreign exchange market is typical in the sense that money dealers quote a different rate for buying and selling. The money dealer will sell a particular currency at a rate that is higher than the rate at which he will buy the same currency. The rates quoted by a dealer include the money dealer’s profit or margin. If not, then profit is recovered in the form of a commission or fee. A dealer typically has different exchange rates for cash, traveler’s checks and prepaid debit cards and credit cards. The difference in rates is primarily due to the extra time and cost involved in processing traveler’s checks and plastic money.
The Retail Market for Foreign Currencies
Foreign currency is required by different people for various purposes. Individuals traveling to another country to buy the currency of the country they plan to visit. For this purpose, they have to approach a local bank or a money dealer for buying foreign currency in shape of cash notes, traveler’s checks or plastic money acceptable in the country/countries they will be visiting. Most people usually prefer traveler’s check or travel cards over cash due to security concerns associated with it. People who travel without buying foreign currency in their home country may exchange their home currency at destinations from money dealers at airports, hotels, ATMs or at a bank. While making purchases at stores, they can use their credit or debit cards, which will convert the charged amount to the traveler’s home currency at the current exchange rate.
In case of traveler’s checks or travel card, no exchange of currency is involved if they are in the local currency. Whatever amount of money in a prepaid travel card remains unspent or leftover traveler’s checks can be exchanged back into home currency on return. However, each transaction carries a small cost. Moreover, exchange rates vary on daily basis, sometimes in a matter of hours.
Exchange rates quoted in the retail market vary significantly from dealer to dealer as well as the form in which currency is requested. According to a study conducted by CardHub.com the rates offered by credit card companies, MasterCard and Visa are the most favorable and results in savings of as much as 8% when compared to exchange rates offered by banks and up to 15% when compared with money kiosks at airports and malls.
Currency Pair Quotations
Any currency may be bought or sold in exchange for another currency. This means that while buying and selling US dollars one must necessarily pay or receive another currency. This necessitates that in the foreign exchange market currency rates be quoted for currency pairs; for example the Euro against the US dollar (EUR/USD). A 1.1200 quote for the EUR/USD pair means that one Euro fetches 1.200 US$.
An established convention determines which currency in a currency pair will be the base currency; the other currency in the pair is the term currency. The convention accepted in most parts of the world follows this order: EUR – GBP – AUD – NZD – USD – others. A quotation thus denotes how much units of the term currency will be paid or received for one unit of the base currency. For example, in the EUR/USD pair, the EUR is the base currency and the quotation refers to how many US dollars can be exchanged for one EURO.
However, there are aberrations in certain markets. In some markets in UK, particularly the non-professional, and certain areas in Europe, the Euro/GBP pair is quoted with GBP as the base currency. Another aberration is the Japanese Yen, which is always quoted as the base currency regardless of the other currency in the pair. Where both currencies fall under the ‘other’ category, base currency is the currency which provides an exchange of the value higher than 1.000.
There are also price quotations from the perspective of a particular country. This refers to direct rates wherein the home currency of a country is quoted as a price; for example, AUD 0.98524 = USD 1.00. Similarly, indirect quotations, which are popular in British newspapers and in Australia New Zealand and Eurozone, use the home currency as the term currency; AUD 1.00 = USD 1.01259 (in Australia).
When the home currency is increasing in value or appreciating, in a direct quotation, the quoted exchange rate goes down. On the contrary, when the foreign currency appreciates and the home currency depreciates, the quoted exchange rate goes up.
There is a market convention for the number of decimal places to be used in different quotations. Until 2006, for spot transactions quotations of most currency pairs were quoted up to 4 decimal places and 6 decimal places for forward contracts and swaps. In foreign exchange market, the fourth decimal place is called a pip.
However, where the exchange rate of a pair is less than 1.000, the rate was normally quoted up to 5 or 6 decimal points. Another exception to the rule was that exchange rates of values greater that 20 were quoted up to 3 decimal places and those above 80, in 2 decimal places.
This convention was broken by Barclays Capital when it started a fresh practice of quoting rates with 5 to 6 decimal points on its electronic trading platform. This resulted in smaller spreads, which in turn brought about a change in pricing; quotations got finer and spreads contracted. Spread in foreign exchange market refers to the difference between the buy-price and sell-price. This allowed banks to look for and benefit from arbitrage opportunities due to difference in quotations from different banks on various trading platforms. However, this did not last long because, over time, all banks adopted the same system.
Exchange Rate Management
Every country has its own way of managing its currency’s value. This is accomplished by adopting one of the various available options. It may choose to peg (fix) the value of the currency or let it float freely or choose to make situational switches between the two.
A value of a free-floating currency in terms of other currencies is determined by market demand and supply forces. This means that exchange rates quoted by banks of free-floating currencies will invariably keep changing.
A fixed exchange rate means that the value of the country’s currency in relation to another is pegged at a particular level albeit with a condition that it may choose to devalue it if situations demand it. From 1994 to 2005, the Chinese currency was fixed at RMB 8.2768 to one USD. Most of the Western European Countries also followed a fixed exchange rate regime from 1945 (end of World War II) to 1967 and had a fixed exchange rates with USD based on the monetary management established under the Bretton Woods Agreements.
The Bretton Woods system of July 1944 was necessitated by the need to prepare for rebuilding the international economy as the World War II was still being fought. However, by 1970s, pressures from the market and speculator activities forced countries to give up the fixed exchange rate regime and adopt market based free floating exchange rate regimes.
There are still some governments that have chosen a fixed or range bound exchange rate regime. The end result is undervaluation or overvaluation of currencies requiring action so as to manage balance of trade problems.
Exchange Rate Fluctuations
The exchange rate of currencies following a free floating regime keeps on changing according to market forces. Whichever currency is in demand and there is less supply will rise in value. The opposite is true for when supply is greater than demand. This simply means that people prefer to hold their money in another currency or another form and is by no means a reflection that people do not want the currency anymore because its value is falling.
Demand and supply of a currency varies due to a variety of factors. Demand may increase when businesses need to sell home currency to buy foreign currency to fund imports or due to increased speculative activity. Business demand depends largely on the economic health of the country, its gross domestic product (GDP) and level of employment. Increase or decrease in demand for money due to business demand is easily manageable by Central Banks. Speculative demand, however, is difficult to manage and requires using monetary policy tools such as interest rates and open market operations.
Central banks often try to reduce speculative demand by making adjustments in interest rates. As a general rule, higher interest rates attract speculators to buy a currency as they get a higher return on investment. Some experts opine that high speculative activity can negatively affect a country’s economy. A downward pressure created by large speculators can force the central bank to sell its currency. This increases supply and fall in currency values. Speculators then move in and buy from the bank at a lower rate and make a killing and take profit home.
Purchasing Power Parity
Purchasing power refers to the amount of goods and services that can be bought with a specific unit of home currency. Purchasing power parity, on the other hand, refers to the amount of money needed for purchasing the same amount of goods and services in the two countries the currency pair refers to. This brings out the question of real exchange rate (RER), which refers to a currency’s purchasing power in relation to the other currency. Price level in two countries is determined by using a GDP deflator, which is set to 1 for the base year. A deflator is a statistical factor designed to remove the effect of inflation. Purchasing power parity would hold between two countries only in the event of all good being freely tradable in two countries. In that case the RER would be equal to one and unvarying.
Effective Exchange Rate
Exchange rate of a currency pair is a bilateral exchange rate and refers to the value of one currency against the other. An effective exchange rate, on the other hand, is a measure of external competitiveness of a country. It is a statistical figure arrived at by calculating the weighted average of a number of foreign currencies.
NEER or nominal effective exchange rate takes into account the inversely weighted value of asymptotic trade weights. REER or real effective exchange rate, on the other hand, is the adjusted value of NEER after considering appropriate price levels in domestic and foreign country. However, considering globalization, an effective exchange rate that takes into account GDP weights is more appropriate than NEER.
Uncovered Interest Rate Parity and Exchange Rate
The theory of uncovered interest rate parity asserts that currency exchange rate of two countries can be managed by changing interest rates. In effect, if the interest rate in Australia increases and that of Japan remains unchanged, then the Australian dollar will depreciate against the Yen. The depreciation will be to the extent to prevent arbitrage. The forward exchange rate quoted today reflects the expected rate in future, which in this example, means that the Australian dollar is at a discount and the Japanese Yen at a premium. Since as per the forward rate AUD buys less Yen, the Japanese Yen is at a premium.
This, however, is true only in theory because in reality, it appreciates in the short term. This theory did not work in 1990s as currencies of countries with high interest rates actually appreciated. This was due to the fact that higher interest rate contains inflation and increases in demand for the currency because it gives a higher return on investment. It is simple economics that demand for a currency increases if the interest rate in the country is higher than the other.
Effect of Balance of Payments on Exchange Rate
A country with a trade deficit is short on foreign exchange reserves, which in turn depreciates currency value. This means that a foreign exchange rate must be at an equilibrium level that ensures a stable balance on the current account. It works like this. If the currency is cheap, it means that its exports are more competitive in the global market. On the other hand, imports are more expensive. Over time, exports increase and imports are curtailed, which translates into an improved trade balance and eventually, the currency moves towards its equilibrium level.
Just as in the case of purchasing power parity, this model ignores the effect of capital outflows. Current account stability is not the only issue in the present scene of globalization. Money is not only chasing goods and services these days but also financial assets like stocks and bonds. This brings us to the effect of capital outflows.
Net Capital Outflow and Currency Value
For long it has been believed, and rightly so, that currency value depends upon the country’s economy, its growth, inflation and productivity. However, things have changed with the dramatic increase in trading in financial instruments such as stocks and bonds. Today, the impact of import-export related foreign exchange transactions is far less than that of currency transactions due to inter-country trading in financial assets.
Currencies have come to be viewed as a tradable asset. Investors and speculators can make (or lose) money in the foreign exchange market just like it is in the stock market by making intelligent buying and selling decisions. This, in effect, has resulted in a situation where the impact of net capital outflow on currency values can no longer be ignored.
Exchange Rate Manipulation
A major benefit can be derived by nations by manipulating and keep currency value lower at artificial levels. This is accomplished by central banks by indulging in open market buying and selling of domestic as well as foreign currencies. Many economists suggest that China has been successfully doing this since a long time.
Even Japan and Brazil tried to do this in 2010 when they attempted to devalue their currencies to give a boost to their economies. Low exchange rate means the exports of the manipulating countries become cheaper for consumers in foreign countries. At the same time, it makes imports more expensive than before for domestic consumers.