Exchange Rate - Explained
What is an Exchange Rate?
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What is an Exchange Rate?
An exchange rate refers to the value of one currency in relation to another currency. It is the rate at which a currency will be exchanged for another currency. In finance, an exchange rate reflects the worth of one currency over others or when compared to the others. Exchange rate is important in international trade and relations, when there are two currencies involved in trade, exchange rate is important. It is important that exchange rate fluctuates as it is affected by several economic factors.
Types of Exchange Rate
There are several types of exchange rate, they include the following;
- A currency peg: this is the actual rate a country pegs its currency against another. The exchange rate stays within the range of the peg.
- A free-floating exchange rate: which is influenced by changes in the exchange market, this exchange rate rises and falls.
- Onshore rate: This is the rate a currency is exchanged within the countrys border.
- Offshore rate: This exchange rate is used outside of the countrys border. It is used for trades outside the country.
- Restricted currencies: This refers to rate restricted within the country's border.
- Spot and Forward rate: The spot rate of a currency is the current market value or cash value of the currency while the forward value is the rate of a currency depending on if it rises or falls in relation to its spot price.
Here are some important points to know about an exchange rate:
- An exchange rate is the value of a country's currency in relation to another currency.
- It refers to the rate at which a currency is exchanged for another currency.
- There are many types of exchange rates but most countries use the free-floating exchange rate which is determined by supply and demand in the market.
Real World Example of How Exchange Rates Work
At a time in 2019, you need $1.13 to buy 1, presently, with $1, you can get 0.91. This means if you have $150, you get to exchange it for 136.5. Given that; $150 * 0.91 = 136.5 The above illustration is applicable to all other currencies, all you need to get is the exchange rate of each currency and multiply by the value at hand. For instance, $1 will give you 110 yen. Hence to change $350 to yen, you have; $350 * 110 = 38,500.00
How is the Conversion Rate Used?
The amount of currency within a system generally controlled by that country's central bank. Individuals from foreign countries can purchase that country's currency in a currency market or the Foreign Exchange market (FOREX). Depending on whether the central bank intervenes to establish its price, the exchange rate can be either fixed or floating.
Fixed Conversion Rate
To establish the value of its national currency, the government of a country associates this value with that of the currency of another country. The fixed exchange rate has several exchange rate regimes that are dependent on the performance of the central bank. They are as follows starting with the strictest to the most flexible:
- Convertibility regime or currency board. This is the most stringent category, and it is established by law. Since the same rules govern it as gold, the central bank has a mandate to immediately convert the currency linked when a citizen coverts this money to cash. However, one must have his total money supply backed by dollars saved in his reserves.
- Conventional fixed-rate regime. This is when a country decides to fix its currency with margins of (+, -) 1% on another currency or basket of currencies. An individual can utilize direct intervention policies or indirect intervention policies.
- Exchange rate within horizontal bands. This provides for better flexibility when compared to the previous one. It is an exchange rate with a target area.
- Mobile exchange rate. This is an exchange rate that is adjusted frequently. Usually, it adjusts for higher inflation which affects the linked currency. It can be carried out passively or actively.
- Type of change with mobile bands. This is a type of change where the width of the bands is increasing bit by bit unlike that with horizontal bands typically used as a step to the floating exchange rate.
- Floating Conversion Rate. This is an exchange rate that is determined by the forces of demand and supply in the market. There are two types, one completely free and the other intervened.
- Clean float. This is the exchange rate which is purely obtained from the forces of demand and supply without the intervention of the central bank.
- Dirty float. This is an exchange rate obtained from the game of supply and demand, but the central bank intervenes by buying or selling to stabilize the currency and achieve its economic goals. It is also known as a managed floating exchange rate.
The Conversion Rate in the Foreign Exchange Market
Taking the exchange rate between the euro and the dollar as an example (EUR / USD), the euro is the base currency since the currency of the numerator is always the base currency, while the dollar is the quote currency. The forex market has two prices, the bid price which is the price at which one must sell and the asking price at which one should buy. The offer price is lower than the demand price at all times. The difference realized between the bid and ask price is referred to as the spread. A small spread means a market is liquid. However, many agents try to increase this spread to reap benefits. When an individual takes a position in the financial market, he must do the opposite of what he did in the beginning to close the operation, that is, if one buys, he has to sell. The price of selling has to be lower than buying at the time the operation is opened because if at the time of the operation the sale price is higher than the purchase price, everyone would sell a product at $5 and then buy it immediately at $3 to close the position and have an assured profit of $2. For example EUR / USD Sell = 1.0826 Buy = 1.0828 The offer price means that one will receive $1.0826 for the sale of 1 euro. This is the amount of the quote currency to be received in exchange for the sale of a unit of base currency. The price of demand means that an individual pays $1.0828 to receive one euro. This is the amount of quote currency to be paid to receive a unit of base currency.
Different ways of seeing the conversion rate
- Direct types. These are when the dollar is the base currency. E.g., USD / JPY
- Indirect types. When the dollar is the quote currency. E.g. EUR / USD
- Cross types. The dollar is not a base or a quote currency. They operate with one currency against another which is not the dollar. However, the dollar is taken into account since even though it does not appear in the final crossing, it is used in the calculation. Very few currencies, however, are exchanged directly.
- What Does it Mean to Dollarize
- Foreign Exchange Market
- Who Demands and Supplies Currency in a Foreign Exchange Market?
- Greenfield Investment
- Brownfield Investment
- Portfolio Investment
- Dealers in the Interbank Market
- Weak and Strong Currency
- Exchange Rate
- Real Effective Exchange Rate (REER)
- Limited Flexibility Exchange Rate System
- Expectations about Future Exchange Rates Shift Demand
- Expected rate of return shift demand and supply for a currency
- Relative Inflation Shifts Demand and Supply for a Currency
- Purchasing Power Parity (PPP)
- Relative Purchasing Power Parity
- Law of One Price
- Balassa-Samuelson Effect
- Tobin Tax
- Foreign Exchange Market
- Foreign Exchange Contract
- Why Central Banks Care About Exchange Rates
- How Do Exchange Rates Affect Aggregate Demand and Aggregate Supply?
- What Causes Exchange Rate Fluctuations?
- Exchange Rate Policy
- Fixed Exchange Rate
- Floating Exchange Rate
- Hard and Soft Peg
- What is a Merged Currency?
- Capital Control
- Exchange Stabilization Fund