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In finance, an exchange rate is the rate at which one currency will be exchanged for another currency. (2025). 9780393644494, W.W. Norton & Company. ISBN 9780393644494 Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of the euro. (2025). 9780393644494, W.W. Norton & Company. ISBN 9780393644494
The exchange rate is also regarded as the value of one country's currency in relation to another currency. For example, an interbank exchange rate of 141 Japanese yen to the United States dollar means that ¥141 will be exchanged for or that will be exchanged for ¥141. In this case it is said that the price of a dollar in relation to yen is ¥141, or equivalently that the price of a yen in relation to dollars is $1/141.
The exchange rate may be quoted as a ratio, for instance, USD/EUR might be equal to 0.8625. In this case, the ratio must be interpreted as adimensional, that is, USD/EUR=0.8625, or 1 USD = 0.8625 EUR, meaning that 1 United States dollar will be exchanged for 0.8625 Euros, or that 1 Euro will be exchanged for 1/0.8625=1.1594 United States dollars. Equivalently, EUR/USD = 1.1594.
Each country determines the exchange rate regime that will apply to its currency. For example, a currency may be floating, pegged (fixed), or a hybrid. (2025). 9780393644494, W.W. Norton & Company. ISBN 9780393644494 Governments can impose certain limits and controls on exchange rates. Countries can also have a strong or weak currency. There is no agreement in the economic literature on the optimal national exchange rate policy (unlike on the subject of trade where free trade is considered optimal). Rather, national exchange rate regimes reflect political considerations.
In floating exchange rate regimes, exchange rates are determined in the foreign exchange market, The Economist – Guide to the Financial Markets (pdf) which is open to a wide range of different types of buyers and sellers, and 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 is the current exchange rate, while the forward exchange rate is 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, different buying and selling rates 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 that 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, a documentary transaction or for electronic transfers. The higher rate on documentary transactions has been justified as compensating for the additional time and cost of clearing the document. On the other hand, cash is available for resale immediately, but incurs security, storage, and transportation costs, and the cost of tying up capital in a stock of banknotes (bills).
In some areas of Europe and in the retail market in the United Kingdom, EUR and GBP are reversed so that GBP is quoted as the fixed currency to the euro. In order to determine which is the fixed currency when neither currency is on the above list (i.e. both are "other"), market convention is to use the fixed currency which gives an exchange rate greater than 1.000. This reduces rounding issues and the need to use excessive numbers of decimal places. There are some exceptions to this rule: for example, the Japanese often quote their currency as the base to other currencies.
Quotation using a country's home currency as the price currency is known as direct quotation or price quotation (from that country's perspective)
For example, = in the Eurozone and is used in most countries.
Quotation using a country's home currency as the unit currency (for example, = in the Eurozone) is known as indirect quotation or quantity quotation and is used in United Kingdom newspapers; it is also common in Australia, New Zealand and the Eurozone.
Using direct quotation, if the home currency is strengthening (that is, appreciating, or becoming more valuable) then the exchange rate number decreases. Conversely, if the foreign currency is strengthening and the home currency is depreciating, the exchange rate number increases.
Market convention from the early 1980s to 2006 was that most currency pairs were quoted to four decimal places for spot transactions and up to six 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 five or six decimal places. Although there is no fixed rule, exchange rates numerically greater than around 20 were usually quoted to three decimal places and exchange rates greater than 80 were quoted to two decimal places. Currencies over 5000 were usually quoted with no decimal places (for example, the former Turkish Lira). e.g. (GBPOMR : 0.765432 - : 1.4436 - EURJPY : 165.29). In other words, quotes are given with five digits. Where rates are below 1, quotes frequently include five decimal places.
In 2005, Barclays Capital broke with convention by quoting spot exchange rates with five or six decimal places on their electronic dealing platform. The contraction of spreads (the difference between the bid and ask rates) arguably necessitated finer pricing and gave the banks the ability to try to win transactions on multibank trading platforms where all banks may otherwise have been quoting the same price. A number of other banks have since followed this system.
In free-floating regimes, exchange rates are allowed to vary against each other according to the market forces of supply and demand. Exchange rates for such currencies are likely to change almost constantly as quoted on , mainly by , around the world.
A movable or adjustable peg system is a system of fixed exchange rates, but with a provision for the revaluation (usually 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. But that system had to be abandoned in favor of floating, market-based regimes due to market pressures and speculation, according to President Richard M. Nixon in a speech on August 15, 1971, in what is known as the Nixon Shock.
Still, some governments strive to keep their currency within a narrow range. As a result, currencies become over-valued or under-valued, leading to excessive trade deficits or surpluses.
In September 2019 Argentina restricted the ability to buy US dollars. Mauricio Macri in 2015 campaigned on a promise to lift restrictions put in place by the left-wing government including the capital controls which have been used in Argentina to manage economic instability. When inflation rose above 20 percent transactions denominated in dollars became commonplace as Argentines moved away from using the peso. In 2011 the government of Cristina Fernández de Kirchner restricted the purchase of dollars leading to a rise in black market dollar purchases. The controls were rolled back after Macri took office and Argentina issued dollar denominated bonds, but when various factors led to a loss in the value of the peso relative to the dollar leading to the restoration of capital controls to prevent additional depreciation amidst peso selloffs.
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. 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 . 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 buy their own currency to keep it stable. (When that happens, the speculator can buy the currency back after it depreciates, close out their position, and thereby make a profit.)
For Ship transport shipping goods from one nation to another, exchange rates can often impact them severely. Therefore, most carriers have a CAF charge to account for these fluctuations.
Thus the real exchange rate is the exchange rate times the relative prices of a market basket of goods in the two countries. For example, the purchasing power of the US dollar relative to that of the euro is the dollar price of a euro (dollars per euro) times the euro price of one unit of the market basket (euros/goods unit) divided by the dollar price of the market basket (dollars per goods unit), and hence is dimensionless. This is the exchange rate (expressed as dollars per euro) times the relative price of the two currencies in terms of their ability to purchase units of the market basket (euros per goods unit divided by dollars per goods unit). If all goods were freely Tradable good, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the exchange rate and (price levels) of the two countries, and the real exchange rate would always equal 1.
The rate of change of the real exchange rate over time for the euro versus the dollar equals the rate of appreciation of the euro (the positive or negative percentage rate of change of the dollars-per-euro exchange rate) plus the inflation rate of the euro minus the inflation rate of the dollar.
There is evidence that the RER generally reaches a steady level in the long-term, and that this process is faster in small open economies characterized by fixed exchange rates. Any substantial and persistent RER deviation from its long-run equilibrium level, the so-called RER misalignment, has shown to produce negative impacts on a country's balance of payments. An overvalued RER means that the current RER is above its equilibrium value, whereas an undervalued RER indicates the contrary. Specifically, a prolonged RER overvaluation is widely considered as an early sign of an upcoming crisis, due to the fact that the country becomes vulnerable to both speculative attacks and currency crisis, as happened in Thailand during the 1997 Asian financial crisis. On the other side, a protracted RER undervaluation usually generates pressure on domestic prices, changing the consumers' consumption incentives and, so, misallocating resources between tradable and non-tradable sectors.
Given that RER misalignment and, in particular overvaluation, can undermine the country's export-oriented development strategy, the equilibrium RER measurement is crucial for policymakers. Unfortunately, this variable cannot be observed. The most common method in order to estimate the equilibrium RER is the universally accepted Purchasing Power Parity (PPP) theory, according to which the RER equilibrium level is assumed to remain constant over time. Nevertheless, the equilibrium RER is not a fixed value as it follows the trend of key economic fundamentals, such as different monetary and fiscal policies or asymmetrical shocks between the home country and abroad. Consequently, the PPP doctrine has been largely debated during the years, given that it may signal a natural RER movement towards its new equilibrium as a RER misalignment.
Starting from the 1980s, in order to overcome the limitations of this approach, many researchers tried to find some alternative equilibrium RER measures. Two of the most popular approaches in the economic literature are the Fundamental Equilibrium Exchange Rate (FEER), developed by Williamson (1994), and the Behavioural Equilibrium Exchange Rate (BEER), initially estimated by Clark and MacDonald (1998). The FEER focuses on long-run determinants of the RER, rather than on short-term cyclical and speculative forces. It represents a RER consistent with macroeconomic balance, characterized by the achievement of internal and external balances at the same time. Internal balance is reached when the level of output is in line with both full employment of all available factors of production, and a low and stable rate of inflation. On the other hand, external balance holds when actual and future CA balances are compatible with long-term sustainable net capital flows. Nevertheless, the FEER is viewed as a normative measure of the RER since it is based on some "ideal" economic conditions related to internal and external balances. Particularly, since the sustainable CA position is defined as an exogenous value, this approach has been broadly questioned over time. By contrast, the BEER entails an econometric analysis of the RER behaviour, considering significant RER deviations from its PPP equilibrium level as a consequence of changes in key economic fundamentals. According to this method, the BEER is the RER that results when all the economic fundamentals are at their equilibrium values. Therefore, the total RER misalignment is given by the extent to which economic fundamentals differ from their long-run sustainable levels. In short, the BEER is a more general approach than the FEER, since it is not limited to the long-term perspective, being able to explain RER cyclical movements.
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.
Like purchasing power parity, the balance of payments model focuses largely on tradeable 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 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 effectively.
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 Stock.
Like the stock exchange, money can be made (or lost) on trading by investors and speculators in the foreign exchange market. Currencies can be traded at spot and foreign exchange options markets. The represents current exchange rates, whereas options are derivatives of exchange rates.
Other nations, including Iceland, Japan, Brazil, and so on have had a policy of maintaining a low value of their currencies in the hope of reducing the cost of exports and thus bolstering their economies. A lower exchange rate lowers the price of a country's goods for consumers in other countries, but raises the price of imported goods and services for consumers in the low value currency country. "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
This practice is known as "modern mercantilism", namely lowering the exchange rate below its real and fair price, to increase the competitiveness of trade and exports, and encourage economic growth. Rodrik said that this practice was quite effective in encouraging economic growth in developing countries but at the expense of other deficit countries.
In general, exporters of goods and services will prefer a lower value for their currencies, while importers will prefer a higher value.
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