Currently, there are over a hundred and ninety currency rates being traded all over
the world at the same time every day, twenty four hours a day. From Afghanistan's
afghan to Zimbabwe's Zimbabwean dollar, people all over the world engage
themselves in the exciting world of foreign exchange for profits.
In the world of finance, the exchange currency rate between two different currencies
will specify the worth or value of one currency rate in relation to the other that
it is being compared with. For instance, a US Dollar vs. Japanese Yen rate of 123.00
(quoted as USD/JPY: 123.00) means 1unit of US $ = 123 units of JapaneseYen. Fast
fact: the forex market is one of the world’s largest markets and research shows
that around two trillion United States dollars’ worth of currency gets traded every
single day.
You Can Quote Me on That
A currency rate always has a quotation which is based on a “base currency” (the
currency on the left) and its relative value in terms of the counter currency (the
currency on the right). The quoting conventions follow the international ISO codes
which set formats on quoting various currency pairs when transacting with them. Normally
the major currency or the currency with greater economic significance (historically/politically)
will take its position as the base currency. It will be valued in terms of how many
units of the counter currency it can be exchanged for, for instance EUR/USD currency
rate of 1.3000 implies 1 unit of Euro will exchange for 1.3000 units of US Dollars
(simply 1 euro = 1.3000 US$)
Any quote that uses the home currency of a country as a price currency is known
as a direct or price quotation. On the other hand, any quote that uses the home
currency of a country as the unit currency is known as an indirect quotation. Take
note that all currency pairs have four decimal places, with the exception of the
Japanese Yen having only two. Similarly, currencies with more than the double digit exchange or triple like the Yen are normally quoted out to two decimal places as
well.
To Be or Not to Be…Pegged?
If a currency rate is considered as free-floating, then its exchange rate will
be allowed to vary against other currencies and can then be determined by the supply
and demand forces of the market. The exchange rates for these currency rates can
change as frequently as determined by financial markets and banks all over the globe.
A fixed exchange rate, also known as pegged exchange rate, is an exchange rate regime
where a currency’s value is shadowed or linked directly to the value of another
currency or a basket of currencies. The pegged currency moves in direct realtion
to the reference currency and moves up and down with it (normally within a band).
As value rises and falls, so does the currency pegged to it. Pegging has its own
positives and negatives, as positive it provides stability to instable currencies
of instable countries. On the negative side countries central bank cannot make use
of an independent monetry policy. It also gives undue advantages to some countries
(who have pegged their cuurencies) in import/export transactions. For instance if
a countries currency should be stronger or higher in value than where it is currently
pegged, it makes its goods and services more attractive than competing nations whose
curencies may have increaed in value due to their economic strength.
Nominal Exchange Rates
As a definition, the price expressed in domestic currency of a single foreign currency
unit is called a nominal exchange rate. Nominal exchange rate can be determined
by changing the base currency to the home currency by simply dividing the currency
rate by 1 (if the home currency under quoting convention is the counter currency).
For instance EUR/USD=1.3000 (1 Euro = 1.3000 US$) and assuming US$ is the home currency
we can simply inverse the equation by dividing this rate by 1 and we get the value
of 1 US Dollar in terms of Euro which would be 0.7600 in this case (1 US$ = 0.7600
Euros).
Going up and down the Currency Rollercoaster
An exchange rate that is based on the market will change every time the value of
one or both currency matchup changes. If the demand for a particular currency rate
is higher than the ready supply, it will become a lot more valuable. However, the
currency rate can lose some of its value if there is an excess in supply and a shortage
in demand – which only translates into people preferring to hold on to their money
in some other form, usually another currency.
An increased demand in transaction for money will increase the demand for a particular
currency. If the transaction demand is high, then one can naturally assume that
it has something to do with that particular country’s level of business productivity,
its gross domestic product and an upsurge in employment levels and capabilities.
If in a country where the unemployment rate is high, then the general populace will
spend very little on goods and services. And because of this, most market demand
supply will generally dictate the relative value which can be affected or temporarily
manipulated by central banks taking open market transactions, buying and selling
to stabilize strengthen or weaken their currency.
Banking’ on Your Assets
Central banks usually have a hard time accommodating the demand and supply for money,
so they try to compensate by adjusting the interest rates. Any investor may decide
to purchase a currency if the corresponding return or interest rate is satisfactorily
high. And it then generally follows that the higher the interest rate of a country’s
currency are, the greater will be the demand for that currency. This is
however a simplistic approach as higher interest is not the only factor that determines
a currency demand, and in fact too high an interest rate may reflect negative or
economic weakness which can reduce the demand of a currency. A lot of financial
experts have debated that currency speculation can contribute to the undermining
of true economic growth. Especially since the larger currency speculators could
purposefully and intentionally create a pressure on a currency so as to force its
central bank to sell more of it in order to maintain stability. But generally in
major currencies the demand supply is so large that no single proponent can maintain
pressures on one side for too long and market forces tend to prevail, and after
all, the demand and supply in the long run is the actual reflection of the value
of a currency which is ever changing.
Choosing Your Asset
The primary consideration of most people when it comes to choosing their assets
is how much value a particular asset can retain in the future. A lot of people certainly
would not be interested in a particular currency rate if they see that it is on
the road to losses. As a tip, a currency rate will only lose its value (relative
to, of course, other currencies) if that particular country has a high level of
inflation or if the kind of output it produces is subpar, or that country is rocked
by political turmoil as is often the case with most third world countries.
A basic understanding of these details is a good start to get you on your way to
making better, more informed decisions.