The foreign exchange rate of a currency (= a currency) is the course (in other words the price) of this currency compared to another. One also speaks about the “ parity of a currency”.

Foreign exchange rates, sides on the foreign exchange market, vary permanently; they also vary according to the place of quotation.

Examples

For example, the foreign exchange rate of the Euro in dollar will be noted: 1  EURO = 1,4283  USD; the foreign exchange rate of the dollar in Yen will be noted 1  USD = 110.95  JPY.

(EURO = Euro, USD = US Dollar, JPY = Yen according to international monetary coding, standard ISO 4217 differentiating each currency by an abbreviation from three letters, cf complete listing)

Fixed or floating foreign exchange rate

This foreign exchange rate of a currency is:

• is fixed , in other words constant compared to a Monnaie of reference (in general the US Dollar or the Euro), by decision of the State which emits this Monnaie. The rate can then be modified only by a Décision of Dévaluation (or revaluation) of this State. A State cannot however decide to adopt any foreign exchange rate of its currency. If it fixes this foreign exchange rate at a too high or too low level, foreign exchange rate could be “attacked” on the foreign exchange market. If the monetary authorities do not manage to face (thanks to their Monetary reserves), they will have to modify their parity.

• is floating and given with each transaction by the balance between offer and request on the foreign exchange market . It is about an interbank worldwide market of the Monnaie S, less and less centralized on specific spot of quotation and exchanges, because resting on connections Informatique S between Banque S.

Foreign exchange rate is:

• either a course “ Spot ”, i.e. “ the cash ”, for the immediate purchases and sales of currencies,
• or a course “ Forward ”, i.e. “ in the long term ”, for the operations of Exchange in the future term.

Factors influencing foreign exchange rates

Foreign exchange rate is determined by supply and demand of each of the two currencies (if demand exceeds, the course increases).

Since the currency of a country is at the base a credit held on the Central bank of this country (see monetary Base), the detention of a foreign currency can be seen as the detention of a credit “at sight” on the country which emitted it.

On the short term

Foreign exchange rates strongly vary during the same day, these variations cannot be explained by the theory of the PPP previously described. Within this framework of analysis of short term, it is necessary to refer to other explanations.

These daily variations rest on the concept of anticipated profitability of the deposits in currencies . The economic agents will determine their request of the various currencies according to the profitability which they anticipate of deposits in these currencies.

Let us imagine an alive agent in the Euro area, he wonders whether it is more profitable to hold deposits in Euro S or deposits in dollars.

Its deposits in euros will bring back an interest rate anticipated to him $i\_d$ (interest rate on the deposits in the Euro area). Thus the anticipated profitability $R\_d$ of these deposits is in euros : $R\_d\; \backslash \; (in\; \backslash \; euros)\; =\; i\_d$

On another side, if it intends to place its deposits in dollars, they will bring back an interest rate anticipated to him $i\_f$ (interest rate on the deposits in the United States), i.e. this time American interest rate. The difference is that, as our agent is European, it will wish to find them in Euro S, from where the need for reconverting them into this currency. Consequently, it must also take into account the variation of foreign exchange rate between the currencies over the period of its deposit. It will thus have this time a anticipated Rentabilité:
$R\_f\; \backslash \; (in\; \backslash \; euros)\; =\; i\_f\; -\; \backslash \; frac\; \{\backslash \; Delta\; (e\_\; \{t+1\})\}\{e\_t\}\; =\; i\_f\; -\; \backslash \; frac\; \{(e\_\; \{t+1\}\; -\; e\_t)\}\{e\_t\}$

with $e\_\; \{T\}$ the current foreign exchange rate (at the moment $t$) of the euro compared to the dollars and $e\_\; \{t+1\}$ the anticipated foreign exchange rate of the euro compared to the dollars when it withdrew its deposit (at the moment $t+1$).

Ansi $\backslash \; frac\; \{\backslash \; Delta\; (e\_\; \{t+1\})\}\{e\_t\}$ is the anticipated variation measured in euros of the value of the deposits related to the variation of foreign exchange rate euro/dollar over this period.

Our agent thus will arbitrate between these two outputs (i.e. to choose the best). An American agent would make the same thing but contrary.

This arbitration, carried out by the whole of the agents and within the framework of a perfect and free circulation of the Capital , brings us to an equalization of these two profitabilities (due to the choices of detention of different the currencies). This equalization implies the following equation, named condition of parity of interest rates (PTI) :
$i\_d\; =\; i\_f\; -\; \backslash \; frac\; \{\backslash \; Delta\; (e\_\; \{t+1\})\}\{e\_t\}$

I.e.: $R\_d\; =\; R\_f$

These profitabilities initially depend, as we have just seen it, anticipated Interest rates and value anticipated on foreign exchange rate. The evolution of interest rates (and thus of foreign exchange rates) depends on the following data:

• the relative Inflation anticipated
• variations of the Trade barriers relative
• relative variations of Request of goods
• of the relative growth anticipated

All these values are regarded as relative because they are to be considered each time relative with the other economy. More clearly, if anticipated inflation is of 2  % in the United States AND in the euro area, relative anticipated inflation is null, therefore no effect.

On the long run

In the long run, the currencies must theoretically approach the parities of balance obtained starting from structural parameters. Imbalances - and, much more rarely, balances in the valorization of the currencies, are measured starting from the purchasing power parities (PPP). It is about a statistical exercise complexes, which consists in comparing in the duration the Purchasing power of a Consommateur - standard in a country and a product range consumption given with that of another consumer-type in a country different and for a product range from near desired consumption, but corresponding however to other local practices as regards Lifestyle and of structure of the Coût S. In practice, one generally uses the US Dollar like currency of the common index and one thus each time will compare the Purchasing power of a Consommateur - type of a country X and that of a Consuming - standard American.

The Purchasing power parity, if it is useful for the international comparisons of Standard of living, where margins of error of some pourcents are not significant, its use for the analysis of the foreign exchange market must be carried out with more the greatest caution.

Monetary crisis

A country will suffer from a monetary Crise when the capacity to refund the Foreign debt (public and private) made out in foreign currency of the country is strongly questioned (crisis of confidence). The short-term outflow of capital then makes fall the foreign exchange rate of the currency, making refunding even more difficult.

Economic role of foreign exchange rates

Foreign exchange rates (and the Interest rate S, which is closely dependant for them) act of course on the Prix with the Importation and the Exportation. They have an influence on the direction of flows of Capitaux between economic zones.

So the economic countries and zones can be tried to act on foreign exchange rates, under pretext often to avoid the Spéculation (makes this handling of them rather tend to encourage it), and with an aim of improving (foreign exchange rate drops):

• the Competitiveness-price of their well S and services;
• their attractivity as regards flow of IDE.

This fall of foreign exchange rate will also have negative effects (increase in the imports, etc), it is not inevitably desirable.

Interventions of the central banks

See also: Interventions on the foreign exchange market

Operation of the exchange markets

Particular case of the rate euro/dollar

Foreign exchange rate known as Euro/dollar is the course of the Euro quantified to US Dollar, from where the bar of fraction (not to confuse with the Eurodollar S).

It is the the financial instrument most active and more treated world. Its value is thus an indicator followed permanently not only by the financial economic circles and, but also by the Médias, specialized as well as general practitioners, of the whole world.

This definition is in fact, the external value of the Euro compared to the American dollar.

Profession (moneychanger)

Those which carry out exchange transactions on a purely professional basis are called moneychangers . The Banque S in particular have teams of moneychangers, to as well carry out the clean operations of these institutions on the market as to satisfy the needs for exchange of their customers, for example, concerning the companies, for their operations of International business. They act like Market maker S , i.e. they " make prix", for a quantity either standard or specified, and provide at the same time that where they buy ( bid , in English) and that to which they sell ( ask , in English), for example: 1 EURO = 1.2343/1.2346 USD.

Units of quotation

The moneychangers express the unit of quotation of a bearing foreign exchange rate on a couple of currencies in points called pips . Pip is the English acronym of " price interest point" , or “not of swap ” in French. In the beginning, as its name indicates it, this one indicated the unit of “offset” or “carryforward” of the Change in the long term but ended up being applied to the unit of the spot market. It indicates the last decimal used :

• in the case of the Euro, it is the fourth decimal. A quotation on three " pips" , which is the standard on the interbank market of the Euro/dollar, will be thus in the first example (1 EURO = 1,2345 USD) of paragraph 1 above: 1 EURO = 1,2343/1,2346 USD.
• in the case of the Yen, it will be the second decimal, and a quotation on four " pips" will be then, always for the example above, 1 USD = 110,93/110,97 JPY.

The " pip" thus represent a different and nonfixed percentage for each parity. This variation depends:

1. of the currency in which one chooses by convention to express foreign exchange rate (the “dubious one” of the comparison), the other being taken for unit of goods (“some”).
2. of the number of decimals of quotation.

These differences between the courses " acheteur" and " vendeur" of a currency against another are much lower than those which a private individual can note when it wishes to carry out an operation of Change in a dispensary of Change (or with its bank) for a modest amount.

In the first example, the Share (minimal quantity) of an operation of Exchange on the Forex being of 100.000 euros (the standard transaction being rather of tens of million), one will note that a pip for such a exchanged quantity is worth 10 dollars. In the second example, the share of an operation of Exchange being of 100.000 dollars, a pip for this quantity is worth 1.000 Yen S (either approximately 9 dollars).

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