Exchange rate
Encyclopedia
In finance
, an exchange rate (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies
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 terms of another currency. For example, an interbank exchange rate of 91 Japanese yen
(JPY, ¥) to the United States dollar
(US$) means that ¥91 will be exchanged for each US$1 or that US$1 will be exchanged for each ¥91. Exchange rates are determined in the foreign exchange market
, which is open to a wide range of different types of buyers and sellers 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, a different buying rate and selling rate 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 the 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 (usually notes only), a documentary form (such as traveller's cheques) or electronically (such as a credit card purchase). The higher rate on documentary transactions is due to the additional time and cost of clearing the document, while the cash is available for resale immediately. Some dealers on the other hand prefer documentary transactions because of the security concerns with cash.
There are variations in the quoted buying and selling rates for a currency between foreign exchange dealers and forms of exchange, and these variations can be significant. For example, consumer exchange rates used by Visa
and MasterCard
offer the most favorable exchange rates available, according to a Currency Exchange Study conducted by CardHub.com
. This study, which examined the U.S. dollar-to-Euro exchange rates provided by the major worldwide credit card networks, 15 of the largest consumer banks in the U.S., and Travelex, showed that the credit card networks save travelers about 8% relative to banks and roughly 15% relative to airport companies.
An exchange rate is usually quoted in terms of the number of units of one currency that can be exchanged for one unit of another currency - e.g., in the form: 1.2290 EUR/USD. In this example, the US$ is referred to as the "quote currency" (price currency, payment currency) and the Euro is the "base currency" (unit currency, transaction currency).
There is a market convention that determines which is the base currency and which is the term currency. In most parts of the world, the order is: EUR – GBP – AUD – NZD – USD – others. Accordingly, a conversion from EUR to AUD, EUR is the base currency, AUD is the term 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 to the USD and others were recently removed from this list when they joined the Euro.
In some areas of Europe and in the non-professional market in the UK, EUR and GBP are reversed so that GBP is quoted as the base currency to the euro.
In order to determine which is the base currency where both currencies are not listed (i.e. both are "other"), market convention is to use the base currency which gives an exchange rate greater than 1.000. This avoids rounding issues and exchange rates being quoted to more than 4 decimal places. There are some exceptions to this rule e.g. the Japanese often quote their currency as the base to other currencies.
Quotes using a country's home currency as the price currency (e.g., EUR 0.735342 = USD 1.00 in the euro zone) are known as direct quotation or price quotation (from that country's perspective) and are used by most countries.
Quotes using a country's home currency as the unit currency (e.g., EUR 1.00 = USD 1.35991 in the euro zone) are known as indirect quotation or quantity quotation and are used in British
newspapers and are also common in Australia
, New Zealand
and the eurozone
.
Using direct quotation, if the home currency is strengthening (i.e., appreciating
, or becoming more valuable) then the exchange rate number decreases. Conversely if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating
.
Market convention from the early 1980s to 2006 was that most currency pairs were quoted to 4 decimal places for spot transactions and up to 6 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 5 or 6 decimal places. Although there is no fixed rule, exchange rates with a value greater than around 20 were usually quoted to 3 decimal places and currencies with a value greater than 80 were quoted to 2 decimal places. Currencies over 5000 were usually quoted with no decimal places (e.g. the former Turkish Lira).
e.g. (GBPOMR : 0.765432 - EURUSD : 1.5877 - GBPBEF : 58.234 - EURJPY : 165.29). In other words, quotes are given with 5 digits. Where rates are below 1, quotes frequently include 5 decimal places.
In 2005 Barclays Capital broke with convention by offering spot exchange rates with 5 or 6 decimal places on their electronic dealing platform. The contraction of spreads (the difference between the bid and offer rates) arguably necessitated finer pricing and gave the banks the ability to try and win transaction 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.
that will apply to its currency. For example, the currency may be free-floating, pegged or 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 bank
s, around the world.
A movable or adjustable peg system is a system of fixed exchange rate
s, but with a provision for the 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
. http://www-econ.stanford.edu/faculty/workp/swp99020.pdf#search=%22western%20europe%20fixed%20exchange%20rate%201970%20us%20dollar%22 But that system had to be abandoned due to market pressures and speculations in the 1970s in favor of floating, market-based regimes.
Still, some governments keep their currency within a narrow range. As a result currencies become over-valued
or under-valued, causing trade deficits or surpluses.
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 bank
s 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 rate
s. 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 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 sell their currency to keep it stable. (When that happens, the speculator can buy the currency back from the bank at a lower price, close out their position, and thereby take a profit.)
), which is arbitrarily set equal to 1 in a given base year. Therefore, the level of the RER is arbitrarily set depending on which year is chosen as the base year for the GDP deflator of two countries. The changes of the RER are instead informative on the evolution over time of the relative price of a unit of GDP in the foreign country in terms of GDP units of the domestic country. If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity
(PPP) would hold for the GDP deflators of the two countries, and the RER would be constant and equal to one.
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 reality the opposite, appreciation, quite frequently happens, 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.
balance. A nation with a trade deficit will experience reduction in its foreign exchange reserves
, which ultimately lowers (depreciates) the value of its currency. The cheaper currency renders the nation's goods (exports) more affordable in the global market place while making imports more expensive. After an intermediate period, imports are forced down and exports rise, thus stabilizing the trade balance and the currency towards equilibrium.
Like PPP
, 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.
, 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 the foreign exchange market
by investors and speculators buying and selling at the right times. Currencies can be traded at spot and foreign exchange option
s markets. The spot market represents current exchange rates, whereas options are derivatives
of exchange rates
if they manipulate the value of their currency
by artificially keeping its value low, typically by the national central bank
engaging in open market operations. It is argued that the People's Republic of China has succeeded in doing this over a long period of time. However, in a real-world situation, a 2005 appreciation of the Yuan by 22% was followed by a 38.7% increase in Chinese imports to the US.
In 2010, other nations, including Japan and Brazil, attempted to devalue their currency in the hopes of subsidizing cheap exports and bolstering their ailing economies. A low exchange rate lowers the price of a country's goods for consumers in other countries but raises the price of goods, especially imported goods, for consumers in the manipulating country.
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, an exchange rate (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
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 terms of another currency. For example, an interbank exchange rate of 91 Japanese yen
Japanese yen
The is the official currency of Japan. It is the third most traded currency in the foreign exchange market after the United States dollar and the euro. It is also widely used as a reserve currency after the U.S. dollar, the euro and the pound sterling...
(JPY, ¥) to the United States dollar
United States dollar
The United States dollar , also referred to as the American dollar, is the official currency of the United States of America. It is divided into 100 smaller units called cents or pennies....
(US$) means that ¥91 will be exchanged for each US$1 or that US$1 will be exchanged for each ¥91. Exchange rates are determined in the foreign exchange market
Foreign exchange market
The foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...
, which is open to a wide range of different types of buyers and sellers 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, a different buying rate and selling rate 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 the 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 (usually notes only), a documentary form (such as traveller's cheques) or electronically (such as a credit card purchase). The higher rate on documentary transactions is due to the additional time and cost of clearing the document, while the cash is available for resale immediately. Some dealers on the other hand prefer documentary transactions because of the security concerns with cash.
Retail exchange market
People may need to exchange currencies in a number of situations. For example, people intending to travel to another country may buy foreign currency in a bank in their home country, where they may buy foreign currency cash, traveller's cheques or a travel-card. From a local money changer they can only buy foreign cash. At the destination, the traveller can buy local currency at the airport, either from a dealer or through an ATM. They can also buy local currency at their hotel, a local money changer, through an ATM, or at a bank branch. When they purchase goods in a store and they do not have local currency, they can use a credit card, which will convert to the purchaser's home currency at its prevailing exchange rate. If they have traveller's cheques or a travel card in the local currency, no currency exchange is necessary. Then, if a traveller has any foreign currency left over on their return home, may want to sell it, which they may do at their local bank or money changer. The exchange rate as well as fees and charges can vary significantly on each of these transactions, and the exchange rate can vary from one day to the next.There are variations in the quoted buying and selling rates for a currency between foreign exchange dealers and forms of exchange, and these variations can be significant. For example, consumer exchange rates used by Visa
Visa
Visa or VISA may refer to:* Visa , a document issued by a country's government allowing the holder to enter or to leave that country...
and MasterCard
MasterCard
Mastercard Incorporated or MasterCard Worldwide is an American multinational financial services corporation with its headquarters in the MasterCard International Global Headquarters, Purchase, Harrison, New York, United States...
offer the most favorable exchange rates available, according to a Currency Exchange Study conducted by CardHub.com
CardHub.com
CardHub.com is a credit card comparison website owned and operated by Evolution Finance, Inc., a personal finance company founded in 2008 and based in Arlington, Virginia in the United States....
. This study, which examined the U.S. dollar-to-Euro exchange rates provided by the major worldwide credit card networks, 15 of the largest consumer banks in the U.S., and Travelex, showed that the credit card networks save travelers about 8% relative to banks and roughly 15% relative to airport companies.
Quotations
There is a market convention that determines which is the base currency and which is the term currency. In most parts of the world, the order is: EUR – GBP – AUD – NZD – USD – others. Accordingly, a conversion from EUR to AUD, EUR is the base currency, AUD is the term 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 to the USD and others were recently removed from this list when they joined the Euro.
In some areas of Europe and in the non-professional market in the UK, EUR and GBP are reversed so that GBP is quoted as the base currency to the euro.
In order to determine which is the base currency where both currencies are not listed (i.e. both are "other"), market convention is to use the base currency which gives an exchange rate greater than 1.000. This avoids rounding issues and exchange rates being quoted to more than 4 decimal places. There are some exceptions to this rule e.g. the Japanese often quote their currency as the base to other currencies.
Quotes using a country's home currency as the price currency (e.g., EUR 0.735342 = USD 1.00 in the euro zone) are known as direct quotation or price quotation (from that country's perspective) and are used by most countries.
Quotes using a country's home currency as the unit currency (e.g., EUR 1.00 = USD 1.35991 in the euro zone) are known as indirect quotation or quantity quotation and are used in British
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
newspapers and are also common in Australia
Australia
Australia , officially the Commonwealth of Australia, is a country in the Southern Hemisphere comprising the mainland of the Australian continent, the island of Tasmania, and numerous smaller islands in the Indian and Pacific Oceans. It is the world's sixth-largest country by total area...
, New Zealand
New Zealand
New Zealand is an island country in the south-western Pacific Ocean comprising two main landmasses and numerous smaller islands. The country is situated some east of Australia across the Tasman Sea, and roughly south of the Pacific island nations of New Caledonia, Fiji, and Tonga...
and the eurozone
Eurozone
The eurozone , officially called the euro area, is an economic and monetary union of seventeen European Union member states that have adopted the euro as their common currency and sole legal tender...
.
Using direct quotation, if the home currency is strengthening (i.e., appreciating
Appreciation
In accounting, appreciation of an asset is an increase in its value. In this sense it is the reverse of depreciation, which measures the fall in value of assets over their normal life-time...
, or becoming more valuable) then the exchange rate number decreases. Conversely if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating
Depreciation (currency)
Currency depreciation is the loss of value of a country's currency with respect to one or more foreign reference currencies, typically in a floating exchange rate system. It is most often used for the unofficial increase of the exchange rate due to market forces, though sometimes it appears...
.
Market convention from the early 1980s to 2006 was that most currency pairs were quoted to 4 decimal places for spot transactions and up to 6 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 5 or 6 decimal places. Although there is no fixed rule, exchange rates with a value greater than around 20 were usually quoted to 3 decimal places and currencies with a value greater than 80 were quoted to 2 decimal places. Currencies over 5000 were usually quoted with no decimal places (e.g. the former Turkish Lira).
e.g. (GBPOMR : 0.765432 - EURUSD : 1.5877 - GBPBEF : 58.234 - EURJPY : 165.29). In other words, quotes are given with 5 digits. Where rates are below 1, quotes frequently include 5 decimal places.
In 2005 Barclays Capital broke with convention by offering spot exchange rates with 5 or 6 decimal places on their electronic dealing platform. The contraction of spreads (the difference between the bid and offer rates) arguably necessitated finer pricing and gave the banks the ability to try and win transaction 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.
Exchange rate regime
Each country, through varying mechanisms, manages the value of its currency. As part of this function, it determines the exchange rate regimeExchange rate regime
The exchange-rate regime is the way a country manages its currency in relation to other currencies and the foreign exchange market. It is closely related to monetary policy and the two are generally dependent on many of the same factors....
that will apply to its currency. For example, the currency may be free-floating, pegged or 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 bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
s, around the world.
A movable or adjustable peg system is a system of fixed exchange rate
Fixed exchange rate
A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold.A fixed exchange rate is usually used to...
s, but with a provision for the devaluation of a currency. For example, between 1994 and 2005, the Chinese yuan renminbi (RMB) was pegged to the United States dollar
United States dollar
The United States dollar , also referred to as the American dollar, is the official currency of the United States of America. It is divided into 100 smaller units called cents or pennies....
at RMB 8.2768 to $1. China was not the only country to do this; from the end of World War II
World War II
World War II, or the Second World War , was a global conflict lasting from 1939 to 1945, involving most of the world's nations—including all of the great powers—eventually forming two opposing military alliances: the Allies and the Axis...
until 1967, Western European countries all maintained fixed exchange rates with the US dollar based on the Bretton Woods system
Bretton Woods system
The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century...
. http://www-econ.stanford.edu/faculty/workp/swp99020.pdf#search=%22western%20europe%20fixed%20exchange%20rate%201970%20us%20dollar%22 But that system had to be abandoned due to market pressures and speculations in the 1970s in favor of floating, market-based regimes.
Still, some governments keep their currency within a narrow range. As a result currencies become over-valued
Kemal Kurdas
Kemal Kurdas was Turkish Minister of Finance, the IMF’s adviser to Latin American governments and deputy head of the Turkish Treasury. But those jobs were just a small part of a long career. He went on to develop Middle East Technical University, build a distinctive campus for it and create a...
or under-valued, causing trade deficits or surpluses.
Fluctuations in exchange rates
A market based exchange rate will change whenever the values 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 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 bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
s 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 rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
s. 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 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 sell their currency to keep it stable. (When that happens, the speculator can buy the currency back from the bank at a lower price, close out their position, and thereby take a profit.)
Purchasing power of currency
The "real exchange rate" (RER) is the purchasing power of a currency relative to another. It is based on the GDP deflator measurement of the price level in the domestic and foreign countries (), which is arbitrarily set equal to 1 in a given base year. Therefore, the level of the RER is arbitrarily set depending on which year is chosen as the base year for the GDP deflator of two countries. The changes of the RER are instead informative on the evolution over time of the relative price of a unit of GDP in the foreign country in terms of GDP units of the domestic country. If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parityPurchasing power parity
In economics, purchasing power parity is a condition between countries where an amount of money has the same purchasing power in different countries. The prices of the goods between the countries would only reflect the exchange rates...
(PPP) would hold for the GDP deflators of the two countries, and the RER would be constant and equal to one.
Bilateral vs. effective exchange rate
Bilateral exchange rate involves a currency pair, while an effective exchange rateTrade weighted index
The Trade Weighted Index, also known as the effective exchange rate, is a multilateral exchange rate which is a weighted average of exchange rates of home and foreign currencies, with the weight for each foreign country equal to its share in trade...
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.
Uncovered interest rate parity
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 arbitrageArbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
(in reality the opposite, appreciation, quite frequently happens, as explained below). The future exchange rate is reflected into the forward exchange rate stated today. In our example, the forward exchange rate
Forward exchange rate
The forward exchange rate is the rate at which a bank is willing to exchange one currency for another at some specified future date. The forward exchange rate is a type of forward price...
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
Spot price
The spot price or spot rate of a commodity, a security or a currency is the price that is quoted for immediate settlement . Spot settlement is normally one or two business days from trade date...
. 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
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
and a higher-yielding currency.
Balance of payments model
This model holds that a foreign exchange rate must be at its equilibrium level - the rate which produces a stable current accountCurrent account
In economics, the current account is one of the two primary components of the balance of payments, the other being the capital account. The current account is the sum of the balance of trade , net factor income and net transfer payments .The current account balance is one of two major...
balance. A nation with a trade deficit will experience reduction in its foreign exchange reserves
Foreign exchange reserves
Foreign-exchange reserves in a strict sense are 'only' the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, Special Drawing Rights and International Monetary Fund reserve positions...
, which ultimately lowers (depreciates) the value of its currency. The cheaper currency renders the nation's goods (exports) more affordable in the global market place while making imports more expensive. After an intermediate period, imports are forced down and exports rise, thus stabilizing the trade balance and the currency towards equilibrium.
Like PPP
Purchasing power parity
In economics, purchasing power parity is a condition between countries where an amount of money has the same purchasing power in different countries. The prices of the goods between the countries would only reflect the exchange rates...
, the balance of payments
Balance of payments
Balance of payments accounts are an accounting record of all monetary transactions between a country and the rest of the world.These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers...
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
Stocks
Stocks are devices used in the medieval and colonial American times as a form of physical punishment involving public humiliation. The stocks partially immobilized its victims and they were often exposed in a public place such as the site of a market to the scorn of those who passed by...
and bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
. Their flows go into the capital account
Capital account
The current and capital accounts make up a country's balance of payment . Together these three accounts tell a story about the state of an economy, its economic outlook and its strategies for achieving its desired goals...
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.
Asset market model
The expansion in trading of financial assets (stocks and bonds) has reshaped the way analysts and traders look at currencies. Economic variables such as economic growthEconomic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...
, inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
and productivity
Productivity
Productivity is a measure of the efficiency of production. Productivity is a ratio of what is produced to what is required to produce it. Usually this ratio is in the form of an average, expressing the total output divided by the total input...
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
Correlation
In statistics, dependence refers to any statistical relationship between two random variables or two sets of data. Correlation refers to any of a broad class of statistical relationships involving dependence....
with other markets, particularly equities.
Like the stock exchange
Stock exchange
A stock exchange is an entity that provides services for stock brokers and traders to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and redemption of securities and other financial instruments, and capital events including the payment of income and...
, money can be made or lost on the foreign exchange market
Foreign exchange market
The foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...
by investors and speculators buying and selling at the right times. Currencies can be traded at spot and foreign exchange option
Foreign exchange option
In finance, a foreign-exchange option is a derivative financial instrument that gives the owner the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date.The FX options market is the deepest, largest and...
s markets. The spot market represents current exchange rates, whereas options are derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
of exchange rates
Manipulation of exchange rates
Countries may gain an advantage in international tradeInternational trade
International trade is the exchange of capital, goods, and services across international borders or territories. In most countries, such trade represents a significant share of gross domestic product...
if they manipulate the value of their currency
Market manipulation
Market manipulation describes a deliberate attempt to interfere with the free and fair operation of the market and create artificial, false or misleading appearances with respect to the price of, or market for, a security, commodity or currency...
by artificially keeping its value low, typically by the national central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
engaging in open market operations. It is argued that the People's Republic of China has succeeded in doing this over a long period of time. However, in a real-world situation, a 2005 appreciation of the Yuan by 22% was followed by a 38.7% increase in Chinese imports to the US.
In 2010, other nations, including Japan and Brazil, attempted to devalue their currency in the hopes of subsidizing cheap exports and bolstering their ailing economies. A low exchange rate lowers the price of a country's goods for consumers in other countries but raises the price of goods, especially imported goods, for consumers in the manipulating country.
See also
- Bureau de ChangeBureau de ChangeA bureau de change or currency exchange is a business whose customers exchange one currency for another. Although originally French, the term bureau de change is widely used throughout Europe, and European travellers can usually easily identify these facilities when in other European countries...
- Currency PairCurrency pairA currency pair is the quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market. The currency that is used as the reference is called the counter currency or quote currency and the currency that is quoted in relation is called the base...
- Currency strengthCurrency strengthCurrency strength expresses the value of currency. For economists, it is often calculated as purchasing power, while for financial traders, it can be described as an indicator, reflecting many factors related to the currency; for example, fundamental data, overall economic performance or interest...
- Effective exchange rate
- Euro calculatorEuro calculatorA euro calculator is a very popular type of calculator in European countries that adopted the euro as their official monetary unit. It functions like any other normal calculator, but it also includes a special function which allows one to convert a value expressed in the previously official unit ...
- Foreign exchange marketForeign exchange marketThe foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...
- Forex scamForex scamForeign exchange fraud is any trading scheme used to defraud traders by convincing them that they can expect to gain a high profit by trading in the foreign exchange market. Currency trading "has become the fraud du jour" as of early 2008, according to Michael Dunn of the U.S...
- Functional currencyFunctional currencyFunctional currency refers to the main currency used by a business or unit of a business. It is the monetary unit of account of the principal economic environment in which an economic entity operates....
- Tables of historical exchange rates to the USD
- USD Index