The currency exchange rate is the rate at which one currency can be exchanged against another. The currency exchange rate indicates the stature of the national economy with respect to the world economy. The factors impacting currency exchange rates are inflation rates, interest rates, terms of trade, political stability and performance, public debt and current account deficits.
Currency exchange rates are relative and are represented as the relation between the currencies of two countries.
A currency exchange rate is the price of base currency expressed in terms of the price currency. For example AUD/USD = 1.4 means USD (base currency) costs 1.4 AUD.
Base currency is the domestic or accounting currency and Price currency is the foreign currency.
Foreign Exchange Market
The trading on the foreign exchange market is conducted through currency pairs. Common currency pairs are USD/GBP, USD/CAD and AUD/USD.
Direct quote is defined as how many units of domestic currency is required to exchange for one unit of foreign currency.
Indirect quote is defined as how many units of foreign currency is required to exchange for one unit of domestic currency.
Bid Ask Spreads
Bid price is the price at which a dealer is willing to buy one unit of base currency.
Ask price is the price at which a dealer is willing to sell one unit of base currency.
From a customers point of view, it is opposite of dealer. Sell the base currency at bid rate and buy the base currency at ask rate.
The size of the bid ask spread from customers point of view depends on:
- Bid ask spread in the interbank market
- Size of the transaction
- Relationship between dealer and client
The size of the bid ask spread from dealers’ point of view depends on:
- Currency pair involved
- Time of day
- Market volatility
Cross currency exchange rates
Cross currency exchange rate is the exchange rate between two currencies implied by their exchange rates with a common third currency. For example AUD/CAD cross currency exchange rate can be calculated by multiplying the respective bid and ask rates of AUD / USD and USD / CAD currency exchange rates.
Exchange Rate Types
- Floating and Fixed Exchange Rate
- Floating Exchange Rate is constantly changing and is the rate determined by market conditions.
- Fixed Exchange Rate is the rate of exchange fixed by the Government and it remains constant.
- Spot and Forward Exchange Rate
- The Spot Exchange Rate is the current exchange rate for immediate delivery.
- The Forward Exchange Rate is the exchange rate that is decided today but the delivery and payment will be at a future date.
International Parity Relationships and forecasting exchange rates
- Covered interest rate parity is an arbitrage condition that must hold when international financial markets are in equilibrium. It holds forward premium or discount should be equal to the interest rate differential between two countries. If it is violated then arbitrageurs can make profits due to mispricing.
- Uncovered interest rate parity links spot exchange rates, expected spot exchange rates and nominal interest rates. Expected currency depreciation should offset the interest rate differential between two countries over the term of the interest rate.
- Purchasing power parity states that the exchange rate between countries should be equal to the ratio of the countries price levels.
- International fisher relation states that the interest rate differential between two countries should be equal to the expected inflation differential.
- Carry trade involves taking long positions in high yielding currencies and short positions in low yielding currencies. It perform well during low volatility periods and if uncovered interest rate parity does not hold.
Warning signs of currency crisis
- Real exchange rate is higher than its mean level during tranquil periods
- FX reserves decline as crisis approaches
- Terms of trade deteriorate
- High inflation in pre-crisis period
- Money supply relative to bank reserves increases
- Nominal private credit grows
- Equity markets experience a boom bust cycle
Currency exchange rates are an important indicator of health of a country’s economy. The currency exchange rates effects trade and foreign investments across countries. The currency exchange rates influences the rate of return on investments.