Exchange rate
In finance, an exchange rate is the rate at which one currency will be exchanged for another currency. 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.
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, or a hybrid. 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. Rather, national exchange rate regimes reflect political considerations.
In floating exchange rate regimes, exchange rates are determined in the foreign exchange market, 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. 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, money dealers offer different prices for buying and selling currencies. 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 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.
The retail exchange market
Currency for international travel and cross-border payments is predominantly purchased from banks, foreign exchange brokerages and various forms of bureaux de change. These retail outlets source currency from the interbank markets, which are valued by the Bank for International Settlements at US$5.3 trillion per day. The purchase is made at the spot contract rate. Retail customers will be charged, in the form of commission or otherwise, to cover the provider's costs and generate a profit. One form of charge is the use of an exchange rate that is less favourable than the wholesale spot rate. The difference between retail buying and selling prices is referred to as the bid–ask spread.Retail foreign exchange trading
Retail foreign exchange trading is a small segment of the larger foreign exchange market where individuals speculate on the exchange rate between different currencies. This segment has developed with the advent of dedicated electronic trading platforms and the internet, which allows individuals to access the global currency markets. As of 2016, it was reported that retail foreign exchange trading represented 5.5% of the whole foreign exchange market.Quotations
There is a market convention that rules the notation used to communicate the fixed and variable currencies in a quotation. For example, in a conversion from EUR to AUD, EUR is the fixed currency, AUD is the variable currency and the exchange rate indicates how many Australian dollars would be paid or received for 1 euro.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, 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
For example, = in the Eurozone and is used in most countries.
Quotation using a country's home currency as the unit currency is known as indirect quotation or quantity quotation and is used in British newspapers; it is also common in Australia, New Zealand and the Eurozone.
Using direct quotation, if the home currency is strengthening 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.. 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. e.g.. 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 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.
Exchange rate regime
Countries are free to choose which type of exchange rate regime they will apply to their currency. The main types of exchange rate regimes are: free-floating, pegged, or a hybrid.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 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 revaluation of a currency. For example, between 1994 and 2005, the Chinese yuan renminbi 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.
Exchange rate classification
; From the perspective of bank foreign exchange trading:- Buying rate: Also known as the purchase price, it is the price used by the foreign exchange bank to buy foreign currency from the customer. In general, the exchange rate where the foreign currency is converted to a smaller number of domestic currencies is the buying rate, which indicates how much the country's currency is required to buy a certain amount of foreign exchange.
- Selling rate: Also known as the foreign exchange selling price, it refers to the exchange rate used by the bank to sell foreign exchange to customers. It indicates how much the country's currency needs to be recovered if the bank sells a certain amount of foreign exchange.
- Middle rate: The average of the bid price and the ask price. Commonly used in newspapers, magazines or economic analysis.
- Spot exchange rate: Refers to the exchange rate of spot foreign exchange transactions. That is, after the foreign exchange transaction is completed, the exchange rate in Delivery within two working days. The exchange rate that is generally listed on the foreign exchange market is generally referred to as the spot exchange rate unless it specifically indicates the forward exchange rate.
- Forward exchange rate: To be delivered in a certain period of time in the future, but beforehand, the buyer and the seller will enter into a contract to reach an agreement. When the delivery date is reached, both parties to the agreement will deliver the transaction at the exchange rate and amount of the reservation. Forward foreign exchange trading is an appointment-based transaction, which is due to the different time the foreign exchange purchaser needs for foreign exchange funds and the introduction of foreign exchange risk. The forward exchange rate is based on the spot exchange rate, which is represented by the "premium", "discount", and "parity" of the spot exchange rate.
- Basic rate: Usually choose a key convertible currency that is the most commonly used in international economic transactions and accounts for the largest proportion of foreign exchange reserves. Compare it with the currency of the country and set the exchange rate. This exchange rate is the basic exchange rate. The key currency generally refers to a world currency, which is widely used for pricing, settlement, reserve currency, freely convertible, and internationally accepted currency.
- Cross rate: After the basic exchange rate is worked out, the exchange rate of the local currency against other foreign currencies can be calculated through the basic exchange rate. The resulting exchange rate is the cross exchange rate.