When an exporter plan to start international trading, it becomes more important to understand how International currency exchange rates make difference. International currency exchange rates (Forex rate) influenced by various events that happen worldwide. The International currency exchange rates are extremely unpredictable in nature and keep changing swiftly.
The exchange rate at which one currency can be exchange for another between two countries is known as foreign exchange rate. The foreign exchange rate is also known as the FX rate or Forex rate. For example exchange rate of currency between US and India is 1 USD = 62.3849 INR. Later we discuss various topics related to foreign exchange rates.
The rate at which foreign currency is available on the spot is called Spot exchange rate. Spot rate of foreign exchange is very useful for current transactions but it is also necessary to find what the spot rate is.
Exchange rate that prevails in a forward contract for purchase or sale of foreign exchange is called Forward Rate. This rate is settled now but actual transaction of foreign exchange takes place in future.
The main confusion for those who are new to the currency market is the standard for quoting currencies. In this section, we'll go over currency quotations and how they work in currency pair trades. There are two methods of quoting exchange rates:
1. Direct Currency Quote
2. Indirect Currency Quote
Direct Currency Quote: In this method, fixed units of foreign currency against variable amounts of the domestic currency are quoted. For example, in the U.S., a direct quote for the Canadian dollar would be US$0.85 = C$1. Now a days bank are quoting rates on direct basis only.
Indirect Currency Quote: In this method, fixed units of domestic currency against variable units of foreign currency are quoted. For example, in the U.S. an indirect quote for the Canadian dollar would be US$1= C$1.17.
Most currency exchange rates are quoted out to four digits after the decimal place, with the exception of the Japanese yen (JPY), which is quoted out to two decimal places.
If a currency quote is given without the U.S. dollar as one of its components, then it is called a cross currency. The most common cross currency pairs are the EUR/GBP, EUR/CHF and EUR/JPY. These currency pairs expand the trading possibilities in the forex market, but it is important to note that they do not have as much of a following as pairs that include the U.S. dollar, which also are called the majors.
Trading in the financial markets, when you are trading a currency pair there is a bid price (buy) and an ask price (sell). These are in relation to the base currency. Bid price is how much the market will pay for the quoted currency in relation to the base currency. Ask price refers to the amount of quoted currency that has to be paid in order to buy one unit of the base currency. For example: USD/CAD= 1.2000/5 (here Bid =1.2000 and Ask = 1.2005)
A spread is a difference between bid prices and ask price. For example EUR/USD = 1.2500/05, the spread would be 0.0005 or 5 pips which is also known as points. The pip is the smallest amount a price can move in any currency quote. In forex market the smallest point change can result in thousands of dollars being made or lost.
In a forward market foreign exchange always is quoted against the U.S. dollar. How many U.S. dollars are needed to buy one unit of the other currency is effects the pricing.
High interest rates
In foreign countries currency which has higher interest rates makes it more attractive. Investors like to buy this currency because they can lend money to people in that country and make a profit from the extra margin offered by the higher rates. As a result, higher rates increase demand, which increases a currency’s value and vice-a-versa.
Inflation affects value of a currency. Lower inflation lets you buy more. Actually investors like it because they want to buy that currency which pushes up its value and vice versa.
Strength of the economy
Rise and falls of a country’s currency depends on performance of its economy and the reaction of its investors. Higher the demand of a currency pushes the currency’s value up which depends on business activity, employment and GDP.
Level of government debt
Higher the government debt, lower the currency’s value.
Terms of trade
Terms of trade is a ratio which compares export prices to import prices. If terms of trade increase then demand of that country’s export increase which means more demand for its currency, which increases its value and vice versa.