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Exchange rate


In finance, the exchange rate between two currencies specifies how much one currency is worth in terms of the other. For example an exchange rate of 120 Japanese Yen to the Dollar means that 120 is worth the same as $1. An exchange rate is also known as a foreign exchange rate, or FX rate.
An exchange rate quotation is given by stating the number of units of a price currency can be bought in terms of a unit currency . For example, in a quotation that says the Euro - United States Dollar exchange rate is 1.2 dollars per euro, the price currency is the dollar and the unit currency is the euro. The usual unit currency varies by geographic location. For example, British newspapers quote exchange rates with British pounds as the unit currency. This is known as indirect or quality terms quotation and is also common in Australia and New Zealand.
 
Quotes using a country's home currency as the unit currency are known as direct or price quotation and are used in most other countries.

Note if a unit currency is strengthening / appreciating (i.e. if the currency is becoming more valuable) then the exchange rate number increases. Conversely if the price currency is strengthening, the exchange rate number decreases and the unit currency is depreciating.

In practice it is rarely possible to exchange currency at the exact rate quoted. Market makers who match together buyers and sellers will take a commission. This is achieved by quoting a bid/offer spread. For example if you are bidding to buy Japanese yen you would do so at the bid price of say, 115 per dollar, and if you were offering to sell yen you might do so at 125 yen per dollar.

If a currency is free-floating its exchange rate against other countries can vary against other such currencies. In fact such exchange rates are likely to be changing almost constantly as quoted by financial markets and banks around the world. If the value of the currency is " pegged " its value is maintained by the government in question at a fixed rate relative to the other currency. For example, in 2003 the Hong Kong dollar was pegged to the United States dollar .

Fluctuations in exchange rates

A market based exchange rate will change whenever the value of either of the two component currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than available supply (this does not mean people no longer want money, it just means they prefer holding their wealth in some other form, possibly another currency).

Increased demand for a currency is due to either an increased transaction demand for money, or an increased speculative demand for money. The transaction demand for money is highly correlated to the countries level of business activity, gross domestic product (GDP), and employment levels. The more people there are out of work, the less the public as a whole will spend on goods and services. Central banks typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions.

The speculative demand for money is much harder for a central bank to accommodate but they try to do this by adjusting interest rates. An investor may choose to buy a currency if the return (that is the interest rate) is high enough. The higher a country's interest rates, the greater the demand for that currency.

In choosing what type of asset to hold, people are also concerned that the asset will retain its value in the future. Most people will not be interested in a currency if they think it will devalue. A currency will tend to lose value, relative to other currencies, if the countries level of inflation is relatively higher, if the country's level of output is expected to decline, or if a country is troubled by political uncertainty. For example, when Russian President Vladimir Putin dismissed his Government on Feburary 24 2004, the price of the Ruble dropped. When China announced plans for its first manned space mission the price of the Yuan jumped.

Like the stock exchange, money can be made or lost on the foreign exchange market by investors and speculators buying and selling at the right times. Currencies can be traded at spot and foreign exchange options markets. The spot market represents current exchange rates, where options are derivatives of exchange rates.

This article is licensed under the GNU Free Documentation License . It uses material from the Wikipedia article "Exchange rate" . 


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