Understanding Exchange Rates: A Comprehensive Overview
In finance, the exchange rate between two currencies specifies how much one currency is worth in terms of the other. For example an exchange rate of 120 Japanese Yen to the Dollar means that ¥120 is worth the same as $1. An exchange rate is also known as a foreign exchange rate, or FX rate.
An exchange rate quotation is given by stating the number of units of a price currency can be bought in terms of a unit currency. For example in a quotation that says the Euro–United States Dollar exchange rate is 1.2 dollars per euro, the price currency is the dollar and the unit currency is the euro. The usual unit currency varies by geographic location. For example British newspapers quote exchage rates with British pounds as the unit currency. This is know as indirect or quality terms quotation and also common in Australia and New Zealand. Quotes using the US dollar as the unit currency are known as direct or price quotation and used in any other country.
- direct quotation: Home Currency / Foreign Currency
- indirect quotation: Foreign Currency / Home Currency
Note if a unit currency is strengthening / appreciating (i.e. if the currency is becoming more valuable) then the exchange rate number increases. Conversely if the price currency is strengthening, the exchange rate number decreases and the unit currency is depreciating.
In practice it is rarely possible to exchange currency at the exact rate quoted. Market makers who match together buyers and sellers will take a commission. This is achieved by quoting a bid/offer spread. For example if you are bidding to buy Japanese yen you would do so at the bid price of say, ¥115 per dollar, and if you were offering to sell yen you might do so at ¥125 yen per dollar.
If a currency is free-floating its exchange rate against other countries can vary against other such currencies. In fact such exchange rates are likely to be changing almost constantly as quoted by financial markets and banks around the world. If the value of the currency is “pegged” its value is maintained by the government in question at a fixed rate relative to the other currency. For example, in 2003 the Hong Kong dollar was pegged to the United States dollar.
Fluctuations in exchange rates
An exchange rate will change whenever the value 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 (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 is due to either an increased transaction demand for money, or an increased speculative demand for money. The transaction demand for money is highly correlated to the countries level of business activity, gross domestic product (GDP), and employment levels. The more people there are out of work, 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.
The speculative demand for money is much harder for a central bank to accommodate but they try to do this by adjusting interest rates. An investor may choose to buy a currency if the return (that is the interest rate) is high enough. The higher a countries interest rates, the greater the demand for that currency.
In choosing what type of asset to hold, people are also concerned that the asset will retain its value in the future. Most people will not be interested in a currency if they think it will devalue. A currency will tend to lose value, relative to other currencies, if the countries level of inflation is relatively higher, if the counties level of output is expected to decline, or if a country is troubled by political uncertainty. For example, when Russian President Vladimir Putin dismissed his Government on Feburary 24 2004, the price of the Ruble dropped. When China announced plans for its first manned space mission the price of the Yuan jumped.
Like the stock exchange, money can be made or lost on the foreign exchange market by investors and speculators buying and selling at the right times. One device for doing this is foreign exchange options, which are derivatives of exchange rates.
The Markets
The foreign exchange markets are usually highly liquid particularly in the G7 currencies (USD, JPY, EUR, CHF, GBP, CAD, AUD). The main international banks are continually provide the market with both bid (buy) and ask (sell) offers. The volume of trading in the foreign exchange markets exceeds that in any other market, liquidity is extremely high.
In the foreign exchange markets there is little or no ‘inside information’. Rate fluctuations are usually to do with world economy or the national economies so significant news is released publicly so, at least in theory, everyone in the world receives the same news at the same time. This is in contrast to the Equity Market where a stock may lose value by 5% or more, and only later do the reasons for this become apparent when a newspaper reports that forecasts for that company have been revised downward, or that a key executive has resigned (this why insider trading in stock markets can be a problem).
Big foreign exchange trading centres are located in New York, Tokyo, London, Hong Kong, Singapore, Paris and Frankfurt amongst others and the foreign exchange market is open 24 hours per day throughout the week (closing worldwide Friday afternoon and reopening Sunday afternoon). If the European Market is closed the Asian Market or US will be open on the other and so all world currencies can be continually in trade. Traders can react to news when it breaks, rather than waiting for the market to open, as is the case with most other markets. This enables traders to take positions anticipating the impact on the exchange rate of important news items.
In the foreign exchange markets is there is never a ‘bear’ market. Currencies are traded in pairs, every trade involves the selling of one currency and the buying of another. If some currencies are going down, others must be going up.
