Exchange rate: concept and types

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

In finance, the exchange rate is the rate at which one currency will be exchanged for another. It is also seen as the value of the currency of one country in relation to another. For example, an interbank exchange rate of 114 Japanese yen to the US dollar means that 114 will be exchanged for every $1, or that 1 USD will be exchanged for every 114. In this case, the price of the dollar against the yen is said to be 114.

Currency rates are determined in the foreign exchange market, which is open to a wide range of buyers and sellers of various types. It trades continuously: it goes 24 hours a day, except weekends.

The retail foreign exchange market quotes different rates of purchase and sale. Most transactions are related to or derived from the local unit of money. The buy rate is the rate at which participants will buy foreign currency, and the sell rate is the rate at which they will sell it. Quoted rates will take into account the size of the dealer's margin (or profit) when trading, otherwise it can be recovered in the form of a commission or in some other way. Different rates can also be specified for cash, its documentary form or electronic form.

Retail Market

Currency for international travel and cross-border payments is predominantly purchased from banks and foreign exchange brokerages. The purchase here is made at a fixed rate. Retail customers will pay additional funds in the form of a commission or otherwise to cover the costs of the provider and earn a profit. One form of such a levy is the use of an exchange rate that is less favorable than the option rate. This can be seen by examining any currency informant. The rate will be somewhat overpriced to bring profit to the seller.

Currency pair

In the financial market, a currency pair is a quotation of the relative value of a unit of one currency against a unit of another. So, EUR/USD quote 1:1, 3225 means that 1 euro will be bought for 1.3225 US dollars. In other words, it is the price of a euro unit in US dollars, or the euro exchange rate. In this ratio, EUR is called a fixed currency, and USD is called a variable.

A quote that uses the country's domestic currency as a fixed one is called a direct quote and is used in most countries. Another variation, using the national unit as a variable, is known as indirect or quantitative quotation, and is used in British sources. This quote is also common in Australia, New Zealand and the Eurozone. This should be taken into account when studyingcurrency informant, the rate of which may look unusual.

If the domestic currency strengthens (that is, becomes more valuable), the value of the exchange rate decreases. Conversely, if the foreign unit strengthens and the domestic unit depreciates, then this figure increases.

Exchange rate regime

Each country determines the exchange rate regime to be applied to its currency. For example, it can be free floating, tethered (fixed), or hybrid.

If a currency floats freely, its exchange rate can fluctuate markedly with the value of other units and is determined by the market forces of supply and demand. Exchange rates for that kind of money are likely to change almost constantly, as seen in financial markets around the world.

What is a fixed system?

A movable, or adjustable, peg system is a system of fixed exchange rates, but with a reserve for revaluation (usually devaluation) of the currency. For example, between 1994 and 2005, the Chinese yuan was pegged to the US dollar at a value of 8.2768:1. China was not the only country to do so. From the end of World War II until 1967, the countries of Western Europe maintained fixed exchange rates with the US dollar based on the Bretton Woods system. But this system is already moving away in favor of floating market regimes. However, some governments are keen to keep their currencies within a narrow range. As a result, these unitsbecome excessively expensive or cheap, resulting in trade deficits or surpluses.

Classification of exchange rates

In terms of bank foreign exchange trading, the purchase price is the cost used by a bank to purchase foreign currency from a client. In general, the exchange rate at which a foreign unit is converted into a smaller amount of a domestic unit is the purchase rate, which indicates how much of a country's currency is required to purchase a given amount of foreign denomination. For example, having studied the exchange rate of the dollar and the euro on the currency informant, you can determine how much of another denomination you need to pay for them.

The selling price of a foreign currency refers to the exchange rate used by the bank to sell it to customers. This value indicates how much of the country's currency must be paid if the bank sells a certain unit.

The average rate is the average price of offer and demand. Usually this number is used in newspapers, magazines or other sources of economic analysis (where you can see the exchange rates for tomorrow).

Factors affecting the change in the exchange rate

When a country has a large balance of payments or trade deficit, this means that its foreign exchange profit is less than the cost of the currency, and the demand for this denomination exceeds supply, so the exchange rate rises and the national unit depreciates.

Interest rates are cost and profitloan capital. When a country raises its interest rate, or its domestic datum higher than that of a foreign one, it will result in an inflow of capital, thereby increasing the demand for the domestic currency, allowing it to appreciate and devalue the other.

When the inflation rate in a country rises, the purchasing power of money decreases. Paper currency depreciates domestically. If inflation occurs in both countries, the units of countries with a high level of this process will depreciate against the nominal values of countries with a low level.

Financial and monetary policy

Although the impact of monetary policy on changes in a country's exchange rate is indirect, it is also very important. Overall, the huge budget and spending deficits caused by expansionary fiscal and monetary policies and inflation will devalue the domestic currency. The strengthening of such a policy will lead to a reduction in budget expenditures, stabilization of the monetary unit and an increase in the value of the national face value.

Venture Capital

If merchants expect a certain currency to be highly valued, they will buy it in large quantities, causing the unit's exchange rate to rise. This has a particularly strong effect on the exchange rate of the dollar and the euro. Conversely, if they expect a unit to depreciate, they will sell large amounts of it, leading to speculation. The exchange rate immediately falls. Speculation is an important factor in short-term fluctuations in the exchange rate of the foreign exchange market.

Influence on the market by the state

When exchange rate fluctuations adversely affect a country's economy, trade, or government, certain goals need to be achieved through exchange rate adjustments. Monetary authorities may be involved in trading currencies, buying or selling local or foreign denominations in large quantities in the market. Currency supply and demand causes the exchange rate to change.

In general, high economic growth does not contribute to the rapid growth of the local currency in the market in the short term, but in the long term they strongly support the strong momentum of the local unit.

Exchange rate fluctuations

The stock exchange rate will change whenever the values of either of the two component currencies change. This can be traced through various currency informants. The dollar exchange rate for tomorrow, for example, fluctuates constantly. This happens for the following reasons. A unit becomes more valuable when the demand for it is greater than the available supply. It becomes less valuable when the demand for it is less than the available supply (this does not mean that people no longer want to buy it, it means that they prefer to hold their capital in some other form).

The increase in demand for currency may be due to an increase in transactional demand or speculative demand for money. The demand for a transaction is highly correlated with the level of business activity of the country, the gross domestic product(GDP) and employment rate. The more unemployed people, the less the public as a whole will spend on goods and services. Central banks generally have a hard time adjusting the available money supply to account for changes in the demand for money due to business activities.

What is speculative demand?

Speculative demand is much more difficult for central banks, which it affects by adjusting interest rates. A speculator can buy a currency if the yield (that is, the interest rate) is high enough. In general, the higher the interest rates in a country, the greater will be the demand for that unit. So, if the dollar rate grows according to the currency informant, it will be actively bought.

Financial analysts argue that such speculation could undermine real economic growth as big businessmen could deliberately create downward pressure on the currency to force the central bank to buy its own unit to keep it stable. When this happens, the speculator can buy the currency after it depreciates, close his position and thereby make a profit.

Purchasing power of currency

Real exchange rate (RER) - the purchasing power of a currency relative to another at current exchange rates and prices. This is the ratio of the number of units of a given country's currency required to purchase a market basket of goods in another country after acquiring its monetary value. Thus, it is not enough to study the euro exchange rate using a currency informant (for example) in order to evaluate this unit in a givencontext.

In other words, it is the exchange rate multiplied by the relative prices of a market basket of goods in two countries. For example, the purchasing power of the US dollar against the price of the euro is the dollar value of the euro (dollars per euro) multiplied by the euro price of one market basket unit (EUR unit/commodity) divided by the dollar prices from the market basket (in dollars per unit of commodity).) and hence is dimensionless. This is the exchange rate (expressed in US dollars per euro) against the relative price of the two currencies in terms of their ability to purchase units of the market basket (euro per unit divided by dollars per 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 be 1.

The rate of change in the real exchange rate over time for the euro against the dollar is equal to the rate of appreciation of the euro (positive or negative interest rate of change in the dollar for the euro exchange rate) plus the euro inflation rate minus the inflation rate of the dollar.

Real exchange rate equilibrium

The real exchange rate (RER) is the nominal exchange rate adjusted for the relative price of domestic and foreign goods and services. This indicator reflects the competitiveness of the country in relation to the rest of the world. More details: rate increasecurrency or higher domestic inflation leads to an increase in the RER, which worsens the country's competitiveness and reduces the current account (CA). On the other hand, currency depreciation creates the opposite effect.

There is evidence that RER generally reaches a sustainable level in the long run and that this process occurs faster in a small open economy characterized by fixed exchange rates. Any significant and permanent deviation of such an exchange rate from its long-term equilibrium level has a negative impact on the country's balance of payments. In particular, a protracted revaluation of the RER is widely seen as an early sign of a coming crisis, due to the fact that the country becomes vulnerable to both speculative attacks and a currency crisis. On the other hand, a prolonged underestimation of the RER usually generates pressure on domestic prices, changing consumer consumption incentives and, consequently, a misallocation of resources between tradable and non-tradable sectors.