Exchange rate lets you know how much your money is worth in another country.
Whether you’re planning to start a business that involves international trading or are planning on travelling abroad, one thing that you will primarily come across is the term ‘exchange rate’. Naturally, you would want to know what is an exchange rate, why is it needed and how does it impact you. Well, let’s find out.
The exchange rate is the “price of one currency in terms of another currency”, meaning that it is the value of a country’s currency for the purpose of conversion to that of another nation or economic zone. For example, according to the latest exchange rate, 1 United States Dollar equals 74.27 Indian Rupees ($1 = Rs 74.27)
Now the question arises, How is exchange rate calculated?
Since the it is a conversion method for currencies of different countries of the world, there are different methods that are used by different countries for calculation. The following segment can also be read as the types of exchange rates on the basis of calculation methods.
Exchange rates are calculated in the following ways:
Free-floating or Flexible
A free-floating, also known as flexible or fluctuating, exchange rate is a type of exchange rate system in which the value of a currency is measured in terms of the foreign exchange market, commonly known as forex short for foreign exchange. Forex is a global marketplace that determines the exchange rate for currencies around the world. Participants in this marketplace buy, sell, exchange, and speculate about their respective currencies.
In this system, the rate of exchange can rise or decline based on economic factors, including the strength of a nation’s overall financial health. Hence, the flexible exchange rate can change on a daily basis. A country that uses a floating exchange rate is called to have a floating currency. The most prominent example of a floating currency is the US Dollar.
The floating exchange rate is considered as the best possible system since it automatically adapts to economic conditions of a country as well as the foreign exchange market. This exchange rate system allows countries to reduce the impact of shocks in the international financial markets and help prevent a balance of payments crisis. However, as a result of their dynamism, free-floating exchange rates are not useful for predicting exchange rates.
For example, an American dollar might buy 1 British Pound today, but it might buy only 0.95 pounds tomorrow, therefore, indicating the free-floating value of the exchange rate.
Fixed or Pegged
A fixed exchange rate is one at which a country fixes its currency value relative to an entity such as gold or another currency. Although most countries estimate their currency differences based on the foreign exchange market, some countries control the exchange rate of their currencies relative to other currencies. This simply is referred to as the fixed exchange rate. It is also known as a country ‘pegging’ its currency to that of another nation, hence ‘pegged exchange’ rate.
Fixed rates maintain a “stable” rate by controlling how much a foreign currency is worth. This system of the exchange rate is periodically adjusted and fixed in accordance with the state of the entity against which they measure their currency. Different governments maintain different rationales for maintaining a fixed exchange rate.
For example, the Hong Kong dollar is always pegged against the US dollar in the range of 7.75 to 7.85. Or, if you go to Saudi Arabia, 1 US dollar will always buy you 3.75 Saudi Riyals as the exchange rate is fixed.
Some countries even have restricted currencies, limiting the exchange rate within the country’s borders. The government can set a limited price for a restricted currency. For example, Brazilian Real is considered to be a restricted currency as Fund transfers in this currency cannot be sent outside of Brazil. This leads to a limitation of trade in a currency.
The US Dollar is the most widely used reserve currency in the world; more than 60% of the central bank's foreign exchange reserves around the world are stored in US Dollar.
Onshore Vs. Offshore
Exchange rates can vary within a country itself. In some countries, the exchange rates system comprises of onshore and offshore exchange rates. Onshore exchange rates are applied domestically, while offshore currency exchange rates apply to foreign trade transactions.
The difference between onshore and offshore exchange rates is that onshore exchange rates are controlled by a country’s central bank (restricted currencies), while offshore exchange rates are almost entirely determined by forex. Generally, a more favourable exchange rate can often be found within a country’s border versus outside its borders.
For example, China is a major country with this exchange rate structure. Chinese currency Yuan is a government-controlled currency. In the case of Yuan, onshore exchange rate transactions are strictly controlled by the People’s Bank of China, and overseas transactions are freely traded according to forex standards.
Spot and Forward
Exchange rates too have a rate called the ‘spot rate’, which is indicative of the cash value of the currency in the current market. Alternatively, an exchange rate also has an expected value, which is called ‘forward rate’. The forward rate is based on the expectation that the value of the currency will rise or against its spot price in future. Forward rate values may fluctuate due to changes in expectations for future interest rates in one country versus another.
For example, let’s say that traders have the view that the US will ease monetary policy for India. In this case, traders could buy the Indian Rupee versus the US Dollar, resulting in the value of the US Dollar falling.
Why do you need to know about exchange rates?
Before undertaking any task that involves international transactions, whether it is business, export or travelling, you need to have a clear understanding how the exchange rate system of your country as well as the country you want to undertake the activity in works. The rate lets you know how much your money is worth in another country.
It helps you in financial budgeting of your prospective business or other plans. Moreover, an understanding of exchange rates can help you get the best deals on currency conversion before you convert your currency into foreign money.
The exchange rate plays an important role in international trade and investment as well. For example, if the US dollar rises in value than the Euro, Americans trading with Europe will have an upper hand in the purchasing power, while it will become harder for European companies to export goods to the US.
What impacts an exchange rate?
The US Dollar is the most widely used reserve currency in the world; more than 60% of the central bank’s foreign exchange reserves around the world are stored in US Dollar. The country’s central bank stores reserves to facilitate business and financial transactions. These reserves are subject to a country’s economic strength, which in turn, is measured by the Gross Domestic Product (GDP) and numerous financial and trade instruments. And economic conditions of the world, especially of the developed countries like the US and the European Union, have a major impact on the exchange rate used around the world.
Fluctuations in the exchange rate are highly dependent on a wide range of factors, such as interest rates, price levels, geopolitical safety concerns, and expected future market conditions. Some of these factors are explained below.
A change in the interest rate on money borrowed or lent by a country affects its currency value and exchange rate significantly. A rise in interest rates leads to an increase in the country’s currency value, as higher interest rates give higher rates to lenders, thus attracting more foreign capital and leading to an increase in exchange rates.
Volatility in market inflation rates causes changes in exchange rates of a country’s currency. A country with a lower inflation rate sees an increase in the value of its currency, whereas a high inflation rate in a country depreciates the value of its currency. Therefore, lower inflation rates result in a higher valuation of currency and strengthen its exchange value.
Government debt is a national debt owed by the national government to financial entities. If a country has massive government debt, it is less likely to receive foreign capital and have much higher inflation rates. This can lead to flooding of the country’s market with foreign investors selling their stakes in the open market, creating the case of excessive supply and no demand. Thus, the currency value will drop significantly and the country’s exchange rate will fall.
The political position of a country severely affects the strength of its currency. Countries that are less at risk from political unrest are more attractive to foreign investors, attracting more foreign investment. Foreign capital increase leads to the increment in the valuation of a country’s currency. Countries with solid monetary and commercial policies promise great returns to investors and this significantly affect the country’s currency exchange rate.
If a country has a delicate economy that shows grave signs of economic recession, i.e., reduction in GDP growth rate for three consecutive quarters, it loses decreasing large foreign capital investments. As a result of this, the currency of the country weakens and the exchange adversely lowers.
Expected Market Speculations
If a country is estimated to witness growth in its currency value, investors acquire more and more of that country’s currency with the hopes of massive profit in future. Subsequently, the value of the currency increases with the increase in demand. And therefore, the exchange rate of the currency increases as well.
It is a conversion method for currencies of different countries of the world, there are different methods that are used by different countries.
It is, therefore, clear that the exchange rate of a country’s currency is not only a key determinant of a country’s relative level of economic health, it also holds much importance for prospective business owners and individuals who aim to reach the global heights of success. The valuation of a currency, driven by numerous factors, makes a country’s imports and exports competitive in the global market, thereby, giving businesses across the global spectrum a chance for growth and profit.
They also play an important role in Foreign Direct Investment (FDI), i.e., the investments made by business entities into companies, projects and businesses located in different countries across the world through various capital assets and formats.