Foreign Exchange Rates

When a US resident wants to travel in Great Britain, then he first must exchange United States dollars (USD) for British pounds (GBP). However, because foreign exchange rates fluctuate continually, the value of the American dollar in Great Britain will differ, sometimes greatly, at different times.

For instance, suppose an American family budgets 10,000 USD. Then the number of British pounds that can be purchased, or exchanged, for $10,000 will be about 1.5 times greater if the currency is exchanged on March 13, 2009 then on November 9, 2007. (Symbol for pounds: £).

Graph of the GBP/USD exchange rate from late 2006 to April, 2011.
Graph of the GBP/USD exchange rate from late 2006 to April, 2011.
Date of Exchange GBP/USDGBP Amount that 10,000 USD can buy.
11/9/20072.0894$10,000 / 2.0894 ≈ £4,786
3/13/20091.3971$10,000 / 1.3971 ≈ £7,158

For businesses or governments that trade billions of dollars, even small changes in the exchange rate become significant.

When the United States dollar becomes stronger, then foreign goods and services become cheaper for Americans, while goods and services from the United States will become more expensive for foreigners, causing imports to rise and exports to decline.

A weaker dollar causes the reverse scenario: more expensive imported goods and services decreases imports, while cheaper American goods and services increases exports.

Thus, the trade balance of any country is largely determined by the value of the domestic currency in relation to other currencies. However, when the foreign exchange rate of a currency changes, it takes at least several months before it has any effect on the volume of imports and exports.

For instance, if the dollar suddenly weakens, the U.S. trade balance will usually worsen for a few months. Immediately after a currency's value drops, the volume of imports remains about the same, because most import/export orders are taken months in advance, but the prices, which are listed in domestic currency, rise. On the other hand, the value of the domestic exports remains the same, and the difference in values worsens the trade balance until the imports and exports adjust to the new exchange rates. This can be represented graphically by the J-Curve:

The J-Curve depicts the lag between the currency depreciation
of a country and the improvement in its trade balance.

  1. Depreciation occurs.
  2. Trade balance worsens at first because the cost of previously ordered imports rises, while the home currency price of previously ordered exports remains the same.
  3. Trade balance starts to improve as the lower cost of exports stimulates foreign demand while the demand for imports declines because of their higher prices.
Diagram of the J-Curve that depicts the lag between the currency depreciation of a country and the improvement in its trade balance.

Balance of Trade = Dollar Price of Exports × Quantity of Exports – Dollar Price of Imports × Quantity of Imports

Exchange rates must also be considered for international investments, since exchange rates affect both the amounts that can be invested and the returns on investment. There is also foreign exchange risk for future cash flows from foreign sources. There may be additional risks, such as political risks, that may greatly affect the return on investment, such as when a country institutes capital controls.

Determination of Foreign Exchange Rates

The ultimate determinant of foreign exchange rates is a currency's supply and demand, which, in turn, is influenced by the following factors in the domestic economy:

Generally, if the supply of currency increases faster than demand, then its value will fall; likewise, the value of currency will increase if the demand increases faster than the supply.

The supply of a nation's currency is influenced by that nation's monetary authority, which is usually its central bank, which closely monitors economic activity to keep money supply at a level appropriate to achieve its economic goals. If the supply of money increases faster than the economy, then the result will be inflation, causing the value of the currency to decline and domestic prices to rise; whereas if the money supply grows more slowly than the economy, economic growth can slow, causing rising unemployment.

FX Market and Investment Returns

Although the desirability of a country's goods or services will influence the demand for its currency, investment opportunities in the country will also be a major factor. In particular, traders in the foreign exchange (FX) market will buy or sell currency based on their expectations of how a foreign exchange rate will change:

Theoretical Currency Exchange Rates

There are some who believe that some currency exchange rates are not what they should be. For instance, there is a bill in Congress to correct any fundamental exchange rate misalignment, a bill which is actually aimed at China because Congress believes that the Chinese yuan is seriously undervalued against the United States dollar. But how does one ascertain the misalignment of currency rates? Is there a true exchange rate and can it be determined?

There are at least 3 methods that purport to reveal the true exchange rate, or to at least reveal misalignments.

One common method is purchasing power parity (PPP), which is the common assumption that the amount of currency needed to purchase a specified basket of goods should be equal to any other currency needed to buy that same basket of goods. However, this measure disregards the effects of comparative advantage, which is the advantage that some countries have over others in producing a particular product because of location or other factors. Moreover, purchasing power parity is difficult to measure, although the Economist magazine publishes a Big Mac Index, which is the price, in local currencies, to buy a Big Mac hamburger at the many McDonald's restaurants located throughout the world, and compares this to the United States dollar (USD). The Big Mac Index shows what the implied PPP is in USD, which is equal to the price in local currency divided by the price in the United States, and compares this to what the actual exchange rate is. None of the exchange rates shown in the latest index shows purchasing power parity, although some come close, which could simply be a coincidence.

Indeed, some forex traders use the Big Mac Index as a predictor of long-term exchange rates. By converting the price of the Big Mac to USD, a determination can be made whether the local currency is overvalued or undervalued. If after converting the currency, the Big Mac is more expensive than what it is in the US, then it is considered to be overvalued, thus predicting that the price of the foreign currency will decrease with respect to USD, which will move the foreign currency back toward PPP; if it is undervalued, then the reverse is predicted.

While a currency may be over- or undervalued, differences in PPP may also arise because of differences in productivity or income, which more sophisticated models take into account.

However, purchasing power parity does not account for international capital flow, which is far more important in determining exchange rates. For instance, countries with investments that yield the highest return will have large inflows of foreign capital, which will certainly have an impact on exchange rates, but capital flows are not related to PPP.

Another method to calculate what the exchange rate should be is the fundamental equilibrium exchange rate (FEER), which is based on a sustainable current-account balance and internal balance, with low inflation and full employment. A sustainable current-account balance is predicated on the simple fact that a country cannot continue accumulating more and more of a single currency unless it is actively intervening to keep the exchange rate low. Thus, China's continually growing current-account surplus of United States dollars is given as evidence that the yuan is seriously undervalued. However, a large current-account surplus may result because the people of a country invest more in foreign countries, or because the country has a low interest rate. A good example of why the current-account balance could be misleading is to examine why the Japanese yen is low compared to other currencies. The current interest rate in Japan is about 0.5%, the lowest of the developed countries. Because the interest rate is so low, and much higher elsewhere, many Japanese investors invest their money outside of their country, but to do so, they must exchange Japanese yen for other currencies. Another factor is the carry trade, where investors all over the world borrow yen at the low interest rate, and convert it into currencies where interest rates are higher, such as in New Zealand, which currently has an interest rate of 8%.

Then there is the behavioral equilibrium exchange rate, which is predicated on the invariance of cause and effect, so what economic variables influenced currency exchange rates in the past, such as productivity growth or net foreign assets, will also influence future currency exchange rates. While this seems plausible, how does one determine that a particular set of variables and their relative importance determined the exchange rate in the past? Will the importance of each economic variable change when other variables change, and if so, how?

The Actual Determination, or Microeconomics, of Foreign Exchange Rates

The study of a single economic unit, which may be a firm, a household, or an organization. The interaction of all of these units is the purview of macroeconomics.
Swapping 1 forex contract for another with a later delivery date, which is usually done because the trader who agreed to the contract, does not actually want the delivery of the currency, but simply wants to trade for profit.

While there are many theories about what actually sets the foreign exchange rate, there is a simple way to visualize the true determiner of rates. Keep in mind that banks do most of the actual trading and all of it is done in the over-the-counter market, where 1 bank communicates with other traders, mostly other banks, to satisfy its currency needs. You may be a forex trader trading with a broker, but that broker trades with banks. Also, most forex trading done by retail traders does not actually involve the transference of currency. The currency contracts are simply rolled over into new contracts before actual delivery takes place. However, if you were a businessperson or a government with a real need to trade actual currency, you would go to a bank to satisfy your needs, because that's what banks do.

Now imagine that you owned an international bank in Switzerland. The main currency of Switzerland is the Swiss franc (CHF), but since you are an international bank, you must deal in other currencies as well. Let's take the United States dollar as an example. Some of your customers will want to exchange francs for dollars, and some will want dollars for francs. But how many dollars do you want to keep? You want enough to satisfy your customers' need for dollars plus some reserves for unknown immediate future demands.

Now, because an international bank actually needs different currencies to do business, it will keep some of the dollars that it gets from customers so that it can give other customers the dollars that they demand. But what happens when the bank starts getting too many dollars in relation to that bank's customers' demand for dollars. The simple solution is to simply reduce the price of the dollar in terms of Swiss francs. When a customer comes in to exchange dollars for francs, you start giving fewer francs per dollar, which immediately lowers the number of francs that your bank pays for each dollar. Ergo, this lowers the exchange rate of dollars for francs.

But suppose you continue to get more dollars than you can use in your local business—maybe because some local exporter has a hot new product that's selling wildly in the United States, so the exporter has no choice but to trade dollars for francs, because he has to pay his workers and suppliers in Swiss francs, since the business is in Switzerland.

As an international banker, you know that there are other banks that will have a need for dollars, and so you call them, or communicate with them over an electronic network, such as the Internet, and trade dollars for Swiss francs. You call another bank in another town that happens to have a United States international firm doing business in the town. While the business pays its local workers in francs and receives revenues in francs, it needs to send dollars back home in the United States, so it goes to the local bank to exchange francs for dollars. Because the bank doesn't have enough dollars on hand to satisfy the U.S. business, that bank readily agrees to exchange dollars for francs with your bank. You can also contact banks in New York, some of which, will have a need for more francs than dollars.

But you also know that the Swiss government wants to keep the exchange rate of francs for dollars low, so that exports to the United States increase and imports decrease, so you contact the central bank of Switzerland, the Swiss National Bank. To carry out the government's policy of lowering the exchange rate of the franc against the dollar, the central bank agrees to buy your dollars for francs. If there is no other need for the dollars, the central bank simply holds them in reserve to satisfy the Swiss government's desire to lower the exchange rate of francs for dollars.

Thus, the exchange rate that your bank sets will be determined by the total demand from your customers and from other banks. But note that this exchange rate will tend to be equal to the rate set by other banks. Why is this necessarily so? Remember, the exchange rate that you set ultimately depends on demand on both your customers and other banks that your bank trades with. If you are offering fewer dollars per franc than other banks because of the excess of supply over demand from your customers, then those banks will buy dollars from your bank until your rates become equal. So this is how demand and supply actually work in the microeconomic view.

The demand and supply of currency ultimately originates with the people; even when governments set monetary policy through their central banks, it is to satisfy the needs of their residents; banks simply equalize this supply and demand all over the world by trading with each other.

Diagram showing how supply and demand set currency exchange rates, using USD and CHF as an example.

In the end, it could be concluded that the true currency exchange rate is what it actually is.