Determination of Exchange Rates

An exchange rate is the price of one currency in terms of another – in other words, the purchasing power of one currency against another.

Currencies are traded in foreign exchange markets and the volume of money bought and sold is huge! Daily foreign exchange market turnover averages over $4 trillion

Exchange rates are an important instrument of monetary policy – a growing number of countries are intervening in currency markets as part of their economic strategies

Measuring the exchange rate

Exchange rates are expressed in various ways:

• Spot Exchange Rate – the spot rate is the rate for a currency at today’s market prices
• Forward Exchange Rate – a forward rate involves the delivery of currency at a specified time in the future at an agreed rate. Companies wanting to reduce risks from exchange rate volatility can buy their currency ‘forward’ on the market
• Bi-lateral Exchange Rate – the rate at which one currency can be traded against another. Examples include: $/DM, Sterling/US Dollar, $/YEN or Sterling/Euro
• Effective Exchange Rate Index (EER) – a weighted index of sterling’s value against a basket of currencies the weights are based on the importance of trade between the UK and each country.
• Real Exchange Rate – this is the ratio of domestic price indices between two countries. A rise in the real exchange rate implies a worsening of competitiveness for a country

Factors affect the value of a nation’s currency?

• In floating exchange rate systems, the market value of a currency is determined by the demand for and supply of a currency
• Most currency dealing is speculative but trade and investment decisions also have a role to play

Some of the key factors that can affect a currency are as follows:

(1) Trade balances – countries that have strong trade and current account surpluses tend (ceteris paribus) to see their currencies appreciate as money flows into the circular flow from exports of goods and services and from investment income. This increases the demand for a currency and brings about an appreciation in its value. Persistent trade deficits can lead to currency depreciation.

(2)Foreign direct investment (FDI) – an economy that attracts high net inflows of capital investment from overseas will see an increase in currency demand and a rising exchange rate.

(3) Portfolio investment – much currency trading is used to finance cross-border portfolio investment, for example investors putting their funds into stocks and shares, government bonds and property. Strong inflows of portfolio investment from overseas can cause a currency to appreciate

(4) Interest rate differentials – if a country’s interest rates are higher than rates on offer in other countries then ceteris paribus we expect to see an inflow of currency into banks and other financial institutions. The higher the interest rate differential, the greater is the incentive for funds to flow across international boundaries and into the economy with the higher interest rates. Countries offering high interest rates can expect to see ‘hot money’ flowing across the currency markets and causing an appreciation of the exchange rate.

There are inevitable risks in shifting funds across international markets. What might happen to the currency if you leave $200,000 worth of cash in a UK bank account?

What happens to the value of your investment if sterling depreciates against the US dollar? What are the risks in exchanging a similar value of US dollars and putting it into the UK stock market or into government bonds? Investors often consider the risk-adjusted relative rate of return from different financial investments