10.4 Exchange rates Flashcards
Definition of Exchange Rates
An exchange rate is the price of one currency in terms of another. It indicates how much of one currency you need to spend to purchase another currency.
The gold standard
The gold standard is a monetary system where a country’s currency or paper money has a value directly linked to gold. Under this system, countries agree to convert paper money into a fixed amount of gold.
Basket of currencies
A basket of currencies refers to a group of different currencies used to measure the value of a particular currency or assess exchange rates against a weighted average.
Advantages of using a basket of currencies as an exchange rate
Advantages:
* Using a basket provides a more comprehensive view of a currency’s strength or weakness, reflecting its performance against multiple currencies rather than just one.
* It helps to mitigate the impact of fluctuations in a single currency and provides a broader assessment of global competitiveness.
Example of a basket of currencies
The U.S. Dollar Index (DXY) is a well-known example, measuring the value of the U.S. dollar against a basket of six major currencies: Euro (EUR), Japanese Yen (JPY), British Pound (GBP), Canadian Dollar (CAD), Swedish Krona (SEK), and Swiss Franc (CHF).
Each currency in the basket has a different weight based on its importance in international trade or financial markets. For instance, the euro has a higher weight in the U.S. Dollar Index than the Swedish krona.
What is the Foreign Exchange Market (Forex)
Definition: The foreign exchange market (Forex or FX) is a global decentralized market where currencies are traded.
It is the largest financial market in the world, with a daily trading volume exceeding $6 trillion.
The six Key Features of the Forex Market
- Decentralized Market
- 24-Hour Trading
- Currency Pairs
- Liquidity
- Leverage
- Participants
First 3 Key Features of the Forex Market
Decentralized Market:
Unlike stock markets, the Forex market operates over-the-counter (OTC), meaning that trades occur directly between parties, typically through electronic trading platforms.
24-Hour Trading:
The Forex market operates 24 hours a day, five days a week. It opens in Sydney, followed by Tokyo, London, and New York, allowing for continuous trading and liquidity.
Currency Pairs:
Currencies are traded in pairs (e.g., EUR/USD, USD/JPY), where the first currency (base currency) is quoted against the second (quote currency).
The exchange rate indicates how much of the quote currency is needed to purchase one unit of the base currency.
Last 3 Key Features of the Forex Market
Liquidity:
The Forex market is highly liquid due to the large volume of transactions. Major currency pairs, such as EUR/USD and USD/JPY, typically experience tight spreads and rapid execution of trades.
Leverage:
Forex trading often involves leverage, allowing traders to control larger positions with a smaller amount of capital. While this can amplify profits, it also increases risk.
Participants:
The Forex market comprises various participants, including:
- Banks and Financial Institutions: Facilitate currency transactions for clients and engage in speculative trading.
- Central Banks: Implement monetary policy and stabilise or influence their currency’s value.
- Corporations: Engage in Forex to hedge against exchange rate fluctuations in international trade.
- Retail Traders: Individuals trading through brokers to speculate on currency movements.
Electronic Trading in Forex:
- Trading Platforms
- Algorithmic Trading
- Market Makers and ECNs
- Mobile Trading
- Data Analytics
FOREX: Market Analysis Techniques
Technical Analysis:
Involves studying historical price movements and trading volumes using charts and technical indicators (e.g., moving averages, RSI, MACD).
Traders use patterns and trends to make predictions about future price movements.
Fundamental Analysis:
Focuses on economic indicators (e.g., GDP, inflation rates, employment data) and geopolitical events to assess currency strength and potential movements.
Traders analyze central bank policies, interest rate changes, and macroeconomic trends.
Sentiment Analysis:
Gauges market sentiment by evaluating traders’ emotions and behaviors, often through indicators like the Commitment of Traders (COT) report.
Real Exchange Rate Definition
The real exchange rate (RER) measures the value of a country’s currency relative to a basket of other major currencies, adjusted for differences in price levels (inflation) between countries. It provides a more accurate reflection of a currency’s purchasing power than the nominal exchange rate.
How is the RER is closely related to PPP
The RER is closely related to the concept of purchasing power parity, which states that in the long run, exchange rates should adjust to equalize the price of identical goods and services in different countries.
A change in the RER indicates a change in the relative purchasing power of a currency.
How is the RER related to Competitiveness?
A rising real exchange rate (appreciation) indicates that a country’s goods and services have become more expensive relative to those of other countries, potentially reducing export competitiveness.
Conversely, a declining RER (depreciation) suggests that a country’s exports may become cheaper and more competitive abroad.
Formula for Real Exchange Rate
The RER can be calculated using the following formula:
Index of the domestic price level
/
Index of weighted foreign price level
Or
RER = (E x P*P) / P
Where:
E = Nominal exchange rate (foreign currency per unit of domestic currency)
P∗P = Price level in the foreign country (using a relevant index, like CPI)
P = Price level in the domestic country
