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In finance, an exchange rate 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 relation to another currency. For example, an interbank exchange rate of 114 Japanese yen to the United States dollar means that ¥114 will be exchanged for each US$1 or that US$1 will be exchanged for each ¥114. In this case it is said that the price of a dollar in relation to yen is ¥114, or equivalently that the price of a yen in relation to dollars is $1/114.
Exchange rates are determined in the foreign exchange 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.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, different buying 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 money dealers will buy foreign currency, and the selling rate is the rate at which they will sell that currency. The quoted rates will incorporate an allowance for a dealer's margin (or profit) 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 has been justified as compensating for the additional time and cost of clearing the document. On the other hand, cash is available for resale immediately, but brings security, storage, and transportation costs, and the cost of tying up capital in a stock of banknotes (bills).
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 from the inter-bank markets, which are valued by the Bank for International Settlements at 5.3 trillion US dollars per day. The purchase is made at the spot contract rate. Retail customers will be charged, in the form of commission or otherwise, to cover the provider's costs and generate a profits. One form of charge is the use of an exchange rate that is less favourable than the wholesale spot rate. The difference between retail buying and selling prices is referred to as the bid–ask spread.
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, in 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[clarification needed] to the USD and others, were recently removed from this list when they joined the Eurozone.
In some areas of Europe and in the retail market in the United Kingdom, EUR and GBP are reversed so that GBP is quoted as the fixed currency to the euro. In order to determine which is the fixed currency when neither currency is on the above list (i.e. both are "other"), market convention is to use the fixed currency which gives an exchange rate greater than 1.000. This reduces rounding issues and the need to use excessive numbers of decimal places. There are some exceptions to this rule: for example, the Japanese often quote their currency as the base to other currencies.
Quotation using a country's home currency as the price currency is known as direct quotation or price quotation (from that country's perspective)[clarification needed] For example, EUR 0.8989 = USD 1.00 in the Eurozone and is used in most countries.
Quotation using a country's home currency as the unit currency[clarification needed] (for example, USD 1.11 = EUR 1.00 in the Eurozone) is known as indirect quotation or quantity quotation and is used in British newspapers ; it is also common in Australia, New Zealand and the Eurozone.
Using direct quotation, if the home currency is strengthening (that is, appreciating, or becoming more valuable) then the exchange rate number decreases. Conversely, if the foreign currency is strengthening and the home currency is depreciating, the exchange rate number increases.
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. (The fourth decimal place is usually referred to as a "pip"). 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 no fixed rule, exchange rates numerically greater than around 20 were usually quoted to three decimal places and exchange rates greater than 80 were quoted to two decimal places. Currencies over 5000 were usually quoted with no decimal places (for example, the former Turkish Lira). e.g. (GBPOMR : 0.765432 - : 1.4436 - EURJPY : 165.29). 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 quoting spot exchange rates with five or six decimal places on their electronic dealing platform. The contraction of spreads (the difference between the bid and ask rates) arguably necessitated finer pricing and gave the banks the ability to try and win transactions 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.
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 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 (usually 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. 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. But that system had to be abandoned in favor of floating, market-based regimes due to market pressures and speculation, according to President Richard M. Nixon in a speech on August 15, 1971, in what is known as the Nixon Shock.
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.
A market-based exchange rate will change whenever the values of either of the two component currencies change. A currency becomes 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 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 (GDP), 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 (that is the interest rate) 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[by whom?] 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. (When that happens, the speculator can buy the currency back after it depreciates, close out their position, and thereby take a profit.)
The real exchange rate (RER) 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 various ways to measure 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 (dollars per euro) times the euro price of one unit of the market basket (euros/goods unit) divided by the dollar price of the market basket (dollars per goods unit), and hence is dimensionless. This is the exchange rate (expressed as dollars per euro) times the relative price of the two currencies in terms of their ability to purchase units of the market basket (euros per goods unit divided by dollars per goods unit). If all goods were freely tradable, and foreign and 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 rate over time for the euro versus the dollar equals the rate of appreciation of the euro (the positive or negative percentage rate of change of the dollars-per-euro exchange rate) plus the inflation rate of the euro minus the inflation rate of the dollar.
The Real Exchange Rate (RER) represents the nominal exchange rate adjusted by the relative price of domestic and foreign goods and services, thus reflecting the competitiveness of a country with respect to the rest of the world. More in detail, an appreciation of the currency or a higher level of domestic inflation drives up the RER, worsening the country’s competitiveness and reducing the Current Account (CA). On the other hand, a currency depreciation generates an opposite effect, improving the country’s CA.
There is evidence that the RER generally reaches a steady level in the long-term, and that this process is faster in small open economies characterized by fixed exchange rates. Any substantial and persistent RER deviation from its long-run equilibrium level, the so-called RER misalignment, has shown to produce negative impacts on a country’s balance of payments. An overvalued RER means that the current RER is above its equilibrium value, whereas an undervalued RER indicates the contrary. Specifically, a prolonged RER overvaluation is widely considered as an early sign of an upcoming crisis, due to the fact that the country becomes vulnerable to both speculative attacks and currency crisis, as happened in Thailand during the 1997 Asian financial crisis. On the other side, a protracted RER undervaluation usually generates pressure on domestic prices, changing the consumers’ consumption incentives and, so, misallocating resources between tradable and non-tradable sectors.
Given that RER misalignment and, in particular overvaluation, can undermine the country’s export-oriented development strategy, the equilibrium RER measurement is crucial for policymakers. Unfortunately, this variable cannot be observed. The most common method in order to estimate the equilibrium RER is the universally accepted Purchasing Power Parity (PPP) theory, according to which the RER equilibrium level is assumed to remain constant over time. Nevertheless, the equilibrium RER is not a fixed value as it follows the trend of key economic fundamentals, such as different monetary and fiscal policies or asymmetrical shocks between the home country and abroad. Consequently, the PPP doctrine has been largely debated during the years, given that it may signal a natural RER movement towards its new equilibrium as a RER misalignment.
Starting from 1980s, in order to overcome the limitations of this approach, many researchers tried to find some alternative equilibrium RER measures. Two of the most popular approaches in the economic literature are the Fundamental Equilibrium Exchange Rate (FEER), developed by Williamson (1994), and the Behavioural Equilibrium Exchange Rate (BEER), initially estimated by Clark and MacDonald (1998). The FEER focuses on long-run determinants of the RER, rather than on short-term cyclical and speculative forces. It represents a RER consistent with macroeconomic balance, characterized by the achievement of internal and external balances at the same time. Internal balance is reached when the level of output is in line with both full employment of all available factors of production, and a low and stable rate of inflation. On the other hand, external balance holds when actual and future CA balances are compatible with long-term sustainable net capital flows. Nevertheless, the FEER is viewed as a normative measure of the RER since it is based on some “ideal” economic conditions related to internal and external balances. Particularly, since the sustainable CA position is defined as an exogenous value, this approach has been broadly questioned over time. By contrast, the BEER entails an econometric analysis of the RER behaviour, considering significant RER deviations from its PPP equilibrium level as a consequence of changes in key economic fundamentals. According to this method, the BEER is the RER that results when all the economic fundamentals are at their equilibrium values. Therefore, the total RER misalignment is given by the extent to which economic fundamentals differ from their long-run sustainable levels. In short, the BEER is a more general approach than the FEER, since it is not limited to the long-term perspective, being able to explain RER cyclical movements.
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 (NEER) is weighted with the inverse of the asymptotic trade weights. A real effective exchange rate (REER) 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.
In many countries there is a distinction between the official exchange rate for permitted transactions and a parallel exchange rate that responds to excess demand for foreign currency at the official exchange rate. The degree by which the parallel exchange rate exceeds the official exchange rate is known as the parallel premium.
Uncovered interest rate parity (UIRP) 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 (in reality the opposite, appreciation, quite frequently happens in the short-term, as explained below). 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.
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 (depreciates) the value of its currency. A cheaper (undervalued) currency renders the nation's goods (exports) 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.
The increasing volume of trading of financial assets (stocks and bonds) 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 (or lost) 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.
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 in the foreign exchange market. In the early twenty-first century it was widely asserted that the People's Republic of China had been doing this over a long period of time.
Other nations, including Iceland, Japan, Brazil, and so on have had a policy of maintaining a low value of their currencies in the hope 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, exporters of goods and services will prefer a lower value for their currencies, while importers will prefer a higher value.
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