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In finance, the exchange rates (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies specifies how much one currency is worth in terms of the other. It is the value of a foreign nation’s currency in terms of the home nation’s currency.[1] For example an exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (USD, \$) means that JPY 91 is worth the same as USD 1. The foreign exchange market is one of the largest markets in the world. By some estimates, about 3.2 trillion USD worth of currency changes hands every day.

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.

Quotations

An exchange system quotation is given by stating the number of units of "quote currency" (price currency, payment currency) that can be exchanged for one unit of "base currency" (unit currency, transaction currency). For example, in a quotation that says the EUR/USD exchange rate is 1.4320 (1.4320 USD per EUR, also known as EUR/USD; see foreign exchange market), the quote currency is USD and the base currency is EUR.

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. Thus if you are doing a conversion from EUR into AUD, EUR is the base currency, AUD is the term currency and the exchange rate tells you how many Australian dollars you would pay or receive 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)[2] 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.

• direct quotation: 1 foreign currency unit = x home currency units
• indirect quotation: 1 home currency unit = x foreign currency units

Note that, 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[3]. 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.

While official quotations are given with the full number, for example 1.4320, many investors and analysts drop the integer for convenience and use only the fractional part, such as 4320. These are used frequently where a move in price is being described, for example 4320 to 4290 as opposed to 1.4320 to 1.4290[4]

Free or pegged

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 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. [1]

The RER{Real Exchange Rate}is based on the GDP deflator measurement of the price level in the domestic and foreign countries (P,Pf), 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.

Bilateral vs. effective exchange rate

Bilateral exchange rate involves a currency pair, while effective exchange rate is 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) adjust 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 arbitrage. 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 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.

This model holds that a foreign exchange rate must be at its equilibrium level - the rate which produces a stable current account 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 tradable 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.

Asset market model

The blowing up in trading of financial assets (stocks and bonds) has reshaped the way analysts and traders look at currencies. 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 the foreign exchange market by investors and speculators buying and selling at the right times. 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

Fluctuations in exchange rates

Exchange rates display

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 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 country's level of business activity, gross domestic product (GDP), and employment levels. The more people there 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.

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 country's interest rates, the greater the demand for that currency. It has been argued that currency speculation can undermine real economic growth, in particular since large currency speculators may deliberately create downward pressure on a currency in order to force that central bank to sell their currency to keep it stable (once this happens, the speculator can buy the currency back from the bank at a lower price, close out their position, and thereby take a profit).

References

1. ^ O'Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 458. ISBN 0-13-063085-3.
2. ^ Understanding foreign exchange: exchange rates
3. ^ http://www.finextra.com/fullstory.asp?id=13480
4. ^ How prices are displayed
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In finance, the exchange rates (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies specify how much one currency is worth in terms of the other. It is the value of a foreign nation’s currency in terms of the home nation’s currency.[1] For example an exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (USD, \$) means that JPY 91 is worth the same as USD 1. The foreign exchange market is one of the largest markets in the world. By some estimates, about 3.2 trillion USD worth of currency changes hands every day.

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.

Quotations

An exchange system quotation is given by stating the number of units of "quote currency" (price currency, payment currency) that can be exchanged for one unit of "base currency" (unit currency, transaction currency). For example, in a quotation that says the EUR/USD exchange rate is 1.2290 (1.2290 USD per EUR, also known as EUR/USD; see foreign exchange market), the quote currency is USD and the base currency is EUR.

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. Thus if you are doing a conversion from EUR into AUD, EUR is the base currency, AUD is the term currency and the exchange rate tells you how many Australian dollars you would pay or receive 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)[2] 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.

• direct quotation: 1 foreign currency unit = x home currency units
• indirect quotation: 1 home currency unit = x foreign currency units

Note that, 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.[3] 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.

While official quotations are given with the full number, for example 1.4320, many investors and analysts drop the integer for convenience and use only the fractional part, such as 4320. These are used frequently where a move in price is being described, for example 4320 to 4290 as opposed to 1.4320 to 1.4290.[4]

Free or pegged

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 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. [1]

The RER (Real Exchange Rate) refers to the purchasing power of two currencies relative to one another. It is based on the GDP deflator measurement of the price level in the domestic and foreign countries ($P,P^f$), 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.

Bilateral vs. effective exchange rate

Bilateral exchange rate involves a currency pair, while effective exchange rate is 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) adjust 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 arbitrage (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 of payments model

This model holds that a foreign exchange rate must be at its equilibrium level - the rate which produces a stable current account 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.

Asset market model

The blowing up in trading of financial assets (stocks and bonds) has reshaped the way analysts and traders look at currencies. 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 the foreign exchange market by investors and speculators buying and selling at the right times. 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

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 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 country's level of business activity, gross domestic product (GDP), and employment levels. The more people there 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.

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 country's interest rates, the greater the demand for that currency. It has been argued that currency 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 (once this happens, the speculator can buy the currency back from the bank at a lower price, close out their position, and thereby take a profit).

Manipulation of exchange rates

Countries may gain an advantage in international trade if they manipulate the value of their currency by artificially keeping its value low. 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.[5][6]

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.[7]

 File:EUR 1 (2007 issue).png Business and economics portal

References

1. ^ O'Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 458. ISBN 0-13-063085-3.
2. ^ Understanding foreign exchange: exchange rates
3. ^ http://www.finextra.com/fullstory.asp?id=13480
4. ^ How prices are displayed
5. ^ "Appreciate This: Chinese Currency Rise Will Have a Negligible Effect on the Trade Deficit" article by Daniel J. Ikenson in The Cato Institute March 24, 2010
6. ^ "Economists Ignore the Facts in Supporting Chinese Currency Legislation" article by Daniel Ikenson in The Cato Institute October 1, 2010
7. ^ "More Countries Adopt China’s Tactics on Currency" article by David E. Sanger and Michael Wines in The New York Times October 3, 2010, accessed October 4, 2010