As the name would imply, the exchange money rate, also called the foreign exchange rate, the forex rate or the currency exchange rate is the rate at which one currency can be exchanged for another. As such, exchange rates are always quoted in pairs, between two currencies, with a bid price and an ask price for each currency against the other; the difference between the bid price and the ask price is also known as the spread. This spread between the offer and sale price for any currency pair will comprise the profit margin for intermediaries, such as banks, brokers and forex dealers, who execute forex transactions for their retail and institutional clients.
Exchange rates between most major currencies are said to “float”, meaning that the quoted rates change continually throughout the day based on a number of factors including economic and political news, demand for one currency versus another (or lack thereof) and the perceived strength of an issuing nation’s economy. On the most macroeconomic level, exchange rates are also highly influenced by interest rates, as capital tends to be attracted to countries where interest rates on borrowed monies are low, and interest paid to invested monies are high, while fleeing from countries where interest charged on borrowed monies is high and interest paid on invested monies is low. Capital tends to flow into the former, increasing the demand for the currency and thus, decreasing its supply in the foreign currency market, which will result in the price for the currency—the exchange rate vis-à-vis another nation’s currency—increasing. The currency appears more desirable and hence “stronger’, and is said to have appreciated against other floating rate currencies.
Other currencies which do not float according to market conditions and the perceived value of one currency against another are said to be “fixed”, and to have a fixed exchange rate vis-à-vis other currencies. Fixed currencies are pegged to external, unrelated yardstick indicators such as the US dollar, the euro, a basket of currencies, the price of gold or other indices and generally are perceived as importing an artificial value to the pegged currency in question; typically, this artificial value is exaggeratedly high. In most cases, countries whose currency is fixed against a third value such as the US dollar or a basket of currencies are centrally-planned, tightly governed sovereign entities or are less-developed countries whose currency’s value would be minimal, reflecting the weakness of their home economy, if it were allowed to float. In such cases, the central bank of the country issuing the pegged currency commits itself to supporting its currency at the artificially-derived exchange rate. Examples of countries whose pegged currencies are subject to fixed exchange rates are many African, Caribbean and Middle Eastern countries, as well as the countries of the former Soviet Union.
Most foreign currency transactions take place in what is known as the spot forex market. In the spot market, contracts are entered into for the purchase or sale of a currency against another—a so-called “currency pair”—at the prevailing exchange rate in place at the time that the contract is entered into. Such transactions are executed immediately, for delivery two days later, resulting in the immediate booking of the exchange of one currency for another. Examples of spot foreign currency transactions range from the casual traveler exchanging his Dollars for Euros at the airport (and vice-versa), wherein the money changer’s risk is the risk that the quoted rate will move against him in two days, causing such transactions to be particularly expensive due to the wide spread between the retail bid and ask prices as the money changer hedges his position, to corporations having been paid in a foreign currency who are seeking to convert that payment back into their home currency for repatriation purposes.
Foreign currency transactions that do not take place in the spot market are said to take place in the so-called “forward market”. In the forward market, an agreement is entered into today between a buyer and a seller for the delivery of the currency at a specified date in the future, at an exchange rate agreed-to between the parties at the time that the contract is entered into. This exchange rate is not the prevailing spot rate at the time of the agreement but rather, is a different rate agreed-to between the parties based on their perception of how the two currencies will have moved against each other by the time that the forward contract is scheduled to come due. This exchange rate is arrived at taking into account such external factors as political developments (such as elections), economic developments (whether planned, such as scheduled announcements from the US Federal Reserve or the European Central Bank, or whether unplanned), and important geopolitical and economic events. In fact, the foreign exchange markets are highly susceptible to such outside influences and as such, serious forex traders, retail and institutional alike, put a great deal of stock into staying abreast of news and developments that can influence movements in the price of one currency against another as they go about their regular trading activities. A good example of an entity interested in entering into a forward forex contract would be an internationally-active corporation needing to make foreign-currency denominated payments overseas (such as local salaries or rent) who, believing that the foreign currency will appreciate vis-à-vis their home currency in the interim, will enter into a forward contract today in order to protect themselves against the future perceived depreciation of their home currency.
Because foreign exchange rates are understood to be a reflection of the perceived strength of any given currency, and by extension, a reflection of the strength of the issuing country’s economy, most developed nations are willing to take measures to support the value of their home currency if necessary. Such measures might include the buying up of excess dollars by the Federal Reserve or even the selling of dollars into the market by the Fed if it chooses to head off strong appreciation of the dollar against a friendly currency. Actions undertaken by governments and central banks to influence their domestic currency’s movements are of great significance, since exchange rates and currency strength have a direct influence on import and export figures and thus, ultimately, on inflation. Monetary policy, therefore, is also a factor that regularly affects foreign exchange rates and is typically on the agenda of most major international policy meetings and trade summits of any real significance.
As the foregoing summary demonstrates, foreign currency exchange rates are anything but random, and are arrived at based on a number of factors of primary importance to all sovereign currency issuers. Foreign exchange rates and national monetary policies go hand-in-hand, and the trader who understands this balance, who understands his currency pair and who stays abreast of developments is well-positioned to benefit from trading in the dynamic currency markets.
If you have any questions or looking for further information, please do not hesitate to contact us. It is our pleasure to help you.