What is an exchange rate and how is it used?

all about exchange rates

Exchange rate

The exchange rate of a currency (the name of the currency that is accepted abroad) is the rate, that is, the price, of this currency in relation to another currency.

On financial information websites or on specialized pages of newspapers, we can read, for example, EUR/GBP=0.8250/0.8252. The first price is the selling price of the first currency mentioned, in this case the euro. The second price is the purchase price of the first currency.

In explicit terms, EUR/GBP=0.8250/0.8252 means that one euro (EUR) is sold for 0.8250 pounds sterling (GBP) and one euro is bought for 0.8252 pounds sterling. By convention, these exchange rates are expressed to four decimal places.

It's easy to tell the selling price from the buying price if you remember that the selling price is always lower than the buying price. Depending on the commission held by the stockbroker, the difference between the ask price and the buy price, also known as the spread, can be larger or smaller.

For simplicity and in order to establish an international standard that allows you to talk about all currencies, wherever you are, without language barriers, each currency has a three-letter abbreviation. . Often - but this is by no means a general rule - the first two letters indicate the country, and the third refers to the name of the currency. For example, here are the abbreviations for the currencies of the US, UK, China and Japan:

US

USD for the US, D for the dollar
GBP GB for the UK, P for the pound in France) CNY CN for China, Y for RMB
JPY JP for Japan, Y for Yen

Note: The euro is a notable exception as it has the abbreviation EUR.

Finally, we cannot estimate the value of a currency in absolute terms. That is why it is always expressed in relation to another currency through the exchange rate and by observing the changes in this rate over time. Thus, each currency has an exchange rate against each of the other currencies. We are talking about a bilateral exchange rate to denote the exchange ratio between two currencies, and an efficient exchange rate when all bilateral exchange rates are considered. To establish it, each bilateral exchange rate is usually weighted by the share of a country's international trade in that currency.

Why are exchange rates important?

Exchange rates are of great importance for a country's economy and, in particular, for its foreign trade.

For example, suppose the euro appreciates against the dollar, i.e. the exchange rate of the euro against the dollar increases and depreciates a few months later from EUR 1 = USD 1.35 to EUR 1 = USD 1.50.

In terms of goods and services, US exports to the Eurozone will be more competitive. Example: 1 $20 Made in USA DVD cost €14.8 in the Eurozone (i.e. $20/$1.35). In a few months, it will cost 13.3 euros (i.e. 20/1.50 dollars). Conversely, goods exported from the Eurozone will have a higher price in US dollars and will be less competitive in the US compared to local goods.

But if national production is not enough to avoid an increase in imports (which may be the case with energy or raw materials, often coming from developing countries), this can be a inflation factor in a country whose exchange rate is falling , in this case USA in our example.

Finally, at the individual level, with an appreciation of the euro/dollar, American tourists will have purchasing power in the eurozone, and conversely, it will cost them less for French tourists or Germans to stay in the eurozone for the United States. In terms of placements and investments, European assets are more expensive for US investors, and US assets are cheaper for investors in the Eurozone: therefore, the depreciation of the dollar logically benefits US investments.

Currency exchange rates are fixed in the foreign exchange market. Each country or currency area determines its own exchange rate regime, fixed or floating.

Exchange rate policy

In the European Union, the euro area is a currency area in which the exchange rates of member countries have been irreversibly fixed and local currencies have been replaced by a common currency. On the other hand, the euro is in a floating exchange rate against most other currencies. Outside the euro area, some countries, such as Poland or Romania, have floating exchange rate regimes. Denmark, on the other hand, maintains a quasi-fixed exchange rate against the euro.

With floating exchange rates The United States and the Eurozone have a laissez-faire policy on exchange rate changes. Thus, the European Central Bank does not intervene in the foreign exchange market to influence the euro. Since 2005, China has opted for a managed floating exchange rate against a basket of currencies. Between July 2005 and July 2008, the yuan (also referred to as the yuan) appreciated about 21% against the dollar. But this system was suspended in July 2008, effectively restoring a fixed link between the yuan and the dollar, in the name of necessary protection for the Chinese economy from the effects of the global financial crisis.

This situation is causing discontent on the part of China's economic partners - the United States is in the lead - because this control exercised by the People's Bank of China (Chinese central bank) over the currency according to them, leads to an undervaluation of the yuan on the foreign exchange market. Donald Trump, in particular, accused China of artificially keeping its currency low. However, these criticisms, based in the past, seem to have lost their relevance since 2016 as the Chinese yuan has risen and is no longer considered undervalued (however, estimating what the "normal" exchange rate of the motto should be is difficult and there is controversy on this point).

Following the 2010-2011 crisis that swept the Eurozone, the foreign exchange market faced a new case of central bank intervention in exchange for currency. Indeed, the Swiss National Bank (SNB) decided to set a floor euro/CHF after a very strong strengthening of its currency in 2011; growth mainly due to uncertainty about the repayment of sovereign debt in the euro area and the United States.

The bottom rate of CHF 1.20 = EUR 1 was intended to prevent the euro from falling below CHF 1.20. Thus, it was the SNB that supported the euro, which is a rather exceptional case, since central bank interventions tend to go in the other direction (the central bank of a weak currency tries to stop its currency from falling by buying it in bulk in the markets).

However, these interventions by the Swiss National Bank ended in January 2015, which immediately led to the appreciation of the Swiss franc, i.e., to the fall of the euro below the minimum rate.

Equilibrium exchange rate?

Balanced exchange rates, neither overvalued nor undervalued, would in principle correspond to the situation of internal and external equilibrium of various economies. However, the determination of equilibrium exchange rates is not an exact science, and it is difficult to assess the undervaluation or overvaluation of a currency. As a rule, to estimate what the equilibrium exchange rate should be, the purchasing power parity method is used, that is, the exchange rate, which should balance the price of a basket of goods between two countries. For example, if the same basket of goods costs €100 in Europe and $120 in the US, then the equilibrium exchange rate is estimated at €1 = $1.2 (divide 120 by 100).

High exchange rate volatility

In fact, ever since floating exchange rate regimes have prevailed, that is, since the 1970s, equilibrium exchange rates have become a reality with great difficulty. On the contrary, exchange rate instability is the main feature of the modern world economy. For example, from 1999 to 2002, the dollar appreciated by 45% against the nascent euro. Then from 2002 to 2009 it lost 75% of its value. Exchange rate fluctuations of 5% or more within a month are not uncommon. For example, from late October to late November 2010, the euro lost 8% against the dollar following the financial crisis in Ireland.

As an illustration, you can observe the evolution of the euro/dollar exchange rate since the introduction of the euro in 1999:

Therefore, the stabilization of exchange rates is a difficult task. First of all, there is a variety of regimes in place: although there has been a trend towards floating exchange rate regimes since the 1970s, some currencies remain fixed exchange rates. and some central banks are no longer hesitant to intervene to impose favorable exchange rates on their economies. Finally, it is clear that after the liberalization of the 1970s, the foreign exchange market became more speculative. Thus, certain fluctuations in the foreign exchange market do not necessarily correlate with the real state of the national economies of the respective currencies.

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It is therefore very important, especially for multinationals and banks that manage very large amounts of cash and are exposed to multiple currencies, to hedge against strong exchange rate fluctuations. The foreign exchange market gives them access to various hedging instruments such as forwards or more complex derivatives such as swaps or options.


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