Definition of a Foreign Exchange Rate: It refers to the value of a particular nation’s currency taken against the currency of another economic zone or country. For example, if someone asks how many United States dollars does it take to buy one Japanese yen? The answer to this question is nothing, just the exchange rate.
KEY POINTS
- An exchange rate is simply one value of currency considering the cost of another currency.
- Most of the exchange rates are free-floating and will fall or rise depending on demand and supply in the market.
- Some currencies have restrictions and are not free-floating.
Foreign Exchange Rate classification
From the viewpoint of bank trading by foreign exchange
- Buying Rate: It is also known as the purchase price. It is the price used by the international exchange bank to buy global currency from the consumer. Commonly, the exchange rate is similar to the purchasing rate when the foreign currency or token is transformed into many smaller units of the domestic currency. It reflects the capacity of a country’s currency to purchase a specific amount of foreign exchange.
- Selling Rate: It is also known as the foreign exchange selling price. It symbolises the exchange rate charged by the banks to sell international exchange to the consumer. It reflects the amount of currency that can be recovered in case the bank decided to sell a specific amount of foreign exchange.
- Average Rate: The overall mean value of ask-bid price refers to as average rate. Its uses include economic analysis, data for newspapers and magazines.
According to the Size of delivery After Transactions
- Spot Exchange Rate– It refers to the exchange rate of the transaction carried out with spot foreign exchange. The price listed on the foreign exchange market is nothing but a spot rate (unless the forward exchange price is not mentioned). It is delivered within two days of the exchange transaction.
- Forward Exchange Rate– It is the rate associated with the monetary transaction that will take place in future. This term may also reflect the rate fixes for future financial commitments such as the rate of interests on a loan payment. They are calculated from the spot rates (discussed above), this represents the “premium”, “parity”, and “discount” (of the spot exchange rate).
Forward foreign exchange trade is a type of appointment-based transaction; this is due to the different time the international exchange buyer needs for foreign funds exchange and the induction of foreign exchange risk.
According to the Method of Establishing the Exchange Rate
- Basic Rate: It usually selects a primary convertible currency which is commonly used in foreign economic transactions and for the accounts of a large proportion of exchange reserves. Its exchange rate is decided by comparing it with other countries’ currency. This type of exchange rate is the basic form of the exchange rate. Key currency refers to the global currency, used for settlement, freely convertible, pricing, reserve currency and internationally accepted currency.
- Cross Rate: The exchange rate of local currency calculated against other international currencies refers to a cross rate.
Other Classifications
According to the Payment Process in International Exchange Transactions
- Telegraphic exchange rate
- Demand draft rate
- Mail transfer rate
According to the Level of Restriction of the Exchange
- Official Rate: It is the rate announced by the foreign exchange officials of a country. It is usually used by countries which have strict controls over international exchanges.
- Market Rate: The market exchange rate indicates the real exchange rate for trading international exchange in the free market. It fluctuates with the change in the demand and supply in the foreign market.
According to the Global Exchange Rate Authority
- Fixed Exchange Rate: It reflects the difference between the exchange rates of the two countries. It is a fixed rate and generally does not fluctuate very much.
- Floating Exchange Rate: It means that the financial authorities of a country are not specifying the official exchange rate against other currency, nor does they have any lower and upper limit for rate fluctuations.
According to the Inflation
- Nominal Exchange Rate: The exchange rate that is marketed or officially announced defines the nominal rate. It does not include inflation.
- Real Exchange Rate: It is the same as the nominal rate; the only difference is that it does include inflation.
Factors Affecting the Exchange Rate
1) Balance of Payment: If a country has a more substantial value of trade deficit, it means that its earning is less than its expenditure and the demand for international exchange exceeds its supply. In such cases, rates rise, leading to depreciation in currency value.
2) Interest Rate Level: The condition of capital inflow comes when a country raises its domestic interest rate, higher than the foreign price. In such a situation, the demand for local currency increases resulting in the appreciation of currency and depreciation of foreign exchange.
3) Inflation Factor: With the decline in the purchasing power of money, inflation rises, and in the same way with the depreciation in paper currency, foreign currency appreciates.
4) Fiscal and Monetary Policy: Although the influence of economic policy on the exchange rate is indirect, still, it is crucial. The strict monetary policies help in reducing the fiscal expenditure upholds the currency and surges the value of the local currency.
5) Venture Capital: If the market speculator anticipates a particular currency to increase, they will purchase a large amount of that currency, thus will increase the exchange rate of the currency. Conversely, if they want to depreciate a currency, they will sell a massive amount of it. It will devalue the exchange rate. Thus speculation is a vital factor in the short-term fluctuations.
6) Government Market Intervention: The exchange rate fluctuations adversely affect the economy and trade of the country. To overcome this government tries to amend its monetary policy to achieve stability. It can be achieved by purchasing or selling domestic or foreign currencies in large quantities in the financial market. The demand and supply change the rate of exchange of the country.
