Exchange rate
Family IX · Macro
Not to be confused with inflation rate, interest rate, interest rate decision.
Exchange rate is the relative price of two currencies, quoted as the number of units of one currency needed to buy one unit of the other. It is not a fixed property of a currency but a market price that moves with trade flows, capital flows, interest-rate differentials and official intervention. Every cross-border payment, hedge and conversion is settled at some exchange rate.[1]
Quotation conventions
A quote names a base currency and a quote (or counter) currency. In the convention EUR/USD = 1.10, the euro is the base and the US dollar the quote: one euro costs 1.10 dollars. The reciprocal, USD/EUR = 0.9091, is the same price read the other way round.
Most pairs are quoted to a fixed number of decimal places, and the smallest permitted change is the pip. A bid is the rate at which a dealer buys the base currency; an ask is the rate at which it sells. The gap between them is the spread.
Worked example: converting a payment
A firm must pay an invoice of USD 250,000 and holds euros. The bank quotes EUR/USD 1.0850 bid / 1.0855 ask. Because the firm sells euros to buy dollars, the relevant rate is the bid.
Had the firm bought euros instead, it would have used the ask of 1.0855, paying fewer dollars per euro and receiving a worse rate.
What moves a rate
Exchange rates respond to relative prices and relative returns. Higher domestic inflation erodes purchasing power and tends to weaken a currency over time; higher domestic interest rates attract capital and tend to strengthen it in the short term. Trade balances, official reserves, intervention and expectations of future policy all feed into the same price.
Regimes vary. Some currencies float freely, some are pegged within a band, and some are fixed by decree. The mechanism that sets the rate therefore differs by country and by period, and no single rule describes all of them.
Often confused with
- inflation rate
- The inflation rate measures the change in the general price level within one economy, whereas an exchange rate is a relative price between two currencies; the visible sign is that inflation is reported as a percentage over a period, while an exchange rate is a ratio of currency units.
- interest rate
- An interest rate is the cost of borrowing or the return on lending in a single currency, while an exchange rate is the price of that currency against another; the visible sign is that interest rates appear as annual percentages and exchange rates as paired currency quotes.
- interest rate decision
- An interest rate decision is a policy announcement by a central bank setting or holding its target rate, whereas an exchange rate is a continuously traded market price; the visible sign is that a decision has a scheduled release date and a single announced value, while an exchange rate changes tick by tick.
See also
References
- ↑ ISO 4217, the international standard that assigns each currency its three-letter code. The codes used in every pair quotation come from this standard, not from brokers.