The value of a currency, expressed in terms of another, is the exchange rate. ,This value consists of the units of one currency required to buy one unit of the other. In this section, we will cover the basics of currency exchange rates, the factors determining these rates and the meaning of some important terms used in relation to the forex rates.
The first currency in the exchange pair is called the base currency and the second currency is called the quote or counter currency. The base currency is always expressed as 1.
To understand the situation better, let’s start with our currency, the US Dollar (USD) and a foreign currency, say the Japanese Yen (JPY). On a certain day, assume that one USD is able to buy 100 JPY. The base currency is thus the US $, and the quote currency is the JPY. This means that on that day, the exchange rate is 1:100, or one to hundred ratio.
This exchange rate, expressed in ratios, is called pairing. Cross rates are used to relate two foreign currencies, that is, when the dollar is not used to express the rate of a currency. Thus, cross rates for Euros and JPY will express the exchange rates of these currencies in the US.
Forex markets also commonly use the terms pips or basis points. Simply put, the pip rates express the rates expressed up to 4 decimal points, and reveal whether these are positive or negative movements. For example, say you exchange dollars for yens at 99.1045, and then the dollar goes up to 99.1050, then this is called a 5 pip improvement.
All exchange rates are quoted on a two tier system, that is a difference in the bid/ask. This difference between the buying and the actual selling price (in a transaction) is called a ‘spread’. The spread of a currency depends on various factors such as market conditions, strength of the currency and general perceptions about it, and trader’s instincts. These factors, as well as the resulting spread, can fluctuate considerably even in the course of a day.
Apart from these basic terms, you will also probably come across ‘nominal’ forex rate, that is, the rate at which one can trade one currency for the other. As opposed to this, economists often use ‘real’ exchange rates, based on the purchasing power of a particular currency. Mainly used for theoretical purposes, this is the rate at which a trader/ organization can trade goods and services of a country for that of another.
Factors Affecting Exchange Rates
The forex rate changes whenever the value of one of the two currencies changes. Thus, by simple deduction, the factors which affect the value of a currency, say the dollar, also affect its exchange rate.
When there is an increased demand for the dollar without a commensurate increase in its supply, the value will rise or the dollar will become ‘more expensive’ with respect to other foreign units of money. The demand for the dollar will increase when the transaction demand for it increases, which in turn is influenced by the level of business activity, GDP, and aggregate demand/employment levels in the economy. Simply spoken, the healthier your economy, the more is the demand for your currency.
Another factor which influences the exigency is the speculative demand. If traders expect the price of, say, the dollar to increase, they try to ‘buy’ more dollars, thereby increasing its demand and value.
As is evident, the exchange rates are a complex function of various factors pertaining to the economies of various countries. What remains true, however, is that Forex rates are independently derived, that is, based purely on the demand and the supply in the free or floating rate of exchange system that are currently followed.