A foreign exchange (FX) rate or international exchange rate is the price of one country's money (currency) in terms of another's. Technically, this is known as the nominal exchange rate, as contrasted with the real exchange rate, which is the relative price of comparable goods between two countries. In general usage, however, when someone refers to the exchange rate, he or she is referring to the nominal rate. Due to government interventions, some currencies also have multiple exchange rates for different purposes.
Exchange rates are determined by the supply of and the demand for currencies, many of which are traded on foreign exchange markets. Such trading is fundamental to the modern market-based global economy, as it enables a rapid and relatively fair exchange of goods or services across national borders.
As nations and their economies have become increasingly interdependent, the FX market has emerged as a global focal point. With an estimated daily FX turnover exceeding $1 trillion, equal to around one-eighth of U.S. annual gross domestic product, this is by far the world's largest market. In order to remain competitive in the world economy, it is vital for businesses dealing in international markets to manage the risk of adverse currency fluctuations.
Nations have used three main mechanisms to establish exchange rates for their currencies: I) the gold standard, in which a currency is denominated in a unit of gold; 2) pegged rates, under which governments denominate their currencies in units of a strong global currency—often the U.S. dollar; and 3) free-floating rates, which are set by free (or relatively free) market forces.
Most countries abandoned the gold standard in the 1970s; however, pegged and free-floating methods are used widely. Pegged rates are usually sought by countries with emerging economies that want the stability of a major currency but may not have the economic presence to ensure that stability on their own. This method is by no means flawless, though, and countries with pegged currencies still face currency crises even when the currency to which they are pegged remains stable. Floating rates are employed by most of the world's largest economies, including that of the United States, most of the industrial economies, and some of the emerging economies. Some governments participate in the market system, but also attempt to insulate their currencies by placing certain arbitrary restrictions on trading, such as specifying a "band" or range of acceptable trading values.
Several factors influence exchange rates, including:
All of these, and possibly other, factors can affect the market's perception of the strength of the foreign currency. Analogous to the buying and selling of corporate stocks, if signs loom that a national economy could be weakening or troubled, traders may quickly reduce their holdings of its currency. This typically causes the currency to loose value relative to other currencies the market favors.
Because exchange rates express one currency in terms of another, a change in the rate may be triggered by positive or negative influences from either side. For instance, if the U.S. dollar weakens versus the yen, it's not necessarily because there is bad news about the U.S. economy. Rather, it could simply mean there is good news about the Japanese economy and no change in the perception of U.S. economic health.
Currency trading is not always grounded in cautious, rational analysis, however. Since currency investors make many short-term decisions about how best to position their assets, a small item in the daily news may trigger an onslaught of buying or selling of a particular currency, which on a macro scale could result in a an exchange rate fluctuation of several U.S. cents or more per unit.
Exchange rates can significantly alter a particular country's trade position by changing the relative value of its exports and imports. In general, when the currency in Country A is strong relative to Country B, Country A's exports are more expensive and less attractive to buyers in Country B, but imports from Country B may be at a favorable price in Country A. Conversely, if Country A's currency is weak, its exports would likely be more robust and imports from Country B would be less attractive.
As these converse relationships illustrate, there are advantages and disadvantages to a nation having a currency that is considerably stronger or weaker than those of major trading partners. Certainly, a rapid weakening of a currency can produce an economic crisis, as noted below in the discussion on Asia, but a stable yet weak currency can be a boon to an export-based economy because exporters from a weak-currency country tend to have a price advantage over competitors based in a stronger-currency economy. Still, the market nature of exchange rates usually ensures there is no great imbalance between a country's broader economic health and the strength of its currency; when a currency remains weak compared to others, it often reflects a lack of investor confidence in that country's economy.
While any nation can suffer from a volatile or weak exchange market for its currency, smaller, emerging economies tend to be most susceptible to wide, and potentially catastrophic, fluctuations. Some of the most dramatic recent examples of this phenomenon ravaged east Asian economies in the late 1990s Asian financial crisis. While the roots of the region's economic malaise were diverse and complex, much of the tangible damage occurred when currency traders—mostly from outside the region—balked at perceived weaknesses and sold off Asian currencies at a frenetic pace. The resulting drop in value of currencies such as South Korea's won and Indonesia's rupiah had devastating consequences for individuals, businesses, and even governments.
One of the most immediate effects of these currency devaluations was the appreciation of foreign-denominated debt relative to the local currencies. For example, consider an Indonesian company with a $1 million loan, denominated in dollars, from a U.S. bank. If the monthly payment on the loan were $10,000, at pre-crisis exchange rates (approximately 2,500 rupiahs to the dollar) the company would have paid 2.5 million rupiahs per month. However, once the Indonesian currency plummeted in 1997 to 10,000 rupiah to the dollar, the amount needed to service this debt would instantly skyrocket to 10 million rupiahs per month. Assuming the company had no substantial assets or revenue streams denominated in dollars to help insulate it, its revenues in rupiahs would at best remain flat, thus creating a shortfall of 7.5 million rupiah per month. In effect, the company's debt would have quadrupled without any corresponding change in its local business conditions. If anything, its revenues would likely drop as its customers faced similar hardships and cut back on spending, leading to a cycle of mounting debts and falling revenues.
SEE ALSO : Foreign Exchange
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Rosenberg, Michael R. Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination. New York: Irwin/McGraw-Hill, 1995.