In a previous article, we explored central banks quite a bit which is highly relevant to this article. Central banks have a measurable impact on the exchange rate (or price) of their nation’s currency. What we will do now is actually define what an exchange rate is so we can understand what is actually happening when currency prices move.
What is an Exchange Rate?
“The exchange rate is the price of a nation’s currency which is expressed in terms of another currency”.
That is a rather academic definition so 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 U.S. Dollars to buy 1 Euro.
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 of examples of the different ways to express exchange rates will offer clarification.
Exchange Rate Examples
I 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 training 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 Technical Aspects 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 the Forex rate.
Most exchange rates use the U.S. 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 as a Forex trader, you 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.
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.
Exchange rates between different currencies can have a significant effect on the pricing of their related currency pairs. What is meant 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 has traditionally been a stable economy and the interest rate just went up so this is appealing to Forex traders. This means that the British pound will likely go up against other currencies. Said another way, the exchange rate for British Pound pairs will go up.
For example, the British Pound vs. the Canadian Dollar (GBP/CAD) pair will likely go up over time 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. What would make buying the GBP/CAD pair more appealing would be if the Bank of Canada was cutting interest rates while the Bank of England was raising interest rates. The two central banks are doing the opposite of each other which makes buying GBP/CAD even more appealing.
Exchange Rate Pricing Theories
There are 2 theories that attempt to explain the pricing of exchange rates which are purchasing power parity and portfolio balance.
Purchasing Power Parity (PPP)
This theory makes the claim that currency exchange rates move to keep the international purchasing power of each nation’s citizens in balance when compared to another country.
For example, if US inflation is 6% and United Kingdom inflation is 4% then the US Dollar should move 2% to maintain Purchasing Power Parity with the United Kingdom.
Is this always the case? No. 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 academics are saying.
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 the 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.