The foreign exchange (FX) market is where sovereign currencies are bought and sold. In terms of volume, it is one of the largest and most liquid financial markets in the world. Currency trading follows the sun around the globe, so that it is a 24/7 market somewhere on the planet.
Corporations and individuals involved in international activities often need to convert one currency into another. They FX market supports this purpose. The FX market can also be used for the purpose of trading in currencies. The combination of “real users” and “financial users” creates a stable two-sided market of buyers and sellers.
Exchange Rates
Each currency is associated with a currency symbol (like $ for U.S. dollar) and a three-letter currency code (like USD for U.S. dollar). Here is a list of currency symbols and codes. Currency codes are used in the foreign exchange market as the unique identifier for a currency, similar to the use of a ticker for a stock.
An exchange rate is the price between two currencies. This is why exchange rates are bi-lateral pairs of currencies. Therefore, the international value of a currency is measured relative to other currencies. To get an overall picture of the value of a currency, these bi-lateral exchange rates must be averaged together. The trade-weighted dollar index (or “dixie”) is a good measure of the value of the U.S. dollar. It is a weighted average of exchange rates that uses relative trade volume as the weights. In other words, it places the greatest weight on the most important trade partners.
Exchange rates are quoted as the combination of two three-letter currency codes, which forms a six-letter sequence. The first currency in the sequence is the “base currency.” Typically, the base currency is the “stronger” currency, meaning it buys more than 1 unit of the other currency. For instance, EURUSD (or EUR/USD) is the exchange rate between the European Euro and the U.S. Dollar. As of February 10, 2021, the EURUSD exchange rate is 1.213. This means that 1 Euro buys 1.213 Dollars. It is typically quoted in this way because the Euro is stronger than the Dollar. The exchange rate can be quoted using the reverse sequence, which is simply the inverse (1/x) of the other exchange rate. The same exchange rate quoted as USDEUR is 0.824 (which is 1/1.213), which means that 1 Dollar buys 0.824 Euro. When the dollar buys more than 1 unit of the other currency, the dollar is typically the base currency. For instance, a USDJPY exchange rate of 105 indicates that one dollar buys 105 Japanese Yen.
A currency is said to appreciate when it increases in value relative to another currency and depreciate when it decreases in value relative to another currency. In addition, the term “strengthen” is used for appreciate and “weaken” is used for depreciate. If the EURUSD exchange rate changes from 1.2 to 1.3, then the Euro has appreciated against the Dollar. In other words, one Euro will buy more Dollars than previously. This also means that the Dollar has depreciated against the Euro. These are simply two different perspectives on the same exchange rate. Appreciation and depreciation are measured as percentage change. In this example, a change from 1.2 (old) to 1.3 (new) is a percentage change of 8.33%. The Euro has appreciated by 8.33% relative to the Dollar and the Dollar has depreciated by 8.33% relative to the Euro. Nasdaq reports percentage changes in exchange rates. An increase (green) indicates that the base currency has appreciated and a decrease (red) indicates that the base currency has depreciated.
Determinants of Exchange Rates
Exchange rates are influenced by factors in the two countries on either side of the exchange rate. In this way, every exchange rate factor is relative, not absolute. It is the strength of the factor in country A relative to country B that will determine the exchange rate between countries A and B.
Currencies tend to strengthen when economies strengthen. As economic growth increases, so does investment opportunity. Therefore, demand for a currency tends to increase as economic growth increases. This means that strong economies tend to be reflected in strong currencies. One could say that exchange rates between two currencies reflect the relative performance of those two economies. If one economy outperforms the other, the currency of that economy will tend to appreciate relative to the other. This is why some U.S. politicians and economists favor a “strong dollar” as a sign of national strength.
One of the determinants of exchange rates is relative inflation. Inflation is a reduction in the purchasing power of a currency in its local economy. As inflation rises, a currency also tends to weaken relative to other currencies. Exchange rates are bi-lateral pairs, so effect on the exchange rate depends on the relative amount of inflation between the two economies. More specifically, currency A will tend to depreciate relative to currency B if inflation is higher in economy A relative to economy B.
Another determinate of exchange rates is relative fiscal policy and monetary policy. Fiscal stimulus and monetary stimulus both tend to cause a currency to depreciate. Conversely, fiscal contraction and monetary contraction both tend to cause a currency to appreciate. The effect on the exchange rate will depend on the relative actions of the other government. Exchange rates are bi-lateral pairs, so it also depends on the fiscal and monetary policy of the other country in the exchange rate pair. For instance, in the EURUSD exchange rate, the effect of monetary policy depends on the relative stimulus or contraction of the European Central Bank and the Federal Reserve. You can think of monetary stimulus as lower interest rates, which is less attractive to foreign investors.
The overarching concept is real rates of return. When the real rate of return in an economy is higher, funds will flow into that economy and the currency will appreciate.
Here is a chart of the Trade-Weighted U.S. Dollar Index (“Dixie”) since the financial crisis in 2008-2009:
An increase in the index is an appreciation (strengthening) of the dollar and a decrease is a depreciation (weakening). As can be seen, the dollar weakened in the years following the crisis as the U.S. economy struggled to recover. The exchange rate then maintained a relatively flat level as the global economy was relatively weak everywhere and central banks around the world used Quantitative Easing. The clear inflection point was in late 2015 when the U.S. economy began to strengthen relative to other economies and the Federal Reserve began tightening monetary policy (raising the federal funds rate). The U.S. Dollar appreciated (strengthened) on average over several years until the COVID-19 crisis hit the U.S. economy. In 2020, the U.S. economy slowed and fiscal and monetary stimulus were expanded dramatically. This has caused the U.S. dollar to depreciate (weaken). There is now debate about whether the Dollar will begin to rise in value again as the U.S. economy recovers from the pandemic.
Exchange Rates and International Trade
Exchange rates have a significant impact on international trade, because they influence the price of international goods and services.
A strong currency is viewed as a positive indicator of economic strength for the reasons mentioned above. However, the major downside of a strong currency is its effect on international trade. A strong currency means imports are cheaper (buy more foreign goods) but exports are more expensive (foreigners buy fewer of the tradable goods). Therefore, a stronger currency tends to increase trade deficits. In contrast, a weaker currency tends to increase exports and reduce imports. This increases net exports. For the U.S., an increase in net exports would reduce the trade deficit.
This is why some U.S. politicians and economists favor a “weak dollar” as a means of increasing U.S. exports. Historically, the U.S. has promoted market-determined exchange rates. Janet Yellen, the nominated Treasury Secretary, supported this view in her confirmation hearing. This caused the dollar to rise, because it was a change from the “weak dollar” position of the Trump administration.
Note that a strong exchange rate will also have a negative effect on the earnings of U.S. firms with international sales. When converted back to U.S. dollars, those sales in the local currency are worth less.
Managing Exchange Rate Risk
Exchange rate risk is the risk that exchange rates will change in a way that is unfavorable to a transaction. For instance, a company sells a product to a foreign customer but the payment in the foreign currency will not be received for another 30 days. The amount of the payment is set in the contract, but the value of that payment could change. If the foreign currency depreciates over those 30 days, the value in U.S. dollars of the foreign payment will be less.
To hedge exchange rate risk, corporations can try to lock in an exchange rate. This can be done with a forward contract or a futures contract. These forms of hedging reduce exchange rate risk. On the other side, speculators may offer these contracts under the view that the currency may appreciate. Currency options are another way to manage extreme exchange rate fluctuations.
Exchange Rate Systems
The Bretton Woods agreement after W.W. II established a system in which other currencies were pegged to the U.S. dollar. This is one of the main reasons why the U.S. dollar was established as a global reserve currency. Bretton Woods also created the International Monetary Fund (IMF) as an international lender of last resort for supporting stable exchange rates.
Bretton Woods was eventually dismantled in the 1970s in favor of floating exchange rates. This was partially due to President Richard Nixon taking the U.S. dollar off the gold standard in 1971 due to rising inflation in the U.S. The anchor to the Bretton Woods agreement was the peg of the U.S. dollar to gold.
A floating exchange rate is an exchange rate that is determined by market supply and demand. This is what is meant by a market-determined exchange rate. A truly floating exchange rate is a market price that is unaffected by government policy or intervention.
Some central banks intervene in the foreign exchange market to influence their currency’s exchange rate. However, this is becoming less and less common among developed countries. Since 1995, the U.S. has only intervened in currency markets three times—in 1998, 2000 and 2011.
A fixed exchange rate is when one currency is pegged to another in value. In other words, the relative value of the two currencies is fixed. This is accomplished by the central bank of the country that has set the peg. One common example is a developing country that pegs its currency to the value of the currency of a developed country like the U.S. Dollar. This is typically done to prevent the developing country’s currency from depreciating. In this situation, the central bank of the developing country must buy its own currency with U.S. dollars to maintain the peg. The central bank must be holding a large quantity of U.S. dollars to do this, which is called dollar reserves. If it runs out of dollar reserves, the central bank will be forced to abandon the peg and the value of their currency will fall immediately. This can sometime result in a currency crisis. The Asian financial crisis in 1998 was an example of this.
The People’s Bank of China (the central bank of China) sets a managed peg between the Chinese Yuan (CNY) and the U.S. Dollar. This means that the USDCNY exchange rate is influenced by the actions of the PBoC. The South China Morning Post has provided a brief explanation and history of the U.S. Dollar – Yuan exchange rate. At times, the U.S. Treasury has labeled China as a “currency manipulator” for this reason. The argument is that the PBoC is keeping the value of the Yuan artificially low to promote Chinese exports. However, the PBoC has often had to sell Dollars and buy Yuan to keep the Yuan from depreciating as much as it would under market forces. Therefore, the goal is more of exchange rate stability than a low exchange rate.