In finance, the exchange rate is the value at which one currency will be exchanged for another. It is also regarded as the value of the monetary unit 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, it is said that the price of the dollar against the yen is 114 .
Exchange rates are determined in the foreign exchange market, which is open to a wide range of buyers and sellers of various types. It is continuous trade: it runs 24 hours a day, except weekends.
In the retail foreign exchange market, various sale and purchase rates are quoted. Most transactions relate to or derive from a local unit of money. A purchase rate is the rate at which participants will buy foreign currency, and the rate of sale is the rate at which they will sell it. The quotation rates will take into account the size of the dealer’s margin (or profit) during trading, otherwise it can be restored in the form of a commission or in some other way. Different rates can also be indicated for cash, their documentary form or electronic form.
Retail market
Currency for international travel and cross-border payments is mainly purchased from banks and foreign exchange brokerage companies. Purchases here are 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 make a profit. One form of such levy is the use of an exchange rate that is less favorable than the option rate. This can be seen by studying any currency informant. The course will be slightly inflated 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, a quote of EUR / USD 1: 1.3225 means that 1 euro will be bought for 1.3225 US dollars. In other words, this is the unit price of the euro in US dollars, or the exchange rate of the euro. 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 fixed is called direct and is used in most countries. Another option using a national unit in the form of a variable is known as an indirect or quantitative quote, 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 studying a currency informant, the rate at which may look unusual.
If the domestic currency strengthens (i.e. becomes more valuable), the value of the exchange rate decreases. Conversely, if a foreign unit is strengthened, and the domestic one is depreciated, then this figure increases.
Exchange rate mode
Each country determines the exchange rate regime that will apply to its currency. For example, it can be freely floating, tethered (fixed) or hybrid.
If a currency floats freely, its exchange rate can vary significantly depending on the value of other units and is determined by the market forces of supply and demand. Exchange rates for such money are likely to change almost constantly, as can be seen in financial markets around the world.
What is a fixed system?
A movable or regulated pegging system is a system of fixed exchange rates, but with a reserve for revaluing (usually devaluing) currencies. For example, between 1994 and 2005, the Chinese yuan was pegged to the US dollar with a value of 8.2768: 1. China was not the only country to do this. From the end of World War II until 1967, Western European countries maintained fixed exchange rates with the US dollar based on the Bretton Woods system. But this system today is already leaving in favor of floating market regimes. However, some governments seek to keep their currency in a narrow range. As a result, such units become excessively expensive or cheap, which leads to a trade deficit or surplus.
Exchange Rate Classification
From the point of view of banking currency trading, the purchase price is the value used by the bank to purchase foreign currency from a client. In general, the exchange rate in which a foreign unit is converted to a smaller amount of the domestic one is the purchase rate, which indicates how much the country's currency is required to purchase a certain amount of foreign denomination. For example, having studied the exchange rate of the dollar and the euro on a currency informer, you can determine how much other nominal value you need to give for them.
The selling price of foreign currency refers to the exchange rate used by the bank to sell it to customers. This value indicates how much the country's currency needs to be paid if the bank sells a certain unit.
The average rate is the average price of supply and demand. Usually this number is used in newspapers, magazines or other sources of economic analysis (in which you can see the exchange rates for tomorrow).
Factors Affecting Exchange Rate Changes
When a country has a large deficit in the balance of payments or trade, this means that its foreign exchange profit is less than the cost of the currency, and the demand for this denomination exceeds the supply, so the exchange rate rises and the national unit depreciates.
Interest rates are the cost and profit of borrowed capital. When a country raises its interest rate or its domestic given value is higher than that of a foreign one, this will lead to an inflow of capital, thereby increasing the demand for domestic currency, allowing it to value and depreciate another.
When inflation in a country rises, the purchasing power of money decreases. Paper currency is depreciating domestically. If inflation occurs in both countries, the units of countries with a high level of this process will depreciate against the ratings of countries with a low level.
Fiscal and monetary policy
Although the influence of monetary policy on changes in the country's exchange rate is indirect, it is also very important. On the whole, the huge budget and spending deficits caused by expansionary fiscal and monetary policies and inflation will devalue the domestic currency. Strengthening 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 valued highly, they will buy it in large quantities, which will lead to an increase in the exchange rate of this unit. This especially affects the exchange rate of the dollar and the euro. Conversely, if they expect a certain unit to depreciate, they will sell large amounts of it, which leads to speculation. The exchange rate drops immediately. Speculation is an important factor in short-term fluctuations in the exchange rate of the currency market.
State influence on the market
When exchange rate fluctuations adversely affect the economy, trade or government of a country, certain goals must be achieved by adjusting the exchange rate. Monetary authorities can participate in the trading of monetary units, the purchase or sale of local or foreign denominations in large quantities in the market. Foreign exchange supply and demand cause a change in the exchange rate.
In general, high economic growth rates do not contribute to the rapid growth of local currency in the market in the short term, but in the long run they strongly support the strong dynamics of the local unit.
Exchange rate fluctuations
The exchange rate will change whenever the values of either of the two component currencies change. This can be traced to 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 demand for it is greater than available supply. It becomes less valuable when demand for it is less than the available stock (this does not mean that people no longer want to buy it, it means that they prefer to keep their capital in some other form).
The increase in demand for foreign currency may be due to an increase in transactional demand or speculative demand for money. Demand for a transaction is strongly correlated with the level of business activity of the country, gross domestic product (GDP) and level of employment. The more unemployed people, the less the public as a whole will spend on goods and services. It is usually not easy for central banks to adjust the available money supply to account for changes in money demand due to business transactions.
What is speculative demand?
Speculative demand is much more difficult for central banks, which it affects by adjusting interest rates. A speculator can buy currency if the yield (i.e. interest rate) is high enough. In general, the higher the interest rates in the country, the greater the demand for this unit. So, if the dollar exchange rate is growing at the currency informer, they will actively buy it.
Financial analysts argue that such speculation can undermine real economic growth, as large traders can intentionally create downward pressure on the currency to force the central bank to buy its own unit in order to keep it stable. When this happens, the speculator can buy the currency after it depreciates, close its position and thereby make a profit.
Currency purchasing power
Real exchange rate (RER) - the purchasing power of a currency against another at current exchange rates and prices. This is the ratio of the number of currency units of a given country to purchase a market basket of goods in another country after purchasing its monetary value. Thus, it is not enough to study the currency exchange rate for the euro (for example) in order to evaluate this unit in this context.
In other words, this is the exchange rate multiplied by the relative prices of a market basket of goods in the two countries. For example, the purchasing power of the US dollar in relation to the price of the euro is the dollar value of the euro (dollars per euro) multiplied by the euro price of one unit of the market basket (unit euro / item) divided by dollar prices from the market basket (in dollars per unit item ) and, therefore, is dimensionless. This is the exchange rate (expressed in US dollars per euro) with respect to the relative price of the two currencies in terms of their ability to acquire market basket units (euro per unit of goods divided by dollars per unit of goods). If all goods were freely traded, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would be for the exchange rate and GDP deflators (price level) 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 (the positive or negative interest rate on the change in the exchange rate of the dollar against the euro) plus the rate of inflation of the euro minus inflation 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 country's competitiveness in relation to the rest of the world. In more detail: an increase in the exchange rate or a higher level of domestic inflation leads to an increase in RER, which worsens the country's competitiveness and reduces the current account (CA). Depreciation of the currency, on the other hand, creates the opposite effect.
There is evidence that RER usually reaches a steady level in the long run and that this process is faster in a small open economy characterized by fixed exchange rates. Any significant and constant deviation of such an exchange rate from its long-term equilibrium level negatively affects the country's balance of payments. In particular, the protracted revaluation of the RER is widely regarded as an early sign of an impending crisis due to the fact that the country is becoming vulnerable to both speculative attacks and the currency crisis. On the other hand, a protracted underestimation of RER usually creates pressure on domestic prices, changing incentives for consumer consumption and, consequently, improper allocation of resources between traded and non-traded sectors.