It is common when we travel to a foreign country; we have to change our money for the currency of our destination. The same happens when we buy online stores located in those countries. But how are those changes made? What does it depend on? In this article, we will discuss what the exchange rate is and how it affects when going from one currency to another, and in the financial market itself.
Definition of Exchange Rate
The exchange rate corresponds to the proportional relationship that exists between the value of two currencies. This type of change indicates the units that we are going to need from one to be able to get one from the other.
The origin of establishing an exchange rate system is found in the existence of international trade since these countries have different currencies. All those companies that are interested in buying currencies from other countries for their transactions must do so in the currency market. This is in charge of establishing the price of the different currencies in relation to the national currency. That price is called the exchange rate.
As a curious fact, the ten most used currencies in the world are:
- American dollar.
- Euro.
- Japanese yen.
- Pound sterling.
- Australian dollar.
- Swiss franc.
- Canadian dollar.
- Mexican peso.
- Chinese yuan.
- New Zealand Dollar.
Currency market
The currency market is also known as Forex. And it is the abbreviation of the Anglo-Saxon term Foreign Exchange. The different currencies are traded in it, and it is a decentralized and global market.
The origin of this market was intended to simplify and favor the monetary flow from trade between countries. This type of market is the largest in the world in financial terms. With its volume of transactions, it is possible to reach figures of up to five trillion dollars every day.
The currency market has the following characteristics:
- It covers many countries.
- Great variety of people and companies that intervene in the market.
- Trading hours change.
- The factors that generate the exchange rates are very different.
- It operates 24 hours a day. Except for weekends.
- Trading volume.
- Excessive market liquidity.
Forex Analysis
At this point, we will talk about the two types of analyses that are carried out to be able to evaluate the currencies and have certainty of where it could evolve.
#1. Fundamental analysis
It is often used with a long-term view of investors. It estimates the different areas, such as GDP, inflation, the interest rate, the unemployment rate, or the industrial production index. And from there, the possible forecast is developed in relation to the development of these aspects.
#2. Technical analysis
Forex market technical analysis is used in a shorter period, or in the medium term. It is done to determine the evolution of more frequent or day-to-day movements in the currency market. The function of technical analysis is to predict the closest time flows of currency prices.
What affects the exchange rate?
The exchange rate can be affected by various factors. Below we talk about them:
Political factors. The different conflicts or problems of the countries in this area can be reflected in monetary policy, either in the same country or internationally, due to globalization. We have been able to see it many times on the Stock Exchange.
Economic factors. This is caused by problems such as inflation, the public and commercial deficit, unemployment, GDP, or the CPI, among others.
Market psychology. A priori it may seem like the least important factor or the one that can least affect the exchange rate. But the truth is that, especially in recent years, with tools such as social networks, non-real situations have been created that have destabilized the market, due to rumors or false news. As it happened in April 2013, with a hoax posted on Twitter about a possible attack in the White House. This translated into Wall Street indices of a drop of more than 1%. This behavior is reflected in the foreign exchange market prices.
Exchange rate systems: fixed and flexible
There are two exchange rate systems, fixed and flexible. Next, we will see what they consist of and how they differ from each other.
Fixed exchange rate
The competent authorities of the foreign exchange market have established an exchange rate as fixed in order to maintain it. This is not related to the supply and demand that a certain currency may have, but is done to prevent potential investors from speculating on the currencies. This would be the main reason, although there may be others. The tactics that are usually used are to hold the value of the country’s own currency to a foreign one or to attach it to a material good, such as gold.
Establishing fixed exchange rates is not only for investors but also for banks since they will not be able to take measures to act in the currency market. The positive side of this policy is found in the benefits it provides to international trade. It makes it more inalterable before possible exports and imports that may be carried out in the future. As a disadvantage, central banks have the role of influencing currency markets, but they will not be able to touch interest rates.
Setting a fixed exchange rate is done for a long period of time. If a significant problem occurs in politics and/or in the economy, as we said before, it can be subject to adjustment so that it remains in a fair status. But for the exchange rate to be preserved, a series of measures must be taken related to different circumstances.
A fixed exchange rate currency can be found, for example, in the Franc (CFA), the official currency of several countries in sub-Saharan Africa such as Mali, Ivory Coast, Todo, or Benin.
Among the situations that can occur are:
Excess of foreign currency. This supposes an increase in the reserves of the central bank. To deal with this situation, foreign currency will be purchased, offering the national currency of the country in question.
Excess demand for foreign currency. The central government of the countries must offer the foreign currency. This is reflected in a decrease in state reserves.
Flexible exchange rate
In contrast to the fixed, this is related only to supply and demand. Market flows are responsible for regulating the exchange rate between two currencies.
Depending on the circumstances of the moment, a different problem will occur, as was already the case with the fixed exchange rate. An example is a case of having an oversupply of the national currency. The balance is reached when there is a devaluation of this currency, which causes its price to drop. Another situation that may occur is an excess in your demand. The equilibrium in the market will be reached with an increase in its price.
Among the advantages that this type of exchange offers, we find that the system will be more flexible, in addition to monetary autonomy, in which countries will be able to determine interest, depending on the economic situation.
As for its negative side, we can find the speculation that appears when large amounts of money are moved, something that destabilizes the market. This insecurity also damages international trade, being a very big risk for the possible investor.
