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 exchage rates with British pounds as the unit currency. Quotes using the US dollar as the unit currency are more common than any other. Note if a unit currency is strengthening (i.e. if the currency is becoming more valuable) then the exchange rate number increases. Conversely if the price currency is strengthening the exchage rate number decreases.

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. Big foreign exchange trading centres are located in New York, Tokyo, London, Hong Kong, Singapore, Paris and Frankfurt amongst others. 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.

There are three main factors which influence a countries exchange rate. These are:

• Level of unemployment - The more people there are out of work, the less the public as a whole will spend on goods and services. This starts a vicious circle, with less money going in to the economy the Government receives less tax and so the value of their currency decreases.
• Interest rate - Central banks can stimulate the economy by cutting or increasing the interest rate. By lowering rates the public is encouraged to spend, as paying back amounts on credit cards and mortgages leaves more disposable income.
• Domestic affairs - Events that impact the future of a country can have a profound effect on the exchange rate too. 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.

Foreign exchange options are derivatives of exchange rates.

Like the stock exchange, money can be made by investors on the foreign exchange market by investing at the right time.