Alrighty, we are starting to get deep into various areas of fundamentals. It might seem a bit confusing but we have organized it all in a way that we think will help your new knowledge build on previous concepts already explored. We are building a foundation here; it will all make sense in the end!
We have been exploring central banks quite a bit and we now know that they have a measurable impact on the exchange rate (price) of their nation’s currency. What we will do now is actually define what an exchange rate is to help us understand what is actually happening when currency prices moves.
In this Article:
- What is an Exchange Rate?
- Exchange Rate Examples
- The Academics of Exchange Rates
- Exchange Rate Pricing Theories
What is an Exchange Rate?
“The exchange rate is the price of a nation’s currency which is expressed in terms of another currency”.
Yikes, that felt really academic! Let’s try and break it down a bit more.
What this means is that an exchange rate will have two components:
- The domestic currency
- and a foreign currency
For example, the EUR/USD currency pair is the Euro expressed in American Dollars. If the price was 1.2500 for the EUR/USD pair then this means that it takes $1.25 to buy 1 Euro. Apologies, if you have got this far into this guide then you probably already know that but it helps with the rest of the info to come in this article.
The exchange rate can be quoted either directly or indirectly. So what does that mean?
In a direct quotation, the price of a unit of foreign currency is expressed in terms of the domestic currency.
In an indirect quotation, the price of a unit of domestic currency is expressed in terms of the foreign currency.
Direct and indirect quotations are basically the opposite way to measure the exchange rate but both are the same information just expressed backwards from one another. Both are used interchangeably by different groups of people.
Maybe a couple examples of the different ways to express exchange rates will offer clarification.
Exchange rate examples:
We have found that traders will refer to the exchange rate as the current tradeable price on their trading platforms. If the price of the EUR/USD currency pair is 1.2500 then a trader will say that it is priced at 1.2500. Simple enough! This is how we will refer to exchange rate throughout this guide because…..well, we are traders!
On the other hand, the talking heads on your local financial television station like to quote the exchange rate in terms of the value compared to their local currency. So if you live in Europe the financial station would report the EUR/USD backwards. They would give you the quote in terms of USD/EUR which of course is not a currency pair.
They do this because they want to let you know what your Euro is worth in USD rather than the normal way we trade it on our trading platforms. So they would give you a quote of €0.80. This means that it would take €0.80 to buy $1 USD. It’s the exact opposite thing as saying it takes $1.25 to buy 1 Euro if the traded price right now was 1.2500 for the EUR/USD pair.
Does all that make sense? The talking heads do their best to make us all confused. If everyone just spoke like us traders everything would be so much smoother! Let’s just operate on what the actual traded price is on our trading platforms to keep things sane. But it’s good to get an idea of what the financial news is saying so that we are not confused as to what they are actually quoting.
Let’s get back to the academics of exchange rates now.
The Academics of Exchange Rates
An exchange rate that does not have the domestic currency as one of the two currencies in the pair is known as a cross currency, or cross rate.
An exchange rate is also referred to as a currency quotation, the foreign exchange rate, or forex rate.
Most exchange rates use the US dollar as the base currency and other currencies as the counter currency. However, there are a few exceptions to this rule, such as the Euro and Commonwealth currencies like the British Pound, Australian Dollar, and New Zealand Dollar.
That was a pretty academic definition that may get a little confusing. For the sake of simplicity we are going to be trading the spot market which means you will be trading the Euro against the US Dollar (EUR/USD pair) or the Great British Pound against the US Dollar (GBP/USD Pair) and so on.
Remember that you don’t need to become a master memorizer of definitions; you just need to be aware of the terms so that when you come across them in your daily analysis you will know what they are. It’s always good to know what the analysts are talking about so that you can pull out what is important information that you can use to trade right now.
Exchange rates between different currencies can have a significant effect on the pricing of their related currency pairs. What we mean by this is made a bit simpler by showing an example below.
If the United Kingdom raises their benchmark interest rate then this will be very positive for the British Pound currency because the Forex market really likes stable economies with higher interest rates. The United Kingdom is pretty a darn stable economy and the interest rate just went up! This means that the British pound will likely go up against other currencies. Said another way, the exchange rate for Pound pairs will go up. For example, the British Pound Canadian Dollar (GBP/CAD) pair will go up because of the positive news from the United Kingdom. This is effectively the same thing as saying that the Canadian Dollar dropped against the British Pound.
Exchange Rate Pricing Theories
There are 2 theories that attempt to explain exchange rates:
Nr. 1. Purchasing Power Parity (PPP):
This theory makes the claim that currency exchange rates move to keep international purchasing power of each nation’s citizens in balance when compared to another country.
For example, if U.S. inflation is 6% and UK inflation is 4% then the US Dollar should move 2% to maintain Purchasing Power Parity with UK.
Is this always the case? Nope! It’s the academic way of trying to quantify price behaviour. But it never hurts to at least have a basic understanding of what the nerds are saying.
Nr. 2. Portfolio Balance:
Portfolio balance suggests that exchange rates in the currency market move to balance the total returns within portfolios. This is basically saying that currency prices move to adjust to make sure that portfolio returns are not disproportionately greater in one country over another.
These 2 theories are very simplified explanations. In actual market application, it’s a combination of both these theories that contribute to pricing structure of the Forex market. We as human beings simply have a need to quantify everything we do so that we can feel more comfortable with our place in the financial markets and in the universe.
If you want a more in depth understanding of these theories there are many great websites, such as Investopedia, that will break it all down if you wish to get into that level of understanding. For our purposes here we are just giving you a broad knowledge base. You will see the complete picture once you go through the entire guide.
Up Next:
Cool, now that you are all up to speed on central banks, hawks and doves, and now exchange rates, let’s start taking a look at what the central banks actually look at in order to implement their monetary policies.