Exchange rate

Exchange rate

The foreign exchange market is a global, decentralized market where the world’s currencies trade. The main participants in the market are commercial banks, investment banks, central banks, hedge funds, and retail investors. 

What is the exchange rate? 

The price of one currency stated about another, or a set of currencies is known as an exchange rate. Changes in the currency rate impact the decisions made by people, corporations and the government. This impacts the balance of payments, inflation, and economic activity altogether. 

An exchange rate is one at which one currency may be swapped for another between countries or economic zones. It is crucial in assessing the dynamics of commerce and capital movement since it is used to calculate the worth of different currencies compared to one another. 

Understanding exchange rate 

Currency is traded in pairs, with the first currency being the base currency and the second being the quote currency. The base currency is the currency being bought or sold, while the quote currency is the currency being used to price the base currency. For example, in the EUR/US$ currency pair, EUR is the base currency, and US$ is the quoted currency. This means that one euro is being traded for one US dollar. 

Several factors, including economic and political conditions, interest rates, inflation, and the supply and demand of the currencies, determine exchange rates. 

Two factors influence the exchange rates: 

• The value of a domestic currency 
• The value of a foreign currency 

Furthermore, the rates may be given directly, indirectly, or by using cross-rates. 

Exchange rate classifications 

There are two main types of exchange rate classifications: floating and fixed.  

• Floating 

A floating exchange rate is one where the value of a currency is allowed to fluctuate in response to market forces, such as supply and demand. 

• Fixed 

A fixed exchange rate is one where the value of a currency is pegged to another currency or a basket of currencies. 

Measuring the exchange rate 

• Bilateral exchange rate 

An exchange rate can be calculated in various ways. The most common approach is to evaluate a bilateral exchange rate. The valuation of one currency against another is referred to as a bilateral exchange rate. Since the US$ is the most traded currency worldwide, bilateral exchange rates are often stated against it. 

Our everyday lives are affected by bilateral exchange rates, frequently covered in the media. When customers buy products and services from other nations or go abroad, they are exposed to them. When companies sign agreements to sell their services and products to other countries and buy manufacturing inputs from other nations, they are exposed to them. 

• Trade-weighted index (TWI) 

Although bilateral exchange rates remain the ones most usually used (and are more likely to appear in the media), a trade-weighted index (TWI) offers a more comprehensive indicator of overall movements in a currency. This is so because a TWI measures the value of a local currency as a weighted average of a collection of currencies, or “basket” (rather than a single foreign currency). 

The percentage of trade performed among each country’s trading partners is often used to determine the weights of each currency in the basket (usually total trade shares, but import or export shares can also be used). A TWI may therefore determine whether a currency is, on average, appreciating or depreciating about its trade partners. 

• Cross rates 

The “cross rates” calculation is also based on bilateral exchange rates. An exchange rate determined using a third currency is a cross rate.  

For instance, if both the exchange rates for the SGX and the euro (EUR) against the US$ are known, the exchange rate between the two currencies may be determined using the SGX/US$ and EUR/US$ rates (i.e., EUR/SGX = EUR/US$ x US$/SGX). 

Exchange rate regimes 

There are three main exchange rate regimes: floating, fixed and pegged.  

• Floating exchange rate regime 

In a floating exchange rate regime, the currency is allowed to fluctuate based on market forces.  

• Fixed exchange rate regime 

In a fixed exchange rate regime, the currency is pegged to another currency, usually the US dollar.  

• Pegged exchange rate regime 

The currency is pegged to a basket of currencies in a pegged exchange rate regime. 

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