Learn what's behind currency exchange rates.
Currency exchange rates measure the value of one currency relative to another on the foreign exchange market, also known as the FX or Forex market. The Federal Reserve Bank of New York notes that the currency market is the largest in the world; in 2001 alone, more than $1.2 billion changed hands each day. Four currencies counted for 80 percent of the trading: the Japanese yen, the U.S. dollar, the British pound and the euro.
When scanning the pages of the Wall Street Journal, an investor might encounter a currency quote that looks something like this: EUR/USD = 1.437. This notation is called a currency pair. The base currency is listed on the left, in this case the euro. The currency listed after the slash, the U.S. dollar in this example, is the quoted currency. The number represents how much of the quoted currency it would take to buy the base currency. Here, it would cost $1.437 to purchase one euro.
The Council for Economic Education reports that currency value has a broad impact on international trade. If a country's currency is relatively strong, demand for its goods in the international market might drop since they become more expensive to purchase. However, the country's purchasing power would increase, since the cost of imported goods would go down. When a country's currency is relatively weak, demand for its goods may increase over time since they are less expensive internationally, but that country would have less power to purchase abroad.
For this reason, central banks may participate in the FX market to influence the value of a country's currency and help shift the balance of trade in its favor. Investopedia notes that currencies with relatively low rates of inflation tend to be worth more against currencies with a higher inflation rate. So, a government could implement both monetary and spending policies that keep inflation low to boost the currency's worth worldwide.
For instance, keeping interest rates high would drive the cost of a currency up, since a high rate of return would be attractive to foreign investors. Deficit spending would decrease a currency's value, since it tends to lead to inflation. Current account deficits also decrease currency value because they show that the economy as a whole is buying more imported goods than it can pay for, financing the debt with foreign money, which means that demand for the country's currency is low.
Political stability also affects currency prices; when news of political unrest or war start to percolate, investors want to move their cash to someplace with a stable government and economy.
Though government policies have their effect, some two-thirds of all FX trading takes place between banks that buy and sell to one another at a profit. Brokers, who call around to various banking institutions in search of the best deal, thus maintaining anonymity between the buyer and seller, mediate this trading.
Both business and private consumers participate in the FX market; this could be as simple as a traveler changing money on a trip overseas. Or, a business in the United States might need to import goods from China. Because foreign suppliers are usually paid in their own currency, the business would have to dip into the FX market to change dollars for yuan. Companies that do a lot of business in foreign markets can take steps to shield themselves from the possibility that a currency will rise or fall dramatically by participating in forward transactions.
When a company makes a deal to purchase goods abroad, it could just change out money immediately to avoid the hassle of currency fluctuations; but if it did so, it would lose out on the interest it would make before the invoice was due. Instead, a company's financiers could either purchase futures or participate in a currency swap. A currency future is an agreement to buy a specified amount of currency on a predetermined day at a predetermined price. Whether, by that date, the cost of the currency has risen or fallen, the buyer and seller are locked in.
Currency swaps are much more common; instead of purchasing a future, two parties agree to swap some amount of currency for a period of time and then re-exchange later. For instance, a U.S. company doing business in China could find another company that was willing to change $100,000 at, perhaps, 6.82 yuan to $1. The two companies would also agree on an interest rate. The U.S. company would get 682,000 yuan and hold it for a period of two months, when it expected its order to be complete. At the end of that period, both parties would get their money back, with interest.