The definition of foreign exchange rates

Foreign exchange rates represent the value at which one currency can be traded for another. They are essential for international transactions, as they determine how much of a foreign currency can be obtained for a unit of domestic currency.

Key aspects of foreign exchange rates:

• Foreign exchange rate - The price of one currency expressed in terms of another, such as the cost of the domestic currency when buying a foreign one. For example, if £1 equals €1.15, this rate shows how many euros one pound can purchase.
• Role in trade - These rates affect the affordability of goods and services between countries, influencing decisions on buying, selling, and investing internationally.

The impact of currency appreciation and depreciation

Changes in a currency's value, known as appreciation or depreciation, have significant effects on a country's trade balance. Appreciation occurs when a currency rises in value relative to another, while depreciation happens when it falls.

Effects of currency appreciation

When a country's currency appreciates:

• On exports - Domestic goods become more expensive for overseas buyers, potentially reducing demand and sales abroad.
• On imports - Foreign goods become cheaper for domestic consumers, which can increase import volumes and benefit businesses reliant on imported materials.

Effects of currency depreciation

When a country's currency depreciates:

• On exports - Domestic goods become cheaper for foreign buyers, which can boost export competitiveness and increase overseas sales.
• On imports - Foreign goods become more expensive for domestic consumers, potentially decreasing import levels and encouraging the use of local alternatives.

Worked example - Calculating costs with currency appreciation

A Canadian company exports machinery priced at $950 to the European market. Initially, the exchange rate is €1 = $1.30. Later, the euro appreciates, changing the rate to €1 = $1.15. Calculate the machinery's price in euros at both rates.

Step 1: Identify the values

• Machinery price = $950
• Initial exchange rate = €1 = $1.30
• New exchange rate = €1 = $1.15

Step 2: Calculate initial price in euros

Price in euros = $950 ÷ 1.30 = €730.77 (to 2 d.p.)

Step 3: Calculate new price in euros

Price in euros = $950 ÷ 1.15 = €826.09 (to 2 d.p.)

Step 4: Interpretation

The price rises from €730.77 to €826.09 due to the euro's appreciation, making the machinery more expensive for European buyers and illustrating the impact on exports.

Floating exchange rates and market determination

Floating exchange rates are not fixed by governments but fluctuate based on economic forces. They are common in many economies and allow currencies to adjust naturally to global conditions.

Characteristics of floating exchange rates:

• Floating exchange rate - A system where the value of a currency is set by market supply and demand, without direct intervention from authorities.
• Foreign exchange market - This decentralised network involves banks and other financial bodies trading currencies for clients, including individuals and companies. It operates globally, with no single physical location.

Currency values in this market are shaped by the balance between how much of a currency is demanded and supplied, leading to price adjustments similar to other markets.

Factors influencing demand and supply of currencies

The demand for and supply of a currency in the foreign exchange market determine its exchange rate. Various economic activities drive these forces, affecting how traders buy or sell currencies.

Reasons for demand (buying) domestic currency

Currency traders purchase domestic currency for several purposes:

• Trade facilitation - To allow clients to buy goods and services from the domestic country.
• Investment inflows - To support investments in domestic assets, such as stocks or property.
• Speculation - To profit from expected future increases in the currency's value.
• Institutional trading - Financial organisations may buy on their own account, anticipating value rises.

Reasons for supply (selling) domestic currency

Currency traders sell domestic currency in these scenarios:

• Import purchases - To acquire foreign currencies needed for buying overseas goods.
• Overseas investments - To fund investments in foreign markets or assets.
• Speculation on declines - In anticipation of a drop in the currency's value, prompting sales to avoid losses.